Delaware courts evaluate a self-dealing transaction with a controlling stockholder through the lens of entire fairness — meaning that both the deal process and price must be deemed fair. The burden of proving entire fairness lies initially with the board of directors and can be a challenging standard to satisfy. There presently are only limited means to blunt the onerous burden of the entire fairness standard. For example, the board of directors can shift the burden of proof to a challenging party if the transaction was approved by a majority of the minority stockholders or by an effective special committee of disinterested directors. Alternatively, where completion of the transaction is predicated at the outset of negotiations upon approval of the majority of the minority stockholders and an effective special committee of disinterested stockholders, the court will defer to the business judgment of the board rather than require proof of entire fairness.
The procedural costs associated with the accepted methods for negating application of entire fairness can quickly overwhelm the value of many transactions. Merely shifting the burden of proof on entire fairness is often an unsatisfying solution to this conundrum. There is accordingly always a deal value below which outside directors are exposed to overspending to demonstrate entire fairness simply because a controlling stockholder is involved with the transaction.
As of yet, no workable solution has been approved by a Delaware court to allow for less than entire fairness review where compliance with the standard outspends the transaction value. The Delaware Court of Chancery is not blind to the issue however; and most recently, identified an academic debate over affording deferential review to directors’ approval of lower valued-transactions with a controlling stockholder where the approving directors’ board membership is subject to minority stockholder vote.[1] The ability of minority stockholders to vote such directors out of office conceptually enhances the independence of these directors. It was ultimately concluded that a number of issues beyond the contours of that case would need to be resolved before a Delaware court could truly consider adoption of an enhanced-independence director deference.
For example, directors are presumed independent, and how one is nominated or selected to a board position is typically not assessed when considering the director’s independence under Delaware law. The enhanced-independence director paradigm would diverge from this rule by deeming a director independent merely on account of being elected by minority stockholders. Another doctrinal challenge is whether the standard of review for a transaction with a controlling stockholder approved by enhanced-independence directors should pass from entire fairness all the way to a deferential business judgment evaluation. One might consider application of an intermediate enhanced scrutiny review so that the court could reserve the ability to dismiss weak complaints, while exercising discretion to allow more meaningful allegations of director conflict to proceed.
What scope of transactions are subject to the deferential gloss of enhanced-independence director approval must also be considered. Generally speaking, deference to enhanced-independence directors’ consideration of a transaction with a controlling stockholder is intended to address those circumstances where the costs and burdens of stockholder voting are not proportional to the value of the transaction itself. This proportionality concept should adequately confine deference to enhanced-independence directors’ decision-making of appropriately-sized transactions, while allowing closer scrutiny of more substantial controller transactions. How to establish this demarcation is uncertain however.
In conclusion, affording deferential review to approval of transactions with a controlling stockholder by enhanced-independence directors offers a potentially promising opportunity to address circumstances where the costs of entire fairness compliance outpace deal value. This review structure certainly requires further debate and fine tuning before its potential can be transformed to operative reality. That the discussion has been opened at all is an important first step, however.
[1] In re Pilgrim’s Pride Corp. Derivative Litig., 2019 Del. Ch. LEXIS 89 (Del. Ch. Mar. 15, 2019).
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