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The Business Lawyer

Spring 2022 | Volume 77, Issue 2

Optimizing the World’s Leading Corporate Law: A Twenty-Year Retrospective and Look Ahead

Lawrence A Hamermesh, Jack B Jacobs, and Leo E Strine Jr


  • In a 2001 article (Function Over Form: A Reassessment of Standards of Review in Delaware Corporation Law) two of us, with important input from the other, argued that in addressing issues like hostile takeovers, assertive institutional investors, leveraged buyouts, and contested ballot questions, the Delaware courts had done exemplary work but on occasion crafted standards of review that unduly encouraged litigation and did not appropriately credit intra-corporate procedures designed to ensure fairness. Function Over Form suggested ways to make those standards more predictable, encourage procedures that better protected stockholders, and discourage meritless litigation, by restoring business judgment rule protection for transactions approved by independent directors, the disinterested stockholders, or both.

    This article examines how Delaware law responded to the prior article’s recommendations, concluding that the Delaware judiciary has addressed most of them constructively, thereby creating incentives to use procedures that promote the fair treatment of stockholders and discourage meritless litigation. The continued excellence and diligence of the Delaware judiciary is one of Delaware corporate law’s core strengths.

    But some recent cases have articulated standards of review that involve greater than optimal litigation intensity and less than ideal respect for decision-making in which independent directors and disinterested stockholders have potent say. Those standards also impair the integrity of Delaware’s approach to demand excusal in derivative cases and the identification of controlling stockholders. We also propose eliminating concepts like substantive coercion that do not provide a legitimate basis for resolving cases. Finally, we urge action to correct new problems such as the unfair targeting of corporate officers for negligence claims in representative actions and the frustrating state of practice under Delaware’s books and records statute.
Optimizing the World’s Leading Corporate Law: A Twenty-Year Retrospective and Look Ahead
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I. Introduction

A generation ago, two of us, together with our late friend, Professor and former Chancellor William T. Allen as co-author, and the third of us as a primary sounding board, published Function Over Form: A Reassessment of Standards of Review in Delaware Corporation Law. We were all deeply committed to the integrity, fairness, efficiency, and thus effectiveness of Delaware corporate law. And we understood the challenge of helping to assure that a corporation law dependent on judicial common law responded appropriately to new market developments. In the main, the Delaware judiciary, supported by those who drafted and enacted Delaware’s statutory corporate law, had done an exemplary job of addressing new phenomena such as hostile takeovers, assertive institutional investors, management- and controller-led leveraged buyouts, and contested ballot questions of various kinds.

We also recognized, however, that when courts charged with doing equity, often under considerable time pressure, confront novel situations involving corporate action arguably tainted by a conflict of interest to the detriment of the corporation and its stockholders, they may be tempted to develop litigation-intensive standards of review specifically tailored to each emerging situation. Such standards can cause systemic inefficiency. Incentivizing transactional planners to use mechanisms that are both costly and risky, such as special committees or stockholder votes, requires that those mechanisms meaningfully restrain judicial review. Review standards that afford courts undue freedom to second-guess transactions, even after negotiation by a special committee of independent directors or a fully informed vote by the disinterested stockholders, discourage transactional planners from using those processes. Litigation costs rise unnecessarily, when newly articulated standards of review increase the ability of plaintiffs’ lawyers to extract a fee-generating settlement solely because the anticipated costs of discovery and litigating a case that cannot be dismissed on the pleadings exceeds the cost of a settlement.

Function Over Form identified specific areas where these tendencies had crept into Delaware law and eroded its effectiveness. To address them, we argued first that standards of review must make functional sense, and we proposed criteria for defining such functionality. Second, we proposed that Delaware’s equitable common law of corporations function on the basis of three standards of review: (i) the business judgment rule, to govern decisions approved by impartial decision makers and to address damages claims based on a lack of due care; (ii) intermediate scrutiny, to address takeover defenses, corporate sales processes, and potential ballot manipulation; and (iii) the entire fairness standard, to address self-dealing transactions that were not approved by impartial decision-makers. We suggested ways to make the application of these standards more predictable, to encourage decision-making procedures that better protected stockholders from abuse, and to afford a less litigious path where the challenged corporate decision was made by independent directors or approved by the disinterested stockholders, or both.

In particular, Function Over Form advocated rationalizing standards of review that developed in response to the takeover and M&A boom of the 1980s and 1990s. At the outset of that era, the courts had not yet developed a standard of review that adequately and flexibly balanced the utility of applying business judgment rule deference to impartial decision-making against the reality that takeover bids presented new forms of conflicts of interest. To achieve that balance, the Delaware Supreme Court, in its foundational Unocal and Revlon decisions, created an intermediate standard of review that was more stringent than business judgment rule non-review yet less demanding and more flexible than entire fairness review.

Function Over Form concluded that the Delaware courts’ responses to the rapidly evolving market for corporate control, “viewed collectively and from a policy perspective, were balanced and productive.” But even so, a period of such intense doctrinal innovation would predictably leave the law more complex, less clear, and less than optimally fair and efficient. “From a technical corporation law perspective . . . th[e] results were often rationalized in a manner that gave inadequate guidance to lawyers whose task was to plan, and render advice to clients about, transactions based upon these post-1985 judicial opinions.”

To address this concern, Function Over Form examined how standards of review should function consistently with fundamental principles of equity:

Our thesis is that certain key Delaware decisions articulated and applied standards of review without adequately taking into account the policy purposes those standards were intended to achieve. [N]ew standards of review proliferated when a smaller number of functionally-thought-out standards would have provided a more coherent analytical framework. [W]e suggest a closer alignment between the standards of judicial review used in Delaware corporate law and the underlying policies that that body of law seeks to achieve.

A core theme was that the Delaware Supreme Court’s efforts to link all the emerging standards of review to the business judgment rule had created a complex and ambiguous framework for standards of review that was clunky and unpredictable. The article therefore proposed “mid-course corrections” to simplify these standards of review and make them more functional. Specifically:

To be functional, a standard of review should:

  1. provide judges with a practical and logical framework to determine whether corporate directors have fulfilled their duties in a particular context and the appropriate remedies if they have not;
  2. avoid needless complexity that creates opportunities for inefficient processing of cases that have little likelihood of ultimate success; and
  3. be aligned with the public policies that animate the corporate law by providing incentives for directors to act in a manner most likely to advance corporate and stockholder interests, and by deferring to outcomes reached through effective intra-corporate dispute resolution mechanisms.

To us, a reliable test of whether a standard of review is truly functional is utilitarian: is the standard a useful tool that aids the court in deciding the fiduciary duty issue? . . . Put another way, the truly functional standard of review is the test actually used by the judge to reach a decision, not the ritualistic verbal standard that in truth functions only as a conclusory statement of the case’s outcome.

The bottom-line recommendation was that Delaware courts should apply the three core standards of review in a manner functionally consistent with those principles. Where a specific standard applied, the court should apply it on a standalone basis, and not attempt to link it to other standards in an effort to fabricate a kind of unified field theory.

In this article, we examine how Delaware corporate law has responded to the prior article’s recommendations. We conclude that, in general, the Delaware judiciary has addressed most of the original article’s concerns consistent with those recommendations. More specifically, the Delaware courts successfully clarified (and in some instances reshaped) review standards so as to create incentives for transactional planners and corporate boards to use decision-making processes that promote the fair treatment of stockholders and discourage meritless litigation.

Nevertheless, there are several areas where the concerns expressed in Function Over Form have persisted or acquired renewed resonance. The case law of the new century has generated certain standards of review and other doctrinal approaches that create excessive litigation intensity and suboptimal respect for intra-corporate decision-making processes in which independent directors and disinterested stockholders have potent say. Those areas of renewed concern—all but the last two of which implicate articulation of standards of review—are addressed below. Those problematic areas are summarized below, along with the remedies we propose:

  1. Extending the inherent coercion theory expressed in Kahn v. Lynch beyond freezeout mergers to all controller transactions, thereby (i) making the procedural requirements specified in MFW applicable to decisions for which they were not designed and do not rationally pertain, and (ii) inappropriately expanding the range of full discovery and judicial review for fairness. We advocate abandoning Lynch’s inherent coercion rationale and limiting the reach of MFW to transactions in which a controlling stockholder seeks to acquire the minority’s shares, or a statute requires the approval of both the board and the stockholders.
  2. Enlarging the definition of “controlling stockholders” to include persons having little or no share voting power, and to lump together unaffiliated stockholders into a “control bloc,” so that a different standard of review applies, thereby expanding the range of full discovery and judicial review for fairness. To address this concern, we propose limiting the concept of “controlling stockholder” to the situation where a stockholder’s voting power gives it at least negative power over the company’s future, in the sense of acting as a practical impediment to any change of control.
  3. Insufficiently distinguishing between transactions involving classic self-dealing and transactions in which a fiduciary (whether a director or controlling stockholder) receives an additional benefit only because of being differently situated, thereby extending entire fairness review to a context where it does not fit. We advocate restoring that distinction, at the injunctive stage, by applying Unocal and Revlon intermediate judicial review to transactions where a fiduciary merely receives (but does not force) a benefit, such as a post-merger compensation package, not received by other stockholders. In a post-closing damages case, the review standard should require the plaintiff to prove a breach of the duty of loyalty and resulting damages.
  4. Circumscribing the reach of the second prong of Aronson, by prescribing dismissal of a well-pleaded loyalty claim unless a majority of the directors face likely liability on a non-exculpated claim. We advocate reinvigorating Aronson’s second prong “safety valve” to allow demand excusal if the particularized facts support an inference that a breach of fiduciary duty has harmed the company. Alternatively, if that is not the case, and Delaware law presumes that independent directors who approved a transaction alleged to involve unfair self-dealing can turn around and impartially sue their interested colleague on the board over that same transaction after the fact, then logically it should also presume they can perform the easier and less dramatic upfront function of effectively negotiating a fair transaction or saying no if fair terms are not reached. Otherwise, Delaware law will rest on incoherent premises about independent directors.
  5. Maintaining doctrinal complications like “substantive coercion” and the “waste” vestige of business judgment review that obscure proper application of standards of review and frustrate the principles that should drive case outcomes. We advocate (i) eradicating the concept of “substantive coercion” as a basis for board authority to block a non-coercive bid and relying instead simply on the board’s ordinary authority; (ii) interring the vestigial “corporate waste” claim where the disinterested stockholders approve the challenged transaction; and (iii) overruling Cede II’s and Unitrin’s effort to link together all three core standards of review.
  6. Enabling the plaintiffs’ bar to exploit the omission of coverage of corporate officers under § 102(b)(7), and avoid dismissal by singling out officers as defendants, where the challenged decisions are made by a majority independent board. To remedy this exploitation, we propose that § 102(b)(7) be amended to permit exculpation of officers for duty of care claims in class or derivative actions, but not for claims brought by the company to enforce a contract or corporate common law.
  7. Expanding the scope of what constitutes “books and records” under § 220, thereby enabling stockholder plaintiffs to prospect for a claim challenging a merger that requires stockholder approval. That in turn encourages defendants to interpose delaying tactics and objections that frustrate the intended summary character of these statutory proceedings. To address these problems, we recommend amending § 220 to provide that where a public company stockholder vote is held on a merger, “books and records” should be limited to the equivalent of SEC Rule 13e-3 materials within the company’s control.

II. A Roadmap of the Article

In what follows, Part III traces how Delaware corporate law responded to the major concerns identified in Function Over Form. Part IV addresses areas where the original article’s concerns have either persisted or re-emerged, largely because of the inescapably difficult judgments that Delaware’s excellent corporate law judges must make, in real time and on imperfect records. Part IV also elaborates on the ameliorating policy changes previewed above. We submit that these measured but important recalibrations will enhance the ability of Delaware corporate law to fairly balance efficiency and fairness, reduce rent-seeking in the litigation process, provide meaningful incentives for faithful fiduciary conduct, and remain true to the business judgment rule tradition without detracting from the ability of Delaware courts to remedy genuine inequities.

