Delaware Chancery Court Allows Board to Abandon Sales Process

Earlier this year, the Delaware Chancery Court dismissed a claim by shareholders of First Niles Financial, Inc., alleging that the directors breached their fiduciary duty by abandoning a sales process, despite receiving offers that its financial adviser found to be “within a range supported by its financial models.” The court's decision in Gantler v. Stephens, 2008 WL 401124 (Dec. Ch. Feb. 14, 2008), is important in two respects. First, the court affirmed a Delaware board's right to abandon a sales process and, in effect, “just say no” to a merger proposal. Second, the court applied the deferential business judgment rule, rather than a more intrusive standard, in reviewing the Board's actions.

First Niles Sales Process

In August 2004, the Board of Directors of First Niles authorized a process to sell the company, and retained financial and legal advisers to assist with this process. The Board's financial adviser, Keefe, Bruyette & Woods, a well-known financial services sector investment banking firm, contacted six prospective bidders, three of whom submitted bids. One bidder, Farmers National Banc Corp., stated it had “no plans to retain the current First Niles board.” A second bidder, Cortland Bancorp, offered a mix of cash and stock representing a 3.4% premium over First Niles' share price. A third bidder, First Place Financial Corp., offered a stock-for-stock transaction with an exchange ratio representing a 3.4% to 6.3% premium. At the next regularly scheduled Board meeting, Keefe, Bruyette & Woods reported that “all three bids were within a range supported by its financial models, and the stock-based offers would be better than retaining First Niles shares.” The Board directed management and its financial adviser to continue the process with Cortland and First Place (but not with Farmers).

Management apparently dragged its feet in permitting the two bidders to conduct due diligence, stating that “there was other more pressing business at the Bank.” Frustrated, Cortland withdrew its bid. First Place eventually was allowed to conduct due diligence and revised its proposed exchange ratio to an amount representing an 11% premium. Keefe, Bruyette & Woods again found this bid to be “within an acceptable range and to exceed the mean and median comparable multiples” for comparable transactions. Subsequently, and before the First Niles Board met to consider its offer, First Place again revised its bid to increase the exchange ratio. A special meeting of the First Niles Board was called to consider the First Place proposal and a memorandum from Keefe, Bruyette & Woods “positively describing First Place's revised offer” was circulated to the directors. When the Board met, but without any discussion, the directors rejected First Place's offer by a 4-to-1 vote and abandoned the sales process. Instead, the Board decided to pursue, and ultimately completed, a reclassification transaction to privatize the company which left the Board and management in place.

Fiduciary Duty Claims Brought By Shareholders

In November 2006, the plaintiffs (who included the former director who cast the sole vote in favor of proceeding with the First Place bid) filed suit against First Niles and several of its directors and officers claiming, among other things, that the directors had breached their duties of loyalty and care by rejecting First Place's offer and abandoning the sales process. The plaintiffs sought both equitable relief in the form of rescission of the reclassification transaction and compensatory damages.

The directors attempted to argue that their decision to reject First Place's offer and terminate the sales process “cannot form the basis of a breach of fiduciary duty, because the directors owed no duty to the shareholders to sell the company.” Rejecting this argument, the court found that “while the Directors may not have had any duty to sell the Company, they still had to satisfy their traditional fiduciary duties.” Accordingly, the court proceeded with an examination of the directors' conduct in connection with the sales process and the reclassification transaction. Following a detailed analysis of the relevant facts and judicial precedent, the court concluded that the directors' actions were “entitled to the business judgment presumption” and granted their motion to dismiss the fiduciary duty claims relating to the sales process.

Unocal 'Enhanced Scrutiny' Standard Not Applicable

The first issue the Gantler court confronted was the standard of review to apply in scrutinizing the Board's actions. Plaintiffs argued that enhanced scrutiny under the doctrine developed in Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 949 (Del. 1985), was appropriate because, in their view, the directors had abandoned the sales process in order to entrench their positions with the company. The Unocal doctrine was developed by the Delaware courts as the standard of review when “directors took defensive measures in response to a perceived threat to corporate policy and effectiveness which touches upon issues of control.” Generally, the Unocal standard is applied to analyze defensive measures adopted by a board in response to a hostile takeover attempt or deal-protection measures included in a negotiated merger agreement. The Gantler court, recognizing that the sales process was undertaken at the behest of the Board, rejected plaintiffs' argument, largely due to the absence of a hostile takeover attempt or any threatening action to indicate that the directors' actions were “defensive” in nature. According to the court, “in the context of a board's rejection of a merger offer, as opposed to taking a defensive measure against a tender offer, unexceptional entrenchment allegations of the kind made here are insufficient to take the challenged decision out of deferential business judgment review.”

