The following article appeared in the current issue of the Delaware Business Court Insider:
Recent Decision Clarifies Safe Harbors in DGCL § 144 for Board Action
By: Francis G.X. Pileggi* and Chauna A. Abner**
The recent Superior Court decision in Toedtman v. Turnpoint Medical Devices, Inc., C.A. No. N17C-08-210 RRC (Del. Super. Ct., Jan 23, 2019), adds clarity to the case law interpreting Section 144 of the Delaware General Corporation Law (“DGCL”), 8 Del C. § 144. This case is important for the clear guidance it provides for anyone who seeks to understand Section 144(a)’s safe harbors when one or more board members are conflicted in connection with a board vote.
In Toedtman, the court discussed Section 144(a)’s three safe harbors and considered the application of two of the safe harbors to a former director’s employment agreement as a CEO. Ultimately, the court decided that even though a self-interested director entered into the agreement, the agreement was nonetheless valid because it fell within at least one of Section 144(a)’s safe harbors.
The plaintiff in Toedtman filed suit alleging, among other things, that the defendant company breached his employment agreement by terminating his employment without cause. Slip op. at 2. The company argued that the employment agreement was invalid because it was a self-interested transaction as a result of the plaintiff entering into the agreement on behalf of himself and the company. Id. at 12.
The court explained that the purpose of § 144 is “to provide ‘safe harbors’ for interested director transactions, to prevent the transaction from being void or voidable solely because an interested director was involved.” Id. at 14. Relying on a 1976 Delaware Supreme Court decision, the court explained that § 144(a)’s safe harbors prevent an agreement from being invalid solely because an interested director was involved. Id. (quoting Fliegler v. Lawrence, 361 A.2d 218, 222 (Del. 1976)).
The court summarized Section 144(a)’s three safe harbors: “First, the transaction may be approved by a majority of disinterested directors. Second, the transaction may be approved by a majority of disinterested shareholders. Third, the transaction may be shown to be entirely fair to the corporation at the time it was authorized by interested directors or shareholders.” Id.
Under the first two safe harbors, the court assesses the validity of the transaction using a two-step analysis. First, the court determines whether the transaction falls within the safe harbor, and if it does, the court will then review the transaction under the business judgment rule. Id. “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 was taken in the best interest of the company.” Id. at 14-15.
If the transaction falls outside of the first two safe harbors, the third safe harbor applies the entire fairness standard. Id. at 15. The court explained that “the concept of fairness has two basic aspects: fair dealing and price,” id., and the burden is on the interested director to prove entire fairness. Id. The court further explained that “fair dealing” concerns the conduct of corporate fiduciaries in effectuating the transaction while “fair price” concerns the economic and financial considerations of the contract. Id. at 18. The court analyzes the fair price of the contract as of the time the transaction was approved. Id. at 21.
The court held that the employment agreement fell within the § 144(a)(1) safe harbor because it was approved by a majority of disinterested directors. Id. at 17. In reaching this decision, the court first identified who the interested versus disinterested directors were, and concluded that the plaintiff was the only interested director. Id. Next, the court noted that disinterested directors delegated to a corporate officer the board’s power to negotiate and enter into employment agreements. Id. at 16. The court explained that the delegation was a proper exercise of business judgment. Id. at 17. The court declined to replace its judgment with that of disinterested directors and held that the employment agreement was valid because the board properly delegated its authority to negotiate and enter into employment agreements. Id.
The court also held that the employment agreement satisfied the intrinsic fairness test in the § 144(a)(3) safe harbor. Id. at 18. As for fair dealing, the court concluded that the employment agreement followed “good corporate practice.” Id. The court also concluded that the negotiation and structure of the agreement also appeared to be fair, and there was no evidence that the plaintiff acted in bad faith. Id. at 19. Regarding fair price, the court concluded that the board authorized plaintiff’s salary and the court refused to question the business judgment of disinterested directors in approving the plaintiff’s salary. Id. at 21. The court held the agreement was valid because it was a product of both fair dealing and fair price, and was therefore intrinsically fair. Id. at 18.
The key takeaway is that DGCL Section 144 prevents an otherwise valid agreement from being invalidated solely because an interested director or shareholder was involved, as long as the challenged matter fits within one of the three safe harbors in Section 144(a).
*Francis G.X. Pileggi is a litigation partner and Vice-Chair of the Commercial Litigation Practice Group at Eckert Seamans Cherin & Mellott, LLC. His e-mail address is email@example.com. He comments on key corporate and commercial decisions, and legal ethics rulings, at www.delawarelitigation.com.
**Chauna A. Abner is an associate in the Commercial Litigation Practice Group of Eckert Seamans Cherin & Mellott LLC.