As a reader of legal opinions, your author sometimes gets the sense that an appellate court, faced with a difficult issue, simply avoids the problem by making alternative findings that moot the choice. This aftertaste is brought to your author by HCI Investors, LLC v. Fox, 2013 WL 5525841 (Mo. App. W.D. 2013).
Evidently Hillcrest Bank, owned through a holding company, had substantial non-performing assets. To address the problem, those in charge came up with a plan under which non-performing assets would be sold to LLCS, to be owned by holding company shareholders who elected to participate. Whether membership had its “privileges” is another question–LLC members were subject to capital calls. The incentive to participate: Participating bank holding company shareholders who participated could obtain, for free, additional shares of the holding company in the amount equal to 25% of the non-participating shareholders’ interests. Oh, so here we have the stick.
Although in a Missouri court, the holding corporation had been incorporated in Kansas, which referenced Delaware corporate law in unsettled matters, says the court. So, the court is not looking to a Rodd Electrotype close corporation approach.
It might be something of a tricky matter to determine whether this transaction is subject to entire fairness or the business judgment rule (more on that below). But, not to worry, the court avoids the question, assuming the entire fairness standard applies, and then defers to the trial court’s determination that entire fairness has been met.
More after the break …
What Entire Fairness Requires
Where a transaction is subject to the entire fairness standard, the burden is on the fiduciary to prove that the transaction is entirely fair. Let’s try a relatively recent Delaware Chancery court statement concerning what entire fairness requires:
Entire fairness is Delaware’s most onerous standard. When a party challenging a board’s decision alleges and later proves facts sufficient to overcome the business judgment rule, “the burden then shifts to the director defendants to demonstrate that the challenged act or transaction was entirely fair to the corporation and its shareholders.” Walt Disney, 906 A.2d at 52. Once entire fairness applies, the defendants must establish “to the court’s satisfaction that the transaction was the product of both fair dealing and fair price.” Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1163 (Del.1995) (internal quotation marks omitted) [hereinafter Technicolor Plenary ]. “Not even an honest belief that the transaction was entirely fair will be sufficient to establish entire fairness. Rather, the transaction itself must be objectively fair, independent of the board’s beliefs.” Gesoff v. IIC Indus., Inc., 902 A.2d 1130, 1145 (Del.Ch.2006).
Reis v. Hazelett Strip-Casting Corp., 28 A.3d 442, 459 (Del. Ch. 2011). Reis, by the way, is an interesting case indicating the impact of failure to engage in “fair dealing” over and above concerns as to “fair price”. See also Emerald Partners v. Berlin, 726 A.2d 1215 (Del. 1999) for further discussion of the burden of proof as to fairness (noting that certain circumstances can result in shifting the burden of proof).
So, then, what of the evidence? That’s an interesting valuation question. Why not 15% dilution? Or 20%? I look forward with anticipation to seeing what proves that the 25% amount is fair. Here the court goes off the rails:
The Fox Family inaccurately presumes that the percentage of warrant issuance must bear a direct relationship to the risk shareholders are being asked to undertake.FN14 Yet, they offer no authority to support this position. In fact, logic suggests that in order for warrant issuance to incentivize performance (an objective as to which the Fox Family expresses no animus), the risk of nonparticipation must exceed to some meaningful degree the risk of participation. Whether that disparity can be “objectified” by a formula is immaterial. It is only material that the disparity appears reasonably fair. Having conceded that incentivizing participation by all Holding Company shareholders was an appropriate objective, the Fox Family cannot now be heard to complain that the 25% rate of incentive suggested by Fingersh and Blitt was unfair merely because neither could explain, with precision, how the rate “tied” to the risk of participation. This conclusion is particularly appropriate given the fact that the Fox Family has not in any manner suggested what they believe would have been a reasonably fair rate of warrant issuance, commensurate with the objective of incentivizing participation. They appear instead to have adopted the myopic strategy of challenging whether the 25% rate was proven to be entirely fair, disregarding their concession that an incentivizing mechanism of some sort was wholly appropriate.
Understanding that it distinctly is not the complaining party’s duty to explain what it believes to be the proper incentive when the transaction is subject to the entire fairness standard, the HCI Investors court misses the mark with analysis by taxonomy–normally a poor technique. It simply describes the complaining party’s view as “myopic”. That the fiduciary has difficulty in formulating a basis for demonstrating the fairness of the transaction does not allow it to avoid its duty to demonstrate entire fairness.
Proper Standard of Review
As noted above, the court avoids deciding whether the transaction is subject to entire fairness or the business judgment rule. Let’s see if we can answer the question, shall we?
Defective process imposes entire fairness review. The opinion recites that Mr. Fingersh (a director of the bank and its holding company (identified in appellant’s brief as chairman of the board), and the representative of a family owning over 30% of the holding company) stated “that the professionals ‘came up with the percentage, and I looked at it after they were finished, and that’s the metric I used’ “.
What’s up with that? A fiduciary cannot avoid responsibility by simply deferring to a third party.
The business judgment rule … has no role where directors have … abdicated their functions ….
Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984)
The referenced “professionals”, by the way, appear to be outside counsel and the CFO. And the deference did not even extend to paying attention to the recommendation:
Fingersh testified that he confirmed the 25% rate but did not create it. He testified that the professionals first arrived at a 20% rate and that he did not know “how it got from 20 to 25.”
It is not clear how there could even be a question that a decision is protected by the business judgment rule when the one in charge of this matter (i) delegated the determination to another and (ii) cannot explain how the pricing came to be changed (in a way more adverse to the complaining party). Is that what this court is suggesting as a possibility?
Entire fairness even if decision-making not grossly negligent. Let’s see if we can help the court in deciding whether the entire fairness standard should apply, even had the decision-making process not been defective.
Does offering the same terms to all shareholders necessarily preclude application of the “entire fairness” standard? No. Let us consider, for example, eBay Domestic Holdings, Inc. v. Newmark, 16 A.3d 1 (Del. Ch. 2010)–a case I discussed with my students in Business Organizations last year and, as chance would have it, I will be discussing with this year’s crop of students in class on 10/11/13.
The eBay court applies the entire fairness standard to a transaction in which controlling shareholders granted the issuer a right of refusal on shares they held, in exchange for the right to one new share for each five shares subject to the right of first refusal. The objecting shareholder, eBay, was given the right to join the arrangement on the same terms. So, here we have a coercive arrangement–in eBay, dilution through issuance of stock for free as a method to create incentives to engage in some other undertaking (there, sign a right of first refusal). Seem similar? In HCI Investors, it is participation in financing nonperforming assets, and becoming subject to a capital call, that is “incentivized” by a dilutive issuance of stock.
The eBay court applies the entire fairness standard. 16 A.3d at 28. And, in case one is wondering, the court as a remedy provides for rescission.