Corwin Cleanse Clarified: Key Lessons for Interested Directors
Since Corwin v. KKR Financial Holdings LLC, Delaware courts have adhered to the proposition that “when a transaction not subject to the entire fairness standard is approved by a fully informed, uncoerced vote of the disinterested stockholders, the business judgment rule applies.” However, The Delaware Court of Chancery recently issued an opinion (available here) clarifying the application of Corwin to the fiduciary duties of interested directors. The Court declined to dismiss a complaint alleging that the defendant directors’ approval of a merger was a breach of the directors’ duty of loyalty and constituted unjust enrichment. Specifically, the Court rejected the defendant directors’ contention that Corwin “cleansed” the transaction, and, as a consequence, explained that a duty of loyalty analysis was still appropriate. In what follows, we describe this case and offer some important takeaways concerning interested directors.
Key Factual Background
In May 2020, the board of directors of WinView, Inc. closed a merger whereby WinView merged with a wholly owned subsidiary of a Canadian company to create a new entity, Engine Media Holdings, Inc. Following the consummation of the merger, several stockholders sued, claiming that the named directors breached their fiduciary duties to the company and its shareholders and were unjustly enriched as a result.
Prior to the merger, several directors had received incentive awards and securities in connection with a series of debt and equity financings. The progression of these financings resulted in the named directors being both secured creditors and preferred stockholders. This created a potential conflict of interest, as the contemplated merger treated WinView’s common stockholders differently from secured creditors and preferred stockholders.
The merger agreement eliminated WinView’s common stock. Instead, the contemplated capital structure tied common stockholders’ compensation to the success of patent lawsuits and afforded the new entity, Engine Media, the authority to take “reasonable efforts” to monetize the company’s existing patent portfolio. As a result, one shareholder plaintiff sent a letter to the board opining that the company’s own pursuit of patent litigation was a better alternative to consummating the merger. The letter also highlighted the director defendants’ conflicts of interest as dual stakeholders, noting that the director defendants had threatened to foreclose on the company’s patents as secured creditors to gain leverage. The plaintiffs’ complaint alleged that one of the named directors had interfered with attempts to secure financing to pursue patent litigation, as had been previously suggested.
On March 11, 2020, the merger was approved by WinView’s board of directors without having commissioned a fairness opinion or retained outside advisors to evaluate the treatment of various classes of stock under different options. As both secured creditors and preferred stockholders, the named directors received $13.8 million (of WinView’s $35 million valuation) in stock.
Reliance on Corwin
In their defense, the named directors relied on Corwin, asking the Delaware Court of Chancery to dismiss the complaint because the merger had been “approved by a fully informed, uncoerced vote of the disinterested stockholders” and thus claiming that the business judgment rule shielded them from any fiduciary liability. The Court explained that the rationale underlying the business judgment rule, and Corwin, is that the court “should acquiesce to the judgment expressed by a majority of unconflicted shareholders.” However, the Court clarified that the vote of a majority of stockholders may be effective to approve the merger in such cases, but that review of the merger “under traditional principals [sic] of fiduciary duty” shall nevertheless proceed. Having found that the stockholder plaintiffs had adequately pled claims of breach of fiduciary duty and unjust enrichment, the Court denied the director defendants’ motion to dismiss in relevant part.
The Delaware Court of Chancery’s reaction to the named defendants’ arguments offers valuable insights into the treatment of fiduciary duty claims involving interested directors.
- Excluding an interested director from the vote may not be enough if the director negotiated the transaction. The board of directors had formed a Special Committee to negotiate the merger and excluded one interested director from the committee. Despite this, however, the plaintiffs alleged that the excluded director had personally negotiated a binding term sheet for the merger. The Court explained that “Delaware law does not allow directors who negotiated a transaction to specifically shield themselves from any exposure to liability by deliberately absenting themselves from the directors’ meeting at which the proposal is to be voted on.”
- Potential conflicts may exist when directors are also creditors. As in this case, special issues arise when directors are also creditors, but the duty of loyalty “does not require self-sacrifice.” The Delaware Court of Chancery’s opinion suggested that a key consideration is whether a director’s actions go beyond the mere exercise of her rights as a creditor and extend into “unfairness” territory. While this suggests that a director’s dual position as shareholder and creditor is not fatal, an enhanced financial stake could be looked at with heightened scrutiny.