CHAPTER THREE

Standards of Review

HOW JUDGES DECIDE WHETHER DIRECTORS ARE PUTTING SHAREHOLDERS FIRST

In chapter 2, we showed that in the United States, and particularly in Delaware, courts have settled on the rule of shareholder primacy. In this chapter we will discuss the details of how courts enforce that rule. In corporate law, the critical question in enforcing fiduciary duties is the “standard of review,” which is the formula that a court will use when a shareholder brings a lawsuit claiming that directors have violated their obligations. Understanding the enforcement mechanism is critical to understanding how both shareholder primacy and benefit corporation law operate. This chapter discusses how the standard of review operates under conventional corporate law. Later in the book, after discussing the new benefit corporation statutes, we will return to this subject and address how those standards are likely to operate for benefit corporations. In addition, chapter 9 includes a discussion of how those standards have been interpreted in states that have adopted “constituency statutes,” which reject shareholder primacy but do not include the purpose, accountability, and transparency requirements imposed by benefit corporation statutes.

Function of Standards of Review

Standards of review establish the role of a court in determining whether a challenged board decision was made consistently with fiduciary obligations.¹ Delaware courts generally use one of three standards when reviewing most actions taken by the board of directors. These three standards are the business judgment rule, the entire fairness standard, and the “intermediate” or “enhanced” scrutiny standard. Determining which standard of review to apply is a fact-specific inquiry. Although these three standards are used in most cases, the courts on occasion use other standards for judging actions that interfere with the free exercise of voting rights by shareholders.

In deciding which standard to apply, a court must first determine whether the directors were disinterested and independent. If so, the business judgment rule will apply, giving great deference to board decisions. In the absence of such independence—where the board has conflicts of interest—a very strict standard of review will apply: entire fairness. In intermediate situations, where structural conflicts are inherent—such as company sales and hostile takeovers—an intermediate standard of review—enhanced business judgment—will apply.²

Table 2 (on page 37) summarizes the different standards that courts will apply, depending on the situation. These standards will be applied to benefit corporations as well, and it is important to understand the underpinnings of the standards, as their application to benefit corporations may require certain modifications, and these changes will affect the viability of the benefit corporation form.

The Business Judgment Rule

Under the business judgment rule, disinterested directors are given very broad discretion to make decisions. While the business judgment rule functions as a litigation standard, it also implements an important substantive law concept: in order to effectively fulfill their management role, directors should be able to make rational judgments and take calculated risks without fear of judicial second-guessing. David Yosifon explains the substantive policy rationale for this procedural rule:

Several justifications are given for the business judgment rule. Most simply it is seen as giving force to the statutory injunction that “the business and affairs of every corporation… shall be managed by or under the direction of a board of directors.” Del. Gen. Corp. L. § 141(a). Since somebody has to have the last word on what corporate decisions are legitimate, the business judgment rule sees to it that, per the statute, it is the directors who decide, not complaining shareholders, not other stakeholders, and not indifferent courts. Directors are likely to know more about the particulars of problems their firms face than are relatively ignorant shareholders, stakeholders, and judges.³

In order to support director authority, the business judgment rule provides that initially only the directors’ decision-making process can be reviewed—not the substance of the decision itself. Accordingly, the first question in a proceeding challenging a business decision made by directors is whether they were independent, careful, and acting in good faith.⁴ If so, then under the business judgment rule, the analysis is ended—the court does not examine the substance of the decision.⁵ The business judgment rule provides that a decision will not be interfered with by the courts, even if it appears to have been unwise or to have caused loss to the corporation or its shareholders, so long as the board is independent and informed and acts in good faith.⁶ However, when applying this rule, courts do not permit decisions that are “irrational” to stand.⁷

TABLE 2: STANDARDS OF REVIEW

Although this ability to review decisions for “rationality” might appear to be a review of substance, courts have explained that this minimal standard of substantive review is a means by which to detect bad faith.⁸ It will be important to bear this minimal substantive test in mind when applying the business judgment rule to decisions made by directors of benefit corporations, where this substantive test may be the only litigation tool available to challenge any “trade-off” decisions made among stakeholders.⁹

