Special committees in Delaware have an important role for cleansing various kinds of conflicted transactions, everything from negotiating controlling shareholder deals to vetting derivative lawsuits.  There is no rule regarding committee size; the Board can populate a committee with as many or as few people as it wants.

That said, Delaware caselaw suggests that courts will be somewhat suspicious of special committees consisting of only one member.  That member must be “’like Caesar’s wife… above reproach.” Gesoff v. IIC Industries, 902 A.2d 1130 (Del. Ch. 2006).  In Gesoff, VC Lamb stated that a single member special committee would get “a higher level of scrutiny,” and noted that in that case, the special committee member deferred too much to a controlling shareholder – something that might not have happened if a “moderating influence,” via a second member, had been available.

Since then, however, a couple of decisions have blessed the actions of single-member special committees.

And then came the Delaware Supreme Court’s decision in In re Match Group Derivative Litigation, which held that – at least when a corporation attempts to cleanse a controlling shareholder transaction – all special committee members, and not just a majority of them, must be independent.

Which raises the question: in controlling shareholder situations, should boards create committees of one?

Independence is assessed after the fact, and especially in recent years – as the Delaware courts have become more nuanced in their analysis – it’s not always obvious who will count as independent after the fact.  The more members you add to a committee, the more chance that, later, a court will determine one of them was not independent.

And though there’s a lot of language in Delaware opinions about gimlet eyes being cast on single-member committees, it’s not exactly clear what the discount rate is.

Anyway, this is obviously an issue in Tornetta v. Musk; there, the “ratification” procedure involved a committee of one, and it’s not clear how Chancellor McCormick will approach the matter.  There are a lot of different directions she could go – she could say that ratification simply isn’t possible, she could say that Musk was only a controlling shareholder for the purposes of the original package and not for the ratification, or anywhere in between.  But Tornetta is an unusual situation in a lot of ways; I’m wondering what the calculus will be going forward for more traditional transactions.

In an opinion released earlier today, Judge Kernodle of the Eastern District of Texas has stayed the rule from going into effect.  

Although I have not had time to sit and digest it at length, Chevron‘s demise plays a significant role.  Consider this passage:

In reviewing agency action under the APA, “[c]ourts must exercise their independent judgment in deciding whether an agency has acted within its statutory authority” and should “set aside any [] action inconsistent with the law as they interpret it.” Loper Bright, 144 S. Ct. at 2261, 2273; see also Chamber, 885 F.3d at 369 (“A regulator’s authority is constrained by the authority that Congress delegated it by statute.”). A court should no longer defer to an agency’s interpretation of a statute but should decide for itself “whether the law means what the agency says.” Loper Bright, 144 S. Ct. at 2261 (overruling Chevron U.S.A. Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984)).

The Court thus owes no deference to DOL’s interpretation of ERISA, but rather “begins with the text” of the statute—as all courts do. E.g., Ross v. Blake, 578 U.S. 632, 638 (2016); United States v. Lauderdale Cnty., 914 F.3d 960, 961 (5th Cir. 2019); see also Conn. Nat’l Bank v. Germain, 503 U.S. 249, 253–54 (1992) (“[A] legislature says in a statute what it means and means in a statute what it says there.”). In doing so, the Court applies the “fundamental canon of statutory construction” that the words “should be interpreted as taking their ordinary meaning at the time Congress enacted the statute.” E.g., New Prime Inc. v. Oliveira, 586 U.S. 105, 113 (2019) (cleaned up); see also ANTONIN SCALIA & BRYAN A. GARNER, READING LAW: THE INTERPRETATION OF LEGAL TEXTS 69–77 (2012) (“The ordinarymeaning rule is the most fundamental semantic rule of interpretation.”); Loper Bright, 144 S. Ct. at 2266 (“[E]very statute’s meaning is fixed at the time of enactment.” (quoting Wis. Cent. Ltd. v. United States, 585 U.S. 274, 284 (2018))). The Court, moreover, must examine “the language and design of the statute as a whole.” E.g., K Mart Corp. v. Cartier, Inc., 486 U.S. 281, 291 (1988); see also Bustamante-Barrera v. Gonzales, 447 F.3d 388, 397 (5th Cir. 2006) (Courts “must read the statute as a whole, so as to give effect to each of its provisions without rendering any language superfluous.”).

This text could be cut and pasted into almost any decision reviewing an agency’s rule.

The opinion also rejects the idea that people giving their life’s savings to a financial adviser actually do indeed trust the adviser.  It follows the 5th Circuit to say that these relationships, unless ongoing, are simple ordinary arms-lengths market transactions.  It also finds that any adviser getting a commission cannot be a fiduciary. 

In November 2021, Hertz authorized a buyback of its stock.  The effect of the buyback to was transform CK Amarillo from a 39% stockholder – who also had board seats – into a 56% stockholder.

Public stockholders of Hertz sued, alleging that the Hertz directors violated their fiduciary duties by transferring control of Hertz to CK Amarillo, without requiring that CK Amarillo pay a control premium.

