Delaware Chancery Clarifies Duty of Disclosure

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Law360, New York (August 04, 2008) -- The Delaware Chancery Court recently issued two

opinions focusing on, among other things, the duty of disclosure in the context of merger

transactions.

In In re Transkaryotic Therapies, Inc. (Del. Ch., Civil Action No. 2776-CC 6/16/08),

Chancellor Chandler granted summary judgment in favor of the defendants for alleged

breaches of the duty of disclosure in connection with a merger of two unrelated Delaware

corporations.

In Berger v. Pubco Corp. (Del. Ch., Civil Action No. 3414-CC 5/30/08), Chancellor Chandler

created a “quasi-appraisal” to remedy breaches of disclosure duties in connection with a

short-form merger, as well as to remedy breaches of the formal requirements of the

Delaware short-form merger statute.

While each of these decisions grappled with claims and issues in addition to the duty of

disclosure, the conclusions of the Chancery Court in each case with regard to the duty of

disclosure are particularly instructive.

The Duty of Disclosure

The duty of disclosure represents the proposition that directors of Delaware corporations

have a fiduciary responsibility “to disclose fully and fairly all material information within the

board’s control when it seeks shareholder action.”[1]

While often called a duty, the requirement to disclose material facts is not a separate duty

of a company’s board of directors. Rather, the duty of disclosure is “the application in a

specific context of the board’s fiduciary duties of care, good faith and loyalty.”[2]

While associated with well established duties, the elements and requirements of the duty of

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disclosure remain unsettled and are not absolute.

Due to the unique issues and considerations that impact the assessment of whether to

disclose information, attorneys and their clients must use judgment and reason when faced

with evaluating what information to disclose as well as in determining what liability may

arise from the failure to make proper disclosure.[3]

With regard to remedies for breaches of the duty to disclose, the position of the Delaware

courts has evolved over time, and at one point, it appeared that the failure to properly

disclose material information would result in per se damages for breach of the fiduciary duty

of disclosure.[4]

Recently, however, the Delaware courts have refined their view of damages for breaches of

the duty of disclosure so that the current position is that a “breach of the duty of disclosure

does not automatically result in a nominal damages award.”

In fact, in Transkaryotic, the Delaware Chancery Court proclaimed that “[i]t is now clear

that some breaches of the disclosure duty result in no award of damages at all.”[5]

The current preference of the Delaware courts appears to avoid post-transaction damage

awards in lieu of pre-transaction motions for preliminary injunctions because the courts

generally view such failures as causing irreparable harm and a jury would be ill-suited to

adequately assess monetary damages.[6]

That is, the Delaware courts would rather have plaintiffs raise disclosure deficiencies in

advance of any stockholder action so the court can issue a preliminary injunction to provide

adequate time for the disclosure problems to be remedied.

The courts view the injunctive process to be much more efficient and rational in the context

of disclosure shortcomings as opposed to a post-facto attempt to assess monetary damages

for such failures.[7]

By using the injunctive relief process, plaintiffs can seek to have all relevant, material

information disclosed prior to taking a shareholder action and avoid the uncertainty of

having a court or jury attempt to quantify the damages after the transaction is

consummated.

In connection with the duty to disclose, the Delaware courts also have recognized that the

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standard of materiality with regard to discussing information has been well settled by the

Delaware courts.[8] In fact, Delaware has adopted the federal standard of materiality.[9]

Information is generally material “if there is a substantial likelihood that a reasonable

shareholder would consider it important in deciding how to vote ... ”[10]

Furthermore, “[i]t does not require proof of a substantial likelihood that disclosure of the

omitted fact would have caused the reasonable investor to change his vote.”

Instead, to establish materiality one must show “a substantial likelihood that the disclosure

of the omitted fact would have been viewed by the reasonable investor as having a

significantly altered the ‘total mix’ of information made available.”

Transkaryotic and the Traditional Merger

The Chancery Court in Transkaryotic was presented with a case in which plaintiffs were

alleging breaches of fiduciary duty, charges of aiding and abetting those breaches and a

claim of unlawful merger. The case focused on the merger of Transkaryotic Therapies, Inc.

(“Transkaryotic”) and Shire Pharmaceuticals Group (“Shire”).

