Delaware Chancery Clarifies Duty Of Disclosure

Page 1 of 12 Portfolio Media. Inc. 648 Broadway, Suite 200 New York, NY 10012 www.law360.com Phone: +1 212 537 6331 Fax: +1 212 537 6371 customerservice@portfoliomedia.com Delaware Chancery Clarifies Duty Of Disclosure Law360, New York (August 04, 2008) -- The Delaware Chancery Court recently issued two opinions focusing on, among other things, the duty of disclosure in the context of merger transactions. In In re Transkaryotic Therapies, Inc. (Del. Ch., Civil Action No. 2776-CC 6/16/08), Chancellor Chandler granted summary judgment in favor of the defendants for alleged breaches of the duty of disclosure in connection with a merger of two unrelated Delaware corporations. In Berger v. Pubco Corp. (Del. Ch., Civil Action No. 3414-CC 5/30/08), Chancellor Chandler created a quasi-appraisal to remedy breaches of disclosure duties in connection with a short-form merger, as well as to remedy breaches of the formal requirements of the Delaware short-form merger statute. While each of these decisions grappled with claims and issues in addition to the duty of disclosure, the conclusions of the Chancery Court in each case with regard to the duty of disclosure are particularly instructive. The Duty of Disclosure The duty of disclosure represents the proposition that directors of Delaware corporations have a fiduciary responsibility to disclose fully and fairly all material information within the board s control when it seeks shareholder action. [1] While often called a duty, the requirement to disclose material facts is not a separate duty of a company s board of directors. Rather, the duty of disclosure is the application in a specific context of the board s fiduciary duties of care, good faith and loyalty. [2] While associated with well established duties, the elements and requirements of the duty of

Page 2 of 12 disclosure remain unsettled and are not absolute. Due to the unique issues and considerations that impact the assessment of whether to disclose information, attorneys and their clients must use judgment and reason when faced with evaluating what information to disclose as well as in determining what liability may arise from the failure to make proper disclosure.[3] With regard to remedies for breaches of the duty to disclose, the position of the Delaware courts has evolved over time, and at one point, it appeared that the failure to properly disclose material information would result in per se damages for breach of the fiduciary duty of disclosure.[4] Recently, however, the Delaware courts have refined their view of damages for breaches of the duty of disclosure so that the current position is that a breach of the duty of disclosure does not automatically result in a nominal damages award. In fact, in Transkaryotic, the Delaware Chancery Court proclaimed that [i]t is now clear that some breaches of the disclosure duty result in no award of damages at all. [5] The current preference of the Delaware courts appears to avoid post-transaction damage awards in lieu of pre-transaction motions for preliminary injunctions because the courts generally view such failures as causing irreparable harm and a jury would be ill-suited to adequately assess monetary damages.[6] That is, the Delaware courts would rather have plaintiffs raise disclosure deficiencies in advance of any stockholder action so the court can issue a preliminary injunction to provide adequate time for the disclosure problems to be remedied. The courts view the injunctive process to be much more efficient and rational in the context of disclosure shortcomings as opposed to a post-facto attempt to assess monetary damages for such failures.[7] By using the injunctive relief process, plaintiffs can seek to have all relevant, material information disclosed prior to taking a shareholder action and avoid the uncertainty of having a court or jury attempt to quantify the damages after the transaction is consummated. In connection with the duty to disclose, the Delaware courts also have recognized that the

Page 3 of 12 standard of materiality with regard to discussing information has been well settled by the Delaware courts.[8] In fact, Delaware has adopted the federal standard of materiality.[9] Information is generally material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote... [10] Furthermore, [i]t does not require proof of a substantial likelihood that disclosure of the omitted fact would have caused the reasonable investor to change his vote. Instead, to establish materiality one must show a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having a significantly altered the total mix of information made available. Transkaryotic and the Traditional Merger The Chancery Court in Transkaryotic was presented with a case in which plaintiffs were alleging breaches of fiduciary duty, charges of aiding and abetting those breaches and a claim of unlawful merger. The case focused on the merger of Transkaryotic Therapies, Inc. ( Transkaryotic ) and Shire Pharmaceuticals Group ( Shire ). The board of directors of Transkaryotic approved the merger on April 16, 2005 and the company provided its shareholders with a proxy statement and held a meeting of shareholders to solicit approval of the proposed merger.[11] On July 27, 2005, the Transkaryotic shareholders approved the merger with Shire and the transaction was promptly closed.12 The plaintiffs in Transkaryotic alleged that the Transkaryotic failed to disclose certain relationships and communications between directors of Transkaryotic and management of Shire, the fact certain directors opposed the merger, the existence of additional valuations prepared by third party financial advisors, the possibility of alternative transactions in lieu of the merger with Shire and the interests of certain directors in those other transactions, and potential conflicts of interests and potential undue influence of Transkaryotic s bankers.[13] Basically, the plaintiffs contended that the defendants breached their fiduciary duties by failing to disclose or by misrepresenting these facts to shareholders of Transkaryotic prior to the shareholder vote on July 27, 2005. In addition to the claims of breach of duty of disclosure, the plaintiffs claimed that certain

