By Jay McMillan
Section 144 of the Delaware General Corporation Law provides a “safe harbor” for self-interested transactions between a corporation and one or more of its directors or officers, or between a corporation and another entity in which a director or officer has a material interest. The statute provides that a transaction is not “void or voidable” solely because of such a conflict. Similar provisions sometimes appear in partnership agreements or operating agreements of limited liability companies. However, those safe harbor provisions provide little protection from claims for breach of fiduciary duty against officers and directors.
The Section 144 safe harbor applies if (1) the conflicted transaction is approved by a majority of fully informed disinterested directors, or (2) it is approved in good faith by a vote of fully informed stockholders, or (3) it is “fair as to the corporation” at the time it is approved by the board of directors, a committee of the board, or the stockholders. In Cumming v. Edens, C.A. No. 13007-VCS, mem. op. at 54-59 (Del. Ch. Feb. 20, 2018), the director defendants argued that compliance with Section 144 triggered review of a conflicted transaction under the deferential business judgment standard. They further argued that because Section 144 refers only to “disinterested” directors, the Court should not consider whether the directors approving the transaction were also independent of any interested directors. The defendants relied on Benihana of Tokyo, Inc. v. Benihana, Inc., 906 A.2d 114 (Del. 2006) (“Benihana II”), in which the Delaware Supreme Court stated that under Section 144(a)(1) “[a]fter approval by disinterested directors, courts review the interested transaction under the business judgment rule . . . .”
In Cumming, Vice Chancellor Joseph R. Slights III found that despite Benihana II, “compliance with Section 144(a)(1) does not necessarily invoke business judgment review of an interested transaction” and that common law principles still apply when determining the standard of review. The Court referred to the opinion of Vice Chancellor Parsons in Benihana of Tokyo, Inc. v. Benihana, Inc., 891 A.2d 150, 185 (Del. Ch. 2005) (“Benihana I”), aff’d, 906 A.2d 114 (Del. 2006), which was affirmed in Benihana II. In Benihana I the Court stated that compliance with Section 144 does not “always” trigger business judgment review, and that “equitable common law rules requiring the application of the entire fairness standard on grounds other than a director’s interest still apply.”
The Court in Cumming noted that before Section 144 was enacted in 1967 “a corporation’s stockholders had the right to nullify an interested transaction” and that Section 144 was enacted to prevent that “potentially harsh result.” Under Section 144, stockholders cannot void a transaction “solely” because of the presence of director self-interest. Cumming makes clear, however, that compliance with Section 144 does not provide a safe harbor against claims for breach of fiduciary duty.
An appeal of the Cumming decision based on the Delaware Supreme Court’s language in Benihana II is unlikely to succeed. The Court in Cumming also noted that in an article by Delaware Supreme Court Chief Justice Leo E. Strine, Jr. et al., the authors stated, “The question of whether section 144 was intended to create a safe harbor from equitable review… is controversial…. To date, the Delaware courts have generally read the statute more narrowly, while drawing on it in crafting rulings in equity.” On appeal, the Delaware Supreme Court is likely to read Section 144 “narrowly.”
The Court in Cumming also disagreed with the view that compliance with Section 144 shifts the burden of proving the fairness of a conflicted transaction to the plaintiff. In the respected treatise Folk on the Delaware General Corporation Law, the authors (attorneys in the Delaware office of Skadden Arps) state “[c]ompliance with Section 144 merely shifts the burden to the plaintiffs to demonstrate that the transaction was unfair.” The Court stated “[w]hile I cannot say that I share that view of our law, I need not weigh in on that issue at this stage in the proceedings.”
Having rejected the Section 144 defense, the Court in Cumming denied the defendants’ motion to dismiss for failure to state a claim, finding that the complaint adequately alleged “that the Board acted out of self-interest or with allegiance to interests other than the stockholders’.” Based on that finding, the Court applied the entire fairness standard of review and concluded that, based on the allegations of the complaint, the transaction was not fair to the corporation’s stockholders because it was not the product of “fair dealing” and did not reflect a “fair price.”
In short, a transaction that complies with Section 144 based on an informed vote of disinterested directors or stockholders will not necessarily be subject to business judgment review and will not necessarily pass entire fairness review. The Section 144 “safe harbor” is not safe from claims for breach of fiduciary duty.
Also of interest in the Cumming opinion is that the Court found that two directors were not independent based on ties to an interested director through (1) common ownership of a unique asset and (2) common board membership. In the first case, the director had been invited by the interested director, Edens, to invest with him in the Milwaukee Bucks NBA basketball franchise, an opportunity available to only 25 investors, and had assisted Edens in an effort to build a new arena for the team. Although the joint investment did not require the cooperative planning that the ownership of a private plane did in Sandys v. Pincus, the Court found that the “dynamics” of the relationship were not “any less revealing of a unique, close personal relationship.”
In the second case the director in question also served with Edens on the board of another company, both of which were managed by Fortress, a company of which Edens was a principal. Fortress was the parent company of the counter-party to the challenged transaction. The director was placed on both boards by Fortress and derived 60% of his publicly reported income from Fortress-managed companies. He also listed Fortress as his forwarding address on public filings for unrelated investments. The Court concluded that the director lacked independence because of his “material ties” to Edens and Fortress.
James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.