Litigation Lookout: PE Industry Guide To Legal Developments

With summer now in the rearview mirror, we are pleased to share another update on recent court decisions and litigation developments with particular relevance to our private equity clients. We hope that this will serve not only as a refresher on several notable developments but also as a guide to the issues that may materialize in the coming months. We welcome your thoughts on topics of particular interest for future issues.

In This Issue

Developments in Delaware Law (Page 2):

• Court of Chancery Imposes Sanctions for Failure to Preserve Text Messages (Page 2). Delaware courts are part of a growing trend whereby courts and regulators have second-guessed defendants' document preservation efforts and imposed substantial merits-based penalties for failures to preserve potentially relevant documents.
• Potential Consequences of Omitting Legal and Financial Advisor Fees From Transactional Disclosures (Page 2). In two decisions issued in March and May of 2024, the Delaware Supreme Court reinforced that early-stage dismissals are not available to issuers who do not adequately disclose material advisor conflicts.
• Delaware State Legislature Amends the Delaware General Corporation Law to Address Common Law Developments (Page 3). Recent DGCL amendments addressed recent Delaware Court of Chancery decisions limiting the enforceability of numerous provisions found in a typical agreement between a company and major stockholders, among other things.
• Delaware Supreme Court Affirms Use of MFW Cleansing Outside of Squeeze-Out Transactions (Page 4). A recent decision highlights the importance of selecting independent directors for special committees, particularly in the context of controller transactions, and rejected attempts to lower the procedural standards for evaluating controlling stockholder transactions outside of the M&A context.
• Delaware Plaintiffs Attack Net Operating Loss Poison Pills (Page 5). Companies with NOL poison pills should closely examine the pill's language, consider targeted revisions of the pill where appropriate, and ensure that the board implements best practices on the process of implementing or renewing the pill.
• Delaware Supreme Court Clarifies the Standard Required to Challenge Bylaws (Page 5). The Court's clarification of the standard for facial review of bylaws should pare back the number of complaints filed in Chancery challenging bylaws absent a true case or controversy. Corporations should nonetheless consider whether their bylaws are intelligible and clarify any that are overly unwieldy.

Developments in Antitrust (Page 6):

• Recent Trends in Antitrust Enforcement (Page 6). Private equity is an increasingly high-priority enforcement area for the current administration, and recent trends suggest this is unlikely to slow down. Financial sponsors should be mindful of this increased government oversight and everchanging laws and regulations when pursuing expansion opportunities, and continually assess their portfolios to identify risks of interlocking directorates.
• Texas Federal Court Dismisses FTC Case Against Private Equity Firm (Page 7). A sponsor's recent dismissal from antitrust litigation brought by the FTC represents a significant victory for the private equity industry, and provides guidance on potential antitrust risks for sponsors involved in roll-up acquisition strategies.

Developments in Restructuring (Page 8):

• Texas Federal Court Weighs in on Liability Management Transaction (Page 8). Recent Bankruptcy Court rulings impact the calculus of borrowers and creditors when entering credit facilities or weighing unique financing options, such as "uptier" transactions.
• Third Circuit Lends Support to Mandatory Appointment of Independent Examiner (Page 8). Large and medium-sized debtors in bankruptcy proceedings should know about the potential impacts the FTX Trading decision will have on future bankruptcy cases, particularly given the number of corporate bankruptcies that are filed in bankruptcy court in Delaware. Developments in Administrative Law (Page 9):
• The Supreme Court's Decisions in Jarkesy and Loper Bright (Page 9). The Supreme Court's most recent term featured a series of decisions that reshaped longstanding tenets of administrative law and signaled its willingness to take a robust and skeptical approach to judicial review of agency actions.

Developments in Delaware Law

Court of Chancery Imposes Sanctions for Failure to Preserve Text Messages

The Background: In a recent decision, Vice Chancellor Laster of the Delaware Court of Chancery imposed severe pre-trial sanctions in light of the defendants' failure to preserve relevant text messages. In the underlying lawsuit, stockholders of Bioverativ, Inc. claim that Sarissa Capital— with the help of its controlling principal, Alex Denner, who also served as a Bioverativ director—used inside information to octuple its stake in Bioverativ before the company was sold to Sanofi at a substantial premium.

