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An Introduction to the Law of Corporations: Cases and Materials, Fall 2017

Standards of Conduct and Standards of Review

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When determining whether directors have breached their fiduciary duties, Delaware corporate law distinguishes between the standard of conduct and the standard of review. See William T. Allen, Jack B. Jacobs, & Leo E. Strine, Jr., Realigning the Standard of Review of Director Due Care with Delaware Public Policy: A Critique of Van Gorkom and its Progeny as a Standard of Review Problem, 96 Nw. U.L.Rev. 449, 451-52 (2002) [hereinafter Realigning the Standard]. The standard of conduct describes what directors are expected to do and is defined by the content of the duties of loyalty and care. The standard of review is the test that a court applies when evaluating whether directors have met the standard of conduct. It describes what a plaintiff must first plead and later prove to prevail.

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Under Delaware law, the standard of review depends initially on whether the board members (i) were disinterested and independent (the business judgment rule), (ii) faced potential conflicts of interest because of the decisional dynamics present in particular recurring and recognizable situations (enhanced scrutiny), or (iii) confronted actual conflicts of interest such that the directors making the decision did not comprise a disinterested and independent board majority (entire fairness). The standard of review may change further depending on whether the directors took steps to address the potential or actual conflict, such as by creating an independent committee, conditioning the transaction on approval by disinterested stockholders, or both. Regardless, in every situation, the standard of review is more forgiving of directors and more onerous for stockholder plaintiffs than the standard of conduct. This divergence is warranted for diverse policy reasons typically cited as justifications for the business judgment rule. See, e.g., Brehm v. Eisner, 746 A.2d 244, 263 (Del.2000) (explaining justifications for business judgment rule).

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The Standard Of Conduct

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Delaware corporate law starts from the bedrock principle that "[t]he business and affairs of every corporation ... shall be managed by or under the direction of a board of directors." 8 Del. C. § 141(a). When exercising their statutory responsibility, the standard of conduct requires that directors seek "to promote the value of the corporation for the benefit of its stockholders."

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"It is, of course, accepted that a corporation may take steps, such as giving charitable contributions or paying higher wages, that do not maximize profits currently. They may do so, however, because such activities are rationalized as producing greater profits over the long-term." Leo E. Strine, Jr., Our Continuing Struggle with the Idea that For-Profit Corporations Seek Profit, 47 Wake Forest L.Rev. 135, 147 n. 34 (2012) [hereinafter For-Profit Corporations]. Decisions of this nature benefit the corporation as a whole, and by increasing the value of the corporation, the directors increase the share of value available for the residual claimants. Judicial opinions therefore often refer to directors owing fiduciary duties "to the corporation and its shareholders."Gheewalla, 930 A.2d at 99accord Mills Acq. Co. v. Macmillan, Inc., 559 A.2d 1261, 1280 (Del.1989) ("[D]irectors owe fiduciary duties of care and loyalty to the corporation and its shareholders ...."); Polk v. Good, 507 A.2d 531, 536 (Del.1986) ("In performing their duties the directors owe fundamental fiduciary duties of loyalty and care to the corporation and its shareholders."). This formulation captures the foundational relationship in which directors owe duties to the corporation for the ultimate benefit of the entity's residual claimants. Nevertheless, "stockholders' best interest must always, within legal limits, be the end. Other constituencies may be considered only instrumentally to advance that end." For-Profit Corporations, supra, at 147 n. 34.

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A Delaware corporation, by default, has a perpetual existence. 8 Del. C. §§ 102(b)(5), 122(1). Equity capital, by default, is permanent capital. In terms of the standard of conduct, the duty of loyalty therefore mandates that directors maximize the value of the corporation over the long-term for the benefit of the providers of equity capital, as warranted for an entity with perpetual life in which the residual claimants have locked in their investment. When deciding whether to pursue a strategic alternative that would end or fundamentally alter the stockholders' ongoing investment in the corporation, the loyalty-based standard of conduct requires that the alternative yield value exceeding what the corporation otherwise would generate for stockholders over the long-term. Value, of course, does not just mean cash. It could mean an ownership interest in an entity, a package of other securities, or some combination, with or without cash, that will deliver greater value over the anticipated investment horizon. See QVC, 637 A.2d at 44 (describing how directors should approach consideration of non-cash or mixed consideration).

