March 29, 2024

Delaware Corporate Litigation Highlights: 2023

Patrick Reagin | Lauren Robertson

Delaware's Court of Chancery, the preeminent source of developments in American corporate law, rendered several notable decisions in its 2023 term. This article summarizes those which illustrate emerging trends affecting liability and other considerations for corporate directors, officers and their advisors.

In re McDonald's Corp. Stockholder Derivative Litigation Extended Caremark Oversight Duties to Corporate Officers

The Delaware Court of Chancery began 2023 with the blockbuster decision, In re McDonald's Corp. Stockholder Derivative Litigation, 291 A.3d 652 (Del. Ch. 2023), which held for the first time that corporate officers owe a fiduciary duty of oversight to a corporation and its shareholders. These so-called "Caremark duties" previously extended only to corporate directors and derived from the seminal decision In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). The duty of oversight arose from the duty of loyalty and required directors to make good faith efforts to ensure that corporations implemented proper reporting systems and addressed "red flags" suggestive of corporate wrongdoing. Following McDonald's, the duty of oversight now expressly applies to corporate officers.

Caremark claims are subject to a two-pronged pleading standard in Delaware, under which a plaintiff must allege either: "(a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention." Oversight duty claims therefore are commonly referred to as "prong-one" or "prong-two" Caremark claims. In McDonald's, Vice Chancellor Travis Laster introduced new, more functional terminology to describe these as "Information Systems" and "Red Flags" claims, respectively.

Information Systems Claims arise when directors fail "to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists[.]" Red Flags Claims arise when information and reporting systems have "generated red flags indicating wrongdoing" and the company's directors fail to respond accordingly.

Importantly, the McDonald's court acknowledged that the scope of the oversight duty may differ between officers and directors. While "the board has oversight duties regarding the corporation as a whole," officers "generally have a more constrained area of authority." Thus, officers' oversight duties may extend only to their respective areas of responsibility. That said, where a red flag is sufficiently prominent, an officer "cannot turn a blind eye and dismiss the issue as 'not in my area.'" The court additionally clarified that officers' oversight liability requires a showing of bad faith, not gross negligence.

Also noteworthy, the oversight claims at issue in McDonald's involved workplace harassment allegations, which the court found to be actionable disloyal conduct. Thus, practitioners and companies should be mindful that certain forms of misconduct typically relegated to the domains of employment and/or tort law may also now be elevated to the realm directors' and officers' fiduciary duties. Following McDonald's, shareholders' and plaintiffs' firms may increase their efforts to investigate officer misconduct. Thus, Directors should prepare for increased books and records demands under Section 220 of the Delaware General Corporation Law seeking information related to corporate officers.

Gandhi-Kapoor v. Hone Capital, LLC Imposed Severe Sanctions for Failing to Fulfill Advancement Obligations

In Gandhi-Kapoor v. Hone Capital LLC, No. 2022-0881-JTL, 2023 WL 4628782 (Del. Ch. July 19, 2023), the court imposed a $1,000 per day fine for a company's failure to comply with an order to advance expenses to its former officer.

The petitioner, Purvi Gandhi-Kapoor, had served as chief financial officer and partner of the respondent, Hone Capital LLC, until she was terminated along with her supervisor. In 2020, Hone sued Gandhi-Kapoor for breach of fiduciary duties and fraud, to which Gandhi-Kapoor and her supervisor responded with counterclaims. Facing substantial litigation expenses, Gandhi-Kapoor sought and obtained an order for advancement of these expenses by the company. Hone neither objected nor paid any of the expenses, forcing Gandhi-Kapoor to turn to the court for relief via a contempt judgment.

Delaware law, like that of many states, permits corporations to agree to pay an officer's or director's litigation expenses in advance of the final disposition of a lawsuit or similar proceeding. This feature is designed to encourage able candidates to participate in corporate service by protecting them from personal financial exposure related to their corporate roles. Because "[a] lack of timely advancements prejudices the covered person's ability to defend the underlying litigation, potentially resulting in irremediable consequences, such as an adverse judgment or a conviction," the consequences for violating an advancement order can be severe.

In Gandhi-Kapoor, the court allowed expedited discovery to determine whether a limited receiver should be appointed over the company, and notably, the court granted Gandhi-Kapoor's requested daily fine of $1,000 during the period that Hone failed to comply with its advancement obligations. The court also awarded Gandhi-Kapoor all of her fees and expenses incurred in obtaining the contempt order.

This decision serves as a cautionary tale for companies facing advancement demands from officers or directors sued in their official corporate capacities. A corporate official's right to advancement is "deeply rooted in the public policy of Delaware corporate law" and is "viewed less as an individual benefit arising from a person's employment and more as a desirable mechanism to manage risk in return for greater corporate benefits." By imposing a contempt sanction and $1,000 per day fine for noncompliance, the Court of Chancery sent a strong signal about Delaware's policy of enforcing corporate advancement obligations.

Anderson v. Magellan Health, Inc. Marks Continued Trend of Scrutinizing Corporate Benefits in the Context of Mootness Fee Awards

In Anderson v. Magellan Health, Inc., the Delaware Court of Chancery reaffirmed the standards surrounding mootness fees and the corporate benefit doctrine in shareholder litigation. The court confirmed that it will continue to be more demanding in scrutinizing the actual benefits flowing to shareholders from resolved litigation, and to prevent the awarding of fees for frivolous litigation.

