Reed Smith Client Alerts

The Delaware Court of Chancery regularly reviews challenged corporate transactions to determine whether fiduciary duties owed by directors were fulfilled.1 Recently, on a motion to dismiss in Salladay v. Lev, the Court of Chancery addressed the standard of review that applies to a conflicted transaction and determined that the "entire fairness" standard - as opposed to the "business judgment rule" - applied to the conflicted merger transaction.2

作者: Brian M. Rostocki Benjamin P. Chapple Alexandria P. Murphy

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