Vaughn Marshall has posted on Tyson, the second of the backdating cases decided by the Delaware Court of Chancery. Another of the interesting points concerns the never explained, hard to justify standard used by Delaware courts to dismiss claims for breach of the duty of loyalty.
The Delaware courts have determined that a conflict of interest transaction will be reviewed under the all but impossible to overturn business judgment rule if it is approved by a board with a majority of independent directors. The courts have never explained why a transaction is entitled to an almost irrebutable presumption of validity when the conflict of interest is still present in the decision making process (interested and non-independent directors can participate, they just can't be a majority of the board). Moreover, the courts employ a definition of "independence" that does not ensure that majority is in fact independent. I discuss all of this in much greater detail in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.
The misguided standard also conveniently overlaps with the standard for dismissing a derivative suit. For demand to be excused under Aronson, shareholders must show reasonable doubt that: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. As we have discussed often on this Blog, the Delaware courts routinely throw out challenges to director independence through the use of inconsistent tests and excessively high pleading standards. Characterizing the board as independent effectively resolves the duty of loyalty claim. It means the transaction was approved by a majority of independent directors and therefore a valid exercise of business judgment. Thus, the courts conflate the finding of an independent board in the context of demand excusal context with the substantive claim of breach of the duty of loyalty. /as a result, the excessively high pleading standards in the case of demand excusal prevent the underlying claim of breach of the duty of loyalty from ever being reached.
This came up in Tyson. Chancellor Chandler concluded that the board was not independent and, therefore, demand was excused. Defendants, however, also made a motion to dismiss the underlying claim for breach of the duty of loyalty. The court admitted that the two tests (Aronson and the standard for determining a violation of the duty of loyalty on a motion to dismiss) were similar. Both required "reason to doubt the independence or interestedness of a majority" of the board. The two, however, were subject to different pleading standards. As he noted:
- "In the context of a motion to dismiss under Rule 23.1 [the standard for demand excusal], the Court considers the directors in office at the time a plaintiff brings a complaint, and plaintiffs may not rely upon the notice pleading standards of Rule 8 (a). In the context of a motion to dismiss for failure to state a claim, on the other hand, the directors relevant to the Court's decision will usually be those in office at the time the challenged decision was made, and the standard, while perhaps more rigorous in derivative cases than in some others, does not reach so high a bar as Rule 23.1. In both cases this Court must make all inferences in favor of plaintiffs, but in the Rule 23.1 context such inferences may only be drawn from particularized facts, while in the former case I may draw from general, if not conclusory, allegations." (footnote omitted).
In this case, however, the different standards only mattered because the court found demand excusal. With demand excusal, it could apply the separate and lower pleading standard to the substantive claim. Had it not found demand excusal, the case would have been dismissed without ever applying this standard to the underlying claim.
The language by Chancellor Chandler is in fact an admission that the courts use the standards for demand excusal to dismiss claims that would otherwise be sustained if reviewed under more reasonable pleading standards. In other words, as long as you meet the weak standards in Delaware for a majority independent board, there is no need to worry about judicial review of the substance of a duty of loyalty claim. No wonder conflict of interest transactions -- like executive compensation -- seem so out of control.