III. Twenty Years of Doctrinal Evolution

A. The Duty of Care: Towards Doctrinal Clarity

The opportunity to enforce a duty of care tempts law-trained judges to consider imposing monetary liability on directors and managers who make business judgments in real time, by superimposing judicial views of appropriate business tactics with the benefit of hindsight. The business judgment rule exists to keep that temptation at bay. Consistent with that concern, Function Over Form questioned the Delaware Supreme Court’s attempt in Cede II to turn a conventional inquiry into whether a due care violation had occurred into a tour through multiple unrelated standards of review. The article criticized that ruling on several grounds: first, the basic rationale for entire fairness review—the difficulty of ascertaining, in non-arm’s-length transactions, the price at which a deal would have been effected—is alien to due care analysis; second, in cases not involving a specific transaction, an entire fairness analysis is of little or no utility; third, Cede II’s unprecedented standard-changing and burden-shifting treatment of the duty of care was procedurally unfair to directors, and would diminish their incentive to engage in risky wealth-creating transactions that, as a policy matter, boards should be encouraged to undertake; and fourth, that treatment conflicted with the policy for § 102(b)(7) provisions exculpating directors for duty of care damages claims without any showing of entire fairness, by seeming to require directors affirmatively to establish entire fairness to earn their statutory entitlement to exculpation. This attempt to unify disparate standards of review that address quite distinct circumstances and concerns was confusing. Function Over Form advocated a straightforward approach to due care damages cases: the plaintiff should have to prove a due care breach and resulting damages.

The article also questioned decisions treating the existence of an exculpatory charter provision as a factual matter that could not be considered at the motion to dismiss stage. Thus, one case suggested that a director who would be exculpated from liability for a due care breach had to remain a defendant in a case challenging an interested transaction, even if the complaint pled no facts inferentially establishing a non-exculpated breach of fiduciary duty. This procedural oddity conflicted with other decisions, undermined the intended purpose of § 102(b)(7), raised litigation costs, and added needless complexity.

The Delaware Supreme Court has eliminated this ambiguity and oddity, by taking the side of those cases that had ruled that an exculpatory charter provision must be considered on a motion to dismiss. If the complaint does not plead facts that rationally support a loyalty claim, it should be dismissed. Thus, the intended function of § 102(b)(7) is now better served.

The concern about Cede II’s due care/entire fairness linkage persists, however: the Delaware Supreme Court has yet to disavow that linkage explicitly, even though no Delaware court has since cited that aspect of Cede II approvingly. We view this silence as an implicit recognition that the Cede II linkage was dysfunctional, but hope that it will be given an overdue formal interment.

B. Dispatching the “Triad”: Restoring Good Faith as a Fundamental Requirement of a Loyal Fiduciary

Function Over Form noted another problem arising out of Cede II, namely its pronouncement that in addition to the two core fiduciary duties—loyalty and care—there was a third duty, that of “good faith.” This additional duty, creating what was described as a “triad,” made little sense. As Function Over Form noted:

Although corporate directors are unquestionably obligated to act in good faith, doctrinally that obligation does not exist separate and apart from the fiduciary duty of loyalty. Rather, it is a subset or “subsidiary requirement” . . . subsumed within the duty of loyalty . . . .

Later case law, culminating in Stone v. Ritter, has put the “triad” to rest. This clarified our law and aligned basic fiduciary doctrine with Caremark, which premises director liability on a failure to make a good faith effort to monitor the company’s compliance with law.

C. Unocal Review Should Stand on its Own

Consistent with its focus on functionality, Function Over Form urged that the three basic standards of review operate independently: where a standard applies, the court’s employment of that standard should be case-dispositive, and not invite an unnecessary detour into a different, unrelated standard of review. Function Over Form therefore urged that the attempt to link Unocal review (of the reasonableness of a target company board’s defensive measure) to the entire fairness and business judgment standards of review served no useful function. According to both Unocal and Unitrin, however, finding a defensive measure reasonable (or not) under the Unocal standard would not end the inquiry. Rather, (i) if the board satisfies Unocal, its defensive actions would be subjected to a second layer of review under the business judgment standard, and (ii) if the board’s actions fail Unocal, the defensive measures could still survive judicial scrutiny if the board can demonstrate that its actions were entirely fair. But it made no analytical sense to suppose that a board that passed the more stringent reasonableness test would fail the less demanding business judgment standard. Nor did it make sense to suppose that a board found to have acted unreasonably could nonetheless satisfy the more exacting entire fairness standard.

Perhaps recognizing that illogic, courts have made little use of Unitrin’s attempt to link Unocal and the business judgment and entire fairness standards. Rather, the Delaware courts have applied Unocal, and its sister Revlon, as free-standing standards of review.

D. Securing the Ballot Box’s Integrity Under the Intermediate Standard of Review

The goal of simplifying standards of review into a tri-partite functional framework requires making policy choices. One such choice made in Function Over Form concerned using Blasius’s “compelling justification” standard as a functional standard of review. That article—co-authored by the judge who authored Blasius—acknowledged that because of the broad authority entrusted to boards of directors, the legitimacy of Delaware corporate law would be suspect if it did not police ballot manipulation strictly, and applauded Blasius as an iconic reaffirmation of the principle that stockholders have a right to elect directors without electoral manipulation by management.

Even so, Blasius functioned not as a standard of review but as a label for a result, because the trigger that invoked the test was whether there was an intentional effort to disenfranchise the stockholders. Few if any cases, however, involve action so patently ham-handed; in most electoral cases there are plausible reasons, unrelated to blocking a free exercise of stockholder will, for the challenged action. The court’s task, then, is to determine whether that action was legitimate, or merely a pretext to thwart a fair exercise of voting rights. Function Over Form urged that Blasius be eliminated as a standalone standard of review, and that its concerns be addressed by applying Unocal and requiring the board to identify a threat that justified their action and demonstrate that it was reasonable in light of that threat. That position did not condone board action designed to disenfranchise stockholders or tilt an election unfairly; it merely asserted that the Unocal test would be more effective in identifying such behavior, because boards never confess to acting in bad faith. That two-part test gave the Court of Chancery a sound basis to smoke out pretext and determine whether action was unfairly preclusive, while permitting flexibility in the timing and conduct of voting in corporate elections and on transactions in a manner that serves the interests of stockholders.

The post-2001 case law developed in this direction: in Liquid Audio, the Delaware Supreme Court essentially incorporated Blasius’s and Schnell’s spirit into the Unocal test. Applying that approach in cases involving debt provisions that impeded proxy contests by operating like a poison pill if an insurgent slate were elected, the Court of Chancery has vindicated the right of stockholders to run a proxy contest free of such impediments. And a more recent decision adopting that approach invalidated an aggressive poison pill triggered at a level intended to be so low as to eliminate any economic incentive to engage in ballot-box activism. According to the court’s reading of the testimony, the board’s rationale was that allowing any stockholder vote during the pandemic would be adverse to the company’s best interests and stockholders might hurt the company by electing new directors or changing corporate policy during this delicate time. Rejecting that rationale, Vice Chancellor, now Chancellor, McCormick stated:

Viewing all stockholder activism as a threat is an extreme manifestation of the proscribed we-know-better justification for interfering with the franchise. That is, categorically concluding that all stockholder efforts to change or influence corporate direction constitute a threat to the corporation runs directly contrary to the ideological underpinnings of Delaware law. The broad category of conduct referred to as stockholder activism, therefore, cannot constitute a cognizable threat under the first prong of Unocal.

Citing Blasius’s rejection of the idea that a board may protect stockholders from themselves by cutting off their ability to act at the ballot box, the court enjoined the pill under Unocal.

As advocated two decades ago in Function Over Form, we applaud this use of Unocal. It provides a functional way for courts to expose and invalidate pretextual behavior even where a subjective inequitable purpose cannot be clearly established. That said, and as stated in Function Over Form: “our recommendation that voting issues be reviewed under Unocal rests on the assumption that courts will apply that test with rigor and that the doctrine of Schnell v. Chris-Craft Industries, Inc. retains vitality.”

E. Restoring Foundational Principles by Cabining Kahn v. Lynch’s Inherent Coercion Doctrine

Function Over Form also questioned the intrusive standard of review articulated in Kahn v. Lynch Communication Systems, Inc. That decision upheld the view that neither approval by a special committee of disinterested directors nor approval by an informed “majority of the minority” stockholder vote would change the standard of review, and that entire fairness would remain the standard of review, but the burden would shift to the plaintiff to prove that the transaction was unfair. The rationale was that a controlling stockholder that wished to take a company private had such retributive powers that both independent directors and stockholders would be subject to a form of inherent coercion and could not exercise the free will to say no.

In so ruling, the court, surely unintentionally, created a disincentive to seek an approving “majority of the minority” stockholder vote, because the acquired company’s board could obtain the same protection by using a lower cost, less risky “special committee” process as a “cleansing” mechanism. Although Lynch did not explicitly say so, the decision implied that even if both a special committee and a majority of the minority stockholder vote were required, the most that a controller could gain was the same burden shift as if it used only one of those cleansing mechanisms.

Function Over Form urged that Lynch be re-thought, for several reasons. The inherent coercion theory could not be squared with market realities, which demonstrated both the vigor and ability of stockholders to oppose transactions they considered inadequate, and the effectiveness of properly advised independent directors when acting as a bargaining agent to extract a robust price from a controller. And Delaware law itself was much more potent in policing retribution than Lynch gave it credit for.

Function Over Form therefore advocated that the inherent coercion rationale of Lynch be cabined:

The better policy . . . is to afford business judgment review treatment to self-interested mergers that are approved by either an effective independent director committee or by a majority of the minority stockholder vote . . . .

. . . . In today’s environment there is insufficient justification for giving less than full cleansing effect to a self-interested merger that is conditioned on approval of a majority of the minority stockholders. That is especially true now that disclosure regulation by the Securities and Exchange Commission and the efforts of the private plaintiffs’ bar are being augmented by the increased activism of institutional investors, and being facilitated by the enormous information flow made possible by new technology. . . . [W]e propose that the more sound approach would be for the courts to defer to the business decision reached in good faith by the elected independent directors of the corporation. At the very least, the burden-shifting rule of Lynch Communication should be altered in the case of self-interested mergers that are conditioned expressly on majority of the minority shareholder approval.

This recommendation rested on another fundamental premise: that where a controlling stockholder or other interested party proposes a self-dealing transaction that does not involve a going private merger, the entire fairness standard presumptively applies, but if any of the traditional cleansing protections are employed to approve the transaction—i.e., (i) approval by a board comprised of a majority of independent directors; (ii) approval by a special committee of independent directors; or (iii) approval by a majority of the disinterested stockholders—the business judgment rule standard should apply. In particular, approval by disinterested stockholders was a well-understood basis for invocation of the business judgment rule, a position thoroughly documented in the Delaware Supreme Court’s 2015 decision in Corwin.

Even in the context of a going private merger, Function Over Form did not embrace inherent coercion, and it certainly did not embrace that concept in any other context. Nor did it embrace having one set of equitable rules for controlling stockholders and another for other interested parties. Function Over Form did not advocate that Lynch be applied to all controller transactions, especially ones that did not involve a statutorily required vote; to the contrary, the thrust of the article was to confine Lynch, not extend it.

Although the path was long (about twenty years) and not entirely straight, Delaware law did evolve in the direction advocated in Function Over Form, culminating (almost fully) in the Delaware Supreme Court’s decision in Kahn v. M&F Worldwide Corp. in 2014. The path was bumpy, however, in several respects. First, because Lynch gave no credit for using both a special committee followed by a majority of the minority vote, that cleansing structure was not used, thereby depriving stockholders of the optimal set of protections. Second, because defendants were unable to dismiss cases seemingly inexorably subject to an entire fairness standard, plaintiffs’ lawyers obtained fees by filing suit immediately upon announcement of a going private merger proposal, and thereafter settling as soon as the special committee negotiated for a higher price than the controller initially offered. Evidence indicated that any benefit for stockholders derived from the efforts of the special committees, not plaintiffs’ lawyers, who were often willing to settle for less than what the committee was able to achieve.

Third, Delaware law was incoherent. If a controller proposed to effect a going private tender offer, it could do so without any duty of fairness so long as it disclosed the material facts and did not coerce the stockholders. In fact, it was this differential treatment in the law that enabled the controller in Lynch to credibly threaten that it could bypass rejection by the special committee and still avoid entire fairness review. This potential influenced the adoption of the inherent coercion approach in Lynch because it seemed to leave the special committee with what the court believed to be inadequate protective clout. But, instead of using the case to subject going private tender offers to fairness review and thereby prevent the controller from escaping fairness review by bypassing the committee, Lynch deepened this incoherent treatment by subjecting a controller to unavoidable discovery costs and fairness review when it took the more stockholder-protective route by seeking cleansing via a minority stockholder vote, and seemingly even where it used a combination of two traditional cleansing protections—special committee approval and a minority of the majority vote—in tandem.

