The following article was published by Corporate Counsel on March 21, 2022. Click here to view. Republished with permission.
In the last year, Delaware courts have adapted familiar jurisprudence to new contexts, including a boom in special purpose acquisition companies (SPACs) and the COVID-19 pandemic. Recent decisions have addressed the showing stockholders must make to pursue derivative claims for breach of fiduciary duty on behalf of Delaware companies; reaffirmed that material adverse effect (MAE) clauses and ordinary course covenants provide little recourse to buyers seeking to terminate merger agreements due to post-signing events; and provided guidance to SPAC investors seeking to remedy disappointing investment returns. Understanding these developments in Delaware law is essential to boards’ prudent management of strategic and litigation risks this proxy season.
A Streamlined Test for Demand Futility in Derivative Cases
A stockholder seeking to bring a derivative action on behalf of the corporation must serve a pre-suit demand on the board or show demand would have been futile. For decades, Delaware courts employed two similar but distinct demand futility tests: one used where the directors who would have considered any litigation demand also approved the challenged corporate action and another used where plaintiff alleged that the board had failed to act or challenged a decision by a majority of directors no longer serving on the board. The distinction between the two tests proved difficult to apply, particularly where plaintiffs challenged a number of corporate actions (or omissions) over time and amid director turnover.
In United Food and Commercial Workers Union v. Zuckerberg, the Delaware Supreme Court answered longstanding calls by the Chancery Court and Delaware practitioners to simplify its demand futility jurisprudence by announcing a single, universal test. Under Zuckerberg, a stockholder is excused from pre-suit demand and may assert a derivative claim on the corporation’s behalf only where a majority of the members of the board that would have evaluated the demand (1) received a material personal benefit from the alleged misconduct that is the subject of the litigation demand; or (2) faces a substantial likelihood of liability on any of the claims that would be the subject of the litigation demand; or (3) lacks independence from someone who received a material personal benefit from the alleged misconduct that would be the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand.
The new standard provides welcome clarity and predictability to litigants and reaffirms the long-established principle that control over corporate litigation is entrusted to the board in the absence of reasonable doubt that a majority of the directors can impartially consider the demand. As most Delaware corporations exculpate their directors for mere negligence, demand futility cases often turn on whether the board complied with its duties of loyalty and good faith to the corporation. To minimize personal liability and safeguard the corporation from imprudent derivative litigation, directors should monitor potential conflicts of interest and ensure appropriate oversight of “mission-critical risks.” Increasingly, the latter requires not only a fully engaged Board (or specialized committees, if appropriate) but also frequent updates from management and ongoing assessment of what constitute mission-critical risks for a business.
Ordinary Course Covenants and MAE in the Era of COVID-19
Many M&A agreements allocate the risk of significant changes between signing and closing to the seller by affording buyers termination rights upon the failure by the target to operate in the ordinary course of its business or the occurrence of a material adverse event (MAE). Historically, Delaware courts have enforced these buyer-protective provisions only in extraordinary circumstances. (The Delaware Chancery Court found its first MAE only in 2018.)
Notwithstanding severe business disruptions caused by COVID-19, Delaware courts have continued to construe MAE clauses in favor of the seller. Decisions last year found, for example, that the pandemic fell within contractual exceptions to the definition of MAE for “natural disasters and calamities” and effects “arising from or related to … changes in any Laws, rules, regulations, orders, enforcement policies or other binding [government] directives,” i.e., stay-at-home orders that depressed consumer demand. These decisions also reiterated that MAEs must be “durationally significant,” with adverse changes “measured in years rather than months”—an established touchstone of MAE jurisprudence that will continue to apply in a post-pandemic world.
In contrast, buyers have had mixed success invoking ordinary course covenants to terminate deals signed pre-pandemic. In AB Stable VIII LLC v. Maps Hotels and Resorts One LLC, the Delaware Supreme Court held that a buyer was entitled to terminate because the seller—despite taking what could be considered reasonable actions to address business disruptions caused by the pandemic—failed to operate the target hotel companies in the ordinary course of business, having closed properties and furloughed employees without securing the buyer’s consent. The Chancery Court came to the opposite conclusion in Snow Phipps Group, LLC v. KCAKE Acquisition Inc., where a target cake company faced with dramatically reduced sales took purportedly “severe cost-cutting measures” to limit marketing, labor, and other costs. Trial testimony established that these were not novel responses to the pandemic, but a continuation of the target’s historical practice in periods of sales declines.
Scrutiny of de-SPAC Transactions
2021 was a record-breaking year for transactions involving SPACs and new class actions challenging those that fail to yield desired returns. In January 2022, the Chancery Court issued its first de-SPAC decision, denying a motion to dismiss a lawsuit arising from an $11 billion transaction in which a SPAC acquired MultiPlan, a healthcare service provider. Plaintiffs, SPAC stockholders, alleged that when they chose to participate in the transaction, foregoing rights to redeem their SPAC units for a set contractual price, the SPAC sponsor had failed to disclose that MultiPlan’s largest customer was developing a competing product. The plaintiffs argued that the sponsor and its board had financial incentives to pursue the deal and minimize stockholder redemptions because they held “founder shares” whose value was contingent on consummating a de-SPAC transaction. Agreeing that these financial incentives conflicted with the interests of other SPAC investors, the Chancery Court held that the business judgment rule did not apply, and defendants instead had to establish that the price paid, and the process used in the transaction was fair (“entire fairness”).
It remains an open question whether future Delaware cases will limit MultiPlan to situations in which plaintiffs allege credible disclosure violations. SPAC stockholders will, no doubt, interpret it broadly to require searching, entire fairness review in any breach of fiduciary duty case against SPAC sponsors and directors who possess unique financial interests in consummating the de-SPAC transaction. At a minimum, SPAC boards contemplating de-SPAC transactions should ensure robust disclosure and explore ways to demonstrate director independence, including forming a special committee, appointing new, unconflicted directors, and considering cash or other alternatives to compensation in founder shares.