Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

Cummings v. Eden et al was a case where the Delaware Court of Chancery examined allegations that members of a board of directors breached their fiduciary duties in connection with the approval of an asset acquisition at an unfair price from an entity controlled by an investment group.  The Plaintiff asserted that a majority of the Board were either interested in the transaction or disabled by conflicts arising from various relationships with the founder of an investment group that was also a member of the Board.  Central to the Court’s analysis in analyzing the motion to dismiss was whether to apply the business judgment or entire fairness standard of review.

The Defendants maintained that the Court should review Plaintiff’s claims under the business judgment rule as a result of compliance with Section 144(a)(1) of the Delaware General Corporation Law. Section 144(a)(1) provides as follows:

No contract or transaction between a corporation and 1 or more of its directors or officers, or between a corporation and any other corporation, partnership, association, or other organization in which 1 or more of its directors or officers, are directors or officers, or have a financial interest, shall be void or voidable solely for this reason, or solely because the director or officer is present at or participates in the meeting of the board or committee which authorizes the contract or transaction, or solely because any such director’s or officer’s votes are counted for such purpose, if:

(1) The material facts as to the director’s or officer’s relationship or interest and as to the contract or transaction are disclosed or are known to the board of directors or the committee, and the board or committee in good faith authorizes the contract or transaction by the affirmative votes of a majority of the disinterested directors, even though the disinterested directors be less than a quorum; . . .

In particular, the Defendants argued:

  • approval by a majority of disinterested directors under Section 144(a)(1) triggers review under the business judgment rule;
  • for purposes of applying the safe harbor of Section 144(a)(1), the Court should consider only whether directors are interested in the transaction, and should not be concerned with whether the majority of the board is also independent; and
  • since Plaintiff only challenged three directors on grounds they were interested in the challenged transactions, the majority of the Board met the requirements of Section 144(a)(1) and their decisions must, therefore, be protected as valid business judgments.

While the Court noted that Delaware case law interpreting Section 144(a) was “murky at best”, the Court disagreed with the Defendants’ theory. The interaction between Section 144(a) and the common law business judgment rule must be considered.  Looking to precedent, the Court noted satisfaction of Section 144(a)(1) simply protects against invalidation of the transaction “solely” because it is an interested one and that equitable common law rules requiring the application of the entire fairness standard on grounds other than a director’s interest still apply.

To illustrate the point, the Court quoted Finding Safe Harbor: Clarifying the Limited Application of Section 144 (Del. J. Corp. L. 719, 737– 38 (2008)) which explains:

section 144(a)(1) provides that a covered transaction will not be void or voidable solely as a result of the offending interest if it is approved by an informed majority of the disinterested directors, even though the disinterested directors be less than a quorum. Under the section 144 statutory analysis, so long as there is one informed, disinterested director on the board, and so long as he or she approves the transaction in good faith, the transaction will not be presumptively voidable due to the offending interest. In other words, a nine-member board with a single disinterested director may approve a covered transaction and reap the benefits of the section 144 safe harbor.

Under the common law, however, the factor is somewhat different; approval must be by a disinterested majority of the entire board. That is, a plaintiff may rebut the presumption of the business judgment rule by showing that a majority of the individual directors were interested or beholden. In the common-law analysis, therefore, a transaction approved by the nine-member board discussed above (with the single disinterested director) will be subject to the entire-fairness standard. The standards are phrased similarly for the statutory and common-law analyses, but they are in fact quite different.

Quoting Orman v. Cullman, the Court described the test for overcoming the business judgment presumption at the pleading stage by alleging that the Board acted out of self-interest or with allegiance to interests other than the stockholders’:

As a general matter, the business judgment rule presumption that a board acted loyally can be rebutted by alleging facts which, if accepted as true, establish that the board was either interested in the outcome of the transaction or lacked the independence to consider objectively whether the transaction was in the best interest of its company and all of its shareholders. To establish that a board was interested or lacked independence, a plaintiff must allege facts as to the interest and lack of independence of the individual members of that board. To rebut successfully business judgment presumptions in this manner, thereby leading to the application of the entire fairness standard, a plaintiff must normally plead facts demonstrating that a majority of the director defendants have a financial interest in the transaction or were dominated or controlled by a materially interested director.

In this case, the Court found the Plaintiff plead sufficient facts to overcome the presumption of the business judgment rule at the pleading stage.