The Business Judgement Rule and the Entire Fairness Standard As It Applies to Controlling Stockholders

Directors owe a duty of loyalty to their company and its stockholders. That duty requires that a director act in good faith and in the best interests of the company and stockholders, rather than in the directors own interests or in the interests of someone to whom the director is beholden, controlled by, or otherwise dependent upon.[i] 

Courts employ up to two standards of review when assessing challenged business transactions: the business judgment rule; or the entire fairness standard.  Paramount to the outcome of the challenge is the standard under which a directors actions are reviewed.  If the court finds that the business judgment rule is not applicable, and applies the entire fairness standard instead, it is highly unlikely that the matter will be dismissed at the pleading stage on a motion to dismiss. 

I. The Business Judgment Rule

The court places the initial burden of proof on the plaintiff challenging an officers or directors decision. If a plaintiff can plead a reasonably conceivable set of facts showing that a majority of the board approving the transaction was interested, or a majority stockholder stands on both sides of the transaction, the complaint will be found to state a claim for relief that entitles the plaintiff to proceed and conduct discovery.[ii] If the plaintiff fails to meet this burden, the business judgment rule protects officers and directors and the decisions they made.[iii]

The business judgment rule affords corporate fiduciaries a presumption that they acted on an informed basis, in good faith and in the honest belief that the action was taken in the best interests of the company.[iv] By placing the focus on the reasonableness of a boards decision-making process, the business judgment rule prevents courts from second-guessing business decisions of independent and disinterested directors who have acted with due care.[v]

II. The Entire Fairness Standard

If the party challenging the transaction can prove that those involved in the decision-making process lacked independence or otherwise breached their fiduciary duties, then the business judgment rules presumption is overcome, and the court will apply the entire fairness standard.[vi]  The entire fairness standard is triggered where a majority of the directors approving the transaction are interested or where a majority stockholder stands on both sides of a transaction.[vii] 

A. Controlling Stockholder

A plaintiff can rebut the business judgment rule and trigger the entire fairness standard by showing that: (i) a controlling stockholder stands on both sides of a transaction, received consideration different than that received from other stockholders, or received a unique benefit from the transaction; or (ii) at least half of the directors who approved the transaction were not disinterested or independent.[viii] 

The first step in the analysis is to determine whether there is a conflicted controlling stockholder. Delaware law is clear that a stockholder does not owe fiduciary duties unless such stockholder is deemed to be controlling. A stockholder or member, such as a private equity firm, will be deemed to be a controlling stockholder, thereby owing a fiduciary duty, only when it owns more than 50 percent of the company’s stock or membership interest, or if the member or stockholder owns less than 50 percent of the company’s stock or membership interest, but nevertheless exercised actual control over the company.[ix] This is referred to as the actual control test.

The actual control test requires the court to determine whether, despite owning a minority of shares, the alleged controller wields such formidable voting and managerial power that, as a practical matter, it is no differently situated than if it had a majority voting control.[x] Determining whether a minority stockholder or member exercised actual control over the company is a fact-sensitive analysis involving multiple factors, including:

• Ownership or control over a significant portion of the company’s equity;
• The ability to designate directors;
• The existence of provisions in governance documents that enhance the power of the stockholder or member, such as negative voting power;
• The degree of control the stockholder or member has over particular directors;
• The degree of control the stockholder or member has over key managers or advisors that play a critical role in presenting information and making recommendations;
• The ability to exercise contractual rights to channel the company into a particular outcome by blocking or restricting other paths;
• Other commercial relationships with the company that provide the stockholder with leverage over the company, such as lending relationships; and
• The ability to influence decisions through high-status roles, such as CEO, chairperson, or founder, or coercive action, such as threats of retribution.[xi] 

For example, a 43.3 percent stockholder was held to exercise control, not based on the number of shares it owned but because the board of directors deferred to the stockholders wishes.[xii]  Likewise, a 35 percent stockholder[xiii] and 17 percent stockholder[xiv] were each found to be controllers, but in contrast, a 33 percent stockholder was found not to be a controller where it did not have outsized influence;” its representatives fully recused themselves; it did not attempt to influence the board; it did not have a history of dominating the board; and there was a special committee process (with independent advisors and a fairness opinion).[xv]  In these cases, the court emphasized the stockholders unusual level of influence, such as through the stockholders other critical roles at the company (such as founder, CEO, or chairperson), the stockholders indispensability to the company, and the stockholders history of dominating board decisions. The level of influence exerted by the stockholder in these circumstances was viewed by the court as no less than a majority stockholder would have.