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The duty to act for the ultimate benefit of stockholders does not require that directors fulfill the wishes of a particular subset of the stockholder base. See In re Lear Corp. S'holder Litig., 967 A.2d 640, 655 (Del.Ch.2008) ("Directors are not thermometers, existing to register the ever-changing sentiments of stockholders.... During their term of office, directors may take good faith actions that they believe will benefit stockholders, even if they realize that the stockholders do not agree with them.");Paramount Commc'ns Inc. v. Time Inc., 1989 WL 79880, at *30 (Del.Ch. July 14, 1989)("The corporation law does not operate on the theory that directors, in exercising their powers to manage the firm, are obligated to follow the wishes of a majority of shares. In fact, directors, not shareholders, are charged with the duty to manage the firm."),aff'd in pertinent part, Time, 571 A.2d at 1150TW Servs., 1989 WL 20290, at *8 n. 14("While corporate democracy is a pertinent concept, a corporation is not a New England town meeting; directors, not shareholders, have responsibilities to manage the business and affairs of the corporation, subject however to a fiduciary obligation."). Stockholders may have idiosyncratic reasons for preferring decisions that misallocate capital. Directors must exercise their independent fiduciary judgment; they need not cater to stockholder whim. See Time, 571 A.2d at 1154 ("Delaware law confers the management of the corporate enterprise to the stockholders' duly elected board representatives. The fiduciary duty to manage a corporate enterprise includes the selection of a time frame for achievement of corporate goals. That duty may not be delegated to the stockholders." (citations omitted)).

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More pertinent to the current case, a particular class or series of stock may hold contractual rights against the corporation and desire outcomes that maximize the value of those rights. See MCG Capital Corp. v. Maginn, 2010 WL 1782271, at *6 (Del.Ch. May 5, 2010) (noting that preferential contract rights may appear in "the articles of incorporation, the preferred share designations, or some other appropriate document" such as a registration rights agreement, investor rights agreement, or stockholder agreement). By default, "all stock is created equal." Id. Unless a corporation's certificate of incorporation provides otherwise, each share of stock is common stock. If the certificate of incorporation grants a particular class or series of stock special "voting powers, ... designations, preferences and relative, participating, optional or other special rights" superior to the common stock, then the class or series holding the rights is known as preferred stock. 8 Del. C. § 151(a); see Starring v. Am. Hair & Felt Co.,191 A. 887, 890 (Del.Ch.1937) (Wolcott, C.) ("The term `preferred stock' is of fairly definite import. There is no difficulty in understanding its general concept. [It] is of course a stock which in relation to other classes enjoys certain defined rights and privileges."), aff'd, 2 A.2d 249 (Del.1937). If the certificate of incorporation is silent on a particular issue, then as to that issue the preferred stock and the common stock have the same rights. Consequently, as a general matter, "the rights and preferences of preferred stock are contractual in nature." Trados I, 2009 WL 2225958, at *7accord Judah v. Del. Trust Co., 378 A.2d 624, 628 (Del.1977) ("Generally, the provisions of the certificate of incorporation govern the rights of preferred shareholders, the certificate of incorporation being interpreted in accordance with the law of contracts, with only those rights which are embodied in the certificate granted to preferred shareholders.").

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A board does not owe fiduciary duties to preferred stockholders when considering whether or not to take corporate action that might trigger or circumvent the preferred stockholders' contractual rights. Preferred stockholders are owed fiduciary duties only when they do not invoke their special contractual rights and rely on a right shared equally with the common stock. Under those circumstances, "the existence of such right and the correlative duty may be measured by equitable as well as legal standards."] Thus, for example, just as common stockholders can challenge a disproportionate allocation of merger consideration, so too can preferred stockholders who do not possess and are not limited by a contractual entitlement. Under those circumstances, the decision to allocate different consideration is a discretionary, fiduciary determination that must pass muster under the appropriate standard of review, and the degree to which directors own different classes or series of stock may affect the standard of review.

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To reiterate, the standard of conduct for directors requires that they strive in good faith and on an informed basis to maximize the value of the corporation for the benefit of its residual claimants, the ultimate beneficiaries of the firm's value, not for the benefit of its contractual claimants. In light of this obligation, "it is the duty of directors to pursue the best interests of the corporation and its common stockholders, if that can be done faithfully with the contractual promises owed to the preferred." LC Capital, 990 A.2d at 452. Put differently, "generally it will be the duty of the board, where discretionary judgment is to be exercised, to prefer the interests of the common stock — as the good faith judgment of the board sees them to be — to the interests created by the special rights, preferences, etc .... of preferred stock." Equity-Linked, 705 A.2d at 1042. This principle is not unique to preferred stock; it applies equally to other holders of contract rights against the corporation. Consequently, as this court observed at the motion to dismiss stage, "in circumstances where the interests of the common stockholders diverge from those of the preferred stockholders, it is possible that a director could breach her duty by improperly favoring the interests of the preferred stockholders over those of the common stockholders." Trados I, 2009 WL 2225958, at *7accord LC Capital, 990 A.2d at 447 (quoting Trados I and remarking that it "summarized the weight of authority very well"). …

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The Standards Of Review

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To determine whether directors have met their fiduciary obligations, Delaware courts evaluate the challenged decision through the lens of a standard of review. In this case, the Board lacked a majority of disinterested and independent directors, making entire fairness the applicable standard.

