The Delaware Supreme Court addressed the scope of entire fairness review again, this time outside of the controller buyout context, in its 1997 decision Kahn v. Tremont Corp. Tremont involved a related-party transaction between a corporation and a blockholder owning 44.4 percent of its outstanding stock. In the transaction, the blockholder sold to the corporation shares of a third entity under common control with the blockholder. Consistent with at least one other post-Weinberger Supreme Court ruling, the Delaware Supreme Court confirmed the Court of Chancery’s extension of the entire fairness review to this type of self-interested controller transaction outside the controller buyout context. As the Delaware Supreme Court explained, “[o]rdinarily, in a challenged transaction involving self-dealing by a controlling shareholder, the substantive legal standard is that of entire fairness, with the burden of persuasion resting upon the defendants.” While the Delaware Supreme Court ultimately concluded in Tremont that a special committee “did not operate in an independent or informed manner” and reversed the burden shift afforded by the trial court on the basis of the committee’s involvement, the Supreme Court explained that “[e]ntire fairness remains applicable even when an independent committee is utilized because the underlying factors which raise the specter of impropriety can never be completely eradicated and still require careful judicial scrutiny.”
In the years between Tremont and Match, several Delaware Supreme Court opinions applied the entire fairness standard to non-buyout transactions with conflicted controlling stockholders, referencing the effect of an independent committee or disinterested stockholder approval as a burden shift within this standard of review. But in these cases, the applicable standard of review was not necessarily litigated by the parties or directly raised before the Delaware Supreme Court. This led to continued suggestions, in some Court of Chancery cases, that controller transactions outside of the buyout context received the protections of the business judgment rule if negotiated and approved by an independent board or committee.
In EZCORP, the Court of Chancery conducted a thorough analysis of this conflicting precedent to hold “that the weight of authority calls for” a broad application of the entire fairness framework extending to “any transaction between a controller and the controlled corporation in which the controller receives a non-ratable benefit.” The Court explained in EZCORP the rationale for extending the entire fairness framework to controller transactions outside of the buyout context based on the “threat of implicit coercion” faced by directors of controlled companies. Moreover, EZCORP suggested that such transactions may only receive the protections of the business judgment rule through use of the MFW framework. This approach was widely accepted by the Court of Chancery in numerous other cases, with this broad view of entire fairness review under Kahn v. Lynch applied to an array of different corporate transactions.
Still, this view was not shared by all, including former members of the Delaware Supreme Court and at least one esteemed Delaware law scholar who disagreed with this broad application of entire fairness review. Match finally put an end to this debate, adopting EZCORP’s interpretation of Delaware entire fairness jurisprudence at it relates to “self-dealing [transactions] when a controlling stockholder stands on both sides of a transaction and receives a non-ratable benefit.” As the Supreme Court confirmed in Match, these transactions can only implicate a lesser standard of review if “the defendants can satisfy all of MFW’s requirements to change the standard of review to business judgment.”
B. The Inefficiencies of Entire Fairness Review
Where a challenged transaction implicates entire fairness review, the defendants initially bear the burden of proving that the transaction was “entirely fair.” Because of the factual nature of this inquiry, the application of entire fairness review, in and of itself, “typically precludes dismissal of a complaint” on a motion to dismiss. Many claims challenging controller transactions are therefore capable of proceeding to trial in the absence of a settlement. These types of claims may take several years to defend up through trial at significant cost. The Court of Chancery recently estimated the costs of defending an entire fairness case through trial “conservatively at figures between $10 million and $30 million depending on the number of defendants and firms involved, the hourly rates of the defense lawyers, and the cost of the experts.”
But for many entire fairness claims, the expected recovery does not justify anywhere near this level of cost. Corporations often begin to incur these costs quite rapidly, even before derivative litigation is filed. In recent years, these costs have been amplified by the growing scope of books and records that the Delaware courts have ordered corporations to produce pursuant to Section 220 of the DGCL. This has led to stockholders frequently seeking the production of emails, text messages, and other electronic messages as part of Section 220 demands. Before any complaint is filed, negotiating narrowed scopes for overbroad Section 220 demands, and producing documents in response to them, can alone cost millions. By contrast, plaintiffs are often able to prepare complaints challenging controller transactions capable of withstanding a motion to dismiss at relatively little cost.
Upon the filing of derivative litigation, corporations continue to bear an outsized portion of the litigation’s costs. At this stage, corporations may face significant additional costs, including the advancement of legal fees and expenses incurred by defendant directors and officers. Advancement costs can be significant from the start of litigation, particularly if various defendants represented by different counsel intend to file separate motions to dismiss. In comparison, motions to dismiss may also be less costly for stockholder-plaintiffs, as they are often capable of opposing them with a single brief. After the dismissal stage, and given the fact-intensive nature of entire fairness review, corporations and their directors and officers receive and must respond to expansive discovery requests. In comparison, stockholder-plaintiffs face relatively limited discovery burdens in derivative actions, as they are unlikely to themselves have significant documents to collect, review, and produce.
The uneven allocation of these burdens is ripe for exploitation, given the agency problems inherent in stockholder prosecution of derivative litigation. While stockholder management of derivative claims solves one agency problem when a board lacks independent decision-makers capable of impartially assessing the claims, it poses the risk of others recognized in a “mountain of academic literature” examining the incentive structures of representative litigation. Unlike a board or committee focused on the corporation’s bottom line, entrepreneurial counsel bringing derivative litigation face compensation structures that generally incentivize the pursuit of claims without regard to their costs on the corporation on whose behalf the claims are brought. Even if this misalignment of interests does not knowingly affect the prosecution of derivative litigation, together with hindsight bias, confirmation bias, and other biases and agency problems, it may present a considerable risk of suboptimal decision-making. Suboptimal decisions can include the commencement of opportunistic derivative litigation, including suits asserting derivative claims with little or marginal value. This is especially true for derivative challenges to controlling stockholder transactions, as even those with little to no merit can, and often do, have millions in settlement value. This, in turn, has made transactions between public corporations and their controlling holders the focus of many in the plaintiffs’ bar. For many public corporations, it is now the default expectation that a transaction between the corporation and its controlling stockholder will be challenged as a breach of fiduciary duty irrespective of its terms.
With the prevalence of entire fairness challenges and the escalating costs to defend those challenges, corporations and controllers now regularly face what some have characterized as an entire fairness “tax” attributable to the litigation costs and risks often associated with related-party transactions. In addition to litigation costs, the regularity of related-party transaction challenges imposes an array of indirect costs on public corporations. This trend, for example, has likely contributed to the extraordinary rise in directors’ and officers’ insurance costs in recent years. And the tax of entire fairness likely dissuades some interested parties from pursuing mutually beneficial transactions that would otherwise generate positive value for corporations and all of their stockholders. Even where the potential costs of entire fairness review do not dissuade a controller, they may result in the controller requiring a greater return in exchange for bearing them—a prospective cost of entire fairness review that comes at the expense of the same minority stockholders the standard is intended to protect.
