Corporate Governance

Delaware Courts and the Influence of Federal Preemption (part 2)

By J. Robert Brown

As an example, lets take a quick look at Oss v. Ross, 2008 Del. Ch. LEXIS 175 (Del. Ch. Nov 26, 2008).  This was not a traditional corporate law case but a derivative suit for breach of fiduciary duty by the Board of Trustees of a Delaware statutory trust.  What we found interesting was footnote 43 and the discussion of Section 144 of the Delaware Corporate Code.  Section 144 is the provision that deals with the voidability of interested transactions.  Approval by shareholders or disinterested directors will result in the transaction not being voidable. 

Delaware courts have used this language to go well beyond voidability.  A number of suits have found that conformity with Section 144 results in the application of the business judgment rule.  Thus, approval by disinterested and independent directors under Section 144(a) results in the application of the business judgment rule.   See  Oberly v. Kirby, 592 A.2d 445, 466 (Del. 1991)("First, section 144 allows a committee of disinterested directors to approve a transaction and bring it within the scope of the business judgment rule.").   Subsequent cases repeated the dictum.  See Cinerama, 663 A.2d 1156, 1170 ("In Oberly, even though Section 144(a) did not apply to the action being contested, this Court relied upon the provisions in that statute to illustrate the general principle that, as to the duty of loyalty, approval of a transaction by a board of which a majority of directors is disinterested and independent 'brings it within the scope of the business judgment rule.'").  The same has been found true of shareholder approval under Section 144(a).  See Ryan v. Lyondell Chem. Co., 2008 Del. Ch. LEXIS 105 (Del. Ch. July 29, 2008)("Ratification in those instances is governed by statute, 8 Del. C. 144, and the effect of a fully-informed vote of the shareholders is to sustain the protections of the business judgment rule."). 

There are several problems with this.  First, Section 144 says nothing about the standard of review.  It merely renders a transaction not voidable.  Second, the Section says nothing about approval by disinterested and independent directors.  By its terms, the transaction is limited to disinterested director approval (because it was dealing with voidability not the standard of review).  The courts have nonetheless used the provision to justify the application of the business judgment rule to conflict of interest transactions that are approved by a majority of independent and disinterested directors.  By relying on Section 144, they have not taken any steps to require elimination or sterilization of the conflict of interest from the approval process. 

Thus, for example, in the area of executive compensation, the CEO can participate in the debate and even vote on his/her compensation.  So long as the compensation is approved by a majority of independent and disinterested transactions, it is subject to the business judgment rule.  This is more than speculation.  CEOs appear to be very involved in compensation decisions.  It is this example of judicial legerdemain that at least in part explains the explosion in executive compensation (discussed more fully in Returning Fairness to Executive Compensation).

Coming back to Oss v. Ross, Vice Chancellor Parsons largely igored those decisions and had this to say about Section 144.

• Section 144(a) protects against the invalidation of a transaction solely because it is an interested one. Satisfying its requirements alone, however, does not automatically trigger application of the protections of the business judgment rule.  "Nothing in the statute sanctions unfairness to [the Company] or removes the transaction from judicial scrutiny."  As this Court explained in Benihana of Tokyo, Inc. v. Benihana, Inc., 144 is best seen as establishing a floor for board conduct, but not a ceiling. Because the parties have not shown that they are likely to succeed in proving they have satisfied the requirements of 144(a), it follows that they also have failed to demonstrate that the TRCLP Transaction and the Rights Offering are likely to qualify for business judgment rule protection in light of the interestedness or nonindependence of a majority of the Board. (citations omitted). 

In other words, the court appeared to be backing off the proposition that conformity with Section 144 automatically resulted in application of the business judgment rule.  Perhaps this quote portends a more reasonable approach by the Delaware courts, one that determines the standard of review based on the underlying rational of the business judgment rule (a presumption of fairness applied to transactions devoid of a conflict of interest) rather than a misreading of the statute.  Alternatively, it reflects a temporary shift designed to minimize federal intrusion into fiduciary obligations.

Full post as published by The Race to the Bottom on December 16, 2008 (boomark / email).