On January 11, 2010, a year after a major corporate battle between the Dow Chemical Company (“Dow”) and Rohm & Haas Company (“ROH”) regarding a $19 billion merger, Chancellor Chandler dismissed derivative claims including Caremark-type allegations against Dow’s current directors and officers for failure to adequately plead demand futility under Court of Chancery Rule 23.1.
Anatomy of the Deal — “Ticking” Fee but No “Financing Out” or MAE Clause
In December 2007, Dow entered into a memorandum of understanding with Kuwait’s Petrochemicals Industries Company (“PIC”) for a joint venture referred to as “K-Dow.” Dow was to receive $9 billion in cash following the transfer of 50% interest in five Dow commodities chemical businesses. In July 2008, Dow entered into an $18.8 billion merger agreement wherein it would acquire all of ROH at $78 per share. The closing was scheduled to occur within 2 business days of receiving regulatory approval. Because Dow recognized that “uncertainty” regarding any aspect of the deal would be a death knell for the deal, Dow did not condition the closing on a financing or any other traditional “outs.” Dow assumed the risk of a material adverse effect in the chemical industry and financial markets. The merger agreement, however, did contain traditional penalties for delay or failure to close including specific performance and substantial “ticking” fees (interest on the cash portion of the deal which was estimated to be approximately $3.3 million per day).
As for financing, Dow had $9 billion from PIC, $4 billion from Berkshire Hathaway Inc. and the Kuwait Investment Authority, and a $13 billion bridge loan (available to be drawn upon if the ROH merger closed before K-Dow closed even though Dow’s position publicly was that the ROH merger was not contingent upon the closing of K-Dow).
Tightening of Credit Markets — Dow’s Picture Worsens
In July 2008, Dow’s earnings were strong, however, by 2009 Dow’s outlook and the economy in general took a downward turn. Dow’s credit ratings nearly fell to junk bond levels, which possibly meant that either Dow did not have the necessary cash reserves for the ROH deal or, if it closed, Dow would be insolvent following several credit defaults. Dow nonetheless proceeded with pre-closing plans for both K-Dow and ROH.
In late November 2008, Dow received approval for K-Dow from Kuwait’s Supreme Petroleum Council (the “SPC”) to close, which was slated for January 2, 2009. That approval was later rescinded by the SPC (without giving any reason) in late December 2008 – which prompted Dow to quickly issue a press release stating that the ROH closing was not contingent upon K-Dow. (Allegedly, behind the SPC’s rescission were inferences of “external interference,” “politicizing” of the oil industry, and other suspicions that suggested bribery on Dow’s behalf.) Dow Tries to Extend the Closing
As of January 9, 2009, the only remaining regulatory approval needed was that of the FTC. According to the Plaintiffs, Dow lobbied the FTC to delay approval and also asked ROH to extend the closing deadline. Neither request succeeded. The FTC granted final antitrust clearance for the transaction on January 23, 2009, which triggered a closing no later than January 27, 2009. Two days before closing, Dow refused to close citing two reasons: (i) a change in the economic climate; and (ii) the likelihood that the combined Dow-ROH entity would fail. ROH sued Dow on January 26, 2009 for specific performance. That litigation settled before as trial was about to start and the merger closed on April 1, 2009 “on substantially altered financial terms.”
Plaintiffs brought a litany of claims including breaches of fiduciary duties by the Directors for: “(a) approving the [ROH] Transaction, (b) misrepresenting the relationship between the [ROH] and K-Dow transactions, (c) failing to detect and prevent alleged bribery in connection with the K-Dow transaction, (d) failing to detect and prevent the alleged misrepresentations, (e) failing to detect and prevent insider trading, and (f) failing to prevent the payment of allegedly excessive and wasteful compensation.”
