A friend sent along this question via email:
Would shareholder ratification/approval immunize the dividend policy in Dodge v. Ford (assuming Ford's votes don't count, and the Dodge brothers can't otherwise control the outcome)? The reason I don't immediately say "yes" is because I wonder about the extent to which the dividend policy can be characterized as waste or bad faith -- thus potentially limiting the effect of SH approval/ratification.
If the facts of Dodge[1] came up today, my analysis would start with the premise that Henry Ford was the controlling shareholder of FMC. In Kahn v. M & F Worldwide Corp.,[2] the Delaware Supreme Court expanded the protections potentially available to controlling shareholders. It held that a freeze-out merger would be reviewed under the business judgment rule rather than the fairness standard if six conditions are met: (1) the controlling stockholder conditions the transaction on the approval of both a special committee and the majority of the minority stockholders, (2) the special committee is independent, (3) the special committee is empowered to select its own advisors and to say no definitively, (4) the special committee meets its duty of care in negotiating a fair price, (5) the vote of the minority stockholders is informed, and (6) there is no coercion of the minority stockholders. A vote by the majority of the minority shareholders, standing alone, thus is not enough to invoke the business judgment rule as the standard of review.
To be sure, Dodge involved a closely held corporation not a public company. But that is not a problem, because MFW has been applied to transactions involving privately held companies.[3]
Likewise, Dodge did not involve a freezeout merger. Again, however, this is not a problem, because the expanded protections offered by MFW are not limited to freeze-out mergers, but have been extended to other types of controlling shareholder transactions. In Tornetta v. Musk,[4] for example, the Delaware Chancery Court provided new guidance on how to structure conflict of interest transactions to which a corporation’s controlling shareholder is a party. The case involved a shareholder lawsuit challenging an incentive compensation plan granted to Tesla, Inc.’s CEO, Elon Musk.
Are we sure MFW applies?
Henry Ford might argue that MFW is inapplicable because he did not personally benefit from the transaction. Accordingly, he would argue, that the decision to cancel the special dividends would not trigger entire fairness review. Because MFW is intended to shift the standard of review from entire fairness to the business judgment rule, it is inapplicable. This argument would find some support in the older Sinclair Oil v. Levien[5]decision. It held that controlling shareholders owe a fiduciary duty to the company’s minority shareholders. But what standard of review should a court apply to such disputes? The Delaware Supreme Court identified two standards potentially applicable in such situations: the business judgment rule and the intrinsic fairness rule. Under the business judgment rule, the directors of Sinven get the benefit of a rebuttable presumption of good faith. Under the intrinsic fairness test, the burden of proof is on the directors to show, subject to close scrutiny, that the transactions were objectively fair to Sinven.
Under Sinclair Oil, a court will apply the intrinsic fairness standard, as opposed to the business judgment rule, when the parent has received a benefit “to the exclusion and at the expense of the subsidiary.” In other words, the more exacting intrinsic fairness standard comes into play only when the parent is on both sides of the transaction and, moreover, used its position to extract non-pro rata benefits from a transaction to the minority shareholders’ detriment.
If the transaction is subject to business judgment rule review from the outset, shareholder ratification would eliminate any duty of care-based claims.[6]
Assume MFW is not limited to conflicted interest transactions
As I read the Tornetta opinion, there is a strong argument that MFW is not limited to conflicted interest transactions.
In his opinion, Vice Chancellor Joseph Slights acknowledged that Delaware courts normally approach boards’ executive compensation decisions with a high degree of deference. Critically, however, Musk is not just Tesla’s CEO but also its controlling shareholder.[7] A controlling shareholder has been analogized to the proverbial 800-pound gorilla,[8] which gives rise to “an obvious fear that even putatively independent directors may owe or feel a more-than-wholesome allegiance to the interests of the controller, rather than to the corporation and its public stockholders.”[9]
In Tornetta, the Tesla defendants argued that MFW was irrelevant to the facts of this case:
They rely heavily on a “statutory rubric” argument, claiming MFW’s dual protections, devised in the context of a squeeze-out merger, mimic the approvals required by 8 Del C. § 251 but have no practical application to transactions where our law does not mandate approval at both the board and stockholder levels. . . . I do agree with Defendants that nothing in MFW or its progeny would suggest the Supreme Court intended to extend the holding to other transactions involving controlling stockholders.
Vice Chancellor Slights, however, observed that the risk of coercion is just as present when a conflicted controller enters into a compensation arrangement as when it proposes a freezeout merger:
Indeed, in the CEO compensation context, the minority knows full well the CEO is staying with the company whether vel non his compensation plan is approved. As our Supreme Court observed in Tremont II:
[I]n a transaction such as the one considered . . . the controlling shareholder will continue to dominate the company regardless of the outcome of the transaction. The risk is thus created that those who pass upon the propriety of the transaction might perceive that disapproval may result in retaliation by the controlling shareholder.
