Latest Delaware Decisions Reveal the Limits of the Business Judgment Rule

When it comes to understanding the nuances of the business judgment rule, the Delaware courts never disappoint. New Delaware cases shed light on this judicial doctrine, often applied when courts opine on fiduciary duties.

Director defendants sued for fiduciary duty violations typically ask for the protections of the business judgment rule, no matter how their decisions turn out. They trust that the principle will protect them as long as they have made reasonably informed choices in good faith without conflicts of interest.

But director defendants do not always succeed in attaining this protection. Over the years, many shareholder plaintiffs have succeeded in convincing courts to apply stricter standards. One of the standards is enhanced scrutiny. As this term implies, this standard requires the court to look closely into the details of director decision-making. The other standard (applied only to transactions when there is a controlling owner) is entire fairness, which includes both substantive fairness (fair price) and procedural fairness (fair dealing). When plaintiffs ask for enhanced scrutiny or entire fairness rather than the business judgment rule, they argue that the court should not trust directors’ judgment in the matter, because they failed to inform themselves or had conflicts.

In making such arguments, plaintiffs often say that the defendants fail to meet the “MFW” test,  named after the legal case Kahn v. M & F Worldwide Corp. That case said that any sale of a company requires approval by an independent and disinterested separation committee and a majority of uncoerced, fully informed, and unaffiliated stockholders. Another standard plaintiffs may invoke is the Caremark standard, derived from In re Caremark International Inc. Derivative Litigation, which requires directors to “attempt to assure a reasonable information and reporting system exists” (a standard the original defendants had met).

There have been 14 Delaware cases so far this year in which courts have applied, or declined to apply, the business judgment rule. Only three cases—all in the Chancery Court (Conte v. Greenberg, In re Carvana Co. Stockholders Litigation, and Clem v. Skinner)—have applied it, while 11 cases have declined to do so. But knowing how many business judgment rule requests failed is less important than understanding why they failed. The following case summaries provide insights.

In the Delaware Court of Chancery

BV Advisory Partners, LLC v. Quantum Computing Inc. et al. This case involved an alleged breach of fiduciary duties in the sale of QPhoton to Quantum Computing.  While dismissing many of the claims brought by the plaintiffs, the court did allow for a breach of fiduciary duty claim against the QPhoton founders. If the allegations of conflicts of interest can be proved, these founders will be liable to the plaintiff for damages or injunctive relief. The opinion notes that a plaintiff bringing suit “may rebut the presumption of business judgment if… the plaintiff adequately alleges that the corporation’s controlling stockholder has engaged in a conflicted transaction.” That question will be resolved as the case proceeds.

Clem v. Skinner. This case, a derivative action against Walgreens Boots Alliance, invoked the business judgment rule in the context of the 1996 Caremark opinion, which requires directors to “attempt to assure a reasonable information and reporting system exists.” Writing for the court, Vice Chancellor Lori W. Will notes that over the past several years, “Caremark suits have proliferated in Delaware,” but only a few are viable; most fall outside the scope of a legitimate Caremark claim. “Fueled by hindsight bias, they seek to hold directors personally liable for imperfect efforts, operational struggles, business decisions, and even when the corporation is the victim of a crime,” Will writes. She called the complaint against Walgreens an “unexceptional member of this broader group,” noting that “more harm than good comes about if Caremark claims are reflexively filed whenever a government investigation is announced, a class action lawsuit succeeds, or a big-dollar settlement is reached. From a doctrinal perspective, this expansion risks weakening the ‘core protections of the business judgment rule.’” Will dismissed the case.

Conte v. Greenberg. This was a derivative case filed on behalf of Skechers USA. (In a derivative case, the plaintiffs allege that the board won’t take action against management so they will do so on behalf of the company.) The plaintiffs sued because they said that the board failed to oversee executives’ use of corporate airplanes. But Vice Chancellor Morgan T. Zurn granted the defendants’ motion to dismiss the case, noting that “a board’s decision to respond to a red flag, including a decision not to act, is protected by the business judgment rule.”

HBK Master Fund v. Pivotal Software. The plaintiff in this case challenged Pivotal’s valuation and the defendant (Pivotal) said it should fall under the business judgment rule and be judged by the MFW standard. Chancellor Kathaleen St. J. McCormick disagreed. “Accordingly, this decision foregoes the MFW analysis urged by Respondent. Surely, deal price is relevant.”  The court conducted a valuation and ordered the defendant to pay the petitioner the difference between the amount paid and the court’s valuation.

In re Carvana Co. Stockholders Litigation. When directors and controlling shareholders in Carvana sold their shares, minority shareholders sued, alleging a failure to fulfill fiduciary duties. The special litigation committee evaluating the sale found that no wrongdoing had occurred. Based on precedent (Zapata Corp. v. Maldonado), the committee had the burden of proof to show its independence and good faith, and to demonstrate that it conducted an investigation of reasonable scope and conclusions that yielded reasonable bases supporting its conclusions. The court then applied “its own business judgment” to the matter and found that the special litigation committee did prove its case, so the court granted the defendants their motion to dismiss.

Kuramo Capital LLC et al v. Larry Seruma et al. The plaintiffs accused the defendant, Seruma, executive chair at Feronia, and others, of cheating them out of a majority stake in shares of a company they jointly owned with Seruma when Seruma sold the company. The defendant wanted to be judged on the business judgment rule; he said that the asset sale was approved by Feronia’s independent directors with the advice of counsel, implemented by an independent trustee, and approved by a Canadian bankruptcy court. But the Delaware Court of Chancery disagreed, saying that the defendant had defined his fiduciary relationships too narrowly; Seruma owed fiduciary duties to the debtor and creditors as well. The court opted to review the transaction under the entire fairness standard and asked both parties to submit new pleadings.

