In the consolidated appeal In re Cornerstone Therapeutics Inc., Stockholder Litigation and In re Zhongpin Stockholders Litigation, Nos. 564, 2014 and 706, 2014, 2015 Del. LEXIS 231 (Del. May 14, 2015), the Delaware Supreme Court considered for the first time the pleading burden a stockholder plaintiff must meet when seeking to recover monetary damages from an independent and disinterested director who is protected by an exculpatory charter provision authorized under 8 Del. C. § 102(b)(7). The Court held that to survive a motion to dismiss by that director, the complaint must plead a non-exculpated claim against that director, even if the underlying standard of review is entire fairness. Cornerstone confirms the need for the Chancery Court to analyze exculpation on a director-by-director basis in all cases at the earliest practical time, including at the pleading stage, in order to fulfill Section 102(b)(7)’s legislative purpose.
The facts were essentially the same in both appeals. Minority stockholder plaintiffs sought damages from the directors following a “freezeout” merger in which the controlling stockholder, who had representatives on the board of directors, acquired the remainder of the shares that it did not own. A special committee of independent directors negotiated the merger with the controlling stockholder. Plaintiffs filed suit in the Delaware Court of Chancery alleging that the directors, including the independent directors, breached their fiduciary duty by approving the merger at a price unfair to the minority stockholders. Despite having used certain procedural safeguards to protect the minority stockholders, defendants conceded that the entire fairness standard applied (but with the burden of persuasion possibly falling on plaintiffs). An exculpatory charter provision adopted in accordance with 8 Del. C. § 102(b)(7) insulated the directors from liability for monetary damages for duty-of-care breaches.
While before the Court of Chancery, the independent director defendants in Cornerstone moved to dismiss plaintiffs’ claim because plaintiffs failed to plead allegations supporting a non-exculpated claim against them (i.e., one based on disloyalty or bad faith). They argued that when a corporation’s certificate of incorporation contains an exculpatory provision, the plaintiff bears the burden of pleading a non-exculpated claim against independent directors, even where the transaction at issue (such as a freezeout merger) presents the risk of a duty-of-loyalty breach high enough to warrant entire fairness review. The Chancery Court, however, followed Delaware Supreme Court precedent it believed required it to decide the exculpation question only after deciding liability on a fully developed record where entire fairness review applies. Whether plaintiffs had alleged a non-exculpated claim did not matter. The Chancery Court thus denied the motion. The Chancery Court in Zhongpin deferred to Cornerstone’s approach and similarly denied a motion to dismiss by the independent directors in that case.
The Supreme Court reversed. It first acknowledged the “powerful pro-plaintiff effect” that imposing entire fairness review has on a breach of fiduciary duty claim against interested directors. Indeed, when entire fairness is invoked at the pleading stage, the conflicts of interest of directors affiliated with a controlling stockholder alone “supports a pleading-stage inference of disloyalty” and defeats such interested directors’ motion to dismiss. And, under entire fairness, any finding of liability against that director at trial is automatically treated as a breach of the duty of loyalty regardless of whether there is any actual finding of subjective bad faith. The Court noted, however, that, under its precedent, this “pro-plaintiff effect” did not necessarily apply to independent, non-conflicted directors.
The Court next rejected the notion that an independent director’s role in facilitating an interested transaction by serving on a special committee was enough to support an inference of disloyalty. It noted that “each director has a right to be considered individually when the directors face claims for damages in a suit challenging board action.” Moreover, under Delaware law, independent directors are presumed to act with fidelity to the corporation and its stockholders. The Court observed that precluding the dismissal of claims against an independent director at the pleading stage merely because that director assented to an interested transaction, and notwithstanding the absence of facts suggesting an improper motive, could harm minority stockholders. Independent directors who serve on special committees play a vital role in protecting minority stockholders. Such a rule might dissuade them from serving as independent directors and approving transactions. Hence, it would defeat Section 102(b)(7)’s goal of encouraging director service and business risk-taking by reducing the threat of duty-of-care lawsuits. The Court disagreed that its prior precedents required the development of a full discovery record before a Chancery Court could decide whether an independent director’s liability fell within an exculpation provision or not.
In the end, the Court held that a claim against an independent director protected by an exculpatory charter provision avoids dismissal only when it pleads facts “supporting a rational inference that an independent director harbored self-interest adverse to the stockholders’ interests, acted to advance the self-interest of an interested party from whom they could not be presumed to act independently, or acted in bad faith.” This rule applies whether the underlying standard of review is the business judgment rule, enhanced scrutiny or entire fairness. The mere fact that a plaintiff is able to plead facts supporting the application of the entire fairness standard to the transaction does not relieve the plaintiff of the responsibility to plead a non-exculpated claim against each independent director who moves for dismissal.
Cornerstone is a significant development. Delaware Chancery Courts have previously hesitated to dismiss claims on exculpation grounds before trial, based on the particular standard of review and procedural stage of the litigation. Cornerstone authorizes Chancery Courts to more actively approach and decide exculpation questions at the earliest practical stage to promote Section 102(b)(7)’s legislative purpose.