With limited exceptions, the Court of Chancery must approve the settlement of derivative actions to ensure that a representative plaintiff has fairly obtained a just outcome for the class he or she represents. In performing this review, the court must “exercise its business judgment to determine whether the settlement is fair and reasonable in light of the factual and legal circumstances of the case,” as the court held in In re Resorts International Shareholders Litigation Appeals, 570 A.2d 259, 266 (Del. 1991). Exercising business judgment — a task Delaware courts recognize is best left to corporate fiduciaries — presents unique challenges for the court, which is necessarily limited in its review by the record the parties before it develop. Vice Chancellor J. Travis Laster’s February 6 decision in Forsythe v. ESC Fund Management, C.A. No. 1091-VCL (Del. Ch. Feb. 6, 2013), highlights this difficulty and provides useful guidance for litigants hoping to obtain court approval of (or to challenge) good, but not great, derivative settlements.
The Forsythe litigation began years ago and, hotly contested, has now generated eight written opinions. The dispute relates to an investment fund (nominal defendant CIBC Employee Private Equity Fund) created to allow senior employees of the Canadian Imperial Bank of Commerce to pursue private equity opportunities alongside the bank. As a result of the fund’s lackluster performance, the plaintiffs brought derivative claims for breach of fiduciary against the fund’s general partner, the members of the board of the fund’s general partner, the fund’s investment adviser and the fund’s special limited partner.
The February 6 decision is the second time the court considered the fairness of the Forsythe settlement. On May 9, 2012, over the objections of the named plaintiffs and other fund members, the court, in Forsythe v. ESC Fund Management, C.A. No. 1091-VCL (Del. Ch. May 9, 2012), approved a settlement in which the fund would receive a settlement payment in the amount of $10.25 million in cash and the defendants would waive their claims against the fund for indemnification, valued at $3 million. In the May opinion, the court had considered the pros and cons of approving the settlement. Favoring approval, the parties negotiated a settlement at arm’s length, with the benefit of an experienced and respected mediator. The settlement provided for a significant cash payment, with ample information about the case developed after trial and a number of rulings that helped the parties evaluate the merits of their respective claims. Considering factors that counseled against approval, the court noted the large number of objectors with significant holdings (including the named plaintiffs) and the objectors’ meaningful concerns about the adequacy of the settlement. Nonetheless, after considering the economic incentives of the interested parties, including the plaintiffs, plaintiffs counsel, the objectors, the defendants and the fund, the court found the settlement fell “within a range of fairness, albeit at the low end.”
As a result of its finding that the settlement was at the low end of the range of fairness, the court took a unique approach in determining reasonableness by allowing the objectors the opportunity to pursue the case and seek a higher recovery. The court gave the objecting members 60 days to lodge a “secured bond, letter of credit or similar security for the benefit of the fund in the amount of the settlement consideration.” If successful, the fund would benefit from their efforts. If their efforts failed, the fund would have the right to execute on the security to collect the difference between the ultimate recovery and the secured settlement value.
Rather than accept Laster’s May offer, the objectors proposed to litigate the case by securing the fund’s settlement with a combination of $1.35 million in cash and an $11.9 million litigation bond that had the effect of financing the settlement security with a portion of the fund’s recovery. By financing the security in this way, “the objectors and their counsel cleverly sidestepped the choice that the May decision tried to foist upon them” and in the process, made it impossible for the court to evaluate the reasonableness of the settlement based on what objectors chose. As the court explained, “I originally anticipated that the objectors and their counsel would have to decide whether to go out-of-pocket for the cost of the bond without the potential for extra upside, a choice that would force them to assess whether the risk-adjusted potential for greater recovery made the cost of the bond worthwhile. … I expected them to use their own assets, internalize the risk and make the decision about whether it made sense to pay for the bond.”
The objectors’ fancy footwork thrust the reasonableness inquiry back to the court, which could not assess the reasonableness of the proposed settlement with knowledge of the objectors’ risk-reward calculation because the objectors largely avoided the question. Of course, the investors still bore the downside risk because if their litigation efforts failed to provide a greater recovery than the settlement, the fund could still collect against the cash portion of the security the objectors provided themselves. Notwithstanding that the objectors were willing to put some, although not all, of their money where their mouths were, the court ultimately rejected the objectors’ competing proposal and approved the original settlement.
Holding that the objectors did not carry their burden to prove the reasonableness of their proposed alternative, the court approved the original settlement for several reasons. First, the court was concerned that the objectors’ proposal did not provide a sufficient percentage recovery for the fund. The court explained that although it was economically rational for the fund to favor the objectors’ proposal — because even a small percentage share of an additional recovery would provide a benefit to the fund — the court had to consider more than just economic efficiency in evaluating the propriety of a proposed settlement and the court was unwilling to allow the objectors to obtain a disproportionate recovery at the fund’s expense. Second, the parties did not present the court with a fully developed record because the objectors refused to permit any discovery concerning the financing of the litigation bond or the determination of the portion of the recovery used to finance the litigation bond. Third, the company that funded the litigation bond represented that it justified its underwriting, in part, to promote the market for litigation finance, which suggested to the court that the market does not support continuing the litigation. While the court found the objectors’ proposal superior to the settlement, because it presented the fund with the chance of a greater recovery, the court did not find the proposal reasonable.
Three lessons emerge from Forsythe. First, even when called upon to exercise their “judicial business judgment” in evaluating the propriety of proposed settlements, courts are not nearly as well positioned to make business judgments as are the principals, whose interests the court must balance in the derivative settlement context. Although the court was less than satisfied with the original settlement, the court did not want to foreclose the objectors (and derivatively the fund) from seeking a higher recovery without considering the alternatives. Even when the court considered the objectors’ proposed alternative, the court lacked the fully developed record (and resulting market information) necessary to test the reasonableness of the objectors’ proposal. Second, the court will take great pains to balance the competing interests of the many constituencies impacted by the derivative settlement. Here, the court postponed its final approval of the settlement by 60 days, gave those objecting to the settlement the change to improve upon, and issued two written opinions — all to ensure that it exercised its business judgment carefully. Finally, burdens of proof matter and the court ultimately disposed of its inquiry by finding that the objectors failed to carry their burden to demonstrate the reasonableness of their alternative proposal.
Reprinted with permission from the February 13, 2013 issue of Delaware Business Court Insider. (c) 2013 ALM Media Properties, LLC. Further duplication without permission is prohibited.