LiabiLity and Litigation 16 directors & boards T he harsh consequences of being a faithless fidu- ciary were evident in 2007, when increased efforts by the Securities and Exchange Commission and U.S. Attorneys’ Offices resulted in a wave of indictments, convictions, and guilty pleas. In May 2007, the former general counsel of Comverse Technology became the first executive to receive a prison sentence for stock option backdating. In July 2007, Conrad Black, the former chairman and CEO of Hol- linger International, was convicted of defrauding shareholders. In August 2007, the former CEO of Brocade Communications was convicted of securities fraud for stock option backdating (the company’s HR director was later convicted of conspir- ing with the CEO to conceal the practice). And, in October 2007, the former general counsel of Amkor Technology was convicted of securities fraud. These are but a few examples, as many executives pleaded guilty to stock option backdating, insider trading, and other offenses in 2007. Although often inextricably linked to the federal securi - ties laws, poor corporate governance rarely results in criminal prosecution; however, it can result in civil liability for directors and officers, economic losses for shareholders, and delays in the implementation of board decisions. In 2007, the courts of the State of Delaware — America’s “Corporate Capital” and the state of incorporation for more than 62% of the Fortune 1000 — once again provided lessons for boards and manage- ment. Several of those decisions are summarized below. Stock option pricing manipulation The impetus for the stock option backdating scandal was a March 2006 report issued by Merrill Lynch, which conducted a statistical analysis of the timing of stock option grants dur- ing the period of 1997-2002. In 2007, the Delaware Court of Chancery decided several cases alleging that directors ma- nipulated the pricing of stock options, three of which are discussed here. The first case to be decided, Ryan v. Gifford, addressed whether backdating violates a director’s fiduciary duties. In Ryan, the options at issue were granted by the Compensation Committee of Maxim Integrated Products Inc. to the com- pany’s founder, chairman, and CEO, John F. Gifford, pursu- ant to a stockholder-approved option plan filed with the SEC. The court ruled that backdating is tantamount to a “lie” and cannot be the loyal or faithful act of a fiduciary. The court’s opinion was at the early procedural stage and without factual findings; however, the court discussed the portion of the Mer- rill Lynch report dealing with Maxim: “Merrill Lynch found that the twenty-day return on option grants to management averaged 14% over the five-year period, an annualized return Corporate Governance Litigation: 2007 Review Report from Delaware: A spotlight on several court rulings that moved the governance needle. by John L. Reed and Paul d. brown John L. Reed (left) is a partner and Paul D. Brown is an associate in the Wilmington, Del., office of Edwards Angell Palmer & Dodge LLP, a full- service law firm with more than 600 attorneys in major U.S. markets and London (www.eapdlaw.com). They maintain a national business litiga- tion and corporate counseling practice that covers all facets of corpo- rate law and governance and issues arising under the Delaware General Corporation Law. Mr. Reed is listed in Chambers USA: America’s Leading Lawyers for Business and Delaware Super Lawyers. Continued on page 59 LiabiLity and Litigation annual report 2008 59 of 243%, or almost ten times higher than the 29% annualized market returns in the same period.” The report noted that if backdating did not occur, then company management must have had an uncanny ability to time option pricing events. Issued the same day as the Ryan decision, In re Tyson Foods, Inc. Consolidated Shareholder Litigation involved “spring loading,” not backdating. “Spring loading” is the practice of issuing stock option grants shortly prior to the release of in- formation likely to drive up the price of the issuer’s stock. As a result, the optionee receives options that are almost instantly “in the money.” Plaintiffs alleged that directors of Tyson Foods “spring loaded” options while representing in public disclo- sures that such options were granted at market prices. The court accepted these allegations as true, which it was required to do at this early stage of the litigation, and held that plain- tiffs stated an actionable claim for breach of fiduciary duty. The court compared “spring loading” to backdating and found that while the latter is essentially a lie, the former “implicates a much more subtle deception” — i.e., the authorization of options with a market-value strike price in accordance with a stockholder-approved option plan at a time when the authorizing directors know that the shares are actually worth more than the exercise price. Once again, the court reiterated that directors who engage in this type of conduct cannot “be said to be acting loyally and in good faith as