These words apply with equal force to the compensation setting.
Accordingly, in order for a conflicted controller transaction to be reviewed under the business judgment rule rather than entire fairness, the transaction must satisfy all of MFW’s requirements.
Because the Tesla board had not satisfied all of those conditions, VC Slights invoked the older Kahn v. Lynch rule,[10] which explained that in controlling shareholder transactions:
The initial burden of establishing entire fairness rests upon the party who stands on both sides of the transaction. However, an approval of the transaction by an independent committee of directors or an informed majority of minority shareholders shifts the burden of proof on the issue of fairness from the controlling or dominating shareholder to the challenging shareholder-plaintiff.
Likewise, in Dodge, if the board did not comply with all of the MFW conditions, the burden would have shifted to the Dodge brothers to show that the transaction was unfair. Because “an entire fairness analysis is the only proper standard of judicial review,” however, shareholder ratification—absent full compliance with MFW would not invoke the business judgment rule.
Assume MFW applies and was fully complied with
If we assume that MFW applies and that FMC’s board complied fully with all six requirements. What happens next?
If they did, then a version of the business judgment rule applies under which the only remaining claim is one for waste. See In re Books-A-Million, Inc. S’holders Litig., 2016 WL 5874974, at *1 (Del. Ch. Oct. 10, 2016), aff’d, 164 A.3d 56 (Del. 2017) (TABLE). The waste exception is more theoretical than real, because to state a claim for waste, the terms of the transaction must be so extreme “that no rational person acting in good faith could have thought the [transaction] was fair to the minority.” In re MFW S’holders Litig. (MFW Chancery), 67 A.3d 496, 500 (Del. Ch. 2013), aff’d sub nom. MFW, 88 A.3d at 635. At that point in the analysis, two groups of rational people—the committee and the minority stockholders—would have approved the transaction. It is “logically difficult to conceptualize how a plaintiff can ultimately prove a waste or gift claim in the face of a decision by fully informed, uncoerced, independent stockholders to ratify the transaction.” Harbor Fin. P’rs v. Huizenga, 751 A.2d 879, 889 (Del. Ch. 1999). The resulting version of the business judgment rule is thus rightfully described as “irrebuttable.”[11]
I'm not sure how you would attack a decision to cancel a dividend as waste.
[1] 170 N.W. 668 (Mich.1919). In 1916, Henry Ford owned 58% of the stock of Ford Motor Co. (FMC). The Dodge brothers owned 10%. The remainder was owned by five other individuals. Beginning in 1908, FMC paid a regular annual dividend of $1.2 million. Between 1911 and 1915 FMC also regularly paid huge “special dividends,” totaling over $40 million. In 1916, Henry Ford announced that the company would stop paying special dividends. Instead, the firm’s financial resources would be devoted to expanding its business.
Although the court reviewed Ford's decision under an abuse of discretion standard, I'm assuming that under modern law it would be reviewed under either the business judgment rule or the entire fairness standard.
[2] Kahn v. M & F Worldwide Corp., 88 A.3d 635, 644 (Del. 2014), overruled on other grounds by Flood v. Synutra Intl., Inc., 195 A.3d 754 (Del. 2018).
[3] See, e.g., Swomley v. Schlecht, C.A. 9355-VCL, Transcript Op. (Del. Ch. Aug. 27, 2014).
[4] 2019 WL 4566943 (Del. Ch. Sept. 20, 2019).
[5] 280 A.2d 717 (Del.1971).
[6] See In re Wheelabrator Technologies, Inc. Shareholders Litigation, 663 A.2d 1194 (Del.Ch.1995).
[7] In an earlier decision involving Tesla, Vice Chancellor Slights had determined that Musk was Tesla’s controlling shareholder despite owning only 22% of Tesla’s voting stock. See In re Tesla Motors, Inc. Stockholder Litig., 2018 WL 1560293 (Del. Ch. Mar. 28, 2018), appeal refused sub nom. Musk v. Arkansas Teacher Ret. System, 184 A.3d 1292 (Del. 2018).
[8] In re Pure Resources, Inc. S’holders Litig., 808 A.2d 421, 436 (Del. Ch. 2002).
[9] Leo E. Strine, Jr., The Delaware Way: How We Do Corporate Law and Some of the New Challenges We (and Europe) Face, 30 Del. J. Corp. L. 673, 678 (2005).
[10] Kahn v. Lynch Commun. Sys., Inc., 638 A.2d 1110 (Del. 1994).
[11] In re Dell Techs. Inc. Class V Stockholders Litig., CV 2018-0816-JTL, 2020 WL 3096748, at *14 (Del. Ch. June 11, 2020).