The board of directors of Transkaryotic approved the merger on April 16, 2005 and the

company provided its shareholders with a proxy statement and held a meeting of

shareholders to solicit approval of the proposed merger.[11]

On July 27, 2005, the Transkaryotic shareholders approved the merger with Shire and the

transaction was promptly closed.12

The plaintiffs in Transkaryotic alleged that the Transkaryotic failed to disclose certain

relationships and communications between directors of Transkaryotic and management of

Shire, the fact certain directors opposed the merger, the existence of additional valuations

prepared by third party financial advisors, the possibility of alternative transactions in lieu of

the merger with Shire and the interests of certain directors in those other transactions, and

potential conflicts of interests and potential undue influence of Transkaryotic’s bankers.[13]

Basically, the plaintiffs contended that the defendants breached their fiduciary duties by

failing to disclose or by misrepresenting these facts to shareholders of Transkaryotic prior to

the shareholder vote on July 27, 2005.

In addition to the claims of breach of duty of disclosure, the plaintiffs claimed that certain

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directors based their decision to approve the merger on “extraneous considerations or

influences” and as a result, they had conflicting loyalties.[14]

The plaintiffs also claimed that Shire aided and abetted these directors in the breaches of

their duty of loyalty and disclosure.

The Chancery Court evaluated each of these claims against the individual directors and

granted summary judgment in favor of all of the defendant directors, except for one director

who did not seek summary judgment on these claims.[15]

The Chancery Court also granted summary judgment to Shire on the claims of aiding and

abetting, except with respect to the one director that failed to seek summary judgment.[16]

Lastly, the plaintiffs charged that the merger was not approved by the shareholders as

required by the Delaware General Corporations Law (“DGCL”).

The Chancery Court allowed the plaintiffs to continue with this claim because it had

demonstrated that there was a question of fact as to whether the votes were properly

tallied. However, the Chancery Court did note that, while it was permitting the claims to

continue, it believed the plaintiffs’ claims were weak.[17]

As discussed above, the treatment of the duty of disclosure by Delaware courts has been

evolving. In reaching its conclusions in Transkaryotic, the Chancery Court noted that a

breach of the disclosure duty causes irreparable harm.[18]

“[T]he right to cast an informed vote is ‘peculiar’ and specific and it cannot be adequately

quantified or monetized.”[19]

Once the merger closes, even if by vote of shareholders who do not possess adequate or

accurate information, the Delaware courts generally do not have the power to undo or

reverse a merger.

As a result, the preferred remedy would be injunctive relief to prevent the vote from taking

place without complete and accurate information.[20]

In Transkaryotic, the shareholders approved the merger in 2005, but by the time the

Chancery Court finally heard this case three years have passed since the merger was

consummated.

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The Chancery Court noted that, because the merger was consummated, an injunctive order

requiring supplemental disclosure at this time would be pointless.[21]

“Because a disclosure would result in irreparable harm and because [the Chancery] Court

can no longer provide the equitable cure for such harm, [Chancellor Chandler granted] the

… [defendants’] motion for summary judgment with respect to the disclosure claims.”[22]

As a result, the Chancery Court determined it could not grant monetary or injunctive relief

for disclosure violations after a merger was consummated and there was no evidence of

breach of the duty of loyalty or good faith by directors who authorized the disclosures.

Berger and the Short-Form Merger

In Berger, the Chancery Court also was presented with a case in which the merger was

already completed; however, this time the merger was consummated pursuant to the

Delaware short-form merger statute.

The plaintiff, Barbara Berger, held less than ten percent of the shares of common stock in

Pubco Corporation (“Pubco”), a corporation organized under the laws of Delaware.[23]

The controlling shareholder holding more than 90 percent of the outstanding shares of

Pubco was Robert H. Kanner, who was the president and sole director of Pubco and who was

also a defendant in the case.[24]

In November 2007, Pubco notified Ms. Berger that Pubco’s controlling shareholder had

effected a short-form merger and she and the other minority shareholders were being

cashed out at $20 per share.[25]

Under Section 253 of the DGCL, controlling shareholders that hold more than 90 percent of

all classes of outstanding shares of a company can effect a merger of the company without

the consent of the minority shareholders so long as after the effectiveness of the merger the

minority shareholders receive a notice that informs them that they have rights to appraisal

under Section 262 of the DGCL, includes a current copy of the current Delaware appraisal

statute, and discloses all material information with respect to the minority shareholders’

decision whether or not to seek appraisal.[26]

In December 2007, Ms. Berger brought a class action suit against Pubco on behalf of all

minority shareholders and claimed that the minority shareholders were entitled to the

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difference between the $20 per share received as merger consideration and the fair value of

his or her shares, regardless of whether a minority shareholder demanded appraisal under

Delaware corporate law.[27]

In general, if the minority shareholders are not satisfied with the merger consideration

received in the short-form merger, their only recourse is to seek appraisal of the value of

their shares under Section 262 of the DGCL.[28]

In accordance with Delaware corporate law, Pubco’s notice to the minority shareholders

explained that shareholder approval was not required to effect the merger, but it did

indicate that the minority shareholders did have the right to seek appraisal.[29]

Pubco’s notice also included information about Pubco’s business, the names of its officers

and directors, the number of shares and classes of stock, a description of related business

transaction, and copies of Pubco’s recent financial statements, among other limited

information.[30]

The Chancery Court noted that, except for the financial statements, Pubco’s notice did not

provide much detail and was vague or failed to provide meaningful disclosure in a number of

important areas, including how the merger consideration of $20 per share was determined.