Where claims proceed to trial, the stringent entire fairness standard designed for end-stage transactions may be an imperfect standard of review for other types of corporate transactions. For example, while the standard’s “fair price” prong sensibly applies to controller buyouts, it may be an imprecise tool for reviewing certain charter amendments and other matters that do not, at their core, involve an exchange of tangible economic value. Similarly, the entire fairness standard’s “fair process” component, which has been found to require “adversarial negotiations” between a board and controller, is well suited for reviewing the end-stage, zero-sum negotiation over value in controller buyouts. But as the Delaware courts have recognized in other contexts, the path to value maximization is not always amenable to such a one-size-fits-all approach. A “substantial body of contract law scholarship” recognizes that an overly adversarial negotiating posture may erode goodwill and be suboptimal in negotiations among “repeat players” with ongoing relationships, including negotiations between corporations and their executives. While this has been rejected as a basis for deviating from the type of adversarial negotiations that are traditionally looked for under entire fairness review, in doing so, “[t]he court [has] recognize[d] that negotiations over CEO compensation give rise to strange dynamics because the parties need to work collaboratively after the negotiations have ceased,” which “is true in many negotiations and in virtually every salary negotiation.” In certain circumstances, engaging in hard-nosed negotiations to meet the scrutiny of entire fairness could risk straining critical relationships and other future adverse consequences, even if this approach yields superior results in the short term. In any event, situations implicating more dynamic interests than the “zero-sum game” and distributive negotiations of controller buy-outs may be particularly susceptible to diverging views on a transaction’s “fairness.”
The burdens of entire fairness review have been exacerbated by the increasing frequency with which non-majority stockholders have been found, after trial or for purposes of the pleading stage, to constitute a controller or control group. “Under Delaware law, it was historically difficult to establish that a stockholder having less than majority ownership was a controlling stockholder.” Recently, Delaware cases have largely trended in a different direction, and in one instance, a less than 22 percent stockholder (albeit one with the influence of Elon Musk) has now been found, after trial, to constitute a controlling stockholder. Outside of the context of judicial rulings, one member of the Court of Chancery has personally expressed support for applying a presumption of control to 20 percent stockholders. Other cases illustrate that questions may arise as to when multiple stockholders constitute a control group. Recent controlling stockholder and control group jurisprudence has considerably expanded the universe of public companies and potential controlling holders that could, at least at the pleading stage, be subject to the burdens and costs of entire fairness review. Even if a relatively small blockholder would not ultimately be found to constitute a controller, at this stage, real costs can arise from mere allegations of control given the entire fairness standard’s uneven leverage that often encourages settlement before significant defense costs are incurred.
II. The Limitations of Delaware’s Existing Safeguards
Corporations and fiduciaries facing entire fairness claims are not entirely devoid of safeguards, particularly with respect to derivative entire fairness challenges outside of the controller buyout context. These safeguards, however, offer imperfect solutions that do not fully address the problems presented by the modern entire fairness paradigm.
A. The MFW Framework
The MFW framework was adopted to provide a path for controlling stockholders to avoid the burdens and costs of entire fairness review and the opportunistic controller buyout challenges that emerged following Kahn v. Lynch. While MFW also supplies a path for avoiding entire fairness review of other transactions implicating unique interests of controllers, the MFW framework has shown that it is often not a practical solution and, at times, may not even be feasible.
For many public companies, especially those with smaller market capitalizations, it may be almost impossible to obtain a majority-of-the-minority vote regardless of a transaction’s merits. Following the emergence of retail trading platforms, many public companies are owned by a growing concentration of retail holders prone to “rational apathy” with a “traditionally . . . poor record of attending and voting at meetings.” This trend has coincided with several brokerage firms’ adoption of policies of declining to exercise discretionary authority over shares held in “street name,” as well as changes that have “significantly narrowed” “the ability of brokers to exercise discretionary voting . . . in recent years.” These developments have created such a problem that “many public corporations have encountered significant difficulty in securing various stockholder votes and, in particular, a vote necessary to effect a reverse stock split to help a corporation maintain the minimum share price amount necessary to be listed on a national securities exchange,” that is “often attributable not to the merits of the proposal,” as “few stockholders, it would seem, would support a de-listing that would assuredly diminish the liquidity of the stock.” This problem has even been recognized by the Delaware General Assembly. In 2023, the General Assembly adopted amendments to Section 242 of the DGCL that addressed this problem by reducing the default stockholder vote required to authorize charter amendments changing the authorized number of shares of a class of stock or reclassifying a class of stock to effect a reverse stock split in specified circumstances. Public companies experiencing this phenomenon frequently have no way of escaping entire fairness review of non-ratable controller transactions. These are, unfortunately, the same public companies most likely to lack the funds required to defend an entire fairness lawsuit (and advance the defense costs of its director and officer defendants) through trial.
Even where a company’s stockholder base leaves open the possibility of obtaining a majority-of-the-minority vote, the imposition of this condition can add considerable deal risk and uncertainty. As has been widely recognized, an agreement to follow the MFW framework may present considerable leverage to those with a relatively small stake, which could invite resistance from activists and arbitrageurs buying into a target’s stock in an attempt to extract hold-up value. For transactions not otherwise requiring a stockholder vote, seeking majority-of-the-minority approval adds timing delays and costs associated with soliciting minority stockholder approval, including proxy solicitation costs and, where a special meeting is needed, the costs of holding an additional stockholder meeting.
The timing delays associated with seeking a majority-of-the-minority vote may be especially problematic in the types of dire financial situations in which transactions with controllers, such as controller-led rescue financings, are most valuable. Committing to the MFW framework also comes at the cost of some degree of flexibility. The flexibility lost by committing to the MFW framework may again be most critical in desperate times when a transaction is needed to ensure corporate survival and rational apathy among stockholders may be highest. And even if the receipt of a majority-of-the-minority vote is feasible in these circumstances, controllers attempting to preserve value for all could still face arguments that “situational coercive factors” render MFW unavailable.
Other practical difficulties may arise from MFW’s “ab initio” requirement. Unlike the negotiation of controller buyouts, which often begin upon an initial overture made by a controlling stockholder, negotiations over other transactions may have a more organic beginning. Transactions emerging from day-to-day discourse in the ordinary course of business may be prone to some high-level discussion of potential financial terms between business principals not well versed in MFW’s requirements before lawyers become involved. At the outset of a process to consider a potential transaction with a controlling stockholder, the existence of even minimal prior discussions can call into question MFW’s application and undermine the primary incentive of following its framework.