a fiduciary.” A third option case from 2007 is im- por tant for how it differs from both Ryan and Tyson. In Desimone v. Bar- rows, the court dismissed a stockholder derivative complaint alleging miscon- duct in the issuance of stock options by the board of directors of Sycamore Networks Inc. The directors had granted three categories of options: (i) options to employees; (ii) options to outside (i.e., nonemployee) directors; and (iii) options to officers. Regarding the em- ployee options, the cour t found that plaintiff failed to plead facts sufficient to demonstrate that the Sycamore directors were aware that certain grants to employees were backdated. The plaintiff also alleged that the directors failed to exercise proper oversight, but the court dismissed that claim because plaintiff did not allege “any fact to suggest that Sycamore’s internal controls were deficient, much less that the board, the Audit Committee, or Sycamore’s auditors had any reason to suspect that they were or that backdating was occurring.” As to the option grants to outside directors, the court rejected plaintiff ’s claims because the outside director grants were is- sued in accordance with Sycamore’s stockholder-approved stock option plan, which permitted options to be priced below market. In this situation, it is within the board’s exercise of business judgment to issue options at a low point in a trading period (as long as the directors satisfied disclosure and other regulatory requirements). With regard to the officer option grants, most of them involved allegedly backdated options and the court concluded that plaintiff had failed to allege that any member of the board had knowingly approved backdated op- tions. In a later case, Conrad v. Blank, the court distinguished Desimone v. Barrows and refused to dismiss a derivative action against the directors of Staples Inc. because the stock option plan provided no discretion and the company admitted that backdating had occurred. Postponing stockholder votes In Mercier v. Inter-Tel (Delaware), Inc., the Delaware Court of Chancery considered plaintiffs’ application to enjoin a merger between Inter-Tel and Mitel Networks Corp. On the morning of the special meeting at which Inter-Tel’s stockholders were to vote on the merger, and after becoming aware that the merger would not be approved, a special committee of Inter-Tel’s board decided to reschedule the vote. As a justification, the special committee pointed to, among other things: (i) giving stockholders time to consider general market conditions that would impact the possibility of alternate deals; (ii) providing stockholders with the com- pany’s downwardly revised sales results; and (iii) Mitel’s announcement that it would not increase its offer price. At the rescheduled meeting, the merger was approved by an overwhelming major- ity. Plaintiffs sought to enjoin the con- summation of the merger based on the theory that the last-minute rescheduling of the vote was an attempt to thwart the will of the majority of the company’s stockholders, who, at the time of the original vote, were against the merger. This is significant because Delaware law places an onerous burden on directors to justify conduct that interferes with stockholder voting rights. The majority of the Mercier opinion was dedicated to a scholarly discussion regarding the appropriate standard of review by which a court should analyze a decision by manage- ment to reschedule a vote, the particulars of which are beyond the scope of this article. From a practical point of view, what one can take away from the decision is as follows. The court held that the Mercier board would bear the initial burden to identify a legitimate corporate objective served by a postpone- ment. Then, the board was required to demonstrate that its actions in furtherance of such objective were reasonable and Governance litigation review Continued from page 16 Delaware’s guiding principles are strict adherence to fiduciary duties, prompt enforcement of articles of incorporation and bylaws, and maximization of shareholder value. LiabiLity and Litigation 60 directors & boards did not preclude stockholders from exercising their right to vote or coerce them into voting in a particular way. Ultimately, the court denied the injunction and held that the company’s directors had a “compelling justification” for the postponement of the vote. The directors were well-moti- vated and independent and sought to prevent the stockholders from making “a huge mistake” by rejecting a deal that would result in Mitel walking away and causing the company’s stock price to plummet. Trickery and deceit in the boardroom In Fogel v. U.S. Energy Systems, Inc., the Delaware Court of Chancery considered several issues of corporate governance, all of which hinged on whether or not three independent di- rectors of a four-member board validly terminated the em- ployment of the fourth director, Asher E. Fogel, who served as the CEO of U.S. Energy. The inde- pendent directors claimed to have first learned of