Corporate law – and judicial application of that law – considers two facets of a transaction: (1) whether a corporation’s management used processes that are fair to stockholders to reach its decision (“process”), and (2) whether the economic results of that decision were substantively fair to stockholders (“substance”). That said, because courts generally view judicial review of economic substance as improper second-guessing of business judgment, corporate law has often given primacy to process-based concerns.
In recent decades, Delaware courts have pushed corporate law’s emphasis on process even further. In so doing, they have turned their eye toward a challenged decision’s qualitative procedural attributes – such as whether there was stockholder ratification – and discouraged trial judges from engaging in extensive quantitative examination of the economic substance of a decision, regardless of whether the deferential business judgment rule or some heightened standard of scrutiny applies.
In a new article, I evaluate and critique the substance/process dichotomy in corporate law. Although I largely agree with corporate law’s focus on process, I argue that courts have at times overlooked the difficulties with analyzing process and the complex relationship between process and substance, which are often inseparable as a practical matter. As my article contends, there is significant room for improvement in our understanding of the interactions between substance and process and thus throughout corporate law’s various legal standards.
To begin with, I largely agree with courts’ position that, as a matter of judicial policy, it is generally wise for courts to shy away from financial analysis, particularly in public or otherwise liquid markets. Notwithstanding some criticism (see here and here for examples), the courts are probably correct to be skeptical of their ability to measure the substantive economics of corporate decisions. The leading business court in the world, the Delaware Court of Chancery, is properly held in high regard for its business-law acumen, but it is nevertheless not an investment bank or business strategy hub.
Still, as my article marches through a number of corporate law doctrines, it finds that the distinction between substance and process often blurs at the edges, leading to doctrinal and practical issues when courts instead treat the two as a Manichean duality or otherwise gloss over the complex interactions between substance and process. For example, in merger cases to which the Revlon doctrine applies, courts have held that breakup fees exceeding a certain level inappropriately impair the sales process to the detriment of shareholders. But as theory and data indicate, the levels of these fees are integral to the substantive economic terms of merger agreements, which courts say should be left to the market. Similarly, in poison pill cases, the courts have held that defensive devices that directly impair voting or management rights (e.g., dead-hand pills) are impermissible, but those that operate via economic mechanisms (e.g., flip-in or flip-over pills) are allowed. But the underlying effect of both types of defensive devices is arguably the same: delay the ability of a majority of shareholders to sell their shares to a would-be acquirer.
Issues also arise when courts attempt to center their inquiry on procedural questions that turn out to be less procedural than envisioned. For example, Corwin attempted to shift courts’ focus away from more complex mixed issues of a deal’s substance and process by instead asking courts to examine whether there was an uncoerced and fully informed stockholder approval of such a deal. But as subsequent litigation has shown, analyses of stockholder votes under Corwin often devolve back into the substantive economic considerations surrounding the deal. Similarly, my article argues that Caremark, which requires boards to monitor corporate risks and respond to red flags of imminent dangers, is not the simple process-only question that the courts claim. As shown by recent cases, courts applying Caremark do and perhaps must consider the economic substance of those risks and dangers. Likewise, to the extent that Caremark inquires into monitoring processes and red-flag responses, there is reason to wonder at what point these processes and responses are but manifestations of substantive business decisions.
Finally, there are instances where the courts have chosen an arguably wrong procedural guardrail. Perhaps the most (in)famous example of this is the much-maligned Van Gorkum case, in which the Delaware Supreme Court ruled 3-2 that a board was liable for breach of fiduciary duty because it approved a merger too quickly, without sufficient evaluation. As my article argues, the problem with Van Gorkum was that – as the Van Gorkum dissenters point out – it imposed an unreasonably high standard for sale processes. Similarly, in appraisal cases such as Dell and DFC, the Court of Chancery and the Delaware Supreme Court have butted heads on whether the sale process likely resulted in a fair deal price. Regardless of who is right, the dispute shows that the question is far from easy, and that a judicial migration from focusing on substance to focusing on process may not be as simple or effective as one might imagine. Moreover, these cases also serve to underline the fact that process-centered rules are not inherently strict or forgiving, but rather depend on where courts draw the lines.
My article makes a small number of suggestions for reform. As to the fair value inquiries in entire fairness and appraisal proceedings, I suggest that, among other things, the Delaware General Assembly remove the statutory exclusion of “value arising from the accomplishment or expectation of the merger,” which requires courts to engage in difficult estimations of merger “synergies” and control premia. In the Corwin context, I suggest that courts revisit in depth what it means for a shareholder vote to be (1) “fully informed,” where I suggest that courts untether themselves from the difficult and circular definition of “materiality” used in securities law, and (2) “uncoerced,” where I suggest that courts more explicitly tie the term to the nature of the fiduciary breach. And as to Caremark, I suggest that courts focus on its more tractable red-flags prong. However, perhaps the most salient red-flags claims lie against officers (who are the likely the first to observe any red flags). Derivative claims against officers are unlikely to survive demand futility, while a board that brings such claims may mark itself as a difficult and capricious boss and unable to attract the best talent going forward, which makes for obvious conflicts with the board’s duties toward shareholders. Thus, courts should also consider how such structural conflicts might inform rules such as demand futility.
Ultimately, although there is an intimate connection between how judicial standards examine substance and process and the efficacy of judicial review, that connection cannot be reduced to a simple formula. The issues that arise out of the complex interplay between substance and process manifest themselves in many different ways. It cannot be said simply that mishandling the substance-process divide leads to law that is too shareholder-friendly, too management-friendly, too complicated, too simple, or any other singular descriptor. Rather, the issues that arise are the mixed results of complex interactions between legal theory and business practice, the latter of which of course changes over time. Mitigating these issues requires that courts squarely confront a host of issues and interactions, thus allowing them to synthesize judicial standards that are both more effective and more straightforward.
 For obvious reasons, this shortcoming is significantly diminished in the duty of loyalty context, where corporate fiduciaries are alleged to not even be trying to do right by their stockholder beneficiaries. Thus, corporate law generally takes a harder look at alleged duty of loyalty breaches.
This post comes to us from James An at Stanford Law School. It is based on his recent article, “Substance and Process in Corporate Law,” available here.