Controlling Shareholder
Duty of Loyalty: Entire
Fairness or Business
Judgment
Webb Hecker
May 29-30, 2014
University of Kansas School of Law
CONTROLLING SHAREHOLDER DUTY OF LOYALTY: ENTIRE FAIRNESS OR
BUSINESS JUDGMENT RULE?1
Edwin W. Hecker, Jr.
Professor of Law
University of Kansas School of Law
Lawrence, Kansas 66045
(785) 864-9231
whecker@ku.edu
I. Directors’ duty of loyalty.
A. Common law.
1. Business Judgment Rule.
a. As long as directors are acting in good faith, with sufficient information, and not
subject to a self-dealing conflict of interest, they should be free from having their
business decisions second-guessed by minority shareholders and judges.
b. This judicial deference is known as the business judgment rule, and it protects
directors’ decisions that fall short of being characterized as waste: those rare,
unconscionable cases in which directors irrationally squander corporate assets or
make decisions that cannot be attributed to any rational business purpose. In re
Walt Disney Co. Derivative Litigation, 906 A.2d 27, 74 (Del. 2006).
c. In Delaware and Kansas, the business judgment rule 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
interests of the company.” Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984);
accord Becker v. Knoll, 239 P.3d 830, 834 (Kan. 2010).
2. Entire Fairness.
a. The easiest way for a plaintiff to rebut the business judgment rule is to show that
directors have a self-dealing financial interest in the subject matter of their
decision. Fliegler v. Lawrence, 361 A.2d 218, 221 (Del. 1976).
b. Such a situation is inherently suspect, because the director is receiving a
pecuniary benefit not available to other similarly situated shareholders, thus
creating the danger that a fiduciary may be profiting at the expense of his or her
beneficiaries.
c. Consequently, at common law, such a contract or transaction is not reviewed
under the director-friendly business judgment rule. Aronson v. Lewis, 473 A.2d
805, 812 (Del. 1984). Rather, its substantive merits are subject to strict judicial
scrutiny under the entire fairness standard, with the burden of proof on the
interested director(s) to establish good faith and fairness. Newton v. Hornblower,
582 P.2d 1136, 1145-47 (Kan. 1978).
d. Entire fairness has two aspects: procedural (fair dealing) and substantive (fair
deal). Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983); Becker v. Knoll,
239 P.3d 830, 835 (Kan. 2010).
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This outline is based in substantial part on Hecker, Fiduciary Duties in Business Entities Revisited, 61 U. KAN. L.
REV. 923 (2013).
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i. “Fair dealing” includes when the transaction was timed, how it was initiated,
structured, negotiated, disclosed to the board, and how the director and
shareholder approvals were obtained. Weinberger v. UOP, Inc., 457 A.2d 701,
711 (Del. 1983).
ii. “Fair deal” relates to price and includes assets, market value, earnings, future
prospects, and any other relevant factors. Id.
3. Disinterested shareholder ratification.
a. If, after disclosure of all material facts, the holders of a majority of the voting
shares held by persons who are not interested in a director self-dealing transaction
vote to approve it, the taint of interest is removed, and the standard of judicial
review reverts to the business judgment rule with the burden of proof on the party
attacking the transaction to show waste. Gottlieb v. Heyden Chemical Corp., 91
A.2d 57, 58-59 (Del. 1952).
b. The policy underlying this exception is as follows:
i. The business judgment rule is premised on the proposition that the interests of
the corporation and its shareholders are best served by a board of directors
free to make business decisions without being second-guessed by courts as
long as the directors are informed and acting in good faith and unselfishly.
ii. If, however, those decisions are potentially selfish rather than unselfish, the
interests of the corporation and shareholders need the additional protection of
careful scrutiny of the merits (second-guessing) by a fully informed and
disinterested party (the judge).
iii. However, if the merits of the decision have already been subjected to careful
scrutiny by fully informed and disinterested parties (the disinterested
shareholders), further scrutiny by the court is unnecessary and redundant.
iv. In other words, this exception views “fairness” as a process of careful scrutiny
of the merits of a conflicted decision by fully informed, disinterested
observers, and equates scrutiny by disinterested shareholders with scrutiny by
a disinterested judge.
B. Codification.
1. The Delaware legislature approved the view that fairness is a process of informed
scrutiny by a disinterested party or parties and went one step farther than the common
law when it recodified its Delaware General Corporation Law (“DGCL”) in 1967.
Kansas followed suit in its 1972 recodification of the Kansas General Corporation
Code (“KGCC”).