[31]

Pubco also attached to the notice a copy of the Delaware appraisal statute, as required by

Delaware law, but the copy attached was outdated and incorrect because it did not reflect

changes that took effect in August 2007.[32]

As discussed above, the Chancery Court in Berger noted that the “duty of disclosure”

represents the “well-recognized proposition that directors of Delaware corporations are

under a fiduciary duty to disclose fully and fairly all material information within the board’s

control when it seeks shareholder action.”[33]

In the case of a short-form merger, the minority shareholders are not asked to vote on the

transaction and ordinarily would not have any right to prevent the consummation of the

merger.

However, since the only choice is to accept the merger consideration or seek appraisal

under the DGCL, the minority shareholders “must be given all of the factual information that

is material to that decision.”[34]

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The parent company is not required to disclose all information necessary for the minority

shareholders to independently determine fair value, but rather, the parent company need

only disclose information that is material to the minority shareholders’ decision of whether

or not to seek appraisal.[35]

The Chancery Court in Berger noted that while a minority shareholder may find additional

information helpful, it does not necessarily mean the additional information is material to

the minority shareholder’s decision of whether to seek appraisal.[36]

Therefore, it is the minority shareholders’ burden to demonstrate “why receiving information

in addition to the basic financial data already disclosed will significantly alter the total mix of

information available.”[37]

In Berger, the Chancery Court determined that the notice was defective because it failed to

include the current version of the Delaware appraisal statute, which the Chancery Court

noted was a clear violation of Section 253 of the DGCL, and that there was a breach of the

duty of disclosure because there was a failure to provide all material information relevant to

the minority shareholders’ decision of whether to seek appraisal.

With regard to the duty to disclose, the Chancery Court noted that Pubco’s notice failed to

provide appropriate disclosure relating to Pubco’s plans or prospects, any meaningful

disclosure of Pubco’s actual operations, a more detailed disclosure of Pubco’s finances by

division or line of business, any discussion or explanation of how Pubco’s cash and

securities, noted on its financial statements, were utilized or going to be utilized by Pubco,

and interestingly, no disclosure of how the merger consideration was calculated.[38]

While Pubco’s notice was defective in a number of ways, the Chancery Court was most

concerned with the failure to disclose the methodology behind calculating the merger

consideration. Pubco was an unregistered company that made no public filings and the

notice provided to the minority holders was “terse and short on details.”[39]

As a consequence of the lack of publicly available information about Pubco, the Chancery

Court determined that “the method by which [the defendants] set the merger consideration

is a fact that is substantially likely to alter the total mix of information available to the

minority shareholders.”[40]

However, the Chancery Court did recognize that certain aspects of the information may not

be material and declared that the defendant should not have to provide every trivial detail

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about the valuation process employed in setting the price, but rather companies need only

disclose in broad terms what the process, if any, was used to determine the value of the

merger consideration.[41]

The Chancery Court concluded that “the minority shareholders of an unregistered, non-

reporting company are entitled to know at least whether the parent did or did not use such

methods when setting the merger consideration, because such a fact ‘would have assumed

actual significance in the deliberations of a reasonable shareholder’ faced with the decision

of whether or not to trust and accept the price offered by the parent.”[42]

Due to the fact the short-form merger was effective under Section 253 of the DGCL before

the disclosures were required to be made to the minority shareholders, rescission remedies

were not available to the minority shareholders of Pubco.

Instead, the Chancery Court determined that the minority shareholders suffered an

irreparable injury and relied on its inherent powers of equity to create the appropriate relief

for the parties.[43]

Because the short-form merger does not require shareholder approval, the disclosure

deficiencies would not have provided adequate standing to prevent the merger, and instead,

the minority shareholders only had a right to appraisal.

Therefore, the Chancery Court, relying on its equitable powers, created a remedy of “quasi-

appraisal” that attempted to mirror as best a possible the statutory appraisal remedy of

Section 263 of the DGCL and the related instructions of the Delaware General Assembly.