Mootness fees are payments awarded to plaintiffs' attorneys in corporate litigation when their lawsuit prompts a voluntary action by the defendant company that addresses the plaintiffs' concerns, rendering the lawsuit moot. This compensation is intended to recognize the benefit brought to the corporation or its shareholders by the litigation, even if the case does not reach a formal adjudication. The corporate benefit doctrine, which informs the award of mootness fees, hinges on three criteria: 1) the suit's merit at filing; 2) a pre-judgment action by defendants that benefits the corporation; and 3) a causal link between the suit and the benefit.

Anderson v. Magellan Health, Inc., examined the practice of awarding mootness fees in the context of "don't ask, don't waive" provisions in merger agreements. "Don't ask, don't waive" provisions are a specific type of clause found in merger agreements that restrict a seller from soliciting other offers or from providing information to, and engaging in discussions with, potential alternative bidders once a merger agreement has been signed. Essentially, these provisions prevent sellers from "asking" for additional bids or "waiving" the prohibition on seeking other proposals. The intent behind such provisions is to protect the agreed-upon deal from being derailed by subsequent, potentially higher, offers. The provisions are a tool to secure the transaction and provide certainty to the buyer that the seller will not seek out or entertain other bids. The provisions have sparked debates over the balance between deal certainty for buyers and the fiduciary duties of sellers to maximize shareholder value.

Corporations facing challenges to "don't ask, don't waive" provisions historically have mooted the plaintiffs' claims by issuing supplemental disclosures. A wave of litigation around supplemental disclosures emerged as shareholders began challenging the adequacy of information provided ahead of merger votes, asserting that omissions or inadequacies could make disclosures materially deficient. This led to a significant number of lawsuits where plaintiffs sought, and often obtained, mootness fees after companies issued additional disclosures in response to these challenges. The trend was fueled by perceptions that even minor supplemental disclosures could justify attorneys' fees, leading to a proliferation of what some viewed as opportunistic litigation.

In 2016, the Delaware Court of Chancery significantly tightened standards for approving disclosure-only settlements in shareholder litigation in In re Trulia, Inc. Shareholder Litigation, 129 A.3d 884 (Del. Ch. 2016). In that case, the court expressed skepticism about the real value of supplemental disclosures obtained through such settlements and criticized the practice of awarding plaintiffs' attorneys' fees for securing these disclosures. The ruling emphasized that disclosure-only settlements would be approved only if the supplemental disclosures were "plainly material," meaning they should significantly alter the "total mix" of information available to shareholders, thus aiming to curb frivolous litigation and ensure meaningful benefits to shareholders.

In Anderson, the Court of Chancery continued the post-Trulia trend, and refused to award mootness fees for supplemental disclosures deemed to have "little-to-no value" to shareholders. In so doing, the court overruled precedents that allowed recovery of fees for disclosures providing information that did not meet the higher "plainly material" standard.

This decision has significant implications for M&A litigation in Delaware and signals the court's intention to deter what it considers to be frivolous deal litigation providing little material benefit to shareholders. It is widely expected that, following Anderson, the number of disclosure-related lawsuits filed in the Delaware courts will decrease, as plaintiffs' firms lose the incentive of mootness fees for other than meritorious cases.

Ainslie v. Cantor Fitzgerald, L.P. Illustrates Teetering Scales of Delaware Policy in the Face of Broad Restrictive Covenants

Purchasers frequently insist on noncompete provisions in deal documents associated with the acquisition of a business. These provisions are intended to help ensure that key personnel remain in place and preserve the business' value, while foreclosing opportunistic sellers from quickly turning around and competing with the divested business line after the deal closes. Because of this, the Court of Chancery's interpretation and enforcement of noncompetes and other restrictive covenants is highly relevant to transaction parties and their counsel.

There is a split of approaches among the states as to the enforceability of noncompete agreements, the level of deference afforded to them and specifically whether courts will "blue pencil" any such agreements found to be overbroad. Blue penciling allows a court to rewrite the provision to make it enforceable on a narrowed basis, rather than rendering the provision unenforceable in its entirety.

Delaware courts do not mechanically enforce noncompete agreements, and instead scrutinize them on a case-by-case basis. To be enforceable, a noncompete provision must "(1) [be] reasonable in geographic scope and temporal duration, (2) advance a legitimate economic interest of the party seeking its enforcement, and (3) survive a balancing of the equities."

In recent years, Delaware's lower courts have shown an increasing hostility to the enforcement of noncompete provisions perceived as overreaching and a reluctance to "blue pencil" the provisions to allow them to survive. This trend continued in 2023 in Ainslie v. Cantor Fitzgerald, L.P., No. 9436-VCZ, 2023 WL 106924 (Del. Ch. Jan. 4, 2023), in which the court considered a limited partnership agreement that contained "interlocking provisions designed to restrict former partners from competing, soliciting clients or employees, or using the Partnership's confidential information for four years after the partner leaves."

After assessing the language of the restrictive covenants as overbroad in scope and geographic reach, and unsupported by a legitimate business interest, the court found the provisions to be unenforceable. Importantly, the court refused to blue pencil either provision, meaning it refused to narrow them so as to allow them to be enforced. This required the limited partnership to pay withheld funds to former partners despite their alleged breaches of the restrictive covenants.

However, on appeal, the Supreme Court of Delaware reversed and held that provisions of the limited partnership agreement were enforceable conditions precedent to pay former partners. This reversal may call into question what had appeared to be a trend of increasing skepticism as to the enforceability of noncompetes among the lower courts. It remains to be seen whether Ainslie may mark a turning point in this line of decisions.

In light of the still unsettled climate around noncompetes, transaction parties seeking to protect valuable intellectual property rights, customer information and preserve key employees, should carefully assess the scope of any restrictive covenants included in their deal documents to avoid the risk that the provisions will be rendered unenforceable due to perceived overreach.

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