Uncertainty can also arise at the beginning of a process with respect to which stockholders constitute part of the minority for purposes of obtaining MFW’s majority-of-the-minority approval. This question has arisen with greater frequency in recent years, as past commercial or investment relationships have been found to render a stockholder part of a control group or otherwise undermine a director’s or stockholder’s independence. And most often, it arises with respect to the disinterestedness of relatively large blockholders whose inclusion as part of the minority may determine the feasibility of obtaining a majority-of-the-minority vote. Where ambiguity regarding the composition of a corporation’s minority stockholder base is present, those considering the merits of following the MFW framework must consider the risk this presents. That is, the risk of potentially being left defending an entire fairness claim despite intending to adhere to the MFW framework if a court later finds it reasonably conceivable, at the pleading stage and based on the plaintiff-friendly inferences arising from the plaintiff’s own complaint, that the majority-of-the-minority vote should have been calculated differently.
Further uncertainty as to the benefits of seeking to follow the MFW framework can arise from the disclosures in proxy statements or other solicitation materials seeking majority-of-the-minority approval. Frequently, these disclosures are the primary target of stockholder-plaintiffs attempting to overcome MFW to challenge a transaction under entire fairness review. Importantly, “[o]ne disclosure violation is enough to defeat” the effectiveness of a disinterested stockholder vote and prevent the invocation of the business judgment rule through the MFW framework. Materiality is “a ‘context-specific inquiry,’” and questions regarding the materiality of a particular disclosure can, and frequently do, give rise to the type of “close call” on which the views of even seasoned corporate law jurists can diverge. Reasonable views may therefore differ as to whether specific negotiating events or relationships truly alter the “total mix” of information available to stockholders voting on a transaction, and disclosure deficiencies can arise even in the absence of any misconduct or bad faith. Even the prospect of diverging views may alone be problematic, as “[i]ssues of materiality are often fact-intensive,” and MFW’s principal benefit of pleading-stage dismissal may be lost if a complaint, “when fairly read,” simply “supports a rational inference that material facts were not disclosed or that the disclosed information was otherwise materially misleading.” While controllers facing potential entire fairness claims generally bear most of the risk of disclosure deficiencies, by recusing themselves from the company’s side of the transaction, controllers often lack principal responsibility for the company’s solicitation materials and disclosures. Regardless of the cause of any disclosure deficiencies, or the sound policy reasons that prevent MFW’s application where a stockholder vote is not fully informed, transactional planners considering the MFW framework must weigh the risk that disclosure issues could ultimately prevent the invocation of the business judgment rule.
Taken together, these types of considerations often lead parties to conclude that the benefits of following the MFW framework, as adjusted to reflect the various risks that could undermine its invocation of the business judgment rule, do not justify the costs and risks of conditioning a transaction on this framework, particularly in the case of transactions not otherwise requiring a stockholder vote and/or corporations with apathetic minority stockholder bases.
B. Demand Futility, as Reframed and Confirmed in Zuckerberg
The controller buyouts traditionally reviewed under the entire fairness standard generally give rise to direct claims from target stockholders cashed out in the transaction. But many other types of controller transactions implicating entire fairness review are quintessential derivative claims. This includes financing transactions with controlling stockholders, as reinforced in a 2021 Delaware Supreme Court decision overturning prior cases that permitted direct challenges to dilutive controller financings. Today, challenges to financings, compensation awards, and other commercial arrangements and related-party transactions in the course of business are, in most cases, derivative in nature.
Longstanding Delaware law recognizes that the management of derivative claims is principally vested in a corporation’s board of directors through the board’s general management authority under Section 141(a) of the DGCL. “Because directors are empowered to manage, or direct the management of, the business and affairs of the corporation” under Section 141(a), “the right of a stockholder to prosecute a derivative suit is limited to situations where the stockholder has demanded that the directors pursue the corporate claim and they have wrongfully refused to do so or where demand is excused because the directors are incapable of making an impartial decision regarding such litigation.” “The demand requirement,” implemented through Court of Chancery Rule 23.1, “is a substantive requirement that ‘[e]nsure[s] that a stockholder exhausts his intracorporate remedies, provide[s] a safeguard against strike suits, and assure[s] that the stockholder affords the corporation the opportunity to address an alleged wrong without litigation and to control any litigation which does occur.’”
The Delaware courts traditionally assessed demand futility based on two tests: the Aronson test and the Rales test. Under this historical framework, “[t]he Aronson test applie[d] where the complaint challenge[d] a decision made by the same board that would consider a litigation demand.” Under the Aronson test, demand was futile where “the particularized facts alleged” gave rise to “a reasonable doubt . . . that: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.”
“The Rales test applie[d] in all other circumstances.” When applicable, the Rales test found demand futile if a complaint’s “particularized factual allegations . . . create[d] a reasonable doubt that” the board of directors, as comprised at the time of the filing of the complaint, “could have properly exercised its independent and disinterested business judgment in responding to a demand.”
In 2021, the Delaware Supreme Court reframed the Aronson and Rales tests in United Food & Commercial Workers Union & Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, supplanting them with a “universal test for assessing whether demand should be excused as futile.” Under this universal test, demand is futile if a complaint’s particularized allegations raise a reasonable doubt, with respect to at least half of the directors who would consider a demand, as to their ability to consider the demand with “impartial business judgment” based on whether each director (or someone from whom the director lacks independence) “faces a substantial likelihood of liability on any of the claims that would be the subject of the litigation demand” or “received a material personal benefit” from the alleged misconduct that would be the subject of the claims. The universal test addresses the “same question” at the core of the Aronson and Rales tests—“whether the board can exercise its business judgment on the corporat[ion]’s behalf in considering demand.” As such, Zuckerberg’s universal test reframed the historical demand futility analysis in “an orderly fashion” to characterize more accurately the modern application of the Aronson and Rales tests by the Delaware courts. The “refined test [did] not change the result of demand-futility analysis.”
Perhaps most notably, part of the Delaware Supreme Court’s rationale for reframing Aronson and Rales through Zuckerberg’s universal test was to account for and confirm the holdings of a series of Court of Chancery decisions addressing demand futility for controller transactions implicating entire fairness review. Under the Aronson test as originally articulated in 1984, its second prong purported to render demand futile where a reasonable doubt was raised as to whether “the challenged transaction was otherwise the product of a valid exercise of business judgment.” Interpreting this literally, some litigants argued “that demand would be excused as a matter of law whenever a transaction between a corporation and its putative controlling stockholder implicates the entire fairness standard,” “even if the business judgment rule is rebutted for a reason unrelated to the conduct or interests of a majority of the directors on the demand board.”
But, as the Supreme Court explained in Zuckerberg, “[t]he Court of Chancery’s case law developed in a different direction, . . . concluding that demand is not futile under the second prong of Aronson simply because entire fairness applies ab initio to a controlling stockholder transaction.” Notwithstanding the phrasing of the second prong of Aronson, the Court of Chancery explained that this literal interpretation cannot be reconciled with Aronson’s holding:
[I]n the demand context even proof of majority ownership of a company does not strip the directors of the presumptions of independence, and that their acts have been taken in good faith and in the best interests of the corporation. There must be coupled with the allegation of control such facts as would demonstrate that through personal or other relationships the directors are beholden to the controlling person.
