The Delaware Court of Chancery recently clarified the application of two landmark Delaware Supreme Court cases to a claim for injunctive relief where a corporation’s board of directors (the Board) adopted defensive measures allegedly designed to entrench the Board against stockholder activism. In In re Edgio, Inc. Stockholders Litigation, C.A. No. 2022-0624-MTZ (Del. Ch. May 1, 2023) (Edgio), the Court of Chancery held that enhanced scrutiny applies to Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985) (Unocal) injunctive relief claims, even where the action in question is approved or ratified by a majority of uncoerced, fully informed disinterested stockholders.
In Edgio, a struggling publicly traded telecommunications corporation attracted a potential industry investor. The two parties negotiated a deal by which the corporation would acquire one of the investor’s portfolio companies. The corporation paid for the acquisition in stock and issued a 35 percent stake in the resulting entity to the investor. Pursuant to the stock issuance, the resulting entity and the investor entered into a stockholders’ agreement that restricted the investor’s transfer and voting rights. For example, the agreement required that so long as the investor owned 35 percent or more of the company’s common stock, the investor would vote in favor of the Board’s director nominations and would vote with the Board or the company’s stockholders pro rata for nonroutine votes. The stockholders’ agreement also included a transfer restriction that prevented the investor from transferring or selling its stock without Board consent for two years, and then restricted the investor from transferring its shares for 12 months to anyone included on a list of the 50 “most significant” activist investors. A majority of the corporation’s disinterested stockholders reviewed and approved the stockholders’ agreement. Two stockholders alleged that the directors breached their fiduciary duties by prioritizing their own interests. Though the stockholders agreed that the transaction itself was a boon to the company, they sought to enjoin the defensive provisions of the stockholders’ agreement on the basis that they enabled a stockholder voting block “designed to entrench the board and protect it from stockholder activism.” The stockholders only sought to enjoin the defensive provisions and did not seek damages.
The defendants moved to dismiss the complaint, arguing that Corwin v. KKR Financial Holdings LLC, 125 A.3d 304 (Del. 2015) (Corwin), was the proper framework by which to judge the transaction. In Corwin, the Delaware Supreme Court held that a fully informed, uncoerced vote of disinterested stockholders that ratifies corporate action could “cleanse” a post-closing claim for damages. Such ratification would give rise to an irrebuttable presumption of the deferential business judgment rule.
Conversely, the plaintiffs argued that Corwin could not cleanse the defensive measures and that Unocal’senhanced scrutiny should be applied instead. The Court noted that it was an unresolved question of Delaware law whether Corwin can apply to a claim governed by Unocal and seeking injunctive relief. Unocal was decided in the midst of the hostile takeover wave of the 1980s, when boards of directors often adopted defensive measures in response to hostile takeover bids. The Delaware Supreme Court held that where stockholders sought to enjoin a board’s defensive measures, the courts should apply enhanced scrutiny. Enhanced scrutiny requires that fiduciary defendants bear the burden of persuasion that their motivations were proper and not selfish and that their “actions were reasonable in relation to their legitimate objective.” While the hostile takeover wave has subsided, the Court noted that “the corporate world has seen the emergence and proliferation of the activist stockholder. Activists use the threat of proxy contests to influence changes to board composition and corporate policy, among other things.” Activists often target companies that underperform or have depressed stock prices. According to the Court, this activist-rich climate has caused some boards to adopt preventive or defensive measures. The defendants further argued that even if enhanced scrutiny would apply under Unocal, the stockholders’ fully informed, uncoerced majority vote cleansed any alleged breaches of fiduciary duty under Corwin and restored business judgment review.
The Court of Chancery denied the motion to dismiss and held that Corwin stops “short of cleansing claims seeking to enjoin defensive measures.” Concluding that Corwin’scleansing power is limited to post-closing damages claims, the Court stated it could not be used to invoke the business judgment rule in Unocal injunctive relief claims. As the Court stated, “a claim for injunctive relief under Unocal’s enhanced scrutiny is not susceptible to restoration of the business judgment rule under Corwin.” The Court of Chancery instead applied the Unocal standard of enhanced scrutiny. It held that Unocal applies where “a plaintiff has pled facts supporting a reasonable inference that a board acted defensively in response to a perceived threat.” The Court explained that Unocal’s enhanced scrutiny applies even if the measures have been properly ratified or approved by the stockholders, because Unocal’s enhanced scrutiny was designed to prevent irreparable injury caused by entrenched directors disenfranchising stockholders. On the other hand, Corwin post-closing claims may be cleansed by stockholders satisfied with the economic consideration they have already received from the transaction.
The Edgio case makes clear that, even with a fully informed vote of the disinterested stockholders, where a stockholder is seeking to enjoin corporate action that entrenches the board of directors, Unocal’s enhanced scrutiny will apply. Corporate boards should therefore be careful that any protective measures they adopt in the wake of recent stockholder activism are able to withstand Unocal’s enhanced scrutiny. Corwin’s more forgiving business judgment standard will not be available.