Litigation holds were issued to Mr. Denner and other relevant Sarissa custodians—including its general counsel and head trader—as soon as plaintiffs filed lawsuits challenging the sale of Bioverativ. At the time, Sarissa's outside counsel determined not to collect those custodians' text messages based on the general counsel's representations that (i) neither he nor Mr. Denner texted for business; (ii) Sarissa had a policy against texting for business; and (iii) he had personally looked through Mr. Denner's phone and had found no responsive texts. Outside counsel asked that Sarissa personnel preserve their texts and check in with outside counsel before replacing their phones.

Ultimately, texts were not preserved. Sarissa's head trader never turned off the 30-day auto-delete function that was enabled on his phone. Mr. Denner upgraded his phone to a new model without consulting outside counsel and claimed that the upgrade caused the loss of all of his data. And the general counsel took his phone to be repaired after it fell into a pool and claimed that the repair caused the loss of all of his data.

Vice Chancellor Laster ultimately held that Sarissa failed to take adequate steps to preserve potentially relevant text messages. Importantly, the vice chancellor held that circulating a litigation hold was not enough—Sarissa should have "take[n] steps to ensure that the recipients of the hold" understood what it meant and abided by it, including by having outside counsel (i) conduct custodian interviews as soon as the duty to preserve arises in order to determine where sources of potentially relevant data are located; and (ii) backing up or imaging the relevant devices around the same time.

To remedy the prejudice caused to the plaintiffs, the court imposed severe sanctions, including a presumption at trial that (i) Sarissa purchased Bioverativ stock based on inside information; and (ii) the lost texts would have supported the plaintiff's position. The court also raised the defendants' "standard of proof by one level," from a preponderance of the evidence to "clear and convincing evidence." Six days before trial was scheduled to begin, the parties filed a letter informing the court that they had agreed to settle the case and requesting that the trial be removed from the court's calendar.

The Takeaway: This decision is the latest development in a growing trend whereby courts and regulators secondguess defendants' preservation efforts and impose substantial merits-based penalties for failures to preserve potentially relevant documents. It also shows that the Court of Chancery expects defendants and their counsel to actively preserve potentially relevant documents, including text messages, and that simply sending a litigation hold and presuming compliance may no longer be sufficient. Failure to take adequate preservation steps could cause the court to infer that messages that were deleted—even inadvertently—would have supported the plaintiffs' claims. At a minimum, document preservation issues may cause the court to disregard witness testimony about the nature of the deleted messages, which can similarly undermine defendants' ability to present an effective case at trial.

Potential Consequences of Omitting Legal and Financial Advisor Fees From Transactional Disclosures

The Background: In two decisions issued in March and May of 2024, the Delaware Supreme Court reinforced that the favorable standard of review for conflicted controller transactions under Kahn v. M&F Worldwide Corp. (which offers business judgment rule protection where the transaction is approved by a fully empowered, independent special committee and a fully informed majority of the minority stockholders) provides no protection for issuers who do not disclose material advisor conflicts. And, in a third decision issued in May of 2024, the Delaware Court of Chancery held that disclosures made to stockholders who have not been asked to vote (and whose only decision is whether to tender their shares for appraisal) must similarly disclose all material advisor conflicts.

In the first of the three decisions (Brookfield), the Delaware Supreme Court reversed the Court of Chancery's dismissal of claims challenging a squeeze-out merger pursuant to which Brookfield Asset Management acquired the remaining 38% of shares in Terraform Power, Inc. that it did not already own. The court found that the minority stockholder vote was not fully informed, and that MFW's requirements were therefore not met, because the proxy statement did not disclose that Morgan Stanley, one of the special committee's two financial advisors, had invested $470 million in Brookfield-affiliated entities. The court also held that the proxy was misleading because it stated that Morgan Stanley "may have committed and may commit in the future to" invest in funds managed by Brookfield, despite the fact that it had already invested in those funds. In so holding, the court accepted the plaintiffs' allegation that the $470 million was held for Morgan Stanley's own benefit.

The Brookfield decision also addressed disclosures concerning legal advisors, as the court held that the proxy statement improperly failed to disclose that the special committee counsel was concurrently representing Brookfield in other matters at the time of the transaction. The court concluded that an advisor's "concurrent engagement with a transaction counterparty can present legitimate concerns" warranting disclosure.

