Entire Fairness for One, Entire Fairness for All
As most lawyers familiar with corporate litigation in the Court of Chancery can tell you, determining the standard of review of a director's actions can be one of the most important aspects of a case. Although determining the proper standard of review is important throughout the life of an action, it can be most important at the outset, as it will dictate whether a complaint is subject to a pleadings-stage motion or whether discovery is inevitable. Not surprisingly, most defendant directors argue that their conduct is shielded by the business judgment rule rather than the harsher entire fairness standard of review that, in almost all instances, means the complaint will survive a motion to dismiss.
Determining the appropriate standard of review to apply to the conduct of facially independent directors in an action challenging a transaction that requires application of the entire fairness standard, such as a transaction between a corporation and its controlling stockholder, presents an interesting challenge. Certain decisions have held that even if the challenged transaction requires entire fairness review, to state a claim against independent directors, a stockholder must plead a non-exculpated breach of fiduciary duty. Courts adopting this view hold that it is the controlling or dominating stockholder that bears the burden of proving the fairness of such a transaction, not the disinterested and independent directors who may have voted in favor of it. Other courts, however, have held that when the entire fairness standard of review applies to the transaction ab initio, even independent directors cannot escape a review of their conduct based on a factual record because, according to the Delaware Supreme Court's decision in Emerald Partners v. Berlin, 787 A.2d 85 (Del. 2001), when the entire fairness standard of review applies, the exculpatory provision of a certificate of incorporation cannot apply until liability has been decided.
These two competing theories went head to head in In re Cornerstone Therapeutics Stockholder Litigation, C.A. No. 8922-VCG (Del. Ch. Sept. 9, 2014). There, the plaintiffs challenged the acquisition of the minority interest in Cornerstone Therapeutics by its controlling stockholder. The board of Cornerstone Therapeutics established a special committee of five facially independent directors. The special committee negotiated the transaction and then voted, along with other disinterested directors, to recommend the transaction to the stockholders. These directors moved to dismiss the claims against them, arguing that even though the challenged transaction between the corporation and its controlling stockholder required application of the entire fairness standard of review, because the independent directors were shielded from liability by an exculpatory provision in the company's certificate of incorporation, the plaintiffs were required to plead a non-exculpated claim against the independent directors (i.e., rebut the business judgment rule) to survive a motion to dismiss. The plaintiffs, not surprisingly, argued that the Emerald Partners theory applied, and the defendant directors cannot be dismissed at the pleadings stage because the entire fairness doctrine applies ab initio, and therefore the exculpatory language cannot be applied until liability has been determined.
The court first engaged in a detailed comparison of the theory of fiduciary liability for interested transactions and the theory of liability for disinterested fiduciaries if they facilitated an interested transaction. Interested fiduciaries would be liable unless they could prove the transaction was entirely fair; disinterested fiduciaries could also be liable, but only if they breached a separate duty. Considered in this manner, the court viewed the question as whether it was "enough at the motion-to-dismiss stage to have pleaded that a disinterested director facilitated a transaction with a controller that was not entirely fair, upon which pleading the actions of the director, as regards her personal liability, must receive judicial scrutiny upon a fully developed record?"
The court found there was "much" to recommend in a pleading requirement that would require a plaintiff to plead a non-exculpated breach of duty to maintain a claim against facially disinterested directors who approved a transaction subject to entire fairness review. In particular, the court stated that a rule that raises an inference of disloyalty simply by approving a transaction between the controlling stockholder and the company "makes service on a special committee risky, and thus unattractive to qualified and disinterested directors." In addition, the notion that mere approval of a transaction raises a pleading-stage inference of disloyalty seems inconsistent with the holding in Kahn v. M&F Worldwide, 88 A.3d 635 (Del. 2014), which suggested that a motion to dismiss may be granted if a transaction is conditioned on a majority-of-the-minority vote and disinterested special-committee approval.
Despite these misgivings, the court found that it was not free to make a policy determination because it was bound by the precedent in Emerald Partners, which "made clear" that a controlling stockholder transaction was subject to entire fairness review ab initio, and therefore, any exculpatory clauses in the charter can only be applied after the basis for liability has been decided.
As with any common-law-based system that relies on development of the law through judicial action rather than statutory amendment, the development of the law can be a slow process. For instance, the concept that a controlling stockholder transaction could be subject to business judgment review under the right circumstances likely would have been thought a folly shortly after the Supreme Court's decision in Kahn v. Lynch Communications Systems, 638 A.2d 1110 (Del. 1994). Twenty years of development in the law later, however, such a result is possible. The Emerald Partners opinion relied on here, decided only 13 years ago, however, may be due for reconsideration. Since Kahn and Emerald Partners, Delaware law has been more accommodating to, and empowering of, disinterested, independent directors. The Emerald Partners opinion, however, is a roadblock to the development of that law. Until the Supreme Court speaks, however, it remains the law of Delaware and must be addressed by both litigators and lawyers advising directors of their litigation risk.