The Special Negotiating Committee and the Business Judgment Rule: A Modest Proposal

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For graybeard practitioners of Delaware corporate law and other gnarled observers of its extensive decisional precedent, the business judgment rule has stood as an unshakable doctrinal foundation amidst some relatively recent renovations to the standards for the judicial review of director decisions.

Even the famously reliable "entire fairness" test, for generations the trusty counterweight to the business judgment rule on the continuum of judicial standards of review, bears the scars of these reconstruction efforts; take for example its dalliance with the proper business purpose requirement for cash-out mergers and, some might add, its more recent expansion to cover alleged violations of the duty of care, thus requiring defendants accused of gross negligence to prove that they secured an entirely fair price, presumably by accident.

Yet these relatively superficial alterations pale in comparison to the facades that have been erected to fill what was once the yawning space between the business judgment rule and the entire fairness test.  Included here of course is the enhanced scrutiny test of Revlon[1] in the context of a sale of control, mandating a modicum of judicial second-guessing with respect to the target board's negotiating strategy; the augmented judicial examination of defensive maneuvers authorized by Unocal[2] and Unitrin,[3] pursuant to which the court is obligated to defer to the board's business judgment the moment it has convinced itself that the board made the right decision; and the compelling justification test announced in Blasius,[4] which arguably ensures the judicial invalidation of all but the most ministerial of director attempts to fiddle with shareholder elections.

Each of these legal constructs reflected a judicial recognition that modern commercial realities require a greater measure of subtlety and flexibility than the rather stark alternatives presented by the business judgment rule on the one hand and the entire fairness test on the other - i.e., either to defer completely to even the most inane board decision or to engage in an outright, post hoc substitution of the court's judgment for that of the duly elected board.

Beset by the innumerable prongs and presumptions that accompanied these new legal tests, buffeted by the seemingly endless burden-shifting that they appear to invite, observers could nonetheless find sense and solace in the simple constancy of the business judgment rule, comprising both threshold evidentiary presumptions of good faith and adherence to fiduciary standards, and substantive preclusion of judicial intermeddling in the absence of a showing that those presumptions are unwarranted.  Like a law of nature it stands, immutable, each invocation merely serving to enhance the evidence of its essential truth.

The Business Judgment Presumptions and the Special Committee

Or not. Some may have felt the foundation shuddering a bit of late from what would seem to be some new construction.  Take for example In re Western Nat. Corp. Shareholders Litigation,[5] a recent decision of the Court of Chancery.  In that case, the Court considered defendants' motion for summary judgment with respect to a challenge from a class of stockholders to a merger between Western National and its 46% stockholder, American General, a proposal wrought and recommended by a special committee of the Western National board.  On defendants' motion for summary judgment, the Court first took up plaintiffs' allegations that a majority of the members of Western's board were conflicted.  Though openly skeptical of plaintiffs' allegations of disqualifying interest on the part of a majority of the board, the Court nonetheless credited these accusations for purposes of the motion at hand, and deemed five of Western's eight directors burdened by bias-inducing conflicts with respect to the transaction at issue.

None of these directors served on the Western special committee, however, and the Court therefore next turned to the effect of that fact upon its inquiry.  Following a painstaking analysis of the record and of the numerous challenges to the special committee process advanced by the plaintiffs, the Court concluded that there existed no material fact calling into question the validity or effectiveness of the committee process, noting in particular that the committee members and their advisors were plainly independent and free of any control on the part of American General, that they were fully informed and that they had negotiated vigorously and at arm's length.  The Court therefore found that summary judgment in defendants' favor was warranted.

There would be little controversy in any of this, but for the Court's ensuing resort to an unusual analytical flourish.  Rather than concluding on the basis of this examination that the defendants had satisfied their burden of establishing the entire fairness of the transaction, and despite its assumption that a majority of the Western board was conflicted, the Court chose to rest its disposition of the case upon the application of the business judgment standard of review, which it held to be "the most appropriate analytical standard to apply to this transaction…."

