2003 was a busy year for the Delaware courts. The three major decisions published during the year underscore the increased focus on board room governance. In early April 2003, the Delaware Supreme Court published its 3-2 decision in Omnicare, Inc. v. NCS HealthCare, Inc., finding that a fully locked-up merger agreement without a "fiduciary out" was invalid and unenforceable under Delaware law. This decision has spawned debate over the limits on a board's ability to protect a transaction that it believes is in the shareholders' best interests and has led some to believe that even good facts can make bad law. Next, in late May the Court of Chancery issued its decision in In re The Walt Disney Co. Derivative Litigation, in which the court held that the plaintiff shareholders' facts, if true, gave rise to a cognizable question as to whether disinterested directors should be held personally liable to the corporation for a knowing or intentional lack of due care. In particular, notwithstanding an exculpatory provision in the Disney charter, the court refused to dismiss the plaintiff's complaint because it gave rise to a reason to doubt whether the board's actions were taken honestly and in good faith. Finally, in June the Court of Chancery in In re Oracle Corp. Derivative Litigation held that dismissal of a derivative suit was not warranted where a special litigation committee of the board failed to meet its burden of demonstrating that its members were independent. In so doing, the court explained that a director's independence can be compromised by "personal or other relationships" and not only by economic factors.
General. It is probably a safe assumption that a reference to the Omnicare decision was made at some point during the negotiations of nearly every public company merger that has followed the release of the 87 page opinion and dissent on April 4, 2003. Phrases such as "locked-up," "fait accompli" and "force-the-vote," while familiar to M&A practitioners, have certainly gained in popularity since the decision. Although the practical effects of the opinion may not be material - the number of transactions involving a controlling stockholder group that is willing to irrevocably lock up the deal is small - the decision has nonetheless sparked controversy over whether a board should be subject to limits on its ability to take actions that it believes are in the best interests of stockholders at the time such actions are taken. Omnicare quite clearly stands for the proposition that there are some circumstances that, notwithstanding how informed and diligent a board is in its decision-making process, its actions cannot under any circumstances be permissible. Under Omnicare, these circumstances exist where the target's board agrees to enter into a merger agreement that requires the target to present the transaction to its shareholders and that does not give the target a right to terminate the merger agreement under any circumstances that involve a competing transaction, and at the same time the acquirer enters into a voting agreement with one or more stockholders of the target who collectively own enough target stock to ensure that the requisite approval of the transaction is obtained.
The Facts. Beginning in late 1999, NCS had been experiencing financial difficulties and had been exploring strategic alternatives, but by October 2000 NCS had received only one non-binding indication of interest. By 2001, the strategic alternatives included consideration of a pre-packaged bankruptcy and Omnicare, Inc. was invited by NCS to bid. Omnicare made a proposal in the summer of 2001, which was structured as an asset sale in bankruptcy and provided only a small recovery for the NCS subordinated noteholders and no recovery for the NCS stockholders - a structure and amount of consideration that NCS believed was inadequate. In early 2002, Genesis was invited to bid, and with NCS' operating performance then improving, the Genesis bid contemplated a stock-for-stock merger between the companies and a package of cash and stock to the holders of the NCS notes. Genesis had a prior history with Omnicare, losing a bidding war to Omnicare in a different transaction. This led Genesis to insist on exclusivity and, later in the negotiations, that the deal be supported by voting agreements of NCS stockholders representing in excess of the votes necessary to approve the transaction.
