4.2.4 Section 102(b)(7) DGCL as an affirmative defence

The recent Cornerstone decision underlines that it is appropriate to allow 102 (b)(7) defences to be asserted at the motion to dismiss stage. To allow cases to go forward, shareholders-claimants are required to satisfy a pleading standard: if a complaint unambiguously alleges only a breach of the duty of care, the exculpatory clause may be properly applied to allow early dismissal.1 However, only when the complaint alleges a breach of the duty of loyalty, and the complaint cites specific facts, rather than mere allegations, an exculpatory clause will not warrant early dismissal.2 In the latter well-pleaded cases, section 102(b)(7) continues to carry its legal implication as an affirmative defence.3 To understand the function of an affirmative defence, it is important to review Emerald Partners v. Berlin4 in order to discern appropriate guidelines.

In this seminal case, the claimant alleged that the director defendants committed waste by approving a transfer of assets to a fellow director (the CEO) in order to secure that director’s personal loans while providing the company with little or no consideration in return. The claimant was successful in rebutting the business judgement presumption and the burden of proof shifted to the directors to demonstrate that the transaction was entirely fair to the claimant. The defendants invoked the exculpatory provision. At trial, the Delaware Supreme Court had to decide when it is procedurally appropriate to consider the substantive effect of a section 102(b)(7) provision invoked by the directors pursuant to the entire fairness standard of judicial review. The Delaware Supreme Court first characterised the Delaware limited liability statute as an affirmative defence.5 As the court held, an affirmative defence is “[a] defendant’s assertion raising new facts and arguments that, if true, will defeat the claimant’s claim, even if all allegations in the complaint are true.” In other words, a 102(b)(7) provision functions not to defeat the validity of a claimant’s claim on the merits, but may defeat the claimant’s ability to recover monetary damages. The application of the defence is fact-based and the defendant directors have the burden of proof regarding those issues of fact. In its analysis, the court reasoned that, where the entire fairness standard is applicable, ‘injury or damages becomes a proper focus only after a transaction is determined not to be entirely fair.’6 And thus, the exculpatory effect of a section 102(b)(7) provision becomes the subject of judicial scrutiny after the directors’ potential personal liability has been established.7 Accordingly, when a transaction requires an entire fairness review, a section 102(b)(7) charter provision cannot eliminate an entire fairness analysis by the court. In the post-trial decision on remand, the Chancery Court reviewed and confirmed the affirmative defences. The central issue of review on remand was whether the defendants’ conduct involved a violation of the duty of loyalty or of care. As in the earlier Delaware Supreme Court decision, the defendants can be exculpated only if the unfairness in the merger was found to have resulted ‘solely from a violation of the duty of care.’ The Chancery Court ultimately decided that the merger was in fact entirely fair and, even if it were unfair, the ‘unfairness could only have been the sole result of a breach of the defendants’ duty of care for which the directors were exculpated from monetary liability due to the exculpatory clauses.’8