Chancery takes it on the chin

Delaware Supreme Court Justice Jack Jacobs clarified several points of law in a Jan. 28 reversal of a decision from the state's Court of Chancery. Gantler v. Stephens involved the restructuring of First Niles Financial Inc., a small, publicly traded commercial bank in Ohio. Vice Chancellor Donald F. Parsons Jr. dismissed the claim last year, and several First Niles shareholders appealed.

The bank embarked on a sales process in 2004 and received indications of interest from three potential buyers. First Niles negotiated with one of the bidders for several months before abruptly ending the talks in March 2005. Instead, the bank proposed a transaction in which owners of 300 shares or less would receive a new class of stock that would have the higher dividends and the same liquidation rights as the common but would carry a vote only on a proposed sale of First Niles. The deal would have allowed the bank to deregister the company's stock, saving perhaps $400,000 annually. Shareholders barely approved the measure in December 2006.

Writing for an unanimous court, Jacobs overturned Parsons' dismissal of the case, which some shareholders brought. Parsons employed the business judgment rule to dismiss the plaintiffs' claim that the First Niles directors violated their fiduciary duties by abandoning the sales process. The business judgment rule is the legal standard most deferential to directors and officers. But First Niles admitted in the proxy it sent to shareholders on the reclassification that its directors and officers had "a conflict of interest" on the deal.

Jacobs agreed. First Niles chairman and CEO William Stephens was sufficiently unenthusiastic about a sale of the company that he acted disloyally for purposes of a motion to dismiss, the justice found. And board members P. James Kramer and Ralph Zuzolo provided business and legal services to the bank, meaning their decision to end the sales process could also have constituted disloyalty for purposes of a motion to dismiss.

Thus, Jacobs held, Parsons should have analyzed that decision under the entire fairness standard, which is more stringent than the business judgment rule.

J. Travis Laster, a partner at Abrams & Laster LLP in Wilmington, Del., cautioned against reading this aspect of Jacobs' ruling too broadly. An aggressive reading of the decision, Laster wrote in a memorandum to clients, might "claim that the Delaware Supreme Court has now endorsed business judgment rule review for a 'just say no' defense," absent the conflicts of interest that Jacobs found. But such a reading would be to conflate the legal treatment of a board's flat rejection of a firm bid with that of a board's decision to end a sales process.

Instead, Laster believes, the latter decision, like the one to start a sales process, would normally be subject to business judgment review rather than entire fairness.

The case featured at least two other important holdings. First, Jacobs followed Chancery precedent in holding that officers owe the same fiduciary duties as directors, a point on which Delaware's Supreme Court had never ruled. Second, Jacobs discussed shareholder ratification, a doctrine that the justice called "unclear." The basic concept is that shareholder approval of a board action will afford directors the protections of the business judgment rule in lawsuits arising from the action.

Jacobs clarified that shareholders may act to "ratify" a board action only where their approval is not otherwise legally required -- as in, for example, a shareholder vote on a merger. "Moreover," the judge continued, "the only director action or conduct that can be ratified is that which the shareholders are specifically asked to approve." Lawyers being lawyers, that sentence raises the question of what "specifically" means.

While the issue sounds arcane, it may be relevant for stock option plans, which do not require approval under Delaware law. Thus, shareholder ratification of a stock option plan may offer legal protection to a board that installs it. But it's unclear whether the ratification would extend to all grants in accordance with the plan or merely apply to its adoption. Laster suggests that companies can safely assume the latter but not the former.

David Marcus is a senior writer at Corporate Control Alert.