In this edition of Dechert’s Securities & Derivative Litigation Quarterly Update, we examine: (1) the Delaware Court of Chancery’s latest post-trial decision showing how the special committee process is critical in the successful defense of claims for breaches of fiduciary duties; (2) the Delaware Court of Chancery’s signaling of a possible evolution in Delaware’s oversight caselaw based on a failure to oversee business risk; (3) an update in the Ninth Circuit on its decision to rehear en banc a panel decision enforcing an exclusive forum selection clause favoring state court derivative claims; and (4) the SDNY’s ruling in a rare Regulation FD enforcement action.

Special Committee Process Critical for Trial Defense of Stockholder Challenge to Controller Transaction

On August 19, 2022, the Delaware Court of Chancery ruled in a post-trial decision in In re BGC Partners, Inc. Derivative Litigation¹ challenging BGC Partners, Inc.’s (“BGC”) late 2017 acquisition of Berkeley Point Financial, LLC (“Berkeley Point”) for $875 million from an affiliate of Cantor Fitzgerald, L.P., with BGC simultaneously investing $100 million in a Cantor affiliate’s mortgage-backed securities business.² At issue in BGC was whether the transaction, which had a controlling stockholder standing on both sides of the deal, satisfied entire fairness review—one of the highest levels of scrutiny the Court will apply to a corporate transaction.³ The Court credited some of Plaintiffs’ concerns about the process, yet ultimately held that the diligent effort displayed by the special committee of BGC’s Board of Directors in negotiating the transaction and staying informed of its options led to the conclusion that the transaction had been entirely fair to BGC and its minority stockholders. The Court’s decision in BGC, along with other recent authority,⁴ demonstrates that a sufficiently robust special committee process is a critical tool for the successful defense of claims for breach of fiduciary duty.

At trial, Plaintiffs argued that “Howard Lutnick—the controlling stockholder of both BGC and Cantor—caused BGC to undertake a deal that benefitted him at the expense of BGC’s stockholders.”⁵ Plaintiffs further argued “that the transaction was a fait accompli constructed by” the controller with an ineffective special committee “repeatedly acceding to [the controller’s] whims.”⁶

The Court found that Plaintiffs had established some weakness in the committee process at trial.⁷ The Court noted that BGC’s controller initiated the deal and had financial incentive to make BGC overpay for Berkely Point.⁸ In addition, BGC’s controller “overstepped in identifying advisors for the special committee and asking its co-chairs to serve.”⁹ The Court added that “[i]information was slow rolled to the special committee … [and] [f]inal negotiations unfolded over a compressed time period.”¹⁰ At the time of final negotiations, “the special committee’s written counterproposal did not reflect its preferred structure … [a]nd there remains some mystery around how the ultimate deal was reached.”¹¹

Despite these concerns, the Court ultimately concluded that the special committee’s process was sufficiently robust, thereby shifting the burden of proving unfairness to Plaintiffs. The Court noted several key factors in favor of the special committee having done its job:

• The majority of the special committee was independent and advised by independent advisors;¹²
• After the special committee was empowered, the controller removed himself from the committee’s deliberations;¹³
• The timing of the deal was a result of bargaining and did not favor the controller or disadvantage minority stockholders;¹⁴
• The special committee acted carefully, having met at least nine times over a three-month negotiation period and possessing the information and due diligence needed to negotiate the deal;¹⁵ and,
• Robust negotiations led to approval of the final deal, with the committee members working tirelessly, pushing back on the controller when needed, and obtaining meaningful concessions through its bargaining with Cantor.¹⁶

For all these reasons, the Court believed that “the Special Committee process was sufficient to merit a shift of the burden of proving unfairness to the plaintiffs. . . .”¹⁷ The Court further found that, based on contemporaneous evidence (including the opinion of the special committee’s investment banker’s) and expert testimony, the acquisition price of $875 million for Berkeley Point, “a unique asset particularly appealing to BGC,” fell within the range of fair values.¹⁸ Accordingly, the Court concluded that the transaction was entirely fair and entered judgment for Defendants.

Controller transactions often will draw fiduciary litigation. While Delaware courts have provided a rigorous process for obtaining deferential review of a controller transaction under the business judgment rule,¹⁹ for various reasons that process or deferential review may be unavailable. In those situations, the BGC decision provides another data point that a finding of liability is not inevitable whenever a transaction is subject to entire fairness review. Indeed, a sufficiently robust special committee and transaction process can defeat claims subject to entire fairness review, provided that a detailed, carefully maintained record exists that the committee was able to negotiate the transaction at the critical stages without interference from the controller and that the price paid was fair.

