Character of the Corporation: The Delaware Court of Chancery and the Board
The following is an excerpt of a keynote conversation that took place at MLR Media's Character of the Corporation conference.
Don Delves: How does the court approach situations when evaluating a stockholder challenge to board action?
Andre Bouchard: I would look at it from the perspective of four different concepts. One is, what are the fundamental duties of directors? Second, what is the standard of conduct associated with those duties? Third, what are the standards of review a court applies to look at board actions and transactions? The last concept involves considerations of personal liability. The common law associated with those four concepts in a nutshell provides a basic framework for evaluating stockholder challenges to board action.
The duties are very straightforward. There is a fiduciary duty of care and a fiduciary duty of loyalty, which subsumes the obligation to act in good faith. The standard of conduct that applies in the case of care is that you must be reasonably informed. This means that you must learn material information that is available about the issue at hand. In that regard, you are entitled to rely on advisors and professionals to make informed judgments. The standard of review for the duty of care is gross negligence, which is a high standard under Delaware law.
The duty of loyalty is a fundamental precept. It requires that you always put the interests of the corporation above your own personal interests and do what is in the best interests of the corporation and all of its stockholders collectively, including acting in good faith to do so.
Let me turn to standards of review in the context of challenging a transaction. When a problem comes to the court, how does a judge evaluate a board’s decision-making in a given circumstance? The court does not just start from scratch every time with a clean slate. The critical thing is that the court starts with standards of review that have been developed over many years as part of the common law that it applies to a particular situation.
On the one hand, in circumstances where no self-interest is at play in a board decision, or you at least have independent decision-making by a majority of the directors who are aware of any potential conflict of interest of another director, the business judgment rule will apply and the court will defer to the board’s decision unless it was simply irrational, which is extremely rare. The reason the court is not going to second-guess a board decision in this situation is because it allows for creativity and for people to take risks, to do what they honestly believe is best for the economic prospects of the company. Directors will not be exposed to liability in those circumstances.
The other end of the spectrum is where a majority of directors making a decision suffer from conflicts of interests or you have a controlling stockholder who has a conflict of interest. In that situation, the entire fairness standard will apply, in which case the burden is on the defendants to demonstrate that the transaction is entirely fair. That is a process as well as a price-oriented test, but it is all looked at holistically.
There are also intermediate standards of review between these two ends of the spectrum the court will apply in certain situations where there is not a disabling conflict of interest per se, but where the nature of the situation calls for a level of heightened scrutiny to ensure independent decision-making. The two situations in particular where that is the case is when a board adopts takeover defensive measures or decides to sell control of the company.
At the end of the day, in terms of the potential for personal liability, directors who put the corporation’s interests above their own should feel very safe because, as a practical matter, it is only in a very narrow circumstance where that would be applicable. That is because Delaware authorizes companies to put in their charters a provision that exculpates directors from personal liability for breaches of the duty of care; so there is zero practical exposure in the care context for liability because essentially every public corporation has such a provision. Delaware also recently enacted a statute to permit exculpation of officers in the class context, but not in a derivative context. In terms of exposure to liability, the issue is really all about loyalty. Where Delaware is extremely vigilant is in self-dealing circumstances where fiduciaries seek to extract for themselves a benefit that is not shared by all the shareholders equally. Conflicts of interest can be addressed by oversight and by independent decision-making, but if you do not apply those measures and a fiduciary engages in self-dealing or acts in bad faith to put his or her own interests above those of the corporation, that is where the exposure is.