As a result, in Teamsters Union 25 Health Services & Insurance Plan v. Baiera, the Court of Chancery interpreted Aronson’s second prong more narrowly by looking to this principal holding of Aronson, as well as the inherent authority over litigation conferred on “directors by 8 Del. C. § 141(a)”—which was cited in Aronson and is embodied in the requirements of Court of Chancery Rule 23.1 that must be satisfied for a stockholder to “infringe[] upon the board’s managerial authority” and commence derivative litigation. Based on the foregoing and other guidance from the Delaware Supreme Court, the Court of Chancery held in Baiera that “regardless of” whether Aronson or Rales applied, “the demand futility analysis focuses on whether there is a reason to doubt the impartially of the directors, who hold the authority under 8 Del. C. § 141(a) to decide ‘whether to initiate, or refrain from entering, litigation.’” The Baiera Court explained that, “[u]nder these authorities, neither the presence of a controlling stockholder nor allegations of self-dealing by a controlling stockholder change the director-based focus of the demand futility inquiry” or “remove . . . derivative claims . . . from the purview of the Demand Board to decide for themselves under 8 Del. C. § 141(a) whether to exercise the Company’s right to bring such a claim.”
Subsequent Court of Chancery decisions reached the same conclusion. In Zuckerberg, the Delaware Supreme Court explained that this was one of the key developments following Aronson “both appropriate and necessary” to address through the new universal test for demand futility. In doing so, the Supreme Court adopted the reasoning articulated in Baiera and expressly rejected the notion that demand is automatically futile where “the entire fairness standard of review applies ab initio to a conflicted-controller transaction” based, in large part, on the board’s managerial authority under Section 141(a). The Delaware Supreme Court explained:
[Plaintiff]’s argument presumes that a stockholder has a general right to control corporate claims. Not so. The directors are tasked with managing the affairs of the corporation, including whether to file action on behalf of the corporation. A stockholder can only displace the directors if the stockholder alleges with particularity that “the directors are under an influence which sterilizes their discretion” such that “they cannot be considered proper persons to conduct litigation on behalf of the corporation.” As such, enforcing the demand requirement where a stockholder has only alleged exculpated conduct does not “undermine shareholder rights;” instead, it recognizes the delegation of powers outlined in the DGCL.
Finally, [plaintiff]’s argument collapses the distinction between the board’s capacity to consider a litigation demand and the propriety of the challenged transaction. It is entirely possible that an independent and disinterested board, exercising its impartial business judgment, could decide that it is not in the corporation’s best interest to spend the time and money to pursue a claim that is likely to succeed. Yet, [plaintiff] asks the Court to deprive directors and officers of the power to make such a decision, at least where the derivative action would challenge a conflicted-controller transaction. This rule may have its benefits, but it runs counter to the “cardinal precept” of Delaware law that independent and disinterested directors are generally in the best position to manage a corporation’s affairs, including whether the corporation should exercise its legal rights.
The principal authority over derivative claims vested in boards under Section 141(a) of the DGCL, and embodied in the requirements of demand futility and Court of Chancery Rule 23.1, does limit, to some degree, inefficient derivative litigation incapable of supporting the costs and burdens of its continued prosecution. But corporations with controllers prone to entire fairness challenges may tend to have board compositions more susceptible to a finding of demand futility. Indeed, many controlled companies take advantage of the “controlled company exemption” offered by the New York Stock Exchange and NASDAQ, which relieves them of the requirement of having an independent board majority.
Corporations with an independent board majority for stock exchange purposes are also not immune to a finding of demand futility. Unlike stock exchange independence requirements based on specified independence criteria, “Delaware law does not contain bright-line tests for determining independence but instead engages in a case-by-case fact specific inquiry.” Delaware’s fluid standard of director independence—capable of turning on innumerable types of different relationships—may create situations in which a director whose independence was not previously believed to be in question may be compromised for purposes of demand futility. Indeed, in recent years, numerous directors deemed independent for exchange purposes have been found by the Delaware courts to lack independence and disinterestedness for purposes of demand futility. If a bare majority of a board is nominally independent for stock exchange purposes, the independence and disinterestedness of only one director needs to be impugned to render demand futile.
And even if a corporation truly has an independent board majority, a plaintiff may be able to raise reasonable questions as to the independence of one or more directors and survive a Rule 23.1 motion, thereby generating considerable settlement leverage. Demand futility is typically assessed under Rule 23.1 on a motion to dismiss. When Rule 23.1 is invoked at this stage, plaintiffs’ demand futility arguments are bolstered by a heightened, yet still plaintiff-friendly, pleading standard. While a complaint must allege “particularized factual statements that are essential to the claim” to satisfy Rule 23.1’s heightened pleading standard, this “does not entitle a court to discredit or weigh the persuasiveness of well-pled allegations” in the complaint. Rather, the particularized allegations that a plaintiff may plead and utilize to establish demand futility may still include “cherry-picked” or mischaracterized factual allegations, even if they later prove inaccurate or untrue. Indeed, when demand futility is decided on a motion to dismiss, plaintiffs benefit from these and any other particularized factual allegations set forth in their complaint, which “are accepted as true on such a motion.” Plaintiffs’ establishment of demand futility is further aided at this stage by “all reasonable factual inferences that logically flow” from the complaint’s particularized factual allegations, which are all drawn in favor of the plaintiff. While there are also circumstances in which demand futility may be assessed on summary judgment, the Court of Chancery recently stated that “[d]emand futility generally should be evaluated on the pleadings, without the benefit of discovery,” and in any event “should be analyzed early in the case and not addressed (or readdressed) at later phases.” As the Court of Chancery explained, “defendants generally should expect one bite at the demand-futility apple,” which may leave them bound to a conclusion on demand futility based on plaintiff-friendly pleading-stage inferences.
C. The Special Litigation Committee
The managerial authority of boards under Section 141 of the DGCL is further embodied in longstanding Delaware law, dating back to the Delaware Supreme Court’s 1981 opinion in Zapata Corp. v. Maldonado, recognizing the ability of boards to form special litigation committees (or “SLCs”) for the purpose of investigating and, as appropriate, prosecuting and/or seeking to stay, dismiss, or settle derivative claims previously filed by stockholders. In Zapata, the Supreme Court explained that this board authority arises from “the fount of directorial powers” provided under Section 141 of the DGCL. As the Supreme Court explained, “Rule 23.1, by excusing demand in certain instances, does not strip the board of its corporate power”; “the board entity remains empowered under [Section] 141(a) to make decisions regarding corporate litigation.” Demand futility, therefore, addresses a “problem . . . of member disqualification, not the absence of power in the board.” Holding that a conflicted board is still empowered under Section 141 of the DGCL to “legally delegate its authority to a committee of . . . disinterested directors,” Zapata recognized the power of boards to create SLCs that “can properly act for the corporation to move to dismiss derivative litigation that is believed to be detrimental to the corporation’s best interest.”