2. DGCL § 144 and KGCC § 17-6304, in effect, provide that director or officer selfdealing contracts or transactions are not voidable on the basis of interest if:
a. The material facts regarding the conflict of interest and the contract or transaction
are disclosed to the board or a board committee, and the board or committee in
good faith authorizes the contract or transaction by the affirmative vote of a
majority of the disinterested directors; or
b. The material facts regarding the conflict of interest and the contract or transaction
are disclosed to the shareholders and the shareholders in good faith authorize the
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contract or transaction by the affirmative vote of a majority of the shares held by
[disinterested]2 shareholders; or
c. The contract or transaction is fair to the corporation as of the time it is entered
into.
3. Thus, fully informed, good faith approval of a director self-dealing transaction by
either a majority of the disinterested directors or a majority of the shares held by
disinterested shareholders obviates the necessity of judicial approval on the basis of
interest and permits invocation of the business judgment rule with the burden on the
plaintiff to prove waste. Benihana of Tokyo, Inc. v. Benihana, Inc., 906 A.2d 114,
120 (Del. 2006); Oberly v. Kirby, 592 A.2d 445, 466-67 (Del. 1991); Marciano v.
Nakash, 535 A.2d 400, 404-05 & n.3 (Del. 1987).
4. As stated by the court in Oberly: “The key to upholding an interested transaction is
the approval of some neutral decision-making body. Under 8 Del.C. § 144, a
transaction will be sheltered from shareholder challenge if approved by either a
committee of independent directors, the [independent] shareholders, or the courts.”
592 A.2d at 467.
II. Controlling shareholders’ duty of loyalty.
A. Fiduciary status.
1. A fiduciary relationship is one in which a person transacts business or manages
money or property for the benefit of another. It involves discretionary authority on the
part of the fiduciary and dependency and reliance on the part of the beneficiary.
Carson v. Lynch Multimedia Corp., 123 F. Supp. 2d 1254, 1258-59 (D. Kan. 2000).
2. Because they manage the business for the benefit of the shareholders, corporate
directors and officers have long been held to occupy a fiduciary relationship to both
the corporation and its shareholders. Newton v. Hornblower, Inc., 582 P.2d 1136
(Kan. 1978).
3. In contrast, shareholders are not normally subject to fiduciary duties, because when
acting as a shareholder, a person acts as an owner and not in a representative,
managerial capacity. McDaniel v. Painter, 418 F.2d 545, 547 (10th Cir. 1969).
4. However, if a controlling shareholder places its agents on the board and dominates
and controls their conduct, the shareholder will be held to have indirectly acted in a
managerial capacity and thus to have assumed the burden of fiduciary responsibility.
Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110, 1113-14 (Del. 1994);
Sinclair Oil Corp. v. Levien, 280 A.2d 717, 719 (Del. 1971).
B. Entire Fairness.
1. As is the case with corporate directors, if a controlling shareholder engages in a selfdealing transaction with its controlled corporation, the case will initially be subject to
the entire fairness standard of judicial review. Kahn v. Lynch Communication
Systems, Inc., 638 A.2d 1110, 1115 (Del. 1994).
2. Unlike the situation with directors and officers, however, there are no statutory safe
harbors, compliance with which will shift the standard to the business judgment rule.
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Both statutes are defective in that neither explicitly requires the shareholder vote to be disinterested. This defect
has been remedied judicially in both states. Marciano v. Nakash, 535 A.2d 400, 405 n.3 (Del. 1987); Oberhelman v.
Barnes Inv. Corp., 690 P.2d 1343, 1349-50 (Kan.1984).
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3. Moreover, a trilogy of Delaware Supreme Court opinions stands for the proposition
that neither approval of the transaction by independent directors, nor ratification by
disinterested shareholders is sufficient to remove the case from entire fairness review.
Americas Mining Corp. v. Theriault, 51 A.3d 1213 (Del. 2012); Kahn v. Tremont
Corp., 694 A.2d 422 (Del. 1997); Kahn v. Lynch Communication Systems, Inc., 638
A.2d 1110 (Del. 1994).
4. The rationale is that because control carries with it the potential for oppression, even
disinterested directors or shareholders may feel pressured in a way that prevents them
from being able to safeguard the corporate interest adequately. Therefore, their
approval is not viewed as a substitute for close judicial scrutiny of the merits of the
transaction. Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110, 1116-17
(Del. 1994).
