Derivative Suits, Delaware and the Race to the Bottom: Schoon v. Smith (Part 2)

We are discussing Schoon v. Smith, a recent decision by the Delaware Supreme Court denying a single director the right to bring a derivative suit.  We mentioned in the last post that the Court used some disingenuous reasoning.  It did so by relying on Section 144 to emasculate the duty of loyalty.  

In giving an example of the importance of independent directors, the Court cited Section 144(a) and indicated that "independent directors may cleanse conflict of interest transactions," resulting in the application of the business judgment rule.  This has been one of the most audacious and little discussed changes in a board's fiduciary obligations implemented over the last few decades by the Delaware courts.  Delaware courts have determined that approval of a conflict of interest transaction by a majority of independent directors results in the application of the business judgment rule, eliminating the duty of loyalty and any consideration of fairness. 

The courts (including this one) have done so by relying on Section 144 of the Delaware Corporation Code.  As I discussed extensively in my paper, Disloyalty without Limits, this is misconstruction of Section 144.  Section 144 was a sleepy provision adopted in the 1960s in order to codify the common law principle that conflict of interest transactions were not voidable if appropriately approved.  Approval included not only disinterested directors but also shareholders (with no limit that they be disinterested).  The section never contemplated that these approval mechanisms would "cleanse" the taint and change the traditional standard of review from the duty of loyalty to the all but insurmountable duty of care and business judgment rule.  Indeed, were that the case, then approval by a majority of shareholder, even those interested in the transaction, would have the same affect. 

Under traditional common law notions of fiduciary obligations, the approach makes no sense.  It ignores the fact that even with a majority of "independent" directors, the conflict of interest is still present in the boardroom.  The courts have never required that the interested influence be excluded from the decision making process.  Thus, the interested director can attend the meetings, participate in the debate, and even vote on the matter, yet have the transaction receive the protection of the business judgment rule as long as a majority of board is independent.   

It is, therefore, inappropriate to apply the business judgment rule in these circumstances.  The business judgment rule is an over inclusive presumption that shields directors from negligence and even gross negligence.  This heightened degree of insulation from liability only makes sense where the decision was not motivated by self interest.  By allowing the interested director and those controlled by the interested director to remain in the decision making process, the courts cannot rule out the possibility that the decision was made not in the best interests of shareholders but in an effort to benefit the interested director. 

As a result, the Delaware courts have taken transactions where the interested influence is still present and applied the presumption of the business judgment rule, eliminating any consideration of fairness.  They cannot justify the extension based upon the common law so they purport to rely on Section 144, a misreading of the provision.  Moreover, in this case, the Court went out of its way to incorrectly apply Section 144.  The reference was dictum and not necessary for the holding of the case.  Nonetheless, the statement will henceforth be cited often for the proposition that Section 144 commands application of the business judgment rule to any transaction approved by a majority of "independent" directors. 

In the race to the bottom in Delaware, it is the outcome not the integrity of the reasoning that is important, as this Court demonstrates. 

We have posted the opinion and redacted briefs on the DU Corporate Governance web site.