Post-Lynch cases and scholarly articles exposed and criticized this incoherent scheme of transactional review. In Pure and Cox, the Court of Chancery suggested that all controlling stockholder going private transactions be treated comparably, and that even in this starkly zero-sum context, the business judgment standard should be applied if either a going private merger or a tender offer were made subject to approval by both a special committee of independent directors and a majority of the minority from the inception of the bid and offer process. That approach would be coherent regardless of transactional form and would address Lynch’s bypass concern.

Not until 2011, however, did a controller take the chance of employing both cleansing protections in combination in an effort to invoke business judgment rule protection. That enabled the Delaware courts to have a chance to consider, for the first time, the continuing viability of Kahn v. Lynch’s inherent coercion doctrine.

In MFW, MacAndrews & Forbes, M&F Worldwide’s 43 percent stockholder, acquired M&F Worldwide’s remaining shares in a cash merger. Under the procedure adopted, “upfront, MacAndrews & Forbes said it would not proceed with any going private transaction that was not approved: (i) by an independent special committee; and (ii) by a vote of a majority of the stockholders unaffiliated with the controlling stockholder.” Granting summary judgment, the court held that “when a controlling stockholder merger has, from the time of the controller’s first overture, been subject to (i) negotiation and approval by a special committee of independent directors fully empowered to say no, and (ii) approval by an uncoerced, fully informed vote of a majority of the minority investors, the business judgment standard of review applies.”

The Court of Chancery decision also explained why the inherent coercion rationale of Lynch gave too little weight to current market realities, to experience with special committees and stockholder votes, and to the ability of the Delaware courts to police retribution. Adopting the trial court’s reasoning, the Delaware Supreme Court affirmed, and the viability of a motion to dismiss a complaint challenging a controller freezeout merger is now established in Delaware law, as Function Over Form advocated, where an informed and uncoerced special committee and the minority stockholders approve it.

IV. Twenty-First Century Doctrinal Developments that Warrant Doctrinal or Legislative Change

In this part we identify concerns that Delaware law may have again created unnecessary complexity and potential for systemic unfairness and propose solutions to make Delaware law more functional and predictable.

A. The Continued and Expanded Life of Lynch’s Inherent Coercion Theory and Its Negative Consequences

As described earlier, MFW reined in Lynch’s “inherent coercion” rationale and the mischief it caused in connection with going private mergers. The Delaware Supreme Court’s affirming decision in that case, and its later decision in Flood v. Synutra International, Inc., essentially rejected the inherent coercion theory and restored traditional principles for determining the standard of judicial review applicable to conflict transactions. It did so by recognizing that (i) independent directors and stockholders can exercise real leverage and make informed choices when faced with a conflict transaction involving a controller, and (ii) Delaware law is vibrant enough to protect minority stockholders from retribution by a controller that did not get its way.

At the same time, MFW and its progenitors viewed going private mergers as a context in which the dangers of overreaching are particularly grave, and therefore developed a bespoke solution that could invoke the business judgment rule. We did not view those decisions as imposing that solution on all controlling stockholder conflict transactions, but as instead normalizing the approach Delaware law would take to controller transactions and to treat them equally with other conflict transactions, at the very least where what was at issue was not a transaction or decision that required both the approval of the board and the approval of stockholders under the Delaware General Corporation Law (“DGCL”).

But the common law evolves on a case-by-case basis, and precedent is sometimes applied, in good faith, in a manner that the decisions did not intend or contemplate. That is what seems to have happened in the wake of MFW, leading to a phenomenon we describe occasionally as “MFW creep.” Rather than confining MFW to the going private merger context for which that case was specifically designed, plaintiffs have successfully urged Chancery in several cases to require the full MFW suite of protections for any conflict transaction with a controlling stockholder, in order to invoke business judgment review, even where no statutory vote is required. The decisions that take this view are grounded not in reasoning in the cases leading up to MFW, but in Lynch’s inherent coercion logic, which those cases cast doubt upon, and which MFW and Flood implicitly abandoned. Admittedly, the decisions culminating in MFW necessarily referred to the inherent coercion doctrine in a way that was respectful, but in our view, clearly indicating that the doctrine was not convincing. But, instead of reading MFW as a move away from the inherent coercion doctrine toward the traditional approach, the recent Chancery cases have instead taken the view that inherent coercion exists in any situation where a controller has a conflict.

By way of leading example, in a scholarly and encyclopedic decision, the Court of Chancery in EZCORP reviewed the post-Lynch case law and concluded that the weight of authority did not cabin Lynch to the going private context, but applied its inherent coercion doctrine to all conflict transactions involving controllers. In so doing, the court cited decisions leading up to MFW that said otherwise, including Friedman v. Dolan, Canal Capital Corp. v. French, and Tyson, an important Chancery decision holding that because a special committee of independent directors approved executive compensation to a member of a controlling stockholder’s family, the business judgment standard applied.

EZCORP concluded, however, that cases like Tyson, which applied traditional Delaware corporate law to controller transactions not requiring a statutory vote, were not persuasive, because it viewed the inherent coercion theory of Lynch as a continuing principle of the corporate common law. In adopting that view, EZCORP relied upon the power of a controlling stockholder to wield influence at both the board level and the stockholder level, to justify subjecting any controller conflict transaction to the entire fairness standard, even a transaction not requiring a stockholder vote. Nevertheless, EZCORP was careful to indicate that the Delaware Supreme Court had not spoken to the question of whether the MFW dual process approach was required outside of the going private merger context, or whether use of any of the traditional cleansing devices would henceforth suffice, to invoke business judgment review.

We would answer that question differently than EZCORP and would not apply MFW to all transactions with controlling stockholders: the MFW solution was tailored specifically to the problem created by the Lynch line of cases, namely that those cases created poor incentives in the going private merger context for transactional planners and encouraged wasteful litigation yielding no benefit for investors or society. The solution MFW embraced credits procedures that, if implemented with fidelity, give minority stockholders in a squeeze-out merger the key protections they would receive in a merger with a third-party acquiror: (i) fiduciaries actively negotiating for their benefit and (ii) the right to determine for themselves as stockholders whether the transaction is in their best interests. This solution addressed concerns unique to the controller going private context: the requirement that the controller concede that the special committee of independent directors could say no responded directly to the concern that the controller could bypass that committee decision by presenting a tender offer directly to the minority stockholders.

The MFW solution was never designed to apply to all transactions between controlling stockholders and companies. MFW repeatedly emphasized that it was addressing only the context of going private mergers: it defined the question presented as “what should be the correct standard of review for mergers between a controlling stockholder and its subsidiary,” and recited that “[o]utside the controlling stockholder merger context, it has long been the law that even when a transaction is an interested one but not requiring a stockholder vote, Delaware law has invoked the protections of the business judgment rule when the transaction was approved by disinterested directors acting with due care.” Thus, the idea that MFW meant, without saying so, to define the treatment of all transactions with controlling stockholders is at odds with MFW’s own text.

It is also at odds with widespread practice. One of the historical functions of audit committees has been to review and approve such related party transactions, and controlling stockholders—many of which are businesses themselves—often provide or acquire services or goods to or from the controlled company. Likewise, controlling stockholder representatives often serve and are compensated as executives, and compensation committees comprised of independent directors were developed in part to address the potential for such conflicts. We never understood that entire fairness review would be universally required in these common situations, or that the potential for controller self-dealing makes it impossible for the company’s directors to avoid a judicial fairness inquiry.

Rather, if one of the traditional cleansing techniques is used, the presumption should be that the transaction or compensation was approved by impartial fiduciaries who could faithfully represent the company’s interest in getting a fair deal for itself. In that case, the business judgment rule would apply unless the plaintiff could use the waste doctrine to create an inference that an “apparently well motivated board” might not have been. The plaintiff could use this equitable “safety hatch” by pleading that the “decision is so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.”

Section 144 of the DGCL further supports this view. The techniques that statute requires to validate an interested transaction largely reflect those that the common law of corporations had deemed necessary for the transaction to receive the protection of the business judgment rule, rather than inflexibly remain subject to entire fairness review. With important judicial adaptations to maintain credibility—e.g., the cleansing vote must be one of only the disinterested stockholders, and special committee members must be independent as well as disinterested—the techniques prescribed in § 144 were considered sufficiently robust to eliminate the need for a fairness inquiry. Just as § 144 was built on equity cases involving fiduciary duty, and not just technical legal validity, later equity cases were built on the foundation established by § 144’s codification of the then-recognized techniques for addressing conflict transactions.

In stating that, we do not exaggerate the consistency or precision with which Delaware case law addressed the standard of review ultimately applicable to conflict transactions. In earlier eras, the costs of discovery and the volume of cases facing corporations were smaller, and the importance of determining whether a case should proceed past the pleading stage was not as salient.

We also acknowledge the many cases stating that any conflicted self-dealing transaction with a controlling stockholder is subject initially to the entire fairness standard. Vice Chancellor Laster’s exhaustive review of cases in his scholarly EZCORP decision well documents that reality. And as far as that goes, we agree with that proposition. But that proposition does not, in itself, answer the important question the Delaware Supreme Court has yet to answer post-MFW: outside of the going private context, what cleansing techniques will change that initial standard from entire fairness to business judgment review?

When Function Over Form was published, independent directors had already shown themselves capable of standing up to corporate managers, and CEO tenure had been declining as a result. Independent directors increasingly owed their continued access to directorships not to ties to management, but to their willingness to support policies that powerful institutional investors liked. These same institutional investors had shown themselves willing to criticize companies—including those with controlling stockholders—and to dissent at the ballot box. Moreover, Delaware courts had proven vigilant in policing electoral manipulation and coercion of stockholders in the voting process, and would readily address any controller who reacted to a negative vote with retribution. Likewise, even controllers had to be sensitive to the prospect that replacing independent directors who said no to a conflict transaction with ones who would do their bidding would impair their ability to raise debt and other capital. Decisions of the Delaware courts and actions by the U.S. Securities and Exchange Commission had enhanced the information base available to stockholders about salient developments like M&A transactions. For those reasons, Function Over Form argued that Lynch’s inherent coercion theory was empirically baseless.

Market activity since then has only strengthened that argument. Institutional investors have a powerful voice and no fear of controlling stockholders or corporate management. Stockholders challenge them frequently, and they have hedge funds and the media to help them. Independent directors are under great scrutiny too, and they are expected to act aggressively in M&A situations to make sure that the public investors get a good deal. Proxy advisors and analysts scrutinize deals and help institutional investors decide how to vote. Annual say-on-pay votes exist at most companies, and independent directors who run afoul of investor and proxy advisor sentiment over pay policies at one company (even ones with a controlling stockholder) can face withhold votes at other companies on whose boards they serve. In light of these market developments, all of the constraints discussed earlier—judicial review under the entire fairness standard where a controller replaces directors who stand in its way, the prospect of adverse effects on financing, and reputational damage with institutional investors and the press—would at least as forcefully deter a controller in settings involving conflict transactions other than going private mergers. Thus, even more now than when Function Over Form was published, there is no reason to base the law on the view that stockholders cannot protect themselves at the ballot box, or that independent directors do not take their duties seriously when considering conflict transactions.

The retributive rationale underlying the inherent coercion doctrine has also been undercut in a decisive way by MFW, if it and its predecessors are taken seriously. As we have discussed, Lynch’s inherent coercion doctrine rested on the premise that a controller could bypass a special committee, make a going private tender offer, and escape ultimate fairness review. That premise, unique to the going private context, would disappear if the Delaware Supreme Court were to make clear that a going private tender offer by a controller would be subject to the same level of judicial review as a going private merger, and the condition in MFW that the controller cannot bypass the special committee or the minority stockholders would be rendered superfluous. Put simply, if, as MFW, Cox, Pure, and leading scholars suggest, the equitable review of a going private transaction should not be driven primarily by statutory form, especially when the merger route is more protective of minority stockholders, a foundational premise of the entire Lynch doctrine goes away.

For these reasons, MFW should be viewed as articulating a targeted solution to a targeted problem created in large measure by the anomaly in the case law arguably allowing a controller to use a tender offer to escape both a special committee’s veto and fairness review, and not as prescribing a rigid set of procedures applicable to any transaction between a controlling stockholder and a company. Given the importance of going private mergers and ​the concerns this anomaly ​creates, we embrace the principled approach MFW took to replicating the protections afforded to stockholders under the DGCL in a third-party, arm’s-length merger. Because this bypass anomaly does not exist in other settings and because the inherent coercion doctrine is flawed and should not form a further basis for making corporate common law, we would not extend MFW beyond the going private context. But if it is to be extended, at most MFW’s two key protections should apply when a self-dealing transaction is statutorily required to be approved by stockholders. Applying MFW when a self-dealing transaction must be approved by the stockholders and the board would have some logic, because it would match the basic reasoning of the decision. But where no stockholder vote is required, MFW’s procedures have no fit, and their extension to such contexts involves judicial action better described as statute writing.

