• Supreme Court Confirms that Officers Owe Fiduciary Duties and Clarifies the Doctrine of Common-Law Stockholder Ratification
  • December 21, 2009
  • Law Firm: Richards, Layton & Finger, P.A. - Wilmington Office
  • In Gantler v. Stephens, No. 132, 2008 (Del. Jan. 27, 2009), the Delaware Supreme Court reversed and remanded the Court of Chancery's dismissal of a complaint challenging a board's decision to reclassify shares in lieu of a merger proposal previously rejected by the board. In its opinion, the Supreme Court held that, while a board's decision to reject a merger proposal is generally protected by the business judgment rule, the plaintiffs had sufficiently alleged director self-interest and rebutted the presumptions of the business judgment rule. The Court also explicitly held that officers of Delaware corporations owe the same fiduciary duties as directors. Finally, the Court clarified the doctrine of stockholder ratification, holding that stockholder approval that is statutorily required cannot also operate as ratification.

    According to the complaint, the board of directors of First Niles Financial, Inc. ("First Niles") initiated a process to sell the company in 2004 and retained financial and legal advisors to assist in that process. First Niles's management instead advocated abandoning the sales process in favor of a proposal to privatize the company. The board received bid letters from three potential buyers, all of which were deemed reasonable by First Niles's financial advisor. The board did not pursue one of the offers after the bidder stated that it had no plans to retain the board. A second bidder withdrew its bid after two defendants (both members of management) failed to provide it with any due diligence materials. The third made an offer, but the board rejected it without discussion or deliberation.

    Soon thereafter, the Chairman and CEO circulated to the board a plan to privatize First Niles through a reclassification of the shares of holders of 300 or fewer First Niles shares into a new issue of preferred stock that had no voting rights except in the case of a sale of the company. The reclassification would enable First Niles to delist its stock and therefore save expenses relating to public disclosure and reporting requirements. The board voted unanimously to amend First Niles's certificate of incorporation to reclassify the shares. The reclassification became effective after 57.3% of the company's outstanding shares were voted in its favor, including 50.3% of the shares owned by persons other than the directors and officers.

    The plaintiffs set forth three counts in their complaint. Count I alleged that the defendants breached their duty of loyalty in rejecting the merger offer and abandoning the sale process. Count II alleged that the defendants breached their duty of disclosure by disseminating a materially false and misleading proxy regarding the reclassification. Count III alleged that the defendants breached their duty of loyalty by effecting the reclassification. The Court of Chancery dismissed all three counts for failure to state a claim, holding that the business judgment rule, rather than the heightened Unocal or entire-fairness standards, applied to the board's decision to abandon the sale process; that the proxy statement contained no material omissions or misstatements; and that the approval of the holders of a majority of the unaffiliated shares constituted ratification of the reclassification.

    On appeal, the Supreme Court reversed the Court of Chancery's decision on all three counts.

    Regarding Count I, the Supreme Court agreed that Unocal enhanced scrutiny did not apply because the decision to reject the merger offer was not defensive. However, the Supreme Court applied the entire-fairness standard because it found that the plaintiffs had sufficiently alleged that the board had not reached its decision to terminate the sales process in the good-faith pursuit of a legitimate corporate interest. The Supreme Court required the plaintiffs to plead facts other than a motive to retain corporate control sufficient to state a claim that the directors had acted disloyally. This requirement was met, the Court found, because the plaintiffs had pleaded facts providing a sufficient basis to conclude that a majority of the board acted disloyally.

    The Supreme Court also found that the Court of Chancery had erred in dismissing Count I as to the officer defendants. The Court explicitly held that officers of Delaware corporations owe fiduciary duties of care and loyalty and that the fiduciary duties of officers are the same as those of directors. The Supreme Court then concluded that the complaint sufficiently alleged detailed acts of wrongdoing to support reasonable inferences that the officer defendants breached their duty of loyalty.

    Regarding Count II, the Supreme Court concluded that the statement in the reclassification proxy that the board rejected the merger proposal after "careful deliberations" was materially misleading. First, the Court held that the statement was material to the stockholders because, given the defendants' admitted conflicts of interest, the First Niles stockholders would likely have found it significant that the board's decision was made only after "careful deliberations." Furthermore, the complaint alleged that the board had rejected the merger proposal without any discussion. Because the board had partially disclosed its consideration of the merger proposal (by referring to the "careful deliberations"), the Court held that the board had an obligation to provide the stockholders with an accurate, full and fair characterization of its deliberations.

    Finally, regarding Count III, the Supreme Court concluded that the Court of Chancery erred in dismissing Count III on ratification grounds for two reasons: First, because a stockholder vote was statutorily required to amend First Niles's certificate of incorporation, that vote could not also operate to ratify the challenged conduct of the interested directors. Second, the (adjudicated cognizable) claim that the reclassification proxy contained a material misrepresentation meant that the stockholder vote was not fully informed, as is required for ratification. The Court further clarified the scope and effect of the common-law doctrine of stockholder ratification, holding that stockholder ratification is limited to circumstances where a fully informed stockholder vote approves director action that does not statutorily require stockholder approval to become effective. The Court also made clear that--with the exception of a claim of lack of authority--a ratifying stockholder vote will not extinguish a claim altogether, but will only provide for business judgment review of the challenged action.