Earlier this month, Vice Chancellor Morgan T. Zurn of the Delaware Court of Chancery issued a decision regarding an unsettled question of Delaware corporate law: whether an uncoerced and fully informed vote of disinterested stockholders may ratify and defeat a post-close claim seeking to enjoin certain governance measures and alleged entrenchment devices negotiated by a company’s board as part of a transaction. The court concluded that such a vote, known commonly as “Corwin cleansing,” does not apply to post-close claims for injunctive relief under Unocal Corp. v. Mesa Petroleum Co. The court’s decision, at least for now, will have immediate significance for company boards and their advisors when negotiating transactions or stockholder agreements that include measures that may be characterized as defensive or entrenching existing management or directors.
Limelight Network, Inc. (“Limelight”), a public company that provides network service for digital media content and software, had missed its earnings forecasts and underperformed relative to analysts’ estimates since July 2020, when its stock had reached an all-time high. Despite efforts to turn around the business, Limelight’s performance continued to slide and market commentators speculated Limelight might be targeted by activist investors.
In 2022, Limelight entered into a stock-for-stock transaction with the owners of Edgecast, Inc. (“Edgecast”), to create Edgio, Inc. (“Edgio”). The purchase agreement contemplated Limelight’s issuance of $300 million of its stock — a 35% ownership stake — to College Parent, L.P., Edgecast’s parent company, and, pursuant to a stockholders’ agreement, College Parent was permitted to fill three of nine Board seats. In addition, College Parent agreed to: (i) vote in favor of Board recommendations regarding director nominations and against nominees not recommended by the Board; (ii) vote in favor of the Board’s recommendation, or pro rata with all other stockholders, for non-routine matters requiring a stockholder vote; (iii) refrain for two years from transferring its newly acquired shares unless the Board approved the transfer or if such transfer was made in connection with a third-party tender offer, business combination, or other similar transaction recommended by the Board; and (iv) refrain for an additional year from transferring its shares to a competitor or any known activist investor appearing on the “SharkWatch 50” list.
Limelight issued a press release and filed a Form 8-K with the Securities and Exchange Commission, which publicly disclosed to all stockholders the terms of the agreement with College Parent. In a proxy statement seeking approval of the transaction, Limelight again publicly disclosed the terms of the contemplated agreement with College Parent. Thereafter, Limelight’s fully informed and disinterested shareholders voted overwhelmingly in favor of the transaction. Following disinterested shareholder approval, the acquisition closed and the stockholders’ agreement was executed.
Two plaintiff stockholders brought a consolidated class action against the legacy Limelight directors and Edgio, alleging defendants breached their fiduciary duties by prioritizing their own interests and approving the acquisition and the terms of the stockholders’ agreement. While recognizing that the acquisition was a “boon” and highly favorable to the company, Plaintiffs nonetheless alleged the terms of the stockholders’ agreement established a 35% voting bloc designed both to entrench, and to deter or defeat any activist threats to, the existing Board. To that end, Plaintiffs sought only to enjoin the enforcement of the stockholders’ agreement; they did not seek damages.
Defendants moved to dismiss the complaint, arguing that the deferential “business judgment rule” applies and protects the Board’s decisions concerning the challenged provisions of the stockholders’ agreement, because enhanced scrutiny is not triggered under Unocal in the absence of a threat and defensive action. Defendants further argued that even if the enhanced scrutiny standard applied, the court must dismiss Plaintiffs’ post-close claims pursuant to the Delaware Supreme Court’s holding in Corwin v. KKR Financial Holdings, LLC, because a fully informed, uncoerced majority of the company’s disinterested stockholders approved the transaction, which cleansed any alleged breaches of fiduciary duty and restored business judgment review.
Vice Chancellor Zurn denied Defendants’ motion to dismiss, concluding Plaintiffs sufficiently pleaded allegations warranting a conceivable inference that the challenged terms of the stockholders’ agreement were adopted as defensive measures against a perceived threat of investor activism, and that enhanced scrutiny under Unocal applied. Furthermore, the court held that Corwin cleansing does not apply to post-close claims seeking injunctive relief.
