Under Delaware law, board decisions are often entitled broad deference under the business judgment rule, unless plaintiffs can establish the board's decision cannot be "attributed to any rational business purpose."3 Typically, the Court will not second-guess directors' business decisions if the directors act on an informed basis and in good faith.4 Transactions involving interested directors that stand on both sides of a deal, however, "raise questions of whether the directors have acted in their own, and not the corporate, interest."5 Thus, in a conflicted transaction, the presumption of business judgment is overcome and the Court's scrutiny increases, shifting the burden to the conflicted directors to show the transaction was "entirely fair."6
There are some conflicted transactions where, as in Salladay, procedural safeguards are implemented in an attempt to "cleanse" a conflicted transaction and, thus, the defense could re-invoke business judgment review.7 In Salladay, the board of directors (as opposed to a controlling stockholder) entered into a merger agreement that was considered a conflicted transaction because at least half of the directors lacked independence and were interested in the merger.8 The Court of Chancery explained that, under Delaware law, although conflicted transactions are typically reviewed under entire fairness, it is possible to "replicate the value-enhancing structure of an arms-length transaction and thereby re-invoke the business judgment rule" if the transaction was properly cleansed through procedural safeguards.9
To revive the business judgment rule where there is no controlling stockholder, the Court explained the board must either (i) "mak[e] the transaction subject to the informed, un-coerced vote of the majority of shares held by those free of conflict" or (ii) "permit[] an unconflicted committee of the board full scope to negotiate and enter any transaction."10 A board that effectively implements one (or both) of the procedural safeguards will likely be found to have “cleansed” the transaction.11
Although the directors in Salladay implemented both procedural safeguards, by (i) forming a special committee of unconflicted directors and (ii) obtaining a vote of the stockholders, the Court determined the entire fairness standard nonetheless applied because the procedural safeguards were inadequate.12
First, the issue before the Court in connection with the formation of the special committee involved the timing of formation.13 The Court found the special committee entered the negotiations after the point at which it could act to replicate an arms-length transaction and, thus, was not effective in cleansing the transaction.14 To effectively revive business judgment rule and cleanse a conflicted transaction with the formation of a special committee, the committee must be formed "ab initio" and prior to substantive economic negotiations.15 Because the committee in Salladay did not meet this requirement, it was insufficient to revive business judgement review.16
Second, the Court found the disclosures made to the stockholders in way of the vote on the merger were inadequate to invoke business judgment review.17 In some instances, where an"informed and empowered corporate electorate has accepted the transaction in light of, and in spite of, any conflicts of interest or other fiduciary defects," the Court will not second-guess such an informed vote by the corporate stockholders.18 However, where, as in Salladay, there is missing material information regarding the transaction - such as disclosures to the stockholders omitting material facts regarding the special committee’s engagement with financial advisors - the stockholder vote will not cleanse the transaction.19
Key takeaways
The Court of Chancery's decision in Salladay underscores well-established Delaware law that, even where there is a conflicted transaction, a board may still be entitled to the presumption of the business judgment rule if it effectively implements procedural safeguards to insulate the transaction from the conflict.
In the absence of a controlling stockholder, employing either a special committee or obtaining majority approval by independent stockholders can restore business judgment review to a conflicted transaction where entire fairness review otherwise would apply.
If a board of directors of a Delaware corporation seeks to pursue a potentially conflicted transaction, it should establish an independent special committee at the outset, such that the committee is fully authorized and independent.
Fiduciaries seeking the benefit of stockholder ratification and/or making disclosures to stockholders must fairly communicate and disclose all material facts so that stockholders may make an informed decision, particularly where stockholders must make a decision to approve or reject a proposed transaction (e.g., a merger).
- See Salladay v. Lev, 2020 WL 954032 (Del. Ch. Feb. 27, 2020).
- Id. at *1.
- See In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 73-74 (Del. 2006).
- See Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361, 1373 (Del. 1995); see also (noting the business judgment rule is a presumption that in making a business decision, the directors acted on an informed basis, in good faith, and in the honest belief that the action was taken in the best interest of the corporation).
- See Salladay, 2020 WL 954032, at *1.
- Id. at *8 ("Where entire fairness is the standard of review, and where, as here, a plaintiff alleges facts making it reasonably conceivable that the transaction was not entirely fair to stockholders, the granting of a motion to dismiss is inappropriate, because the burden is on the defendants to develop facts demonstrating entire fairness.").
- Id. at *8-9 (citing Kahn v. M & F Worldwide Corp., 88 A.3d 635, 644 (Del. 2014)) ("[E]ven where half or more of the directors are interested, and even if a conflicted controller is present, a company can implement procedural safeguards that cleanse the transaction and regain business judgment review, resulting, where appropriate, in dismissal of the action.").
- See Salladay, 2020 WL 954032, at *9 ("[T]he Amended Complaint adequately pleads (and the Defendants do not contest) that at least half the Board lacked independence because they were interested parties in the Merger.").
- Id. at *8 ("However, even where half or more of the directors are interested, and even if a conflicted controller is present, a company can implement procedural safeguards that cleanse the transaction and regain business judgment review, resulting, where appropriate, in dismissal of the action.").
- Id. at *8 (internal quotations omitted) ("Absent a looming conflicted controller, approval by a fully informed, un-coerced vote of disinterested stockholders can cleanse the transaction - even where entire fairness would otherwise apply . . . Alternatively, absent a conflicted controller, a fully empowered, independent special committee can potentially cleanse the transaction.").
- Id. at *8 (noting where a conflicted controlling stockholder is present and entire fairness applies, "a board can recover business judgment review by making the transaction contingent from inception upon the presence of a fully constituted, fully authorized special committee and a vote of informed and uncoerced minority stockholders").
- Id. at *1 ("I find that the special committee of unconflicted directors entered the negotiations after the point at which it could act to replicate an arms-length transaction, and that the disclosures to the stockholders in way of the vote were inadequate to invoke business judgement review.").
- Id. at *9 (noting the issue relating to the timing of the formation of the committee was whether the committee must be "sufficiently constituted and authorized ab initio").
- Id. at *10 (noting concerns that "commencing negotiations prior to the special committee’s constitution may begin to shape the transaction in a way that even a fully-empowered committee will later struggle to overcome").
- See Kahn v. M & F Worldwide Corp., 88 A.3d 635, 644 (Del. 2014). ("[B]usiness judgment is the standard of review that should govern mergers between a controlling stockholder and its corporate subsidiary, where the merger is conditioned ab initio upon both the approval of an independent, adequately-empowered Special Committee that fulfills its duty of care; and the uncoerced, informed vote of a majority of the minority stockholders.").
- See 2020 WL 954032, at *10.
- Id. at *1, 12.
- Id. at *12.
- Id. at *13 ("Under Delaware law, when a board chooses to disclose a course of events or to discuss a specific subject, it has long been understood that it cannot do so in a materially misleading way, by disclosing only part of the story, and leaving the reader with a distorted impression.").
Client Alert 2020-162