Business judgment rule review is appropriate, it seems to me, for two broad reasons.  First, Delaware law will not attach liability to decisions of independent, disinterested and informed directors.  Second, Delaware law generally respects the committee process as a legitimate method to produce disinterested and independent decisions, where some arguably have conflicting interests.  The synthesis of these two principles, in my opinion, produces a general principle that liability will not attach to disinterested, independent and informed directors sitting on a special committee who recommend a merger, even if other directors on the board may have actual or potential conflicts of interest, where the board as a whole follows and accepts the committee's good faith recommendation.[6]

Some might regard this as a bit surprising.  Having found that a majority of the board was conflicted, a conclusion that many once viewed as an inevitable harbinger of the entire fairness test, the Western National court nonetheless declared the business judgment standard applicable, primarily in recognition of the involvement of a special committee.  But it did so, oddly enough, only after engaging in an unidentified but searching inspection of the committee process itself, a demanding preliminary inquiry that does not appear to have credited in any appreciable degree the traditional threshold business judgment presumptions of independence and faithful conduct.  While it accorded the committee's decision a measure of deference not unlike that contemplated by the traditional business judgment rule, the Court plainly did not presume that such deference was appropriate from the outset.

In re Freeport-McMoran Sulphur

In re Freeport-McMoran Sulphur, Inc. Shareholders Litigation[7] appears to be to similar effect.  In that case, the Court of Chancery granted a motion to dismiss a complaint challenging a merger on the grounds that a majority of the target board suffered from disabling conflicts of interest.  The motion to dismiss was based in large part upon defendants' assertion that the applicable standard of judicial review was business judgment, not the entire fairness test, by reason of what defendants asserted to have been an independent and effective special committee process that had insulated the negotiations from any such conflicts and rendered them irrelevant.  Plaintiffs responded that the entire fairness test necessarily applied by reason of the well-pleaded allegations that a majority of the board was conflicted, and that the Court's evaluation of the effectiveness and effect of the special committee process within the context of the entire fairness test should await a more fully developed record.

The Court agreed that the central issue was the appropriate standard of review to be applied.  "That issue is critical," the court stated, "because it is outcome-determinative.

" … if the standard is entire fairness, the motion must be denied because the complaint adequately states a claim that the Merger consideration was unfair.  If, however, the applicable standard of review is business judgment, the complaint states no cognizable claim because (a) the plaintiffs have not adequately pled that the FSC defendants acted disloyally or in a grossly negligent manner, and (b) even if the Merger consideration paid to FSC shareholders was unfair, to overcome the business judgment rule presumption the plaintiff must allege that the price was so low as to constitute waste or fraud.  Neither claim is alleged here.[8]

In proceeding to determine which of these competing standards applied, the Court declared itself obligated to address "as a threshold matter the legal consequence of the fact that the FSC special committee negotiated the Merger terms on behalf of the target company." ( Emphasis supplied).  Citing Western National, the Court stated as follows:

Under Delaware law, where a transaction is negotiated and approved by an independent committee of directors and is subsequently approved by the stockholders of the company in an uncoerced, fully informed vote, the transaction is normally reviewed under the business judgment standard.[9]

Availing itself of defendants' proxy statement, which it held plaintiff to have incorporated by reference in its complaint, the Court noted that plaintiff had failed to contradict or challenge disclosures to the effect that the special committee had retained independent legal and financial advisors, had met on several occasions to consider the issues and had recommended the merger to the full board, which approved the committee's recommendation in its entirety.  Because the terms of the challenged merger had been negotiated by such a committee, the Court found the business judgment review standard applicable, and the complaint was dismissed for failure to state a claim.  Once again, the Court found the business judgment standard of review applicable notwithstanding an undisputed conflict of interest on the part of a majority of the board, relying primarily upon the absence of a legally viable challenge to the objectivity or operation of a special negotiating committee of that board.

Along much the same line is a recent and in many ways groundbreaking article authored by two current members of the Court of Chancery and a highly respected former Chancellor that offers a critical analysis of a variety of prevailing judicial standards under Delaware corporate law.[10]  With respect to the appropriate standard of review in the case of an interested board that adopts the recommendation of a special negotiating committee, these uniquely qualified authors observe as follows:

As a practical matter, a judicial analysis of the special committee's effectiveness will involve a close examination of the transaction's fairness.  To obtain liability-insulation from using a special committee, the directors must demonstrate that the special committee functioned in a manner such that the controlling stockholder did not dictate the terms of the transaction and that the special committee exercised real bargaining power at arm's length.  Once a scrutinizing court concludes that the special committee operated as an effective proxy for arm's length, non-coerced bargaining, any incremental value created by an additional layer of review - allowing the plaintiff to prove that the transaction was nonetheless unfair - seems de minimis. …  [W]e propose that the sounder approach would be for the courts to defer to the business decision reached in good faith by the elected independent directors of the corporation.

* * * *

Where the challenged transaction involves self-dealing, the directors would have to demonstrate the fairness of the transaction, unless the defendants have used one of the protective approval mechanisms set forth in 8 Del. C. §144.  In contrast to current practice, however, we would apply the business judgment review standard to self-interested mergers, in cases where the merger:  … (2) was approved as fair by an effective and uncoerced special committee of independent directors.[11]

The Special Committee as Presumptive Safe Harbor?

