Delaware Law, Voidable Transactions, and the Implications for the Duty of Loyalty: SPTA v. Volgenau
One classic example of a shift in Delaware law to the detriment of shareholders occurred in connection with a misapplication of Section 144 of the DGCL. The provision deals with transactions involving director conflicts of interest and provides that no agreement shall be "shall be void or voidable" as a result of the conflict where the transaction is approved by shareholders, disinterested shareholders, or is otherwise fair.
The meaning of the provision is plain. It was intended to prevent conflict of interest transactions from being voidable (something that was possible under the old common law standard). Nonetheless, Delaware courts have misapplied the provision and used it to significantly change the standard of review for conflict of interest trnasactions. The courts have concluded that Section 144, if properly used, results in the application of the duty of care rather than the duty of loyalty to a conflict of interest transaction.
The incorrect nature of the interpretation is clear from the language of the statute (it speaks only to voidability) and from the standards set out in the statute. Voidability is avoided through a showing of fairness, approval by disinterested directors, or approval by shareholders. Despite suggestions by the Delaware courts to the contrary, the statute does not require approval of the transaction by disinterested shareholders. Thus, if Section 144 were read to change the standard of review (instead of addressing only voidability), it would effectively be allowing a change in the standard in the unjustifiable circumstances of approval by interested shareholders. For a more detailed discussion of this issue, see Returning Fairness to Executive Compensation.
We note all of this because of the recent decision by the Chancery Court that shows how Section 144 ought to work. In Southeastern Pennsylvania Transportation Authority v. Volgenau, 2012 Del. Ch. Lexis 206 (Del. Ch. Aug. 31, 2012), the court had to interpret Section 124, the ultra vires provision. The provision provided that "[n]o act of a corporation . . . shall be invalid by reason of the fact that the corporation was without capacity or power to do such act" but provided that the lack of authority could only be raised in certain circumstances, including "a proceeding by a stockholder against the corporation to enjoin the doing of any act or acts".
Plaintiffs challenged a merger approved by the board and argued that the transaction was ultra vires because it violated the articles of incorporation. Defendants sought dismissal of the action alleging that plaintiffs had not met the requirements of the statute because the action was for damages, not an injunction.
The court declined to dismiss the action, however. It noted that Section 124 spoke to voidability, that is a claim "that the act could not occur." Actions by corporations that are not voidable under the statute could still be challenged as a violation of the board's fiduciary obligations. The court noted that the Section did not speak to fiduciary obligations.
The General Assembly could have stated in 8 Del. C. 124 that a director's decision to cause a corporation to take an act in violation of the corporation's certificate of incorporation shall not constitute a breach of that director's fiduciary duties. But the General Assembly did not do that. Instead, it enacted a statute directed solely to the acts of corporations that are beyond challenge or that may only be challenged in a limited manner.
The same paragraph could have been written about Section 144. The provision references voidability but says nothing about fiduciary duties. Nothing in Section 144 addressed the right of shareholders to challenge transactions that were found not to be voidable. In other words, the standard of review for these transactions is a matter of common law, not a matter of statutory mandate.
The inapplicability of Section 144 matters. To the extent that the courts want to provide benefits to boards that use a disinterested approval mechanism, they have the flexibility as a matter of common law to decide those benefits. Delaware courts already provide that disinterested approval of transactions with controlling shareholders (a type of transaction not expressly covered by Section 144) will not result in a shift from the duty of loyalty to the business judgment rule but simply results in a shift of the burden of showing unfairness to the challenging shareholders.
A shift in the burden would mean that fairness still mattered. The terms of the transaction would be relevant to the analysis. Shareholders would not be limited to the impossible standard of waste. The result would be a more exacting standard of review by directors and, in the case of executive compensation, downward pressure on amounts. Yet as long as the courts point to Section 144, they can lay the blame for an inadequate standard of review at the feet of the Delaware legislature.
Primary materials are posted on the DU Corporate Governance web site.