This article examines legal principles and strategies that govern conflicts of interest confronting officers and directors responsible for asset management decisions and transaction approvals in complex corporate structures, including those created for investments in energy, infrastructure, and mining assets made by corporations, private equity funds and pension funds.
Where conflicts arise, Canadian courts have gauged the actions of management according to the legal requirements of the business judgment rule and, in doing so, have often looked to developments under American case law for guidance and direction.
Under US law a leading role has been taken by the courts of Delaware1 in the evolution of the business judgment rule. It has focused on whether proper steps are taken by officers and directors to protect share values for shareholders. The Delaware approach has not however been universally adopted. Some US states have chosen instead to enact legislation (called ‘other constituencies statutes’) which direct courts in these states to consider a broader list of stakeholder interests beyond shareholder value. This article will review these emerging developments in more detail and will examine how these trends in the US law have impacted the Canadian courts and how they may be expected to impact the Canadian courts in the future.
Defenses under Canadian Business Judgment Rule—The Canadian courts have long recognized and applied the so called ‘business judgment rule,’ which is the principle that courts will defer to properly made business decisions and not impose liability for losses based on judicial hindsight.2 Canadian courts do not expect or require that business decision makers make perfect decisions, only that the decisions must be reasonable under the circumstances.3 However, in order for the rule of deference to apply, Canadian courts typically take the position that either the decision maker must not be in a disqualifying conflict of interest,4 or that the conflict must be isolated from the decision makers by using established mechanisms, such as special committees and independent legal and financial advisors. The more pressing the conflict, the more the courts will find such ‘mechanisms’ necessary.5
The Delaware courts have chosen to focus on situations that give rise to inevitable divergences of interest between business decision makers and shareholders. For example, where directors lack independence because they are nominees of another entity engaged in business with the corporation, where directors of a corporation adopt defensive measures aimed at thwarting a hostile take over of control, or where directors, having determined to sell control of the corporation, must consider competing bids. The Delaware courts have created new and more stringent tests aside from the deferential business judgment rule to deal with such situations.
Leading Trends Established in Delaware—Under the law of Delaware, courts employing the business judgment rule presume 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 taken was in the best interests of the company.6 This presumption can of course be rebutted, if a plaintiff can demonstrate that the directors have breached their fiduciary duty of care or have acted in bad faith.7 Alternatively, the presumption can be rebutted by facts which, if accepted as true, would establish that the board was either self interested in the outcome of the transaction or lacked the independence to consider objectively whether the transaction was in the best interest of the company.8 Because directors are presumed to have acted properly, the evidentiary burden is on the party challenging the board’s decision;9 however, if a plaintiff successfully establishes facts rebutting the rule’s presumption, the burden shifts to the defendant directors to prove the ‘entire fairness’ of the transaction.10
Therefore, where a majority of the board has a personal interest in a transaction, or where a controlling director controls or dominates the board as a whole, the evidentiary burden is on the board to demonstrate to the court’s satisfaction that the transaction involved is ‘entirely fair’ to the interests of the shareholders as a whole. Under this non-deferential standard, the courts will examine whether the deal was procedurally fair, and also whether the financial aspects of the deal were objectively acceptable (the ‘fair dealing’ and ‘fair price’ tests).11 The defendant bears the burden of proving that there were no flaws in procedure that were likely to lead to an unfair result, and of persuading the court that the financial terms of the transaction were fair, based on objective evidence, which is an exceptionally difficult task.12 However, the defendant can shift the burden of proof back onto the plaintiff if it is able to prove that the decision at issue was made by a properly empowered special committee of independent and disinterested directors.13
The Unocal Test for Unfriendly Takeovers—A board’s decision to adopt defensive measures in response to an unfriendly takeover bid is another example of a situation in which the Delaware courts do not apply the deferential business judgment rule. Such situations raise the concern that members of the board may be acting out of desire to protect their own positions. Therefore, before a board’s defensive measures will be accorded the protection of the business judgment rule, directors must first satisfy the two-step reasonableness test established in the Unocal case.14 The Unocal test requires that directors responding to hostile takeover bids demonstrate: (1) that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed; and (2) that the defensive measures undertaken in response were reasonable in relation to the threat posed. If the defensive measures are found to satisfy the Unocal reasonableness test, the courts will apply the deferential business judgment rule to the transaction; if they do not, the court will apply the non-deferential ‘entire reasonableness’ test described above.
The Revlon Test for Sale Transactions—A variation on the Unocal test is the ‘duty to maximize shareholder value’ standard established by the Delaware Court in Revlon.15 This case holds that where the decision has been made to sell the company or to engage in a transaction that results in a change of control of the company, the directors are under a duty to run a fair process aimed at maximizing shareholder value by getting the best possible price, and full disclosure to shareholders. Unlike the Unocal situation, in this case the directors no longer have any concern about defensive measures—as the decision to sell has already been made—and the director’s sole concern is to obtain the best deal possible for shareholders. In contrast to the deferential business judgment rule, under the Revlon test the courts will engage in a judicial examination of the reasonableness of the board’s decision-making process; nevertheless, the courts applying Revlon will still, in contrast to the ‘entire fairness’ standard, not second guess the director’s choices if they fall within a range of reasonable decisions.