Delaware Court of Chancery Notes the Potential for Director Liability Based on a Failure to Oversee Business Risk

Oversight claims (otherwise known as Caremark claims²⁰) are frequently described by the Delaware Court of Chancery and the defense bar as “one of the most difficult claims to cause to clear a motion to dismiss.”²¹ In Construction Industry Laborers Pension Fund et al. v. Bingle et al., that proved to be the case, with Vice Chancellor Glasscock readily disposing of such claims brought against the Board of Directors of SolarWinds Corporation arising out of a December 2020 cyberattack on the company.²²

The Bingle decision is more significant for the Court’s discussion of a possible evolution in Delaware’s oversight caselaw. Caremark claims have historically been focused on the failure by directors to impose reporting systems or to act in the face of red flags “in connection with the corporation’s violation of positive law.”²³ In Bingle, the Court noted and discussed the potential for oversight liability premised on a failure to monitor business risk­­.

The Court noted that “[m]any Delaware cases have cautioned that whether Caremark should be applied to business risk remains an open question.”²⁴ The Court further explained that Caremark claims have required a “sufficient connection between the corporate trauma and the actions or inactions of the board.”²⁵ In the Court’s view, that Caremark cases have generally focused on violations of applicable law is understandable because it is easier to establish the appropriate nexus between a failed oversight of legal compliance and a corporate trauma based on a breach of the applicable law. With regard to whether such a connection could exist for a failure to monitor business risk, the Court stated “it is possible, I think, to envision an extreme hypothetical involving liability for bad faith actions of directors leading to such liability.”²⁶ The Court ultimately determined that it did not need to address the issues it flagged because the complaint failed the traditional Caremark analysis, which requires pleading facts establishing that the directors knew that they were not discharging their fiduciary obligations.

Nonetheless, there is much about the Court’s discussion of oversight liability for business risk that should give directors and their advisors pause. Under what factual scenarios do attempts to monitor business risk transcend from reasonable business decisions to inactions taken in bad faith?²⁷ Likewise, how would the Court reconcile “the presumption of the business judgment rule, the protection of an exculpatory § 102(b)(7) provision, and the difficulty of proving a Caremark claim” in the context of business risk, and without inviting plaintiffs to offer improper, hindsight challenges “to the prudence of the directors’ business decisions”?²⁸ Given the growing attention within corporate governance circles and the investing community for environmental, social, and governance (“ESG”) risks, these questions are likely to become paramount in the coming years.

One can read the Bingle decision as a warning to companies and their directors, officers, and in-house and outside counsel that oversight liability for business risk is coming. Clients and their counsel should be developing strategies today to prepare for and account for this development.

Ninth Circuit to Rehear En Banc a Panel Decision Over the Validity of Forum Selection Clauses as Applied to Derivative Claims for Violations of Section 14(a) of The Securities Exchange Act

As previously noted in Dechert’s last Securities and Derivative Litigation Quarterly Update, the Ninth Circuit in Lee v. Fisher²⁹ recently affirmed the dismissal of a shareholder derivative action asserting both federal and state claims against Gap Inc’s directors and officers for their alleged failure to uphold diversity and inclusion commitments. The district court dismissed the lawsuit based on a forum selection clause requiring derivative suits to be filed exclusively in the Delaware Court of Chancery. The Ninth Circuit decision affirming the district court’s dismissal has not only been a favorable development to companies and their directors, but also significant because it seemingly conflicts with the recent decision of a divided Seventh Circuit panel in Seafarers Pension Plan v. Bradway,³⁰ which had refused to enforce an exclusive forum selection clause in similar circumstances. Perhaps seeing the uncertainty and conflict around this development, the Ninth Circuit agreed to rehear the matter en banc.

