The Delaware Supreme Court issued a welcome decision, In re Cornerstone Therapeutics Inc. Stockholder Litigation (Del. May 14, 2015), to remove an anomaly that had been inhibiting lower courts from dismissing monetary claims against independent directors based on their roles in the approval of related party transactions. Nevertheless, even as the Delaware Supreme Court adopts principles to distinguish the state’s courts as director-friendly venues, independent directors will continue to bear burdens of discovery in Delaware and consequent risks of actions that seek monetary damages and survive motions to dismiss. In addition, the considerations for the insider counterparties (e.g., the controlling stockholders) participating in related party transactions, as outlined in our prior memoranda, remain unchanged.
The issue. The issue in the Cornerstone decision is the scope of the circumstances under which independent directors may take advantage of the exculpatory provisions, found in most corporations’ charters, to have stockholder actions dismissed on the pleadings – i.e., before any depositions or other discovery. Per Delaware law, these exculpatory provisions generally eliminate the risk of personal monetary liability of an independent director in connection with his or her approval of a related party transaction so long as the director acted in good faith and was not deriving any improper personal benefit in connection with the transaction.
The holding. The Cornerstone holding directs lower courts to dismiss claims against independent directors whenever an exculpatory provision exists in the charter and the plaintiffs are seeking only monetary damages, unless the complaint sets forth particularized allegations of the types of bad faith conduct or conflicts that would not be covered by the charter’s exculpatory provisions. Previously, some courts in Delaware had taken the position that, due to the exacting scrutiny applicable when courts review related party transactions, dismissal of monetary claims on the pleadings would be inappropriate even though the pleadings failed to set forth particularized allegations that would support a non-exculpated claim. Cornerstone sets straight that, even if the transaction is subject to a heightened level of scrutiny, claims seeking monetary damages from independent directors must set forth particularized allegations of bad faith or conflicts to survive an initial motion to dismiss.
Implications for Independent Directors. Last year, the Delaware Supreme Court’s MFW decision laid out a road map for structuring related party transactions in a manner that would subject scrutiny of directors’ fulfillment of their duties to the more relaxed “business judgment” standard, instead of the heightened “entire fairness” standard. Cornerstone establishes that monetary claims against independent directors should be dismissed regardless of whether the transaction takes the path to “business judgment” scrutiny specified in MFW so long as the charter has an exculpation provision and the complaint lacks particularized allegations of bad faith. However, stockholders may, as a matter of course, make books and records requests in response to related party transaction announcements or take advantage of avenues to subject the conduct of independent directors to discovery in legal proceedings and, depending on what is uncovered, thereafter bring monetary claims that would be able to survive dismissal under the rule set forth in Cornerstone. These avenues for discovery include:
- Discovery in connection with non-monetary claims (most frequently for injunctive relief). Purported class action plaintiffs regularly respond to the announcement of related party transactions by filing suits seeking non-monetary damages, especially when approval or implementation of the related party transaction requires not only board action but also stockholder action that the plaintiffs may seek to enjoin (e.g., tendering shares into a tender offer or voting to approve a merger for a buyout of the public float by a controlling stockholder, voting to adopt a charter amendment to implement a new class of non-voting stock that will enhance the ability of the controlling stockholder to maintain control, or voting to approve a merger or sale of substantially all the assets by the corporation in connection with which an insider will acquire a corporate asset). Cornerstone and exculpatory provisions address only monetary claims and therefore provide no basis for dismissal of these non-monetary claims or limiting the discovery of independent directors pursuant to these claims.
- Discovery of independent directors (as non-parties) in connection with claims against the controlling stockholder or other insider counterparties to the related party transaction. Cornerstone and exculpatory provisions do not address claims against the insiders and therefore provide no protection against this class of claims or discovery of independent directors as non-party witnesses in connection with these claims. Plaintiffs would be able to obtain this potentially significant discovery of independent directors even though these directors are not named as defendants at the outset of the litigation challenging the related party transaction, because these directors are participants (indeed, important participants) in the underlying events, and therefore fact witnesses subject to discovery.
It is possible that the MFW decision will make it easier to obtain quick dismissals of challenges to related party transactions, including those seeking injunctive relief or asserting claims against the controlling stockholder or other insider parties and thereby cut off these avenues for discovery, but, as explained in our prior memorandum, we are skeptical of this proposition.
One goal of these discovery efforts against independent directors will likely be the identification of facts that could support a particularized allegation of bad faith and thereby survive dismissal under the rule set forth in Cornerstone. Plaintiffs will be able to file these new claims (or seek leave to re-plead previously asserted but dismissed ones) against independent directors even after a transaction has closed so long as they are filed or re-pled before the expiration of the three-year statute of limitations. For example, plaintiffs can use these avenues to piece together indicia that a director had what may be reasonably inferred to be a meaningful relationship with or interests aligned with the insider counterparty or that imply a knowing failure to maintain the arms-length nature of the negotiations between the insider and the committee of independent directors. Defendant directors may be able eventually to prove these particularized allegations to be insignificant, but, as a result of the collection of information through these avenues for discovery that Cornerstone is powerless to block, the plaintiffs may still be able to craft a complaint for monetary damages against independent directors that would survive a motion to dismiss and thereby increase the settlement value of the claim. Against this background, it is advisable for independent directors involved in the review of related party transactions to continue to maintain excellent records and understand and adhere to protocols to ensure the integrity of their review, negotiation and approval processes.
Implications for Controlling Stockholders and other Insiders. Cornerstone highlights that, when the independent directors are immune from monetary claims as a result of the charter’s exculpatory provisions, the controlling stockholders and other insider counterparties to the related party transaction will serve as “the proverbial deep-pocketed defendants.” If the related party transaction is objectively flawed, then the insider party to the transaction will be liable for the damages – there are no exculpatory provisions for related parties acting in good faith in their capacities as counterparties to the corporation. Thus, notwithstanding Cornerstone, the primary issue that controlling stockholders and other insiders will continue to face in related party transactions is whether to structure the transaction in a way that reduces the standard of scrutiny from the heightened standard of “entire fairness” to the more relaxed standard of “business judgment.” Nothing in Cornerstone changes the calculus, outlined in our prior memoranda, for controlling stockholders when deciding how to structure related party transactions.
 Non-exculpated claims consist of those based on one of the following:
- Bad faith actions (which include violations of the duty of loyalty to the corporation, knowing violations of law, and intentional misconduct)
- Self-dealing by the director (i.e., where the director receives an improper personal benefit) or
- Approvals of dividends or share buybacks in violation of applicable capital adequacy laws (which laws include express provisions to protect directors who rely on corporate information in good faith).
 Thus, in the two consolidated cases at hand, each of which was an action for monetary damages arising from alleged breaches of duties in connection with a cash merger between a corporation and its controlling stockholder to squeeze out the non-controlling stockholders, the Supreme Court ordered the dismissal of the actions against the independent directors since there were no specific acts alleged that would constitute breaches of their duty of loyalty (i.e., actions of bad faith). The complaints in these actions may have set forth allegations that would have adequately supported findings that the terms of these related party transactions failed objectively to meet the applicable “entire fairness” standard for directors’ satisfaction of their duty of care, but claims for monetary damages based on such “objective” flaws in the performance of duties would have ultimately been futile in view of the exculpatory provisions which bar recovery for all but “subjective” or bad faith violations of duty.