Extending Lynch’s inherent coercion doctrine after MFW had effectively rejected it, thereby dooming to failure any motion to dismiss unless the controller employs the costly MFW procedures, will not generate systemic value for diversified stockholders. Instead, it is more likely to result in excessive transaction costs, increased D&O insurance costs, and contrived settlements designed only to avoid the costs of discovery and justify the attorneys’ fee that motivates most corporate representative suits.

Corporate law is not designed for perfection. Although fairness is important, and investors must have protections against abuse, investors and society risk much if courts act as if they can capably address all situational concerns, and impose a toll on innovation, flexibility, and the cost of capital by facilitating litigation rent-seeking in situations when sufficient, intra-corporate guarantees of fairness have been employed. Corporate jurisprudence cannot require a microscopic review of every situation that might involve unfairness. Rather, it must rely on rules that incentivize the use of high-integrity procedures in most cases and reduce the costs to society and investors of litigation and judicial second-guessing.

Accordingly, Delaware law should embrace the direction of MFW and Function Over Form, by reaffirming that most conflict transactions, even with a controlling stockholder, receive the protection of the business judgment rule if one of the three traditional cleansing procedures is credibly employed. Given vibrant stockholder power, the increased information available to them and the plaintiffs who represent them, the reputational and electoral implications for independent directors who bend to controllers’ wills, and the potent ability of Chancery to police retribution by a controller that does not get its way, the benefits of the traditional approach outweigh the risks, and plaintiffs’ lawyers would be encouraged to win cases on the merits, not extract fees based on an overly litigation-intensive standard of review.

B. Expanding MFW by Expanding the Definition of “Controlling Stockholder”

The “MFW creep” described in the previous section has been exacerbated by expanding the definition of a “controlling stockholder.” If pleading that a conflict transaction involves a “controlling stockholder” inexorably requires a trial on entire fairness, the occasion for such after-the-fact economic review expands if courts expand the definition of a controlling stockholder.

Under Delaware law, it was historically difficult to establish that a stockholder having less than majority ownership was a controlling stockholder. Even in Aronson, where the main defendant, the former CEO and chairman, controlled 47 percent of the vote, had close affiliations with several directors, and had an ongoing consulting arrangement, the court declined to infer control at the pleading stage.

Kahn v. Lynch took a more expansive view of the term “controlling stockholder.” Alcatel, a 43.3 percent stockholder that was contractually limited to electing a minority of the board, was nonetheless found to be a controlling stockholder, based on evidence that the non-management directors had previously accepted Alcatel’s refusal to renew management contracts that those directors had supported. Following Lynch, the Court of Chancery in Cysive determined that the founder, CEO, and chairman of the company, who owned 35 percent of the shares (but effectively 40 percent, taking into account stock options and shares owned by family members and subordinates), was a controlling stockholder. The court reasoned that he owned a large enough percentage of shares to be a dominant force in any contested election and exercise managerial supremacy over the company. Still, the court’s reasoning remained deeply tied to voting, not just managerial power: as the court explained, “the analysis of whether a controlling stockholder exists must take into account whether the stockholder, as a practical matter, possesses a combination of stock voting power and managerial authority that enables him to control the corporation, if he so wishes.” And some subsequent rulings have been cautious in determining that a minority holder with a significant role in the company was a controller.

Our concern, however, is that the revival of Lynch’s inherent coercion theory has created pressure to expand the definition of controlling stockholder to reach persons having far less than a voting majority but are either critically important to the company or associated with other stockholders as a group. Tesla Motors illustrates the first of these two categories. Tesla’s CEO, Elon Musk, held only about 22 percent of the company’s voting power, but, taking into account apparent board level conflicts and Musk’s acknowledgements that he had substantial influence over the company and the board, the court found a reasonable inference that Musk was a controlling stockholder.

Although that finding may have been appropriate, we are concerned that the court’s reasoning in applying controlling stockholder doctrine sweeps too broadly. Even if Musk were not a controller, the finding that a majority of the directors were beholden to Musk would in itself invoke fairness review and demand excusal under the first prong of Aronson. The other finding—that Musk was so talented and visionary that the company could not succeed without him—does not rationally imply that someone is a controlling stockholder. Being valuable to the company does not make an executive a controlling stockholder, nor does it implicate the concerns underlying Lynch—namely, the potential to use affirmative voting power to unseat directors and implement transactions that the minority stockholders do not like, and use blocking voting power to impede other transactions.

The second avenue for expanding the controlling stockholder definition is to aggregate the voting power of stockholders holding blocs of shares, even though they are not bound by a voting agreement or founding family ties. These stockholders are then treated as a “control group” with the same force and effect on the standard of review as if they were a majority stockholder. If the only rationale for this treatment of otherwise disaggregated stockholders is that they had a similar view about a specific transaction’s favorability, despite having no obligation or prior record of being tied together as to all issues, this mode of “situational control group” analysis should be applied with great caution. Aggregating into a single unit stockholders united only by a common view of what will optimize the value of their shares would enable plaintiffs to survive a motion to dismiss with no further proof that these stockholders, even if they hold fiduciary positions, breached their duty of loyalty.

To cabin this danger, the Delaware Supreme Court has required plaintiffs seeking to establish that the defendants are part of a control group to demonstrate that they entered into a contract, common ownership, agreement, or other arrangement where they worked toward a common goal. Although several opinions have faithfully applied that requirement, other cases appear more adventuresome. In Dubroff II, the court found that the alleged facts supported an inference that three otherwise unaffiliated investors had acted as a controlling shareholder by engaging in a series of transactions that had enriched them at the expense of the minority shareholders and by “work[ing] together to establish the exact terms and timing” of the challenged recapitalization. In Frank v. Elgamal, plaintiffs survived a motion to dismiss by alleging members of the allegedly controlling group were united in entering into three agreements, despite having no voting agreement or common ownership. Relying on Frank, Hansen Medical held that allegations indicating coordination between the otherwise independent members of the supposed control group in previous transactions precluded dismissal where the members concurrently received benefits unavailable to minority shareholders in the contested transaction.

This phenomenon is troublesome, particularly if extended to putative groups of stockholder-directors. If several directors are “interested” in a transaction for purposes of § 144, then that has important implications for the standard of review. But assessment of those implications should not be oversimplified by lumping together those directors’ shares if they have no obligation to vote those shares uniformly. Delaware law generally regards share ownership by directors as useful, as it helps align the economic interests of directors with those of other stockholders. But the law should not reflexively deem a group of interested directors a controlling stockholder merely because they vote identically in one transaction.

Another troublesome issue arises where a court accepts the claim (at least for purposes of a motion to dismiss) that a person is a controller, with concomitant fiduciary obligations, despite owning no shares of stock at all. To be sure, if a non-stockholder that exercises control through ownership of or managerial authority over a parent entity uses that control to exercise voting or managerial control of a subsidiary entity, that non-stockholder takes on fiduciary duties to the controlled subsidiary. Our concern, however, is that the amorphous concept of “soft power” not arising out of stock ownership could be applied to trigger the entire fairness standard and preclude dismissal, where the premise of control involves circumstances that reflect garden variety commercial dealings, such as “the exercise of contractual rights to channel the corporation into a particular outcome by blocking or restricting other paths, . . . the existence of commercial relationships that provide the defendant with leverage over the corporation, such as status as a key customer or supplier, [or] [l]ending relationships, [which] can be particularly potent sources of influence.” The courts should heed doctrinal guardrails against overuse of this “soft power” concept: “authority [that] takes the form of a contractual right . . . must give the nonstockholder power akin to ‘operating the decision-making machinery of the corporation’ (a ‘classic fiduciary’), rather than ‘an individual who owns a contractual right, and who exploits that right,’ forcing a corporation to ‘react’ (which does not support a fiduciary status).”

Perhaps most important, pressures by plaintiffs to characterize defendants as controlling stockholders when they possess far less than majority ownership, and even unaffiliated defendants as a “situational control bloc,” could be reduced by returning to a robust recognition of the cleansing effect of informed independent director or stockholder approval. Interested transactions would not consequently receive starkly different treatment solely because the interested party defendants are characterized as a control group.

C. The Related Temptation to Expand the Definition of Self-Dealing Transactions

Renewed recognition of the cleansing effect of informed independent director or stockholder approval would solve a separate and increasingly difficult classification problem: determining when a non-ratable benefit to a corporate fiduciary triggers entire fairness review. Non-ratable benefits come in many varieties: severance benefits for management, officer or director positions in the surviving corporation, different liquidity desires even in a pro rata transaction, a higher price for a class of stock with admittedly far greater value because of its voting control, an opportunity to acquire an equity interest in the acquiring company, and elimination of potential derivative claims, to name just a few.

Like the pressure to characterize interested parties as controllers, MFW creep encourages plaintiffs to argue that non-ratable benefits to a fiduciary that accompany otherwise third-party transactions constitute a conflict of interest that triggers entire fairness review. There is precedent supporting this position, and we agree that a non-ratable benefit can require application of the entire fairness standard where (i) neither of the traditional cleansing mechanisms (independent director or stockholder approval) has been used and (ii) the fiduciary who received the benefit negotiated the main terms of the transaction and determined the allocation of the proceeds in a direct self-dealing manner.

But Delaware courts should be cautious about expanding the use of non-ratable benefits as a basis for expanding the scope of the definition of self-dealing transactions. Entire fairness review serves as a check on self-dealing, by requiring a party that essentially negotiated with itself to prove that what it received or gave constituted fair value. That function, however, is not implicated where a third party negotiates a merger with a company that has two classes of shares, and bargains over the price paid for each, and each class has a voluntary, informed class vote. Likewise, managers are entitled to contract for their future services and to receive fair compensation if they lose their job in a deal. Admittedly, it is problematic when directors or stockholders approve a transaction without realizing the existence of a non-ratable benefit to a fiduciary; but where that benefit is fully disclosed and approved, its recipient should not be required to disprove that it came at the expense of the corporation or the stockholders generally. Likewise, the fact that a controlled company makes a decision benefiting its parent should not invoke the entire fairness standard absent harm to the corporation or the minority stockholders. Controllers should not have to pay rents to the minority to, for example, conduct business in a tax efficient manner. So long as the controller does not extract value from the minority, there is no proper basis for fairness review to apply. In sum, we submit that invoking the business judgment rule based on use of any of the traditional cleansing protections would normalize and rationalize the judicial treatment of transactions involving non-ratable benefits to a fiduciary.

More generally, we believe, as with duty of care claims, any plaintiff arguing that a non-ratable benefit was a breach of the duty of loyalty should have to prove breach and resulting damages. The entire fairness standard should not be wheeled out to address these kinds of cases in an awkward and confusing way. So long as the plaintiff has the chance to prove a breach of this kind (e.g., that none of the protective devices was used with credibility or that the recipient fiduciary engaged in bad-faith overreaching) and damages (harm to company and other stockholders), a more than adequate deterrent exists.

D. Undermining Aronson’s Important Second Prong and Creating Inconsistent Assumptions About the Ability of Independent Directors to Make Impartial Decisions

The Delaware Supreme Court recently affirmed a ruling in which the Court of Chancery concluded that the two-prong demand requirement test articulated in 1984 in Aronson v. Lewis is “no longer a functional test,” and that demand can be excused only by demonstrating that a majority of directors face a claim of liability not exculpated by a charter provision under § 102(b)(7). Although we have no quarrel with the result reached in the case (dismissal), that approach precludes the use of the second prong of Aronson’s demand futility test to challenge self-interested transactions where the pled facts support an inference that a conflict transaction unfairly benefited an interested party and the independent directors acted with gross negligence (but not disloyalty) in approving it. That approach also thereby encourages courts to strain to infer bad faith on the part of such directors to avoid dismissing a loyalty claim against the interested party that would historically have satisfied Aronson’s second demand utility prong. Neither development is salutary, in our view. The treatment of Aronson in any event clashes with the inherent coercion rationale discussed above as the foundation for MFW creep, and the two doctrinal approaches cannot logically co-exist.