Thus, although directors are required to pursue value maximization for the corporation’s shareholders, the business judgment rule affords directors wide leeway in deciding how to accomplish this goal. With the substantial deference afforded to their business decisions, directors are able to sacrifice short-term corporate profits and provide benefits to other stakeholders so long as these actions serve a shareholder value maximization strategy, even if that strategy is long term, and does not immediately maximize share value.¹⁰ For example, a board may decide to increase employee salaries based on a judgment that such an action will promote the long-term productivity of the company, despite the fact that the action will temporarily decrease the corporation’s short-term profits, and (perhaps) consequently lower the company’s stock price.¹¹

Some commentators have suggested that the business judgment rule is so broad that it essentially eviscerates the shareholder primacy view of governance inherent in the ownership model.¹² It is very likely the case that directors do, in some instances, consider the interests of stakeholders without directly tying that consideration to shareholder value.¹³ Moreover, it is also true that, if challenged in litigation, such decisions may be fairly easy to defend as related to long-term shareholder value, regardless of the actual motive of the directors. This circumstance does not, however, suggest that no change in the law is needed to permit directors to serve all stakeholders. First, there may be stakeholder benefits that cannot be linked to shareholder value, no matter how long term. Nor should directors be forced to lie, whether in their deliberations or in legal proceedings, even if they can “get away with it.” Finally, such arguments conflate the standard of conduct with the standard of review and are not applicable in enhanced scrutiny or entire fairness cases, where most litigation occurs.

The Entire Fairness Standard

Whereas the deferential business judgment rule applies when there is no conflict of interest, there is no such deference where the directors (or controlling shareholders) have an economic interest that materially conflicts with the interests of the shareholders; in such cases, courts do review the substance of board decisions under the strict entire fairness standard.¹⁴ Under the entire fairness test, the directors must demonstrate that the transaction is entirely fair—as to both price and process¹⁵—to the corporation and its shareholders.¹⁶ In establishing that a transaction was entirely fair, a board must show more than an honest belief that the transaction was fair; instead, “the transaction itself must be objectively fair, independent of the board’s beliefs.”¹⁷ Thus, unlike transactions governed by the business judgment rule, conflict transactions receive very substantial judicial scrutiny if challenged. In chapter 8, we will address how a court might apply such scrutiny to a conflict transaction involving a benefit corporation.

Intermediate Standards of Review: Enhanced Business Judgment Rule

Courts apply an intermediate standard of review when a board takes actions to defend against unwanted acquisitions of the corporation or when the corporation undergoes a change in control. In such situations, even if there is no traditional financial conflict, there may be subtle pressures that undermine the integrity of the board’s process, so courts have found that some extra judicial scrutiny of such situations is appropriate, even though the strict entire fairness test is not applied.¹⁸ Generally, when enhanced scrutiny applies, the defendants “bear the burden of persuasion to show that their motivations were proper and not selfish” and that “their actions were reasonable in relation to their legitimate objective.”¹⁹ When considering how this standard will be applied to a benefit corporation, it is again important to focus on the substantive element of the test: decisions that might favor one stakeholder over another may be subject to this reasonableness standard in defensive and change-in-control situations.

REVLON STANDARD: CHANGES IN CONTROL

Following the Revlon decision, which established that directors must maximize shareholder value in a sale of the company, the courts have imposed a heightened standard on directors who approve any transaction involving a change in control of the corporation.²⁰ This heightened standard does not apply once a transaction has been approved by a fully informed vote of a majority of disinterested shareholders.²¹ The question whether a change in control has occurred focuses on the loss of the value of control. Thus, if a corporation is sold for cash, the sale is said to represent the only chance for shareholders to recognize the full value of the company, including any control premium. Similarly, if a corporation without a controlling shareholder merges with another company and its shareholders receive stock in a combined company that is controlled by a particular group or individual, the Revlon standard applies to board action.²²

When there is a change in control, directors must show that they acted reasonably to obtain the best value reasonably available for shareholders.²³ This measured scrutiny of director decisions is grounded in the fact that, in a change-in-control situation, a corporation’s shareholders have no long-term future, and, therefore, only short-term wealth maximization of the shareholders may be considered.²⁴ Because stakeholder interests do survive such a transaction, courts will have to reconsider the application of the Revlon test to a change in control of a benefit corporation. This question is addressed in chapter 8.

