On Monday, just after the arrival of the blizzard of 2016 in Delaware, the Court of Chancery created its own momentous event with the release of its opinion in In re EZCorp Consulting Agreement Derivative Litigation, C.A. No. 9962 (Jan. 25, 2016). Spanning 91 pages, the opinion treats its subjects with a scholarly level of analysis, worthy of review in its entirety. Publication limits do not permit a complete review of the opinion in this space, but I can focus on one of the many important aspects of the opinion: the identification of a doctrinal tension between an Aronson demand futility analysis, from Aronson v. Lewis, 473 A.2d 805 (Del. 1984), and how to determine the standard of review.
The facts of EZCorp are fairly simple and provide the backdrop for the larger discussion. Phillip Cohen indirectly controlled all of the voting power of EZCorp Inc. through his ownership of the general partner of a limited partnership that held all of the company's Class B voting stock. The company's Class A nonvoting stock was publicly traded. As a result of this arrangement, Cohen controlled all of the voting power in EZCorp but held only 5.5 percent of the equity. Over the years, the company entered into advisory services agreements with affiliates of Cohen. In September 2011, the company entered into an advisory services agreement with a Cohen affiliate to cover the company's 2012 fiscal year. In October 2012, the company entered into an advisory services agreement with a Cohen affiliate to cover the company's 2013 fiscal year. In October 2013, the company agreed to renew the 2012 agreement for the 2014 fiscal year. Each of these advisory services agreements was approved by the audit committee of the board.
On May 20, 2014, the audit committee terminated the renewal of the advisory services agreement. The termination set off separate events. The plaintiff in the case sought inspection of the company's books and records related to the services agreements. Cohen used his voting power to remove three members of the board, two of whom were members of the audit committee. An additional director resigned the same day as the other directors were removed. Cohen replaced these directors with two arguably non-independent directors. The company refused the plaintiff's demand to inspect, and the plaintiff filed his original complaint in July 2014.
After procedural wrangling, the only directors left were Cohen, his affiliates, and one director, Thomas Roberts, who was a member of the audit committee that approved the services agreements in 2011 and 2012. These defendants moved to dismiss for failure to state a claim and failure to plead demand futility.
The court first addressed the motion to dismiss for failure to state a claim. The court began its analysis by noting that numerous Delaware courts have applied the entire fairness doctrine not only to squeeze out mergers between a company and its controller, but also to other transactions between a company and its controlling stockholder. The defendants, relying on previous Court of Chancery decisions inFriedman v. Dolan, C.A. No. 9425-VCN June 30, 2015; In re Tyson Foods Consolidated Shareholder Litigation, 919 A.2d 563; and Canal Capital v. French, C.A. No. 11764 (Del. Ch. July 2, 1992), argued that entire fairness was not the default standard for compensation decisions approved by an independent board or committee even if there is a controlling stockholder. In each of these cases, the Court of Chancery had applied the business judgment rule to compensation decisions benefiting a controlling stockholder that were approved by an independent board or committee. The Court of Chancery in EZCorp distinguished all of these holdings as against the great weight of authority it had previously cited and inconsistent with the notion, recognized by the Delaware Supreme Court, that directors facing a controlling stockholder face a threat of implicit coercion that is more difficult to see and regulate.
More importantly, the Court of Chancery held that Tyson, Dolan and Canal relied on Aronson for the proposition that the business judgment rule—and not the entire fairness rule—provided the standard of review for compensation decisions benefiting a controlling stockholder that were approved by an independent board or committee. The court noted that other Delaware Supreme Court caseshave applied the entire fairness analysis ab initio. The choice between the two doctrines is consequential because it can affect both demand futility and the substantive standard of review.
The Court of Chancery argued that Aronson departed from prior precedent, creating a new analysis, in reaction to the Delaware Supreme Court's decision in Zapata v. Maldonado, 430 A.2d 779 (1981), which held that the court should apply its own business judgment to determine whether to grant a motion by a special litigation committee to dismiss a derivative action. Although it was not without its supporters, or even those who did not think Zapata went far enough, Zapata was also criticized as undermining the business judgment rule. According to the Court of Chancery in EZCorp, in Aronson, the Delaware Supreme Court addressed those concerns by reinforcing the requirement that the plaintiff allege particularized facts calling into question the ability of a board to consider a demand.
The question for the Court of Chancery then became whether the policy judgments that underlie Aronson were intended to extend beyond determining demand futility. That is, whether the policy judgment that the court would respect the business judgment of an independent board in the demand context would extend in the same way when determining the applicable standard of review. The Court of Chancery held that in its view, Aronson should be limited to the demand futility analysis. The Court of Chancery reached this conclusion in part based on the development of the law since Aronson showing that a "reasonableness" review does not involve the courts second-guessing business judgments, as was feared in the wake of Zapata. Also, the law since Aronson has shown that application of entire fairness is not, in fact, outcome-determinative. Finally, the Court of Chancery noted that the recent decision in Teamsters Union 25 Health Services and Insurance Plan v. Baiera, C.A. No. 9503-CB (Del. Ch. July 13, 2015), held that under Aronson demand is not rejected simply because the controlling stockholder stood on both sides of the transaction. This decision highlights the doctrinal tension between Aronson and other analyses.
Based on this analysis, the Court of Chancery held that Aronson should be limited to determining demand futility, not the applicable standard of review. Therefore, in this case, the Court of Chancery would apply the entire fairness standard to the services agreements between the company and Cohen's affiliates, with the possibility that the approval of the audit committee could shift the burden.
While the Court of Chancery's opinion in EZCorp recognizes that the Delaware Supreme Court will have the last word on application of the principles of Aronson to compensation decisions involving a controlling stockholder, the opinion does surface the apparent conflict in past decisions and sets the stage for potential resolution of the conflict in the future. As the Court of Chancery denied the motions to dismiss in this case, we may not know for a while whether this case provides the vehicle for resolving that conflict, but we know it is now out there.