Chancery Court Clarifies How the Defense of Release Can Be Raised, Applies the Unocal Test to Allegedly Defensive Board Actions, and Weighs the Materiality of Proxy Statement Omissions
By: Scott E. Waxman and David Valenti
In deciding a motion to dismiss derivative and direct shareholder claims, the Delaware Chancery Court addresses the defense of release, examines whether allegedly defensive board actions trigger the heightened Unocal test, and judges the materiality of proxy statement omissions. Although the Court made clear that the affirmative defense of release could be considered in a motion to dismiss, it held that Plaintiffs’ claims did not have the “same identical factual predicate” with previously settled federal class litigation. The Court also applied the Unocal test in analyzing whether the alleged adoption of entrenchment measures state a viable claim, and discussed the standard for pleading material omissions to a proxy statement.
In In re Ebix, Inc. Stockholder Litigation, Plaintiff shareholders brought six claims against Ebix, Inc., (“Ebix”) and its board of directors (the “Board”) arising out of several actions taken by the Board in the lead up to a later abandoned merger attempt. Claims I-III challenged several documents that related to executive compensation arrangements made by Ebix and approved by its Board. Claims IV-V challenged several of the Board’s actions as breaches of its fiduciary duties on the grounds that each constituted an improper entrenchment device by the board, including Ebix’s entry into a Director Nomination Agreement (the “DNA”) with a dissenting shareholder and its adoption of a bundle of new bylaws. In claim VI, Plaintiffs alleged the Board breached its fiduciary duties by issuing a materially misleading and incomplete 2014 Proxy Statement and sought a declaration that the 2014 Annual Shareholders’ Meeting’s actions were invalid.
Defendants moved to dismiss all six counts based on three general arguments. First, Defendants asserted that Plaintiffs’ Claims I-III were barred due to the affirmative defense of release because of other previously approved federal class action settlements. One of these federal class actions alleged false and misleading statements by Ebix’s CEO and CFO, and the other, a derivative action, took issue with certain disclosures which purported to falsely portray the financial condition of the company. Both of these cases reached stipulated class settlements that broadly released claims against Ebix and its Board. Second, Defendants sought the dismissal of claims IV-V for failure to state a claim on which relief could be granted by arguing that the Board’s conduct as pled did not amount to improper entrenchment attempts and that these decisions were entitled to the protection of the business judgment rule. Finally, Defendants sought dismissal of claim VI for failure to state a claim because the alleged omissions from the proxy statement were immaterial with relation to the relief requested.
First, the Chancery Court held that although the Defendants could raise the affirmative defense of release in its motion to dismiss, even though the releases were not referenced in the Complaint, the releases in question did not preclude Plaintiffs’ claims I-III. The Court noted, regarding matter extraneous to the complaint, that Court of Chancery Rule 12(b)(6) implies that a court may, sua sponte, “exclude the matter and hear the motion to dismiss, consider it and convert the motion into one for summary judgement, or conclude that it is not extraneous but rather integral to the claims and then proceed with the motion to dismiss.” Although the Court found that the Defendants could raise the defense of release at the current procedural stage, it held that a settlement in a derivative suit will not preclude any later claim of action that an absent stockholder might have in the stockholder’s individual capacity against the corporation or the real defendants. Additionally, to bar claims due to a release from a federal class action settlement, the claims must have an identical factual predicate, meaning that there is a realistic identity of issues between the settled class action and the subsequent suit, and the relationship between the suits is foreseeably obvious to notified class members at the time. The Court held that the releases did not bar Claims I-III because some of the claims were direct claims of shareholders who were absent from the previous suits, and it found that the remaining claims did not share the same operative facts with the settled cases. Defendants’ motion to dismiss claims I-III was therefore denied.
Next, the Court granted in part and denied in part Defendants’ motion to dismiss Plaintiffs’ claims alleging the Board took actions to improperly entrench itself. Plaintiffs’ challenges included the Board’s decision to enter into the DNA whereby the Board agreed to grant two board seats to a dissident shareholder to dissuade him from waging a proxy fight for at least two years, and by adopting a series of bylaws that permitted, among other things, the Board to delay any special shareholder meeting by at least 120 days. The Court noted that while most decisions of a company’s board are entitled to the protection of the business judgment rule, the court will apply the stricter scrutiny of the Unocal test, requiring the defendant to establish the reasonableness of the action, to measures adopted for the purpose of preserving incumbent control of the board of directors. The court decided if each of the measures in question was a defensive measure to determine whether the applicable standard of the action was the business judgment rule or the more stringent Unocal standard.
The Court first found that the DNA — which granted two seats to a dissident shareholder — was not a defensive action. The Court reasoned that a corporate action with collateral effects, including a tendency to preserve incumbent control, is not per se subject to Unocal scrutiny. Consequently, the Court applied the business judgment rule to the Board’s decision to enter into the DNA, holding that Plaintiffs failed to state a claim for this action because they did not plead that the Board’s decision was uninformed or without contemplation.
The Court then reviewed the Board’s adoption of bylaws that would permit the Board to, among other things, delay any special shareholder meeting that might be called by at least 120 days. Defendants argued that the bylaws were not a defensive act because they were adopted after the DNA and, therefore, were not in response to any threat to corporate control. The Court recognized that Delaware law supports the imposition of Unocal scrutiny to defensive board actions in response to a threat perceived to be but a future possibility. The Court found that Plaintiffs had pled facts sufficient to support an inference that the bylaws amounted to entrenchment measures relating to a potential change in control. In support of this conclusion, the Court pointed to three facts. First, the bylaw amendments were prepared six days after the dissident shareholder conveyed an intent to launch a proxy contest. Second, the DNA with the dissident shareholder only had a two-year duration, so the fact that they reached an agreement does not totally remove the threat. Third, the ability of the board to delay a shareholders’ special meeting had clear defensive value. As a result, the Court applied the heightened Unocal test and held that Defendants were unable to establish the reasonableness of the Board’s actions as a matter of law and denied the motion to dismiss with respect to the adoption of the bylaws.
Finally, the Court held that Plaintiffs’ claim VI failed to state a claim because the alleged omissions from the 2014 proxy statement were not material for purposes of electing the directors or performing the advisory vote on the CEO’s pay. Plaintiffs alleged that the proxy statement’s failure to mention the factual background of the DNA, the bylaw amendments, and the omissions relating to the CEO’s compensation, rendered the decisions of the shareholder meeting invalid. Importantly, the Court found that the Plaintiffs failed to identify misstatements or omissions in the proxy statement that were material with respect to the shareholder action being sought. The alleged omissions regarding the factual background of the DNA were immaterial because the proxy statement included descriptions of the DNA and the dissident shareholder’s obligations. Because the bylaws were not drafted until three days after the proxy statement was issued, it was unnecessary that they be included in it, especially since the amendments were publically released two weeks before the shareholders’ meeting. The allegedly missing information about the CEO’s compensation was not material because, among other reasons, it not received because of the prospective merger’s abandonment.
The Chancery Court concluded by dismissing portions of Plaintiffs’ Claim IV and all of claim VI. Otherwise, the Defendants’ motion was denied.