Ward on Iowa Limited Liability Company Law

Delaware Chancery Court Issues an Important Ruling on Poison Pills and Hostile Takeovers

In a comprehensive, 153-page ruling, Chancellor Chandler (say that 5 times real fast) provides a detailed overview of the responsibilities of a target board when faced with a structurally non-coercive, all-cash, fully financed hostile takeover.  In his opinion in Air Products and Chemicals, Inc. v. Airgas, Inc. (Civil Action No. 5349-CC and Civil Action No. 5256-CC, February 15, 2011), Chandler almost begs the Delaware Supreme Court to overrule him.  He feels compelled, however, to rule in light of Delaware precedent that so long as the target board meets the 2-prong test of Unocal(legally cognizable threat to the corporation and a reasonable response proportionate to the threat) it has the power to defeat what it perceives to be an inadequate offer without giving the shareholders an opportunity to decide for themselves.  On several occasions he implies that he is not happy with that conclusion, but feels obligated to follow precedent in reaching it.

While the length of the opinion is daunting, it is well worth the read.  The events of leading up to the decision, including the shareholders tossing out 3 incumbent directors and replacing them with Air Products nominees who then side with the rest of the board in rejecting Air Products' offer and the attempt by Air Products to shorten the time between annual meetings so it could replace the directors serving staggered terms quicker, are unique.  And the Chancellor's opinion thoughtfully and carefully outlines the case law on hostile takeovers, particularly poison pills and their proper place in corporate governance.

- Marc Ward

Special Merger Protections for Minority Shareholders

In 2005 John Q. Hammons Hotels, Inc. was sold to a private company.  The minority shareholders received $24 per share for their 24% interest and John Q. himself received different consideration for his 76% stake.  Hammond's consideration included a small stake in the buyer with a preferential buyout, a line of credit and other consideration.  The parties disagreed on whether his consideration was worth more or less than $24 per share.

The plaintiffs brought a class action alleging that Hammons and the board of directors breached their fiduciary duties by negotiating different consideration and allowing the merger to be approved through a deficient process, respectively.  In re John Q. Hammons Hotels, Inc. Shareholder Litigation (Del. Ch. October 2, 2009).

The plaintiffs argue that Kahn v. Lynch Communication Systems, Inc. is the controlling case.  In Lynch the Delaware court held that when a controlling shareholder makes a cash out merger offer to the minority the standard of review is entire fairness of the transaction and the burden is on the controlling shareholder.  The burden shifts to the plaintiff when the approval of the cash-out merger is required of (1) an independent committee of directors or (2) an informed majority of minority shareholders.  The defendants countered that the business judgment rule should apply because of the safeguards built into the deal.

The court in Hammons declined to find Lynch controlling because John Q was not the purchaser (i.e. not on both sides of the transaction. But it did find that the business judgment rule could not be invoked because the merger process was deficient. 

To make a long story short, in merger transactions involving a controlling shareholder (but not as buyer)the business judgment rule will not be available and instead entire fairness (fair dealing and fair price) will be applied unless (1) an independent committee of disinterested directors approve the deal and (2) a majority of the minority shareholders (not just those voting) approve the merger in a vote that is not waivable by the independent directors.  The court made clear that it was not enough that the committee did not waive even though they could have or a majority of all minority shareholders approved the merger even though only those attending the meeting were required to.  The form controls the substance in this regard.

-Marc Ward

Fooling with the Shareholder Franchise Could Invite Judicial Scrutiny

As you all know, loan agreements include financial and non-financial covenants imposed on the borrower.  Failure to maintain a covenant leads to an event of default.  A financial covenant might be maintaining a certain debt-to-equity ratio.  A non-financial covenant might be preventing a change in control of the board of directors.  Changing the make-up of a board of directors, is of course, the right of the shareholders.  When a board of directors agrees that such a change could trigger a default under a loan it may be impermissibly intruding on the shareholders' franchise.

Here is what Vice Chancellor Lamb had to say on the subject in San Antonio Fire & Police Pension Fund v. Amylin Pharmaceuticals, Inc., 2009 WL 1337150 (May 12, 2009):

“This case does highlight the troubling reality that corporations and their counsel routinely negotiate contract terms that may, in some circumstances, impinge on the free exercise of the stockholder franchise. In the context of the negotiations of a debt instrument, this is particularly troubling, for two reasons. First, as a matter of course, there are few events which have the potential to be more catastrophic for a corporation than the triggering of an event of default under one of its debt agreements. Second, the board, when negotiating with rights that belong first and foremost to stockholders (i.e., the stockholder franchise), must be especially solicitous to its duties both to the corporation and to its stockholders. This is never more true than when negotiating with debtholders, whose interests at times may be directly adverse to those of the stockholders. Outside counsel advising a board in such circumstances should be especially mindful of the board’s continuing duties to the stockholders to protect their interests. Specifically, terms which may affect the stockholders’ range of discretion in exercising the franchise should, even if considered customary, be highlighted to the board. In this way, the board will be able to exercise its fully informed business judgment.”

