“Optimizing” and Match: Bad Policy Threatens to Drive Bad Law

In 2021, Professor Larry Hamermesh and former Court of Chancery and Delaware Supreme Court judges Leo Strine and Jack Jacobs (together, the “MatchMakers”) wrote an article titled Optimizing the World’s Leading Corporate Law: A 20-Year Retrospective and Look Ahead (hereinafter “Optimizing”).[1] The article argues, among other things, that conflicted controller transactions other than controller squeeze-outs should be subject to business judgment review if approved by either a well-functioning special committee or a majority of minority shareholders on a non-coerced and fully informed basis, proposing to set aside 25 years of settled Delaware law to the contrary.[2] All but ignoring this precedent, the MatchMakers attempt to turn settled law on its head by claiming that the expansion of MFW’s defendant-friendly carve-out from universal application of entire fairness review of conflicted controller transactions reflects “MFW creep.”[3] The issue is the subject of further proceedings before the Delaware Supreme Court in the In re Match Group, Inc. Derivative Litigation appeal. The Match briefs, including several amicus briefs, have now been filed and argument has been set before the Court.[4]

We do not revisit here the Match plaintiffs’ arguments or those of the amici, but we do write to express our views with respect to several discreet points advocated in Optimizing and/or by Professor Hamermesh with which we strongly disagree.

First, the MatchMakers observe an inconsistency between, on the one hand, how Delaware courts treat non-squeeze out conflicted controller transactions and, on the other hand, Aronson v. Lewis[5]—as modified by United Food & Commercial Workers Union & Participating Food Industry Employers Tri-State Pension Fund v. Zuckerberg, 250 A.3d 862 (Del. Ch. 2020), aff’d, 262 A.3d 1034 (Del. 2021)—and Zapata Corp. v. Maldonado.[6]

Long-standing Delaware precedent, including Kahn v. Lynch and Kahn v. Tremont, apply the exacting entire fairness standard to conflicted controller transactions because of their inherently coercive dynamic.[7] Kahn v. Tremont stands for the proposition that employment of a single protection—either approval by an independent special committee or a majority of the minority stockholders—is insufficient to invoke business judgment review even for a non-squeeze out conflicted controller transaction.[8] Many subsequent decisions—including several Delaware Supreme Court decisions—say the same.[9] A logical extension of this line of cases is that the concept of inherent coercion should render demand per se excused in derivative challenges to conflicted controller transactions that invoke entire fairness review.

Yet Aronson and Zuckerberg hold that boards remain empowered to consider bringing derivative litigation against controllers. Aronson and Zuckerberg require stockholder plaintiffs to plead particularized allegations demonstrating that a majority of the board is incapable of considering a demand to sue the controller because, e.g., a majority of the board lacks independence of the controller. Aronson and Zuckerberg therefore elevate a board’s control of derivative litigation above the inherently coercive dynamic of conflicted controller transactions.

Why is this the case? Consistent with Vice Chancellor Laster’s analysis in In re Ezcorp Inc. Consulting Agreement Derivative Litigation,[10] we think the distinction is best thought of as a public policy carveout to the general rule that has animated our law for nearly three decades since Lynch. That public policy concern lies in business judgment principles, which emphasize the “freedom of directors” and their “managerial prerogatives” consistent with Section 141(a) of the Delaware General Corporation Law.[11] A narrow carveout to Lynch when analyzing demand futility concepts thus seeks to create salutary results, such as channeling “intracorporate” disputes to the board and “safeguard[ing] against strike suits.”[12]

The MatchMakers now seek to drive a proverbial truck through the narrow Aronson carveout. But we submit that if the resulting disconnect in our law is deemed untenable, the simpler and more intellectually honest approach is to eliminate the Aronson carveout. Still, we submit that the disconnect in the law is in fact tenable, in large measure because, in practice, it is quite narrow.

Indeed, derivative cases since Aronson have folded the presence of a controller into their analysis of director independence for demand futility purposes. As then-Chancellor Bouchard explained in In re BGC Partners, Inc., the “practical realities” of board engagement with a controlling stockholder make “the presence and influence of a controller” “an important factor that should be considered in the director-based focus of the demand futility inquiry under the first prong of Aronson, particularly on the issue of independence.”[13] Thus, although a controller’s presence does not automatically render demand futile, the presence of a controller is highly relevant, and pleading-stage dismissal of derivative conflicted controller transactions is therefore somewhat unusual. This relevant-but-not-dispositive approach leaves it in the capable hands of the Court of Chancery to manage the minor tension between Aronson and other decisional authority.

