Entire Fairness Standard
Entire Fairness Standard- In the last three Lawcasts in this series I discussed the responsibilities of the board of directors and in particular their fiduciary duties related to merger and acquisition transactions. In the last Lawcast I highlighted Delaware case law on director duties. Today I will drill down on directors duties when faced with the heightened “entire fairness standard” of responsibility in a transaction.
The entire fairness standard is invoked when a director has a conflicting interest in the counter party to a merger or acquisition transaction.
Delaware’s General Corporations Law provides that a contract or transaction in which a director has interest is not void or voidable if: (i) a director discloses any personal interest in a timely matter; (ii) a majority of the shareholders approve the transaction after being aware of the director’s involvement; or (iii) the transaction is entirely fair to the corporation and was approved by the disinterested board members.
The third element listed by the Delaware statute has become the crux of review by courts. In determining whether a transaction is fair, courts consider both the process (i.e., fair dealing) and the price of the transaction. Courts look at all aspects of the transaction and the transaction as a whole in determining fairness, not just the portion or portions of the transaction involving a conflict with the director. The entire fairness standard can be a difficult hurdle and is often used by minority shareholders to challenge a transaction where there is a potential breach of loyalty and where such minority shareholders do not think the transaction is fair to them or where controlling shareholders have received a premium.
To protect a transaction involving an interested director, it is vital that all directors take a very active role in the merger or acquisition transaction; that the interested director inform both the directors, and ultimately the shareholders, of the conflict; that the transaction resemble an arm’s-length transaction; that it be entirely fair; and that negotiations are diligent and active and that the advice and counsel of independent third parties, including attorneys and accountants, be actively sought.
Delaware courts have emphasized that involvement by disinterested, independent directors increases the probability that a board’s decisions will receive the benefits of the business judgment rule and helps a board justify its action under the more stringent entire fairness standard. Independence is determined by all the facts and circumstances; however, a director is definitely not independent where they have a personal financial interest in the decision. Where a conflict exists most companies obtain third-party fairness opinions as to the transaction.
The first element of the statute – proper disclosure to shareholders is also of the utmost importance. In the case of a merger or acquisition requiring shareholder vote, for instance, directors must provide shareholders with material information necessary to make an informed decision.
In In Re Pure Res., the court held that the directors had a duty to disclose to shareholders the substantive work performed and total involvement of investment bankers including their compensation in pending merger transactions. The court reasoned that this information would assist an investor in determining whether the value being paid was fair. Other courts have concurred with this opinion and specified that shareholders are entitled to see valuation reports and financial projections prepared by investment bankers in a merger transaction, and it is the board of directors’ duty to supply this information.
A director’s duty of disclosure is based in state law and is separate and distinct from a company’s duty to disclose under both the Securities Act of 1933 and Securities Exchange Act of 1934. Where the state law duty to disclose supports private causes of action, including possible class action lawsuits, the federal duty supports both private causes of action and regulatory enforcement proceedings.