Business Judgment Rule v. Entire Fairness

Having failed in their attempt to convince the court to apply the Unocal standard to the Board's actions, the plaintiffs next sought a determination that the exacting entire fairness standard, rather than the deferential business judgment rule, was applicable. Traditionally, the business judgment rule “applies when a decision of the directors is questioned, and the analysis is primarily a process inquiry.” In Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985), the Delaware Supreme Court described the business judgment rule as “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.” If the business judgment rule applies, “[c]ourts give deference to directors' decisions reached by a proper process, and do not apply an objective reasonableness test in such a case to examine the wisdom of the decision itself.”

In order to rebut the business judgment presumption, plaintiffs “must allege sufficient facts from which the court could reasonably infer (1) a majority of the individual directors were interested or beholden or (2) the challenged transaction was not otherwise the product of a valid exercise of business judgment.” If the plaintiffs are successful in this regard, the business judgment presumption is inapplicable and, the burden is shifted to the defendant directors to prove the entire fairness of the transaction, both in terms of the price paid and the process followed. It is generally very difficult for directors to carry this burden, which often makes the court's selection of the applicable standard of review outcome determinative.

The Gantler court, citing three reasons, determined that it was not appropriate to shift the standard of review from the business judgment rule to the entire fairness standard. First, since the challenged action was the Board's decision not to accept a merger proposal, there was no transaction to subject to an entire fairness analysis. In other words, how could the court examine the fairness of a price when no price was actually paid? Second, alluding to its earlier determination not to apply the Unocal standard, the court reasoned that application of the entire fairness standard would be “anomalous in that it would subject the Board's action not to do a merger to more demanding review than a defensive measure adopted for the express purpose of thwarting a hostile tender offer.”

Third, and probably most important, the court answered affirmatively the two key questions for determining whether to apply the presumption of the business judgment rule: “(1) did the Board reach their decision in good faith pursuit of legitimate corporate interests, and (2) did it do so advisedly?” The first question bears on a board of directors' duty of loyalty, while the second addresses the board's duty of care.

Analysis of the Board's Conduct

Duty of Loyalty

With respect to the first question, the court did not find sufficient evidence to infer that the directors were acting for the primary purpose of entrenching themselves in office or otherwise acting disloyally. “[I]n most instances ' a decision to decline merger discussions will be part of a decision to continue to manage the corporation to enhance long term share value.” The court distinguished its decision from the decision in Chrysogelos v. London, 1992 Del. Ch. LEXIS 61 (March 25, 1992), where the directors' actions beyond “just saying no” to an unsolicited merger proposal “provided much greater cause for suspicion than the facts alleged in this case.” In Chrysogelos, the directors also adopted a shareholders rights plan and then reduced the triggering ownership threshold of that plan, purchased a sizeable block of stock on the market at a “substantial premium” and approved “golden parachutes” for management in the event of a change in corporate control.

Duty of Care

With respect to the second question, the court found that the Board's “extensive discussions with, and the receipt of reports from, its Financial Advissr and the involvement of specially retained outside counsel as part of the Sales Process” rendered the facts alleged insufficient to infer that the Board did not act with due care. It is worth noting that the court reached this conclusion despite the facts that: 1) the Board failed to consider the Farmers bid; 2) Cortland withdrew from the process due to its frustration with its inability to conduct due diligence; 3) Keefe, Bruyette & Woods provided a favorable report to the Board as to the adequacy of the bids; 4) the Board rejected the First Place bid and abandoned the sales process without any deliberations among the directors at the special meeting; and 5) the alternative course pursued, a reclassification resulting in the privatization of First Niles, was orchestrated, and decidedly favored, by management and left the Board of Directors intact. While this was perhaps not the best record from which to argue for the exercise of due care, and the Board certainly could have been more proactive in its oversight of the sales process, it was obviously sufficient for the court's purposes.

Conclusion

Even though the First Niles Board began a sales process and received seemingly attractive offers, but then abandoned the process in favor of a reclassification plan favored by management that kept the directors in office, the Gantler court was not prepared to overturn the Board's decision to “just say no” to the First Place bid. In contrast to situations where a board of directors takes defensive measures to repel a hostile takeover attempt or engages in conduct geared to entrenching their corporate positions, the decision of the First Niles directors to reject the First Place (and other) bids was afforded the protection of the business judgment rule. This result should be of comfort to corporate directors who, when confronted with an unsolicited merger proposal or a decision whether or not to proceed with a sales process, understand that they can pursue other strategies for the company without being second-guessed, as long as they can demonstrate that they exercised due care in reaching their decision and were not subject to a disabling conflict of interest.

Robert S. Reder is a New York-based partner and co-Practice Group leader of the Global Corporate Group of Milbank, Tweed, Hadley & McCloy LLP. Alison Fraser is an associate at the firm. The authors gratefully acknowledgesthe assistance of Kelly Pressler, a summer associate, in the preparation of this article.