The court first analyzed the contours of Corwin cleansing. The court noted the express language of Corwin suggests its application is limited to post-close damages claims only, which, according to the court, furthers Corwin’s underlying policy rationale of ensuring that shareholders may make free and informed choices based on the economic merits of a proposed transaction. The court also grappled with the Delaware Supreme Court’s 1995 opinion in In re Santa Fe Pacific Corporation Shareholder Litigation, which the court described as “a case that plausibly supports the proposition that a stockholder vote cannot cleanse a Unocal or Revlon claim seeking injunctive relief.” Although the court acknowledged the dissimilarities between Santa Fe and the present action — in Santa Fe, the defensive measures at issue served to pressure a stockholder vote and “worked their effect” before the stockholder vote occurred — the court found its guidance more persuasive than two other 1990s-era precedents, Stroud v. Grace and Williams v. Geier, both of which had held that a fully informed, uncoerced stockholder vote could serve to lower the standard of review for enjoining defensive measures from enhanced scrutiny to the business judgment rule. The court noted Stroud and Williams were “inconsistent” with the court’s own reading of Corwin, but concluded neither Stroud nor Williams would inform the court’s decision because neither was discussed or featured in relevant part in the more recent Supreme Court decision in Corwin.
Next, the court determined Plaintiffs’ claims warranted enhanced scrutiny under Unocal. To trigger Unocal enhanced scrutiny, a plaintiff must conceivably plead a company’s board acted with a subjective motivation of defending against a perceived threat, and took defensive measures in response to such threat. Here, the court conceded that Plaintiffs did not “directly plead that the Board perceived a threat and then responded defensively.” But the court found that various factors supported an inference of subjective entrenchment motivation, without questioning the validity of stockholders’ agreement voting and transfer commitments writ large. Specifically, the court concluded the following factors gave rise to a plaintiff-friendly inference of subjective entrenchment motivation with respect to the challenged provisions of the stockholders’ agreement: (i) the Company’s stock price and performance difficulties; (ii) the timing of the transaction; and (iii) market and analyst commentary that the company could be a target for activists. Interestingly, the court pointed out that Plaintiffs had foregone the opportunity to obtain board minutes and materials pursuant to a statutory books-and-records demand, and noted that, had they done so, “they may have been able to plead additional facts evincing the Director Defendants’ motivations for acting” — seemingly drawing yet another plaintiff-friendly inference from the absence of documents, even though they were documents that Plaintiffs chose not to obtain. The court further concluded that the challenged provisions of the stockholders’ agreement had a “defensive effect.” For these reasons, the court concluded the complaint contained allegations supporting “the plaintiff-friendly inference that the directors negotiated the [stockholders’ agreement] with the subjective motive of defending against an activist threat.”
Edgio provides important guidance for boards negotiating stockholder transactions, investments, and changes to corporate governance policies. It seems fair to expect, however, that it may not be the last word on the effect of uncoerced, fully informed stockholder ratification on governance measures that may be characterized as “defensive.” Various transactions, and thus the various terms of same, may be ratified by the stockholder franchise, and stockholders routinely vote on and approve components of transactions beyond the proposed transaction price alone.
The decision also calls into question whether the court would have come to the same result if the disinterested stockholders had been required to vote affirmatively for each of the challenged provisions of the stockholders’ agreement independently; in Santa Fe, a decision upon which the court relied heavily, “the stockholders did not vote in favor of [the] defensive measures, and so the Delaware Supreme Court declined to find ratification.”
Edgio also raises questions regarding what appears to be an expansion of the reach of Unocal’s enhanced scrutiny standard, which had evolved principally as a method to police unilateral board action, rather than corporate action approved by a majority of fully informed, uncoerced, and disinterested stockholders. Indeed, unlike Unocal and its progeny, Edgio did not involve any challenged unilateral board action. To that end, Edgio raises significant questions regarding the doctrine of stockholder ratification.
Just last week, Edgio postponed its upcoming annual shareholder meeting and agreed not to enforce the challenged provisions of the stockholders’ agreement pending trial. And although it is too soon to tell whether Edgio will have lasting effects on Delaware corporate jurisprudence, the decision serves as yet another reminder to company boards and advisors to memorialize decision-making processes clearly and comprehensively, so as to avoid unwarranted, or even untrue, inferences regarding their subjective motivations for their actions.
This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.