In Lee, the Ninth Circuit panel affirmed the district court’s dismissal of the derivative complaint, noting that Plaintiff “conced[ed] that Gap’s forum selection clause is valid” and the “only question” was whether the clause was “enforceable” under the circumstances.³¹ The panel turned to Supreme Court cases, explaining that a plaintiff must show “extraordinary circumstances” to avoid enforcement of a valid forum-selection clause.³² The panel rejected Plaintiff’s antiwaiver argument³³ and explained that the Exchange Act’s exclusive jurisdiction provision is likewise insufficient.³⁴ The panel also observed that Plaintiff had made no argument that she would be unable to obtain relief under state law in Delaware Chancery Court.³⁵ Concluding that the plaintiff did not meet her heavy burden to show that enforcing Gap’s forum-selection clause contravenes strong federal public policy³⁶, the Ninth Circuit panel upheld the provision.

Since then, the plaintiff-appellant in Lee petitioned for rehearing en banc. Plaintiff argued that rehearing en banc is necessary because the panel “knowingly created a conflict with the authoritative decision of the Seventh Circuit in Seafarers Pension Plan. Plaintiff cautioned the Court that the panel’s decision “permits companies to enact bylaws designating a state court forum as the exclusive forum for a variety of claims—including claims subject to the exclusive federal jurisdiction.”³⁷ Defendants-appellees argued in part that the petition did not satisfy the standards for en banc review, arguing the panel correctly enforced the forum selection clause and there was no clear circuit conflict.³⁸ On October 24, 2022, the Ninth Circuit vacated its decision and agreed to rehear the matter en banc.³⁹ It remains to be seen if the rehearing will give more clarity or pave the way for the possibility of Supreme Court review.

Court’s Ruling Sets the Stage for Rare Trial in Regulation FD Enforcement Action

In SEC v. AT&T,⁴⁰ Judge Paul A. Engelmayer of the Southern District of New York denied cross-motions for summary judgment in a “rare litigated enforcement action brought by the Securities and Exchange Commission” under Regulation FD (Fair Disclosure). The SEC promulgated Regulation FD in 2000 to prohibit “selective disclosure” by public companies of material nonpublic information.⁴¹ The regulation’s purpose is two-fold. First, to prevent insider trading-like behavior that enables “a privileged few [to] gain an information edge—and the ability to use that edge to profit—from their superior access to corporate insiders, rather than from their skill, acumen, or diligence.”⁴² Second, to prevent issuers from using “material information as a commodity to be used to gain or maintain favor with particular analysts or investors.”⁴³

In AT&T, the SEC claimed that the company and three members of its investor relations team violated Regulation FD by selectively disclosing material non-public information about AT&T’s consolidated total revenue, wireless equipment revenue, and wireless upgrade rates to analysts at 20 Wall Street firms.⁴⁴ The SEC alleged that AT&T’s goal was to “manage” those analysts to reduce their estimates of the company’s Q1 2016 revenue, to enable the company to beat the consensus revenue estimates for that quarter after missing consensus revenue estimates in two of the three preceding quarters.⁴⁵ According to the SEC, the defendants’ alleged campaign worked, with AT&T’s total revenue exceeding analysts’ final consensus revenue estimate by 0.1%.⁴⁶

In denying AT&T’s motion for summary judgment, the Court first rejected AT&T’s threshold legal challenges to Regulation FD—that it was unconstitutional, promulgated without statutory authority, and logically inoperable.⁴⁷ Turning to the merits, the Court held that the SEC had adduced “formidable” evidence “that the information that the individual defendants selectively disclosed about AT&T in their calls to analysts was both material and nonpublic.”⁴⁸ Applying the traditional test for materiality under the securities laws, the Court held that the “overwhelming” evidence that “AT&T’s disclosures enabled it to avoid again missing consensus was a sufficient basis for the SEC’s claims to reach a jury.”⁴⁹ The Court rejected the defendants’ various quantitative and qualitative attacks on the materiality of the financial metrics, noting that a jury could find that AT&T itself treated those metrics as significant internally and when interacting with investors, and that many analysts addressed them in reports to investors.⁵⁰ Further, with respect to the requirement that “nonpublic” information be disclosed, the Court concluded that “AT&T undisputedly had not publicly revealed the Q1 2016 results at issue.”⁵¹ And, it rejected the defendants’ fact-bound arguments that they did not make the claimed disclosures and that the analysts could have extrapolated the Q1 2016 results from public information.⁵²