One critical question was: Is this claim direct or derivative?

Normally, claims arising out of stock buybacks are derivative claims.  And normally, when a stockholder continues to hold shares in the entity, and nothing has changed about those share characteristics, and the stockholder was not asked to vote on anything, claims arising out of corporate action are derivative.  And just recently, the Delaware Supreme Court decided Brookfield Asset Management, Inc. v. Rosson, 261 A.3d 1251 (Del. 2021), where it held that if a company sells new shares to a controlling stockholder on the cheap, the claim is derivative, not direct – overruling Gentile v. Rossette, 906 A.2d 91 99 (Del. 2006), which held the claim is both.

But, as I argued in my paper, The Three Faces of Control, Brookfield also implied that claims would in fact be direct if the corporate action caused someone who wasn’t a controller to become one, or if the corporate action gave new control rights to someone who hadn’t had them before.  I wrote:

This appears to have been a rather backhanded way of holding that, if an equity issuance did result in a shift from an uncontrolled status to a controlled one, shareholders would be permitted to bring claims for breach of fiduciary duty directly, rather than derivatively….

Additionally, the Brookfield court also seemed to have endorsed the notion that equity issuances might give rise to direct claims even if they did not result in the creation of a new controlling shareholder, so long as they ended up redistributing specific control rights away from the public shareholders

On June 20, in a bench ruling in Cascia v. Farmer, 2023-0520, Chancellor McCormick preliminarily agreed, holding that the plaintiffs could sue both directly and derivatively.  She stated that she might revisit matters later in the case, but for the purposes of a motion to dismiss:

Brookfield appeared to leave open the possibility that a transfer of control might give rise to dual-natured claims. The Court expressly stated in Brookfield that Gentile was overruled only “[t]o the extent the corporation’s issuance of equity does not result in a shift in control from a diversified group of public equity holders to a controlling interest.”

The high court also noted, again, that there was no “practical need for the Gentile carve-out” in part because other legal theories “provide a basis for a direct claim for stockholders to address fiduciary duty violations in a change of control context.” Here, plaintiff’s case is about the harm resulting from a change of control….

Look, I recognize that this is a clarification of Brookfield that I don’t know that our Court has given before. And at base, I’m unwilling to reach a definitive ruling on this factual and legal issue at the pleading stage.  But you-all will have litigation ahead and many opportunities to convince me otherwise. At this stage, given the pleading-friendly standard we apply to plaintiffs, I’m denying the motion to dismiss the direct claims ….

So, obviously, I think this is the correct decision, but in the wake of SB 313, it’s more than that.

Suppose a board hands new control rights to someone via the use of a stockholder agreement. Under my interpretation of Brookfield, which Chancellor McCormick has now tentatively endorsed at least in part, challenges to that action may, at least on some occasions, be brought directly rather than derivatively. And it will be interesting to watch courts untangle when the rights are significant enough to be one or the other.

This is my second blog post this week because I am procrastinating.

Anyway, a while back I blogged about Kellner v. AIM Immunotech, where VC Will invalidated certain advance notice bylaws that had been amended in the middle of a heated proxy contest.  The difficulty was that the case was heard on an expedited basis, in advance of the shareholder meeting, so that Will could determine if the dissident’s nominees could stand for election.  And the dissident was … not great.  The campaign had been orchestrated by a convicted felon who tried to hide his involvement, and the dissident had submitted some false information in response to the bylaw requests.  At the same time, though, the bylaws had been adopted as a blocking mechanism, and some were unintelligible.  

In that context, Will held that four of the amended bylaws failed enhanced scrutiny, but two could stand.  She concluded that the board had acted with a proper purpose – to obtain information so that it could fairly evaluate a director-nominee – but that several of the onerous bylaw amendments were disproportionate to the threat posed.  With respect to one bylaw, which was unreasonably broad, Will blue penciled it back to the original, pre-amendment version and held that the dissident had failed to comply with it.  For that reason, as well as some less important instances of false information submitted in connection with the remaining bylaws, she held that the dissident’s nominees could not be considered at the meeting.

On appeal, the Delaware Supreme Court took a different approach and reversed Will’s factual findings while denying that it had reversed her factual findings.

First, the Delaware Supreme Court held (and we should all take note of this for future cases) that advance notice bylaws may be evaluated for invalidity, and separately for inequity.  A validity challenge is a facial challenge, and relatively narrow: quoting ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), the Court held “A facially valid bylaw is one that is authorized by the Delaware General Corporation Law (DGCL), consistent with the corporation’s certificate of incorporation, and not otherwise prohibited.”  The fact that it might operate inequitably or unlawfully in some circumstances is not sufficient to render the bylaw invalid.

On that analysis, the Court found that one amended AIM bylaw was invalid, because it was unintelligible: “The bylaw, with its thirteen discrete parts, is excessively long, contains vague terms, and imposes virtually endless requirements on a stockholder seeking to nominate directors….An unintelligible bylaw is invalid under ‘any circumstances.'”

