Opinion ID: 2370284
Heading Depth: 2
Heading Rank: 3

Heading: The Court of Chancery Erroneously Dismissed Count III of the Complaint

Text: Finally, we address the issues generated by the dismissal of Count III. That Count alleges that the defendants breached their duty of loyalty by recommending the Reclassification Proposal to the shareholders for purely self-interested reasons (to enlarge their ability to engage in stock buy-backs and to trigger their ESOP put and appraisal rights). The Court of Chancery determined that the relevant Board for analytical purposes was the June 2006 Board that voted to effect the Reclassification, because at any earlier time the Board could have decided to abandon the transaction. [49] The Vice Chancellor then concluded that the complaint sufficiently alleged that a majority of the directors that approved the Reclassification Proposal lacked independence. [50] Despite having so concluded, the court dismissed the claim on the ground that a disinterested majority of the shareholders had ratified the Reclassification by voting to approve it. [51] The plaintiffs claim that this ratification ruling is erroneous as a matter of law. They argue that because the Proxy disclosures were materially misleading, no fully informed shareholder vote took place. The plaintiffs also urge that in determining the number of unaffiliated shares that were voted, the Court of Chancery took improper judicial notice of shares owned by the defendants. The defendants respond that the Vice Chancellor's ratification ruling is correct and should be upheld. Alternatively, they argue that we should overturn the Vice Chancellor's determination that the Board had a disqualifying self-interest. We conclude that the Court of Chancery legally erred in upholding Count III on shareholder ratification grounds, for two reasons. First, because a shareholder vote was required to amend the certificate of incorporation, that approving vote could not also operate to ratify the challenged conduct of the interested directors. Second, the adjudicated cognizable claim that the Reclassification Proxy contained a material misrepresentation, eliminates an essential predicate for applying the doctrine, namely, that the shareholder vote was fully informed.
Under current Delaware case law, the scope and effect of the common law doctrine of shareholder ratification is unclear, making it difficult to apply that doctrine in a coherent manner. As the Court of Chancery has noted in In re Wheelabrator Technologies, Inc., Shareholders Litigation: [The doctrine of ratification] might be thought to lack coherence because the decisions addressing the effect of shareholder ratification have fragmented that subject into three distinct compartments,... In its classic ... form, shareholder ratification describes the situation where shareholders approve board action that, legally speaking, could be accomplished without any shareholder approval.... [C]lassic ratification involves the voluntary addition of an independent layer of shareholder approval in circumstances where shareholder approval is not legally required. But shareholder ratification has also been used to describe the effect of an informed shareholder vote that was statutorily required for the transaction to have legal existence.... That [the Delaware courts] have used the same term is such highly diverse sets of factual circumstances, without regard to their possible functional differences, suggests that shareholder ratification has now acquired an expanded meaning intended to describe any approval of challenged board action by a fully informed vote of shareholders, irrespective of whether that shareholder vote is legally required for the transaction to attain legal existence. [52] To restore coherence and clarity to this area of our law, we hold that the scope of the shareholder ratification doctrine must be limited to its so-called classic form; that is, to circumstances where a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective. Moreover, the only director action or conduct that can be ratified is that which the shareholders are specifically asked to approve. [53] With one exception, the cleansing effect of such a ratifying shareholder vote is to subject the challenged director action to business judgment review, as opposed to extinguishing the claim altogether ( i.e., obviating all judicial review of the challenged action). [54]
The Court of Chancery held that although Count III of the complaint pled facts establishing that the Reclassification Proposal was an interested transaction not entitled to business judgment protection, the shareholders' fully informed vote ratifying that Proposal reinstated the business judgment presumption. That ruling was legally erroneous, for several reasons. First, the ratification doctrine does not apply to transactions where shareholder approval is statutorily required. Here, the Reclassification could not become legally effective without a statutorily mandated shareholder vote approving the amendment to First Niles' certificate of incorporation. Second, because we have determined that the complaint states a cognizable claim that the Reclassification Proxy was materially misleading ( see Part II, supra, of this Opinion), that precludes ruling at this procedural juncture, as a matter of law, that the Reclassification was fully informed. Therefore, the approving shareholder vote did not operate as a ratification of the challenged conduct in any legally meaningful sense. [55] Alternatively, the defendants urge that, apart from ratification, Count III was properly dismissed because the Board was not interested, and that the Vice Chancellor's contrary ruling is erroneous. That argument lacks merit both procedurally and substantively. Procedurally it lacks merit because the Court of Chancery expressly determined that a majority of the Board was interested, and the Defendants have not cross-appealed from that ruling. Substantively, the argument lacks merit, because the defendants concede that Stephens and Csontos were interested in the Reclassification, and our earlier analysis of Kramer's alleged disloyalty with respect to Count I applies equally to Count III. [56] These allegations require that the Vice Chancellor's determination that a majority of the Board was interested be sustained. We conclude that the Court of Chancery erroneously dismissed Count III of the complaint.