As this discussion confirms, there appears to exist an abiding inclination on the Court of Chancery to grant deference to the decision of an independent committee.  Indeed it would appear that the inclination is so pronounced as to prompt favorable comparison to the degree of deference mandated by the business judgment rule.  Yet it is proposed for application in a circumstance that has been traditionally regarded as subject exclusively to the entire fairness analysis, an analysis that was created to serve as the antithesis of judicial deference.[12]

Does this suggest that the business judgment standard of review poised to undergo a fundamental expansion?  Or that the entire fairness standard of review, once plainly applicable upon an adequate showing of interest on the part of a majority of the board or the presence of a majority stockholder standing on both sides of the challenged transaction, is about to go the way of the proper business purpose test?

Probably not.  It seems highly unlikely that these authorities are intended to suggest that the business judgment standard of review, with its attendant presumptions of objectivity and regularity of process, should be applied, without more, to the decisions of an interested board simply because that board appoints a committee.  It is counterintuitive to presume that the interested majority will act contrary to its own interests - that in the typical case it will have appointed entirely disinterested and independent individuals to the committee, that it will have authorized the committee to avail itself of advisors who are also free of untoward influences, that it will have armed the committee with sufficient authority to negotiate meaningfully, and that the committee in fact has actually carried out that mandate.

If such presumptions were warranted, why not simply presume objectivity on the part of the interested majority in the first place and be done with it?  Such a presumption has never found purchase in our law and cannot be reasonably indulged.  And it follows that an interested majority is no more likely to act contrary to its own interests than it is to empower a special committee to do so, at least not without being assured that a reviewing court will be scrutinizing the fairness of the process.

To suggest that the business judgment standard of review should be applied ab initio to an approval process that draws its authority from an interested source, be that source a controlling stockholder or a majority block of directors, is to invite mischief.  It may well be that the right thing has been done, but the only realistic way to be assured of that is to place the threshold burden of proof on the conflicted actors to show that sufficient steps were taken to ensure that the decision making process was fair and untainted by interest.

Indeed, close inspection of the analysis adopted by the authorities referenced above, as opposed to the language they employ, reveals that they are not necessarily at odds with any of this on a conceptual level.  Even as they purport to invoke and apply the business judgment standard of review to the decisions of interested boards, each of the cited cases takes great pains to examine at the outset the elements critical to the operation and effectiveness of the special committee and its process.  It is only upon being satisfied that each such element is present that they declare that deference to the business judgment of the committee is due.[13]

But this is putting the rabbit in the hat.  The very fact that there is need to engage in this preliminary analysis, indeed to overcome what would seem to be the converse of the threshold presumptions of propriety and regularity, confutes any suggestion that what ensues is an application of the business judgment standard of review as it is commonly understood.  It is perhaps more apt to describe these cases as simply declaring that the interested board majority has been subjected to and has satisfied a threshold burden of proof that bears a striking similarity to the fair dealing element of the traditional entire fairness test.  From this perspective, the business judgment standard of review as traditionally perceived can be said to persist alive and well and as immutable as ever. Its name has simply been taken in vain.

Kahn v. Lynch Communications Redux

The next question is why?  The authorities referenced above seem to reflect an enduring discomfort with the holding of the Delaware Supreme Court in Kahn v. Lynch Communications,[14] a decade-old decision that has taken on increasing significance as the use of special committees has become commonplace.  To state it too simply, perhaps, Kahn held that the entire fairness test applies to the judicial evaluation of a merger between a corporation and its controlling stockholder; that the target's use of a bona fide special negotiating committee is an effective way to meet that burden; but that the evidentiary effect of such a special committee process, even upon a showing of its effectiveness and independence, does not result in the reinstitution of the business judgment rule, but rather operates merely to shift the burden to the plaintiff to prove that the transaction is unfair.

One can certainly empathize with those who find this analysis contrived and not a little convoluted.  It contemplates a curious circumstance in which the plaintiffs ultimately are charged with the burden of proving unfairness in the context of a legal analysis that has as its central purpose the imposition of that same burden on the defendants.[15]  And, rather than encouraging the trial court simply to declare a winner by deciding whether the initial burden has or has not been met, it adds yet another level of burden shifting that unnecessarily complicates the analysis and delays the outcome.[16]

But does it really make a difference?  The question whether a valid special committee process should shift the burden within the context of an entire fairness analysis or should resuscitate the business judgment rule seems an occasion for pins and dancing angels.  Perhaps the reader can envision a case in which a transaction would be sustained under one analysis, but found wanting under the other.  The author cannot.