Page 4 of 12 directors based their decision to approve the merger on extraneous considerations or influences and as a result, they had conflicting loyalties.[14] The plaintiffs also claimed that Shire aided and abetted these directors in the breaches of their duty of loyalty and disclosure. The Chancery Court evaluated each of these claims against the individual directors and granted summary judgment in favor of all of the defendant directors, except for one director who did not seek summary judgment on these claims.[15] The Chancery Court also granted summary judgment to Shire on the claims of aiding and abetting, except with respect to the one director that failed to seek summary judgment.[16] Lastly, the plaintiffs charged that the merger was not approved by the shareholders as required by the Delaware General Corporations Law ( DGCL ). The Chancery Court allowed the plaintiffs to continue with this claim because it had demonstrated that there was a question of fact as to whether the votes were properly tallied. However, the Chancery Court did note that, while it was permitting the claims to continue, it believed the plaintiffs claims were weak.[17] As discussed above, the treatment of the duty of disclosure by Delaware courts has been evolving. In reaching its conclusions in Transkaryotic, the Chancery Court noted that a breach of the disclosure duty causes irreparable harm.[18] [T]he right to cast an informed vote is peculiar and specific and it cannot be adequately quantified or monetized. [19] Once the merger closes, even if by vote of shareholders who do not possess adequate or accurate information, the Delaware courts generally do not have the power to undo or reverse a merger. As a result, the preferred remedy would be injunctive relief to prevent the vote from taking place without complete and accurate information.[20] In Transkaryotic, the shareholders approved the merger in 2005, but by the time the Chancery Court finally heard this case three years have passed since the merger was consummated.

Page 5 of 12 The Chancery Court noted that, because the merger was consummated, an injunctive order requiring supplemental disclosure at this time would be pointless.[21] Because a disclosure would result in irreparable harm and because [the Chancery] Court can no longer provide the equitable cure for such harm, [Chancellor Chandler granted] the [defendants ] motion for summary judgment with respect to the disclosure claims. [22] As a result, the Chancery Court determined it could not grant monetary or injunctive relief for disclosure violations after a merger was consummated and there was no evidence of breach of the duty of loyalty or good faith by directors who authorized the disclosures. Berger and the Short-Form Merger In Berger, the Chancery Court also was presented with a case in which the merger was already completed; however, this time the merger was consummated pursuant to the Delaware short-form merger statute. The plaintiff, Barbara Berger, held less than ten percent of the shares of common stock in Pubco Corporation ( Pubco ), a corporation organized under the laws of Delaware.[23] The controlling shareholder holding more than 90 percent of the outstanding shares of Pubco was Robert H. Kanner, who was the president and sole director of Pubco and who was also a defendant in the case.[24] In November 2007, Pubco notified Ms. Berger that Pubco s controlling shareholder had effected a short-form merger and she and the other minority shareholders were being cashed out at $20 per share.[25] Under Section 253 of the DGCL, controlling shareholders that hold more than 90 percent of all classes of outstanding shares of a company can effect a merger of the company without the consent of the minority shareholders so long as after the effectiveness of the merger the minority shareholders receive a notice that informs them that they have rights to appraisal under Section 262 of the DGCL, includes a current copy of the current Delaware appraisal statute, and discloses all material information with respect to the minority shareholders decision whether or not to seek appraisal.[26] In December 2007, Ms. Berger brought a class action suit against Pubco on behalf of all minority shareholders and claimed that the minority shareholders were entitled to the