Plaintiffs, in bringing a derivative action, must satisfy Court of Chancery Rule 23.1 by either making a pre-suit demand or alleging demand futility. The Court stated that the purpose of the demand requirement “is not to insulate [directors] from liability; rather … to preserve the primacy of board decisionmaking regarding legal claims belonging to the corporation.” Demand is futile and therefore excused “only if a majority of the directors have such a personal stake in the matter at issue or the proposed litigation that they would not be able to make a proper business judgment in response to a demand.”
The Court also noted that while the procedural posture was a motion to dismiss, the more liberal standard of Rule 12(b)(6) did not apply. Because the claims were derivative, the motion must be considered under Rule 23.1: “demand futility under Rule 23.1 is ‘logically the first issue [for all derivative claims] and if plaintiffs cannot succeed under the heightened pleading requirements of Rule 23.1 . . . there is no need to proceed to an analysis of the merits of the claim’ under Rule 12(b)(6).” Moreover, two different demand standards applied to Plaintiffs’ claims. For the claims regarding a board action — the Directors’ approval of the ROH merger — the Court applied the Aronson test. For claims regarding board inaction (Caremark claims), the Court applied the Rales test.
Approval of the ROH Merger
Under Aronson, Plaintiffs were required to “plead particularized facts that raise a reasonable doubt either (i) that a majority of the directors who approved the transaction in question were disinterested and independent, or (ii) that the transaction was the product of the board’s good faith, informed business judgment.”
First Prong of Aronson
Plaintiffs allege that demand was excused as futile because half of the board failed the test of being disinterested or independent because of their relationships with director Liveris – yet they did not allege that Liveris was interested in the transaction. Plaintiffs pointed to Liveris’ role as a director at Citigroup – which was the named bank among many that were to provide the bridge loan if needed. Under this theory, the Court noted that Liveris potentially had a conflict of interest if ROH had forced Dow to draw upon the bridge loan to close and had Dow consequently gone into bankruptcy. However, this was merely a potential conflict and does not reasonably lead to the conclusion that a conflict existed. With no conflict of interest, there was no interested director and “without an interested director, the Court stated that the independence of the remaining directors need not be examined. Plainly put, the beholdenness or dominance of any director is irrelevant because there is no fear that the dominating director, without a personal or adverse interest, will do anything contrary to the best interest of the company and its stockholders.” With Plaintiffs failing to meet the burden under Rule 23.1, the Court held that the majority of the Directors were disinterested and independent.
Second Prong of Aronson
The Court held that the complaint failed to indicate that the Directors were not adequately informed. To survive the second prong of Aronson, the “‘plaintiffs must plead particularized facts sufficient to raise (1) a reason to doubt that the action was taken honestly and in good faith or (2) a reason to doubt that the board was adequately informed in making the decision.’”
The Court found that “[n]othing in the complaint indicates the Dow board was not adequately informed about the transaction with [ROH].” Taking into consideration the economic times, the Court noted that “[e]ven accepting all the well-pled allegations as true, plaintiffs do not rebut or address the accepted facts that the board was negotiating in a seller’s market and [ROH] demanded certain deal protections.” The Directors made a decision to enter the merger agreement without a financing contingency because they did not want ROH to seek another partner. The Plaintiffs focused on the “substantive content of the directors’ decision” as opposed to the process. As Chancellor Chandler stated in Citigroup, “substantive second- guessing of the merits of a business decision . . . is precisely the kind of inquiry that the business judgment rule prohibits.”
The Court stated:
“To show that a disinterested and independent board acted outside the bounds of business judgment, plaintiffs must show that directors acted in bad faith. Recently, the Supreme Court clarified the concept of bad faith in Lyondell Chemical Co. v. Ryan, noting that ‘[i]n the transactional context, [an] extreme set of facts [is] required to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties.’ Plaintiffs must show that defendants completely and ‘utterly failed’ to even attempt to meet their duties.”