If the transaction is (1) negotiated by a fully empowered special committee of directors who are independent of the controlling stockholder, and (2) conditioned on the approval of the majority of minority stockholders, then the entire fairness standard will not apply.[xvi]  Instead, the transaction is sanitized and returned to the protection of the business judgment rule.[xvii] 

B. Burden of Proof

Once the entire fairness standard is triggered, the board has the burden of demonstrating that the transaction is inherently fair to the stockholders by demonstrating both fair dealing and fair price.[xviii] The board must show that the transaction was either approved by a qualified special committee of independent directors or by an informed vote of the majority of disinterested stockholders.

When applying the entire fairness standard, the court will consider whether a transaction is fair to both process and price.[xix]  Questions of process include how the transaction was timed, initiated, structured, negotiated and disclosed, and how the approvals of the directors and stockholders were obtained.[xx]  Fair price pertains to the economic and financial terms of the transaction, including any relevant factors that affect the inherent value of a company’s stock, such as market value and assets of the company, and a fairness opinion.[xxi] 

Even under the scrutiny of the entire fairness standard, the board may shift the burden of proof back to the plaintiff by utilizing procedural safeguards.[xxii] The most frequently used safeguard is establishing and empowering a special committee of independent and disinterested directors to safeguard the interests of all stockholders. This special committee must be empowered with the ability to reject the proposed transaction.[xxiii] Another frequently used safeguard is to obtain a fairness opinion from an independent financial advisor stating that, from a financial perspective, the terms of the transaction are fair to the company or the minority stockholders.

III. Conclusion

The standard of review business judgment rule or entire fairness standard will largely dictate the outcome of a business transaction challenge by a plaintiff stockholder. The court will not apply 20/20 hindsight to second guess a boards decision, except in rare cases where a transaction is so egregious on its face that board approval cannot meet the test of business judgment.[xxiv] If the entire fairness standard is triggered, it is exceedingly difficult to secure a dismissal of a fiduciary action at the pleading stage, which means that the action will likely proceed to discovery, which is costly, time-consuming, and distracting to management.[xxv]

This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The content of this document is made available on an as is basis, without warranty of any kind. This document cannot be assumed to contain every acceptable safety and compliance procedures or that additional procedures might not be appropriate under the circumstances. Markel does not guarantee that this information is or can be relied on for compliance with any law or regulation, assurance against preventable losses, or freedom from legal liability. This publication is not intended to be legal, underwriting, or any other type of professional advice. Persons requiring advice should consult an independent adviser. Markel does not guarantee any particular outcome and makes no commitment to update any information herein or remove any items that are no longer accurate or complete. Furthermore, Markel does not assume any liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content.

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References:

[i] See Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334, 1345 (Del. 1987)([D]irectors must eschew any conflict between any duty and self-interest.) Guth v. Loft Inc., 5 A.2d 503, 510 (Del. 1939); see also DEL. CODE ANN., tit. 8, 102(b)(7)(West 2019). 

[ii] Kahn v. M&F Worldwide Corp., 88 A.3d 635, 645-46 (Del. 2014); accord Olenik v. Lodzinski, 208 A.3d 704, 715 (Del. 2019); Sciabacucchi v. Liberty Broadband Corp., 2017 WL 2352152, at *14-15 (Del. Ch. May 21, 2017).   

[iii] Cinerama Inc. v. Technicolor, 663 A.2d at 1162 (Del. 1995); Corwin v. KKR Fin. Hldgs LLC, 125 A.3d 304, 309 (Del. 2015).   

[iv] Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984), overruled on other grounds by Brehm v. Eisner, 746 A.2d 244 (Del. 2000)(citation omitted). 

