George P. Shenas

Can Delaware Directors Rely on Corporate Exculpation Clauses or Do LLC Contractual Exculpation Clauses Offer a Safer Haven?

Two opinions have recently been issued by the Delaware Chancery Court in connection with actions filed against corporate directors who allegedly approved the sale of their respective companies in breach of certain obligations owed by the defendant directors to their shareholders. In each of the two cases, a key issue addressed by the courts was the extent to which certain language contained in the corporate certificates of incorporation for the purpose of eliminating or limiting the personal liability of the corporate directors (i.e. exculpation clauses) effectively shielded the directors against the types of claims being asserted by the plaintiffs. Given that each of these cases arose as a result of acts or omissions by the defendants taken in a mergers and acquisitions context, they bear careful scrutiny by all M&A lawyers and corporate directors.

The cases of Ryan v. Lyondell Chemical Company¹ and McPadden v. Sidhu² involved suits against directors who in each instance relied on broadly worded exculpatory clauses authorized under Delaware GCL Sec. 102(7), eliminating the personal liability of the corporate directors for monetary damages for breach of fiduciary duty as directors, so long as there was: (i) no breach of a director's duty of loyalty to the corporation or its shareholders; (ii) no acts or omissions not in good faith or involving intentional misconduct or knowing violation of law; and (iii) no transactions from which the director derived an improper personal benefit. In each case, the defendant directors argued that they were guilty of no more than acts of gross negligence, at worst, and thus were protected by the exculpatory clauses in the certificates of incorporation.

Curiously, the Chancery Court in Ryan (where the board approved a sale of the company for a "blow-out" premium supported by a fairness opinion) denied the defendants' motion for summary judgment on the grounds that there was sufficient evidence on the record from which a trier of fact could find that the directors' failure to take necessary steps to establish value transcended gross negligence in that it could have involved an "intentional dereliction of duty or a conscious disregard of one's responsibilities." As such it could involve a "non-exculpable, non-indemnifiable violation of the fiduciary duty to act in good faith."

Almost concurrently, in the McPadden case, the directors of another Delaware corporation approved the sale of a subsidiary to an entity substantially owned and controlled by the CEO of the subsidiary, who had been charged with the responsibility of selling the subsidiary. Despite a stunning series of inept decisions and omissions by the board which appeared to ignore the apparent self-dealing by the CEO (resulting in the sale of the subsidiary for $3.0 million to the CEO's entity, which thereafter resold the subsidiary two years later for $25.0 million), the court concluded that the pleadings in the case failed to properly plead that the defendant directors had acted in bad faith through a conscious disregard of their duties. Since the plaintiff had only pleaded facts supporting a claim of gross negligence, the court dismissed the action for failure to state a claim.

Quite obviously, it is hard for any director or his legal counsel to discern a "bright line" path being laid out in these two corporate cases. The subtle distinction between acting in a grossly negligent manner, on the one hand, or engaging in an intentional dereliction of duty or a conscious disregard of one's responsibility, on the other hand, is essentially found in the state of mind of the director when performing or omitting to perform an act. Whereas, in the Ryan case, the Court was willing to attribute to the defendant directors the requisite state of mind to avoid exculpation, the McPadden court was unwilling to do so. These opinions become particularly difficult to reconcile in that the directors in Ryan supported the sale of the company for a "blow-out" premium yet lost their summary judgment motion, while the directors in McPadden who approved the sale of the subsidiary to an insider for a patently inadequate price were able to avoid liability by virtue of the exculpatory language in the certificate of incorporation.

The case of Wood v. Baum³, recently decided by the Delaware Supreme Court, bears some scrutiny in light of the uncertainties raised by the Ryan and McPadden opinions. In Wood, the directors of a Delaware limited liability company were sued in connection with certain alleged wrongdoings. The defendants asserted that the exculpatory clauses contained in the LLC's operating agreement, as permitted by Section 18-1101 of the Delaware Limited Liability Company Act (the "LLCA"), insulated them from all liability except for claims of "fraudulent or illegal conduct," or "bad faith violations of the implied contractual covenant of good faith and fair dealing." Thus, the Court reasoned, in order for the plaintiff to get around the contractual exculpation clause, the plaintiff would have to plead particularized facts that demonstrated that the directors acted with scienter, i.e., that they had "actual or constructive knowledge" that their conduct was legally improper.

Clearly, therefore, it appears that the breadth of exculpation permitted by the LLCA is substantially greater than the protection allowed by Delaware GCL Sec. 102(7), as discussed above in relation to the Ryan and McPadden cases. Consequently, any founder/director forming a new company with the intent of selling the company or its assets as an exit strategy should give serious consideration to using a Delaware LLC rather than a corporation as the business vehicle of choice in order to provide an extra layer of protection against possibly dissident investors.

¹Del. Ch., August 20, 2008
²Del. Ch., August 28, 2008
³ 2008 Del. LEXIS 301  (Del. July 1, 2008)

George P. Shenas