In late July 2002, Omnicare re-entered the scene with a new proposal that provided an attractive recovery for the NCS noteholders and an attractive recovery for the NCS stockholders pursuant to a cash merger. However, this proposal was conditioned upon Omnicare completing its due diligence of NCS. Concerns over the certainty of the Omnicare proposal in view of the due diligence condition and the risk of losing the Genesis offer led NCS to go back to Genesis and seek an improvement in terms, which NCS was successful in achieving. However, in return for improving the economics of its bid, Genesis stipulated that its bid would expire by midnight the following day if not accepted by NCS. The NCS board and independent negotiating committee met prior to the deadline imposed by Genesis and approved the proposed transaction with Genesis. According to the Delaware Supreme Court, the directors of the independent committee were fully informed of all material facts relating to the proposed transaction when they met to consider its approval, and the NCS board concluded that the uncertainty of Omnicare's last proposal balanced against the risk of losing the Genesis offer made that offer the only reasonable alternative for NCS. As such, the NCS board approved voting agreements with two major NCS stockholders who together held sufficient votes to approve the NCS/Genesis transaction, which, together with a "force-the-vote" provision in the merger agreement and no fiduciary right of termination for the NCS board, assured that the transaction would be approved by NCS stockholders.
In connection with Omnicare's subsequent lawsuit attempting to enjoin the NCS/Genesis merger, the Delaware Court of Chancery concluded that the business judgment rule, and not Revlon, applied to the NCS directors' actions because there was no sale of control (NCS already was controlled by a 65% voting block) and because NCS had abandoned previous auction efforts by the time it entered into negotiations with Genesis. The Chancery Court also applied the Unocal standard of judicial scrutiny, discussed below, holding that the NCS board had perceived a threat to the corporation - the potential loss of the Genesis deal - and had approved defensive merger agreement provisions that were not disproportionate to that threat or preclusive or coercive. As such, the Chancery court refused to invalidate the NCS board's actions in approving the merger agreement or enjoin the NCS stockholders meeting.
The Decision. In it analysis, the Delaware Supreme Court first stated that the lower court's decision to review the NCS board's actions in approving the NCS/Genesis transaction under the business judgment rule rather than under the Revlon standard was not outcome determinative and, as such, the Delaware Supreme Court assumed that the business judgment rule generally was applicable to the NCS board's decision. The Delaware Supreme Court also assumed that the NCS board exercised due care in connection with approving the NCS/Genesis transaction. The crux of the court's decision, however, involved the application of Unocal's enhanced scrutiny standard, which is implicated as a result of the presence of structural defenses contained in a merger agreement. Application of Unocal enhanced scrutiny of the board's actions addresses the "inherent conflicts between a board's interest in protecting a merger transaction it has approved, the stockholder's statutory right to make the final decision to either approve or not approve a merger, and the board's continuing responsibility to effectively exercise its fiduciary duties at all times after the merger agreement is executed." Under the Unocal standard, the board's actions must demonstrate that it had reasonable grounds for believing that a danger to the corporation and its stockholders existed if the transaction was not consummated. The board can satisfy this burden by demonstrating that it acted in good faith and after reasonable investigation, which is "materially enhanced" if the transaction is approved by a board consisting of a majority of outside directors or by an independent committee. If the board demonstrates that it had such reasonable grounds for perceiving a threat, then the focus shifts to a determination by the court of whether any defensive measures adopted by the board were reasonable in relation to that threat. The Delaware Supreme Court stated, however, that a court must first determine that those measures are not "preclusive or coercive" before making the proportionality determination.
In applying the Unocal standard, the Delaware Supreme Court determined that the NCS board had identified the possibility of losing the Genesis offer and being left with no comparable alternative transaction as a danger to NCS and its stockholders. To satisfy the second prong of the Unocal test, the NCS board was required to establish that the transaction deal protection measures adopted in response to the threat were not "coercive" or "preclusive" and that they were "within a 'range of reasonableness' to the threat perceived." In this case, the court concluded that the tripartite defenses approved by the NCS board - the "force-the-vote" provision, the controlling stockholders' voting agreements and the lack of a fiduciary right of termination for the NCS board - resulted in both a coercive and preclusive effect. In this regard, the court stated, "the record reflects that any stockholder vote would have been robbed of its effectiveness by the impermissible coercion that predetermined the outcome of the merger without regard to the merits of the Genesis transaction at the time the vote was scheduled to be taken." Quoting Paramount Communications Inc. v. QVC Network Inc., the court further concluded that "[t]o the extent that a [merger] contract, or a provision thereof, purports to require a board to act or not act in such a fashion as to limit the exercise of fiduciary duties, it is invalid and unenforceable." Accordingly, the court held that the NCS board did not have the authority to accede to the Genesis demand for an absolute lock-up of the transaction.