5. In more colorful terms: “Facing the proverbial 800 pound gorilla who wants the rest
of the bananas all for himself, chimpanzees like independent directors and
disinterested stockholders could not be expected to make sure that the gorilla paid a
fair price.” In re Southern Peru Copper Corp. Shareholder Derivative Litigation, 52
A.3d 761, 788 n.79 (Del. Ch. 2011) (Strine opinion), aff’d sub nom., Americas
Mining Corp. v. Theriault, 51 A.3d 1213 (Del. 2012).
6. Nevertheless, although entire fairness remains the standard of review, negotiation by
independent directors or approval by disinterested shareholders may shift the burden
to the plaintiff to prove unfairness. Kahn v. Lynch Communication Systems, Inc., 638
A.2d 1110, 1117 (Del. 1994).
C. Tender offer/short form merger.
1. A parallel, but inconsistent line of Delaware decisions recognizes an exception to the
universal application of the entire fairness standard when a controlling shareholder
makes a tender offer for any and all of the minority’s shares followed by a short form
merger in which any nontendering shareholders are cashed out at the same price.
Glassman v. Unocal Exploration Corp., 777 A.2d 242, 247-48 (Del. 2001) (short form
merger); Solomon v. Pathe Communications Corp., 672 A.2d 35, 39-40 (Del. 1996)
(tender offer); In re Aquila Inc. Shareholders Litigation, 805 A.2d 184, 190-91 (Del.
Ch. 2002) (tender offer/short form merger); In re Siliconix Inc. Shareholders
Litigation, 2001 WL 716787, at *6-8 & n.26 (Del Ch. 2001) (tender offer/short form
merger).
2. This disparate treatment is explainable conceptually by the distinctive features of
tender offers and short form mergers, respectively, as opposed to the long form
mergers at issue in Lynch and Theriault.
a. A tender offer is solely a transaction between the controlling shareholder and the
minority shareholders, as opposed to an entity transaction like a long form
merger. Therefore, because each minority shareholder is free to make an
independent, individual decision, there is no fiduciary duty to offer a “fair” price
as long as the offer is not coercive and the controlling shareholder accurately
furnishes all material information to the minority shareholders. Solomon v. Pathe
Communications Corp., 672 A.2d 35, 39-40 (Del. 1996).
b. If the shares tendered, when added to the shares already owned, raise the
controlling shareholder’s ownership of the subsidiary to at least ninety percent, it
may merge the subsidiary into itself, while cashing out the minority, by a simple
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resolution of its board of directors. There is no requirement of any action by either
the board of directors or the minority shareholders of the subsidiary. DGCL §
253; KGCC §17-6703.
i. Because the short form merger statute was specifically designed to promote
efficiency by obviating the necessity of any dealing between the parent and
subsidiary, the fair dealing prong of entire fairness is inapplicable.
ii. Thus, any potential unfairness must relate only to price, for which, absent
fraud or illegality, statutory appraisal is the exclusive remedy. Glassman v.
Unocal Exploration Corp., 777 A.2d 242, 247-48 (Del. 2001).
3. Nevertheless, at the policy level, the problem of inherent controlling shareholder
oppression that underlies Lynch is equally present in the tender offer/short form
merger cases. Recognizing this similarity, the Court of Chancery first modified its
Aquila/Siliconix line of cases by requiring that a tender offer/short form merger be
subject to an entire fairness review unless it satisfied the following four conditions:
a. The tender offer is subject to the nonwaivable condition that at least a majority of
the minority shares are tendered;
b. The controlling shareholder commits in advance to a short form merger at the
same price if it acquires ninety percent or more of the subsidiary’s shares;
c. The controlling shareholder makes no retributive threats; and
d. The independent directors of the subsidiary are given sufficient discretion and
time to react to the tender offer by hiring their own advisors, providing a
recommendation concerning the offer to the minority shareholders, and disclosing
adequate information for the minority to make an informed judgment. In re Pure
Resources Inc. Shareholders Litigation, 808 A.2d 421, 445 (Del. Ch. 2002)
(Strine opinion).
D. Toward a unified standard.
1. More recently, the Court of Chancery proposed unifying the Lynch and
Aquila/Siliconix lines.
2. If a long form cash out merger is both: (a) negotiated and approved by a special
committee of independent subsidiary directors; and (b) conditioned on the affirmative
vote of the holders of a majority of the minority shares, then the business judgment
rule presumptively should apply. Otherwise, the entire fairness standard would
remain applicable. In re Cox Communications, Inc. Shareholders Litigation, 879 A.2d
604, 606-07 (Del. Ch. 2005) (long form merger) (Strine opinion) (dictum).