certain operational and fi- nancial difficulties of the company at a June 14, 2007, board meeting. At that meeting, the board determined it would need to hire a financial or restructuring advisor and scheduled another meeting for June 29, 2007, to conduct interviews for such an advisor. Soon after the June 14 meeting, but unbeknownst to Fogel, the independent directors began their planning to terminate Fogel. On the morning of the June 29 meeting, the in- dependent directors met and decided to fire Fogel. They confronted Fogel in the boardroom prior to the meeting and asked him to resign by the end of the day or he would be terminated. Fogel left the room, the meeting was held, and when Fogel refused to resign later that evening, the three remaining directors terminated him as CEO. On July 1, 2007, as authorized by the company’s bylaws, Fogel, purport- edly in his capacity as CEO, called for a special meeting of the company’s stockholders. Later that same day, at a regularly scheduled board meeting, the board passed a formal resolu- tion terminating Fogel. The board ignored Fogel’s call for a special meeting. Fogel petitioned the court for an order compelling the board to hold a special meeting. The court determined that Fogel was not terminated on the morning of June 29 because the independent directors’ decision was not a valid corpo- rate act. A board can only take action by means of a vote at a properly constituted meeting. “The mere fact that directors are gathered together does not a meeting make,” noted the court. Although there is not a clear rule indicating that a director must be given notice of all matters to be considered at a meet- ing, directors must be given notice sufficient to allow them to protect their interests. Here, the court observed that even if a proper meeting had been held on June 29, Fogel was tricked or deceived as to the true purpose of that meeting and that the independent directors’ failure to inform Fogel of their plan to terminate him was intentional. The court ordered the board to hold a special meeting. This case is significant because it dem- onstrates how a failure to comply with corporate formalities can have a palpable impact on governance issues. The attorney-client privilege After the Court of Chancery refused to dismiss the Ryan v. Gifford backdating case, discovery proceeded. In a letter opin- ion addressing various discovery motions, the court addressed an issue with potential implications for special committee practice. The court ruled on plaintiffs’ motion to compel the company (including the special committee created to inves- tigate the backdating allegations) and the committee’s legal and accounting advisors to produce all communications be- tween the special committee and its counsel, and between the company and the committee’s counsel. Generally, absent a waiver or plaintiffs’ demonstration of good cause, communications between the special committee and its counsel are privileged. Here, the court ruled that plaintiffs were entitled to communications be- tween the company and the commit- tee’s counsel regarding the committee’s investigation and report, primarily be- cause that information, which was of paramount impor tance to plaintiffs’ case, was unavailable from other sourc- es. Then, the court went on to deter- mine that even if the company and the committee share a joint privilege as to communications between the committee and its counsel, that privilege was waived. The basis for the finding of waiver was the committee’s presentation of the report to third parties, including certain directors who were the subject of the investi- gation. These directors, held the court, did not share common interests with the corporation. Following the court’s ruling, special committees must pro- ceed with caution. If a special committee of independent di- rectors reports the reasoning behind its conclusions to the full board of directors, all of the committee’s communications with counsel addressing the same subject matter are poten- tially subject to discovery. It is important to note, however, that the specific facts of this case compelled the result. In con- trast, the same chancellor who issued the Ryan v. Gifford deci- sion decided Saito v. McKesson HBOC, Inc. in 2002, in which he held that a company does not waive the attorney-client or work product privileges when it shares information with the SEC during an SEC investigation provided that a confidential- ity agreement is in place. Private equity deals: “Go shops” and insufficient disclosures Two decisions from the Delaware Court of Chancery in 2007, In re The Topps Company Shareholder Litigation and In re Lear Corporation Shareholder Litigation, offer some practical The court ruled that backdating is tantamount to a ‘lie’ and cannot be the loyal or faithful act of a fiduciary. LiabiLity and Litigation annual report 2008 61 guidance on how directors can satisfy their duty to maximize stockholder value where a merger agreement is not subject to a pre-signing public auction. Pursuant