Delaware and the Responsibility for SOX: Eliminating Fairness from the Duty of Loyalty

We have been discussing the responsibility of Delaware for the adoption of SOX. The state courts have, over time, weakened the fiduciary obligations imposed on management. For an article that discusses this, go here. 

In general, state law requires that conflict of interest transactions (those between a fiduciary and the company) be fair.  The burden of proving fairness rests with the fiduciary (in most cases, this means the board of directors). One way to establish fairness is to show that the terms of the transaction are comparable to those that would be obtained in an arms length bargain.

Delaware courts, however, provide a procedural mechanism for eliminating fairness.  They take the position that conflict of interest transactions approved by a board consisting of a majority of "independent" directors is entitled to deference and the application of the business judgment rule (exempting only those between the company and a controlling shareholder). The business judgment rule, as all who are versed in fiduciary duties knows, is an almost insurmountable standard that focuses on process, not the terms of the transaction. A good recent example was the Disney case where, despite all the sturm und drang over the employment contract given to Michael Ovitz (the one that reportedly resulted in the payment of $140 million for slightly more than a year of work), the terms were never examined for fairness.

There are many problems with this approach, not the least of which there is little legal basis for it. Some courts contend that the requirement arises out of Section 144 of the Delaware Code, but as I have discussed, this is flat wrong. Moreover, to the extent willing to defer to decisions of independent directors, it would seem that the courts ought to set out a rigorous standard designed to ensure that the directors are in fact independent. They do no such thing, developing a myriad of rules and approaches that prevent examination of a director’s independence.

Most importantly for purposes of this series, however, the approach effectively allows the interested directors to participate in the decision making process and vote on the conflict of interest transaction.  For the business judgment rule to apply, the Delaware courts merely require that a majority of the board be independent.  Effectively, this approach reduces the analysis of the applicable standard to a rote head count.  If a majority of the directors are not independent, the duty of loyalty applies. If not, the duty of care applies. The actual influence of the interested directors plays little or no role in the analysis. Thus, a shift in the independence of a single director can determine dramatically different standards of review that can be outcome determinative.  This is exactly what occurred in the Viacom case discussed elsewhere on this page.

Let us bring this back to the loans and guarantees to Bernie Ebbers.  If they are approved by a board consisting of a majority of independent directors, the terms don't matter.  It is enough that the board was informed, acted in good faith, and in the best interests of shareholders.  Under that standards of review, the loans do not have to meet commercially reasonable standards and be reasonable in amount.  Had the duty of loyalty applied, however, the board would have had to establish the fairness of the loans.  In those circumstances, they likely would have had to meet commercially reasonable standards and be reasonable in amount.