Sometimes It Takes a Non-Delaware Judge to Get Delaware Law Correct: CDX v. Venrock

We are discussing the CDX case, a decision written by Judge Posner that applies Delaware law. 

One of the more inexplicable directions that the courts in Delaware have taken has been to conclude that, with respect to a conflict of interest transaction, if a majority of the directors are independent (and disinterested), the applicable standard of review is the duty of care.  This is true even if the interested and non-independent directors participate in the approval process and even vote on the transaction.  In other words, the interested influence can remain in the decision making process yet the board still gets the benefit of the business judgment rule.

As a matter of common law, the approach is hard to justify.  The duty of care and the business judgment rule is an overinclusive presumption designed to protect risk taking by the board by insulating most decisions from liability.  But the standard applies only when the board's motivation is the best interests of shareholders and does not apply in the context of decisions involving a conflict of interest.  In those circumstances, any harmful decision may have been motivated by a desire to benefit the interested party.  As a result, the logic supporting an overinclusive presumption is gone.  

The Delaware courts have struggled with the justification for the extension of the business judgment rule to conflict of interest transactions approved by a board with a najority of independent directors.  In general, they have increasingly relied on the language in section 144, a provision that deals with the approval of interested transactions.  The provision, adopted in the 1960s, provides that transactions approved by a majority of disinterested directors are not voidable.  In other words, a conflict of interest transaction cannot be challenged solely because there is a conflict.

What the provision does not do is define the standard of review for the underlying behavior.  Yet the Delaware courts have held that it does and have relied on the disinterested approval mechanism as the justification for applying the business judgement rule standard.  This is an incorrect reading of the statute.  Delaware's approach in this area is discussed at length in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.

Which brings us back to CDX. Judge Posner considered the language in Section 144, including the disinterested approval mechanism and correctly interpreted the provision.

Defendants sought to use the disinterested director approval process to gain dismissal of the fiduciary duty claims.  The loans in questions had been fully disclosed to the board (including the conflict of interest) and were approved by disinterested directors.  As such, they seemed to meet the requirements of Section 144.  In Delaware, this would likely result in the application of the business judgment rule and the dismissal of the case. 

Judge Posner, however, took a different approach.  He agreed that disinterested approval eliminated any claim that the conflict itself was actionable.  ("[Defendants]   persuaded   the   district judge  that     disclosure of a conflict of interest excuses a breach of fiduciary duty.  It does not.  It just excuses the conflict.").  At the same time, however, disinterested approval under Section 144 had nothing to do with the applicable standard of review.  That depended upon the substantive claims made by shareholders.  As Judge Posner described: 

• To have a conflict and to be motivated by it to breach a duty of loyalty are two different things —the  first a factor increasing the likelihood of a wrong, the second the wrong itself.  Thus a disloyal act is  actionable even when a conflict of interest is not—one difference being that the conflict is disclosed,    the disloyal act is not.  A director may tell his fellow directors that he has a conflict of interest but that  he will not allow it to influence his actions as director; he will not tell them he plans to screw them.  If  having been informed of the conflict the disinterested directors decide to continue to trust and rely on   the interested ones, it is because they think that despite the conflict of interest those directors will continue to serve the corporation loyally.

This is certainly a correct statement of the meaning of Section 144.  Approval under the Section was intended to prevent the voidability of the transaction, not change the standard of review.  It was not intended to alter the standard of review used to analyze board actions.  Yet this is not the view of the Delaware courts. 

Apparently, it sometimes takes a non-Delaware court to accurately interpret Delaware law.  Another reason, perhaps, for shareholders to litigate Delaware law outside of Delaware. 

Comments

[AnonCorpLawyer]

See Benihana, in which the Delaware court applied 144 to determine that the transaction was not voidable by virtue of the conflict, and then applied a common law analysis to the approval process to conclude that the business judgment rule was the applicable standard of review and not rebutted by plaintiff. This is the better view on Delaware law -- 144 never purported to insulate conflicts of interest, but rather to reverse the old common law rule of voidability. See also 33 Del. J. Corp. L. 719 for an excellent discussion of Delaware law on this issue.

[J Robert Brown Jr.]

I read Benihana very differently. Here is the quote:

Section 144 of the Delaware General Corporation Law provides a safe harbor for interested transactions, like this one, if "[t]he material facts as to the director's . . . relationship or interest and as to the contract or transaction are disclosed or are known to the board of directors … and the board … in good faith authorizes the contract or transaction by the affirmative votes of a majority of the disinterested directors…."

After approval by disinterested directors, courts review the interested transaction under the business judgment rule, which "is a presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company."

It says to me that first you get approval under Section 144 then you apply the business judgment rule. This is in fact the way the courts have interpreted this provision.