While the Plaintiffs claimed that the directors misrepresented the connection between ROH and the K-Dow deals, the Court found no misrepresentation of the relationship. Thus, having failed to show reasonable doubt that the Directors did not exercise valid business judgment, the Court held that Plaintiffs failed to satisfy the second prong of Aronson. Coupled with the failure to prove either interestedness or lack of independence, the Court dismissed with prejudice the claim for breach of fiduciary duties regarding the ROH merger.
Caremark Failure to Supervise
Demand futility for the Caremark monitoring claims was governed by Rales wherein:
[D]efendant directors who face a “substantial likelihood of personal liability” are deemed interested in the transaction and thus cannot make an impartial decision. But “[d]emand is not excused solely because the directors would be deciding to sue themselves.” Rather, “demand will be excused based on a possibility of personal director liability only in the rare case when a plaintiff is able to show director conduct that is ‘so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists.’”
The core of Plaintiffs’ Caremark claims was that the failure to monitor subjected Dow to be exposed to liability for 1) bribery allegations in K-Dow; 2) misrepresentations regarding the need for K-Dow to close to provide financing for ROH; and 3) insider trading and waste allegations.
To prevail on their claim for oversight liability, Plaintiffs must show that the directors knew they were not discharging their fiduciary obligations or that the directors demonstrated a conscious disregard for their responsibilities such as by failing to act in the face of a known duty to act.” Furthermore, the test is “rooted in concepts of bad faith; indeed, a showing of bad faith is a necessary condition to director oversight liability.” Only an “utter failure” will satisfy a showing of bad faith. Moreover, because Dow has adopted a Section 102(b)(7) provision in its charter, plaintiffs must plead particularized facts showing bad faith in order to establish a substantial likelihood of personal directorial liability.
K-Dow Bribery Allegations
Plaintiffs claimed that the Directors failed to detect and prevent bribery related to K-Dow was “supported” by an unsubstantiated charge made by a Kuwaiti Parliament member. Nonetheless, at the motion to dismiss stage the complaint contained facts that allowed the Court to infer that bribery may have occurred. However, Plaintiffs failed to plead the “red flags” that would give the Directors a basis for suspicion. Plaintiffs argued that because members of Dow’s management may have been involved with bribery issues in the past (Dow paid a fine to the SEC in January 2008), the Board should have suspected similar behavior here. However, the Court rejected that argument because it was found that the prior infractions involved different members of management, a different country, and a different transaction.
Lacking both the knowledge of and reason to suspect bribery, the Directors could not have consciously disregarded their duty to supervise. Nor did Plaintiffs plead facts to suggest an “utter failure” to supervise insiders or that any director acted with anything but good faith. Accordingly, Plaintiffs failed to “allege facts that establish a substantial likelihood of director liability due to oversight liability under Citigroup . . . .” The bribery claim was dismissed with prejudice.
Interestingly, in footnote 85, the Court noted that Dow had set up policies to prevent improper dealings with third parties in its Code of Ethics which expressly prohibited unethical payments to third parties. Plaintiffs also made allegations that defendants permitted their corporate governance policies to be compromised. The Court said in essence that you can’t have it both ways – “Plaintiffs cannot simultaneously argue that the Dow board ‘utterly failed’ to meet its oversight duties yet had “corporate governance procedures” in place without alleging that the board deliberately failed to monitor its ethics policy or its internal procedures.”
Director(s) Domination or Control of Board
Finally, Plaintiffs argued that nonetheless Liveris faced a substantial likelihood for failing to supervise and that he dominated and controlled a majority of the Directors. Without reiterating its reasons, the Court held that Plaintiffs had not pled facts sufficient to show that Liveris, like the other directors, was subject to a substantial liability of interest. Having no conflict, it was irrelevant whether he dominated and controlled a majority of the Directors.
In conclusion, having failed to establish that even one director faced a substantial likelihood of liability, Plaintiffs were unable to show that the board was dominated, controlled, and improperly influenced. Thus, under Rales, Plaintiffs failed to establish that demand was excused so the claims were dismissed.
This summary was prepared by Kevin F. Brady and Ryan P. Newell.