With respect to Zapata—a point not raised in Optimizing, but subsequently discussed by Professor Hamermesh—we see no inconsistency in the law.  Under Zapata, the recommendation of a special litigation committee (“SLC”) to dismiss a conflicted controller transaction is not reflexively afforded business judgment deference. In analyzing a dismissal recommendation by an SLC, the court as a first step decides whether the SLC acted independently and in good faith and, as a second step, exercises its own independent business judgment regarding whether dismissal is warranted.[14] This second step is designed for situations where “corporate actions meet the criteria of step one, but the result does not appear to satisfy its spirit, or where corporate actions would simply prematurely terminate a stockholder grievance deserving of further consideration in the corporation’s interest.”[15] Zapata step two requires the court to weigh how “compelling the corporate interest in dismissal is” and to “give special consideration to matters of law and public policy[.]”[16] Thus, far from providing business judgment deference to conflicted controller transactions reviewed by an SLC, Zapata lets the Court of Chancery subject an SLC’s dismissal recommendation to exacting scrutiny akin to entire fairness review.

Second, the MatchMakers observe that there are conflicted controller transactions that cannot reasonably be subjected both to approval by an independent committee and a majority of the minority stockholder vote. We again agree with the premise but disagree with the proposed solution. Where a conflicted controller transaction cannot reasonably be conditioned on the dual prongs of MFW, such transactions should be subject to entire fairness review. Although the MatchMakers apparently foresee doom and gloom from doing so, entire fairness has been the status quo in these cases for the past quarter century and has caused no tectonic shifts in Western civilization or Delaware jurisprudence. (Indeed, as advocates, we wish our results were so consequential). Importantly, most such instances give rise to derivative claims, and the Aronson carveout already serves as a meaningful pleading-stage hurdle for a stockholder plaintiff attempting to seize the reins of corporate machinery. Even were the Delaware courts to consider changes to our law to address conflicted controller transactions that cannot reasonably be subjected to the dual prongs of MFW, the proper approach would be to do so on a case-by-case basis. Overturning an entire doctrine to address a problem of primarily academic interest would be inconsistent with how the Delaware Supreme Court has traditionally operated.[17]

Third, the MatchMakers seem to suggest that there will be a proliferation of litigation if the Delaware Supreme Court confirms that non-squeeze out conflicted controller transactions are subject to entire fairness review when approved by either (but not both of) a well-functioning special committee or a majority of the minority stockholders. Here, we fundamentally disagree. The situation would be no different than it has been for the past quarter century, at least since Kahn v. Tremont made clear that the use of only a special committee did not allow a controller to escape entire fairness review. A ruling in favor of the plaintiffs on this point in Match, therefore, would cause no increase in litigation, much less a proliferation. . From our vantage point, the MatchMakers’ proposal would do little more than make a ‘perfect match’ for corporate controllers.

Fourth, we understand the MatchMakers to suggest that the outcome of a cost-benefit analysis of their proposal is unclear, i.e., that it is hard to compare the benefit of reduced litigation costs, on the one hand, and permitting controlling stockholders to occasionally skim, on the other hand. We again fundamentally disagree. The combination of the Aronson carveout and the ubiquity of D&O insurance renders the benefits of reduced litigation minimal (and, in fact, because the litigations are frequently derivative, the company often receives a monetary benefit when the litigation is resolved).[18] Conversely, as Vice Chancellor Laster discussed in Ezcorp, it is well established that “‘[m]anagers and controlling shareholders (insiders) can extract (tunnel) wealth from firms using a variety of methods.’”[19] Tunneling, in turn, reduces firm value. Adopting the MatchMakers’ position would expand controllers’ avenues for tunneling, undermine investor confidence in Delaware courts to police controller tunneling, and reduce the value of controlled Delaware corporations.

In sum, while the MatchMakers raise some interesting theoretical points, they fall far short of demonstrating that overruling decades of precedent would be in the best interest of Delaware corporations and investors. Sound policy supports the past quarter century of case law that subject conflicted controller transactions to entire fairness review absent compliance with MFW. To depart from this well-understood and well-functioning policy would sanitize controller conflicts in the opaque name of “optimization.”

It is said that bad facts make bad law. Here, the MatchMakers’ misguided policy suggestions threaten to make very bad law indeed. Delaware should not try to outrace Nevada to create a ‘judgment-free zone’ for corporate controllers. The structure of our law—while far from perfect in application—is built on sound legal, social, and economic policy. It should be changed only incrementally and then only on a showing of real need, and not merely to facilitate a wealth transfer from the investing public to powerful controlling stockholders.