You Got to Know When to Hold ‘Em; You Got to Know When to Fold ‘Em: Limits on the Business Judgment Doctrine’s Protection of Officers and Directors

By Joseph Allen Kelly

Being an officer or director of a company involves judgment calls that must be made on a daily basis. Often these are difficult decisions about which reasonable persons may disagree. As a general matter, officers and directors are protected from liability for decisions they make under the business judgment doctrine. That is, generally officers and directors are entitled to make tough business judgments without having to worry about courts second guessing their business judgment. However, a recent decision in Delaware brings into stark relief limits to the business judgment protection for officers and directors.

In August 2004, First Niles Financial, Inc. ("First Niles"), a Delaware Corporation headquartered in Ohio, whose sole business is to own and operate Home Federal Savings and Loan Association of Niles ("Bank"), decided to put itself up for sale. In September 2004, management of First Niles advocated abandoning the sale strategy in favor of privatizing the company. In December 2004, three potential purchasers approached First Niles: Farmers National Banc Corp. ("Farmers"), Cortland Bancorp ("Cortland"), and First Place Financial Corporation ("First Place").

The only fact known about the Farmers bid is that Farmers explicitly stated it had no plans to retain First Niles' Board. First Niles never pursued the Farmers' offer.

On January 18, the Board instructed its advisors to explore Cortland's and First Place's bids. Cortland's offer stated it would terminate all incumbent board members but would consider them for future appointment. Cortland also sent a due diligence request, seeking a response by February 6. That deadline passed with no response from First Niles. Cortland then requested a response by February 8. That deadline passed with no response, and on February 10, Cortland withdrew its bid.

First Place's offer made no representations regarding board retention. On February 7, First Place made its due diligence request, asking for a due diligence review session the following week. First Place received a response to its due diligence request on February 13, and submitted a revised offer for First Niles on March 4. The investment bank advisors advised the Board that this offer was within the acceptable range.

On March 9, without any discussion of the offer, the Board voted 4-1 to reject the offer. The Board also instructed its legal counsel to explore the privatization plan management set forth at the earlier meeting.

On June 29, the Board submitted a preliminary proxy, which was later amended on August 10. On November 16, the Board disseminated a definitive proxy statement.

The proxy statement listed a variety of potential cost savings related to the privatization transaction. The proxy stated that each of the directors and officers of First Niles had "a conflict of interest with respect to [the privatization] because he or she is in a position to structure it in such a way that benefits his or her interests differently from the interests of unaffiliated shareholders." The proxy also disclosed that First Niles had received one merger offer and that "[a]fter careful deliberations, the board determined in its business judgment the proposal was not in the best interests of the Company or our shareholders and rejected the proposal."

First Niles' shareholders approved the privatization plan on December 14.

Shortly after this, a group of shareholders sued the officers and directors of First Niles. Among other things, the complaint alleged that the defendants violated their fiduciary duties by rejecting a valuable opportunity to sell First Niles, deciding instead to reclassify First Niles' shares in order to benefit themselves. The plaintiffs alleged that the director and officer defendants breached their duty of loyalty by abandoning the sale process for self interested reasons.

The defendants moved to dismiss. The Vice Chancellor originally dismissed the case holding that the directors and officers were protected under the business judgment rule. Subsequently, an en banc panel of the Delaware Chancery Court overruled the Chancellor holding that the plaintiffs had alleged sufficient conflicts of interest to overcome the business judgment standard. See Gantler v. Stephens, 2009 WL 188828 (Del. Sup. Ct. 2009). To determine whether the Board's termination of the sale process is entitled to the business judgment standard, the Court applied a two pronged test: 1) whether the decision was reached in the good faith pursuit of a legitimate corporate interest; 2) whether the decision was reached advisedly. For directors and officers to be entitled to the protection of the business judgment standard, both questions must be answered in the affirmative. Id. at *8.

The Court held that plaintiffs plead sufficient facts as to at least three directors to put at issue whether the directors breached fiduciary duties. As to Defendant Stephens, the Chairman of the Board of First Niles and CEO of both First Niles and the Bank, the Court held that the following facts were sufficient to establish an inference of disloyalty: he never responded to Cortland's due diligence request even after being offered an extension; he failed to inform the Board that the Cortland offer was withdrawn due to this failure; and the Cortland offer explicitly stated that board members would be terminated. Id.

As to Defendant Kramer, a director of both First Niles and the Bank and the president and CEO of William Kramer & Son, a heating and air company that provided heating and air conditioning services to the Bank, the Court held that the following facts were sufficient to establish an inference of disloyalty: the Bank was a major client of his company's, and a merger would likely lead to the loss of that client; and Kramer was a man of comparatively modest means, and such a loss would be significant. Id. at *9.

As to directors Zuzolo and Kramer, principals in a small law firm in Niles, Ohio that frequently provided legal services to First Niles and the Bank, the Court found that the potential loss of First Niles and the Bank after a sale created an inference of disloyalty. Id.

As to the corporate officers, the Court made a very important holding, stating, "[i]n the past, we have implied that officers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty, and that the fiduciary duties of officers are the same as those of directors. We now explicitly so hold." Id. (internal citations omitted). In that vein, the Court held that an inference of disloyalty had been sufficiently pled as to CEO Stephens as an officer. In addition, the Court held that disloyalty had been sufficiently pled as to Vice President and Treasurer Safarek (against whom no specific facts were alleged) because it was reasonable to infer that he aided and abetted Stephens' breach as an officer. The Court reasoned that, as Vice President and Treasurer, Safarek was in no position to act independently of Stephens, and that this led to the inference that he aided in the sabotage of the sale process. In addition, the Court determined it could be reasonably inferred that Safarek expected his employment to be terminated as a result of a sale. Id.

But, wait, notwithstanding the inferences of disloyalty, didn't the shareholder vote approving the privatization plan ratify the directors' and officers' actions? Not so fast held the Court. In the face of a material misrepresentation in the proxy, namely that the Board had carefully considered and rejected alternatives when it in fact had not seriously considered alternatives, the shareholder vote approving the privatization plan could not be deemed to be fully informed. If the shareholder vote was not fully informed, it could not be said that the shareholders ratified the Board's actions. Id. at *11.

What lessons can be drawn from this decision for officers and directors? First, officers and directors must carefully consider any potential conflicts of interest and would be well advised to recuse themselves from any decisions that may benefit or harm themselves personally. Second, it is incumbent upon a board to fully consider possible courses of action prior to deciding on a preferred course. Third, to be meaningful, disclosures to shareholders must be full and open and accurate. Boiler plate language that recite that the board "considered options" and warn of vague "potential conflicts," if not fully and accurately described, may not be a full disclosure to shareholders. Directors and officers who act without full transparency to shareholders risk having decisions second guessed in a court of law.