This is more than a purely academic debate, however.  There are powerful, practical consequences at issue.  Plainly there is something amiss, something exasperating and pointless, in requiring the Court to scrutinize the substantive fairness of the transaction itself even though it has been satisfied that the deal was the product of an independent, fully informed and optimally effective special committee process that reasonably approximated arm's-length negotiations.

If the Court of Chancery finds that the agency that negotiated the merger did so objectively and competently, and that this instrumentality was insulated from all sources of disqualifying bias, why is there need for further judicial inquiry of any sort, much less the withering and frequently unwieldy analysis demanded by the entire fairness test?  Why should a court be required in such a circumstance to scrutinize the fairness of a price that resulted from an admittedly fair, arm's-length negotiating process?

It is this question that no doubt has prompted the view that the more appropriate way to deal with this problem is to defer to the "business judgment" of a truly independent and fully functioning special committee with respect to the fairness of the price and terms ultimately achieved.  Seemingly designed to rekindle the pre-Kahn debate, those who ascribe to this analysis would read Kahn as narrowly as possible, limiting it to circumstances in which a controlling stockholder is the source of the conflicting interest.[17]  With respect to the circumstances in which the conflict arises from an interested majority of directors, where no controlling stockholder is present, these observers would sidestep Kahn's refusal to resuscitate the business judgment rule.  And they would go further still, advocating not merely the reinvigoration of the business judgment rule following the initial application of the entire fairness standard but the application of that rule at the very outset of the analysis,[18] bypassing the entire fairness test altogether.

A Modest Proposal

But to label that highly pre-conditioned judicial deferral to the judgment of the committee an application of the business judgment standard of review is profoundly problematic for all the reasons discussed above.  The better approach is to avoid doing violence to the business judgment standard of review while at the same time crediting the understandable aversion to redundant judicial intrusion on effective board process.  This could be accomplished by conceding that the entire fairness test is applicable at the outset to any interested transaction, whether or not a controlling stockholder is present, but to apply that test in a foreshortened fashion where the Court finds the committee process sufficient to satisfy the fair dealing requirement by foregoing judicial scrutiny of the fair price component of that test.  This is in truth what the authorities discussed above appear to be doing, although by way of an egregious misnomer.

In an interested transaction, where a majority of the board is conflicted and/or controlled by a majority stockholder standing on both sides of the challenged transaction, this approach would recognize the inapplicability of the business judgment presumptions and place the burden of proof to establish fairness on the defendants.  If the defendants thereupon demonstrate that, by virtue of their use of an independent, effective, appropriately authorized, fully informed and adequately advised special committee, the fair dealing aspect of the entire fairness test has been satisfied, the judicial analysis ends and the defendants win.  There is neither point nor purpose in requiring the Court to engage either in further burden shifting or in a fair price analysis.[19]

What is to be gained, after all, at least in the absence of the most unusual of circumstances, from a judicial investigation to determine whether this perfectly adequate and objective negotiation mechanism has resulted in an entirely fair price?  It is no more necessary than when the business judgment presumptions of good faith and faithful process that attach to the efforts of an objective board prevail.  As the authorities noted above are at pains to point out, a fair price all but necessarily arises from arm's-length negotiations -- indeed, some might suggest that this is the very definition of a fair price -- whether conducted on behalf of an entirely disinterested board or "approximated" by way of a disinterested special committee.

In either case, judicial inquiry as to the fairness of the price is a mere redundancy.  Fair dealing is where the judicial action is and the evaluation of the propriety of process, as opposed to result, is where the judicial function always has been at its most effective in corporate controversies.  That is why there does not appear to have been a decision in which a Delaware court has found fair dealing without finding fair price as well, and why there probably never will be.

If there is no finding of fair dealing, the Court of course should examine the fairness of the price, at least assuming that the issue of price predominates, and assuming that such a determination could therefore affect the outcome notwithstanding the lack of fair dealing.  Indeed, the Court might well opt to reserve the discretion to evaluate price even where it has found fair dealing, a discretion that may offer some level of additional comfort in cases where nagging doubts about the process linger.  As has proven to be the case with respect to the second appendage of the analysis enunciated in Zapata,[20] however, pursuant to which the Court is authorized (but is seldom inclined) to apply its own business judgment in evaluating the propriety of a committee-recommended dismissal, this discretion will likely atrophy -- as well it should.

Notes