McRitchie v. Zuckerberg. This novel case tested the limits of the business judgment concept. The plaintiff, a longtime governance activist, sued Meta directors for a failure to serve diversified shareholders that own Meta stock. He argued that the business judgment rule should apply only when directors hold a diversified portfolio of shares and can thus consider interests beyond those of the corporation they serve. In the case of Meta directors, they have significant holdings in Meta stock so, as the opinion summarizes, “Meta consciously and openly prioritizes company-specific value over harm to the economy and society.” Vice Chancellor J. Travis Laster disagreed, stating that Delaware law is firm-specific: “directors of a corporation owe duties to the stockholders as investors in that corporation. That point is so basic that no Delaware decisions have felt the need to say it. Fish don’t talk about water.”

Palkon v. Maffei. The plaintiffs charged Tripadvisor with violation of fiduciary duty because a controlling shareholder led a vote to change the company’s domicile to Nevada. The defendants asked the court to dismiss the case, claiming that the decision was a matter of business judgment. But Vice Chancellor Laster concluded that “Here, the defendants did not establish the MFW protections up front, and they will bear the burden of proving entire fairness. The defendants’ motion to dismiss is therefore denied.”

Tornetto v. Musk. In her opinion in this landmark case, Chancellor McCormick opens by asking, “Was the richest person in the world overpaid?” Although she cites the plaintiff’s argument that the Tesla board indeed overcompensated its CEO in 2018, she never opines on that question. Instead, McCormick focuses on the lack of independence in the decision. She lets stand an earlier finding that the business judgment rule did not apply in this case, and she looked at the matter under the entire fairness standard instead. According to McCormick, the Tesla board failed that standard. She ordered recission of the payment to Musk. Note: Following this decision, Tesla announced that there would be a vote at its June 13 annual meeting to affirm the original approval of the pay package in question, as well as a vote on reincorporating in Texas. Plaintiffs, concerned that Tesla would avoid Delaware court orders, filed motions to force court orders implementing the recission but the court dismissed the motions.  

West Palm Beach Firefighters' Pension Fund v. Moelis & Co. The plaintiffs in this case were stockholders in Moelis & Co. They challenged the validity of a restrictive stockholder agreement at Moelis limiting what the Moelis board can do. The plaintiff said that the agreement, which was created after Moelis went public, violates Section 141(a) of Delaware law, which says that the company shall “be managed by or under the direction of” a board.  While the defendant, Moelis, claimed that directors could still exercise their business judgment the court found that under the agreement they could not, and so declared parts of the contract invalid and asked the litigants to return with a revised agreement.

In the Delaware Supreme Court

City of Dearborn Police and Fire Revised Retirement System et al v. Brookfield Asset Management Inc. et al. In this case, the Chancery Court had dismissed plaintiffs’ claims alleging a violation of fiduciary duties in transacting a merger that they allege was unfair to minority shareholders. The Delaware Supreme Court, admitting that the case was a “close call,” reversed the Chancery Court decision on the grounds that the company’s proxy statement failed to disclose conflicts of interest by the advisors to the special committee formed to evaluate the merger.

City of Sarasota Firefighters’ Pension Fund et al v. Inovalon Holdings, Inc. et al. When the board of Inovalon approved the sale of the company to a private equity group, shareholders sued the board members alleging, among other issues, a violation of fiduciary duties. The question before the Delaware Supreme Court in this case was whether the Delaware Chancery Court was right to dismiss the case on the grounds that the decision to sell was a business judgment made with the proper level of independence and approval (the aforementioned MFW standard). The Delaware Supreme Court disagreed, finding that the transaction failed to meet either of the two prongs of the MFW standard. The independent committee charged with overseeing the sale was not involved early enough in the decision, and the vote of the shareholders was not adequately informed because the company’s proxy statement failed to disclose conflicts of interest on the part of some of the special committee’s advisors. The Supreme Court reversed the decision by the Chancery Court and remanded it back to the lower court.

In re Match Group, Inc. Derivative Litigation. Shareholders in Match Group, owner of the Match.com dating site, challenged the fairness of a transaction by Match’s former parent company IAC. The plaintiffs alleged that when Match separated from the parent company, the minority shareholders of Match did not get fair treatment. The case started in the Chancery Court, which found that the board of IAC followed the MFW framework. The lower court had found that the separation committee was sufficiently independent even though one of the separation committee members lacked independence as the former chief financial officer of IAC, but the Delaware Supreme Court stated that the MFW standard requires all members to be independent. The case was remanded back to the Chancery Court to be reviewed under the entire fairness standard.

In re Sears Hometown and Outlet Stores, Inc. Stockholder Litigation. This case involved a CEO who used his power as a controlling stockholder to prevent the liquidation of a poorly performing business unit. The plaintiffs were minority shareholders who alleged that the CEO violated his fiduciary duties. Here, the court applied the enhanced scrutiny standard rather than the business judgment rule. The CEO, said Vice Chancellor Laster, had to “show that he acted in good faith for a legitimate objective and had a reasonable basis for believing that action was necessary.” The court found that the CEO acted in good faith and did not violate his fiduciary duties. However, under enhanced scrutiny, the judge found that the actions of the CEO created an unfair situation and the court ordered payment of $1.78 per share (plus interest) to plaintiffs.  

Understanding the lessons in these latest Delaware cases can help directors decrease the likelihood of getting sued for their decisions in the first place—and when sued, increase the likelihood of receiving business judgment protection.