Despite stating that the evidence “lopsidedly support[ed] the SEC’s claim” on these elements, the Court denied the SEC’s motion for summary judgment, holding that there was “substantial evidence on which a jury could find for either side as to the scienter element.”⁵³ Under Regulation FD, “a selective disclosure of material nonpublic information is ‘intentional’ when the person making the disclosure either knows, or is reckless is not knowing, that the information he or she is communicating is both material and nonpublic.”⁵⁴ The Court explained that a jury, finding the facts for the SEC, could find scienter based on, among other things, the sheer number of disclosures, the variety of data disclosed, the sustained duration of the disclosures, and the training the defendants had received on Regulation FD.⁵⁵ However, the Court also found that a reasonable jury could make a contrary finding in favor of the defendants based on, among other things, defendants’ testimony that they had not appreciated that the information was material and nonpublic, the fact that no one within AT&T “raised an alarm” over the disclosures, and the absence of evidence that any analysts expressed concern over the disclosures.⁵⁶ Accordingly, the Court concluded that, barring settlement, the case will proceed to trial.

While Regulation FD enforcement actions are rare, AT&T is an important reminder that the SEC continues to police selective disclosures, particularly in the areas identified in the adopting release as more likely to be considered material, such as “earnings information.” It remains to be seen whether the SEC will ultimately carry its burden of proof at trial.

Footnotes:

1. --- A.3d ----, No. 2018-0722-LWW, 2022 WL 3581641 (Del. Ch. Aug. 19, 2022).
2. Id. at *1.
3. Id. at *2, *17.
4. See, e.g., In re Tesla Motors, Inc. S'holder Litig., Consol. C.A. No. 12711-VCS, 2022 WL 1237185 (Del. Ch. Apr. 27, 2022).
5. In re BGC Partners, Inc., 2022 WL 3581641, at *1.
6. Id. at *1.
7. Id. at *1.
8. Id. at *1.
9. Id. at *1.
10. Id. at *18.
11. Id. at *1.
12. Id. at *18-20.
13. Id. at *1.
14. Id. at *19.
15. Id. at *1, 24.
16. Id. at *10-11, 24.
17. Id. at *28.
18. Id. at *2, *28-42.
19. In Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) and its progeny, the Delaware Supreme Court held that the business judgment rule would apply to a controller transaction conditioned—before any substantive economic discussions take place—on the uncoerced, informed approval of a majority of the minority stockholders and of a fully empowered special committee of independent directors with the authority to say “no” to the deal.
20. So named, after the seminal decision of In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996), in which Chancellor Allen described the contours of director liability for a failure to monitor for and prevent corporate misconduct.
21. C.A. No. 2021-0940-S.G., 2022 WL 4102492, at *1 (Del. Ch. Sep. 6, 2022).
22. Id. at *4
23. Id. at *1.
24. Id. at *7 (citing cases).
25. Id. at *6 (cleaned up).
26. Id. at 7
27. See id. at *9.
28. In re Citigroup Inc. S’holder Deriv. Litig., 964 A.2d 106, 125-126 (Del. Ch. 2009); cf. Bingle, 2002 WL 4102492, at *8.
29. 34 F. 4th 777 (9th Cir. 2022).
30. 23 F.4th 714 (7th Cir. 2022).
31. Id. at 780
32. Id.
33. Id. at 781.
34. Id.
35. Id. at 782.
36. Pet. Br. at 1 (Dkt. 50).
37. Pet. Br. at 2 (Dkt. 50).
38. Response Br. at 9-16 (Dkt. 54).
39. Order (Oct. 24, 2022) (Dkt. 56).
40. SEC v. AT&T, -- F.3d --, No. 21-cv-01951-PAE, 2022 WL 4110466 (S.D.N.Y. Sep. 8, 2022).Id. (quoting Adopting Release, at *2).
41. Id. at *2 (quoting Final Rule: Selective Disclosure and Insider Trading, SEC Release No. 7881, 2000 WL 1201556, at *2 (Aug. 15, 2000) (“Adopting Release”)).
42. Id. (quoting Adopting Release, at *2).
43. Id. (quoting Adopting Release, at *2).
44. Id. at *1.
45. Id.
46. Id.
47. Id. at *27.
48. Id. at *2.
49. Id. at *47.
50. Id. at *47-*52.
51. Id. at *53
52. Id. at *54.
53. Id. at *58.
54. Id. (quoting 17 C.F.R. § 243.100(a)(1)).
55. Id. at *59.
56. Id. at *60–*62.

* The authors would like to thank Andrew Stahl for his contributions to the OnPoint.