Corporate law - interested board of director's termination of sales process subject to entire fairness review - Gantler v. Stephens.

• Author: Gambale, Richard A.

Corporate Law--Interested Board of Director's Termination of Sales Process Subject to Entire Fairness Review--Gantler v. Stephens, 965 A.2d 695 (Del. 2009)

Although Delaware statutory law entrusts a corporation's board of directors with the power to manage the corporation's business and affairs, fiduciary duties severely circumscribe the authority allocated to the board. (1) Such duties are essential to safeguard the shareholders' equity stake from opportunistic board behavior, for although shareholders are statutorily empowered to replace self-serving directors, widespread dispersion of ownership may effectively usurp such control of the corporate enterprise. (2) In Gantler v. Stephens, (3) the Supreme Court of Delaware considered whether the business judgment rule protected a board's decision to reject a merger proposal and abandon a sale of the company. (4) Under the unique facts presented, the court held that because a majority of the board had breached its duty of loyalty to shareholders, the court would not apply the business judgment rule, but rather would determine the objective fairness of the board's actions. (5)

In August 2004, the First Niles board of directors authorized management to conduct a sale of the company for the alleged purpose of reducing expenses imposed incident to reporting requirements under the Securities Exchange Act. (6) At that time, the board consisted of five members: Stephens, Kramer, Eddy, Zuzolo, and Gantler. (7) In addition to serving on the board, Kramer and Zuzolo dealt with First Niles in other capacities; specifically, Kramer's company provided heating and air conditioning services to the Bank, while Zuzolo provided legal and title services through his law firm and real estate title company. (8) By December 2004, three bidders for First Niles emerged: Farmers National Banc Corporation (Farmers), Cortland Bancorp (Cortland), and First Place Financial Corporation (First Place). (9) On January 18, 2005, the board instructed First Niles's officers, including Stephens, to pursue the Cortland and First Place offers. (10)

Cortland requested due diligence materials and scheduled a due diligence session for February 6, 2005. (11) When Stephens failed to provide the documents, however, Cortland cancelled the meeting and set a February 8, 2005 deadline for submission of the due diligence materials. (12) On February 10, 2005, with First Niles failing to meet its suitor's deadline, Cortland withdrew its offer. (13) First Place submitted its due diligence request on February 7, 2005, and while Stephens initially resisted, he scheduled a meeting once Cortland withdrew its offer. (14) At a special board meeting on March 9, 2005, the directors effectively terminated the sales process by voting four to one to reject First Place's revised offer without any discussion regarding its merits. (15)

Six First Niles shareholders brought suit, alleging in relevant part that the First Niles board breached its fiduciary duties by rejecting the First Place merger offer and abandoning the sales process. (16) The defendant directors moved to dismiss on the grounds that the plaintiffs failed to rebut the protection afforded to the board by the business judgment rule. (17) Finding heightened judicial scrutiny inappropriate under Unocal v. Mesa Petroleum Co., (18) the Court of Chancery of Delaware applied the business judgment rule to the defendant directors' decision to reject the First Place offer and terminate the sales process. (19) Further, because the plaintiffs did not allege sufficient facts demonstrating a breach of the duty of loyalty (or the duty of care), they had not overcome the presumption that the directors held an honest belief that they acted in the best interests of the corporation and its shareholders. (20) Specifically, with regards to the duty of loyalty, the court cited three reasons in support of its conclusion: first, the fair price prong of the entire fairness test would be difficult to apply where no transaction had occurred; second, it would be doctrinally inconsistent to apply a more stringent standard of review (entire fairness) to board action "arguably less intrusive on shareholder interests" than defensive action taken in a hostile takeover attempt (subject to Unocal's less exacting proportionality test); and third, because in the absence of extraordinary entrenchment allegations, a board's decision not to undertake a merger is protected by the business judgment rule. (21) The Supreme Court of Delaware rejected the Court of Chancery's three-pronged rationale and reversed, holding that the plaintiffs rebutted the business judgment rule, thereby establishing entire fairness as the governing judicial standard of review, because disloyalty tainted the directors' rejection of the First Place bid and abandonment of the sales process. (22)