General. While Omnicare addressed the difficult issue of the limits of board power vis-Ã -vis the stockholders, at first glance Disney seems to tell us what we already know about board processes - that is, if directors abdicate their fiduciary responsibilities by failing to act in a diligent and informed manner, then their actions will fall outside of the protection of the business judgment rule. However, Disney stands for a much more important proposition and one that should cause directors to stand up and take notice: if directors are determined to have known that they were making material decisions without adequate information and without adequate deliberation, then they may also be found to have not acted honestly and in good faith to advance the best interests of the corporation. Actions not taken in good faith will, in turn, result in a loss of the protection of the business judgment rule and will fall outside of the liability waiver contained in the corporation's charter pursuant to Section 102(b)(7) of the Delaware General Corporation Law.
The Facts. Disney involved a $140 million severance package that Michael Orvitz received from the Disney Company pursuant to his employment agreement with Disney. The plaintiff stockholders alleged that Michael Eisner, the CEO of Disney and a close friend of Orvitz, hired Orvitz before discussing the merits of such a decision with Disney's board or compensation committee and over the objections of three of the directors. In fact, Eisner sent Orvitz a letter in August 1995 setting forth certain material terms of his proposed employment prior to any involvement by the Disney board or compensation committee. In addition, internal documents raised concerns over the number of stock options to be granted to Orvitz, warning that the proposed number was far beyond what could be viewed as normal and customary, and that a large signing bonus is hazardous because the company would bear the full cost of the bonus even if the executive did not serve the full term of employment. No discussions or presentations were made to the Disney board or compensation committee until September 26, 1995, when the committee approved the general terms of Orvitz's employment but did not condition their approval on being able to approve a final agreement. The facts alleged that the committee met for just under an hour, that the least amount of time was spent discussing the terms of the employment contract, that Irwin Russell (Eisner's personal attorney and a member of the committee) reviewed the employment terms with the committee and answered a few questions, and that the committee was not presented with a draft of the proposed employment agreement. The committee did receive a rough summary of the agreement, but according to the court, the summary was incomplete in that it did not state the exercise price for Orvitz's options. In addition, the committee did not receive any of the materials already produced by Disney regarding Orvitz's possible employment, no spreadsheet or other analytical document showing the potential payout to Orvitz under the proposed agreement or the potential cost of his severance package upon a no-fault termination was created for the benefit of or presented to the committee. The committee also did not receive any information regarding how the proposed terms of Orvitz's contract would compare to similar agreements in the entertainment industry. Finally, no compensation consultant or other similar professional was retained by the committee to advise it during the process.
Following the compensation committee meeting, the Disney board met on September 26, 1995. Neither Russell nor any expert made any presentation to the board, no documents were produced to the board for its review prior to the meeting regarding Orvitz's proposed employment terms, the board did not ask for any additional information and, according to the minutes, the board did not ask any questions regarding Orvitz's salary, stock options or possible termination. The board also did not consider any potential consequences of a termination of Orvitz's employment or the various payout scenarios. Nonetheless, the board approved the appointment of Orvitz as the president of Disney. Final negotiation of Orvitz's agreement was left to Eisner, Orvitz's close friend for over 25 years. Negotiations between Orvitz and Eisner continued through December 12, 1995, the date on which the parties entered into an employment agreement (which was backdated to October 1, 1995 - the date on which Orvitz began serving as Disney's president). The compensation committee had received a brief oral report in October 1995 concerning the status of the negotiations, but was not given a draft of the proposed employment agreement, did not seek any additional information about the negotiations or the proposed terms, and did not receive any input from a compensation consultant.
The final version of Orvitz's employment agreement differed significantly from the draft summarized for the compensation committee and the board in September and the compensation committee in October 1995. In this regard, the final agreement caused Orvitz's stock options to be "in-the-money" due to an 8% increase in the value of the Disney stock between October 16, 1995 and December 12, 1995, and provided Orvitz with no-fault termination so long as he did not act with gross negligence or malfeasance, rather than only if Disney wrongfully terminated him as provided in the earlier draft.
