It is often instructive to keep apprised of case decisions and laws from our sister states. Of particular interest for San Diego corporate lawyers is to watch developments in Delaware law with respect to corporations and entity control issues. Both Delaware and California law have what is called the “business judgment rule”. The business judgment rule protects members of a corporate board of directors from being unfairly held liable by shareholders if their decisions turn out to be “bad” decisions in terms of profitability and gaining marketshare. In general, the business judgment rule presumes that the directors 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.

Legally speaking, the business judgment rule is a “low” standard; California courts — and courts in general — give a lot of deference to corporate boards of directors and it is not too difficult to meet the business judgment rule standard. A court will not impose liability for a “bad” business decision unless the decision was made in bad faith, or certain other circumstances.

Interestingly enough, Delaware has two more exacting standards beyond the business judgment rule – the enhanced judicial scrutiny doctrine and the entire fairness doctrine. See discussion in Central Laborers’ Pension Fund v. McAfee, Inc., 17 Cal. App. 5th 292 (Cal. App. 6th Dist. 2017) (discussing and applying Delaware law).

Delaware Enhanced Scrutiny Doctrine

The enhanced scrutiny doctrine is applied when a board of directors considers and approves the sale of the company, in particular the sale of a controlling interest. In that circumstance, the Delaware courts add to the business judgment rule the requirement that the directors’ conduct and decisions be “reasonable.” The Delaware courts essentially require that the directors take reasonable steps to obtain the best value reasonably available for the stockholders. “Best value” often means the highest price per share; but there are other factors that are applicable. “Reasonable” often means that the directors can point to specific business justifications for their decisions. Delaware courts require that the directors make a reasonable decision, not necessarily a perfect decision.

Delaware Entire Fairness Doctrine

Finally, the most exacting standard is the entire fairness doctrine. The entire fairness doctrine is applied by the Delaware courts when sale of control of the corporation is contemplated and when one or more directors has actual self-interest in the transaction. A common example is where a member of the board of the target corporate will be hired by the acquiring company. Since a job is “waiting” if the sale is approved, that director is considered self-interested.

In applying the entire fairness doctrine, Delaware courts focus on whether the board, individually and collectively, acted fairly and whether the ultimate price-per-share was fair. The two issues are linked in the sense that if the price paid was clearly the best price that could have been obtained, the Delaware courts are less concerned about “bad behavior.”

Among the facts that Delaware courts consider are these:

  • Number of and ratio of disinterested directors — those who do not have any self-interest in the deal
  • Number of “independent” directors — those who are free from control of the self-interest director or directors
  • Whether any sort of independent sub-committee of the board was established
  • Whether any sort of outside report was prepared
  • Conduct of the self-interested directors
  • Conduct of the acquiring corporation
  • Whether the sale was submitted to the shareholders for a vote
  • And more

California has not adopted the entire fairness doctrine (or even the enhanced scrutiny doctrine). However, given trends like requiring gender quotas for corporate boards — see USA Today report here — and decisions like Dynamex, it would not be surprising for California to move in the direction of heightened evaluation of corporate decision-making.

Contact San Diego Corporate Law Today

For more information, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard provides a full panoply of legal services for businesses and corporations including corporate formation, annual maintenance, custom-drafting of articles and bylaws, and all related corporation legal needs. Mr. Leonard can be reached at (858) 483-9200 or via email.

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