Corporate Governance

Delaware's Top Five Worst Shareholder Decisions for 2008 (#4)

By J. Robert Brown

McPadden v. Sidhu, 2008 Del. Ch. LEXIS 123 (Del. Ch. June 17, 2008)

There has been much written about the Delaware Court's exploration of the board's duty of good faith.  The doctrine has an accentuated importance.  Because bad faith behavior is not covered by waiver of liability provisions, the doctrine has the potential to significantly increase the exposure for directors.

Given the pro-management bias of the Delaware courts, the race to the bottom would predict that the courts would craft innovative ways to limit the reach of the doctrine.  This is exactly what they have done. 

An absence of good faith generally requires a showing of something akin to consious disregard.  That is, the board knew about a problem and largely ignored it.  As Disney has shown, almost any board response, no matter how anemic, will be sufficient to meet the good faith test. 

Sidhu shows the lengths the courts will go to avoid characterizing board behavior as insufficient to meet the good faith requirement. This was a case where the board sold a subsidiary to a management group for $3 million.  Six months after the sale, the management group received an offer for the subsidiary of $18.5 million, which it rejected.  The group sold the subsidiary for $25 million two years after the purchase.

The evidence suggested that the subdsidiary had been sold at an artificially low price.  Moreover, the board left to the officer who led the management team that bought the subsidiary the task of finding a purchaser.  The court recognized the obvious conflict of interest.  "The board's first step in the series of actions culminating in the sale of TSC to Dubreville was also its most egregious: tasking Dubreville with the sale process of TSC when the board knew that Dubreville was interested in purchasing TSC."  Nor did the board exercise any significant oversight.  As the opinion noted:

• Despite having tasked a potential purchaser of TSC with its sale, the board appears to have engaged in little to no oversight of that sale process, providing no check on Dubreville's half-hearted (or, worse, intentionally misdirected) efforts in soliciting bids for TSC. Dubreville's limited attempts to find a buyer for TSC did not include contacting the most obvious potential buyers: TSC's direct competitors, particularly a competitor that had previously offered as much as $ 25 million for TSC in 2003.  Perhaps unsurprisingly, Dubreville's group emerged as the highest bidder for TSC from the sale process.

In addition, the board received a number of red flags that suggested problems with the sales efforts.  The board knew that the potential buyers had been approached selectively and did not include any competitors.  They also had evidence suggesting that the management price was not adequate.  Finally, the offer of $3 million "was at the lowest end of the valuation range".  

The sale of an asset potentially worth $25 millon for a bit over 10% of that amount, assigning a person with a conflict to run the sales efforts, and the complete lack of supervision notwithstanding red flags was not enough for the court to conclude that shareholders had alleged bad faith.

• Thus, for the reasons explained above, the Director Defendants' actions, beginning with placing Dubreville in charge of the sale process of TSC and continuing through their failure to act in any way so as to ensure that the sale process employed was thorough and complete, are properly characterized as either recklessly indifferent or unreasonable. Plaintiff has not, however, sufficiently alleged that the Director Defendants acted in bad faith through a conscious disregard for their duties. Instead, plaintiff has ably pleaded that the Director Defendants quite clearly were not careful enough in the discharge of their duties--that is, they acted with gross negligence or else reckless indifference. Because such conduct breaches the Director Defendants' duty of care, this violation is exculpated by the Section 102(b)(7) provision in the Company's charter and therefore the Director Defendants' motion to dismiss for failure to state a claim must be granted.

Said another way, the court refused to find that the directors had any meaningful obligations with respect to their supervisory functions.  

Any notion that good faith would somehow develop to become a meaningful protection for the interests of shareholders was disabused with this case.  But then, that is what the race to the bottom would have predicted.

Full post as published by The Race to the Bottom on December 30, 2008 (boomark / email).