The other bylaws, however, were found to be facially valid.  But, they still had to be “twice-tested” in equity.  And that test is the enhanced scrutiny test, as articulated in Coster v. UIP Companies, 300 A.3d 656 (Del. 2023).  First, the board must identify a threat and act in good faith; second, the board’s response must be proportional.

In this case, the Court found that the totality of the amended bylaws – which were exceptionally broad, required information potentially unknown to the nominee, were ambiguous, unreasonable, and ultimately at odds with the board’s stated purpose of information-collection – suggested that the board did not, in fact, act with a proper purpose when amending them.  Instead, the purpose was to block the dissident entirely.  When it comes to proxy contests, boards may try to inform stockholders, but they can’t substitute their own judgment for the stockholder vote; therefore, all of the bylaws (including the two that Will did not find to be unreasonable) had to be stricken.  They were all fundamentally tainted by the board’s bad faith:

In the middle of a proxy contest, the AIM board adopted one unintelligible bylaw and three unreasonable bylaws. It then used the Amended Bylaws to reject Kellner’s nomination notice…The unreasonable demands of most of the Amended Bylaws show that the AIM board’s motive was not to counter the threat of an uninformed vote. Rather, the board’s primary purpose was to interfere with Kellner’s nomination notice, reject his nominees, and maintain control. As the product of an improper motive and purpose, which constitutes a breach of the duty of loyalty, all the Amended Bylaws at issue in this appeal are inequitable and therefore unenforceable.

So what’s funny here is that the Court claims it’s relying on Will’s own factual findings – she was the one who found the bylaws unreasonable, she was the one who dropped stray comments like “The provision seems designed to preclude a proxy contest for no good reason,” which the Delaware Supreme Court repeatedly quoted – to conclude the board acted with an improper purpose.  But that absolutely was not what Will found, after trial!  She explicitly held the opposite:

AIM’s Board had an objective of obtaining transparency from a stockholder seeking to nominate director candidates…The Board made a reasonable assessment, in reliance on the advice of counsel, that this information-gathering objective was threatened…the Board sought to prevent “the types of manipulative, misleading, and improper conduct” experienced in 2022 from happening again…..

The Board has proven that its actions served proper corporate objectives.  Specifically, it sought to obtain full and fair disclosure so that it could adequately evaluate a nomination and that stockholders could cast informed votes….

Anyway. That part is just drama.

The substantive issue is this: Remember Will’s dilemma.  Both sides had behaved badly.  If the bylaws were struck entirely, the corporation would be unprotected against a lying bad faith actor.  That’s why she felt the need to blue-pencil one bylaw, by restoring an older version, and measure the dissident’s compliance against that bylaw.  Which struck me as a very odd solution, and I wondered how the Delaware Supreme Court would address the problem.

The Delaware Supreme Court, however, did not address the problem.  It was not acting in the middle of a proxy contest; by the time of the appeal, the shareholder meeting was over.  So, in light of the fact that Will had found the dissident behaved badly, the Delaware Supreme Court simply said no further relief was warranted:

We also note that, according to the Court of Chancery, Kellner submitted false and misleading responses to some of the requests.  Given the court’s countervailing findings about Kellner’s and his nominees’ deceptive conduct, no further action is warranted. The judgment of the Court of Chancery is affirmed in part and reversed in part. The case is closed.

Okay … nothing needs to be done because there’s no proxy contest anymore.  But what about in future Kellners?  What do you do when both sides behave badly?

Well, the Court says that if the Board acts for a proper purpose, but is overly aggressive, then Chancery can choose to enforce parts of bylaws as equity demands:

if the bylaws were adopted for a proper purpose but some of the advance notice provisions were disproportionate to the threat posed and preclusive, the Court of Chancery has the discretion to decide whether to enforce, in whole or in part, the bylaws that can be applied equitably

…. it may be necessary to assess how bylaws work together, but one problematic bylaw does not invalidate others when the board has a proper motive. Overbroad invalidation would be extreme and unnecessary when the board acted with proper motive to protect a legitimate corporate interest. 

That discretion does not seem to apply, though, if the Board is not acting for a proper purpose, i.e., when it’s simply trying to block a dissident – even if the dissident really is a for real threat, in the ordinary (criminal) sense of the word.  Then, the lack of a proper purpose seems to mean defenses, including advance notice bylaws, can’t be employed, and stockholder protection is left solely to … I guess (yikes) the federal securities laws.

Anyway, the takeaways then are: (1) improper purpose will completely kill a defensive strategy, with no room for courts to uphold the strategy in part, and (2) the fact of improper purpose can be inferred from nature of the strategy itself.  This plays out very differently in proxy contests than in tender offers, of course; in tender offers, the desire to block the offeror is not an improper purpose; in the context of proxy contests, blocking a dissident from running the contest (as opposed to educating shareholders), is off the table.