THE UNOCAL STANDARD: DEFENSIVE ACTIONS

The intermediate standard of judicial review, including the substantive test of reasonableness, also applies when a board adopts measures to defend against an unwanted acquisition of control. Board action in such circumstances is subject to the enhanced scrutiny standard established in two cases decided by the Delaware Supreme Court.²⁵ A threatened acquisition of control may include a hostile take-over, a proxy contest, or other situation in which the directors take action that might appear to interfere with the ability of shareholders to freely sell their shares or exercise their voting power.²⁶ Unocal scrutiny also may apply if a board adopts defensive measures to ensure the success of a merger.²⁷ The Unocal standard requires the board to demonstrate that it had reasonable grounds for believing that the takeover attempt posed a danger to corporate policy and effectiveness and that the defensive action taken was reasonable in relation to that threat.²⁸ A defensive measure will be found disproportionate if it is either coercive or preclusive, or if it falls outside a range of reasonable responses.²⁹ A response is “coercive” if it is aimed at forcing upon shareholders a management-sponsored alternative to a hostile offer. A response is “preclusive” if it deprives shareholders of the right to receive all tender offers or precludes a bidder from seeking control by fundamentally restricting proxy contests or otherwise.³⁰

As we discussed in chapter 2, directors of conventional corporations may consider the interests of other stakeholders when responding to a threat. However, consideration of other stakeholders is permitted only if it relates to shareholder interest: “While concern for various corporate constituencies is proper when addressing a takeover threat, that principle is limited by the requirement that there be some rationally related benefit accruing to the stockholders.”³¹ Accordingly, when determining whether to take defensive measures against a hostile takeover attempt, directors may consider the interests of other constituencies, but only as they are “rationally related” to value for shareholders, and only where Revlon duties are not also applicable. Benefit corporation law should cut this tie: directors of benefit corporations should be permitted to consider the interests of all stakeholders, for their own sake, in taking defensive action. This change will be discussed in chapter 8.

Standards of Review for Shareholder Voting

The Delaware courts have applied strict standards to situations where the shareholder voting rights are threatened by board action. Thus, when the primary purpose of board action is to prevent the effectiveness of a vote, the board must show a “compelling justification” for taking such action in order to defend the action.³² This is known as the Blasius standard, and it expands on the Delaware Supreme Court’s prior holding in Schnell v. Chris Craft Industries, Inc. In Schnell, the court held that even though advancing the company’s meeting date was in compliance with the relevant statute and the company’s bylaws, the court would not uphold the action because it had been taken for the purpose of obstructing shareholder voting rights. The courts thus place special emphasis on protecting voting rights.³³

What the cases mean, essentially, is that there is no “balancing.” Even if the directors have good faith and reasonable business reasons for obstructing a shareholder vote, they cannot do so, because the very legitimacy of their power comes from the election process and the shareholders’ franchise rights: “It is clear that [the vote] is critical to the theory that legitimates the exercise of power by some (directors and officers) over the vast aggregations of property that they do not own. Thus, when viewed from a broad, institutional perspective, it can be seen that matters involving the integrity of the shareholder voting process involve consideration not present in any other context in which directors exercise delegated power.”³⁴

The Blasius standard, however, is applied sparingly. Instead, the more flexible Unocal standard is applied when a board takes defensive action that interferes with, but does not thwart, the shareholders’ franchise rights. In Yucaipa Am. All. Fund II, L.P. v. Riggio, then–Vice Chancellor Strine reviewed the adoption of a shareholder rights plan (often called a “poison pill”) under the Unocal standard of review.³⁵ This action made it harder for a shareholder to succeed in a proxy contest by simply buying more shares in the market. However, such action did not directly interfere with the ability of each shareholder to effectively exercise voting rights. Accordingly, the court applied Unocal (and not the strict Blasius standard) to the adoption of the rights plan:

If a board can meet its burden under Unocal to show that a rights plan is not unreasonable in the sense that its trigger is at such a reasonable threshold that the owner of a bloc up to the trigger level can effectively run a proxy contest, the pill would not work the type of disenfranchisement that both invokes Blasius review and almost invariably signals a ruling for the plaintiff.³⁶

These standards may be particularly significant for shareholders of benefit corporations: such shareholders may look to franchise rights as more significant than in traditional corporations, given that the directors’ fiduciary obligations to shareholders may in some sense be diluted by the broad stakeholder mandate in the benefit corporation statute. The question how this strict standard protecting voting rights might be altered (or preserved) under a benefit corporation governance model is discussed in chapter 8.

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In the next chapter, we will leave the legal system and consider shareholder primacy from the investor perspective.