Greater Scrutiny to Board Actions Affecting Stockholder Voting Rights
Stockholders’ right to elect corporate directors is “sacrosanct" and holds “transcending importance” under Delaware’s corporate law, providing “the ideological underpinning upon which the legitimacy of directorial power rests[.]. A corporation’s board of directors is charged with its high-level management and oversees officers it appoints to conduct the company’s day-to-day business. Apart from its limited voting rights, particularly the right to elect directors, stockholders have few means to influence the corporation’s management. As a result, when board action adversely impacts or circumvents shareholder voting, the Court of Chancery will stand in the breach and use its rarely-invoked powers at equity to apply a second level of scrutiny, examining the directors’ subjective purpose and motivations to assess their good faith.
Delaware courts are “assiduous in carefully reviewing any board actions designed to interfere with or impede the effective exercise of corporate democracy by shareholders[.]” In Blasius Industries, Inc. v. Atlas Corp., the Court articulated the test if employed in such a review (referred to as the Blasius doctrine or Blasius review). In a Blasius review, Delaware courts ask:
- Were the directors primarily motivated by a desire to thwart a stockholder vote? If not, the inquiry ends.
- If so, did the board have a good faith “compelling justification” for the action? If not, the action must be struck down.
Prior to 2021, the Delaware Supreme Court had not applied Blasius to a board’s actions for nearly 20 years. Practitioners had come to suspect that Delaware’s adoption of more exacting standards for assessing a fiduciary’s conduct subsumed Blasius’ equitable standard, such that a separate Blasius review would be superfluous. In 2021, however, the Delaware Supreme Court reinvigorated Blasius and upended the widespread belief in its demise. In Coster v. UIP Companies, Inc., the Court of Chancery analyzed a board’s action (which broke a voting deadlock by diluting a 50% stockholder’s vote) and found it was permitted under the corporation’s governing documents and satisfied Delaware’s most onerous and demanding fiduciary standard (“entire fairness” analysis) It upheld the board’s action on that basis and did not apply Blasius, believing, like many, that satisfying the entire fairness fiduciary analysis was conclusive.
On appeal, however, the Delaware Supreme Court reversed the Court of Chancery’s decision and remanded the case for further consideration. The Supreme Court agreed that the board’s action did not violate the directors’ fiduciary duties under onerous “entire fairness” fiduciary standard; however, it held the action’s effect – circumventing a shareholder vote – triggered a Blasius review, and clarified that such a review is separate and distinct from the fiduciary analysis, instructing the Court of Chancery:
“After remand, if the court decides that the board acted for inequitable purposes or in good faith but for the primary purpose of disenfranchisement without a compelling justification, it should [strike down the board action.
In Coster, the Court held that a compelling justification requires that the directors show “that their actions were reasonable in relation to their legitimate objective, and did not preclude the stockholders from exercising their right to vote or coerce them into voting a particular way.” This formulation does little to illuminate the nature of a “compelling justification,” defining the term with the equally ambiguous “reasonable in relation to their legitimate objective” proposition. While imprecise, the following guidance on the meaning of “compelling justification” can be gleaned from Delaware cases applying the standard. They do not provide a bright line defining the contours of the standard, and to some extent cannot, given the fact-specific nature of the Court of Chancery’s equitable authority, but offer a crude means by which to navigate.
Remaining in Office is Not a Compelling Justification
Board action intended to prevent stockholders from ousting one or more directors from office cannot be sufficiently justified, even if the board genuinely believes the directors’ continued service is in the corporation’s best interest. Allowing directors to prevent their ouster raises obvious issues, particularly given Delaware’s conviction that stockholder election of directors forms the “ideological underpinning” of directors’ authority. The Court condemns such a justification in strong terms, stating: “the belief that directors know better than stockholders is not a legitimate justification when the question involves who should serve on the board of a Delaware corporation and “[t]he notion that directors know better than the stockholders about who should be on the board is no justification at all..
Dilutive Stock Sale to Break Voting Deadlock Can Be Justified
In Coster, discussed above, the Court of Chancery determined, on remand from the Supreme Court, that the board’s issuance of stock in order to break a voting deadlock was based on a sufficiently compelling justification. The stockholder had forced a deadlock in voting after inheriting the original co-founder’s 50% interest, seeking either to force a higher buyout, though the inheriting stockholder was not entitled to a buyout under the governing documents, or to seek a court order dissolving the otherwise-healthy company to receive her liquidation value. The board issued stock to a long-serving, key employee of the company, who the founders had determined to provide equity prior to the co-founder’s death. This diluted both co-founders and gave the key employee the deciding vote on the slate of new directors. The deceased investor’s inheritor sued to invalidate the dilutive issuance.
The Court found the justification compelling on the facts of the case. It noted that the board’s purpose in diluting both co-founders was not to prevent a vote – a vote could not occur because of the parties’ impasse in electing new directors. Instead, the stock issuance had the dual purpose of preventing the appointment of a custodian (as first step in seeking a judicial order of dissolution), which would have caused the company to implode, and to compensate and incentivize the business’s key employee to continue work for the company.
Coster was a strong renewal of Blasius, one that likely will lead to more frequent application of the Blasius review. It remains to be seen how this reinvigoration of the Blasius standard will develop from Coster to affect board actions, but keep in mind that the voting rights of shareholders are carefully guarded in Delaware, and even compliance with the directors fiduciary duty will not end a Court’s inquiry. The Court will go further and look to purposes and justifications, seeking to permit the board to manage a company and take steps to protect its interest, while also preserving the fundamentally important stockholder right to vote, particularly in the context of director elections.
*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.