As the Delaware Supreme Court narrows the avenues for post-closing challenges to mergers (see our discussions of the implications of the Corwin and Cornerstone decisions here, here, here and here), we expect that plaintiffs’ lawyers will increasingly seek to base their merger suits on specific allegations of conflicts that may have tainted the oversight of processes to sell companies in hopes of supporting claims for breaches of the duty of loyalty and the applicability of the enhanced scrutiny of the entire fairness doctrine. Given that virtually every merger includes some special merger benefits for directors that may be susceptible to an attempt at such a claim, it is timely that the Delaware Court of Chancery issued a decision over the summer of 2016 that provides useful guidance on how to evaluate the most common of special merger benefits to insiders: protection against exposure to pre-merger claims.
Merger agreements regularly protect the directors and officers of target corporations from pre-merger claims through assurances of indemnification, expense advancement, and insurance coverage. Although these protections constitute a special benefit for these insiders that is not shared with the other stockholders, they are not generally viewed as grounds for claims of disabling conflicts. These merger agreement benefits are typically redundant assurances to comply with pre-existing, ordinary course commitments to these insiders and therefore, except for the incremental outlay for the customary purchase of a six-year D&O tail policy, do not increase costs. Moreover, while the D&O tail policy to cover the outgoing target directors is an incremental transaction cost, the amount is usually immaterial and insufficient to support a claim that this payout somehow diverted money that would otherwise have been allocated in the course of negotiations to the merger consideration to the stockholders. Perhaps most importantly, the deference to a merger agreement’s grant of these benefits to a target’s directors and officers is grounded in the reasonableness of such protection as a quid pro quo for taking on the high-pressure position of navigating a public company through a sale process. Without the customary granting of these benefits in merger agreements, the attraction of qualified individuals to serve as fiduciaries for public companies contemplating strategic alternatives would be difficult.
Nonetheless, there are scenarios where directors of target corporations should be concerned that obtaining these types of benefits for themselves in a merger agreement creates a disabling conflict for which they may have personal liability. In July 2016, in the case of In re Riverstone National, the Court of Chancery addressed this question of whether a merger agreement’s insulation of the target corporation’s directors from the risk of pre-merger claims may taint the merger with a problematic conflict. The plaintiff stockholders were suing the target corporation’s directors after the closing of the merger for damages based on their adoption of a merger agreement that included a commitment by the acquiror to assure that the target company would not assert potential claims against these directors for usurpation of corporate opportunities prior to the closing. The claim rested on allegations that this protection diminished the value of the target company to the acquiror (since the right to assert successfully these corporate opportunity claims against these directors was an asset that may have resulted in cash proceeds) and therefore had the effect of diverting value to the directors that would otherwise have been allocated to the merger consideration.
Although the Court denied the defendants’ motion to dismiss the claim that the inclusion of these provisions in the merger agreement constituted a breach of the directors’ duty of loyalty, the Court felt it important to articulate a standard to prevent opening the floodgates to these types of lawsuits. After all, some type of protection of target corporation directors from pre-merger claims is pervasive in merger agreements.
The criteria for a viable claim that directors violated their duties of loyalty based on their adoption of a merger agreement that includes contractual provisions that have the effect of protecting these directors against exposures to pre-merger claims, as explained by the Court, were as follows:
- The personal benefit to the directors must be real, as opposed to highly contingent. Thus, the potential claim from which the directors are being protected by the merger agreement must not be hypothetical claims, but ones that appear to be claims that would have survived motions to dismiss by the defendant directors;
- At the time of the negotiation of the merger agreement, the defendant directors benefitting from these merger agreement provisions must be aware of both these imminent exposures to pre-merger claims and the beneficial provisions in the merger agreement; and
- The potential liability against which these director are being insulated must be of a magnitude that is material to the directors in question.
The Court held that the complaint included specific allegations that satisfied each of these three criteria.
Although these three criteria laid out by the Court in Riverstone National will be helpful in guiding boards on what types of protections for directors are acceptable in merger agreements, there is another distinguishing element of the merger agreement provisions at issue in Riverstone National that is worthy of consideration by boards going forward. The claim against which the merger agreement protects these directors is usurpation of a corporate opportunity which constitutes a breach of the duty of loyalty and therefore is a type of claim that is beyond the scope of claims with respect to which corporate law permits a corporation to grant its directors exculpation or indemnification (although Delaware permits advance waivers of corporate opportunities, Riverstone National makes no mention of the possibility of an advance waiver; rather the issue is the attempt at after-the-fact insulation from the claim by virtue of the merger agreement). Although the record is unclear, it appears that the merger agreement attempted to get around this limitation by having a third party, the acquiror, agree to grant this broad protection to the directors. By contrast, the typical merger agreement provides only for the target corporation, or for the acquiror to cause the target corporation, to protect the directors from pre-merger claims. Accordingly, these more typical contractual protections of the target directors, since they are to be implemented by acts of the target corporation rather than the third party acquiror, are subject to the corporate law limitations against a corporation’s protecting its own fiduciaries from liability for breaches of the duty of loyalty.
Indeed, when reviewing the CVS/Caremark merger in 2007, the Court expressed dismay with a similar negotiation by a target board of an enhanced version of the typical pre-closing claim protections. The Caremark/CVS merger agreement contained what the Court of Chancery characterized as an attempt at an end-run around the provisions of corporate law that prevent a corporation from indemnifying its own directors and officers for breaches of the duty of loyalty and other failures to act in good faith, as opposed to breaches of the duty of care in the absence of bad faith. If CVS, as the merger acquiror, had simply agreed to cause Caremark to continue to indemnify Caremark’s current and former directors and officers after closing for pre-closing claims, then these corporate law limitations would have continued to apply. But the undertaking in the merger agreement required CVS, a third party, to provide a direct indemnity to these directors and officers of Caremark. This creation of a contractual indemnification right from a third party (CVS) would not necessarily be subject to the legal limitations applicable when Caremark is indemnifying its own fiduciaries. This end-run was particularly provocative given the backdrop of pending option-backdating claims against Caremark’s insiders that were potentially of the same type that the Court of Chancery had held earlier would, if proven, constitute violations of the duty of loyalty and therefore leave the defendant directors without the benefits of indemnification by their own corporation. Nevertheless, although the Court had nothing but words of concern for these provisions in the CVS-Caremark merger agreement, the case involved solely a motion to enjoin the Caremark stockholders meeting, which the Court refused to do as a result of the adequate disclosure about these troublesome contractual provisions. The CVS/Caremark case thus never reached the question, taken up in Riverstone National this past summer, of whether there had been a breach of the duty of loyalty by the target directors that would support a post-merger damages remedy.
Given the plaintiffs bar’s heightened focus on conflicts allegations as a means to overcome motions to dismiss claims against target directors premised on merger agreements, the boards of target corporations, when reviewing the protections they are granting themselves when adopting merger agreements, should pay attention to not only the guidance of Riverstone National, but also the arguable legacy of the CVS/Caremark opinion in the Riverstone National decision.