The Delaware Court of Chancery is often called upon to assess whether a plaintiff challenging an interested transaction who fails to make demand on the board to pursue claims based on alleged self-dealing or director interest can overcome the procedural hurdle of a motion to dismiss under Rules 23.1 and 12(b)(6). Case law has established that monetary interest alone is not the sole basis by which a director may be found to lack independence. For example, joint ownership of an airplane which requires substantial close cooperation in use reflective of “detailed planning indicative of a continuing, close personal friendship” may also suffice. Even if a plaintiff can allege sufficient particularized facts to demonstrate that demand would have been futile, a question may arise, if a majority of the disinterested directors (though less than a majority of the disinterested and independent directors) approves a transaction under Section 144(a)(1) of the Delaware General Corporation Law, whether the business judgment rule operates to prevent a plaintiff from having stated a cognizable claim. In Cumming v. Edens, C.A. No. 13007-VCS (Del. Ch. Feb. 20, 2018), the Court of Chancery denied a motion to dismiss a complaint challenging a self-dealing transaction and in the process methodically assessed whether the plaintiff adequately had pleaded facts sufficient to raise a doubt as to the independence and disinterest of a majority of the board and also whether approval under Section 144(a)(1) suffices to invoke the business judgment rule so as to require dismissal of the claim. Practitioners would be well-advised to pay close attention to the guidance the opinion offers concerning what counts as a disabling interest or relationship and also how much protection Section 144(a)(1) approval provides.
At issue were three interrelated transactions. First, the plaintiff alleged that the defendants approved a transaction by which assets were acquired from a sister company at an unfair price. Second, the plaintiff alleged that the acquirer financed the transaction through an equity offering that favored the majority owner of the seller to the detriment of the acquirer. Third, the plaintiff alleged that the acquirer entered into an agreement to manage the acquired assets at a higher-than-market price. The defendants moved to dismiss on the ground that the plaintiffs had failed to plead particularized facts that demand would have been futile and that the plaintiffs had failed to state a claim, in part because the transaction was protected from attack by approval under Section 144(a)(1) of the DGCL.
Court Finds Plaintiff Adequately Alleged That Majority of the Board Was Not Disinterested or Independent
The court examined each of the seven directors individually in counting heads to determine whether plaintiff had pleaded that a majority was not disinterested and independent. The court found there was reason to doubt whether six of the seven defendant directors were disinterested and independent. Two were disabled by their conflicting relationships with the asset management firm on both sides of the transaction, one by his interest in the entity that provided financing for the transaction, and one by his dependence on the self-dealing asset management firm for the majority of his income. Of greater interest was the court’s determination that one director lacked independence because (1) an interested director or his family contributed substantially to the nonprofit for which she worked, (2) the interested director’s wife served on the board of the entity which employed her, and (3) the director served on other nonprofit boards with the interested director and from which cumulatively she derived at least half her income. In combination, these relationships created an inference at the pleading stage of lack of independence. Finally, the court found the sixth director disabled by his having been invited to join an interested director in co-owning an NBA franchise in return for which the sixth director agreed to provide financing for a new arena. The court found that “the dynamics of joining together to own a professional sports team,” which is “a highly unique and personally rewarding asset” revealed a close personal relationship that caused the court to conclude the sixth director may feel beholden to the interested director who offered him that opportunity.
Court Rejects Defendants’ Argument That Transaction Approval by Majority of Disinterested Directors Required Dismissal
Defendants argued that because plaintiff pleaded that only three of the seven directors were actually interested in the transaction and that the transaction was approved by a majority of disinterested directors, that approval warranted the application of the business judgment standard of review under Section 144(a)(1) of the DGCL. The court distinguished defendants’ reliance on the decision in Benihana of Tokyo v. Benihana, 906 A.2d 114 (2006), affirming, 891 A.2d 150 (Del. Ch. 2005) (“Benihana I), by noting that in Benihana I the Court of Chancery had held that approval under Section 144(a)(1) merely prevented the transaction from being void or voidable but did not supplant the court’s review of the transaction under common law principles of fiduciary duty. In Benihana I, the Cumming court observed, the lower court had gone on to review the transaction and dismissed the case only after determining that a majority of the board was disinterested and independent and had not entered into the transaction for an improper purpose. The court found that the approach that Section 144(a)(1) approval prevented a transaction from being void or voidable under the common law but did not relieve the court of subjecting the transaction to traditional equitable principles in determining the appropriate standard of review comported with the weight of authority and outside commentary. Based on its prior analysis of the six directors under the demand futility analysis, the court found that a majority of the board was not disinterested or independent and therefore held that, unlike in Benihana I, entire fairness was the appropriate standard of review. Applying that standard of review, the court held that plaintiff had alleged adequately that the transaction was unfair as to process and price and sustained the complaint.
For transaction planners, this decision provides important guidance as to the standard of review that a court will apply in reviewing a transaction. The mere fact that a majority of disinterested directors approved the transaction will prevent the court from declaring the transaction void or voidable merely because one or more directors has an interest in the transaction. It will not, however, prevent the court from applying common law principles to determine the appropriate standard of review by which to measure director conduct. The opinion provides guidance as well that, in applying those common-law principles, an interested party extending an opportunity to own a unique and valuable asset like an NBA franchise or providing substantial financial support to a non-profit at which a disinterested director works, coupled with other indicia of financial assistance, may suffice to disable a director’s independence at least at the pleading stage. In short, financial disinterest in a transaction alone is not the sole touchstone by which a Delaware court will determine the appropriate standard of review; independence counts as well.