Page 6 of 12 difference between the $20 per share received as merger consideration and the fair value of his or her shares, regardless of whether a minority shareholder demanded appraisal under Delaware corporate law.[27] In general, if the minority shareholders are not satisfied with the merger consideration received in the short-form merger, their only recourse is to seek appraisal of the value of their shares under Section 262 of the DGCL.[28] In accordance with Delaware corporate law, Pubco s notice to the minority shareholders explained that shareholder approval was not required to effect the merger, but it did indicate that the minority shareholders did have the right to seek appraisal.[29] Pubco s notice also included information about Pubco s business, the names of its officers and directors, the number of shares and classes of stock, a description of related business transaction, and copies of Pubco s recent financial statements, among other limited information.[30] The Chancery Court noted that, except for the financial statements, Pubco s notice did not provide much detail and was vague or failed to provide meaningful disclosure in a number of important areas, including how the merger consideration of $20 per share was determined. [31] Pubco also attached to the notice a copy of the Delaware appraisal statute, as required by Delaware law, but the copy attached was outdated and incorrect because it did not reflect changes that took effect in August 2007.[32] As discussed above, the Chancery Court in Berger noted that the duty of disclosure represents the well-recognized proposition that directors of Delaware corporations are under a fiduciary duty to disclose fully and fairly all material information within the board s control when it seeks shareholder action. [33] In the case of a short-form merger, the minority shareholders are not asked to vote on the transaction and ordinarily would not have any right to prevent the consummation of the merger. However, since the only choice is to accept the merger consideration or seek appraisal under the DGCL, the minority shareholders must be given all of the factual information that is material to that decision. [34]

Page 7 of 12 The parent company is not required to disclose all information necessary for the minority shareholders to independently determine fair value, but rather, the parent company need only disclose information that is material to the minority shareholders decision of whether or not to seek appraisal.[35] The Chancery Court in Berger noted that while a minority shareholder may find additional information helpful, it does not necessarily mean the additional information is material to the minority shareholder s decision of whether to seek appraisal.[36] Therefore, it is the minority shareholders burden to demonstrate why receiving information in addition to the basic financial data already disclosed will significantly alter the total mix of information available. [37] In Berger, the Chancery Court determined that the notice was defective because it failed to include the current version of the Delaware appraisal statute, which the Chancery Court noted was a clear violation of Section 253 of the DGCL, and that there was a breach of the duty of disclosure because there was a failure to provide all material information relevant to the minority shareholders decision of whether to seek appraisal. With regard to the duty to disclose, the Chancery Court noted that Pubco s notice failed to provide appropriate disclosure relating to Pubco s plans or prospects, any meaningful disclosure of Pubco s actual operations, a more detailed disclosure of Pubco s finances by division or line of business, any discussion or explanation of how Pubco s cash and securities, noted on its financial statements, were utilized or going to be utilized by Pubco, and interestingly, no disclosure of how the merger consideration was calculated.[38] While Pubco s notice was defective in a number of ways, the Chancery Court was most concerned with the failure to disclose the methodology behind calculating the merger consideration. Pubco was an unregistered company that made no public filings and the notice provided to the minority holders was terse and short on details. [39] As a consequence of the lack of publicly available information about Pubco, the Chancery Court determined that the method by which [the defendants] set the merger consideration is a fact that is substantially likely to alter the total mix of information available to the minority shareholders. [40] However, the Chancery Court did recognize that certain aspects of the information may not be material and declared that the defendant should not have to provide every trivial detail

Page 8 of 12 about the valuation process employed in setting the price, but rather companies need only disclose in broad terms what the process, if any, was used to determine the value of the merger consideration.[41] The Chancery Court concluded that the minority shareholders of an unregistered, nonreporting company are entitled to know at least whether the parent did or did not use such methods when setting the merger consideration, because such a fact would have assumed actual significance in the deliberations of a reasonable shareholder faced with the decision of whether or not to trust and accept the price offered by the parent. [42] Due to the fact the short-form merger was effective under Section 253 of the DGCL before the disclosures were required to be made to the minority shareholders, rescission remedies were not available to the minority shareholders of Pubco. Instead, the Chancery Court determined that the minority shareholders suffered an irreparable injury and relied on its inherent powers of equity to create the appropriate relief for the parties.[43] Because the short-form merger does not require shareholder approval, the disclosure deficiencies would not have provided adequate standing to prevent the merger, and instead, the minority shareholders only had a right to appraisal. Therefore, the Chancery Court, relying on its equitable powers, created a remedy of quasiappraisal that attempted to mirror as best a possible the statutory appraisal remedy of Section 263 of the DGCL and the related instructions of the Delaware General Assembly. [44] As a result, the Chancery Court ordered Pubco to make supplemental disclosures to address the disclosure violations noted by the Chancery Court and to correct the failure to properly notice the minority shareholders by giving them a choice to participate in or opt out of an appraisal action under Section 262.[45] In addition, the Chancery Court order that the quasi-appraisal action should replicate the level of the risk that would exist if there were an actual appraisal action in other words, if the appraisal ultimately was for less than the proposed merger consideration, the minority shareholders would receive less than the merger consideration originally offered.[46] Lastly, the Chancery Court required that the Pubco shares be valued as of the date of the