[44]

As a result, the Chancery Court ordered Pubco to make supplemental disclosures to address

the disclosure violations noted by the Chancery Court and to correct the failure to properly

notice the minority shareholders by giving them a choice to participate in or opt out of an

appraisal action under Section 262.[45]

In addition, the Chancery Court order that the quasi-appraisal action should replicate the

level of the risk that would exist if there were an actual appraisal action—in other words, if

the appraisal ultimately was for less than the proposed merger consideration, the minority

shareholders would receive less than the merger consideration originally offered.[46]

Lastly, the Chancery Court required that the Pubco shares be valued as of the date of the

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merger using the method prescribed by Section 262 of the DGCL.[47]

Conclusion

Both the Transkaryotic decision and the Berger decision highlight the finality of a merger –

whether traditional or short-form. Each case also helps clarify the position of the Delaware

courts when it comes to remedying breaches of the duty of disclosure.

In short, the Delaware courts are not going to undo a merger — traditional or short-form —

as a result of a breach of the duty to disclose.

The Chancery Court in Transkaryotic makes it clear that post-merger remedies will be rare

and puts shareholders on notice that if they believe the disclosure they received in

connection with a proposed shareholder action is inadequate, the shareholders must pursue

injunctive relief in advance of the shareholder action instead of waiting until after the

merger to seek remedies.

In response to the Chancery Court’s position in Transkaryotic, plaintiffs and their counsel

may need to become more proactive and seek injunctive relief more often when questions

regarding the adequacy of disclosure arise.[48]

Due to the apparent lack of post-merger remedies and the reluctance to grant monetary

damages following the effectiveness of a merger, plaintiffs in the future may become

inclined to seek injunction for alleged disclosure problems even in minor circumstances.

The Berger decision serves as a good review of the short-form merger requirements under

Section 253 of the DGCL and reminds us that, while short-form mergers are generally

simple and noncontraversial proceedings, it is important for companies and their counsel to

closely following the statutorily-mandated requirements of Section 253 of the DGCL as well

as to carefully consider the duty of disclosure to ensure that all material information that a

minority shareholder needs to make his or her decision regarding appraisal is adequately

disclosed.

--Michael J. Delaney, Kilpatrick Stockton LLP

Michael Delaney is a partner in Kilpatrick Stockton's Atlanta office.

[1] Continental Oil Co. v. Pauley Petroleum, Inc., 25 A.2d 824, 826 (Del. 1969).

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[2] Malpiede v. Townson, 780 A.2d 1075, 1086 (Del. 2001).

[3] Transkaryotic at p. 3

[4] In re Tri-StarPictures, Inc. Litigation, 634 A.2d 319, 333 (Del 1993).

[5] Transkaryotic at 23.

[6] Transkaryotic at 26; Globis Partners, L.P. v. Plumtree Software, Inc. C.A. No. 1577-VCP,

2007 WL 4292024, at *10 9Del Ch. Nov. 30, 2007).

[7] Transkaryotic at 26

[8] Berger at 5; Transkaryotic at 17.

[9] Transkaryotic at 17.

[10] Berger at 5 citing Rosenblatt v. Getty Oil Co., 493 A.2d 929, 944 (Del. 1985).

[11] Transkaryotic at 14.

[12] Id at 15.

[13] Id at 17-18.

[14] Id at 29.

[15] Transkaryotic at 28, 43.

[16] Id. at 50.

[17] Id. at 61.

[18] Transkaryotic at 25.

[19] Id at 26

[20] Id.

[21] Id at 27

[22] Id.

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[23] Berger at 1.

[24] Id. at 2.

[25] Id.

[26] Section 253 of the Delaware General Corporation Law.

[27] Id..

[28] See Section 253 of the DGCL.

[29] Berger at 2.

[30] Id.

[31] Id. at 2, 3.

[32] Id. at 3.

[33] Id. at 5.

[34] Id. at 6 citing Glassman v. Unocal Exploration Corp., 777 A.2d 242, 247 (Del 2001).

[35] Id. at 9.

[36] Id.

[37] Id. at 6 citing Skeen v. Jo-Ann Stores, Inc., 750 A.2d 1170, 1174 (Del 2000).

[38] Id. at 3.

[39] Id. at 9.

[40] Id. at 11.

[41] Id.

[42] Id. at 9.

[43] Id. at 11.

[44] Id. at 13.

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[45] Id.

[46] Id.

[47] Id. at 14.

[48] Deallawyers.com Blog, June 25, 2008. “Duty of Disclosure: Delaware Chancery Court

Further Limits Availability of Damages.”

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