Corporate Governance

John Q. Hammons: The Unfairness of Proving Fairness

By J Robert Brown Jr.

Our comment on John Q. Hammons is more in the nature of an observation about Delaware law. 

As we have noted on this Blog often (and described at lengh, see Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty) Delaware has quietly and without significant analysis severely weakened the duty of loyalty by substituting process for fairness.  For transactions between directors and the company (compensation paid to the CEO for example), Delaware courts provide that where the board consists of a majority of independent directors, the standard of review will be the duty of care, not the duty of loyalty.  In short, the board will have no obligation to establish fairness.

The standard ignores the fact that the person with the conflict of interest and the directors under his/her control may remain in the board room and influence the decision making process.  In those circumstances, it is not appropriate to presume (as in the presumption of the business judgment rule) that directors have acted in the best interests of shareholders.  Yet Delaware courts do exactly that. 

John Q. Hammons involved not an interested director but a controlling shareholder.  A conflict of interest with respect to a transaction between the company and a controlling shareholder is treated in a different and more appropriate fashion.  As this court noted:  ''[A]n approval of the transaction by an independent committee of directors or an informed majority of minority shareholders shifts the burden of proof on the issue of fairness form the controlling or dominating shareholders to the challenging shareholder-plaintiff.'

In other words, boards have an incentive to put independent directors on the board.  If they have a majority, the burden shifts to plaintiffs to show unfairness.  But the standard does not eliminate consideration of the fairness of the transaction.  Plaintiffs can still show that the transaction was substantively unfair.  They are not limited to the process standard used with respect to the business judgment rule.  

Yet the court in John Q. Hammons seemed to be laying the groundwork for reconsideration of the controlling shareholder standard.  The court concluded that, although involving a controlling shareholder, the board 'may actually have been entitled to business judgment rule protection.'  In other words, the Chancellor sought to reconcile the two standards applicable in the case of conflicts of interest but rather than elevate the standard applicable to conflicts with directors, his solution was to lower the standard applicable to controlling shareholders. 

The approach suggests that the burden shifting standard for transactions involving controlling shareholders may yet go the way of the Dodo and shareholder protections will be weakened yet again. 

Full post as published by The Race to the Bottom on March 02, 2011 (boomark / email).