1. Why Post-Aronson Developments Did Not Warrant Abandonment of the Second Prong

The Delaware Supreme Court’s Zuckerberg opinion largely accepts the analysis of the Court of Chancery, and rests on the proposition that three developments in Delaware law post-dating Aronson made its second prong no longer a useful way to evaluate demand futility. For starters, Zuckerberg suggests that under Aronson merely pleading that the challenged transaction is one that would, as an initial matter, not be subject to the business judgment standard of review itself satisfies Aronson’s second prong, a suggestion that echoes the Chancery decision it affirmed. Second, the opinion explains away several cases decided in the wake of Aronson on the ground that § 102(b)(7) had not been enacted when they were decided. Finally, the court suggested that its decision in Cornerstone, holding that directors against whom no non-exculpated claim has been pled should be dismissed on a proper Rule 12(b)(6) motion even if non-exculpated claims exist against other directors (such as the interested party in a conflict transaction) was a further development undermining the rationale for Aronson’s second prong.

Building on these premises, Aronson’s second prong was seen as somehow too easy to satisfy—because it was triggered solely by pleading an initial standard of review, not particularized facts supporting an inference of ultimate breach (premise one)—and not fitting a world where independent directors can be dismissed under Rule 12(b)(6) if they only face an exculpated due care claim (premise two). The solution to this perceived problem was to abandon the second prong and essentially have the rule of Rales v. Blasband govern all demand cases, thereby requiring a showing that a majority of the demand board face a non-exculpated claim or are not independent from the interested party. The universal demand excusal test thus became the following:

  1. whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;
  2. whether the director would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand; and
  3. whether the director lacks independence from someone who received a material personal benefit from the alleged misconduct that is the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand.

Under this test, if Aronson’s second prong was to be preserved at all, a plaintiff could only satisfy it by pleading particularized facts supporting a non-exculpated claim against the demand board majority. In our view, that approach eradicates the historical function of Aronson’s second prong as a safety valve. Although a rational policy choice, discussed below, can be made in favor of that approach, such an important new policy shift cannot be justified on the grounds that intervening developments have made Aronson’s second prong, as originally intended to be applied, of no continuing utility.

Beginning with the first of the three developments summarized above, we believe that the purpose of the second prong was never about pleading an initial standard of review; rather, it required pleading facts supporting an inference of an ultimate breach of duty. Aronson’s second prong explicitly calls on the Court of Chancery to inquire into “the substantive nature of the challenged transaction and the board’s approval thereof.” This means that a plaintiff cannot plead demand excusal under the second prong simply by noting that the transaction, as an initial matter, is subject to entire fairness review. To the contrary, the second prong has often been found not satisfied when that standard initially applied. If, for example, a special committee of independent directors approves a conflict transaction, and the plaintiff cannot plead particularized facts suggesting that the special committee process was tainted by some wrongdoing (e.g., fraud on the committee by the interested party or gross negligence by the special committee), then demand is not excused. The second prong requires pleading particularized facts that supports a pleading stage inference that an ultimate breach of fiduciary duty occurred. That goes well beyond pleading an initial standard of review. Thus, properly applied, there is not a danger that the second prong of Aronson easily allows a plaintiff to usurp a board’s presumptive authority to control the company’s claims. The rigorous requirement to plead particularized facts to support a rational inference of ultimate breach assures that is not the case.

As for the second and third developments that supposedly undermined Aronson’s second prong, we do not believe that the Delaware courts applied Aronson’s second prong for over thirty years without considering the impact of the enactment of § 102(b)(7) in 1986, and the longstanding potential for due care exculpation should have no bearing upon the continued utility of Aronson’s second prong. Delaware’s corporate bar readily understood that § 102(b)(7) created situations where approving an interested transaction could result in monetary liability of the interested directors, but not of independent directors acting in the good-faith belief the transaction was fair to the corporation. Likewise, Cornerstone was not a seismic change in practice under § 102(b)(7), as it was hardly the first case to recognize that individual directors not subjected to a non-exculpated claim should be dismissed and not have to remain as defendants just because other defendants face non-exculpated loyalty claims. In sum, no case law or legislative developments after Aronson warranted abandoning its important second prong.

2. Rales Should Not Displace Aronson’s Second Prong Because the Contexts of the Two Cases Differ

It is also significant that the Zuckerberg decisions, which stress the functional similarities between the Rales test and the Aronson test, overlook what is different about the context in which Rales applies—namely, when at least a majority of the board that would receive a demand is different than the one that made the decision that is the subject of the complaint. That is, Rales applies when a board either in whole or at least in majority is not asked to cause the company to sue someone over a decision that they had made. Delaware law has often looked to whether an independent board majority exists in terms of the deference it affords a decision, an approach resting on the sound intuition that when the independent directors have voting control of the boardroom they have more freedom for impartial action. The different test in Rales is explained by the demand board’s different responsibility for the transaction under litigation challenge and its effect on the board’s ability to consider a demand.

This difference has important implications in the history of and rationale for Aronson’s second prong. Aronson was decided at a time when the concept of an “independent director” was still nascent, and when there was debate about whether the concept had meaning. Some felt that the natural relationship of fellow directors created a structural bias, and that led to skepticism that even putatively independent directors could impartially decide whether to sue a fellow director. Aronson took note of this debate and the second prong helped to ameliorate this concern by giving a plaintiff two routes to demand excusal. The first was to plead that a majority of the demand board had ties to the interested party that compromised their ability to consider a demand to sue. But even if a plaintiff could not satisfy that first route, Aronson’s second prong gave the plaintiff a chance to get a merits adjudication by pleading particularized facts supporting an inference that the demand board had made a decision that involved a breach of fiduciary duty. When a plaintiff made this difficult showing, Aronson’s intuition was that demand should be excused because it was difficult to presume credibly that a board could sue the interested parties to a transaction the demand board had approved. Aronson thus took into account both the reality of how difficult it is to sue a fellow director (structural bias) and that suing someone else over a decision that you also approved is at the very least exceedingly awkward and involves some degree of hypocrisy. Without addressing this rationale, and the difference between the contexts of Aronson and Rales, Zuckerberg eliminated the historical function of Aronson’s second prong as a safety valve.

3. The Conflicting Rationales of Zuckerberg and Cases Extending the Reach of MFW

The Zuckerberg opinions also create a stark contradiction with the inherent coercion rationale underlying what we call MFW creep. The Chancery decision took the view set forth in EZCORP that a transaction with a controller cannot be subject to business judgment rule review unless the full suite of MFW protections is used. For the abandoned transaction that Chancery focused on, that did not occur. As important, Chancery found that the pled facts supported an inference that a special committee member faced a disloyalty claim for engaging in friendly communications with Mr. Zuckerberg that helped him in his negotiations with the special committee. Furthermore, Chancery found that the pled facts suggested that the special committee was not assertive in responding to Mr. Zuckerberg’s proposal, and the resulting transaction they approved was not fair to Facebook. Thus, the Court of Chancery clearly found that the particularized facts supported an inference that Mr. Zuckerberg and one special committee member had breached their fiduciary duty of loyalty, and that the special committee had failed to assure fair terms. Thus, although EZCORP presumes that even a properly motivated and assertive special committee cannot effectively check a controller and invoke the business judgment rule, Zuckerberg takes the view that the same directors who approved the challenged transaction can make the more difficult decision to cause the company to sue the controller (and the special committee member alleged to have cast his lot with the controller).

We respectfully submit, however, that this approach to Aronson ignores the continuing utility of Aronson’s second prong as an integrity-enhancing safeguard. Properly applied, Aronson’s second prong allows a plaintiff to plead facts suggesting that, despite the presence of a majority of independent disinterested directors and the use of facially adequate procedures, there was a fiduciary breach resulting in harm to the company. This safety valve exists precisely because of the potential for structural bias where (contrary to the assumption underlying Rales) a majority of the demand board approved the business decision under attack in the derivative action. At the same time, by precluding claims, never presented to the board for consideration, when the plaintiff cannot meet either of its two tests, Aronson avoids burdening stockholders with the systemic costs of litigation and judicial second-guessing of matters on which elected directors, not courts, have the ultimate say.

4. The Effect of Abandoning Aronson’s Second Prong

In most conflict transaction cases, the independent directors fulfill the important role of acting as a proxy for third-party bargaining. If the well pled facts support an inference that they failed to fulfill that role, not because of conscious disloyalty but because they did not act with due care, then their actions should have no cleansing effect and entire fairness review should apply. That situation is the one the second prong was designed to address, giving effect to the intuition that even where a board majority is independent of an interested party, structural bias might make it difficult for the directors to sue a colleague. That intuition also accords with Delaware cases recognizing that it is easier to say no to a colleague on a conflicted transaction than to sue him.

The Delaware Supreme Court suggested in Zuckerberg that the well-reasoned decision by Chancellor Chandler in McPadden v. Sidhu was an outlier. We respectfully disagree: McPadden gave traditional and literal effect to Aronson’s second prong. In that case, the company had sold a subsidiary to an officer for $3 million. Two years later the officer sold the subsidiary for $25 million. The plaintiffs alleged that the independent directors had breached their fiduciary duties by failing to oversee a proper sale process, by allowing the officer himself to conduct the sale process despite knowing he was an interested bidder, and then approving the sale to him at the low end of the valuation range. Finding that the particularized pled facts supported a non-exculpated claim against the officer that his loyalty breach was facilitated by the other directors’ gross negligence, the court denied the motion to dismiss under Aronson’s second prong, but dismissed the independent directors against whom no non-exculpated claim was pled under Rule 12(b)(6), leaving the officer who faced a non-exculpated loyalty claim as the sole defendant.

Although the Delaware Supreme Court acknowledged in Zuckerberg that McPadden was “understandable . . . given the plain language of Aronson,” it did not follow that plain language. Instead, the court abandoned the McPadden approach, finding that the second prong of Aronson is not satisfied unless the plaintiff pleads facts showing that a majority of the directors face a non-exculpated claim. This implies that a special committee or independent board majority can impartially consider a demand to sue the controller over a transaction that the committee or board majority had approved in a grossly negligent manner. At the same time, however, the law as articulated in EZCORP and other recent Chancery decisions presumes that independent directors are not capable of standing up to a controller and acting as an effective countervailing negotiating and approval authority in a conflict transaction. The resulting conflict of views about the capability of independent directors leaves Delaware law taking the Kafkaesque position of allowing allegedly careless directors to block a lawsuit over a transaction that would otherwise be unfailingly subject to judicial review for substantive fairness.

5. Creating Incentives to Characterize Director Conduct as in Bad Faith

Another drawback of Zuckerberg’s elimination of Aronson’s second prong is that it pressures well-meaning trial judges to excuse demand by inferring that independent directors with no apparent motive to be disloyal consciously abetted overreaching by an interested party. A recent case In re CBS Corp. adopted that approach, holding that demand was excused because the members of the special committee who negotiated and approved the transaction, despite being independent from the controller, were subject to a claim of disloyalty because their efforts were considered ineffective and their acceptance of some of the controller’s demands that they had earlier rebuffed suggested conscious wrongdoing. Remarkably, this decision came soon after a decision refusing to dismiss a claim that the same transaction was unfair to the stockholders of the other party to the merger. In both decisions, the special committee defendants failed to win dismissal despite having qualified advisors, a lengthy process, and no apparent disloyal motive, because the merger—a zero sum transaction—was, as a matter of pled facts, so unfair to both companies (simultaneously) as to permit an inference that the special committee members were not just grossly ineffective, but also conscious facilitators of unfairness.

The incentives created under Zuckerberg’s new reading of Aronson to question the motives of independent directors in this fashion and subject them to claims of disloyalty are troublesome because that exposure to litigation and reputational damage would give any rational director reason to be cautious about serving on a special committee. It is one thing for a court to infer that a special committee without ties to a controller, and with qualified advisors, fell short of the mark in securing a fair transaction. It is quite another thing for the law to put the onus on the court to infer knowing complicity by the independent directors, just to ensure the interested party is held accountable. Under the traditional and literal reading of Aronson, this perverse incentive did not exist.

The better way to address the potential for meritless litigation and to restore coherence to doctrine is not to undermine the credibility-reinforcing role of Aronson’s second prong. Rather, the business judgment rule principles upon which Aronson rested should be reinvigorated to give appropriate effect to the traditional protective devices, and to then use the second prong to permit cases to proceed where a plaintiff can plead with particularity a non-exculpated claim against any defendant. That result would require acknowledging that McPadden was correctly decided but would not require doctrinal contortion: the court could simply add a fourth element to the three-part demand futility test it adopted in Zuckerberg, excusing demand where the well-pled facts indicate that a majority of the directors acted with gross negligence in approving a transaction with a controlling stockholder.