The Trend Away From the Delaware Law—One of the most significant issues in the United States law dealing with the ambit of the business judgment rule is the extent to which other states have reacted to, and sometimes against, the tends established by the Delaware courts. Other than Delaware, very few states have well-developed jurisprudence concerning the law in this area. One of the most significant legal developments in this respect in the past few years has been the express rejection in Wisconsin of the more stringent requirements imposed by the Delaware courts (described above), notably based on legislation that allows directors to consider ‘other constituencies’ (that is, other than maximizing shareholder value).16 In Wisconsin, the relevant legislation provides as follows:
[I]n discharging his or her duties to the corporation and in determining what he or she believes to be the best interests of the corporation, a director may, in addition to considering the effects of any action on shareholders, consider the following:
- The effects of the action on employees, suppliers and customers of the corporation;
- The effects on the action on communities in which the corporation operates; and
- Any other factors that the director or officer considers pertinent.17
The tension between allowing directors flexibility to consider multiple concerns and preventing self-dealing by directors is a live issue in the laws of the United States and, we would suggest, in the Canadian law as well.
The Impact on Canada—The Delaware courts have applied the tests described above to increase judicial scrutiny of the actions of directors where the potential for conflict of interest exists. Where the courts identify a potential for the interests of directors to diverge from those of shareholders; the effect is in some cases to shift the burden onto directors to demonstrate that their decisions were objectively fair or reasonable. The Canadian law has not, as of yet, adopted these variations on the business judgment rule, and arguably has moved more in the direction of those states which have rejected the strictness of the Delaware courts’ focus on shareholder value. Canadian appellate courts have noted the Delaware law, and have on occasion expressly stated that it is not binding in Canada, but have also found it ‘persuasive’.18 Nevertheless, the current trend in Canada is in the direction of those US states, such as Wisconsin, which have adopted ‘other constituencies’ legislation.
A recent example of the divergence between Canadian courts and the courts of Delaware occurred with the almost simultaneous release of BCE Inc. v. 1976 Debentureholders19 (‘BCE’) by the Supreme Court of Canada and the Lyondell Chemical Co. v. Ryan20 (‘Lyondell’) by the Supreme Court of Delaware. Our Supreme Court stated in BCE that it would not confine the analysis of a director’s duties under the business judgment rule in a change of control situation to merely a duty to obtain the best possible price for shareholders;21 rather, the question the court should ask is whether the directors have exercised their judgment ‘in the best interests of the corporation’ as a whole which involves, depending on the context, looking to the interests of shareholders, employees, creditors, consumers, governments and the environment.22 Meanwhile, in Delaware, the court in Lyondell affirmed the objective of a board directors is to maximize shareholder value and to obtain the best price available for the target company in a change of control situation.23
Recent Delaware Developments—A yet more recent Delaware case has demonstrated the stringency of the Delaware law in scrutinizing the actions of directors. In the 2011 decision In Re Southern Peru Copper Corporation Shareholder Derivative Litigation,24 Chancellor Strine held in an ‘entire fairness’ case involving a self-dealing transaction that, even where the defendants relied on the advice of a special committee comprised of independent, competent, well-qualified directors who retained independent, top-tier advisors, such reliance will not save the directors from liability under the business judgment rule where the special committee falls victim to ‘tunnel vision’ and narrowly focuses with a ‘controlled mindset’ 25 on the transaction proposed by the conflicted majority shareholder.
Similar issues arose again in the very recent decision of Chancellor Strine in Re El Paso Corp. Shareholder Litigation, released on February 29, 2012.26 In that case, Chancellor Strine ‘reluctantly’ denied the plaintiff’s motion for a preliminary injunction to block a takeover offer by a rival corporation in a case where a bank who owned part of that rival served as an advisor to the board of the target, and where potential conflicts of interest by the CEO were not disclosed. Chancellor Strine noted that the denial of the preliminary injunction is not the end of the matter; since if the majority of shareholders vote to approve the transaction in spite of the now-revealed conflicts, the disgruntled minority could still proceed with damages claims.
In typical Canadian fashion, the Canadian courts appear to be steering a course between the stringency of the Delaware law and the more deferential path charted by the states adopting ‘other constituencies’ legislation. On the one hand, the Supreme Court of Canada has signaled that it is willing to look to values other than shareholder price when examining decision-making by directors; on the other hand, Canadian courts continue to look to Delaware for persuasive reasoning. One may reasonably anticipate that Canadian courts will be drawn into scrutinizing decisions made by boards where the circumstances raise an apprehension of conflict of interest. In such cases, officers and directors may wish to take extra care to protect their decisions by identifying possible conflicts at an early stage, adopting effective mechanisms designed to isolate potential conflicts, and obtaining timely legal advice to ensure that they can rely on the protections of the business judgment rule.