to the 1985 case of Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., when a board of directors determines to sell control of a Delaware corporation, the board’s duty shifts from that of a protec- tor of corporate policy to that of a facilitator of a process to maximize value for the stockholders who will be “cashed out.” While the phrase “Revlon duties” is often used as shorthand for a duty to shop or auction the company, Revlon itself imposes no such duty. Indeed, Revlon does not require any particular process, or even an auction at all. Regardless of what process is followed, however, directors must satisfy themselves that the transaction at issue is in the stockholders’ best interests and, in light of other alternatives, offers the best value reasonably obtainable at the time. In this context, “go-shop” provisions become relevant because they provide a mechanism by which a board, in an effort to comply with Revlon, can execute a binding merger agreement without having conducted a pre- signing auction. Instead, the board shops the company during a reasonable period of time after signing. In Topps, Michael Eisner, through a private equity firm he controls, proposed to acquire Topps Co. Inc. in a going-private transaction. The deal contained an open go-shop provision that allowed the company to shop itself for a 40-day period, after which the company could only continue talks if a bidder submitted a superior proposal or, in the determination of the board, was reasonably likely to do so. Operating in tandem with the open go-shop was a two-tiered termination fee that allowed either party to walk away for the payment of a lower fee during the go-shop period and a higher fee thereafter. The court held that the deal process and terms satisfied Revlon. However, the court enjoined a vote on the merger because the company failed to disclose material facts about the negotiation process and because the company refused to release a competi- tor from a standstill agreement that pro- hibited the competitor from launching a tender offer or publicly commenting on the company’s characterizations of the deal process. In accordance with the terms of the injunction, the competitor launched a tender offer that was ulti- mately withdrawn. In Lear, Carl Icahn proposed to take Lear Corp. private. As in Topps, the deal was conditioned on the absence of a pre-signing auction, but was subject to a go-shop provision. Unlike Topps, however, the go-shop in this case was “closed,” which meant that in order for the company to avail itself of a lower ter- mination fee during the go-shop period, a competing deal had to be fully negoti- ated and executed within the 45-day go- shop period. The court was not impressed with this mecha- nism because it determined that it was highly unlikely that a competing deal could be sealed within the go-shop period. The court nevertheless concluded that the company’s directors discharged their Revlon duties. In a third decision from the Cour t of Chancer y, In re Netsmart Technologies, Inc. Shareholders Litigation, stock- holder plaintiffs sought to enjoin a merger between Netsmart Technologies and two private equity firms. After the company decided to sell itself, the board formed a special committee of independent directors, yet the special committee contin- ued to collaborate closely with Netsmart’s CEO and retained Netsmart’s banker as its own advisor. The special committee decided to pursue a private equity buyer and contacted seven private equity firms, four of which responded positively. Ul- timately, Netsmart and one of the private equity firms agreed to a merger. Within days of announcement, lawsuits were filed alleging that Netsmart’s directors failed to secure the best price reasonably available in breach of their Revlon duties and also failed to disclose material information to stockholders. Regarding the Revlon claim, the court noted that the spe- cial committee appeared to have actively pursued the best deal available (within the confines of its pitch to private equity firms, as opposed to strategic buyers). While the court was critical of the special committee’s decision to allow Netsmart’s management to be involved in the due diligence process, the court found that such involvement did not appear to have any adverse affect on the sale process. However, the court found that the plaintiffs demonstrated a likelihood of suc- cess on their claim that the board lacked a reasonable basis for its decision not to do a market check. The court reasoned that informal inquiries of potential strategic buyers over the Enjoined in Delaware: Private equity investor Michael Eisner’s deal for Topps Co. was dealt a judicial snag. Associated Press LiabiLity and Litigation 62 directors & boards prior 10 years were not reliable and there was a basis to be- lieve that Netsmart’s management favored a transaction with a private equity buyer over one with a strategic buyer because the management team would be more likely to be retained in a private equity deal and more likely to