In re Trados (Standards of Review, To Whom Are Duties Owed)

There are two questions we ask in any litigation: (1) Was there a substantive violation, and (2) How much deference should we give? For example, appellate courts don't give any deference on questions of law, reviewing de novo. But appellate courts do give deference on questions of fact, reversing only if there was clear error.

Part of the reason for this is that the trial court and the appellate court have similar access and expertise in interpreting the law. Both have the full set of federal reporters and both are skilled at legal analysis. So when interpreting law, deference doesn't make a lot of sense.

In contrast, for questions of fact, the trial court saw the witnesses testify and saw the broader relationship between the parties and their clients. These can be described in a memo, but it will not convey the full information that the trial court witnessed. So the trial court has information that the appellate court doesn't when resolving factual disputes, and so the appellate court defers somewhat to the trial court's view.

While a board of directors is not a lower court, courts still typically defer somewhat to decisions by directors and officers. This makes sense---directors have more expertise in business and broader information than what's presented at trial. But deference means that some bad acts will go unpunished because the court chooses to defer.

In the case below, a company merged out of existence and the cash from that merger all went to preferred shareholders. The common shareholders got nothing, so they sued, arguing that the board breached its fiduciary duties by approving a deal that eliminated the company and gave them nothing in exchange.

There are two major takeaways.

Standard of Conduct vs. Standard of Review

First, the standard of conduct refers to how directors and officers should properly act. The standard of conduct is the fiduciary duties we've already discussed---the duty of care and the duty of loyalty.

The standard of review, in contrast, refers to how much deference the courts will give. Delaware corporate law has three standards of review: the business judgment rule, enhanced scrutiny and entire fairness. The business judgment rule is the most deferential, enhanced scrutiny is in the middle and entire fairness is the highest level of scrutiny.

The business judgment rule is the default, but there are certain triggers that shift us to entire fairness instead. For example, if the directors have a conflict (e.g., suppose they are causing the corporation to buy their car), the court will look more closely. This makes sense. Some situations, like financial conflicts, make it more likely that the directors will sellout the shareholders' interests. So you look more closely, and that closer look is the entire fairness standard.

You might wonder why we wouldn't use the medium deferential standard, enhanced scrutiny, rather than jump to the most stringent standard, entire fairness. That's because enhanced scrutiny is a special category for a few defined specific scenarios, mostly involving mergers. So unless it's one of those specific situations that uses enhanced scrutiny (which we'll cover later), you start with the business judgment rule. The plaintiff can then try to knock out the business judgment rule in a few ways, for example by showing the directors have a conflict, and if successful, you use the entire fairness standard. In other words, in all but a few specific situations, we use either the business judgment rule or entire fairness.

In the case below, the plaintiffs claim a breach of the duty of loyalty (standard of conduct), and the court reviews using the entire fairness standard (standard of review).

To Whom Are Fiduciary Duties Owed?

The second major takeaway from the case below is that directors and officers owe fiduciary duties only to the corporation and to the residual holders. In practice, this means that if the corporation is helping other groups (e.g., giving grants to charity, raising employee wages or buying fair-trade goods) it must be for the purpose of benefiting the shareholders. The court grapples with whether preferred stock is a contractual claim or a residual claim, and concludes that the preferred stockholders were acting as contractual claimants, so they are not owed a fiduciary duty.