In the second of the three decisions (Inovalon), the Delaware Supreme Court reversed the Court of Chancery's dismissal of claims challenging the acquisition of Inovalon Holdings, Inc. by a consortium led by Nordic Capital. The transaction involved a significant equity rollover from Inovalon's founder and CEO, who controlled approximately 86% of the company's voting power. The court found that the minority stockholder vote was not fully informed, and that MFW's requirements were not satisfied, because the proxy statement (i) did not disclose that affiliates of Evercore—one of the special committee's advisors—were concurrently representing members of the buyer consortium in unrelated transactions; (ii) disclosed that J.P. Morgan—another advisor to the special committee—received $15.2 million in fees for past work from Nordic, but did not disclose that J.P. Morgan had received between $34 million and $383 million in fees for past work from other members of the buyer consortium in the same period; and (iii) did not disclose the fees that J.P. Morgan anticipated earning for concurrent services it was providing to members of the buyer consortium. The court also noted that the proxy statement overstated Evercore's role in the deal process.

In the final of the three decisions (Foundation Building Materials), the Delaware Court of Chancery sustained claims challenging the sale of Foundation Building Materials, Inc., which was controlled by a private equity sponsor, to a third party. The plaintiffs alleged that Foundation Building Materials' sponsor was uniquely incentivized to support a sale transaction because it stood to receive a significant early termination payment under a Tax Receivable Agreement upon a change in control. The transaction was approved by written consent, but the court held that the public stockholders were still entitled to the level of disclosure they would have received had they been asked to vote on the transaction, as the stockholders needed such information to make a fully informed decision as to whether to exercise their appraisal rights. The court ultimately sustained fiduciary duty claims against the company's directors because the information statement did not disclose, among other things, (i) that the special committee's advisors—RBC and Evercore—would receive contingent success fees based in part on the consideration that Foundation Building Materials' private equity sponsor would receive under the Tax Receivable Agreement in connection with the deal; and (ii) RBC's deep relationship with the sponsor, including the more than $70 million in fees that it had received from the sponsor over a 2.5-year period. The decision also reached the novel holding that, at least in the Vice Chancellor's view, special committee advisors should not receive contingent compensation.

The Takeaway: These decisions underscore the Delaware courts' continuing focus on advisor conflicts and related disclosures and the corresponding importance of ensuring that transactional disclosures regarding advisors' potential conflicts of interest are fully and fairly disclosed in a common sense and plain English way.

Delaware State Legislature Amends the Delaware General Corporation Law to Address Common Law Developments

The Background: Recently, the Delaware state legislature amended the Delaware General Corporation Law (DGCL) to address a recent series of surprising decisions by the Chancery Court: (i) West Palm Beach Firefighters' Pension Fund v. Moelis & Co., which limited the enforceability of numerous provisions found in a typical agreement between a company and major stockholders; (ii) Crespo v. Musk, which foreclosed target companies in failed mergers from pursuing lost stockholder premia as damages; and (iii) Sjunde AP-fonden v. Activision Blizzard, Inc., which held that for a board to approve a merger agreement, that merger agreement presented to the board for approval must be "essentially complete."

Stockholder Agreements. The Moelis decision's impact on stockholder agreements drove many of the amendments, including the creation of subsection (18) to Section 122 of the DGCL. The new subsection provides that a corporation can enter into contracts allocating governance rights to current or prospective stockholders, although such contracts cannot include provisions that violate the corporation's charter or Delaware law more generally.

The scope of delegable authority is limited by both the corporation's charter and Delaware law more broadly, such that the board cannot contract away powers it does not have. As with other contracts, the corporation must receive consideration, although the consideration need not be monetary. Consideration for consent rights can include inducing or refraining from certain actions, such as facilitating an IPO or refraining from pursuing an activist proxy campaign. Notably, the amendments do not alter the fiduciary duties of directors or existing standards of review, and the revised statute specifically exempted ongoing litigations. So there are some number of cases in which the Delaware courts will continue to apply the prior statute and case law to determine whether the challenged stockholder agreement violates the DGCL. With the exception of those legacy litigations, this new DGCL provision applies to all Delaware corporations—including those with existing stockholder agreements that included the types of provisions later questioned by the Moelis decision

Merger Agreement Remedies. The amendments also address the Court of Chancery's holding in Crespo v. Musk, which stated in dicta that a target company in a failed merger cannot directly recover lost stockholder premium damages. Specifically, the amendments clarify the ability of parties to a merger to agree to lost stockholder premia as a remedy available in the event of a failed merger.