Page 9 of 12 merger using the method prescribed by Section 262 of the DGCL.[47] Conclusion Both the Transkaryotic decision and the Berger decision highlight the finality of a merger whether traditional or short-form. Each case also helps clarify the position of the Delaware courts when it comes to remedying breaches of the duty of disclosure. In short, the Delaware courts are not going to undo a merger traditional or short-form as a result of a breach of the duty to disclose. The Chancery Court in Transkaryotic makes it clear that post-merger remedies will be rare and puts shareholders on notice that if they believe the disclosure they received in connection with a proposed shareholder action is inadequate, the shareholders must pursue injunctive relief in advance of the shareholder action instead of waiting until after the merger to seek remedies. In response to the Chancery Court s position in Transkaryotic, plaintiffs and their counsel may need to become more proactive and seek injunctive relief more often when questions regarding the adequacy of disclosure arise.[48] Due to the apparent lack of post-merger remedies and the reluctance to grant monetary damages following the effectiveness of a merger, plaintiffs in the future may become inclined to seek injunction for alleged disclosure problems even in minor circumstances. The Berger decision serves as a good review of the short-form merger requirements under Section 253 of the DGCL and reminds us that, while short-form mergers are generally simple and noncontraversial proceedings, it is important for companies and their counsel to closely following the statutorily-mandated requirements of Section 253 of the DGCL as well as to carefully consider the duty of disclosure to ensure that all material information that a minority shareholder needs to make his or her decision regarding appraisal is adequately disclosed. --Michael J. Delaney, Kilpatrick Stockton LLP Michael Delaney is a partner in Kilpatrick Stockton's Atlanta office. [1] Continental Oil Co. v. Pauley Petroleum, Inc., 25 A.2d 824, 826 (Del. 1969).

Page 10 of 12 [2] Malpiede v. Townson, 780 A.2d 1075, 1086 (Del. 2001). [3] Transkaryotic at p. 3 [4] In re Tri-StarPictures, Inc. Litigation, 634 A.2d 319, 333 (Del 1993). [5] Transkaryotic at 23. [6] Transkaryotic at 26; Globis Partners, L.P. v. Plumtree Software, Inc. C.A. No. 1577-VCP, 2007 WL 4292024, at *10 9Del Ch. Nov. 30, 2007). [7] Transkaryotic at 26 [8] Berger at 5; Transkaryotic at 17. [9] Transkaryotic at 17. [10] Berger at 5 citing Rosenblatt v. Getty Oil Co., 493 A.2d 929, 944 (Del. 1985). [11] Transkaryotic at 14. [12] Id at 15. [13] Id at 17-18. [14] Id at 29. [15] Transkaryotic at 28, 43. [16] Id. at 50. [17] Id. at 61. [18] Transkaryotic at 25. [19] Id at 26 [20] Id. [21] Id at 27 [22] Id.

Page 11 of 12 [23] Berger at 1. [24] Id. at 2. [25] Id. [26] Section 253 of the Delaware General Corporation Law. [27] Id.. [28] See Section 253 of the DGCL. [29] Berger at 2. [30] Id. [31] Id. at 2, 3. [32] Id. at 3. [33] Id. at 5. [34] Id. at 6 citing Glassman v. Unocal Exploration Corp., 777 A.2d 242, 247 (Del 2001). [35] Id. at 9. [36] Id. [37] Id. at 6 citing Skeen v. Jo-Ann Stores, Inc., 750 A.2d 1170, 1174 (Del 2000). [38] Id. at 3. [39] Id. at 9. [40] Id. at 11. [41] Id. [42] Id. at 9. [43] Id. at 11. [44] Id. at 13.

Page 12 of 12 [45] Id. [46] Id. [47] Id. at 14. [48] Deallawyers.com Blog, June 25, 2008. Duty of Disclosure: Delaware Chancery Court Further Limits Availability of Damages. All Content 2003-2008, Portfolio Media, Inc.