Recent developments in Delaware corporate law
October 2019 | SPOTLIGHT | COMPANY LAW
Financier Worldwide Magazine
October 2019 Issue
For more than a century, Delaware has been the preeminent jurisdiction for resolving business disputes and contests for corporate control. Delaware’s judiciary is well-known for its ability to promptly address complex issues and hand down decisions that corporations and alternative entities look to when making strategic business decisions.
Recently, the Delaware courts have issued several decisions that altered the course of conduct for those managing companies organised under Delaware law. These decisions address: (i) the interpretation of material adverse effect (MAE) provisions in M&A agreements; (ii) the corporate disclosures required to receive the protections of the business judgment rule from a fully-informed stockholder vote on merger transactions; (iii) post-merger appraisal lawsuits brought by dissenting stockholders; and (iv) exclusive-forum selection provisions in organisational documents.
Delaware’s first M&A termination under an MAE provision
MAE or material adverse change (MAC) clauses are routine provisions found in M&A deal documents. Yet it was not until 2018 that the Delaware courts upheld a buyer’s termination rights based on an MAE clause in Akorn, Inc. v. Fresenius Kabi AG.
Akorn involved the 2017 proposed sale of generic pharmaceutical manufacturing drug maker, Akorn, to Fresenius, a Germany-based pharmaceutical manufacturing company, for $4.75bn. The merger agreement contained customary MAE clauses permitting termination by Fresenius if Akorn: (i) suffered an “effect, change, event or occurrence” that “has had or would reasonably be expected to have a MAE”; (ii) breached its representations and warranties in the merger agreement; or (iii) failed to operate in the ordinary course. Post-signing discoveries by Fresenius triggered all three conditions, the courts found.
First, the court found, post-signing, Akorn suffered egregious financial losses. For 4Q 2017, Akorn was down 34 percent in year-over-year revenue and 292 percent in operating income. For FY2017, Akorn experienced a 25 percent decline in annual revenue, a 105 percent decline in operating income, an 86 percent decline in earnings before interest, tax, depreciation and amortisation (EBITDA), a 51 percent decline in adjusted EBITDA and a 17 percent decline in actual revenue from the low-end of guidance.
Second, Fresenius received whistleblower letters from Akorn employees, and, based on Fresenius’s own internal investigation, it uncovered “overwhelming evidence of widespread regulatory violations and pervasive compliance problems at Akorn”, and which worsened post-signing called into doubt Akorn’s representations and warranties. The court found that regulatory problems reduced the company’s value by approximately 20 percent.
Third, the court determined that Akorn failed to operate in the ordinary course. Among other things, Akorn cancelled regular audits and inspections, failed to adequately investigate the whistleblower letters, and submitted regulatory filings to the FDA that contained “false or fabricated” data. Based on these extreme facts Fresenius terminated the merger pursuant to the MAE clauses.
The Delaware Court of Chancery concluded that Fresenius validly terminated the deal based on the MAE. The decision was upheld on appeal to the Delaware Supreme Court. Commentators have questioned whether this decision will usher in a ‘new normal’ with buyers freely terminating based on MAE. Prior to Akorn, the courts have frequently refused to find an MAE even at great cost to the buyer, including where the target’s share price dropped precipitously between signing and closing. The Akorn court took 246 pages in its opinion in justifying its conclusion that Fresenius validly terminated the merger. In light of the egregious facts in Akorn, the general sentiment among the corporate bar is that the case is an outlier.
Delaware’s focus on adequacy of disclosures in merger transactions: M&A challenges in the post-Corwin landscape
Stockholder ratification of corporate acts has long been a fixture of Delaware law. But the Delaware Supreme Court’s 2015 decision in Corwin v. KKR Financial Holdings LLC refined the doctrine. In Corwin, the Delaware Supreme Court explained that a transaction approved by a fully informed, uncoerced and disinterested stockholder vote will be reviewed under the deferential business judgment rule, so long as the transaction is not subject to an “entire fairness review” (e.g., when the transaction involves a controlling stockholder acquiring the target).
In the wake of Corwin, numerous lawsuits brought by stockholder plaintiffs challenging acquisitions have been dismissed at the pleading stage (i.e., before trial) because plaintiffs could not overcome the ratification by the stockholders. Recently, however, some stockholder plaintiffs have been successful in overcoming Corwin’s protections by challenging the sale process undertaken by the target board and the adequacy of the company’s disclosures in proxy materials.
In Morrison v. Berry the Delaware Supreme Court reversed the Court of Chancery’s dismissal of a lawsuit under the Corwin doctrine, holding that, at the pleading stage, the court could not say that the stockholders were fully informed before the ratification vote. Berry involved a going-private transaction by Apollo, which completed a two-step tender offer for the fresh market in March 2016. A stockholder challenged the transaction based upon a claim that material information was excluded from the proxy statement; namely that the founder of the The Fresh Market had allegedly secretly committed to sell the company to Apollo, which, when it was disclosed to the board, caused undue influence to approve the transaction. This fact was not immediately disclosed in the proxy statement, as the court pointed out, the board “misrepresented the reasons the board formed the committee, because the proxy failed to state the directors were motivated by existing activist pressure”.
The court held that Corwin “requires (the court) to consider whether the plaintiff’s complaint, when fairly read, supports a rational inference that material facts were not disclosed or that the disclosed information was otherwise materially misleading”. Giving the plaintiff the benefit of such inferences at the pleading stage, the court determined the plaintiff “unearthed and pled in her complaint, specific, material, undisclosed facts that a reasonable stockholder is substantially likely to have considered important in how to vote”.