receive additional eq- uity incentives. Ultimately, the court did not enjoin the merger because it was concerned that such an injunction could result in Netsmart losing its only bidder; thus, the court held that a stockholder vote could go forward after Netsmart supple- mented its disclosures. No direct claims by creditors In North American Catholic Educational Programming Foun- dation, Inc. v. Gheewalla, the Delaware Supreme Court put an end to the debate regarding the rights of creditors to bring fiduciary duty ac- tions against the directors of insolvent or nearly insolvent Delaware corporations. The Delaware Supreme Court held un- equivocally that “creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against [a] cor- poration’s directors.” Rather, the court noted, creditors can protect their inter- ests by asserting derivative fiduciary duty claims on behalf of an insolvent corpo- ration or by asser ting any applicable direct nonfiduciary duty-based claims. In Trenwick America Litigation Trust v. Billett, the Delaware Supreme Court affirmed the Court of Chancery’s ruling from 2006 that Delaware does not recognize a claim for “deepening insolvency.” Big, failed deals In 2007 and early 2008, many billion-dollar leveraged buyouts (e.g., Genesco, Alliance Data Systems, Clear Channel, etc.) were terminated pursuant to merger agreements that provided limited rights of specific performance by the targets against the shell acquisition vehicles, leaving no express contractual recourse against the private equity sponsors or the banks that agreed to provide the debt financing because neither the spon- sors nor the banks — though necessary for commencement of the transactions — were parties to the merger agreements. One of those cases went to trial in the Delaware Court of Chancery. United Rentals, Inc. v. RAM Holdings, Inc. involved a dispute as to whether the target in a merger, United Rentals (UR), had the right to specifically enforce the merger agree- ment and compel the buyers (acquisition subsidiaries formed specifically for that purpose by the private equity firm Cer- berus) to close on the deal. The buyers repudiated their obli- gation to close and offered UR two alternatives: a renegotia- tion of the deal terms or a $100 million reverse termination fee, which the buyers contended was UR’s sole and exclusive remedy. Although the case was high profile, it did not involve complex or novel issues of corporate law. Indeed, in the words of the court, the dispute was a “good, old-fashioned contract case prompted by buyer’s remorse.” The court’s opinion is es- sentially a tome on the principles of contract interpretation. The court first determined that each side offered reasonable interpretations of whether the merger agreement provided for specific performance. Second, having found that the merger agreement was ambiguous, the court looked to extrinsic evi- dence (i.e., the parties’ negotiation history) to determine what they intended. As part of this exercise, the court employed what is called the forthright negotiator principle, which pro- vides that “in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.” The UR case stands for the impor- tance during negotiations of clearly and unequivocally communicating to one’s counterparties one’s subjective under- standing as to material elements of the contract. UR’s counsel failed to convey to buyers’ counsel UR’s understanding that, despite multiple revisions to the merger agreement, UR nevertheless re- tained the right to seek specific perfor- mance of the merger. This failure, cou- pled with the court’s finding that buyers’ counsel made it abundantly clear during negotiations that they considered UR’s sole and exclusive remedy to be receipt of the termination fee, prompted the court to conclude that UR was not entitled to specific performance. As noted by the court, the whole dispute could have been avoided by the simple expedient of clearer drafting. Faithless fiduciaries beware What these cases once again demonstrate is that the Dela- ware courts are neither shareholder nor management biased. Faithless fiduciaries beware — because Delaware’s guiding principles are strict adherence to fiduciary duties, prompt en- forcement of articles of incorporation and bylaws, and maxi- mization of shareholder value. However, the business judg- ment rule remains alive and well in Delaware for directors who fully inform themselves, are free of economic or other disabling conflicts of interest, and whose only agenda is that of advancing the best interests of the corporation. While the facts and legal analyses confronting directors are many times complex, the cases often boil down to the smell test. So, don’t be stupid, don’t be greedy, and be able to articulate why, in your best judgment, what you did was in the best interest of the company. ■ The authors can be contacted at firstname.lastname@example.org and pdbrown@ eapdlaw.com. Delaware law places an onerous burden on directors to justify conduct that interferes with stockholder voting rights.