Chancery Court Finds that Although Alleged Disclosure Deficiency Prevents Application of Corwin, It Is Insufficient to Reasonably Imply Breach of the Duty of Loyalty

By: Michelle R. McCreery, Teresa Teng and Sean P. Boyle

In In re USG Corporation Stockholder Litigation, C.A. No. 2018-0602-SG (Del. Ch. Aug. 31, 2020), the Court of Chancery found that an alleged disclosure deficiency by a corporation’s board that is sufficient to prevent the application of the Corwin defense, alone, is insufficient to reasonably imply bad faith and a breach of the duty of loyalty. Further, the Court found that an allegation that a defendant failed to satisfy Revlon, by itself, is insufficient to plead a breach of the duty of loyalty; a pleading must also reasonably imply that the directors’ failure to satisfy Revlon was due to interestedness or bad faith.

This case resulted from the acquisition of USG Corporation (“USG”) by Gebr. Knauf KG (“Knauf”). The plaintiffs, former USG stockholders, alleged that defendants, USG’s board of directors (the “Board”), breached their fiduciary duties in connection with the sale of USG to Knauf.

Prior to the closing of the acquisition, Knauf beneficially owned approximately 15% of USG’s outstanding common stock and Berkshire Hathaway beneficially owned approximately 30% of USG’s outstanding common stock. In November 2017, Knauf met with members of USG’s board and delivered a proposal to acquire USG for $40.10 per share. The Board, having received a detailed valuation from its financial advisors and informed by its own determination of USG’s “intrinsic value,” rejected Knauf’s offer in December of the same year. Berkshire Hathaway notified Knauf that it was displeased with the Board’s rejection, was willing to vote against the directors, and would share its opinion publicly should the offer become public. In March 2018, Knauf proposed a revised acquisition for $42.00 per share, but the Board again rejected it on the basis of USG’s discounted cash flow analysis and the Board’s determination of USG’s “intrinsic value.”

In April 2018, Knauf publicly announced a withhold campaign, in which it solicited proxies from USG’s stockholders to vote against USG’s four director nominees at the 2018 annual meeting. In this announcement, Knauf acknowledged that it had Berkshire Hathaway’s support for any acquisition in excess of $42.00 per share. With the knowledge that USG’s director nominees would likely face a majority vote against their re-election, at the end of April 2018, the Board authorized Jennifer Scanlon, USG’s CEO, to begin merger negotiations with Knauf within a price range of $48.00 to $51.00 per share. In early May 2018, USG met with Knauf and offered a $50.00 per share counterproposal.

A day later, USG’s annual meeting was held; at the meeting, approximately 75% of shares voted were cast against each of USG’s director nominees. After continued negotiations through the month of May (which included indications of Knauf’s continuing willingness to pursue a hostile acquisition), Knauf delivered its “best and final” offer of $44.00 per share in early June. In mid-June, the Board unanimously approved the offer, and the merger agreement was publicly announced the following day. The Board’s proxy statement in connection with the acquisition continued to mention the “intrinsic value” of USG, but the Board did not disclose this value. However, the proxy statement did disclose that the Board believed that a sale should occur in the range of $48.00 to $51.00 per share, but that it was unable to secure a price in that range. USG’s stockholders approved the acquisition at the end of September and the transaction closed the following April.

The amended complaint at issue in the case was subsequently filed and pled breach of fiduciary duty against each member of USG’s board at the time of the acquisition, alleging that USG stockholders “did not receive the highest available value for their equity interest in USG.”

The defendants moved to dismiss the claim based on Corwin v. KKR Financial Holdings LLC. Under Corwin, when the stockholders of a corporation are fully informed of all material facts to a transaction, and the stockholders vote to approve the transaction, then litigation challenging the transaction is subject to dismissal based on the business judgment rule. The Court here found, however, that Corwin was inapplicable because there was a rational inference based on the pleadings that the stockholders were not informed of all material facts.  The Court, noting that the Board disclosed in the proxy statement that it had a view on USG’s intrinsic value, found that the Board’s opinion of the specific amount was material to the acquisition and thus, because it was not disclosed, the USG stockholders were not fully informed. The Court consequently declined to dismiss the plaintiff’s complaint on the basis of Corwin.

Importantly, rather than denying the defendant’s motion to dismiss on that issue alone, the Court went on to separately analyze whether the plaintiffs had adequately pled a breach of fiduciary duty claim against USG’s board members. Because USG’s certificate of incorporation contained an exculpatory provision under Section 102(b)(7) of the Delaware General Corporation Law, the plaintiffs were required to plead a breach of the duty of loyalty. In order to plead a claim that could survive a motion to dismiss, the plaintiffs would need to plead facts supporting a “rational inference” that the Board lacked independence or acted in bad faith.

The Court first determined that the plaintiffs insufficiently pled that the Board lacked independence. The plaintiffs’ only allegation related to the Board’s independence was that the Board members lacked independence from Knauf because of their alleged “fear” of a takeover by Knauf. The Court rejected this as a basis for lack of independence due to the Board’s vigorous opposition to Knauf’s withhold campaign and the “robust negotiations” between USG and Knauf. The plaintiffs also argued that the Board was interested in the acquisition on the basis that a “public ouster by Knauf would have imperiled their other business and career interests.” The Court rejected this argument as well, on the basis that the Board had already lost a public fight with Knauf through the withhold campaign, stating that the Board was willing to accept “the reputational harm of an institutional campaign defeat in order to continue to pursue the corporate interest.”

The Court then turned to the plaintiffs’ argument that the material non-disclosure of the Board’s determination of USG’s intrinsic value was sufficient to give rise to an inference of bad faith. Importantly, the Court rejected this argument, stating that the standard for bad faith is fundamentally different from the required pleading to show an uninformed vote under Corwin; an analysis under Corwin focuses on the reader of the disclosures, while an analysis of bad faith focuses on the drafter of the disclosures. The Court stated that the plaintiffs cannot merely plead that a material non-disclosure exists, but rather are required to plead that the disclosure in question was intentional and constituted more than an error of judgment or gross negligence. The Court concluded that due to the Board’s other disclosures in the acquisition proxy statement, it was not reasonably conceivable that the proxy statement resulted from the deceit or knowing indifference to a duty required to show bad faith.

Lastly, the Court addressed the plaintiffs’ argument that their breach of the duty of loyalty claim should survive dismissal if they have pled facts that indicated that the Board breached their “Revlon duties” to obtain the best price. However, the Court concluded that although Revlon can provide context as to whether the Board’s actions were reasonable as a good faith attempt to secure the highest value in a transaction, a plaintiff must still plead a non-exculpated breach of the duty of loyalty, i.e., that the Board’s failure to act reasonably to maximize price was due to interestedness or bad faith. Given that the Board had obtained professional advice, sought competing bids, and negotiated with Knauf for a higher price, the Court concluded that it was not reasonably conceivable that the Board acted in bad faith in the sales process, and rejected the plaintiffs’ Revlon claim.