The Benefits of Litigating Delaware Law Outside of Delaware: CDX v. Venrock

As we have been discussing, there has been a growing desire on the part of plaintiffs to litigate Delaware legal issues outside of Delaware.  While other courts may be required to follow Delaware precedent (particularly when applying the internal affairs doctrine), their application of the facts to the law may be less management friendly.  Companies have sought to stem this flood through the use of bylaws and charter amendments that limit venue to the Delaware Chancery Court. 

CDX Liquidating Trust v. Venrock, a 7th Circuit case written by Judge Posner, illustrates exactly why plaintiffs would prefer to litigate Delaware legal issues elsewhere.  The case involved an alleged breach of the duty of loyalty brought against the board of Cadant, a bankrupt company involved with "cable modem termination systems" and two venture capital groups, Venrock and JP Morgan, for aiding and abettting. 

In financial trouble, Cadant entered into loans with the two venture capital groups.  The loans included some preferential provisions, particularly the obligation to pay twice the outstanding principle in the event Cadant was liquidated.  Cadant ultimately sold its assets and obtained enough funds to pay off the loan.  Shareholders, however, were wiped out. 

The trial court allowed the suit to go forward but, after shareholders rested, granted judgment as a matter of law in favor of defendants.  On appeal, Judge Posner reversed.

What is the handling of the standard of review?  Delaware applies the duty of loyalty to board transactions that involve a conflict of interest.  A conflict existed in this case.  The board approving a loan made by Vencor and JP Morgan included employees of the two firms.  But Delaware takes the position that if a majority of the board consists of independent directors, the applicable standard of review is not the duty of loyalty but the duty of care.  (For more on this switch in standards, see Returning Fairness to Executive Compensation). 

In Delaware, therefore, the Chancery Court in the first instance would consider whether the board contained a majority of independent directors.  If it did, the case would likely be dismissed.  At the time of the approval of the loans,  Cadant had a seven person board.  There were three directors who worked for JP Morgan or Vencor and were clearly not disinterested.  Three other directors (engineers unconnected to the lenders) were clearly independent.  The outcome of this analysis, therefore, turned upon the status of the 7th director.

The director had been an employee of JP Morgan but had resigned before the loan was approved.  The case revealed no other connection by the director to Vencor or JP Morgan.  In Delaware, prior service as an employee or officer of an interested company does not deprive a director of his or her independence.  This certainly seems to be one of the implications of the analysis in In re Walt Disney, 731 A.2d 342 (Del. Ch. 1998), rev'd in part, 746 A.2d 244 (Del. 2000). In other words, Delaware courts may well have found this director to be independent and, as a result, applied the duty of care rather than the duty of loyalty.  Such a shift in standard would have been outcome determinative. 

Moreover, even had the federal courts found the presence of a "majority" of independent directors, Judge Posner clearly viewed the board as dominated by the interested directors.  As he described:

• The disinterested directors of Cadant (the directors who had no affiliation with Venrock or J.P.  Morgan) who voted for the loan were engineers without financial acumen, and because they didn’t think to retain their own financial advisor they were at the mercy of the financial advice they received from Copeland and the other conflicted directors.

A board dominated by the interested directors could not be independent.  As a result, the duty of loyalty standard still applied. 

The approach used by Judge Posner is reasonable.  The 7th director was a former employee of the lenders and arguably retained loyalties to one of them.  Even if he did not, the interested directors appear to have exercised control over the board.  In either case, the applicable standard of review was the duty of loyalty, imposing on the board the obligation to show that the transaction was fair.   

Delaware courts, however, would likely have decided the case differently.  They almost never find that the interested directors, when a minority of the board, exercised such influence that they impaired the independence of the board.  Moreover, they would likely have found the 7th director to be independent and, based upon a rote head count (4 independent and three not), applied the duty of care. 

By bringing the case elsewhere, shareholders were limited to Delaware law.  Nonetheless, they obtained a non-Delaware judge's view of Delaware law (something Steve Bainbridge thinks Judge Posner got wrong).  And in the eyes of a non-Delaware judge, the outcome was likely more favorable to shareholders.  The moral of the story?  One that is already known.  Better for shareholders to litigate Delaware law in non-Delaware courts.