February 2024 in Brief: Corporations, LLCs & Partnerships

Delaware Court of Chancery Grants Defendants’ Rule 23.1 Motion to Dismiss Plaintiffs’ Derivative Action against Walgreens and Its Board for Failure to Plead a Valid Caremark Duty of Oversight Claim

Clem v. Skinner, C.A. No. 2021-0240-LWW (Del. Ch. Feb. 20, 2024)

By Pamela L. Millard, Potter Anderson & Corroon LLP

In an opinion granting defendants’ Motion to Dismiss, the Court of Chancery (the “Court”) held that despite Caremark suits “proliferating” in Delaware over the past several years, plaintiffs failed to overcome evidence proving that the Board of Directors (the “Board”) of Walgreens Boots Alliance, Inc. (“Walgreens”) actively oversaw certain corporate harms relating to Walgreens’ pharmacy business, and none of the directors faced a substantial likelihood of liability under the Zuckerberg standard for determining Rule 23.1 demand futility. The opinion provides important commentary around the outer bounds of Caremark duty of oversight claims, observing that of many recent Caremark claims filed in Delaware, “[t]he few deemed viable concern severe corporate trauma and rely on board records suggesting a complete failure to oversee related core risks.”

Under Zuckerberg, the Delaware courts apply a three-part test to determine demand futility: (1) whether a director received a material personal benefit from the alleged conduct that is the subject of the demand; (2) whether the director faces a substantial likelihood of liability on any of the claims that are the subject of the demand; and (3) whether the director lacks independence from someone who received a personal material benefit from the alleged misconduct that is the subject of the litigation demand or who would face substantial likelihood on any of the claims that are the subject of the litigation demand.

Over the past decade, Walgreens became the subject of various government investigations relating to its pharmacy services and prescription business. In 2019, Walgreens settled a Department of Justice claim and entered into an agreement with the US Department of Health and Human Services codifying various compliance procedures that the Board’s Audit Committee was required to monitor in connection with dispensing a discrete category of insulin pens.

In 2021, after foregoing pre-suit demand on the Board, plaintiffs filed breach of fiduciary duty and unjust enrichment claims against Walgreens’ current and former directors and officers, claiming that demand on the Board would be futile.

Utilizing the “count heads” approach applicable to the Court’s determination of whether a majority of the Board was disinterested and independent for demand futility purposes, the Court first acknowledged that plaintiffs did not contest the independence of eight of twelve directors serving on the Board at the time plaintiffs’ complaint was filed. Finding prongs one and three of the Zuckerberg test inapplicable to the facts of the case, the Court also noted that plaintiffs were required to plead “particularized facts raising a reasonable doubt that a majority of the Demand Board faces a substantial liability of unexculpated liability” under the second prong of Zuckerberg.

To fulfill the second prong of Zuckerberg, plaintiffs alleged that the Board breached its fiduciary duty of oversight under Caremark. The Court disagreed, finding that the Board (1) exercised good faith oversight under the first prong of Caremark, an “Information Systems Claim” pursuant to which directors utterly fail to implement reporting systems or controls to address business risks, and (2) plaintiffs failed to allege with particularity a “Red-Flags Claim,” which requires a finding that the directors consciously failed to monitor or oversee Walgreens’ operations.

Characterizing plaintiffs’ unjust enrichment claim as “equally frail,” the Court determined that demand on the Board was not futile, and the claim was dismissed in accordance with Rule 23.1.

In conclusion, the Court opined that alleged Caremark claims arguing “hindsight bias” attempting to hold directors personally liable for “imperfect efforts, operational struggles,” and other decisions subject to deferential business judgment review, fall outside the bounds of Caremark including, in the case of Walgreens, “billing practices for a single pharmaceutical product.”

Delaware Court of Chancery Invalidates Certain Governance Provisions in Stockholder Agreement for Impermissibly Restricting Ability of Board to Manage Business of Company in Accordance with DGCL Section 141(a)

West Palm Beach Firefighters’ Pension Fund v. Moelis & Company, C.A. No. 2023-0309-JTL (Del. Ch. Feb. 23, 2024) (Laster, V.C.)

By Garrett B. Lyons, III, Potter Anderson & Corroon LLP

In a decision with far-reaching implications for corporate practitioners and grounded in threshold issues of Delaware corporate governance, the Delaware Court of Chancery (the “Court”) held that several governance provisions contained in a Stockholder Agreement by and among Moelis & Company (the “Company”), Ken Moelis—the founder, Chief Executive Officer, and Chairman of the Board (“Moelis”)—and his affiliates were facially invalid because the provisions impermissibly restricted the ability of the Board of Directors (the “Board”) of the Company to exercise its powers freely, and the requirements were set forth in a stockholder agreement and not in the certificate of incorporation of the Company. While the Court acknowledged that Delaware law favors private ordering, this decision emphasizes the primacy of the General Corporation Law of the State of Delaware (the “DGCL”), specifically Section 141(a) therein, when corporations implement internal governance arrangements in separate contractual agreements, and it provides guidance for corporations that desire to alter the default management structure set forth in Section 141(a).