[v] See, e.g., Grobow v. Perot, 539 A.2d 180 (Del. 1988); Brehm v. Eisner, 746 A.2d 244 (Del. 2000). 

[vi] See Weinberger v. UOP Inc., 457 A.2d 701, 710-11 (Del. 1983). 

[vii] Id. at 714-15; In re Trados Inc. Sholder Litig., 73 A.3d 17, 20 (Del. Ch. 2013). 

[viii] Sciabacucchi v. Liberty Broadband Corp., 2017 WL 2352152, at *16 (Del. Ch. May 21, 2017). 

[ix] Kahn v. Lynch Commcn Sys. Inc., 638 A.2d 1110, 1113-14 (Del. 1994); see also In re KKR Fin. Hldgs LLC S holder Litig., 101 A.3d 980 (Del. Ch. 2014), affd sub nom.; Corwin v. KKR Fin. Hldgs LLC, 125 A.3d 364 (Del. 2015). 

[x] Reither v. Lichtentsein, 2019 WWL 2714065, at *7 (Del. Ch. June 28, 2019); see also Kahn v. M&F Worldwide Corp., 88 A.3d 635, 645 (Del. 2014).  

[xi] In re Zhongpin Inc. S holder Litig., 2014 WL 6735457 (Del. Ch. Nov. 26, 2014)(revd on other grounds); Basho Techs. Holdco B LLC v. Georgetown Basho Invs., LLC, 2018 WL 3326693, at *28 (Del. Ch. July 6, 2018), affd sub nom., Davenport v. Basho Techs. Holdco B LLC, 221 A.3d 100 (Del. 2019). 

[xii] Kahn v. Lynch Commcn  Sys. Inc., 638 A.2d 1110 (Del. 1994). 

[xiii] See In re Cysive Inc. Sholder Litig., 836 A.2d 531 (Del. Ch. 2003). 

[xiv] See In re Zhongpin Inc. S holder Litig., 2014 WL 6735457 (Del. Ch. Nov. 26, 2014)(revd on other grounds). 

[xv]See In re Rouse Properties Inc. Fid. Litig., No. 12194-VCS, 2018 WL 1226015, at *21 (Del. Ch. Mar. 9, 2018). 

[xvi] Kahn v. M&F Worldwide Corp., 88 A.3d 635, 64245 (Del. 2014) (citing Kahn v. Lynch Commcn Sys. Inc., 638 A.2d 111017 (Del. Apr. 5, 1994).  

[xvii] See id. at 645. 

[xviii] See Flood v. Synutra Internatl Inc., 195 A.3d 754 (Del. 2018); Weinberger v. UOP Inc., 457 A.2d 701, 711 (Del. 1983).   

[xix] See Weinberger v. UOP Inc., 457 A.2d 701, 711 (Del. 1983). 

[xx] See id.

[xxi] See id.

[xxii] Kahn v. M&F Worldwide Corp., 88 A.3d 635, 64245 (Del. 2014) (citing Kahn v. Lynch Commcn Sys. Inc., 638 A.2d 1117 (Del. Apr. 5, 1994)(listing the following six conditions that, if met, reduce the standard of review in controller buyout context to business judgment: (i) the controller conditions the procession of the transaction on the approval of a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitely; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority). 

[xxiii] See, e.g., In re Dell Tech. Inc. Class V S holder Litig., 2020 WL 3096748 (Del. Ch. June 11, 2020). 

[xxiv] In re Walt Disney Co. Deriv. Litig., 731 A.2d 342, 362 (Del. Ch. 1998) (quoting Aronsohn v. Lewis, 473 A.2d 805 (Del. 1984)).

[xxv] See Tornetta v. Musk, 250 A.2d 793, 812 (Del. Ch. 2019); see also Hamilton Prs LP v. Highland Cap. Mgmt. LP, 2014 WL 1813340, at *12 (Del. Ch. May 7, 2014); Orman v. Cullman, 794 A.2d 5, 15 n.36 (Del. Ch. 2002)(Th[e] conclusion [that entire fairness applies] normally will preclude dismissal of a complaint on a Rule 12(b)(6) motion to dismiss). 

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