Fair Is Fair: Reforming Fairness Review

Much time and energy is being devoted to determining how corporate decision-making can be structured to avoid fairness review. Comparatively little attention is paid to precisely what it means to subject a contract or transaction to fairness review, or to the purpose that fairness review is supposed to serve.

Here I advance the argument that the purpose of fairness review in corporate law should be to determine whether a proposed transaction or contract is beneficial or harmful to minority or non-controlling shareholders. While this point does (and should) seem obvious, oddly this is not the role currently played by fairness review in Delaware corporate law. Rather, the role currently played by fairness review is to regulate board composition and the procedures employed by boards of directors in making decisions that subsequently become the subject of fairness review by judges.

While it is important to pay attention to board composition and board process, it is far from clear that fairness review is the proper context for doing so because transactions that provide significant benefits for minority and non-controlling shareholders should not be nullified by judges in order to disciple corporations for real or perceived corporate governance failures. The recent, highly unfortunate outcomes in the Delaware Court of Chancery in the legal challenges to Elon Musk’s compensation in the Tornetta v. Musk cases are examples of the problem at hand.  Supposed that one simply assumes, for the sake of argument, that the Musk compensation package being challenged by plaintiffs was approved in a flawed process. Despite any such alleged flaws, the compensation arrangement was overwhelmingly favored and approved by Tesla’s independent (non-Musk affiliated) shareholders. Nullifying this arrangement does not change Tesla’s corporate governance. Nor does it punish the directors and others who were responsible for the supposedly flawed process. As such, nullifying the compensation package on fairness grounds not only makes zero sense; it punishes the ostensible victims, the minority shareholders who wanted the comp package to be respected.

Historically, procedurally flawed deals and deals that were suspect because they involved self-dealing were subject to being automatically voided by courts under ancient rules that refused to countenance contracts that involved conflicts of interest. Over time, courts abandoned the practice of automatically voiding conflict of interest transactions because these procedurally flawed or suspect transactions provided substantial benefits to corporations and to their minority and non-controlling shareholders. Voiding them harmed the very shareholders that the rules were there to protect. Courts stopped voiding conflicted transactions and countenanced them if they were deemed “fair.”

Unfortunately, courts and legislatures have lost sight of the narrow, utilitarian role played by fairness review. Instead of analyzing whether a transaction benefits shareholders, fairness analysis currently is a judicial strategy used to discipline directors and controlling shareholders for procedural flaws in the way that they structure deals in order to compel them to structure deals in the ways preferred by courts. Again, the current approach is misguided because it undermines the purpose of fairness review, which is to salvage from the scrapheap flawed deals that nonetheless benefit shareholders.

This is not to say that process should play no role at all. Under current law, judicial scrutiny of process plays two roles in corporate law, one appropriate, one inappropriate. First, courts study process to determine whether a transaction should be evaluated under the business judgment rule or under the entire fairness test. If there are no problems with the process, then courts invoke the business judgment rule and refrain from analyzing the substance of a transaction. If, however, there are problems with the process that are sufficiently grave to cast doubt on the legitimacy of a corporation’s decision, then courts have no choice but to proceed to a second, far more difficult task, which is to analyze the substantive merits of the transaction. This second-stage inquiry is euphemistically called “fairness review.”

Courts should not scrutinize the process by which a deal is approved a second time when conducting fairness review. Substantive rather than procedural fairness is all that matters at this stage. Further, the most important substantive criteria for determining fairness should be consent. Where consent is lacking courts must determine whether the price was adequate.

Recently, the state of Delaware attempted to boldly go where no state has gone before by proposing a statutory definition of what it means for a transaction or contract to be “fair to the corporation.” Specifically, recently proposed SB 21 says that the phrase “fair as to the corporation” means that “the act or transaction at issue, as a whole, is beneficial to the corporation, or its stockholders in their capacity, as such given the consideration paid to or received by the corporation or its stockholders or other benefit conferred on the corporation or its stockholders and taking into appropriate account whether the act or transaction meets both of the following:

1. It is fair in terms of the fiduciary’s dealings with the corporation.
2.  It is comparable to what might have been obtained in an arm’s length transaction available to the corporation.

This article criticizes this proposed statutory definition of fairness, as well as the common law definition of fairness, and the role currently played by judicial fairness review of deals approved by corporate boards of directors. It suggests a new way to determine whether deals are fair. Specifically, I propose that an informed shareholder vote constitute a final, conclusive and determinative demonstration of the fairness of a transaction, regardless of whether there are flaws in the process by which a deal was approved by company directors. Where no shareholder vote is obtained, then the tools of modern finance, such as Discounted Cash Flow analysis, along with input from relevant expert witnesses. Where the deal makes the minority/ non-controlling shareholders worse off, it should be invalidated. Otherwise, it should be respected.