United States: Shareholder Suits In Delaware: Delaware Supreme Court Applies High Standards of Review

By Francis G.X. Pileggi, Esq. and Sheldon K. Rennie, Esq.

The Delaware Supreme Court has issued two recent decisions that uphold the business judgment rule and remanded a third case because the Court of Chancery did not engage in an "entire fairness" analysis.

Corporate directors and shareholders alike should take note of these decisions as they may impact the future fate of shareholder suits.

The Court noted that there are three basic categories of judicial review when shareholders challenge actions by the Board of Directors:

1. The traditional business judgment rule;
2. The intermediate standard of enhanced judicial scrutiny; and
3. The entire fairness analysis.

As a procedural guideline, the traditional business judgment rule imposes an initial burden of proof on the plaintiff to rebut the presumption that the directors of a corporation in making a business decision acted on an informed basis; in good faith and in the honest belief that the action taken was in the best interest of the company and its shareholders.

The directors of Delaware corporations have a triad of primary fiduciary duties called: due care, loyalty and good faith. These duties do not operate intermittently, but rather the Board of Directors must discharge all three primary fiduciary duties at all times.

In the two cases involving the business judgment rule, Chief Justice E. Norman Veasey wrote the opinions and affirmed the Court of Chancery’s dismissals of the shareholder suits. Veasey’s opinions were based on the inability of the shareholder suits to meet threshold provisions necessary to move to the discovery and trial phase.

The two decisions are:

• White v. Panic, Del. Supr., 783 A.2d 543, No. 66, 2000, Veasey, C.J. (October 3, 2001)

• Malpiede v. Townson, Del. Supr., 780 A.2d 1075 (2001)

The third case of significance involves the entire fairness analysis category of judicial review which recognizes a fundamental principle of Delaware corporate fiduciary jurisprudence that "there is no safe harbor for divided loyalties in Delaware."

In Emerald Partners v. Berlin, the Delaware Supreme Court focused on the fact that once entire fairness is the applicable standard, the director/defendants, at least initially bear the burden of proof. The dual aspects of entire fairness include both fair dealing and fair price. Fair dealing refers to the procedure on how the transaction was initiated, structured, negotiated, disclosed to the directors and how the approvals of the stockholders are obtained. The fair price aspect relates to all relevant factors including assets, market value, future prospects and any other elements that affect intrinsic or inherent value of the company’s stock.

The case of Emerald Partners v. Berlin, Del. Supr., 2001 WL 1568740 (November 28, 2001), is the third time that the Delaware Supreme Court has reviewed this matter after remanding it twice before to the Court of Chancery. The long history of the Emerald Partners case began back in 1988 when a Preliminary Injunction was sought to enjoin a merger. Although the Court of Chancery granted an Injunction after an expedited appeal, only a few months later, the Delaware Supreme Court reversed the grant of the Injunction, but the derivative suit nonetheless continued.

The basic facts of the case involved a merger of entities in which one person held a controlling interest in both entities. Thus, the judicial standard of review applied was the "entire fairness analysis". The specific issue in the Emerald Partners case involved the application of the exculpatory provisions of DGCL § 102(b)(7) in the context of an entire fairness standard of judicial review.

Section 102(b)(7) was enacted in 1996 following the Van Gorkom case where directors were held personally liable for gross negligence in light of errors in the process of their decision making. The purpose of Section 102(b)(7) was to permit shareholders to exculpate directors from personal liability for monetary damages only for breaches of their duty of care, but not for duty of loyalty violations or good faith violations and certain other conduct. Thus, the plaintiff has a burden of proving that the Board in reaching its decision violated any one of its triad of fiduciary duties; due care, loyalty or good faith. If the presumption of the business judgment rule is rebutted, the burden shifts to the director/defendants to prove the trier of fact that the challenged transaction was "entirely fair" to the shareholder/plaintiff.

In Malpiede, the Court recognized that unless there is a violation of the duty of loyalty or the duty of good faith, a trial on the issues of entire fairness is unnecessary because Section 102(b)(7) exculpates director/defendants from paying monetary damages that are exclusively attributable to a violation of a duty of care.

Unlike Emerald Partners, in Malpiede, the applicable pre-trial standard for review of the directors’ action was the business judgment rule. In Emerald Partners it was the entire fairness standard by which the directors’ actions were being reviewed at trial.

Unlike the business judgment rule presumption, notwithstanding a Section 102(b)(7) provision, the type of transactions that require judicial review by an entire fairness standard do so because, by definition, the inherently "interested nature" of those transactions are inextricably intertwined with issues of loyalty. The exculpatory effect of a Section 102(b)(7) provision only becomes a proper focus of judicial scrutiny after the directors’ potential personal liability for the payment of monetary damages has been established. Even if a duty of care is the only allegation and a Section 102(b)(7) charter provision exists, the entire fairness review of a transaction must still be conducted by the Court of Chancery to determine whether other aspects of the fiduciary duties, such as the duty of loyalty and good faith, are implicated. The Court of Chancery must identify the specific types of breaches of fiduciary duty upon which it bases its decision that entire fairness has not been established. Therefore, the determination that director/defendants are exculpated from monetary damages can only be made after the basis for their liability due to the specific type of fiduciary duty breach has been decided.

Based on the facts of the case in Emerald Partners, because the defendant/director stood on both sides of the transaction as a corporate fiduciary, that alone was sufficient to require the demonstration of entire fairness.

The Delaware Supreme Court remanded the case again because it held that the Court of Chancery erred as a matter of law when it failed to engage in an entire fairness analysis and instead simply examined the claims in the context of a Section 102(b)(7) charter provision. If the Court of Chancery finds that the transaction was entirely fair, the director/defendants have no liability for monetary damages and the Court of Chancery need not address the Section 102(b)(7) provision. If, however, the Court of Chancery finds that the challenged transaction was not fair, then the director/defendants can avoid personal liability under Section 102(b)(7) for paying monetary damages only if they have established that their failure to sustain the entire fairness analysis is exclusively attributable to a violation of the duty of care.

The understanding of these three cases clarifies the application of the business judgment rule and the entire fairness analysis. By subjecting shareholder suits to exacting standards, the courts are making it tougher for claims to succeed.

Thus, the question arises, are the courts protecting big business and allowing corporate directors of large corporations a free rein with no one to answer to? The answer is a resounding no. The business judgment rule and the entire fairness analysis are not a carte blanche for directors of companies. Instead, they are safeguards that allow well-informed directors to lead their companies without the constant threat of meritless suits that are both costly and time-consuming to defend.

With the recent rulings on the business judgment rule and the entire fairness analysis, shareholders may now start to take a second look at the merits of a suit before pursuing claims in the Delaware courts.