3. Similarly, if a first-step tender offer is both (a) negotiated and recommended by a
special committee of independent subsidiary directors; and (b) conditioned on the
affirmative tender of a majority of the minority shares, then the business judgment
rule presumptively should apply to the tender offer and a second-step cash out merger
at the same price. Otherwise the entire fairness standard would apply. In re CNX Gas
Corp. Shareholders Litigation, 4 A.3d 397 (Del. Ch. 2010) (tender offer/short form
merger).
III. Kahn v. M & F Worldwide Corp., ___ A.3d ___, 2014 WL 996270 (Del. 2014), aff’g, 67
A.3d 496 (Del Ch. 2013) (Strine opinion).
A. In affirming summary judgment for the defendants, the Delaware Supreme Court held
that the business judgment rule applied to a controlling shareholder-subsidiary long form
cash out merger that was conditioned ab initio on both: approval of an independent fully6
empowered special committee of subsidiary directors that fulfills its duty of care, and the
uncoerced, fully-informed vote of a majority of the subsidiary’s minority shareholders.
2014 WL 996270, at *6.
B. Rationale.
1. The court began its analysis by agreeing with Chancellor Strine that the case was one
of first impression, distinguishing Lynch, Tremont, and Theriault as factually
involving only a special negotiating committee and not also a majority of the minority
vote condition. Id. at *4.
2. It also agreed that a structure that affords the minority both procedural protections is
fundamentally different than a merger having only one of those protections.
a. “By giving controlling stockholders the opportunity to have a going private
transaction reviewed under the business judgment rule, a strong incentive is
created to give minority stockholders much broader access to the transactional
structure that is most likely to effectively protect their interests. . . . That structure,
it is important to note, is critically different than a structure that uses only one of
the procedural protections. The ‘or’ structure does not replicate the protections of
a third-party merger under the DGCL approval process, because it only requires
that one, and not both, of the statutory requirements of director and stockholder
approval be accomplished by impartial decisionmakers. The ‘both’ structure, by
contrast, replicates the arm’s-length merger steps of the DGCL by ‘requir[ing]
two independent approvals, which it is fair to say serve independent integrityenforcing functions.’ ” Id. at *5 (quoting 67 A.3d at 528).
b. The court elucidated these independent integrity-enforcing functions by again
quoting Chancellor Strine: “[T]he adoption of this rule will be of benefit to
minority stockholders because it will provide a strong incentive for controlling
stockholders to accord minority investors the transactional structure that respected
scholars believe will provide them the best protection, a structure where
stockholders get the benefits of independent, empowered negotiating agents to
bargain for the best price and say no if the agents believe the deal is not advisable
for any proper reason, plus the critical ability to determine for themselves whether
to accept any deal that their negotiating agents recommend to them. A
transactional structure with both these protections is fundamentally different from
one with only one protection.” Id. at *7 (quoting 67 A.3d at 528).
c. In other words, negotiation and approval of a controlling shareholder-subsidiary
cash out merger by a fully-empowered independent special committee is an
effective proxy for full board approval of a third party arm’s length merger under
DGCL § 251(b) [KGCC § 17-6701(b)], and a fully-informed, uncoerced majority
of the minority shareholder vote effectively replicates the majority of outstanding
shares vote under DGCL § 251(c) [KGCC § 17-6701(c)] in such an arm’s length
merger.
3. Finally, the court adopted the Chancellor’s six point summary of the conditions
necessary for invocation of the business judgment rule:
a. The controlling shareholder conditions the procession of the transaction on
approval of both a special committee and a majority of the minority stockholders;
b. The special committee is independent;
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c. The special committee is empowered to freely select its own advisors and to “say
no” definitively;
d. The special committee meets its duty of care in negotiating a fair price;
e. The vote of the minority stockholders is informed; and
f. There is no coercion of the minority stockholders. Id. at *7.
C. Notes.
1. The Lynch line of cases will continue to govern controlling shareholder transactions
in which only one of the two protective devices is employed: the controlling
shareholder may achieve the limited benefit of a burden of proof shift, but entire
fairness will remain the standard of review. Id. at *8.
2. The entire fairness standard review makes it virtually impossible for controlling
shareholders to resolve even meritless litigation short of trial except by the most costeffective means: settlement. The prospect of business judgment review and the
possibility of successful motions for summary judgment offered by this opinion
should indeed be a very strong incentive to structure transactions in the manner most
likely to protect the interests of minority shareholders. Ironically, Lynch, which
purports to be minority shareholder-protective fails to offer that same incentive.
3. Not surprisingly, the court refrained from offering any opinion about a unified
standard for controlling shareholder long form mergers and tender offers/short form
mergers. Stay tuned.
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