The case is on appeal.

-Marc Ward

Some Black Letter Law on Claims Against Directors

An opinion last week issued by the US District Court for the Northern District of Illinois provides a nice primer on claims that can be brought against directors, in this case directors of a wholly-owned subsidiary.  Seidel v. Byron, et al, 2009 US Dist LEXIS 40712 (May 12, 2009).

Seidel, the bankruptcy trustee for Mosaic Data Solutions brought an action against the former directors and officers of the debtor for breach of fiduciary duty and similar claims.  The trustee alleged that improper management of the company by the directors and officers led to its insolvency.  Specifically, he claimed that pledging the assets of Mosaic Data for no consideration so that its parent corporation could obtain financing in its bankruptcy was a breach of their fiduciary duty.

This is what you will glean from the case:

1.    Wholly-owned subsidiaries under Delaware law are expected to operate for the benefit of their parent corporations unless the subsidiary is insolvent.

2.    Under the trust fund doctrine directors of insolvent corporations are liable for the debts of the corporation when they breach their fiduciary duties by improperly distributing the corporate assets.

3.    Corporate creditors cannot file direct actions against directors for breach of fiduciary duties but may bring derivative actions against the directors of insolvent corporations for the breach of such duties (the beneficiary of a derivative action is the corporation).

4.    A motion to dismiss pursuant to the business judgment rule can be overcome if the pleading establishes a "reasonable doubt" about whether the actions of the directors are protected by the BJR.  As you may recall, the business judgment rule protects the actions of a board unless it is proven that the board breached its duty of loyalty, the duty of good faith or the duty of care.  That is, "if directors act loyally and carefully, they are not liable even if the transaction goes awry." (quoting Alliant Energy Corp. v. Bie, 277 F. 3d 916, 918 (7th Cir. 2002))

-Marc Ward

Court of Appeals Applies BJR to LLCs

In Terminal Properties, Inc. v. Hampton Propane Terminal, L.C., 2009 Iowa App. LEXIS 231 (March 26, 2009) the Court of Appeals applied the Business Judgment Rule to LLCs formed under Iowa Code Chapter 490A.  The BJR protects corporate boards of directors from liability for their actions if they are disinterested, informed and there is a rationale basis for the actions.  It is not applicable to partnerships.  There probably wasn't much doubt that the rule applied to LLCs in light of the many similarities between the entities (limited liability, often centralized management, perpetual existence) but this case removes all doubt.

This is not important news to 489 LLCs because the BJR was codified in Iowa Code Chapter 489.409(7).

By the way, the trial court used a delightful phrase one will only find in Iowa when he likened the plaintiff's claims of conflict of interest to a "frog calling a garter snake green."  I believe that is the English translation of pari delicto.

-Marc Ward

Iowa Court of Appeals: Business Judgment Rule Applies to LLCs

In Terminal Properties, Inc. v. Hampton Propane Terminal, L.C., 2009 Iowa App. LEXIS 231 (March 26, 2009) the Iowa Court of Appeals confirmed that the business judgment rule applies to Iowa limited liability companies formed under Iowa Code Chapter 490A (for LLCs formed under Iowa Code Chapter 489 the business judgment rule is codified).  You can read the case here.

I am not sure I agree with the court's reasoning that allowed it to avoid the issue of whether the managers of the LLC had conflicts of interest when they voted in favor of the actions that became the subject of the litigation.  The appearance of conflicts would have negated application of the BJR and led to a much more interesting and helpful opinion, albeit a more difficult one for the court.

-Marc Ward

Recent Delaware Cases on Director Liability

It is interesting to watch the Delaware Chancery Court struggle with the Disney concept of the breach of the obligation of good faith which results in the breach of the duty of loyalty by boards of directors.  

A quick recap.  The breach of the duty of care usually requires a finding that the board of directors' actions rose to the level of gross negligence.  It has been defined as "reckless indifference to or a deliberate disregard of the whole body of stockholders or actions which are without the bounds of reason."  Tomczak v. Morton Thiokol, Inc., 1990 Del Ch. LEXIS 47 (Del. Ch. April 5, 1990).