At the same time, Zapata acknowledged “the realities of a situation” in which “directors are passing judgment on fellow directors in the same corporation . . . who designated them to serve.” Zapata therefore declined to extend the protections of the business judgment rule to an independent committee’s decision to terminate previously filed derivative litigation, articulating instead a two-part test intended to serve as “a balancing point where bona fide stockholder power to bring corporate causes of action cannot be unfairly trampled on by the board of directors, but the corporation can rid itself of detrimental litigation.”
“The first prong of the Zapata standard analyzes the independence and good faith of the committee members, the quality of its investigation and the reasonableness of its conclusions.” The SLC bears “the burden of proving independence, good faith and a reasonable investigation.” An SLC may need to undertake considerable investigatory efforts to satisfy this burden, which may require the SLC to “investigate all theories of recovery asserted in the plaintiffs’ complaint” by “explor[ing] all relevant facts and sources of information that bear on the central allegations in the complaint.” It has been noted that, for even “the less serious allegations in plaintiffs’ complaint,” a “total failure to explore” them “may cast doubt on the reasonableness and good faith of an SLC’s investigation” if exploring them, “at least in summary fashion, would have helped the SLC gain a full understanding of the more serious allegations in plaintiffs’ complaint.” In addition, the SLC’s investigation “must be supported by a thorough written record” speaking to the SLC’s investigation, findings, and recommendation.
If the SLC satisfies this burden, “[p]roceeding to the second step of the Zapata analysis is wholly within the discretion of the court.” Under Zapata’s second step, the court can “determine[], in its own business judgment, whether the suit should be dismissed,” thereby “preserv[ing] the court’s role as the ultimate decider of whether litigation should be dismissed.” The Delaware Supreme Court has explained that under Zapata’s second step, “[t]he court should exercise its discretion . . . and refuse to dismiss a derivative suit when ‘corporate actions meet the criteria of step one, but the result does not appear to satisfy its spirit, or where corporate actions would simply prematurely terminate a stockholder grievance deserving of further consideration in the corporation’s interest.’” In this regard, the court is directed to give “‘special consideration to matters of law and public policy in addition to the corporation’s best interests.’”
The availability of SLCs under Delaware law provides a “final arrow in [the] quiver” for a “conflicted board” and serves “as a last chance for a corporation to control a derivative claim in circumstances when a majority of its directors cannot impartially consider a demand.” In comparison to plaintiffs’ law firms facing incentives to pursue derivative claims without regard to corporate costs and other inherent biases, an SLC charged with the investigation of a derivative claim is generally better positioned to weigh “the costs, burdens, and distractions of pursuing the litigation” against the “potential recovery” and, when appropriate, recommend the dismissal of litigation whose continued pursuit is deemed to be contrary to “the long-run best interest of the corporation.” In conducting this assessment, independent directors serving on SLCs often possess confidential information and have a better understanding of the corporation, its business, and its best path forward, even after plaintiffs are equipped with Section 220 productions. Indeed, the Delaware Supreme Court recently reiterated in Match that independent directors are generally better positioned than stockholder-plaintiffs to assess the merits of derivative claims and the advisability of their prosecution.
Accordingly, SLCs are a tool through which Delaware corporations may employ their optimally positioned independent directors to assess derivative claims and limit the costs and burdens of those with little to no value, including inefficient derivative claims that may otherwise proceed to trial under the modern entire fairness paradigm. But the availability of SLCs does not fully address this issue. Given the burdens of the Zapata test, SLC investigations frequently involve comprehensive inquiries requiring extraordinary time commitments from independent directors and outside counsel. SLC investigations often require the devotion of significant corporate resources, including, but not limited to, the legal fees arising from the hundreds, if not thousands, of billable hours incurred by outside counsel to complete the investigation.
But corporations’ ability to form SLCs to investigate and, where appropriate, seek dismissal of derivative claims does not necessarily alter incentives for commencing attorney-driven derivative challenges. In most cases, complaints bringing opportunistic challenges to controller transactions may be drafted in short order without a significant time commitment on the part of stockholder-plaintiffs. Following a relatively limited undertaking, these challenges can have settlement value due to the inherent difficulty of dismissing them on the pleadings and the costs of dismissing them through the SLC process. In addition, the Delaware courts have held that, after an SLC is formed and assumes the management of derivative claims, the corporate benefit doctrine may still support a fee award to the plaintiffs’ attorneys who initially brought the claims, depending on the outcome. In fact, the Court of Chancery has previously been skeptical of arguments seeking to dramatically reduce fee awards sought by plaintiffs’ attorneys who filed derivative litigation that was later investigated and settled by an SLC. The prospect of an SLC may, in some cases, offer plaintiffs’ attorneys a path to a fee award with a considerably reduced workload.
III. The Derivative Authority Provision
Although Delaware law offers several protections that tend to limit the inefficiencies, costs, and burdens of the modern entire fairness paradigm, they do not fully address the problem. Fortunately, the Derivative Authority Provision offers a potential corporate governance solution.
A. Marchand
The Delaware Supreme Court’s opinion in Marchand represented a landmark ruling on the duty of oversight. Marchand confirmed directors’ fiduciary obligation to “make a good faith effort to put in place a reasonable system of monitoring and reporting” on “mission critical” compliance risks. It has also led to “an uptick in Caremark claims” and caused many corporations to “increase[] their focus on risk assessment and compliance.”
In addition to reviewing important principles of the duty of oversight, Marchand addressed the novel issue of demand futility for a corporation deviating from the “one director-one vote” default under Delaware law. Although not entirely overlooked, Marchand’s assessment of demand futility on the basis of director voting power in this context has received relatively little coverage.
In the wake of its listeria outbreak that led to the Caremark claims asserted in Marchand, Blue Bell Creameries USA, Inc. (“Blue Bell”) “faced a liquidity crisis.” To address its liquidity needs, Blue Bell secured an investment from the investment fund Moo Partners. “Moo Partners provided Blue Bell with a $125 million credit facility and purchased a $100 million warrant to acquire 42% of Blue Bell at $50,000 per share.” As part of the investment, “Blue Bell also amended its certificate of incorporation to grant Moo the right to appoint one member of Blue Bell’s board who would be entitled to one-third of the board’s voting power.” After Moo Partners made the investment, its designee was appointed to the Blue Bell board. Upon his appointment, Moo Partners’ designee served as one of Blue Bell’s eleven directors—entitling him, under Blue Bell’s certificate of incorporation, to five of the fifteen total votes entitled to be cast by the entire Blue Bell board.