In Aronson v. Lewis, (23) the Supreme Court of Delaware anointed the business judgment rule as the governing standard in ascertaining the propriety of board action. (24) When the business judgment rule applies, it creates "a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." (25) Thus, unless the party challenging a board's decision demonstrates that it violated the duty of loyalty or the duty of care, the court will not substitute its business judgment for that of the directors if the board's decision can be attributed to any "rational business purpose." (26) When applying the duty of loyalty, courts generally seek to establish whether directors, because of a conflict of interest, deprived the corporation of an economic benefit or otherwise dealt with the corporation in an unfair manner. (27) In determining whether directors violated the duty of care, a court must determine whether the board acted in a grossly negligent manner (i.e., whether the board made an informed decision). (28)

In potential change of control transactions, an incumbent board faces a substantial obstacle before a reviewing court will apply the business judgment rule, which effectively shields directors from personal liability. (29) Because of the "omnipresent specter" that self-interest may dominate the board's decision to oppose an unsolicited offer for corporate control, the business judgment rule only applies if the board possesses a reasonable belief that the offer poses a threat to corporate policy and effectiveness, and the board's response is objectively reasonable in relation to the threat posed. (30) Delaware courts have only applied Unocal, however, when directors have taken defensive action in response to a presently existing external takeover threat or in an environment with an increased danger of hostile takeover. (31)

Generally, Delaware courts have applied the business judgment rule when a board rejected an offer to merge. (32) Application of the business judgment rule to the board's unilateral decision to decline a merger is principally based on the board's statutory ability to propose a merger. (33) Furthermore, such an approach recognizes that the decision not to merge is typically motivated by corporate concerns, as mergers may decrease shareholder wealth by increasing the target's debt and compromising the corporation's long term share value. (34)

In Gantler v. Stephens, the Supreme Court of Delaware first addressed the propriety of applying heightened judicial scrutiny under Unocal to the First Niles board's rejection of the First Place merger proposal and termination of the sales process. (35) The court held Unocal inapposite because the board, in taking such action, did not respond defensively to an external threat. (36) In other words, the record did not disclose a hostile bidder's attempt to gain control by making an unsolicited tender offer to shareholders; rather, the board actively sought out bidders, who in turn submitted their offers to the company. (37) Thus, as the board faced no external threat, the court refused to construe the board's rejection of the merger offer and abandonment of the company's sale as a "defensive measure" under Unocal. (38)

Although a court's failure to invoke the Unocal standard of review in the context of a change of control transaction almost always results in judicial validation of the board's action under the business judgment rule, the Supreme Court of Delaware applied entire fairness review after a searching inquiry into the conflicts facing those board members who opposed continuing the sales process. (39) In response to the plaintiffs' argument that the court should scrutinize the underlying transactions for entire fairness solely because the board may have acted to preserve their positions, the court warned that such an approach would sweep too broadly by calling into question every merger rejection and effectively precluding the board from acting in the best interests of shareholders. (40) Therefore, the court deemed such an entrenchment motive alone insufficient to trigger review under the entire fairness standard; rather, the plaintiffs would have to show additional facts demonstrating that a majority of the board acted disloyally. (41) In concluding that Stephens violated his duty of loyalty to the shareholders, the court looked to the manner in which Stephens conducted the sales process: he not only failed to respond to Cortland's initial due diligence request, causing Cortland to withdraw its bid, but also he initially resisted First Place's attempts at conducting due diligence. (42) Kramer and Zuzolo were also conflicted because they risked losing the Bank as a major client of their personal businesses if they voted in favor of a change of control transaction: Kramer, a man of "comparatively modest means," provided heating and air conditioning to the Bank while Zuzolo regularly rendered legal and title services. (43) Thus, by...