The breach of the obligation of good faith means the board "consciously and intentionally disregarded [its] responsibilities."  In re Walt Disney Co. Deriv. Litig., 825 A.2d 275, 289 (Del. Ch. 2003).

Application of these test matters because Delaware corporations can exculpate boards from the breach of the duty of care by inclusion of the proper provision in the certificate of incorporation.  Thus, the board is off the hook if they are merely recklessly indifferent but liable if they consciously and intentionally disregard their responsibilities.  See the difference?

Check out these three recent Delaware cases regarding the duty of loyalty.  Ryan v. Lyondell Chemical Co., 2008 WL 2923427 (Del. Ch. Jul. 29, 2008); McPadden v. Sidu, 2008 WL 4017052 (Del. Ch. Aug. 29, 2008); and In re Lear Corp. Shareholder Litigation, 2008 WL 4053221 (Del. Ch. Sept. 2, 2008).

-Marc Ward

Duties owed by Directors of Insolvent Entities

Occasionally reading one case sends me off in an unexpected direction to another case and then another.  Such was the case, so to speak, recently.

While skimming a run-of-the-mill breach of fiduciary duty case I eventually ended up reading North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A 2d 92 (Del. 2007) and Trenwick America Litigation Trust v. Ernst & Young et al, 906 A 2d (Del. Ch. 2006).

North American Catholic reminds us that when a corporation is solvent the shareholders may enforce the directors' fiduciary duties owed to them and the corporation by derivative action.  When a corporation is insolvent the creditors "take the place of the shareholders" and have standing to bring a derivative claim against the directors for breaches of fiduciary duty.  North American Catholic, 930 A 2d at 101.  This case stands for the additional proposition that creditors do not have a direct claim against directors for breaches of fiduciary duty.  Id. at 94.

Trenwick nips in the bud another cause of action creditors have tried to advance lately; the claim of "deepening insolvency."  Trenwick, 906 A 2d at 174.  As Judge Strine put it in a delightful, if lengthy, 36 page opinion, "Put simply, under Delaware law, 'deepening insolvency' is no more of a cause of action when a firm is insolvent than a cause of action for 'shallowing profitability' would be when a firm is solvent."  Id.

I recommend both opinions to those interested in the impact of insolvency on the duties of directors.

-Marc Ward

Reliance on Experts is Not Enough

The Eleventh Circuit Court of Appeals put its foot down on using the Business Judgment Rule as a scapegoat in this case. TSG sued its former CFO (Bencini) and accounting firm (D&D) for breach of fiduciary duty, fraud, securities fraud, and breach of contract.  Bencini prepared financial statements for TSG in 2000 showing that the company was earning a profit for the first time.  D&D reviewed the statements and came up with an even bigger profit for the company.  Management and the Board of Directors took a look and believed the company had “turned a corner.”  In May of 2001, Bencini noticed that the cash flow was flowing the wrong way, and a closer look revealed that the 2000 financial statements were just plain wrong—the company was still in the red. The President of TSG was informed of the cash flow issue, but not the 2000 accounting errors, so he proceeded to the annual meeting, and told investors the good news about making a profit. Bencini didn’t jump in to correct the misunderstanding.

A month later, the directors had to act quickly to avoid a lien on one of TSG’s projects.  Investors and Directors opened their own pockets to support TSG, thinking this was an unfortunate blip on the upward trip to continued profitability.  But that profit had never existed—it was the product of numerous accounting errors.  The District Court granted Bencini summary judgment on the basis that the Business Judgment Rule applied because Bencini relied on outside experts (D&D).  The Appeals Court didn’t buy it.  Reliance on outside experts is not determinative, but simply weighs in favor of a finding that there was no abuse of discretion.  The totality of the facts must be considered. In addition, the Appeals Court disagreed with the District Court’s assessment that there was no fact issue as to whether Bencini acted fraudulently, in bad faith, or in an abuse of his discretion.  There were indications of collusion between Bencini and D&D, and evidence that Bencini stood to gain from an inaccurate picture of TSG’s finances.  He sat on his hands at the board meeting instead of correcting the President when the news of profit was announced, and his spreadsheets induced investors to prop up the company with their own cash.  The Appeals Court put it all together and decided Bencini did not deserve summary judgment in his favor.

So now we know that invoking the Business Judgment Rule and relying on experts will not blindfold Lady Justice, at least not in the Eleventh Circuit.

-Emily S.Pontius