The recently introduced Delaware Senate bill that would amend the Delaware General Corporation Law (DGCL) provision dealing with conflict of interest transactions (SB 21) has blown up the financial news, corporate law blogosphere, and corporate law social media.[1]

Most of the attention has focused on the new provisions dealing with conflict of interest transactions involving controlling shareholders. Those provisions are a rather blatant effort by the Delaware governor and legislature to nip in the bud the DExit phenomenon :controlled entities changing their state of incorporation from Delaware to, in most cases, Nevada or Texas.

Attention also needs to be paid, however, to the changes SB 21 makes to the provisions governing conflict of interest transactions involving directors and officers.

Acts versus Contracts

Prior Section 144(a) was limited to a contract or transaction between the director or officer and the corporation (direct conflicts) or between the corporation and an entity that the director or officer served as a director or officer or had a financial interest in (indirect conflicts).

As amended, the pertinent language will read: “An act or transaction involving or between a corporation and 1 or more of its directors or officers, or involving or between a corporation and any other [entity] in which 1 or more of its directors or officers are directors, partners, managers, members, or officers, or have a financial interest . . ..” SB 21 thus swaps “act” for contract. It also adds “involving” to between.

What work do these provisions do?

Director acts or transactions implicate the duty of loyalty and thus trigger entire fairness review when a director stands on both sides of a transaction or receives “a unique financial benefit to the exclusion of the shareholders.”[2] The highly respected Folk treatise on the DGCL claims that cleansing under the pre-SB 21 version of Section 144 extends only to the former type of self-dealing.[3] Does the addition of “involving” extend cleansing to the latter type of self-dealing? The drafters should clarify their intent in this regard.

Entities Covered

The initial changes to the first sentence of paragraph (a) simply make some technical changes that update the statute to reflect the burgeoning number of entities—such as LLCs—that Delaware has recognized since Section 144 was first adopted back in 1969. Curiously, however, the statute has not been amended to deal with a longstanding lacuna, namely, family conflicts of interest. Consider, for example, the facts of Bayer v. Beran,[4] in which the corporation hired the wife of its president. Their spousal relationship gave the president an indirect interest in the transaction. The court applied common law conflict of interest principles to resolve the case. It has always seemed curious that Section 144 does not address these sorts of family-based conflicts, apparently leaving them to the common law. It seems even more curious that the legislature does not use this opportunity to close that gap in the statutory scheme.

Effect on Judicial Review

The second set of changes to the first paragraph of Section 144 get us into serious doctrinal changes. The prior version of Section 144 was understood only to have eliminated the older common law rule that conflicted interest transactions were per se void or voidable. Because the statute thus did not fully validate related party transactions, but only shielded them from per se invalidation, a critical question is whether valid action under the statute precludes judicial review of a properly approved transaction. There is general agreement that valid action under Section 144(a)(1) does not preclude judicial review, but there is some disagreement as to the applicable standard of review.

In Marciano v. Nakash,[5] the Delaware Supreme Court held that “approval by fully-informed disinterested directors under section 144(a)(1) . . . permits invocation of the business judgment rule and limits judicial review to issues of gift or waste with the burden of proof upon the party attacking the transaction.” Likewise, the court in Benihana of Tokyo, Inc. v. Benihana, Inc.[6] held that following “approval by disinterested directors, courts review the interested transaction under the business judgment rule.”

A number of leading commentators, although not all, agree that the business judgment rule applies to transactions approved by a majority of the disinterested directors under Section 144(a)(1).[7] Decisions from other jurisdictions interpreting comparable statutes have reached the same result.[8] Despite these precedents, some Delaware courts have suggested that fairness is the appropriate standard of review rather than the business judgment rule.[9]

By way of contrast, the Model Business Corporation Act long has provided that approval of a conflicted interest transaction by either a fully informed majority of disinterested or a fully informed majority of shareholders precludes judicial review.[10]

The new language introduced by SB 21 adopts the MBCA approach. Indeed, SB 21’s drafters appear to have cribbed their text directly from the MBCA. Both state that a conflicted interest transaction “may not be the subject of equitable relief, or give rise to an award of damages or other sanction” if the transaction receives the requisite approval. As such, we can assume that SB 21’s drafters intend that revised Section 144, like the MBCA, render “a director’s conflicting interest transaction . . . immune from attack by a shareholder or the corporation on the ground of an interest of the director”[11] if the statutory cleansing process is correctly followed.

Presumably, SB 21’s drafters also intend for revised Section 144(a) to track the MBCA by allowing an action to lie where the cleansing process was not properly followed. The comments to the relevant MBCA provision state that:

A challenge to the effectiveness of board action for purposes of section 8.61(b)(1) might also assert that, although the conflicted director’s conduct in connection with the process of approval by qualified directors may have been consistent with the statute’s expectations, the qualified directors dealing with the matter did not act in good faith or on reasonable inquiry. The kind of relief that may be appropriate when qualified directors have approved a transaction but have not acted in good faith or have failed to become reasonably informed—and, again, where the fairness of the transaction has not been established under section 8.61(b)(3)—will depend heavily on the facts of the individual case.

Participation by the Conflicted Director or Officer

Unlike MBCA Section 8.62, which contemplates that the decision to approve a conflicted interest transaction should be made outside the presence of the conflicted party, Section 144(a) long has allowed the conflicted party to participate in and even vote on the transaction. Revised Section 144(a) thus is largely a clarifying amendment. Having said that, however, several Delaware cases suggest that “director should not participate in negotiations if conflict of interest would result.”[12] The new language presumably is intended to legislatively overrule those cases.

Approval by How Many Disinterested Directors?

