The Delaware Supreme Court has launched an attack on the business judgement rule and is holding officers to a higher standard
Did the Delaware Supreme Court just throw corporate officers and directors under the bus and, in the process, launch an attack on the business judgment rule, one of the main pillars of board decision-making? That is one way of reading the January Delaware Supreme Court decision, issued in Gantler v Stephens, which continues to be one of the most talked about cases in corporate legal circles for two reasons.
Number one: In the eyes of many attorneys, ‘Gantler is very bad news for corporate officers,’ says John Jenkins, an attorney in the Cleveland office of Calfee Halter & Griswold. Number two: It is always big news when the Delaware Supreme Court issues a broad-gauge corporate law decision. This is particularly true when the court is tossing out an earlier Chancery Court decision – an extremely rare event – and even more true in a situation in which the Chancery Court had previously permitted the board of a small Ohio bank to use a business judgment presumption to shield itself from lawsuits alleging negligence in exercising fiduciary duties.
Bluntly put, the Gantler decision is saying that corporate officers have the exact same fiduciary duties as directors of Delaware corporations. It is also setting important limits on when ‘business judgment’ can be used to shield a board and corporate officers from actions filed by dissident shareholders. And it raises tantalizing concerns about a board’s decision-making freedoms in rejecting or accepting mergers.
More on all of that soon, but first contemplate the unlikely center of this decision: a bank holding company, First Niles Financial, which does business as Home Federal Savings and Loan Association of Niles and which, at recent share prices, has a market cap around $10 million. The other main players are Leonard Gantler, a member of the board from 2003 to 2006, and William Stephens, First Nile’s chairman, president and CEO.
Changing tacks
What landed First Niles in court in the first place is that in 2004, the company decided to sell itself and quickly got indications of interest from three suitors. First Niles wound up negotiating with one preferred bidder for several months but, in March 2005, the board changed tack and took First Niles off the selling block, instead proposing that the company reconfigure itself.
Specifically, First Niles proposed that owners of 300 shares or less would receive a new stock that carried higher dividends and the same liquidation rights as common stock but with restricted voting rights – namely, a vote only on the possible sale of First Niles.
The upshot would be that First Niles could deregister itself, since it would no longer exceed the minimum number of separate account holders that would require it to be a listed company, saving substantial monies. Shareholders, by a narrow margin, approved the measure in 2006.
But some shareholders were not happy and filed suit in Delaware, alleging that First Nile’s directors violated their fiduciary duty by abandoning efforts to sell the company. The plaintiffs had the case heard in front of the Court of Chancery and were initially unsuccessful. Ruling for the Court of Chancery – widely renowned as one of the most pro-business courts in the US – vice chancellor Donald Parsons, drawing on well-established precedents that protect directors’ ability to exercise reasonable ‘business judgment’, dismissed the plantiffs’ claims.
Despite the defeat, some shareholders refused to give up and appealed the decision to the Delaware Supreme Court. Initially, many legal experts considered this to be a waste of time because the business judgment rule is extremely well established and the Supreme Court very rarely overturns decisions of this kind from the Chancery Court.
However, the Supreme Court – in text authored by Supreme Court Justice Jack Jacobs – roundly threw out Parsons’ conclusion and overturned the prior ruling. And therein lies the problem. ‘When the Delaware Supreme Court speaks, it matters,’ says Jenkins. In this instance, the court has spoken emphatically in favor of shareholders’ rights.
Treating officers as directors
Not everyone was surprised by the ruling, however. To a large extent, the court simply ratified what many had long thought was the case: in certain circumstances, officers hold the same responsibilities as directors. ‘It had always been implied officers have the same fiduciary duties as directors,’ says Lynda Twomey, an attorney with Fenwick and West in San Francisco.
‘The opinion affirms what we had long suspected – that officers have fiduciary duties and liabilities,’ comments Antony Page, an associate professor at the Indiana University School of Law in Indianapolis.
Despite this attitude and the idea that officers and directors share some fiduciary responsibilities, there are specific details in this case that separate it from others and raise questions about the application of the business judgment rule.
In particular, the Supreme Court raised concerns about possible conflicts of interest among board members and outside suppliers to the company. One director, for instance, supplied heating and cooling services to First Nile, which ranked as a large customer.
‘The court found that the complaint adequately alleged that a majority of the directors had a material personal interest in rejecting the transaction, so that the business judgment rule was inapplicable,’ explains Frederick Alexander, an attorney with Morris Nichols Arsht & Tunnell in Wilmington, DE. ‘Instead, assuming those allegations are correct, the directors will be subject to the ‘entire fairness’ standard.’
By that standard, the Supreme Court found considerable fault with First Nile’s decision to spurn merger bids.
That is what put the officers in the hot seat. Directors, as per section 102 (b) (7) of the Delaware General Corporation Law, are typically protected against damages claims arising from a breach of duty of care. Protection is usually provided in a corporation’s certificates of incorporation, and this is explicitly permitted under Delaware law. But no such automatic protections extend to officers acting as officers.
Taking shelter
One upshot of this situation is that ‘boards will be looking for ways to protect their officers,’ says Jenkins, and in no reading does the Delaware Supreme Court preclude this. It will likely be necessary, too, because, predicts attorney Barry Klayman with WolfBlock in Wilmington, DE, ‘we will probably see more lawsuits against officers’ as dissident shareholders probe for weak links. With a more challenging mergers and acquisitions market expected during 2009 and beyond, and as more details emerge about the causes of the financial crisis, it is likely that more shareholder cases will be launched and the spotlight will shine intensely on corporate officers and directors.
Meanwhile, Patrick Quick, an attorney with Foley & Lardner in Milwaukee, stresses that – with Gantler in mind – boards have to be ‘more careful’ when rejecting a possible merger. ‘Before this ruling, we believed a board had considerable leeway,’ he explains.
Now, perhaps, there is less leeway and any board that rejects a merger has to be concerned about the possibility of close review, and specifically a hunt for a lack of independence on the part of directors and officers, suggests Quick. ‘This decision troubles me,’ he adds.
Jenkins elaborates that the key takeaway from Gantler is probably that ‘Delaware has affirmed that the decision of a board regarding a merger is subject to review.’
Sign of the times
Frightening as that image may be, another take on Gantler is that the skepticism it offers regarding officers and boards may simply be ‘a sign of the times,’ says attorney William McGuinness, a partner and head of the litigation department at Fried Frank Harris Shriver & Jacobson in New York.
The way he reads Gantler, the decision is one that favors ‘higher-level scrutiny of corporate officers and directors’ and, in that respect, it is solidly in line with a lot of the thinking coming out of today’s Washington. While there is no doubt that the courts have long held a role in the interpretation of legal statute and assist in evolving the laws in line with public opinion, certain lawyers now question whether this is really appropriate for financial rules, especially in times of such extreme upheaval and intense public opinion.
‘Some people say the Delaware Supreme Court tries to be responsive to overall public opinion,’ notes Page. And looked at through that lens, perhaps what the court was trying to do with Gantler was to position itself in the line of the many who are complaining about negligence and a lack of due diligence in financial services circles.
As Page concludes: ‘We will still be talking about Gantler in five years. It is an important decision.’