Before the Supreme Court issued its landmark decision in Marchand, the Court of Chancery dismissed the same oversight claims under Rule 23.1. In assessing demand futility, the Court of Chancery observed that, under Blue Bell’s certificate of incorporation and pursuant to Section 141(d) of the DGCL, Moo Partners’ designee was “entitled to exercise five of the fifteen votes and each of the other directors is entitled to exercise one vote.” “Accordingly, for demand excusal purposes,” the Court of Chancery explained that “a majority of the Board consists of a collection of [Blue Bell] directors holding a majority of the Board’s voting power (i.e., at least eight votes).” That is, “[the Moo Partners designee] and any three other [Blue Bell] directors constitute a majority of the Board, as do any eight [Blue Bell] directors other than [the Moo designee].” Finding that the complaint failed to raise a reasonable doubt as to the independence of “directors control[ling] eight of the Board’s fifteen votes,” the Court of Chancery dismissed the claims under Rule 23.1.
On appeal, the Delaware Supreme Court articulated its monumental guidance on the duty of oversight and reversed the Court of Chancery’s finding that demand was not futile. With respect to demand futility, the Supreme Court disagreed with the Court of Chancery’s conclusion that the complaint failed to raise a reasonable doubt as to the independence of a director who formerly served as Blue Bell’s CFO. Notably, this director was alleged to have “worked at Blue Bell for decades and owe[d] his entire career” to the father of Blue Bell’s current CEO, a defendant in the case. As the Supreme Court explained, these and other allegations regarding the director’s relationship with the CEO’s family were “suggestive of the type of very close personal [or professional] relationship that, like family ties, one would expect to heavily influence a human’s ability to exercise impartial judgment.” Despite reaching a different conclusion as to this director’s independence and finding demand futile on that basis, the Supreme Court’s demand futility analysis did not call into question the Court of Chancery’s assessment of demand futility in this context based on director voting power, instead of the per capita demand futility analysis traditionally employed under the default “one director-one vote” regime of most corporations. Instead, the Supreme Court reiterated the Court of Chancery’s voting power-based assessment of demand futility and approached demand futility on the same basis, stating: “To survive the Rule 23.1 motion to dismiss, the complaint needed to allege particularized facts raising a reasonable doubt that directors holding eight of the fifteen votes could have impartially considered a demand.” Although the Delaware Supreme Court’s opinion was not as detailed as the Court of Chancery’s on this issue, the Supreme Court explained that it elected not to “belabor[] the details of the Court of Chancery’s thorough analysis” on this issue, which the Supreme Court acknowledged was “somewhat complicated due to the unusual structure of Blue Bell’s board.”
B. The Legal Basis for Derivative Authority Provisions
Despite the novelty of the question, Marchand’s analysis of demand futility based on director voting power is unsurprising and consistent with the DGCL. In fact, it is what the DGCL mandates. Under Section 141(d) of the DGCL, “the certificate of incorporation may confer upon 1 or more directors, whether or not elected separately by the holders of any class or series of stock, voting powers greater than or less than those of other directors.” Where a charter provision vests directors with disparate voting power, unless the provision otherwise provides, it extends to all board decisions, including matters falling under the board’s general authority under Section 141(a). And as discussed, board authority over “decisions whether to initiate, or refrain from entering, litigation[] [is derived] from 8 Del. C. § 141(a),” which serves as the basis for Delaware’s longstanding demand futility requirement and recognition of SLC authority. Accordingly, the DGCL requires that the outcome of any board vote on a derivative demand be determined based on any differential voting powers directors may have under the certificate of incorporation.
Section 141(d) further contemplates that a certificate of incorporation may vest directors with differential voting power on only specified matters. Section 141(d), therefore, supplies statutory authority for a Derivative Authority Provision in a corporation’s certificate of incorporation vesting a subset of independent directors—for example, the directors serving from time to time on the corporation’s audit committee—with the sole and exclusive voting power on board decisions regarding derivative litigation demands and related matters.
Alternatively, a certificate of incorporation could include a Derivative Authority Provision establishing a committee of the board—for example, a corporation’s standing audit committee or conflicts committee—with the full and exclusive power and authority in respect of derivative litigation demands and related matters. Sections 141(a) and 141(c) of the DGCL broadly empower boards to control derivative litigation and establish committees for the purpose of investigating, considering, managing, and addressing derivative claims, litigation, and demands. Section 141(a) further provides that any of “the powers and duties conferred or imposed upon the board of directors by [the DGCL] shall be exercised or performed to such extent and by such person or persons as shall be provided in the certificate of incorporation.” Accordingly, Section 141(a) generally authorizes provisions in a certificate of incorporation establishing a committee of the board and vesting in the committee, on an exclusive or non-exclusive basis, some or all of the power and authority otherwise vested in the board over derivative litigation. Where this type of Derivative Authority Provision is implemented, Marchand and the longstanding Delaware authorities discussed herein recognizing decisions made by independent committees in respect of derivative claims support an assessment of demand futility based solely on the independence and disinterestedness of the members of the committee charged with assessing derivative litigation demands.
Under any such construct, a Derivative Authority Provision is permitted by express authority provided under the DGCL. As such, a Derivative Authority Provision does not contravene Section 102(b)(1)’s limitation on charter provisions “contrary to the laws” of the State of Delaware. As the Delaware Supreme Court has explained, “Section 102(b)(1)’s scope is broadly enabling” and “bars only charter provisions that would ‘achieve a result forbidden by settled rules of public policy.’” Far from contravening Delaware public policy, a Derivative Authority Provision conforms with Delaware’s “important” public policy favoring delegations of derivative litigation authority to independent directors over stockholder representatives, as embodied in Section 141(a) of the DGCL and Delaware’s demand futility requirement, Rule 23.1, and recognition of SLC authority. In effect, a Derivative Authority Provision would create a standing demand review committee, another important concept recognized under Delaware law and supported by the same public policy. In Match and Zuckerberg, the Delaware Supreme Court confirmed that this public policy endures notwithstanding the broad applicability of the entire fairness standard, even when derivative litigation implicates the interests of controlling stockholders, to “elevate a board’s control of derivative litigation above the inherently coercive dynamic of conflicted controller transactions.” As the Delaware Supreme Court explained in Match, it remains a “‘cardinal precept’ of Delaware law that independent and disinterested directors are generally in the best position to manage a corporation’s affairs, including whether the corporation should exercise its legal rights,” “even when it involves a controlling stockholder.”
