Roads to Business Judgment Protection in Transactions with Majority-Conflicted Boards
A February 27, 2020 Delaware Court of Chancery opinion highlights the paths that a majority-conflicted board of directors can travel to reach business judgment deference. Absent “procedural safeguards” provided by Delaware law, the presence of a majority-conflicted board will result in application of the onerous entire fairness standard of review, almost always precluding a successful motion to dismiss. The Court’s recent decision in Salladay v. Lev, provides important guidance for deal planners seeking to limit litigation risk in deals with conflicted fiduciaries.
In Salladay, the Court emphasized that Delaware law has “recognized two methods (absent a controlling stockholder) for boards to revive business judgment review” of transactions where a majority of the board is conflicted. The first is pursuant to the Corwin doctrine: “by making the transaction subject to the informed, un-coerced vote of the majority of shares held by those free of conflict.” The second is pursuant to Trados II: “by permitting an unconflicted committee of the board full scope to negotiate and enter any transaction.” Defendants sought to invoke both routes.
A stockholder of the target company brought suit in Salladay challenging a cash acquisition by a third-party at a 112% premium to the trading price. It was undisputed that three of the target company’s six directors were conflicted with respect to the transaction. However, a special committee of independent directors (the “Committee”) was formed and ultimately approved the deal. Critically, the Committee was only formed after one of the conflicted directors proposed a price range to the acquirer at which the company could be bought. The Committee settled on a share price just below the midpoint initially suggested by the conflicted director.
With respect to Trados II cleansing via the Committee, the Court faced an issue of first impression. For the cleansing effect to attach, must the Committee be formed before any substantive economic negotiations and must the transaction be conditioned ab initio on the Committee’s approval? The Court answered both in the affirmative. It reasoned MFW’s ab initio requirement should apply in a conflicted director situation because even in a non-controlling stockholder setting, “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.” Because substantive economic discussions essentially setting a “price collar” started prior to the Committee’s formation, the special committee process was insufficient to revive business judgment review.
With respect to Corwin cleansing via a fully informed uncoerced vote of the majority of unaffiliated stockholders, the Court concluded various disclosure deficiencies rendered the vote uninformed. The Court found information missing from the proxy significantly altered the total mix of information available to stockholders. This included an unclear and buried disclosure about a dilution threat to current stockholders’ corporate influence if the transaction was voted down, and the failure to explain why the Committee’s first financial advisor abruptly resigned during the compressed deal negotiations. Because stockholder approval of the transaction was not fully informed, Corwin did not apply and entire fairness remained the standard of review.
The Court held “that the procedural safeguards instituted were inadequate to cleanse the Merger and regain business judgment review” and denied the motion to dismiss.
- Business Judgment Deference is Crucial to Secure a Pleading-Stage Dismissal: As the Court explained it is “axiomatic” that “where entire fairness is the standard of review, a motion to dismiss is rarely granted, because review under entire fairness requires a record to be meaningful.” In contrast, when business judgment applies the Court reviews action under its “broadly permissive standard” and dismissal is typically the result.
- Disclosures Remain Key: In all change of control transactions (which implicate intermediate scrutiny under Revlon), or other corporate transactions involving conflicted fiduciaries (which may implicate entire fairness scrutiny), a board must, with its legal counsel’s assistance, ensure disclosures to stockholders are full and fair so that stockholder approval will operate to cleanse the transaction under the Corwin doctrine.
- Early Committee Formation and Involvement is Necessary: In transactions where a majority of the board is potentially conflicted, boards should consult with their legal advisors to form a fully empowered special committee of independent directors prior to any substantive economic negotiations to reduce the standard of review from entire fairness to business judgement.
- C.A. No. 2019-0048-SG (Del. Ch. Feb. 27. 2020).
- If a controlling stockholder is present, business judgment deference can be revived at the pleading-stage only upon compliance with the dual procedural protections of a majority of the minority vote and approval by an independent fully-empower special committee. See generally Kahn v. M & F Worldwide Corp., 88 A.3d 635, 644 (Del. 2014) (“MFW”).
- See Corwin v. KKR Fin Holdings LLC, 125 A.3d 304 (Del. 2016).
- See In re Trados Inc. Shareholder Litigation, 73 A.3d 17 (Del. Ch. 2013) (Trados II).
- This ab initio requirement is now well settled in the controlling stockholder cleansing doctrine under MFW, but appears to have never before been addressed in the Trados II context. See Salladay Opinion at 24-25.