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"Delaware has three tiers of review for evaluating director decision-making: the business judgment rule, enhanced scrutiny, and entire fairness." Reis v. Hazelett Strip-Casting Corp., 28 A.3d 442, 457 (Del.Ch.2011). Delaware's default standard of review is the business judgment rule. The rule presumes that "in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." This standard of review "reflects and promotes the role of the board of directors as the proper body to manage the business and affairs of the corporation." Trados I, 2009 WL 2225958, at *6. Unless one of its elements is rebutted, "the court merely looks to see whether the business decision made was rational in the sense of being one logical approach to advancing the corporation's objectives." In re Dollar Thrifty S'holder Litig.,14 A.3d 573, 598 (Del.Ch. 2010). Only when a decision lacks any rationally conceivable basis will a court infer bad faith and a breach of duty.

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Enhanced scrutiny is Delaware's intermediate standard of review. Framed generally, it requires that the defendant fiduciaries "bear the burden of persuasion to show that their motivations were proper and not selfish" and that "their actions were reasonable in relation to their legitimate objective." Mercier v. Inter-Tel (Del.), Inc., 929 A.2d 786, 810 (Del.Ch. 2007). Enhanced scrutiny applies to specific, recurring, and readily identifiable situations involving potential conflicts of interest where the realities of the decisionmaking context can subtly undermine the decisions of even independent and disinterested directors. In Unocal, the Delaware Supreme Court created enhanced scrutiny to address the potential conflicts of interest faced by a board of directors when resisting a hostile takeover, namely the "omnipresent specter" that target directors may be influenced by and act to further their own interests or those of incumbent management, "rather than those of the corporation and its shareholders."493 A.2d at 954. Tailored for this context, enhanced scrutiny requires that directors who take defensive action against a hostile takeover show (i) that "they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed," and (ii) that the response selected was "reasonable in relation to the threat posed." Id. at 955.

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In Revlon, the Delaware Supreme Court extended the new intermediate standard to the sale of a corporation. See 506 A.2d at 180-82 (expressly applying Unocal test). Here too, enhanced scrutiny applies because of the potential conflicts of interest that fiduciaries must confront. "[T]he potential sale of a corporation has enormous implications for corporate managers and advisors, and a range of human motivations, including but by no means limited to greed, can inspire fiduciaries and their advisors to be less than faithful." In re El Paso Corp. S'holders Litig., 41 A.3d 432, 439 (Del.Ch.2012). These potential conflicts warrant a more searching standard of review than the business judgment rule:

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The heightened scrutiny that applies in the Revlon (and Unocal) contexts are, in large measure, rooted in a concern that the board might harbor personal motivations in the sale context that differ from what is best for the corporation and its stockholders. Most traditionally, there is the danger that top corporate managers will resist a sale that might cost them their managerial posts, or prefer a sale to one industry rival rather than another for reasons having more to do with personal ego than with what is best for stockholders.

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Dollar Thrifty, 14 A.3d at 597 (footnote omitted). Consequently, "the predicate question of what the board's true motivation was comes into play," and "[t]he court must take a nuanced and realistic look at the possibility that personal interests short of pure self-dealing have influenced the board ...." Id. at 598. Tailored to the sale context, enhanced scrutiny requires that the defendant fiduciaries show that they acted reasonably to obtain for their beneficiaries the best value reasonably available under the circumstances, which may be no transaction at all. See QVC, 637 A.2d at 48-49.

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Entire fairness, Delaware's most onerous standard, applies when the board labors under actual conflicts of interest. Once entire fairness applies, the defendants must establish "to the court's satisfaction that the transaction was the product of both fair dealing and fair price." Cinerama, Inc. v. Technicolor, Inc. (Technicolor III), 663 A.2d 1156, 1163 (Del. 1995) (internal quotation marks omitted). "Not even an honest belief that the transaction was entirely fair will be sufficient to establish entire fairness. Rather, the transaction itself must be objectively fair, independent of the board's beliefs." Gesoff v. IIC Indus., Inc., 902 A.2d 1130, 1145 (Del.Ch.2006).

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To obtain review under the entire fairness test, the stockholder plaintiff must prove that there were not enough independent and disinterested individuals among the directors making the challenged decision to comprise a board majority. See Aronson, 473 A.2d at 812 (noting that if "the transaction is not approved by a majority consisting of the disinterested directors, then the business judgment rule has no application"). To determine whether the directors approving the transaction comprised a disinterested and independent board majority, the court conducts a director-by-director analysis.

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Excerpted from: In re Trados Inc. Shareholder Litigation, 73 A. 3d 17, 35 - Del: Court of Chancery 2013

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