Earlier this year, the Delaware Chancery Court dismissed a claim by shareholders of First Niles Financial, Inc., alleging that the directors breached their fiduciary duty by abandoning a sales process, despite receiving offers that its financial adviser found to be “within a range supported by its financial models.” The court's decision in Gantler v. Stephens, 2008 WL 401124 (Dec. Ch. Feb. 14, 2008), is important in two respects. First, the court affirmed a Delaware board's right to abandon a sales process and, in effect, “just say no” to a merger proposal. Second, the court applied the deferential business judgment rule, rather than a more intrusive standard, in reviewing the Board's actions.

First Niles Sales Process

In August 2004, the Board of Directors of First Niles authorized a process to sell the company, and retained financial and legal advisers to assist with this process. The Board's financial adviser, Keefe, Bruyette & Woods, a well-known financial services sector investment banking firm, contacted six prospective bidders, three of whom submitted bids. One bidder, Farmers National Banc Corp., stated it had “no plans to retain the current First Niles board.” A second bidder, Cortland Bancorp, offered a mix of cash and stock representing a 3.4% premium over First Niles' share price. A third bidder, First Place Financial Corp., offered a stock-for-stock transaction with an exchange ratio representing a 3.4% to 6.3% premium. At the next regularly scheduled Board meeting, Keefe, Bruyette & Woods reported that “all three bids were within a range supported by its financial models, and the stock-based offers would be better than retaining First Niles shares.” The Board directed management and its financial adviser to continue the process with Cortland and First Place (but not with Farmers).

Management apparently dragged its feet in permitting the two bidders to conduct due diligence, stating that “there was other more pressing business at the Bank.” Frustrated, Cortland withdrew its bid. First Place eventually was allowed to conduct due diligence and revised its proposed exchange ratio to an amount representing an 11% premium. Keefe, Bruyette & Woods again found this bid to be “within an acceptable range and to exceed the mean and median comparable multiples” for comparable transactions. Subsequently, and before the First Niles Board met to consider its offer, First Place again revised its bid to increase the exchange ratio. A special meeting of the First Niles Board was called to consider the First Place proposal and a memorandum from Keefe, Bruyette & Woods “positively describing First Place's revised offer” was circulated to the directors. When the Board met, but without any discussion, the directors rejected First Place's offer by a 4-to-1 vote and abandoned the sales process. Instead, the Board decided to pursue, and ultimately completed, a reclassification transaction to privatize the company which left the Board and management in place.

Fiduciary Duty Claims Brought By Shareholders

In November 2006, the plaintiffs (who included the former director who cast the sole vote in favor of proceeding with the First Place bid) filed suit against First Niles and several of its directors and officers claiming, among other things, that the directors had breached their duties of loyalty and care by rejecting First Place's offer and abandoning the sales process. The plaintiffs sought both equitable relief in the form of rescission of the reclassification transaction and compensatory damages.

The directors attempted to argue that their decision to reject First Place's offer and terminate the sales process “cannot form the basis of a breach of fiduciary duty, because the directors owed no duty to the shareholders to sell the company.” Rejecting this argument, the court found that “while the Directors may not have had any duty to sell the Company, they still had to satisfy their traditional fiduciary duties.” Accordingly, the court proceeded with an examination of the directors' conduct in connection with the sales process and the reclassification transaction. Following a detailed analysis of the relevant facts and judicial precedent, the court concluded that the directors' actions were “entitled to the business judgment presumption” and granted their motion to dismiss the fiduciary duty claims relating to the sales process.

Unocal 'Enhanced Scrutiny' Standard Not Applicable

The first issue the Gantler court confronted was the standard of review to apply in scrutinizing the Board's actions. Plaintiffs argued that enhanced scrutiny under the doctrine developed in Unocal Corp. v. Mesa Petroleum Co. , 493 A.2d 949 (Del. 1985), was appropriate because, in their view, the directors had abandoned the sales process in order to entrench their positions with the company. The Unocal doctrine was developed by the Delaware courts as the standard of review when “directors took defensive measures in response to a perceived threat to corporate policy and effectiveness which touches upon issues of control.” Generally, the Unocal standard is applied to analyze defensive measures adopted by a board in response to a hostile takeover attempt or deal-protection measures included in a negotiated merger agreement. The Gantler court, recognizing that the sales process was undertaken at the behest of the Board, rejected plaintiffs' argument, largely due to the absence of a hostile takeover attempt or any threatening action to indicate that the directors' actions were “defensive” in nature. According to the court, “in the context of a board's rejection of a merger offer, as opposed to taking a defensive measure against a tender offer, unexceptional entrenchment allegations of the kind made here are insufficient to take the challenged decision out of deferential business judgment review.”

