02 October 2020

Court of Chancery Invokes Rarely Successful “Fraud-on-the-Board” Theory, Permitting Duty of Loyalty Claims to Proceed

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The Court of Chancery recently allowed to proceed post-closing claims that a merger was completed at an inadequate price, premised largely on allegations that the Company’s CEO and chairman was conflicted and tilted the process in favor of the buyer. This decision serves as a reminder for fiduciaries considering end stage transactions — including the Court’s reminder that “the sins of just one fiduciary can support a viable Revlon claim.”

In the Mindbody litigation, plaintiffs alleged that three company fiduciaries were motivated by personal ends to favor the ultimate buyer in the company’s merger. In so alleging, plaintiffs pled “Revlon” claims:  the Revlon doctrine requires that fiduciaries maximize the sale price in an end-stage transaction, though it grants them significant flexibility in determining how to achieve that objective. Plaintiffs alleged that the challenged fiduciaries tilted the transaction in favor of one bidder (the buyer), and the company’s board therefore breached its fiduciary duties.

Typically, a stockholder plaintiff can sustain a claim that directors breached their duty of loyalty only by adequately alleging that a majority of the pertinent board was conflicted. There are, however, exceptions. One is the so-called “fraud-on-the-board” theory, where a conflicted fiduciary fails to disclose material information to the board, meaning information “of a magnitude to be important to directors in carrying out their fiduciary duty of care in decisionmaking.” In practice, this is a two-step inquiry:  (i) were the alleged conflicts material to the pertinent fiduciary; and (ii) would other directors have viewed the information as material.

Vice Chancellor McCormick found that the plaintiffs adequately alleged that the company’s CEO: (i) had a material conflict; and (ii) did not disclose that conflict to the remainder of the Board. This was based on a number of factual allegations, including:

  • The CEO suggested that he preferred to not run a public company and wished to sell “to a private equity fund that would agree to employ him” post-deal;
  • He later personally received an expression of interest from the would-be buyer and facilitated calls to facilitate an “employee recruitment process” but “did not immediately disclose” the expression of interest to the board and told management to do the same;
  • He did not tell the board about his interactions with the would-be buyer; and
  • He “eliminated bidders for whom he did not wish to work from the sales and go-shop process.”

The Court found that “viewed collectively,” these allegations were adequate to support Plaintiffs’ fraud-on-the-board theory and withstand a motion to dismiss, notwithstanding the board’s other transaction-related efforts. These included the formation of a transaction committee, which the Court noted somewhat cut against plaintiffs’ claims, but its characteristics (including an initially limited mandate, unclear formation date, and its deference to the CEO) left the Court unconvinced that it sufficiently mitigated the CEO’s alleged conflict for purposes of this pleading-stage determination.

The Mindbody litigation is a reminder of the importance of candid board-level disclosure regarding the interests of those in an ongoing corporate sales process. This includes disclosure regarding director interactions with bidders and bankers, but also personal interests that could lead a director to make decisions while thinking of anything other than their mandate:  acting in the company’s best interests. Parties should err on the side of over-sharing, knowing that the disclosures may be judged in the harsh glare of hindsight.