Corporate Governance

Eliminating Fairness from the Duty of Loyalty: Hokanson v. Petty

By J. Robert Brown

We have often discussed on this Blog the gradual elimination of fairness by the Delaware Courts in the context of the duty of loyalty.  The courts often cite Guth v. Loft, 5 A.2d 503 (Del. 1939) for the proposition that the duty of loyalty is "broad and encompassing" and demands from the director "the most scrupulous observance."  Whether in fact that was ever true, it is not now.  The Delaware courts have largely extended the impenetrable business judgment rule to claims involving a conflict of interest, eliminating fairness from the analysis.

The most recent example occurred in Hokanson v. Petty, 2008 Del. Ch. Lexis 182 (Del. Ch. Dec. 10, 2008).  The case involved claims by common stockholders of Altiva Corporation that the approval of a buyout by Exactech Inc. violated the board's fiduciary duties.  The buyout price was determined under a stockholder agreement executed by the two companies four or five years earlier.  The early date meant that any plan to challenge the execution of the stockholder agreement was beyond the statute of limitations. 

These facts were enough for the court to decide that the case had to be dismissed.

• Thus, once the reality that the plaintiffs have tried to ignore is confronted, the outcome of this motion becomes inevitable. Because the plaintiffs are not challenging the validity of the Buyout Option itself, have conceded that Purchase Price was consistent with the Contract Price Formula, and have not contested that the proceeds were distributed in accordance with the Altiva Restated Certificate of Incorporation, the plaintiffs are left with no basis to challenge the Altiva board's actions in agreeing to the Merger. Altiva was contractually obligated to enter into the Merger, and the Altiva board could not fail to do so without causing the company to dishonor a contract. The plaintiffs have cited no authority suggesting that the Altiva directors were mandated to cause the company to breach a contract and avoid the Merger. On this basis alone, the motion to dismiss must be granted.

Nonetheless, the court went on for the "sake of completeness" to discuss the contention that the board was not independent or disinterested. 

The board contained five directors.  One of the directors, Petty, was the CEO for Exactech (and chairman of the board).  Thus, the CEO of the acquiring company sat on the board of the acquired company.  The court conceded that the director was "clearly conflicted."  Moreover, the court conceded that at least one other director arguably was not independent.  As the opinion recognized, that left a majority of independent directors on the board.

• Even taking the charitable view that the plaintiffs have suggested that Corrance, Altiva's CEO, could not consider the Merger objectively given his status as a full-time executive and his expectation of continued employment with Exactech, the Complaint would still leave the disinterestedness of three directors, a majority of the board, unchallenged.

With 40% of the directors arguably not independent, the board did not take steps to insulate the conflict from the decision making process.  As the complaint noted, there were no prophylactic measures taken to protect shareholders "from any unfair process or price agreed to by the self-interested Board." P. 61.

Yet despite the presence of the conflict of interest in the decision making process and the obvious opportunity for the person(s) with the conflict to influence the outcome, the court blithely applied the business judgment rule to the transaction.  The business judgment rule, however, was never designed to shield conflict of interest transactions from challenge.  It was an over inclusive protection designed to protect directors from risk taking that subsequently causes harm to the corporation.  Yet Delaware courts have in fact extended the business judgment rule to the duty of loyalty.

Had the court recognized the existence of the conflict, it would have merely imposed on the board the obligation to show that its actions were fair.  Alternatively, boards would likely take steps in future conflict situations to exclude the conflict from the decision making process.  But they need not do so, as Hokanson demonstrates. 

It is this approach that explains the current problems with executive compensation, as explained the paper Returning Fairness to Executive Compensation.

Documents in this case have been posted on the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on January 23, 2009 (boomark / email).