6. Accepting Zuckerberg’s Policy Choice Requires Rejecting the Resurgence of the Inherent Coercion Doctrine

Zuckerberg represents at bottom an important new policy choice of Delaware’s corporate common law and cannot be rationalized on the ground that the logic of Aronson’s second prong has somehow been undermined by developments since the case was decided. As we have shown, that is not so, and properly understood, Aronson’s second prong acts as a check on structural bias by recognizing the difficulty directors have in suing a colleague over a decision the same directors approved in the first place and requiring a judicial adjudication of a breach of fiduciary duty claim when the plaintiffs can meet a higher particularized pleading standard demonstrating a rational inference of an ultimate breach of duty causing harm to the company. This balance, requiring plaintiffs to make a stronger showing than required to survive a Rule 12(b)(6) motion, but then excusing demand so that a claim that meets that demanding pleading requirement can be decided by a court on its merits, rather than gated by the board that approved the very decision under challenge, is one that remains a rational way to ensure the integrity of Delaware corporate law, while not undermining the principle that in most situations the board determines whether a corporation brings a claim belonging to the corporation.

If Zuckerberg is to be justified as a stable doctrine, then it must rest on acceptance of the actual policy choice that underlies it, which is that if a majority of the directors who approved a transaction that particularized facts suggest was tainted by a breach of fiduciary duty do not themselves face a risk of monetary liability, they can impartially decide to cause the company to sue the interested parties who do face that risk. That is a policy decision that no change in intervening law requires to have been made and represents instead a belief that even when making the most difficult decision a director could make—to sue a fellow fiduciary over a transaction that the independent director approved in the first instance—Delaware law presumes impartiality.

Although we favor the balance struck by Aronson’s second prong, we recognize that Zuckerberg’s different policy choice is defensible given the multiple accountability forces that work to hold corporate boards faithful and independent directors in particular vigilant. But, if Zuckerberg’s policy direction is to be embraced, it must be embraced in a coherent manner. We have no doubt that it is much easier for a parent or friend to discourage a young adult from smoking a joint when that is illegal, or from drinking and driving before they engage in that behavior, than it would be to turn that young adult in to the police if they failed to heed the warning. And if the parent or friend condoned the behavior in the first instance, we think it even more doubtful that they could decide impartially to report the violation to the police.

Delaware law has previously recognized that for directors, it is therefore easier for them to act as a check on wrongdoing or overreaching in the first instance, and thus to say no to a self-dealing transaction as a member of the special committee if the terms are not fair, than it would be to sue a fellow fiduciary over a transaction after the fact, especially given that they had approved that transaction in the first place. For these reasons, if Zuckerberg is to form a durable part of a coherent body of corporate law, restricting Lynch’s inherent coercion concept, limiting the application of MFW to going private transactions, and permitting the use of any of the traditional protective provisions with fidelity to cleanse other interested transactions is necessary if the premises on which fiduciary duty law rests are to be consistent and rational. If independent directors who the particularized facts suggest approved an unfair transaction by ineffectively failing to check the interested party’s self-interest are presumed capable of impartially suing, then certainly independent directors advised by qualified advisors should be presumed capable of effectively negotiating for fair terms and their conduct should invoke the business judgment rule. If Zuckerberg signals the beginning of an alignment toward greater respect for the traditional protective measures and toward a confinement of MFW to its originally intended narrow function, then we view that development with more optimism. If, by contrast, Zuckerberg’s policy choice co-exists with MFW creep, then Delaware law will rest on contradictory assumptions about director conduct and will invite criticism for subjecting certain claims to tighter judicial review, while using a change in demand excusal law to render that review illusory in the important context of derivative claims.

E. Eliminating the Vestigial Waste Claim After Disinterested Stockholder Vote

Function Over Form noted that even an arm’s-length transaction approved by a fully independent board, or a conflict transaction approved by one of the traditional cleansing protections, cannot be sustained if it constitutes waste. This potential claim serves an important function where a transaction has not been approved, on full information, by the disinterested stockholders. Where only directors approve a transaction, the waste inquiry serves as a forensic device to ferret out possible covert disloyalty. If, despite approval of the transaction by independent directors, a plaintiff pleads facts supporting an inference that the transaction is so unfair to the corporation that its terms could not be approved as fair by a rational person, the case will go forward.

This safety valve has no logical role, however, where fully informed, disinterested stockholders have voted to approve the transaction. Where the parties with money at stake have made the assessment that the transaction is favorable to the corporation, how, our courts have long asked, can the transaction be considered waste? The logical answer supplied by Function Over Form was that it could not be, and several Chancery cases later concurred. It is now time to limit the waste safety valve to transactions that were not the subject of a vote by the disinterested stockholders.

F. Eliminating the Orwellian Doctrine of “Substantive Coercion”

Function Over Form argued that the parentalistic doctrine of substantive coercion should not be expanded into the electoral context by allowing directors to argue that the stockholders might hurt themselves if, on a fully informed basis, they disbelieved the incumbent boards’ view that it would be harmful to unseat them. Several years earlier, the Delaware Supreme Court had employed the doctrine of substantive coercion to justify the reasonableness of the Time board’s decision to revise a merger agreement so as to avoid a stockholder vote and push through a deal it preferred to a lucrative non-coercive tender offer that the market valued much higher. The Time board maintained that there was a danger that the stockholders would ignore the board’s belief that its preferred transaction, a merger with Warner, would offer more value in the long run than the huge premium offered by Paramount. Holding that the Time board’s fundamental reshaping of the transaction to avoid a stockholder vote was reasonable—despite it involving a much higher cost to Time and larger debt than the original form of the merger that required a stockholder vote—the court held that substantive coercion was a legitimate threat. Moreover, the court characterized substantive coercion as qualitatively different from the threat that the Paramount offer was inadequate.

That ruling was made in the context of dictum criticizing factually unrelated decisions of the Court of Chancery, in particular Interco, which held that a board could not use a poison pill to block a non-coercive tender offer indefinitely, but only for a period of time necessary to generate alternatives, bargain for a higher bid, and give stockholders information about the merits of the board’s position. In essence, Time-Warner used a non-pill case to hold that under Unocal a board could use a pill to preclude a non-coercive tender offer with a pill. In reality, that was a power allocation decision, cloaked in the guise of a pejorative description of the non-coercive offer as being “substantively coercive.”

As has been explained elsewhere, this use of substantive coercion was alien to the intentions of the academics who created it, and is confusing and unhelpful, for a host of reasons that need not be repeated here. In all stockholder votes, there is the potential that stockholders might make a mistake. Delaware law has historically, however, given weight to the decisions of those whose equity capital is at stake, so long as they were fully informed.

If Delaware law wishes to allow boards to take the decision about a non-coercive tender offer out of the hands of stockholders if a board reasonably believes the offer is too low, the Delaware Supreme Court should just say so, as the Court of Chancery suggested in this key footnote to its important Airgas decision:

Our law would be more credible if the Supreme Court acknowledged that its later rulings have modified Moran and have allowed a board acting in good faith (and with a reasonable basis for believing that a tender offer is inadequate) to remit the bidder to the election process as its only recourse. The tender offer [in this case] is in fact precluded and the only bypass is electing a new board. If that is the law, it would be best to be honest and abandon the pretense that preclusive action is per se unreasonable.

Allowing boards to block non-coercive bids may or not be wise, and we think Interco adopted the rule most respectful of Moran’s original promise that pills would be reviewed carefully for reasonableness in the heat of battle. But at the least, Delaware takeover law should candidly rely on the view that it is within the board’s authority to block a non-coercive bid, and not rest on a twisted misuse of the Orwellian concept of substantive coercion.

G. Amending Section 102(b)(7) to Exculpate Officers for Breaches of Duty

1. Origins of Section 102(b)(7) and the Unavailability of Officer Exculpation

After Van Gorkom and the controversy it caused, the Delaware General Assembly enacted § 102(b)(7), which authorized corporate certificate provisions eliminating director monetary liability for breach of the duty of care. Motivated by an ongoing crisis in the market for directors’ and officers’ liability insurance that Van Gorkom exacerbated, the Delaware General Assembly enacted § 102(b)(7) to counteract the prohibitive expense (and in some cases, unavailability) of traditional D&O insurance policies for corporate boards. Notably, the new legislation did not include corporate officers among those eligible for the liability exclusion authorized by § 102(b)(7).

The drafters of § 102(b)(7) explicitly considered whether to permit elimination of monetary liability for officers. Those favoring affording corporate officers the same protections as directors asserted that the drafters “might be perceived of doing too little” if they did not grant to officers the possibility of immunity, and that because officers and directors were treated similarly for purposes of liability there was no need “to draw a distinction between them.”

That position did not prevail, however. The majority of the drafting committee first contended that monetary liability for officers for breach of the duty of care would serve as a disciplining mechanism, encouraging them to bring difficult or troubling matters to the board for resolution. That majority also noted that “there was no pressing need for protection” of officers because jurisdiction over them could not be obtained in Delaware. At that time, Delaware’s long-arm statute (§ 3114) permitted jurisdiction over corporate directors, but not officers. Even recognizing that § 3114 could later be extended to officers, the drafters decided to study the matter further, but they never returned to address this concern.

This history suggests that if § 3114 had provided for jurisdiction over corporate officers in 1986, the question of whether to exculpate officers may have been resolved differently. In any event, nothing in the statute’s history suggests that the drafters excluded officers because they intended to expose them to vastly different liability to stockholder plaintiffs for transactions that the board approved.

2. Post-102(b)(7) Developments in Personal Jurisdiction of Officers

In 2004, eighteen years after § 102(b)(7) was enacted, the Delaware General Assembly amended § 3114 to provide personal jurisdiction over principal corporate officers, as some of the drafters had foreseen. The decision to extend jurisdiction to officers—thereby enabling them to be sued in derivative and class actions—was not inspired by concerns that the threat of monetary liability was necessary to motivate officers to exercise care. Rather, that decision was a response to high-salience developments in corporate governance that exposed a gap in addressing concerns about officer loyalty.

In response to scandals involving fraud within companies like Enron and WorldCom, the federal government and institutions including the New York Stock Exchange and the NASDAQ initiated a panoply of reforms designed to increase public confidence in the integrity of American corporations. These reforms, which included the Sarbanes-Oxley Act of 2002 and listing requirements for the major stock exchanges, caused many corporations to increase significantly the percentage of independent directors sitting on their boards, thereby reducing the presence of management directors in the boardroom.

Although these reforms and the heightened use of independent directors garnered widespread praise, the reduced presence of officer-directors created a “practical problem” for Delaware’s ability to hold top officers accountable for fiduciary disloyalty: because § 3114 only applied to corporate directors, Delaware courts lacked personal jurisdiction over key non-director officers, like those responsible for fraud in infamous scandals at companies such as Enron. The General Assembly reacted by amending § 3114 to grant jurisdiction over key officers even if they were not directors. That reaction arose not out of a concern that officers would fail to exercise care and needed to be held accountable, but in response to a national corporate crisis resulting from flagrant violations of the duty of loyalty by officers who might not otherwise be subject to Delaware jurisdiction.

3. Current Derivative and Class Action Litigation Against Officers

Not long after the amendment to § 3114, the Delaware Supreme Court recognized what the drafters of § 102(b)(7) had kept in mind a generation earlier: namely, that the fiduciary duties of corporate officers should generally be measured by the same principles as those applicable to corporate directors. Because of their exclusion from § 102(b)(7), however, corporate officers inhabit a very different litigation landscape than directors.

Because of the amendment to § 3114, stockholder plaintiffs now have an unhealthy and unfair incentive for stockholder plaintiffs to single out officers for due care claims. Because most public companies have boards with super-majorities of independent directors, plaintiffs are often unable to plead that a majority of the board has any self-interest in approving a suboptimal third-party transaction. With the independent directors therefore insulated from damages for a due care breach, plaintiffs have resorted to naming one or more non-director officers as defendants in suits challenging what was essentially a collective board decision. And because a care claim against an officer or two who lack protection under § 102(b)(7) will survive a motion to dismiss, and trigger discovery that will generate most of the same costs as if the other directors were being sued, the stratagem of suing officers provides significant settlement leverage.