Orvitz's tenure with Disney did not last long and it became clear to both Eisner and Orvitz that Orvitz should leave Disney. However, Orvitz could not unilaterally terminate his employment agreement unless he was not elected or retained as president of Disney, he was assigned duties materially inconsistent with his role as president or Disney made certain reductions to his compensation, none of which had occurred. In addition, if Orvitz resigned outright, he would not have received the benefits under a no-fault termination. Thus, Orvitz turned to Eisner to obtain his no-fault termination benefits and Eisner gave Orvitz such benefits without any board or compensation committee approval. In fact, no documents or board minutes were produced showing an affirmative decision by Disney's board or compensation committee to grant Orvitz the no-fault termination or that any alternatives were considered.
The Decision. To survive the defendants' motion to dismiss, the Disney court stated that the plaintiffs were required to plead facts sufficient to raise (1) a reason to doubt that the action was taken honestly and in good faith or (2) a reason to doubt that the board was adequately informed in making the decision. Although the court stated that it is "appropriately hesitant to second-guess the business judgment of a disinterested and independent board of directors," the plaintiffs had alleged "facts that belie any assertion" that the directors "exercised any business judgment or made any good faith attempt to fulfill the fiduciary duties they owed to Disney and its shareholders." The court further stated that "[t]hese facts, if true, do more than portray directors who, in a negligent or grossly negligent manner, merely failed to inform themselves or to deliberate adequately about an issue of material importance to their corporation." Instead, the court explained, the facts alleged "suggest that the defendant directors consciously and intentionally disregarded their responsibilities, adopting a 'we don't care about the risks' attitude concerning a material corporate decision." Accordingly, the court concluded that the complaint sufficiently alleged a breach of the directors' obligation to act honestly and in good faith in the corporation's best interests, and that, if the facts in the compliant were true, the defendant directors' conduct fell outside the protection of the business judgment rule.
General. In Oracle, the Delaware Court of Chancery addressed the issue of director independence, expanding the scope of relevant relationships that could give rise to a lack of independence. Although it is easy to fall into the habit of examining the independence issue through an economic lense, Oracle demonstrates that the Delaware courts will now look at a much broader range of considerations that fall outside pure financial relationships. When viewed in the context of the corporate governance reforms initiated by The Sarbanes-Oxley Act of 2002, which, together with the related Securities and Exchange Commission and stock exchange initiatives, focus significantly upon director independence and board and committee process, it is not surprising that the Oracle decision falls in line with the ever increasing scrutiny over what it means to be truly disinterested.
The Facts. In Oracle, Oracle Corporation formed a special litigation committee to investigate allegations that certain Oracle directors - Larry Ellison (also Oracle's Chairman and CEO), Jeffrey Henley, Donald Lucas and Michael Boskin - engaged in insider trading while in possession of material, non-public information showing that Oracle would not meet earnings guidance. The Oracle board appointed two Oracle directors to the special litigation committee - Hector Garcia-Molina, Chairman of the Computer Science Department and a tenured Professor in the Electrical Engineering Department of Stanford University, and Joseph Grundfest, a tenured Professor of Law and Business of Stanford, a director of two programs at Stanford Law School, a former SEC commissioner, a graduate student of economics at Stanford, and a steering committee member and senior fellow of Stanford Institute for Economic Policy Research ("SIEPR").
The Oracle special litigation committee was given complete authority to determine whether Oracle should press the insider trading claims raised by the plaintiffs against the four defendant directors, settle the case or terminate it. No additional approval by the Oracle board was required. Garcia-Molina and Grundfest received a modest hourly rate of compensation for agreeing to serve on the Oracle special litigation committee, but also agreed to give up any special litigation committee-related compensation if it was deemed by the court to impair their impartiality. The committee also retained separate outside legal counsel and other experts to advise it, the independence of which was not challenged by the plaintiffs. According to the court, the committee's investigation "was, by any objective measure, extensive." The committee reviewed an enormous amount of paper and electronic records, interviewed 70 witnesses (some of them twice), and participated themselves in several key interviews, including the interviews of the four defendant directors and key management personnel who were responsible for projecting and monitoring Oracle's financial performance. The committee also asked the plaintiffs to identify witnesses that it should interview and interviewed all but one identified by the Federal class action plaintiffs (that witness refused to cooperate). During the course of the investigation, the special litigation committee met with its counsel 35 times for a total of 80 hours. The committee produced an 1,110 page report (excluding appendices and exhibits) concluding that Oracle should not pursue the plaintiffs' claims against the four director defendants.
