In CDX Holdings, Inc. v. Fox, 141 A.3d 1037 (2016), the Delaware Supreme Court, applying a “clearly erroneous” standard of review, deferred to the Court of Chancery’s findings of fact and upheld the Court of Chancery’s determination that a corporation breached its stock option plan in connection with a spinoff and merger transaction.
Caris Life Sciences, Inc. (“Caris”), a privately held Delaware corporation, operated three business units: Caris Diagnostics, TargetNow, and Carisome. With the goal of securing financing for TargetNow and Carisome and generating a return for its stockholders, Caris sold Caris Diagnostics (its only consistently profitable business unit) to Miraca Holdings, Inc. (“Miraca”). To facilitate the transaction, Caris conducted a spinoff by first transferring ownership of TargetNow and Carisome to a new subsidiary and then spinning off that subsidiary to Caris’s stockholders. Following the consummation of the spinoff, Caris was merged with a wholly owned subsidiary of Miraca (the “Merger” and, together with the spinoff, the “Transaction”). The Court found that the Transaction was structured in this manner to minimize taxes.
Following the Merger, holders of options granted under Caris’s 2007 Stock Incentive Plan (the “Plan”) brought claims against Caris asserting that the Plan had been breached in connection with the Transaction. Under the terms of the Plan, each Caris option holder had the right to receive in the Merger the amount by which the Fair Market Value (as defined in the Plan) of each share exceeded the exercise price. Under the Plan, Fair Market Value was defined as an amount determined by the board of directors of Caris (the “Board”). The Board was also the administrator under the Plan. Under the Plan, the Board’s good faith determination of Fair Market Value was conclusive unless it was the result of an arbitrary and capricious process. The Plan also required the Board, as administrator, to adjust the options to account for the spinoff. Plaintiff claimed that Caris breached the Plan because members of management, not the Board, determined the value that the option holders would receive in the Transaction. Plaintiff further claimed that, regardless of who made the determination, the process utilized was arbitrary and capricious and therefore the determination was not made in good faith.
The Court of Chancery found that, rather than the Board, Caris’s chief financial officer (who was also its chief operating officer) had made the value determination required under the Plan, which determination was later signed off on by Caris’s founder. The Court further found that regardless of who made the value determination, the value received by the option holders in the Transaction was not determined in good faith because the value determination was made to obtain tax-free treatment of the spinoff rather than to accurately ascertain the Fair Market Value of the stock under the Plan. Finally, the Court found that the chief financial officer engaged in an arbitrary and capricious process to determine such value. In accordance with these findings, the Court of Chancery concluded that Caris breached the Plan and awarded plaintiff damages, plus pre- and post-judgment interest.
Upon review, the Delaware Supreme Court, in a majority opinion, noted that findings of historical fact are subject to the deferential “clearly erroneous” standard of review. The Court explained that it “must give deference to findings of fact by trial courts when supported by the record, and when they are the product of an orderly and logical deductive reasoning process, especially when those findings are based in part on testimony of live witnesses whose demeanor and credibility the trial judge has had the opportunity to evaluate.” Stating that “the record in this appeal compels an application of that standard of appellate review,” the Delaware Supreme Court affirmed the judgment of the Court of Chancery.
In a lengthy dissent, Justice Valihura disagreed with the majority opinion and concluded that because “[t]he Court of Chancery’s ultimate findings are logically disconnected from the record evidence before it, from the trial court’s own immediate, on the record impressions of the trial, and from the requirements of the legal test established by the Plan,” the Court of Chancery’s findings were not entitled to deference. In this regard, Justice Valihura noted, among other things, that plaintiff was required to prove that the board breached its contractual duty of subjective good faith either by demonstrating that the board acted in subjective bad faith or by showing that it consciously disregarded a known duty to act. Notwithstanding the requirement that plaintiff make such a showing, the dissent found that the Court of Chancery did not make, and that the record below did not support, any finding that the Board acted in subjective bad faith or consciously disregarded a known duty to act. In support of this finding, the dissent noted, among other things, that the Board engaged legal counsel and hired an independent advisor to assist the directors in determining the Fair Market Value of the stock in connection with the Transaction.
In addition to the foregoing reasons for not according deference the Court of Chancery’s conclusions, the dissent also stated that such conclusions were not entitled to deference due to the Court of Chancery’s implicit rejection of trial testimony of the directors on the basis of a “hindsight bias” theory. The dissent explained: “In my view, this Court should be skeptical of court rulings predicated on social science studies, particularly where, as here, such theories impact a trial court’s own post-trial impressions of the testimony offered.”