This situation is not justifiable. The concern about fiduciary responsibility of officers, whether board members or not, has never been about due care, because officers have little incentive to be neglectful, certainly not at the gross level that Van Gorkom recognized as necessary to support liability. The realistic concern is about loyalty: fiduciaries whose livelihoods are tied to full-time employment at the corporation might be more susceptible to conflicts of interest when an opportunity attractive to stockholders (e.g., a strategic acquisition) could endanger their employment.

Although loyalty, not care, is the fundamental fiduciary concern, officers are being targeted with due care claims because plaintiffs cannot plead a loyalty claim against either them or the board. The unfairness of this strategy is accentuated by the realities that: (a) senior managers are subject to frequent replacement; (b) analyst and investor scrutiny has never been more intense; and (c) independent directors dominate most public boards, and private company managers typically are under pressure to perform and have no reason to lack diligence.

Nevertheless, due care claims targeting officers are the latest result of the shareholder plaintiffs’ bar’s efforts to develop litigation tactics that offer potentially lucrative fee awards in the M&A field, especially given the decline of multi-forum litigation and appraisal proceedings and rulings acknowledging that an informed, uncoerced stockholder vote implicates the business judgment rule and warrants dismissal at the pleading stage. One would think that such claims would be rare because independent boards are fulfilling the goals of advocates of an unfettered market for corporate control, by selling the company at a premium after appropriate market checks. But, because these claims are considered “direct” rather than derivative, no procedural obstacle to the plaintiffs’ ability to sue exists. If a plaintiff can state any viable claim against any defendant, the suit proceeds to expensive, time-consuming discovery, and gives the plaintiffs’ lawyers leverage to extract a settlement and its accompanying attorneys’ fee.

The duty of care claims asserted in these cases are highly problematic: plaintiffs accuse officer(s) or officer-director(s) of gross negligence in executing their responsibilities as an officer, most commonly because of their role in preparing the disclosures about the transaction in connection with the stockholder vote. In cases where the targeted officer is also a director but is charged with carrying out a transaction qua officer, different Chancery judges have arguably applied seemingly inconsistent standards to determine in which capacity the individual allegedly acted. Targeting non-director officers avoids that uncertainty, and is the most attractive strategy for plaintiffs because these officers cannot argue that they acted as directors and are therefore subject to exculpation. Either way, disclosure claims against officers (whether board members or not) have proven an effective way for plaintiffs to increase the settlement value of their lawsuits.

Several recent cases featuring due care claims against officers and officer-directors illustrate their perverse consequences:

  • Preserving vestigial care claims after loyalty claims are dismissed.

In City of Warren General Employees’ Retirement System v. Roche, the target company’s board and nearly all of its stockholders approved a merger with two private equity companies. The plaintiff sued only the CEO-President and executive chairman, two officer-directors, in their capacities as officers, but did not assert any claims against any of the other directors. The plaintiff alleged that those officers breached their duty of loyalty by (1) manipulating the board of directors to favor the buyout from the private equity firms, rather than an activist stockholder, in order to secure their own employment, and (2) producing a materially misleading proxy statement. The court concluded that the complaint failed to state a claim that the officer-directors violated their duty of loyalty. Nevertheless, the court determined that the plaintiff adequately pled a non-exculpable claim that the CEO-President breached his duty of care in preparing the proxy statement. As a result, only a single officer-director remained potentially liable, solely for lack of due care in his capacity as an officer. Even though the principal concern was that the officers had been disloyal during transactions—a concern that the court determined was not adequately pled—the plaintiff was able to extract significant settlement leverage because a non-exculpable care claim against one officer survived dismissal.

  • Inconsistent treatment of similar conduct.

In another recent case, officers remained in the suit due to their managerial positions, but defendants who played at least as important a role in the disputed merger were exculpated due to their status as directors. Plaintiff claimed that the directors and an officer of the target company violated their fiduciary duties by not seeking the highest price. The court granted summary judgment in favor of the non-officer defendants on that claim, determining that the company’s § 102(b)(7) charter provision exculpated nearly the entire board, but declined to dismiss the CEO-director and the CFO because of their officer status, even though some board members had similar or even greater levels of involvement as the officer defendants. One non-officer board member fielded, organized, and reported on the initial calls about the potential merger, served as the point of contact with the acquiror’s CEO, spoke with competing bidders, and even attended meetings alone with the CEO-director and the acquiror’s CEO to discuss the final transaction. Because that director was not an officer, however, he was exculpated, while the CEO and CFO, who participated at a similar level, were not.

  • Adding claims against officers to prolong tenuous litigation.

In Cirillo Family Trust v. Moezinia, the court granted summary judgment dismissing a disclosure claim because the plaintiff could not establish that any director had breached their duty of loyalty, and a § 102(b)(7) provision precluded liability for any breach of the duty of care. To keep the suit alive, the plaintiff moved for leave to assert a care claim against two officer-directors. Although the court perceived this new claim as dubious, it allowed the amendment because § 102(b)(7) did not apply to the officer-defendants in their capacities as officers, and the complaint therefore “identified a theoretical path to recovery through a due care claim.” Merely by tacking on an additional claim with a low likelihood of recovery, the plaintiff was able to prolong the litigation and gain leverage to extract a settlement.

4. The Remedy: Amend Section 102(b)(7)

These developments cry out for a solution. Permitting stockholder plaintiffs to claim that officers have lapsed in their use of care over a proxy statement drives up litigation and insurance costs for companies and their stockholders, with little or no compensating benefit. The wave of officer-focused due care claims raises another fundamental concern. A core function of the board of directors is policing the care of its officers. The recent proliferation of due care claims against officers and officer-directors subverts this function by wresting this key managerial prerogative from the board. Particularly where such claims are direct and do not require the plaintiff to make a demand on the board or plead demand excusal, plaintiffs can bypass Rule 23.1’s “stringent requirements of factual particularity” to demonstrate demand excusal.

When an independent board majority protected against due care liability approves a transaction or decision and no loyalty claim stands against any defendant, any damages case should be dismissed. The disparity of § 102(b)(7)’s coverage, however, has forced the courts to treat directors and officers differently for conduct devoid of loyalty concerns. This anomaly should be remedied by amending § 102(b)(7) to provide an option for stockholders to adopt a charter provision exculpating officers for non-loyalty claims, except for claims brought by the company itself. That amendment would be consistent with the legislative intent of § 102(b)(7), and most notably, the drafters’ desire to maintain some liability for officers as a disciplining and information-forcing mechanism for boards.

Amending § 102(b)(7) in this manner would not, in itself, exculpate anyone. It would merely authorize private action, leaving the stockholders to decide whether to adopt or buy into a charter amendment exculpating officers. Stockholders have demonstrated that they can and do resist governance rules that they consider inappropriate. The market-oriented solution we propose would enable stockholders to determine whether it is optimal to allow derivative and class action plaintiffs to bring due care claims against officers.

H. Addressing the Dysfunctional State of Practice Under Section 220

Function Over Form advanced the core claim that the law’s failure to adjust adroitly to new commercial circumstances can lead to inefficiency and unjustifiable costs to our corporate governance system. That is true for statutes as well as case law, and in the past two decades, one form of statutory action has become quite salient and problematic, both in terms of its costs for litigants and for the Court of Chancery itself: actions seeking books and records under § 220.

For stockholder-plaintiffs, § 220 actions have come to resemble trench warfare rather than the summary proceeding the statute contemplates. Extending the metaphor, plaintiffs have been conscripted into battle: the Delaware Supreme Court has admonished plaintiffs to use the “tools at hand” provided by § 220 before bringing a derivative action in which they must plead facts supporting an inference that a breach of fiduciary duty has been committed.

But heeding this advice, plaintiffs have too often met “overly aggressive” responses from corporate defendants, including arguments having no plausible grounding in the statute or precedent under it. In one high-profile case, for example, the plaintiff got the books and records that the Delaware courts found it was entitled to receive, but by that time a derivative suit brought in the company’s hometown that relied solely on publicly available records had been dismissed for failure to plead demand excusal. That judgment—in a forum that most plaintiffs would have never used and that was entered against a plaintiff who did not seek books and records—was then held to preclude the plaintiff who followed the Delaware courts’ “tools at hand” admonition from having its better pleaded claim examined on the merits. This anomalous result creates poor incentives, by advantaging plaintiffs who rush into court without adequate due diligence over those who heed the Delaware courts’ admonition to use § 220 to develop a complaint resistant to dismissal.

Corporations and their investors have also suffered from a new wave of § 220 demands and actions against companies whose boards have entered into an agreement to sell the company at a premium. Stockholders file “placeholder” demands and suits in advance of the deal closing, for the ostensible purpose of policing the deal for fidelity with fiduciary duty. To justify this stratagem in advance of pending public company merger votes, where documents like proxy statements and 13e-3 materials are available, plaintiffs have invoked the Delaware Supreme Court’s admonition to use § 220 in the very different context of derivative suits, where typically few if any public documents are available for plaintiffs to use but particularized facts must be pled to support demand excusal. At times, the Court of Chancery has cited the tools at hand doctrine in the public company merger context, without examining how different it is from the derivative suit context in which the admonition originated.

Seeking to avoid the effect of longstanding Delaware case law that an informed stockholder vote on a third-party transaction invokes business judgment review and enables pleading stage dismissal in cases involving third-party mergers, the plaintiffs’ bar claims to need books and records to plead a claim that the merger proxy was materially misleading. To that end, a new practice emerged: instead of a plenary action being filed in every deal case, companies doing third-party sales transactions now often face multiple demands for books and records.

This practice is problematic for several reasons. First, these cases seek to support pleading what we describe as a “non-Revlon Revlon claim,” even where, unlike in Revlon itself, target boards have employed active market checks and did not erect defenses to any higher bid. Second, the publicly available information on which to base a direct claim is more robust than ever, due to the interaction between Delaware corporate case law and SEC proxy disclosure rules requiring disclosure of management projections, banker’s analyses, and deal protections. In conflict transactions, moreover, Rule 13e-3 requires disclosure of board books and minutes, giving potential plaintiffs even more pleading fodder. Also, other market players supply information useful to plaintiffs. Because sale transactions are salient to institutional investors, analysts and proxy advisors produce reports and recommendations on every deal, encouraging boards to fulfill their fiduciary responsibilities and better enabling stockholders to decide how to vote and whether to sue.

Third, the wave of merger-related § 220 cases creates the oddity that once the challenged merger occurs the plaintiff typically no longer owns shares in the company from which books and records are being sought. Plaintiff therefore must rely on its prior status as a stockholder of a corporation that may no longer exist.

Finally, reliance on § 220 has burgeoned at a time when informal intra-corporate communications and discussions that in prior generations would likely have been conducted in person or by phone without a record, are, like all communications now, more likely to involve emails and texts. This phenomenon exponentially increases the potential grist for the § 220 mill, including more informal and less guarded communications which are of natural interest to plaintiffs’ lawyers and of course legitimately discoverable if a plenary complaint survives dismissal. Despite offering some benefits for plaintiffs, these changes in corporate communications impose staggering costs on both sides of the litigation.

Understandably, plaintiffs would want statutory “books and records” to include all documents that would be discoverable in a plenary action. But that inclusion is inconsistent with the important, yet discrete, function of § 220. The statutory term “books and records” has never been understood to encompass every piece of paper touching on corporate conduct. Rather, that term describes the formal documents that a corporation uses to document important action, such as the minutes of board meetings, resolutions, and contracts. Merely touching on a corporate decision does not make a document a “book” or “record” within the intended meaning of § 220. For some time, case law has admonished that the scope of inspection must be guided by a standard of precision and limited to core materials necessary to satisfy the stockholder’s proper purpose. That scope is far narrower than would be available in discovery after a plaintiff pleads a viable claim.

Unfortunately, practical reality predominates over legal correctness. Companies facing the potential costs of searching for and producing documents, before a complaint has survived a motion to dismiss, find it economically more rational to pay attorneys’ fees to cause a meritless issue to go away rather than expend millions of dollars responding to the § 220 demand or action. This creates countervailing incentives that are equally unproductive: respondent companies that choose not to settle or face a non-settling § 220 demander have sometimes put up a stone wall and made plaintiffs fight for every document. This problem is particularly acute in the case of companies that have not conducted their affairs with typical formality, and therefore have no meeting minutes, management reports, or advisor presentations that are responsive to a legitimate § 220 demand. Such companies have made “sky is falling” arguments when faced with a demand to produce the only records they have—emails and texts. These “sky is falling” arguments are regrettably made credible by the propensity of many § 220 petitioners to seek these informal documents even where traditional formal records are available and have already been produced. This tug and pull of the most unreasonable has exposed companies that do keep adequate formal books and records to the increased risk that the Court of Chancery will require them to produce information akin to a full discovery response in a plenary action. In this way, the entire § 220 regime has become skewed and disserves both plaintiffs and companies in ways one cannot imagine was ever intended.