Business Judgment Rule v. Entire Fairness

Having failed in their attempt to convince the court to apply the Unocal standard to the Board's actions, the plaintiffs next sought a determination that the exacting entire fairness standard, rather than the deferential business judgment rule, was applicable. Traditionally, the business judgment rule “applies when a decision of the directors is questioned, and the analysis is primarily a process inquiry.” In Smith v. Van Gorkom , 488 A.2d 858, 872 (Del. 1985), the Delaware Supreme Court described the business judgment rule as “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.” If the business judgment rule applies, “[c]ourts give deference to directors' decisions reached by a proper process, and do not apply an objective reasonableness test in such a case to examine the wisdom of the decision itself.”

In order to rebut the business judgment presumption, plaintiffs “must allege sufficient facts from which the court could reasonably infer (1) a majority of the individual directors were interested or beholden or (2) the challenged transaction was not otherwise the product of a valid exercise of business judgment.” If the plaintiffs are successful in this regard, the business judgment presumption is inapplicable and, the burden is shifted to the defendant directors to prove the entire fairness of the transaction, both in terms of the price paid and the process followed. It is generally very difficult for directors to carry this burden, which often makes the court's selection of the applicable standard of review outcome determinative.

The Gantler court, citing three reasons, determined that it was not appropriate to shift the standard of review from the business judgment rule to the entire fairness standard. First, since the challenged action was the Board's decision not to accept a merger proposal, there was no transaction to subject to an entire fairness analysis. In other words, how could the court examine the fairness of a price when no price was actually paid? Second, alluding to its earlier determination not to apply the Unocal standard, the court reasoned that application of the entire fairness standard would be “anomalous in that it would subject the Board's action not to do a merger to more demanding review than a defensive measure adopted for the express purpose of thwarting a hostile tender offer.”

Third, and probably most important, the court answered affirmatively the two key questions for determining whether to apply the presumption of the business judgment rule: “(1) did the Board reach their decision in good faith pursuit of legitimate corporate interests, and (2) did it do so advisedly?” The first question bears on a board of directors' duty of loyalty, while the second addresses the board's duty of care.

Analysis of the Board's Conduct

Duty of Loyalty

With respect to the first question, the court did not find sufficient evidence to infer that the directors were acting for the primary purpose of entrenching themselves in office or otherwise acting disloyally. “[I]n most instances ' a decision to decline merger discussions will be part of a decision to continue to manage the corporation to enhance long term share value.” The court distinguished its decision from the decision in Chrysogelos v. London, 1992 Del. Ch. LEXIS 61 (March 25, 1992), where the directors' actions beyond “just saying no” to an unsolicited merger proposal “provided much greater cause for suspicion than the facts alleged in this case.” In Chrysogelos, the directors also adopted a shareholders rights plan and then reduced the triggering ownership threshold of that plan, purchased a sizeable block of stock on the market at a “substantial premium” and approved “golden parachutes” for management in the event of a change in corporate control.

Duty of Care

With respect to the second question, the court found that the Board's “extensive discussions with, and the receipt of reports from, its Financial Advissr and the involvement of specially retained outside counsel as part of the Sales Process” rendered the facts alleged insufficient to infer that the Board did not act with due care. It is worth noting that the court reached this conclusion despite the facts that: 1) the Board failed to consider the Farmers bid; 2) Cortland withdrew from the process due to its frustration with its inability to conduct due diligence; 3) Keefe, Bruyette & Woods provided a favorable report to the Board as to the adequacy of the bids; 4) the Board rejected the First Place bid and abandoned the sales process without any deliberations among the directors at the special meeting; and 5) the alternative course pursued, a reclassification resulting in the privatization of First Niles, was orchestrated, and decidedly favored, by management and left the Board of Directors intact. While this was perhaps not the best record from which to argue for the exercise of due care, and the Board certainly could have been more proactive in its oversight of the sales process, it was obviously sufficient for the court's purposes.

Conclusion

Even though the First Niles Board began a sales process and received seemingly attractive offers, but then abandoned the process in favor of a reclassification plan favored by management that kept the directors in office, the Gantler court was not prepared to overturn the Board's decision to “just say no” to the First Place bid. In contrast to situations where a board of directors takes defensive measures to repel a hostile takeover attempt or engages in conduct geared to entrenching their corporate positions, the decision of the First Niles directors to reject the First Place (and other) bids was afforded the protection of the business judgment rule. This result should be of comfort to corporate directors who, when confronted with an unsolicited merger proposal or a decision whether or not to proceed with a sales process, understand that they can pursue other strategies for the company without being second-guessed, as long as they can demonstrate that they exercised due care in reaching their decision and were not subject to a disabling conflict of interest.

Robert S. Reder is a New York-based partner and co-Practice Group leader of the Global Corporate Group of Milbank, Tweed, Hadley & McCloy LLP. Alison Fraser is an associate at the firm. The authors gratefully acknowledgesthe assistance of Kelly Pressler, a summer associate, in the preparation of this article.