United States: Chancery Forecloses Reliance On Technical Truths, Delayed Disclosures As Defenses To Disclosure-Related Breach Of Fiduciary Duty Claims

Fiduciary duties are fundamental concepts in Delaware corporate law. Directors and officers owe duties of care and loyalty, and from these obligations flows a duty to disclose information to stockholders, as in In re Wayport Litigation, 76 A.3d 296, 314 (Del. Ch. 2013). In Heng Ren Silk Road Investments v. Hamlin Chen and China Automotive Systems, 2019-0010-JTL (Del. Ch. July 16, 2019), the Delaware Court of Chancery relied on these principles to support an order denying a motion to dismiss breach of fiduciary duty claims emanating from disclosure obligations when soliciting stockholder action or offering statements regarding the business or affairs of a corporation.

Background

China Automotive Systems is a publicly traded Delaware corporation managed by a five-member board of directors (the board and, together with the company, the defendants). Three of the directors are nonemployees. Of the remaining two directors, one serves as the board's chairman and the other serves as the company's CEO and holds more than 56% of the company's stock.

In May 2017, the CEO proposed a take-private transaction and offered to purchase all of the minority stockholders' shares at $5.85 per share (the take-private offer). In August 2017, the company announced the nonemployee directors comprised a special committee to contemplate the take-private offer. No action concerning the take-private offer took place over the entirety of the following year. In August 2018, the CEO withdrew his take-private offer. It was later reported that the value of the company's stock fell from a high of $5.85 per share in September 2017—a month after the take-private offer—to a low of $2.50 per share in January 2019. During that same time, however, the board approved a 200% increase in the nonemployee directors' compensation.

In January 2019, the stockholder plaintiffs filed a derivative suit against the board alleging "systematic governance failures and a pattern of false disclosures designed to conceal them." Specifically, the plaintiffs alleged that the board caused the company to make false and misleading disclosures concerning director compensation, director qualifications and stockholder vote results.

Analysis 

The court first considered the plaintiffs' claims involving the defendants' disclosures in a proxy statement soliciting stockholder participation in director elections. In particular, the plaintiffs' complaint alleged disclosure violations concerning representations about director compensation and qualifications.

As for the representations concerning director compensation, a proxy statement issued before the company's 2018 annual meeting disclosed that the nonemployee directors received compensation for their work as directors and for service on any committees. That proxy statement disclosed, but did not explain, the nonemployee directors' 200% salary increase. Although the company later explained the increase in a Form 10-K dated March 2019, the court found the disclosure post-dated the complaint. Because the proxy statement solicited shareholder action, and lacked a timely explanation regarding director compensation that "would be material to a reasonable stockholder voting on the re-election of directors in an underperforming company," the court denied the motion to dismiss.

That same proxy statement contained statements about a certain nonemployee director's qualifications to serve on the board and committees. The proxy statement represented that one of the nonemployee directors served as a "member of the American Institute of Certified Public Accountants" and other certified accountant organizations. The plaintiffs disputed the accuracy of these statements. In defense of the alleged disclosure violation, the defendants argued the statements were "technically" true because the nonemployee director was an inactive CPA in California. The court rejected this "technical truth" defense because the proxy statement sought stockholder action concerning that same nonemployee director's reelection and Delaware law is clear that "directors are under a fiduciary obligation to avoid misleading partial disclosures," as in Zirn v. VLI, 681 A.2d 1050, 1056 (Del. 1996).

The court next considered the plaintiffs' disclosure claims where the defendants made statements about the company's business and affairs in the company's Form 8-K issued in December 2018. The Form-8K disclosed the results of certain stockholder votes at the 2018 annual meeting as follows: "approximately 610,000 shares were voted against the reappointment of the company's independent auditor and votes from approximately 650,000 to 670,000 shares were withheld for each re-elected director [i.e., the defendants in this action]." The plaintiffs disputed these results, alleging they actually "voted [880,000] shares against the independent auditor's reappointment and withheld their votes from the same shares as to the directors." The court found that plaintiffs' allegations, if accepted as true, identified that the Form 8-K "misstated the results of the annual meeting by a margin of at least 20%." Notwithstanding the defendants' failure to address this discrepancy in their papers—which the court cited as a sufficient basis to deny defendants' motion—the court explained that "when the directors are not seeking shareholder action, but are deliberately misinforming shareholders about the business of the corporation, either directly or by a public statement, there is a violation of fiduciary duty." Because the complaint contained allegations about "systematic governance failures and a pattern of false disclosures designed to conceal them," the court concluded the plaintiffs had stated "a claim against the defendants for violation of the duty of disclosure ... sufficient to warrant the remedy sought."

Takeaways

The court's order is consistent with Delaware precedent and serves as reminder for certain fundamentals of Delaware disclosure law. First, Heng  reminds us that when soliciting stockholder action, Delaware fiduciaries should pay prompt and acute attention to the scope of their disclosure obligations. Statements that are "technically true" might be insufficient to satisfy disclosure obligations in this context. Likewise, disclosures that lack material information, are misleading, or are provided after the solicited stockholder action are likely to face claims for disclosure violations. Second, when providing information about the business or affairs of a company, Delaware fiduciaries should remain vigilant in their efforts to communicate complete and accurate information.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.

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