The current reality thus has the virtue of pleasing no one. For the diversified investors of Delaware companies, it creates more costs than benefits. One possible solution might have been to apply the standing rules that govern derivative actions, by denying standing to § 220 plaintiffs who cease to be stockholders. A relatively obscure line of cases, however, has held that former stockholders have standing to seek books and records from their former corporation so long as the reason for doing so related to the period when they were stockholders and they had a recognized proper purpose.

In the first such case, stockholders of record made a § 220 demand but later lost that status as a result of a merger in which some of the Class A stockholders, including the plaintiffs, were cashed out, and the rest (those affiliated with the board) continued as stockholders. The merger was approved by written consent of the stockholders who would continue after the merger. Only after the merger was consummated were the plaintiffs in the § 220 action informed that they would lose their shares. The company argued that the plaintiffs had no standing to seek books and records after the merger closed. The court held, however, that whether or not the merger was valid, the plaintiffs had standing because they had sought books and records while still stockholders, and § 220 does not contain a continuous ownership requirement like that imposed by § 327 in derivative suits.

The court adopted this interpretation of standing ten years later, in a case where the plaintiff lost its stockholder status in a merger occurring after the rights offering that the plaintiff sought to investigate under § 220. The corporation argued that the merger deprived the plaintiff of standing, but the court disagreed, holding that the plaintiff “established that it was a stockholder at the time of its demand and therefore has standing to maintain this action.”

Another ten years later, after Corwin reaffirmed the traditional principle that an informed stockholder vote invokes the business judgment rule, plaintiffs’ lawyers seized upon the two standing cases by routinely submitting § 220 demands before a deal closed—not to stop the deal, but in search of a basis to plead in a post-closing damages action that the vote was not informed. Despite the distinct context in Cutlip, which involved a non-public corporation not subject to SEC disclosure requirements, the Court of Chancery has continued to rule that if a stockholder made a pre-closing demand and filed its § 220 action before the merger, it had standing to maintain a post-merger § 220 suit.

The upshot is that virtually every publicly held Delaware corporation announcing an M&A transaction now faces demands under § 220, in addition to its duty to present the materials required by the SEC and Delaware law in connection with the stockholder vote. Companies often receive multiple § 220 demands and placeholder § 220 suits by plaintiffs who do nothing to seek injunctive relief to stop the deal or to rally other stockholders to vote against it. These suits proceed on the expectation that the deal will close, and the plaintiffs will be allowed to prospect for a post-closing claim. The unbroken line of case law and the absence in § 220 of a continuous ownership requirement akin to that contained in § 327 make it unlikely that this new wave of rent-seeking can be remedied by a judicial decision holding that a plaintiff that is no longer a stockholder of the corporation from which it seeks books and records loses its standing to invoke § 220.

For these reasons, then, any solution must come from the Delaware General Assembly, acting upon the recommendation of the Delaware State Bar Association’s Corporation Law Section Council. To address the problems in the current operation of § 220, the General Assembly might take more measured action that addresses legitimate concerns of each side of the “v.” To address “overly aggressive” defenses, § 220 could be amended to give a stockholder that is not a competitor of the corporation and is willing to enter into a confidentiality agreement the presumptive right to receive specified materials, such as board and committee minutes, resolutions, manager and advisor presentations, and corporate contracts, without having to identify a particular purpose. To assure a fair balance, § 220 could be amended to create a presumption that materials outside that scope are not essential and need not be produced.

This proposed balance would reduce unreasonable obstruction of § 220 demands yet address companies’ legitimate concern that § 220 is being used as a form of full-blown discovery by plaintiffs who never filed a viable plenary complaint. It would also encourage good corporate documentation practices, because a failure to act with traditional formality in documenting important corporate actions would overcome the presumption and allow plaintiffs to receive materials like texts and informal emails because the statutorily prescribed records are either inadequate or nonexistent. This balance would also more efficiently enable the Delaware courts to satisfy legitimate plaintiffs’ needs without subjecting companies to undue expense and overreach.

To deal with the situation where mergers result in termination of stockholder status, the General Assembly could adopt legislation modeled on the sound reasoning in Polygon Global Opportunities Master Fund v. West Corp. There, an arbitrage fund sought books and records under § 220 in aid of seeking appraisal, and bringing a derivative and direct suit, but the court denied inspection under § 220. Even though valuing shares to determine whether to seek appraisal has traditionally been considered a proper purpose for inspection, the court held that the fund could obtain all “necessary and essential” information for the purpose of valuing its stock from public filings:

Polygon seeks additional information beyond that in West Corp.’s public filings in order to value its stock to determine whether or not to seek appraisal, yet it has not shown that the information publicly available in connection with the transaction omits information that is necessary, essential and sufficient for its purpose. There is a dichotomy in § 220 cases between publicly traded companies and closely held companies. With regard to the former, public SEC filings typically provide significant amounts of information about a company, and decisions granting § 220 demands are narrowly tailored to address specific needs, often in response to allegations of wrongdoing. In contrast, stockholders in non-publicly traded companies do not have the wealth of information provided in SEC filings and are often accorded broader relief in § 220 actions.

In the case of a going private transaction governed by Rule 13e-3, the amount of information made publicly available is even more comprehensive than that required in standard SEC periodic filings. Through its preliminary and final proxy materials, and its Schedule 13E-3, and amendments, West Corp. would appear to have disclosed all material information necessary for Polygon to determine whether or not to seek appraisal. This is not to say that there is a per se rule that the disclosure requirements under Rule 13e-3 are coextensive with the “necessary, essential and sufficient” information standard under § 220 demands for valuing stock in the case of a minority squeeze-out merger. Nevertheless, in the present case, the detail and scope of West Corp.’s disclosures makes this so.

Rejecting the fund’s argument that it should “be given access to the same information it would receive through discovery in an appraisal action,” the court determined that § 220 relief is categorically different from discovery in a plenary action, including an appraisal case. Permitting the fund to obtain “additional information beyond the comprehensive disclosure already in the public domain simply because it could receive such information in a later appraisal action would be putting the cart before the horse.”

Amending § 220 in accordance with this reasoning would generally preclude inspection of a public company’s books and records by a person no longer a stockholder. The SEC and Delaware common law have combined to require substantial disclosures if a company seeks stockholder approval of a merger. To entitle stockholders to demand books and records in aid of showing that those disclosures are somehow incomplete or misleading displaces a well-thought-out disclosure regime with a plenary discovery cacophony. That said, the amendment could allow a former stockholder to maintain a § 220 action, if the stockholder seeks to challenge the merger in which she gave up her shares, voted all her shares no, did not sell into the merger, and owned shares before the merger was announced. In that event, however, the plaintiff would only be entitled to the information required by Rule 13e-3 in conflict transactions to the extent it is in the company’s possession. If such information were already publicly available, the case would be dismissed. By this means, Delaware stockholders would have the chance in all mergers on which a vote is required to seek the same books and records as Rule 13e-3 requires, even if the merger is not one involving a conflict transaction to which that rule applies.

Another potential legislative fix would address the issue of companies being whipsawed by multiple § 220 demands. Amending § 220 to allow a company to consolidate all demands and require coordination, so that it has to produce only one consistent data set in response to related demands, would reduce costs of responding to demands often rooted more in jockeying within the plaintiffs’ bar for positioning in a future plenary action.

By these measured and balanced changes, § 220 would better serve its purpose of facilitating prompt production of core books and records to stockholders, while reducing the rent-seeking and cost pressures now imposed on companies by overuse of § 220 in cases where already public information should presumptively suffice.

V. Conclusion

In this article we have identified ways to make standards of review more functional, and to make Delaware’s excellent corporate law in discrete and unrelated areas even more fair and efficient. We do this in a constructive spirit, and with profound respect and admiration for the skill, timeliness, and common sense Delaware’s hard-working Judiciary brings to bear on the resolution of difficult corporate law cases. Our goal is simply to suggest in good faith some measured steps to make the world’s best corporate law fulfill its important role even more effectively. To summarize, our major recommendations are:

  1. Restrict the Lynch inherent coercion doctrine and the bespoke MFW solution to it to the domain of going private mergers and tender offers with controlling stockholders or mergers with another company that the controller also controls. This will reduce the unhelpful pressures by plaintiffs to characterize as “controlling stockholders” defendants who have far less than majority ownership and unaffiliated defendants as a “situational control bloc.” Interested transactions would be treated symmetrically and not receive starkly different treatment simply because of the characterization of the interested party defendants.
  2. For other self-dealing transactions within the meaning of § 144, restore symmetry among interested transactions by reaffirming, per traditional Delaware equity law, that any of the traditional cleansing protections invokes business judgment review if used with integrity.
  3. Require plaintiffs challenging so-called “non-ratable benefits” to fiduciaries to prove that the non-ratable benefit resulted from a breach of fiduciary duty of loyalty and caused specific damage to the company and other stockholders. If the non-ratable benefit was approved by one of the traditional cleansing protections, the business judgment rule should apply.
  4. Apply the second prong of Aronson to provide for demand excusal when the particularized pled facts support an inference of a non-exculpated breach of duty by any director—thereby preserving Aronson’s important integrity-reinforcing role in Delaware law. In any event, harmonize the deference to decisions by independent directors by according them at least the same level of respect in the less difficult realm of policing transactions up front as in determining whether to sue after the fact.
  5. Remove old encrustations on Delaware law that make it unclear and do not add value:
    1. Eliminate the waste vestige qualifying the effect of an informed, disinterested stockholder vote.
    2. Formally overrule Cede II’s effort to impose and link layers of standards of review applicable in disparate contexts.
    3. End Delaware takeover law’s reliance on the concept of substantive coercion and hold that Unocal permits a board acting in the reasonable, good faith belief that a tender offer is too low to use a pill to block the bid, based on power allocation grounds and not on the premise that stockholders might harm themselves by ignoring the board’s contrary view of value.
  6. Amend § 102(b)(7) to allow stockholders to adopt corporate charters exculpating officers for breaches of the duty of care claims brought by way of a class or representative action, but not for claims brought directly by the company itself under a contract or corporate common law.
  7. Restore balance to the litigation process by amending § 220 to require prompt production of core books and records but preclude burdening companies and investors with what amounts to free ranging and expensive pre-filing discovery, especially where federal and state law already provide stockholders with a required and detailed information base on which to base a vote on, or challenge to, a transaction.

We are mindful how difficult it is for courts to address high-stakes corporate cases under extreme time pressure, and with dueling arguments from some of the most persuasive advocates in the nation. Shaping the common law of corporations inevitably involves policy judgments about the comparative value of investing greater trust in impartial decision-making by directors and stockholders, as opposed to allowing for more intensive judicial review. There is no cost-free approach, and trade-offs are unavoidable.

But we continue to believe that the traditional Delaware approach of encouraging impartial decision-making but providing companies with flexible means to effect transactions and conduct their business remains the optimal one. Diverting from that philosophical commitment to facilitate judicial review of the substance of more and more transactions, especially given the vibrancy of stockholder voice, market information flows, press scrutiny, and tied voting policies that make independent directors highly responsive to stockholder sentiment, creates more costs than benefits. Under the standards we have proposed, stockholders have a fair and effective chance to litigate if they can faithfully allege that a fiduciary breach has caused real harm. And simplifying and clarifying Delaware doctrine will enhance the ability of Delaware’s hard-working and expert courts to do equity that makes not just case-specific, but also systemic, sense.

The authors are grateful for the incisive comments of Mark Gentile, Lou Kling, Bill Lafferty, Ryan McLeod, Ted Mirvis, Trevor Norwitz, Eileen Nugent, Kevin Shannon, Greg Williams, and John Mark Zeberkiewicz, and the help of Corey Banks, Michael Klain, Stephen Mattes, Peggy Pfeiffer, Daria Rose, Jarett Rovner, and Lorenzo Villegas.

Firms with which the authors have been affiliated have been involved in some of the cases discussed, which have arisen over a long period in Delaware law, and two of the authors also were involved in several of the cases when they were members of the Delaware Judiciary. Nevertheless, the views of the authors are theirs alone, and not that of any firm or other organization with which they are or have been affiliated.