Corporate Governance

Reis v. Hazelett Strip-Casting: Mistaken Analysis or Freudian Slip?

By J Robert Brown Jr.

Reis is a recent decision issued by the Delaware Chancery Court and involved a reverse stock split.  VC Laster rightfully applies the entire fairness analysis.  The opinion contains a nicely written discussion of the different standards applied by Delaware courts when reviewing the actions of management. 

The Vice Chancellor notes that "Delaware has three tiers of review for evaluating director decision-making: the business judgment rule, enhanced scrutiny, and entire fairness."  He describes "enhanced scrutiny" as "Delaware's intermediate standard of review."  In this category, he places, among others, the modified business judgment rule and the Revlon auction standard.  Entire fairness, in turn, is "Delaware's most onerous standard." 

Fair enough, except for one thing.  He puts the Blasius analysis in the "intermediate standard" category and, perforce, views the standard as less onerous than entire fairness.  He describes it this way:

• Enhanced scrutiny also applies in other situations where the law provides stockholders with a right to vote and the directors take action that intrudes on the space allotted for stockholder decision-making. See Mercier, 929 A.2d at 804-10 (discussing application of enhanced scrutiny to board action affecting stockholder voting); State of Wis. Inv. Bd. v. Peerless Sys. Corp., 2000 WL 1805376, at *10-11 (Del. Ch. Dec. 4, 2000) (applying enhanced scrutiny to meeting adjournment that kept polls open for vote on increasing shares allocated to stock option plan).

The Blasius standard applies when management has engaged in behavior designed to disenfranchise shareholders.  The general test in those circumstances is that management has to show a "compelling justification" for its actions.  The standard is hardly less onerous than entire fairness and, in actual application, is likely far more onerous.  See Blasius Indus. v. Atlas Corp., 564 A.2d 651, 661 (Del. Ch. 1988)(describing stanard as one imposing a "heavy burden" on the board).

As a result, VC Laster may have erred in including Blasius and its progeny in the intermediate category.  Or did he?

His analysis may reflect the fact that he has thrown his lot in with others on the Chancery Court who want to weaken the Blasius standard.  Although the Delaware Supreme Court has affirmed the compelling justification standard (see MM Cos. v. Liquid Audio, Inc., 813 A.2d 1118 (Del. 2003)), at least one Vice Chancellor has sought to abandon the compelling justification standard in favor of a far less protective "reasonableness" standard borrowed from Unocal.  See Mercier v. Inter-Tel (Del.), Inc., 929 A.2d 786, 810 (Del. Ch. 2007).  

As Airgas has shown, application of the Unocal standard provides shareholders with little protection.  Opting for the standard in the Blasius context would effectively remove all meaningful restraints from managerial behavior designed to disenfranchise.  Mercier and the effort to weaken Blasius is discussed here. 

Reasonableness as defined by Unocal would certainly qualify as intermediate (or lower), using VC Laster's categorization, while compelling justification would not.  That in fact would leave entire fairness as the most onerous standard.  So, perhaps by including Blasius in the intermediate category, VC Laster is signaling his agreement with the Vice Chancellor in Mercier and the elimination of meaningful protections for shareholders when management engages in disenfranchising behavior.

Full post as published by The Race to the Bottom on February 28, 2011 (boomark / email).