The court noted its satisfaction that neither of the special litigation committee members was compromised by a fear that support for the procession of the plaintiffs' claims would "endanger his ability to make a nice living." The court also noted that both committee members were distinguished in their fields and highly respected, and that both had tenure at Stanford. In addition, no evidence had been produced showing that either of the committee members had any fundraising responsibilities at Stanford. However, it was with "some shock" that the court found several significant ties between Oracle or the four director defendants and Stanford University - the employer of both of the committee members Garcia-Molina and Grundfest - that were not disclosed in the committee's report but which emerged during discovery. The report disclosed only that director defendant Boskin was a Stanford professor, that the special litigation committee members were aware that director defendant Lucas had made certain donations to Stanford and that among the contributions made by Lucas was a donation of $50,000 worth of stock donated after Grundfest delivered a speech in response to Lucas' request at a venture capital fund meeting in which Lucas' son was a partner.
The additional significant ties between Oracle or the four director defendants and Stanford University that were not disclosed in the committee's report included: (1) Boskin is a Professor of Economics at Stanford and taught Grundfest when Grundfest was a Ph.D. candidate and, although the two do not socialize, they have remained in contact over the years, speaking occasionally about matters of public policy; they also are both senior fellows and steering committee members at SIEPR, the web site of which states that senior fellows actively participate in SIEPR research and participate in corporate governance; (2) Lucas is a Stanford alumnus, having obtained both his undergraduate and graduate degrees there; he is Chairman of a foundation created by his deceased brother, which has given $11.7 million to Stanford since its founding in 1981, including funding for the establishment of a magnetic resonance imaging center at Stanford that bears his brother's name; Lucas also has personally contributed $4.1 million to Stanford, including to SIEPR and Stanford Law School; he is the Chair of SIEPR's Advisory Board and the conference center at SIEPR's Stanford facility bears his name; and (3) Ellison is a "major figure in the community in which Stanford is located"; he is the sole director of the Ellison Medical Foundation, which has paid or pledged $10 million to Stanford; during the time at which Ellison has been CEO of Oracle, the company has made over $300,000 in donations to Stanford and has established a generously endowed educational foundation, with respect to which Stanford was given the right to name four of the foundation's seven directors; the same year in which Ellison made the trades that the plaintiffs contend were made on the basis of material, non-public information and the same year in which Garcia-Molina and Grundfest were asked to join the Oracle board, Ellison discussed with Stanford and SIEPR a donation of $170 million to fund an educational scholars program to be named the Ellison Scholars Program; Ellison considered donating his house - valued at over $100 million - to Stanford.
The Decision. The Oracle court held that the burden of proving independence was on the Oracle special litigation committee and that the committee failed to demonstrate that no material factual question existed regarding its independence. Quoting a 2001 Chancery Court decision, the court stated that "[t]he question of independence turns on whether a director is, for any substantial reason, incapable of making a decision with only the best interests of the corporation in mind." In answering this question, the court explained that a director must base his or her decision on the merits of the subject matter rather than "extraneous considerations or influences" and that a director may be "compromised if he his beholden to an interested person." Most importantly, the court stated that "[b]eholden in this sense does not mean just owing in the financial sense, it can also flow out of 'personal or other relationships' to the interested party." Accordingly, the Chancery Court in Oracle held that the ties between the special litigation committee, the four director defendants and Stanford were "so substantial that they cause reasonable doubt" about the committee's ability to "impartially consider" whether the director defendants should face suit.