There was an interesting distinction between the general director voting rule set out in DGCL Section 141(b) and that set out in pre-SB 21 Section 144(a)(1). The former looks to whether the proposed action was approved by a “majority of the directors present at a meeting at which a quorum is present.” The latter requires the “affirmative votes of a majority of the disinterested directors.” Note the absence of the qualifying word “present” in the latter. Suppose the corporation has five directors, one of whom is interested in the transaction. Two of the four disinterested directors attend the board meeting at which the transaction is to be approved. Because the interested director counts towards a quorum, they can proceed to vote. Assume both disinterested directors vote to approve the transaction, while the interested director abstains. A majority of the directors present at the meeting voted for the transaction, so it is properly approved for purposes of Section 141(b). Yet, two out of four disinterested directors are not a majority and, as such, the transaction seemingly has not been approved for purposes of Section 144(a)(1). Cf. Beneville v. York, 769 A.2d 80, 82 (Del.Ch.2000) (noting that under “traditional rules of board governance” a motion on which the board is evenly divided fails). Presumably the transaction therefore would have to pass muster under Section 144(a)(3).

Oddly, SB 21’s drafters did not avail themselves of the opportunity to clarify that issue.

Approval by the Disinterested Shareholders

In Fliegler v. Lawrence,[13] defendant John C. Lawrence was president of Agau Mines, Inc., a gold and silver mining corporation. Lawrence had individually acquired some antimony properties, which he offered to Agau. In consultation with Lawrence, the Agau board declined on grounds that the corporation’s legal and financial position did not allow it to undertake the venture. Lawrence then formed the United States Antimony Co. (USAC), to which the properties were transferred. USAC granted Agau an option to acquire USAC in exchange for Agau stock, which Agau eventually exercised. The decision to exercise the option was approved by the shareholders. Dissenting Agau shareholders then sued.

Defendants relied on DGCL Section 144(a)(2) in arguing that shareholder approval relieved defendants of the common law obligation to prove the transaction’s fairness. The court agreed that shareholder ratification of a conflicted interest transaction shifted the burden of proof from the defendants to the objecting shareholders. On the facts of this case, however, the burden would not shift. A majority of the shares voted in favor of the transaction had been cast by the interested defendants in their capacities as Agau shareholders. In the court’s view, those votes should not count. Instead, only the votes cast by disinterested shareholders count and only the vote of a majority of such disinterested shareholders has the desired burden-shifting effect.

The court’s reading of Section 144 is inconsistent with a plain-meaning approach to statutory construction. Section 144(a)(1) requires approval by “a majority of the disinterested directors,” but Section 144(a)(2) requires only approval by a “vote of the shareholders.” The statute’s drafters thus inserted a requirement of disinterest in (a)(1) but not in (a)(2). Accordingly, on the face of the statute, shareholder approval ought to be effective even if the shareholders are not disinterested. The court relied on equitable principles, however, to evade the statute’s text.

SB 21 adopts the Fliegler approach.

ENDNOTES

[1] Portions of the discussion of the pre-SB 21 statute and the caselaw thereunder are adapted from Stephen M. Bainbridge, Corporate Law (4^thedition 2020).

[2] Pfeffer v. Redstone, 965 A.2d 676, 690 (Del. 2009).

[3] Robert S. Saunders et al., Folk on the Delaware General Corporation Law: Fundamentals § 144.05 at GCL-306 (2023).

[4] 49 N.Y.S.2d 2 (Sup.Ct.1944).

[5] 535 A.2d 400, 405 n. 3 (Del.1987).

[6] 906 A.2d 114, 120 (Del. 2006).

[7] See, e.g., Michael P. Dooley, Two Models of Corporate Governance, 47 Bus. Law. 461, 490 (1992); Charles Hansen et al., The Role of Disinterested Directors in “Conflict” Transactions: The ALI Corporate Governance Project and Existing Law, 45 Bus. Law. 2083, 2093–94 (1990); Claire Hill & Brett McDonnell, Sanitizing Interested Transactions, 36 Del. J. Corp. L. 903, 905 (2011). But see Melvin Aron Eisenberg, Self-Interested Transactions in Corporate Law, 13 J. Corp. L. 997, 1005 (1988) (contending that “approval by disinterested directors should not insulate a self-interested transaction from judicial review for fairness”).

[8] See, e.g., Cohen v. Ayers, 596 F.2d 733, 740 (7th Cir.1979) (under New York law, after approval by the disinterested directors, “the business judgment rule is again applicable [to an interested director transaction] and the plaintiff can succeed only by meeting the burden applicable to challenges of any corporate transaction”).

[9] See, e.g., Cumming on behalf of New Senior Inv. Group, Inc. v. Edens, 2018 WL 992877, at *22 (Del. Ch. Feb. 20, 2018)  (opining that “compliance with Section 144(a)(1) does not necessarily invoke business judgment review of an interested transaction”; emphasis in original).

[10] MBCA sections 8.61(b)(1) and 8.62.

[11] MBCA Section 8.61 cmt.

[12] Thorpe by Castleman v. CERBCO, Inc., 676 A.2d 436, 442 (Del. 1996) (citing Weinberger v. UOP, Inc., 457 A.2d 701, 710–11 (Del. 1983) and Bershad v. Curtiss-Wright Corp., 535 A.2d 840, 845 (Del. 1987)).

[13] 361 A.2d 218 (Del.1976).

This post comes to us from Stephen M. Bainbridge, the William D. Warren Distinguished Professor of Law at UCLA School of Law. Bainbridge addresses the provisions of SB 21 that affect controlling shareholders in A Course Correction for Controlling Shareholder Transactions.