The take-away from Berry to companies seeking to invoke Corwin’s protections when structuring transactions is a cautionary reminder to directors and the attorneys who help them craft their disclosures: ‘partial and elliptical disclosures’ cannot facilitate the protection of the business judgment rule under the Corwin doctrine. Thus, companies and their counsel are well-advised to focus on executing a robust deal process and fulsome disclosures in proxy statements. The Court of Chancery has followed Morrison’s guidance in several recent decisions, including in Chester County Employees’ Retirement Fund v. KCG Holdings, Inc., holding that the plaintiff’s complaint adequately alleged that there were material misstatements in the proxy materials and, thus, the vote by the disinterested stockholders did not result in the transaction being subject to Corwin’s protections.
Post-merger appraisal claims continue to be a reality post-closing
In Delaware, stockholders who dissent from a merger have the statutory right to challenge the adequacy of the merger consideration by means of an ‘appraisal’ action, where the Court of Chancery will hold a trial to determine the ‘fair value’ of the company’s shares.
Several aspects of appraisal are significant to stockholders. First, appraisal actions often turn into a ‘battle of the experts’, with both sides advocating as to the company’s value based on the opinions of their respective financial advisers. Frequently, these competing opinions wildly range in value.
Second, appraisal actions, which are intended to be summary proceedings, actually tend to span years between commencement of the complaint and trial. Over the last decade, the average time to trial for an appraisal action was 24 months, with some cases taking up to five or six years. The shortest case was just over a year. Thus, appraisal actions cause considerable post-closing distraction to buyers, as well as a significant expenditure of time and resources.
Third, appraisal claims can spawn the filing of new post-closing fiduciary duty cases against directors and officers of the acquired company and aiding and abetting claims against the purchasing party and the target’s financial advisers. This is because the petitioning stockholder in the appraisal action can obtain information through discovery that they use to draft and file a fiduciary duty complaint on behalf of a class of stockholders who tendered their shares in the merger.
In a trio of decisions in 2017-2019 involving the appraisals of Dell, Inc., DFC Global Corp. and Aruba Networks, Inc., the Delaware Supreme Court has solidified the importance of the negotiated deal price and the pre-announcement trading price in the valuation of a public company where there is a wide trading market. Before these cases, over the past decade, the average premium to deal price awarded by the courts was less than 10 percent. The current bias is toward a price that is lower than the deal price because value arising from the merger is not accounted for in the appraisal valuation. This is in contrast to private companies, where the ‘market’ for a target’s securities is not as easily defined: the average premium to deal price awarded by the courts was more than 45 percent.
Despite the trend of lower relative appraisal valuations, the recent trend of ‘appraisal arbitrage’, has occurred where stockholders purchase shares of the target company after the merger is announced with the sole intention of bringing or threatening an appraisal action. These stockholders and their counsel are aware that the corporation is highly incentivised to settle the case early and pay fees and expenses to the stockholder and its counsel, face years of appraisal litigation and, potentially, face new post-closing fiduciary duty claims against their officers, directors and advisers, who seek indemnification from the acquiring entity. This new wave of litigation is now particularly pernicious because other types of M&A lawsuits have become a thing of the past in Delaware, such as pre-merger strike suits seeking quick settlements for plaintiff’s fees in return for supplemental proxy disclosures. Appraisal law in Delaware will continue to develop as a result of this new wave of litigation.
The limits on forum-selection clauses for federal securities-related claims
Delaware corporations in the past few years have judicially and, subsequently, legislatively been granted the right to require, in corporate governance documents, that internal claims be brought exclusively in Delaware. This benefit reduces uncertainty and enterprise costs that often result from defending stockholder litigation in multiple fora.
What has followed are a number of decisions testing the limits of these forum-selection laws. In Solak v. Sarowitz (2016), for example, the Court of Chancery invalidated a bylaw that sought to impose the penalty of shifting attorneys’ fees to a stockholder who violated the company’s exclusive-forum bylaw by bringing an internal claim outside of Delaware, which decision was affirmed by the Delaware Supreme Court.
More recently, in Sciabacucci v. Salzberg (2019), the Court of Chancery invalidated charter amendments adopted by three companies that sought to require stockholder plaintiffs to bring claims alleging violations of the Securities Act of 1933 exclusively in the federal courts (instead of state courts, which have concurrent jurisdiction). This decision followed the US Supreme Court’s decision in Cyan v. Beaver County Employees Retirement Fund (2018), where the court held that state courts have concurrent subject matter jurisdiction with federal courts with respect to 1933 Act claims. The Salzberg court reasoned that a 1933 Act claim is not an “internal corporate claim”, meaning it does not, among other things, touch on the rights, powers and privileges of shares of stock, who holds a corporate office or the fiduciary relationships existing within the corporate form.
The Supreme Court further reasoned that 1933 Act claims are “external” to the corporation; that is, federal law creates the claim, defines the elements, and specifies who can be a plaintiff or defendant. Moreover, the court held, in the case of shares, a 1933 Act claim arises from the purchase of shares. Thus at the time of the predicate act, the security holder is not yet a stockholder and cannot be bound to the corporation’s charter. At the time this article was published, the Salzberg case was being appealed to the Delaware Supreme Court.
Brian Hoffmann is counsel, Ashley R. Altschuler is a partner and Ethan H. Townsend is an associate at McDermott, Will & Emery. Mr Hoffmann can be contacted on +1 (212) 547 5402 or by email: firstname.lastname@example.org. Mr Altschuler can be contacted on +1 (302) 485 3910 or by email: email@example.com. Mr Townsend can be contacted on +1(302) 485 3911 or by email: firstname.lastname@example.org.
© Financier Worldwide
Brian Hoffmann, Ashley R. Altschuler and Ethan H. Townsend
McDermott, Will & Emery