For the same reasons, Delaware public policy supports Marchand’s voting power-based approach to demand futility. As the Delaware Supreme Court explained nearly 100 years ago, “[t]he right of a stockholder to file [a derivative action] to litigate corporate rights is . . . solely for the purpose of preventing injustice, where it is apparent that material corporate rights would not otherwise be protected.” Thus, as the Delaware Supreme Court reaffirmed in Zuckerberg, the demand futility requirement looks to whether the directors vested with derivative authority under Section 141(a) “‘cannot be considered proper persons to conduct litigation on behalf of the corporation.’” This “requirement is not excused lightly because derivative litigation upsets the balance of power that the DGCL.” Where only specified directors are vested with authority over derivative litigation demands, it follows that only the directors so empowered should be considered for purposes of demand futility. Under longstanding Delaware law affording stockholders derivative standing “solely to prevent an otherwise complete failure of justice” in cases where “corporate [litigation] rights would not otherwise be protected,” there would only be a basis for vesting stockholders with derivative standing if the directors with authority over derivative litigation demands could not impartially consider a demand and protect those litigation rights. Because both Delaware law and Delaware public policy favor placing control of these litigation rights in the hands of independent directors, neither supports deviating from this approach in the name of easing the burdens to establish demand futility.
C. The Equities Supporting Derivative Authority Provisions
As contemplated herein, a Derivative Authority Provision would focus demand futility on the subset of directors it empowers with authority over derivative litigation demands. In effect, this would exclude indisputably interested directors—such as executive directors and controller-affiliated directors—from the denominator used to assess demand futility. Rather than needing to establish demand futility based on the proportion of independent and disinterested directors comprising an entire board (which would include such interested directors), stockholders of a corporation with a Derivative Authority Provision in its certificate of incorporation would be required to impugn the independence or disinterestedness of half of the applicable committee or independent directors vested with authority over derivative claims. If a Derivative Authority Provision vests this authority in truly independent directors, it may make demand futility a more difficult hurdle for stockholder-plaintiffs seeking to commence opportunistic derivative litigation. This, in turn, would help preserve independent and disinterested directors’ control over derivative claims, limiting the costs and burdens of inefficient derivative litigation and fostering more efficient outcomes for corporations and their stockholders.
Although a Derivative Authority Provision furthers this interest of stockholders generally, the broad scope of modern entire fairness review, viewed in isolation, may lend some facial appeal to arguments for extending this onerous standard of review to a controlled corporation’s adoption of a Derivative Authority Provision. In one recent case, Palkon v. Maffei, the Court of Chancery found the entire fairness standard applicable to a Delaware corporation’s proposed conversion to a Nevada corporation based on the alleged “fewer litigation rights to stockholders” and “greater litigation protections to fiduciaries” that would result under Nevada law. In finding that the alleged differences in litigation rights implicated entire fairness review of the proposed conversion in Palkon, the Court of Chancery explained:
As depicted, the conversion constitutes a self-interested transaction effectuated by a stockholder controller. The reduction in the unaffiliated stockholders’ litigation rights inures to the benefit of the stockholder controller and the directors. That means the conversion confers a non-ratable benefit on the stockholder controller and the directors, triggering entire fairness. There are no protective devices that could lower the standard of review. Entire fairness governs.
Considerable Delaware authority, however, supports the application of the business judgment rule to the adoption of a Derivative Authority Provision, even when considered in the context of entire fairness’s broad reach under Palkon and other recent Delaware cases. The prospect of receiving the deference of business judgment review could make the adoption of a Derivative Authority Provision viable not just for corporations that are private or in the process of going public, but also for existing public corporations.
As the Delaware Supreme Court reaffirmed in Zuckerberg, Delaware law has long held that stockholders have no general ongoing individual right to bring derivative litigation. Because Rule 23.1 is substantive, “[t]he right to bring a derivative action does not come into existence until the plaintiff shareholder has made a demand on the corporation to institute such an action or until the shareholder has demonstrated that demand would be futile.” Prior to that time, stockholders’ only right in respect of derivative litigation is the right to bring “the equivalent of a suit by the shareholders to compel the corporation to sue” if and in the event “the corporation will not sue because of the domination over it by the alleged wrongdoers.” Stockholders fully retain that right from and after the adoption of a Derivative Authority Provision. Accordingly, the adoption of a Derivative Authority Provision would not infringe on existing stockholder rights and is distinguishable from cases such as Palkon. In contrast to Palkon, for example, in which the Court of Chancery discussed the importance of extending entire fairness review to a proposed corporate conversion to prevent stockholders’ litigation rights from becoming “second-class rights,” a Derivative Authority Provision merely confirms, consistent with Delaware law and important Delaware public policy, that any right of stockholders to commence derivative litigation is already secondary to that of the board or committee thereof principally vested with authority over derivative claims and only arises when that body is incapable of impartially exercising this authority.
Far from adversely intruding into existing stockholder rights, the Delaware courts and plaintiffs’ bar have repeatedly recognized the substantial corporate benefits arising from enhanced concentrations of corporate authority in independent directors. “After all, Delaware law presumes that independent directors enhance the value of the firm and benefit minority stockholders.” For this reason, the Delaware courts have repeatedly deemed independent director appointments and other settlement terms enhancing independent director influence as important governance measures. These measures have been deemed corporate benefits for corporations and their minority stockholders so valuable that they have, on numerous occasions, supported fee awards in the hundreds of thousands, and in some cases, millions of dollars. In particular, this has included governance reforms that, like a Derivative Authority Provision, establish an independent committee or group of independent directors charged with reviewing and making decisions with respect to specified matters that could present a conflict of interest. Indeed, in one recent derivative litigation, leading members of the Delaware plaintiffs’ bar even championed the valuable corporate benefits that specifically arise from the establishment of an independent director base equipped “to deal with future conflict transactions, [and] to actually deal with the disposition of . . . litigation” in the future.
As several recent Delaware cases make clear, a Derivative Authority Provision concentrating authority over derivative litigation demands in independent directors does not foreclose recovery for those claims that are meritorious and worth pursuing. Independent directors can and do authorize the prosecution of derivative claims against controllers and corporate insiders. Coincidentally, one such example is Marchand, in which an SLC formed by Blue Bell’s board concluded, after a thorough assessment of Blue Bell’s oversight claims, that it was in the best interests of Blue Bell and its stockholders to allow representatives of the stockholder-plaintiff who initially commenced the litigation to continue prosecuting the claims on Blue Bell’s behalf. And this evidence is not just anecdotal. A recent study of public SLC recommendations filed in the Delaware courts observed “a reasonably equal distribution” of recommendations in favor of dismissal and recommendations in favor of settling or litigating claims investigated by the SLC. This observation conforms with prior acknowledgments of the Court of Chancery that “in this day and age, . . . the reality is that there is a high degree of scrutiny of independent directors” facing “network effects” that incentivize them to avoid action that could “draw adverse attention” and be seen to compromise their independence. Rather than conferring a non-ratable benefit on a controlling stockholder or other fiduciaries, a Derivative Authority Provision would divest conflicted directors of voting power in respect of derivative claims and reallocate that power in the trusted hands of independent and disinterested directors Delaware law deems “in the best position to manage [those] legal rights,” “even when it involves a controlling stockholder.”
