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Delaware Supreme Court Examines Director Liability for Acquisitions

By | January 19, 2020

In McElrath v. Kalanick et al, the Delaware Supreme Court examined the liability of directors of Uber for an acquisition.  The case arose out of Uber’s acquisition of Ottomotto LLC.  Otto was founded by Anthony Levandowski, a former employee of “Waymo.” Waymo is a subsidiary of Google, and is engaged in developing selfdriving technology. Uber sought to jumpstart its own efforts to develop selfdriving vehicles by acquiring Otto. Uber executives began efforts to recruit Levandowski in June 2015, when he still worked for Google. During the “recruitment period,” Travis Kalanick, Uber’s founder personally exchanged text messages with Levandowski.  Levandowski left Google and hired over a dozen former Google employees at Otto. Weeks later, Uber and Otto signed a term sheet for Uber to acquire Otto.

After signing the term sheet, Uber and its outside counsel hired Stroz Friedberg, LLC, a computer forensic investigation firm, to conduct an independent investigation into whether Otto employees took with them Google’s proprietary information or might breach non-solicitation, non-compete, or fiduciary obligations if they moved from Google to Otto.   The merger agreement included unusual indemnification provisions.  For instance, Otto would not indemnify Uber post-closing for Otto’s breaches of representations and warranties. Also, certain Otto employees, including Levandowski, would have limited indemnification rights for pre-signing misconduct disclosed during the Stroz  investigation, but not for undisclosed pre-signing or any post-signing misconduct.

After Uber acquired Otto, a Google employee noticed that Otto was using what appeared to be Google technology. Google sued Otto and Uber for intellectual property infringement, and Uber ultimately settled for $245 million.  The plaintiff commenced litigation, purportedly on behalf of Uber, against Kalanick, the directors who approved the transaction, and others, and sought damages arising from the Otto acquisition.

The defendants challenged the plaintiff’s failure to first make a demand on the board of directors before pursuing litigation on Uber’s behalf.  This required the Court to examine whether a majority of the board was disinterested because it had no real threat of personal liability due to Uber’s exculpatory charter provision.  Given the protection from due care violations because of the exculpatory charter provision, the plaintiff must plead with particularity that the directors “acted with scienter, meaning ‘they had actual or constructive knowledge that their conduct was legally improper.’” In other words, directors are liable for “subjective bad faith” when their conduct is motivated “by an actual intent to do harm,” or when there is an “intentional dereliction of duty, a conscious disregard for one’s responsibilities.” According to the Court, pleading bad faith is a difficult task and requires “that a director acted inconsistent with his fiduciary duties and, most importantly, that the director knew he was so acting.”  Gross negligence, without more, is insufficient to get out from under an exculpated breach of the duty of care.

First, the plaintiff argued that, because Kalanick as CEO was the one who brought the transaction to the board and was involved with diligence, the directors should have been wise enough not to rely on someone with a reputation as a law breaker. As an example, the plaintiff pointed to one of Kalanick’s prior businesses, Scour, which offered music and film releases. Scour was eventually shut down for copyright violations and sued for $250 billion.

Second, the plaintiff argued that the allegedly unusual indemnification clauses in the merger agreement put the board on notice that Kalanick wanted to steal Google’s proprietary information. The agreement indemnified certain Otto employees for pre-signing misconduct disclosed during the Stroz investigation, but prevented Uber from seeking indemnification from Levandowski for violating noncompete and infringement claims. And, as the plaintiff alleged, Uber hired Stroz to investigate whether Otto employees stole Google’s intellectual property, but the board approved the transaction without personally reviewing the preliminary or final Stroz reports. The plaintiff argued that, viewed holistically, these facts entitle him to a reasonable inference that the board’s failure to inquire or inform themselves about the scope of potential legal and financial risk faced by Uber in connection with the Otto transaction amounted to bad faith.

The Court rejected the Plaintiff’s arguments.  The complaint alleged that Uber’s directors heard a presentation that summarized the transaction, reviewed the risk of litigation with Google, generally discussed due diligence, asked questions, and participated in a discussion. The inference from these allegations shows a functioning board that did more than rubberstamp the transaction presented by Uber’s CEO. The Court noted there is a vast difference between an inadequate or flawed effort to carry out fiduciary duties and a conscious disregard for those duties. It is not enough to allege that the directors should have been better informed as this is a due care violation exculpated by the corporation’s charter provision.

The Court noted Kalanick might have a background that would lead a reasonable board member to dig deeper into representations he made about the transaction. But there were no allegations that Kalanick had a history of lying to the board.

The Court noted the indemnification provisions were unusual but those provisions were clearly explained to the board.  The indemnification provisions did provide some protection for Uber— Uber would not have to indemnify Levandowski and others for conduct that was not disclosed to Uber before closing. The allegations as pleaded did not support a reasonable inference that the directors knew the transaction was nothing more than a vehicle to steal Google’s proprietary information.  Instead, the reasonable inference is the board should have done more, not that it acted in bad faith. Thus, the unusual indemnification provisions approved by the board did not lead to any inference other than the board approved a flawed transaction.

Contact Steve Quinlivan for more information.