Contributed by Andrea Saavedra
A recent decision from the Commercial Division of the New York Supreme Court, Giuliano et al. v. Gawrylewski et al., reaffirms the importance of Delaware’s business judgment rule as a procedural guide for litigants. The business judgment rule substantively protects a board and its decisions by establishing a presumption that, absent evidence to the contrary, its members discharge their duties of loyalty and care in good faith. As a procedural matter, Delaware courts, and New York courts applying Delaware law, routinely dismiss complaints in which plaintiffs fail to rebut the presumption in their pleading.
The facts of Giuliano stem from the events preceding the first chapter 11 cases of NEC Holdings Corp., a/k/a National Envelope.
In 2009, NEC was the largest privately-held envelope manufacturing company in the United States. Its board of directors consisted of four sisters and their 96-year old father; each of the sisters owned 25% of NEC’s equity interests. Two of the sisters’ husbands were former officers of NEC and had also previously served as board members.
In March 2009, NEC d faced a potential covenant default under its secured credit facility. Seeking assistance with its liquidity crisis, NEC’s board of directors retained Stephen Gawrylewski as its Chief Restructuring Officer and his employer, Loughlin Management Partners + Company, as its restructuring advisory firm. NEC also retained an investment bank to explore various capital raising alternatives.
What exactly occurred next became the subject of the underlying complaint in Giuliano. According to the complaint, the investment bank proposed an equity transaction that would increase liquidity for NEC, but likely dilute existing equity. One of the board member-sisters advocated that the board pursue a high yield debt transaction. She believed that the equity transaction was not in the best interests of NEC, but was being pursued by the CRO and the investment bank at the behest of two of her sisters and their husbands. Specifically, the complaining sister alleged that her siblings and their husbands stood to gain further control of NEC through an equity transaction by virtue of aligning themselves with certain prospective investors. Ultimately, the board chose to pursue a sale of the business in chapter 11, and NEC filed for bankruptcy in June 2010.
After closing of the bankruptcy sale in October 2011, NEC and its affiliates converted their cases to chapter 7 and the bankruptcy court appointed a trustee. Subsequently, the trustee and the plaintiff-director, in her individual capacity and as a representative shareholder, jointly commenced the Guiliano litigation against: (i) the advisors for breach of fiduciary duty and negligence; (ii) the defendant directors for breach of fiduciary duties and aiding and abetting the advisors’ alleged breaches; and (iii) the two ex-officer brothers-in-law for aiding and abetting the sisters’ alleged breaches of fiduciary duties as directors. All claims arose from the defendants’ alleged refusal to pursue the high yield bond transaction pre-bankruptcy, purportedly in an effort to take control of the company and reap other personal benefits, all to the detriment of NEC and its other stakeholders.
Applying Delaware fiduciary duty law and the heightened pleading requirements of Rule 3016 of the Civil Practice Law and Rules of the New York Code, the court held, among other things, that the Plaintiffs had failed to adequately allege that the defendants were not entitled to the protection of the business judgment rule given that the majority of the independent directors of the board – i.e., the two non-party members of the board, the plaintiff directors’ father and fourth sister – voted to pursue the sale transaction and there wasn’t a single fact alleged that put the good faith basis for such decision by them at issue. While the complaint alleged, in a single footnote, that the father “generally followed the advice” of the defendants and purportedly exercised his vote “according to their wishes,” the court was not persuaded that these facts alone established that he was unable to exercise his best judgment in approving the equity transaction over the high yield debt alternative. In fact, the court noted that even a “consistent and unvaried pattern” by the father of deferring to the defendants was, by itself, insufficient to establish a lack of independence. The plaintiffs would have had to allege that the father was “beholden” to the defendants or so “under their influence” that his discretion would be “sterilized.” Further, as to the non-party sister, the complaint failed to allege a single fact that would put her independent judgment into question. Accordingly, because the pled facts did not support a reasonable inference that in making the challenged decision the majority of the independent members of the board breached their fiduciary duties, the complaint was subject to dismissal.
As to the counts against the CRO, the court found that dismissal was appropriate because plaintiffs had failed to adequately allege any causal connection between the CRO’s actions in pursuing a bidder for NEC’s assets and the alleged harm suffered by the plaintiffs, particularly where there was no guarantee that the high yield debt transaction would have been approved or resulted in NEC averting bankruptcy. The court also found that, even assuming that the complaint adequately pled the negligence of the advisors, the plaintiffs had failed to adequately allege any damages caused by such negligence, resulting in dismissal of all counts against the advisors.
Setting aside that the facts underpinning the Giuliano decision appear to be an uncanny modern retelling of King Lear – the story of three daughters at odds over control of their elder father’s kingdom or, in more modern times, business – the decision is of interest because it demonstrates that, even when there is dissent within a board, the majority’s decision is subject to protection absent any allegation of self-dealing. Because the two non-party directors were independent and had decided to cast their votes with the defendants and the CRO in favor of the equity transaction, the trustee and plaintiff director could not rebut the presumption of good faith established by the business judgment rule. And, absent any allegations that the non-party directors’ judgment was otherwise tainted, the complaint had to be dismissed.