Consistent with the foregoing, the Delaware courts have repeatedly held that even on a “cloudy day” after potential derivative claims have emerged against certain directors, a board’s decision to delegate the investigation and management of the claims to an independent board committee is subject to the protections of the business judgment rule. Enhanced “judicial review” under Zapata “is limited to those cases where demand upon the board of directors is excused and the board has decided to regain control of litigation through the use of an independent special litigation committee”; it does not extend to the initial decision by a board to delegate investigation and control of potential derivative claims to a committee. Applying the business judgment rule in this context is consistent with Delaware law’s recognition of the “important function” served by SLCs in “‘promot[ing] confidence in the integrity of corporate decision making by vesting the company’s power to respond to accusations of serious misconduct by high officials in an impartial group of independent directors.’” It also conforms with Delaware’s valued public policy of encouraging the use of SLCs for the same reasons. Applying a standard of review more onerous than business judgment to the adoption of a Derivative Authority Provision concentrating authority in independent and disinterested directors, and away from directors who may lack independence, on a “clear day” is incompatible with this longstanding Delaware authority.
While there is arguably “tension” between this conclusion and the broad entire fairness framework upheld in EZCORP and Match, EZCORP, Match, and even leading members of the plaintiffs’ bar all acknowledge that board primacy over derivative claims falls within “a public policy carveout to the general [entire fairness] rule that has animated our law . . . since Lynch,” and which the Delaware Supreme Court adopted in Aronson and recently reaffirmed in Zuckerberg. As explained by the same attorneys who successfully argued before the Court of Chancery in Palkon for entire fairness review of a proposed corporate conversion based on the alleged non-ratable litigation protections the conversion would afford fiduciaries, “Aronson and Zuckerberg . . . elevate a board’s control of derivative litigation above the inherently coercive dynamic of conflicted controller transactions” that support entire fairness review in other contexts. As they have further explained, this is based on the Delaware Supreme Court’s “public policy concern [that] lies in business judgment principles, which emphasize the ‘freedom of directors’ and their ‘managerial prerogatives’ consistent with Section 141(a) of the Delaware General Corporation Law” in this context, and is intended to “create salutary results, such as channeling ‘intracorporate’ disputes to the board and ‘safeguard[ing] against strike suits.’” A Derivative Authority Provision would further precisely the same objective, and far from contravening modern entire fairness jurisprudence, affording the protections of the business judgment rule to the adoption of a Derivative Authority Provision fits squarely within the public policy exception expressly recognized in Match and EZCORP.
This is perhaps best illustrated by a relatively recent Court of Chancery decision, Simons v. Brookfield Asset Management, dismissing fiduciary challenges to the appointment of an independent director. The challenges were brought by a stockholder-plaintiff who, months prior to the director’s appointment, received hundreds of pages of documents upon making a Section 220 demand to investigate a stock repurchase with an alleged controller. The stockholder failed to commence litigation prior to the director’s appointment and, upon filing suit the following month, challenged the appointment as a breach of fiduciary duty based on the impediment it served on the stockholder’s ability to establish demand futility. In this regard, the stockholder argued “that because a majority of the Board was interested [in potential litigation relating to the repurchase] prior to [the independent director]’s appointment, it is reasonably conceivable that [the] appointment was for the purpose of countering a demand futility argument and thus motivated by self-interest.” In dismissing the fiduciary claim based on the appointment, the Court of Chancery first observed “the oddity of a minority stockholder arguing that directors should not create a supermajority independent board,” explaining that “Delaware law presumes that independent directors enhance the value of the firm and benefit minority stockholders.” The Court of Chancery then found that the stockholder’s allegations as to the timing and consequences of the appointment in relation to the stockholder’s Section 220 demand and claims could not, on their own, support a claim for breach of fiduciary duty. In doing so, the Court of Chancery noted the absence of any case cited by the stockholder in which “this court, or any court, has found such an allegation sufficient to support a claim for breach of fiduciary duty.” In addition, the Court of Chancery discussed policy considerations that weigh in favor of promoting the use of independent directors and against imposing fiduciary liability for the appointment of an independent director whose qualifications are not in dispute.
Also illustrative is the demand futility analysis conducted by the Court of Chancery to dismiss fiduciary challenges to the stock repurchase under Rule 23.1 in the same case. Because the challenged repurchase was approved by the corporation’s audit committee, the Stockholder attempted to impugn the independence of a director who did not serve on the audit committee and was not otherwise involved in the audit committee’s decision-making, by arguing that this director “faced a substantial likelihood of liability based on her participation in the [] Board decision to delegate authority to the Audit Committee.” The Court of Chancery rejected this as a basis for undermining the director’s independence, noting that “the Audit Committee members were independent” from the alleged controller. And, as the Court of Chancery explained, “Plaintiff cite[d] no authority for the proposition that a director faces a substantial likelihood of liability in a challenge to a decision that the director agreed should be relegated to a committee of disinterested and independent directors.”
Likewise, similar Delaware policy favoring the use of independent committees in other contexts weighs against the imposition of liability for independent committee delegations and lends further support to business judgment review of the adoption of a Derivative Authority Provision. Delaware’s adoption of the MFW framework, for example, was intended to encourage the use of fully empowered independent committees and disinterested stockholder vote conditions in controller buyouts. The MFW framework offers significant benefits for controlling stockholders in shielding transactions otherwise subject to entire fairness with the protections of the business judgment rule. It could thus be argued that a controlling stockholder realizes a non-ratable benefit from a board’s formation of a special committee with the intent of adhering to the MFW framework. It would nevertheless be antithetical to MFW to subject the board decision forming the committee to a heightened standard of judicial review. Given Delaware’s policy favoring and encouraging the use of independent committees, and in recognition of the interests of minority stockholders served by the use of independent committees, the decision to form an independent committee to consider even a controller buyout, in and of itself, is subject to the protections of the business judgment rule. Likewise, the protections of the business judgment rule should apply to the adoption of a Derivative Authority Provision concentrating board authority over derivative litigation demands that could otherwise present conflicts of interest in the future in independent and disinterested directors best suited to assess these claims and any associated diverging interests.
IV. Conclusion
A Derivative Authority Provision facilitates more efficient oversight and management of derivative claims based on foundational legal principles of Delaware corporate law and the DGCL. In doing so, it offers a solution to the risk of opportunistic derivative litigation and other inefficiencies faced by many corporations under Delaware law’s broad application of entire fairness review. But even after a Derivative Authority Provision is adopted, plaintiffs’ attorneys will remain incentivized, under the corporate benefit doctrine, to seek remedial action in respect of worthwhile derivative claims. And as recent history has shown, independent directors vested with authority over derivative litigation under a Derivative Authority Provision will remain incentivized to independently investigate and pursue those that are worthwhile. By facilitating more efficient management of derivative claims, a Derivative Authority Provision allows for a considerable reduction in the costs and burdens currently faced by many Delaware corporations in respect of derivative claims without compromising the upside of meritorious claims, promoting efficient outcomes and furthering value maximization for Delaware corporations and their stockholders.
