What boards should know about Delaware’s planned reforms

It’s no secret that Delaware – the state of choice for so many companies to incorporate – has come under fire recently, with certain judicial decisions receiving unusually widespread criticism and high-profile companies choosing to reincorporate elsewhere.

These events have prompted Delaware lawmakers to release proposed amendments to the Delaware General Corporation Law in Senate Bill 21 (SB 21). If these amendments become law – and all indications are that they will, and soon – they will have significant ramifications for all Delaware corporations and their fiduciaries.

SB 21, if enacted, is likely to substantially reduce the volume of stockholder litigation and will arm boards with additional defenses at the motion-to-dismiss stage for those claims that are filed. Here’s how.

New protections under SB 21

1. The proposed law creates a new presumption of director independence based on national exchange listing standards:

Under the proposed change in law, if a board certifies a director as independent under the listing standards of a national securities exchange, that determination presumptively controls unless a plaintiff stockholder offers ‘substantial and particularized facts that such director has a material interest in such act or transaction or has a material relationship with a person with a material interest in such act or transaction.’

Current case law takes independence under applicable listing standards into account but does not create a presumption based on such classification.

2. The proposed law offers additional cleansing mechanisms for ordinary conflict transactions:

Under current law, decisions made by conflicted boards are not subject to the business judgment rule and instead will be evaluated under the more onerous entire fairness standard. However, conflict transactions that do not involve controllers can be cleansed if they are ratified by a majority of stockholders. Such ratification effectively bars all fiduciary claims other than for waste.

The proposed reform would allow ratification to be achieved with ‘a majority of the votes cast by the disinterested stockholders’ and would allow ratification by ‘a majority of the disinterested directors, even though the disinterested directors be less than a quorum.’

For example, in a scenario where all directors but one are conflicted, the affirmative vote of the one disinterested director could be sufficient to immunize the board from liability. The ability to self-cleanse ordinary conflict transactions via a majority of the disinterested director votes, even if the disinterested directors constitute a minority of the board, represents a significant new feature of Delaware law.

Whether ratified by stockholders or disinterested directors, the statute would provide a safe harbor that bars all claims.

3. The proposed law redefines who is a controller and makes it easier to cleanse controller transactions:

Delaware law closely scrutinizes controller transactions under the theory that, given the controller’s power, such transactions are inherently coercive.

Under current law, minority stockholders may be deemed controllers if they exercise actual control, whether generally or specific to a particular transaction. Transactions with controlling stockholders are presumptively reviewed under entire fairness and the requirements to cleanse controller transactions are more stringent. As set forth in a case known as MFW and the Delaware Supreme Court’s recent Match decision, boards and controllers can obtain business judgment review of controller transactions if the transaction is conditioned ab initio on both: the approval of a fully independent special committee and the informed vote of a majority of the minority stockholders.

The proposal drastically limits who can be a controller, requiring minority stockholders to own at least one third of the outstanding voting shares and exercise control. The proposal also appears to eliminate the concept of transaction-specific control, referring only to the ‘power to exercise managerial authority over the business and affairs of the corporation.’

The proposed law also makes it easier to cleanse controller transactions. For everything other than going-private transactions, there will be a safe harbor if just one of MFW’s protections is implemented. And for all controller transactions, including going-private transactions, the ab initio requirement will no longer apply and the special committee can be majority (as opposed to fully) independent.

4. The proposed law provides new statutory definitions for key terms:

The proposed law codifies the entire fairness test by defining a fair transaction as one that is fair in terms of the fiduciary’s dealings with the corporations and is comparable to what might have been obtained in an arm’s length transaction.

It also provides statutory definitions for ‘disinterested directors,’ ‘disinterested stockholders,’ ‘material interest’ and ‘material relationship.’ It remains to be seen whether or how existing case law is adopted to fit into these statutory definitions.

5. The proposed law limits stockholder inspection rights:

Under current law, stockholders can inspect books and records if they identify a proper purpose and seek documents reasonably related to that purpose. Under the proposed law, stockholders will have to establish their good faith and proper purpose with ‘reasonable particularity’ and show that the records sought are ‘specifically related’ to that purpose.

More importantly, emails and text messages, which could sometimes be obtained in the absence of formal board-level materials, will no longer be available and records will only be available for three years preceding the date of the demand.

Takeaways
Conflict and controller transactions are routinely challenged by stockholders, with disputes often centering on whether particular directors are conflicted, whether minority stockholders can be deemed controllers or whether cleansing features were properly implemented.

If ‘entire fairness’ is deemed to apply, the complaint is almost certain to survive a motion to dismiss as the board will have to meet its burden of showing that the transaction was entirely fair.

Although it is onerous, entire fairness is not an insurmountable standard and there are several recent cases where defendants have prevailed after trial. Nevertheless, the risks and costs associated with such litigation are significant.

Despite the suite of new protections, significant uncertainty remains. The proposed law constitutes the most sweeping set of changes to Delaware law in modern history and represents a dramatic shift from Delaware’s nuanced, case law-driven approach in favor of a more bright-line statutory scheme. It remains to be seen where challenges will be mounted, how broadly or narrowly courts will construe the statute and how existing case law may be adapted to the statute.

It may be years before enough case law develops for clarity to be achieved. Nevertheless, boards that may have been considering potential reincorporation in other states should consider the new law in their analyses as Delaware’s judiciary remains unmatched in its expertise and speed in resolving corporate disputes.

Renee Zaytsev is a partner with Boies Schiller Flexner and co-chair of the firm’s securities and shareholder disputes practice