May 23, 2014
When Business Judgment Isn’t Enough: The Impact of the Standard of Review on Deal Litigation
By Stephen B. Brauerman
Three recent decisions of the Delaware Court of Chancery, all written by Vice Chancellor Laster, demonstrate the importance and impact of the application of the standard of review to the success of post-transactional shareholder litigation. The decision in In re Orchard Enterprises Inc. Stockholder Litigation, C.A. No. 7840-VCL, 2014 WL 1007589 (Del. Ch. Feb. 28, 2014), holds that entire fairness review should govern the court’s consideration at trial of the board’s approval of a squeeze-out merger effected by the company’s majority stockholder. The court’s post-trial opinion in In re Rural Metro Corp. Stockholders Litigation, C.A. No. 6350-VCL, 2014 WL 1053140 (Del. Ch. Mar. 7, 2014), applies enhanced scrutiny review to hold the company’s financial advisor liable for aiding and abetting the board’s exculpated and previously settled breaches of fiduciary duty. In Chen v. Howard-Anderson, C.A. No. 5878-VCL, 2014 WL 1366551 (Del. Ch. Apr. 8, 2014), the court also applied the enhanced scrutiny standard to grant the directors defendants’ motion for summary judgment in a challenge to a mixed cash and stock merger with a competitor at the expense of other, more lucrative transactions. In each of Orchard, Rural Metro, and Chen, the parties disputed which standard of review to apply and in each instance, the court’s resolution of that procedural question had a dispositive effect. As Delaware law strives to provide greater flexibility and certainty to corporate decision makers, the standard of review continues and will continue to play an impactful, though often unappreciated, role.
Delaware courts apply three standards of review to determine whether corporate fiduciaries have complied with their duties of care and loyalty: (1) the business judgment rule, (2) enhanced scrutiny, and (3) entire fairness. Under the deferential business judgment standard, the court will uphold director conduct unless such conduct cannot be attributed to any rational business purpose.
Enhanced scrutiny, Delaware’s intermediate standard of review, applies to “specific, recurring, and readily identifiable situations involving potential conflicts of interest where the realities of the decision-making context can subtly undermine the decisions of even independent and disinterested directors,” and requires fiduciaries to show that their motivations were proper, not selfish, and reasonable in relation to their legitimate objective. Enhanced scrutiny most often applies when a board adopts defensive measures to protect against a hostile takeover (Unocal), or seeks a transaction to sell the company or cash out stockholders (Revlon).
Entire fairness review applies where the board has an interest in the transaction different from stockholders generally or a controlling shareholder stands on both sides of the deal. In such circumstances, the defendant directors must prove that the transaction is entirely fair – with respect to both process and price – to the corporation. The burden of persuasion may shift to the stockholder plaintiff if the influence of the controller or self-interested fiduciary is neutralized by the creation of a sufficiently authorized committee of independent and disinterested directors, or the transaction is conditioned on the approval a majority of independent stockholders after full disclosure of the extent of the conflicts. Even more deferential review is available if, from the beginning, a conflicted transaction is negotiated by a duly authorized independent committee and approved by a majority of the disinterested stockholders after full disclosure, where the business judgment rule will apply. Kahn v. M&F Worldwide Corp., C.A. No. 334, 2013, 2014 WL 996270 (Del. Mar. 14, 2014).
Three recent decisions of the Delaware Court of Chancery, all written by Vice Chancellor Laster, demonstrate the importance and impact of the application of the standard of review to the success of post-transactional shareholder litigation. The decision in In re Orchard Enterprises Inc. Stockholder Litigation, C.A. No. 7840-VCL, 2014 WL 1007589 (Del. Ch. Feb. 28, 2014), holds that entire fairness review should govern the court’s consideration at trial of the board’s approval of a squeeze-out merger effected by the company’s majority stockholder. The court’s post-trial opinion in In re Rural Metro Corp. Stockholders Litigation, C.A. No. 6350-VCL, 2014 WL 1053140 (Del. Ch. Mar. 7, 2014), applies enhanced scrutiny review to hold the company’s financial advisor liable for aiding and abetting the board’s exculpated and previously settled breaches of fiduciary duty. In Chen v. Howard-Anderson, C.A. No. 5878-VCL, 2014 WL 1366551 (Del. Ch. Apr. 8, 2014), the court also applied the enhanced scrutiny standard to grant the directors defendants’ motion for summary judgment in a challenge to a mixed cash and stock merger with a competitor at the expense of other, more lucrative transactions. In each of Orchard, Rural Metro, and Chen, the parties disputed which standard of review to apply and in each instance, the court’s resolution of that procedural question had a dispositive effect. As Delaware law strives to provide greater flexibility and certainty to corporate decision makers, the standard of review continues and will continue to play an impactful, though often unappreciated, role.
A Brief Review of the Standards of Review
Delaware courts apply three standards of review to determine whether corporate fiduciaries have complied with their duties of care and loyalty: (1) the business judgment rule, (2) enhanced scrutiny, and (3) entire fairness. Under the deferential business judgment standard, the court will uphold director conduct unless such conduct cannot be attributed to any rational business purpose.
Enhanced scrutiny, Delaware’s intermediate standard of review, applies to “specific, recurring, and readily identifiable situations involving potential conflicts of interest where the realities of the decision-making context can subtly undermine the decisions of even independent and disinterested directors,” and requires fiduciaries to show that their motivations were proper, not selfish, and reasonable in relation to their legitimate objective. Enhanced scrutiny most often applies when a board adopts defensive measures to protect against a hostile takeover (Unocal), or seeks a transaction to sell the company or cash out stockholders (Revlon).
Entire fairness review applies where the board has an interest in the transaction different from stockholders generally or a controlling shareholder stands on both sides of the deal. In such circumstances, the defendant directors must prove that the transaction is entirely fair – with respect to both process and price – to the corporation. The burden of persuasion may shift to the stockholder plaintiff if the influence of the controller or self-interested fiduciary is neutralized by the creation of a sufficiently authorized committee of independent and disinterested directors, or the transaction is conditioned on the approval a majority of independent stockholders after full disclosure of the extent of the conflicts. Even more deferential review is available if, from the beginning, a conflicted transaction is negotiated by a duly authorized independent committee and approved by a majority of the disinterested stockholders after full disclosure, where the business judgment rule will apply. Kahn v. M&F Worldwide Corp., C.A. No. 334, 2013, 2014 WL 996270 (Del. Mar. 14, 2014).