The amendments address this issue with subsection (a) (1) to Section 261 of the DGCL to clarify that parties to a merger agreement may contract for penalties or consequences for a breach of the merger agreement that occurs prior to the effective time, and that these penalties and consequences are enforceable regardless of any otherwise applicable provisions of contract law (such as those addressing liquidated damages and unenforceable penalties). So long as the parties contract for it, a target corporation has the right to enforce and retain the benefit of such lost premia agreements. The amendments also add subsection (a)(2) to Section 261 to clarify that parties to an agreement may provide for the appointment of one or more persons to act as a representative to enforce stockholders' rights under the agreement.

Corporate Approval Process. Finally, the amendments address the corporate process to approve a merger agreement. The DGCL contemplates that the board will first adopt a resolution approving the agreement, which will then be executed and submitted to stockholders. In its recent decision in Sjunde AP-fonden v. Activision Blizzard, Inc., the Court of Chancery held that a merger agreement approved by the board must be "essentially complete." The amendments address this holding by adding Section 147 to the DGCL. Under this new section, the agreement approved by the board must be in final form or "substantially" final form. The amendments do not define "substantial," but the synopsis provided to the Delaware General Assembly in connection with the amendments contemplated that the agreement will be in substantially final form if all of the material terms are set forth therein or determinable through other information or materials presented to or known by the board.

Delaware Supreme Court Affirms Use of MFW Cleansing Outside of Squeeze-Out Transactions

The Background: In April, the Delaware Supreme Court ruled that both of MFW's protections (approval of the transaction by an independent and fully empowered special committee and the company's non-controlling stockholders) are required for transactions involving interested controlling stockholders to receive business judgment review. Absent both of MFW's protections, Delaware's harshest standard of review, entire fairness, will apply. Further, the court held that all members of a special committee must be independent of the controller for the transaction to receive MFW's cleansing effect.

The ruling comes in the context of a reverse spinoff of Match.com by IAC. Through ownership of Match.com's super voting class B shares, prior to the spin IAC controlled 98.2% of Match.com's voting power despite only controlling 24.9% of its outstanding common stock. IAC announced an intent to separate from Match.com and conditioned any transaction on the approval of an independent special committee and a fully informed stockholder vote. After negotiation, Match.com's special committee, which included Thomas McInerney (a former IAC executive), approved the transaction. Match.com's stockholders voted on the transaction, which included Match.com paying a pre-separation dividend (primarily to IAC), Match.com guaranteeing IAC's debt, and IAC's near-term governance control of Match.com despite the reclassification of Match. com's structure into a single class of common stock with no controlling stockholder.

Plaintiffs challenged the reverse spinoff as an unfair controlled transaction given that IAC, as controller, stood on both sides. The Court of Chancery granted the defendants' motion to dismiss, finding that the transaction satisfied MFW and was therefore subject to deferential business judgment review. Although the Court of Chancery found that McInerney lacked independence from IAC, it concluded that a majority of the special committee was independent and that McInerney failed to infect or dominate the special committee's consideration of the transaction.

On appeal, plaintiffs challenged the trial court's ruling that an MFW special committee may include non-independent

members and that the stockholder vote was fully informed. In addition to defending the trial court's decision, the defendants argued that because the reverse spin-off was not a squeezeout transaction, they only needed to satisfy one of MFW's safeguards in order to trigger business judgment review.

In determining that both MFW protections are required to "cleanse" non-squeeze-out transactions and avoid entire fairness review, the Delaware Supreme Court held that transactions involving conflicted controlling stockholders are inherently subject to entire fairness and that application of a single MFW protection shifts the burden of proof but does not alter the standard of review.

In addition to requiring the presence of both MFW procedural protections for a transaction to receive business judgment review, the Court held that the special committee must be entirely, and not just majority, independent. The court reasoned that the inclusion of a non-independent special committee member fails to disable a controller's inherent coercion. Accordingly, because the Court of Chancery found that McInerney lacked independence from IAC, the Match.com special committee was not wholly independent, and the transaction did not comply with the MFW protections.

The Takeaway: This decision highlights the importance of selecting independent directors for special committees, particularly in the context of controller transactions. This includes thorough diligence for actual and potential conflicts, and an open dialogue among committee members regarding any conflicts that might arise during the process. In addition, the decision highlights the Delaware courts' continuing suspicion of controlling stockholder transactions in which the controller is receiving some nonratable economic benefit. The decision clearly evidences the court's view that both MFW protections are necessary to simulate arm's-length bargaining with the controller and ensure that the transaction is not coercive.

