In Breach Of Fiduciary Duty Case, Defendants Have Burden To Show Their Assumed Misconduct Caused No Harm
CDX LIQUIDATING TRUST v. VENROCK ASSOCIATES (March 29, 2011)
Cadant was founded in 1998 to develop systems for home Internet access. It was based in Illinois but it was incorporated in Maryland. Two venture capital firms, Venrock and J.P. Morgan, invested in the company and received preferred stock in exchange. Eric Copeland, a Venrock principle, also became a Cadant board member. In early 2000, the Cadant board rejected a tentative $300 million purchase offer. Several months later, the company started experiencing financial difficulties. After considering several options, the board approved an $11 million bridge loan from Venrock and J.P. Morgan. Copeland negotiated the loan on behalf of Cadant. On January 1, 2001, the company reincorporated in Delaware. In May, the company entered into a second bridge loan from Venrock and J.P. Morgan, this time for $9 million. Again, Copeland negotiated for Cadant. The agreement provided that the lenders would be entitled to twice the outstanding principal if Cadant was liquidated. Cadant defaulted and sold its assets for stock valued at $55 million. The sale amount was just enough to pay off creditors and preferred shareholders. It was approved by the board and also a simple majority of shareholders. The common stock shareholders brought suit charging several directors with breaches of their duty of loyalty and also alleging that Venrock and J.P. Morgan aided and abetted the directors. In an earlier appeal to the Seventh Circuit, the Court held that the case was improperly brought and should be brought as a derivative suit. Judge Norgle (N.D. Ill.) bifurcated the trial and granted defendants' motion for judgment as a matter of law at the end of the plaintiffs' liability case. Plaintiffs appeal.
In their opinion, Judges Posner, Flaum, and Sykes reversed and remanded. The Court first addressed choice of law. Illinois choice of law principles direct the Court to the law of the state of incorporation in a breach of fiduciary duty case. Maryland law therefore applied to the first alleged breach (the purchase offer rejection). That allegation was properly dismissed because Maryland imposes no duty on directors to accept, or even respond, to a purchase proposal. The other allegations, relating principally to the bridge loans, straddled the Delaware reincorporation. The negotiations for the first loan began before the reincorporation but the loan was finalized shortly after. Since it could not apply the laws of both states, the Court looked to which state’s law the parties would have expected to govern and which state had the higher regulatory interest. The answer to both questions was Delaware. So the court turned to the merits, applying Delaware law. The district judge had given too grounds for granting judgment: insufficient evidence of proximate cause, and insufficient evidence of a breach of fiduciary duty. The Court disagreed with the district court's approach to causation. Under Delaware law, once a plaintiff rebuts the business judgment defense with evidence of a breach of fiduciary duty, the burden shifts to the directors to prove the transaction's "entire fairness" to the shareholders. If the transaction at issue is the sale of the company, for example, the directors can prove that they obtained the highest reasonable value and therefore "caused" no loss. Here, the defendant directors had to rebut the breach evidence by proving that their misconduct had no effect on the outcome of the deal. In addition to the fact that the district court applied the burden of causation improperly, the Court also concluded that there was enough causation evidence to send the case to a jury. A similar company brought $300 million in the marketplace shortly after Cadant brought $55 million. There is evidence that the oppressive terms of the bridge loans negotiated by Copeland contributed to Cadant's inability to bring fair value. The Court also rejected the defendant directors' argument that there could be no breach of loyalty when their conflict of interest was fully disclosed. But the directors are not accused of disloyalty because they had a conflict of interest -- they are accused of actually being disloyal. Actual disloyalty is not excused by disclosing a conflict of interest. Finally, the Court concluded that the evidence of aiding and abetting on the part of Venrock and J.P. Morgan was sufficient to get the plaintiffs to a jury.
Plaintiffs Hale and others filed a derivative action against China Online, Victor Chu, and others. They alleged that the defendants breached certain fiduciary duties owed to China Online and its shareholders. Chu removed, asserting that diversity exists if China Online is ignored -- and China Online should be ignored because it was fraudulently joined. Plaintiffs moved to remand and Chu moved to dismiss. Judge Kendall (N.D. Ill.) denied the former and granted the latter. The court relied on the fact that the company’s dissolution terminated plaintiffs' status as shareholders and their ability to bring a derivative action. Alternatively, the court stated that it would dismiss for plaintiffs' failure to make the requisite demand or show futility. Plaintiffs appeal.