Delaware Court Of Chancery Holds That Corwin Cleansing Does Not Apply To Claims For Injunctive Relief Related To Alleged Defensive Measures
On May 1, 2023, Vice Chancellor Morgan T. Zurn of the Delaware Court of Chancery denied a motion to dismiss a putative stockholder class action asserting a breach of fiduciary duty claim against the directors of a telecommunications company (the “Corporation”) and seeking to enjoin alleged defensive measures. In re Edgio, Inc. Stockholders Litigation, C.A. No. 2022-0624-MTZ (Del. Ch. May 1, 2023). The action was brought after the Corporation acquired a portfolio company of an investor (the “Investor”) in exchange for a 35% stake in the post-merger entity and entry into a stockholders’ agreement that allegedly “restricted the [I]nvestor’s voting and transfer rights.” The stockholders of the Corporation voted in favor of the transaction in advance. Defendants argued that they were entitled to the “irrebuttable presumption of the business judgment rule” that applies “when a transaction is approved by a fully informed, uncoerced vote of the disinterested stockholders” under Corwin v. KKR Financial Holdings LLC, 125 A.3d 304 (Del. 2015). The Court, however, found that the relevant provisions in the stockholders’ agreement were subject at the pleading stage to “enhanced scrutiny” as alleged “defensive measures . . . designed to entrench the board.” The Court held that “Corwin cleansing” does not apply to a claim seeking to enjoin such alleged defensive measures.
Plaintiffs acknowledged that the acquisition was a “boon” to the Corporation and did not challenge the deal or most of the stockholders’ agreement. Nor did plaintiffs seek monetary damages. Instead, plaintiffs asked the Court to enjoin enforcement of certain provisions of the stockholders’ agreement.
Three provisions of the stockholders’ agreement were at issue: (i) a requirement for the Investor to vote in favor of the board’s director nominees; (ii) a requirement for the Investor to vote with respect to other “non-routine” matters in favor of the board’s recommendation or pro rata with all other stockholders of the Corporation; and (iii) “Transfer Restrictions,” which precluded the Investor from transferring its shares without the board’s consent for two years and for a third year to any investor on a published “SharkWatch 50” list. The Court noted that in the period before the transaction, the Corporation allegedly experienced financial decline, along with a substantially reduced stock price, and that analysts speculated that the Corporation might be a target for activist investors.
The Court explained that the enactment of defensive measures by a board in response to a “perceived threat” triggers “enhanced scrutiny” under Unocal Corporation v. Mesa Petroleum Company, 493 A.2d 946 (Del. 1985). Unocal requires that any such defensive measure be “proportionate and reasonable in relation to the threat posed” and that the board “bear[s] the burden of persuasion.” The Court noted that, to invoke Unocal, plaintiffs generally must plead facts to support a reasonable inference that the board acted with a “subjective motivation of defending against the perceived threat” and that this assessment is “context-specific.”
The Court found that the challenged provisions had “defensive effects” and concluded that the allegations in the complaint were sufficient to support the “plaintiff-friendly inference” that the directors acted with the “subjective motivation of defending against an activist threat.” The Court highlighted that the “SharkWatch 50” aspect of the Transfer Restrictions helped plaintiffs “bear a good deal of [their] burden” because it “expressly and specifically prohibited the transfer” of the Investor’s stock to “a list of entities likely to launch an activist campaign.” The Court also noted that this provision was negotiated in the context of the Corporation’s alleged financial difficulties and stock price decline, as well as speculation that the Corporation was an activist target.
Although the Court acknowledged that prior decisions had not “clearly resolved” the issue, it found that the text and policy of Corwin precluded its application to claims “seeking enhanced scrutiny to support injunctive relief” under Unocal. For instance, the Court noted that Corwin was based on “the long-standing policy . . . to avoid the uncertainties and costs of judicial second-guessing when the disinterested stockholders have had the free and informed chance to decide on the economic merits of a transaction for themselves.” But the Court found that “the injuries Unocal is designed to prevent elude valuation” and, therefore, “they cannot inform a stockholder vote on the economic merits of a transaction.” The Court also noted that Corwin made it clear that it was addressing the appropriate standard of review for a “post-closing damages action”—and not a claim for injunctive relief. Accordingly, the Court found Corwin inapplicable and denied the motion to dismiss.