Delaware Plaintiffs Attack Net Operating Loss Poison Pills

The Background: Following the rash of litigation challenging "acting in concert" provisions within advance notice bylaws, stockholder plaintiffs' firms have begun challenging net operating loss (NOL) poison pills that

use similar language. In these cases, plaintiffs have alleged that agreement, arrangement, and understanding clauses (AAUs) in advance notice bylaws that require a nominating stockholder to disclose coordination with other stockholders, as well as related "daisy chain" provisions imputing agreements between third parties to the nominating stockholder, infringe on the stockholder franchise, are facially unreasonable, and cause a board to breach its duty of loyalty when it enacts or fails to repeal such bylaws. Such provisions are common within NOL poison pills, which are implemented to dissuade stockholders from triggering ownership changes that result in the loss of valuable NOLs. Given the tax code's complex aggregation principles, unforgiving nature, and harsh punishment for an ownership change, relatively broad poison pills may be situationally appropriate to avoid adverse outcomes.

Plaintiffs have primarily targeted companies that are in the process of renewing their NOL poison pills in connection with an upcoming proxy. Usually, these renewed poison pills are unchanged from the poison pills that were previously in place. Nonetheless, plaintiffs' complaints allege that, in service of entrenching incumbent directors, AAUs and "daisy chains" in these NOL poison pills are facially invalid, go beyond what is required by the tax code's aggregation principles, and chill the stockholder franchise.

Rather than litigate plaintiffs' claims, most companies faced with such a challenge to their NOL poison pills have chosen to moot plaintiffs' complaints. They have done so with simple revisions to the language of their poison pills, making clear that the tax code and relevant regulations limit stockholder aggregation by the terms of their pills.

The Takeaway: We expect complaints challenging NOL poison pills will continue to be filed until the law around this issue becomes better developed. However, at present, the cost of litigating these provisions is likely higher than the cost of simply amending the pill, which incentivizes further complaints and reduces the likelihood of new decisional law addressing the merits of these claims. Accordingly, companies with NOL poison pills should closely examine the pill's language, consider targeted revisions of the pill where appropriate, and ensure that the board implements best practices on the process of implementing or renewing the pill.

Delaware Supreme Court Clarifies the Standard Required to Challenge Bylaws

The Background: In July, the Delaware Supreme Court clarified the appropriate standard for evaluating facial challenges to corporate bylaws. The decision addressed a long-running activist battle between AIM ImmunoTech and certain of its stockholders. In connection with that dispute, AIM adopted a set of advance notice bylaws and applied those bylaws to reject the dissident stockholders' submission in support of their board nominations. Although the Court of Chancery upheld the corporation's decision to reject the notice, it struck down several of the bylaws as disproportionate to the threat faced by the corporation.

On appeal, the Delaware Supreme Court held that bylaws are presumed to be valid, and a "facially valid bylaw is one that is authorized by the Delaware General Corporation Law (DGCL), consistent with the corporation's certificate of incorporation, and not otherwise prohibited." As such, a bylaw is only facially invalid when it is invalid in all circumstances. The Supreme Court therefore reversed the Court of Chancery's holding that a number of provisions in AIM's advance notice bylaws were deficient, but affirmed that one provision was invalid because it was simply "incomprehensible."

Turning to the as applied challenge, the court held that bylaws adopted, amended, or enforced in response to a threat, or looming threat, are still reviewed under an enhanced scrutiny standard. This requires a court to review both the board's intent in implementing the bylaws and whether the bylaws were proportional to the threat they were intended to address. If the bylaws fail either one of these tests, they are presumed to be unenforceable. The court held that a number of the bylaws were unenforceable because they were adopted for an improper motive, but refused to take further action because the dissident stockholders' notice contained false and misleading information.

The Takeaway: The Delaware Supreme Court's clarification of the standard for facial review of bylaws should pare back the number of complaints filed in Chancery challenging bylaws absent a true case or controversy. Corporations should nonetheless consider whether their bylaws are intelligible and clarify any that are overly unwieldy. Similarly, when adopting, amending, or enforcing bylaws that could be viewed as defensive, boards will need to consider the enhanced scrutiny that will be applied to those bylaws and ensure that the board record concerning those bylaws is sufficiently developed to support a strong defense in any eventual litigation.

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