On cross-motions for summary judgment, the Court examined precedent decisions that applied Section 141(a) of the DGCL in respect of corporate contracts. From these precedents, the Court discerned a two-step test that applies when a Delaware court is asked to consider whether contractual language impermissibly restricts Board authority. Under this framework, a Delaware court must first consider whether a challenged provision “constitutes part of the corporation’s internal governance arrangement.” If not, the Court’s inquiry ends for purposes of a challenge under Section 141(a) of the DGCL. If it is, Section 141(a) of the DGCL applies, and the Court applies the test set forth in Abercrombie v. Davies (130 A.2d 338 (Del. 1957)), where the provision will be deemed invalid if it has “the effect of removing from directors in a very substantial way their duty to use their own best judgment on management matters” or “tends to limit in a substantial way the freedom of director decisions on matters of management policy[.]”

Applying this framework to the stockholder agreement provisions at issue, the Court held that six provisions failed to satisfy the two-part test and were facially invalid under Delaware law: (1) prior consent rights granted to Moelis for eighteen separate categories of corporate action; (2) Moelis’s ability to choose a majority of the Board’s directors; (3) a requirement that the Board consist of no more than eleven directors; (4) a requirement for the Board to recommend that stockholders vote in favor of Moelis’s designees; (5) a requirement for the Board to fill any vacancy in a Board seat held by a Moelis designee with a new Moelis designee; and (6) a requirement that the Board appoint to each committee of the Board a number of Moelis designees in proportion to the size of the full Board.

In contrast, the Court determined that contractual requirements relating to: (1) Moelis’s ability to designate a majority of Board seats; (2) a requirement for the Board to nominate Moelis’s Board designees for election; and (3) the Board’s obligation to use reasonable efforts to cause Moelis’s designees to be elected to the Board each satisfied the two-part test and were facially valid under Delaware law.

Delaware Chancery Court Upholds Clause Excluding Drafting Evidence, Rules Stockholder Agreement Required Vote in Favor of Stock Issuance Proposal

By Yu-Tyan Lin, LLM Candidate, Class of 2024, NYU School of Law

In Texas Pacific Land Corporation v. Horizon Kinetics LLC et al., C.A. 2022-1066-JTL (Dec. 1, 2023), the Delaware Court of Chancery ruled that a stockholder’s agreement (“SA”) obligated the investor defendants to vote in accordance with the board’s recommendation in favor of a proposal increasing the corporation’s authorized common stock shares. Consequently, the court deemed the investors’ shares to have been voted in favor of the proposal, leading to its ratification.

Texas Pacific Land Corporation (“TPL”) converted from a trust into a Delaware corporation in 2021. Prior to the conversion, the trust negotiated the SA with principal investors who wanted to designate board members, including Horizon Kinetics LLC and SoftVest, L.P. (collectively, the “Investor Group”). The SA contained a commitment binding the signatory stockholders to vote all their shares of common stock in line with the Board’s recommendations (“Voting Commitment”), as well as two main exceptions to the voting obligations.

To advance the company’s acquisition strategy, TPL’s management sought to increase TPL’s authorized common stock, which necessitated shareholder approval, and placed a proposal to do so (“Proposal Four”) in the proxy statement for its fall 2022 annual meeting. Contravening their Voting Commitment, certain members from the Investor Group actively opposed the proposal, advising shareholders to dissent and publicly voicing their opposition, and the Investor Group ultimately voted their shares against Proposal Four, causing it to receive insufficient votes to pass. Consequently, TPL initiated litigation pursuant to Section 225 of the Delaware General Corporation Law to enforce the Voting Commitment.

The key issue of the dispute was the applicability of the Voting Commitment to Proposal Four; the Investor Group contended its exceptions permitted them to vote against the proposal.

In the SA, both parties agreed to the “No Drafting History Clause,” which excluded drafting or preparation evidence in controversy over interpretation of the agreement. Despite TPL challenging its enforceability, the court found it a reasonable measure to address contracting imperfections and reduce litigation costs, without greatly limiting the court’s evaluation of pertinent evidence. The court upheld this clause, excluding the drafting history from consideration while allowing other forms of extrinsic evidence.

Applying the “No Drafting History Clause,” the court found both sides’ interpretations of the exceptions to the Voting Commitment viable and the SA’s language ambiguous.

The court then turned to extrinsic evidence, noting the Investor Group had the burden of proving an exception to their Voting Commitment. Prior to the dispute, two members from the Investor Group acknowledged that they were required to vote for a proposal increasing the number of authorized shares. The court noted any “‘course of performance accepted or acquiesced in without objection’ is ‘given great weight in the interpretation of the agreement.’ Restatement (Second) of Contracts § 202 (1981).” This pre-litigation understanding of the contract indicated by the members’ conduct was considered persuasive, and the court held the Investor Group had not presented extrinsic evidence that was more persuasive and did not prove the exceptions applied to Proposal Four, thus indicating they breached the Voting Commitment.

The Investor Group also argued that the court should not grant relief to TPL based on the doctrine of unclean hands, citing two alleged misrepresentations by TPL in its stockholder materials. However, assessing the doctrine involves evaluating both parties’ conduct, and the court found that the Investor Group’s breaches of the SA by campaigning against Proposal Four were persistent and willful. Given the severity of the Investor Group’s actions compared to TPL’s, the court deemed the Investor Group’s misconduct too significant to allow it to invoke an unclean hands defense. Further, the court issued an order that the company be entitled to an award of costs as the prevailing party.