Disenfranchising shareholders: the future of Blasius after Mercier v. Inter-Tel.

• Author: Kling, Jacob A.
• Position: Delaware

NOTE CONTENTS INTRODUCTION I. AN OVERVIEW OF THE BLASIUS DOCTRINE A. Board Action Designed To Entrench Itself 1. Board Action Interfering with the Electoral Process 2. Corporate Governance Changes Designed To Entrench the Board 3. Share Issuances Designed To Disenfranchise a Dissident B. Board Action Designed To Thwart a Vote on a Transaction II. INTER-TEL V. MERCIER AND ITS IMPLICATIONS A. The Decision in Inter-Tel B. Inter-Tel as a Narrowing of the Blasius Doctrine 1. Replacing Blasius with Unocal in the Context of a Control Contest 2. Limiting Blasius to Entrenchment Cases 3. Inter-Tel and In re MONY III. A CRITICAL ANALYSIS OF INTER-TEL A. Agency Costs and the Case Against Postponement 1. Background on Agency Costs 2. Agency Costs and Shareholder Voting 3. Agency Costs Associated with Postponing a Vote B. Modeling Shareholders' Decision C. Choosing a Default Rule 1. The Justification for a Penalty Default 2. The Role of the Imminence Requirement CONCLUSION INTRODUCTION

Since Chancellor Allen's seminal opinion in Blasius Industries, Inc. v. Atlas Corp., it has been a bedrock principle of Delaware corporate law that when a board acts for the "primary purpose of thwarting" the exercise of the shareholder franchise (1) it is not entitled to the protection of the business judgment rule, (2) and instead must provide a compelling justification for its action. (3) After declaring that "[t]he shareholder franchise is the ideological underpinning upon which the legitimacy of directorial power rests," (4) Chancellor Allen explained why the deferential business judgment rule, according to which courts presume that disinterested directors are informed as to the subject of a business decision and have made a good faith determination that the decision is in the best interests of the corporation, (5) is inapplicable when the board acts for the primary purpose of interfering with the shareholder franchise. (6) According to the Chancellor, "a decision by the board to act for the primary purpose of preventing the effectiveness of a shareholder vote inevitably involves the question who, as between the principal and the agent, has authority with respect to a matter of internal corporate governance." (7) Such a decision, he continued, "does not involve the exercise of the corporation's power over its property, or with respect to its rights or obligations; rather, it involves allocation, between shareholders as a class and the board, of effective power with respect to governance of the corporation." (8) The Chancellor concluded that a decision to alter this allocation of power, even if made in good faith, cannot be left to the board's business judgment. (9)

Although the court in Blasius declined to adopt a rule of per se invalidity, (10) application of the Blasius standard of review has virtually always sounded the death knell for the challenged action. (11) In Mercier v. Inter-Tel (Delaware), Inc., however, Vice Chancellor Strine of the Delaware Chancery Court upheld against a Blasius challenge the Inter-Tel board's decision to postpone its imminent special meeting in order to prevent shareholders from voting against a merger that the company had negotiated with Mitel. (12) The court first suggested that when the board interferes with a shareholder vote touching on matters of corporate control, its actions should not be evaluated under Blasius but instead should be subject to the Unocal reasonableness test, which is generally applicable to defensive action taken by the board in the context of a contest for corporate control, and which requires the board first to identify a legitimate corporate objective served by its action and then to show that it acted reasonably in relation to that objective. (13) According to the court, the postponement in Inter-Tel survived Unocal scrutiny since it was a reasonable means of achieving the legitimate objective of preserving the deal for shareholders.

Because the Vice Chancellor recognized that the Delaware Supreme Court has continued to apply Blasius review even in circumstances implicating Unocal, he upheld the postponement under Blasius as well. Emphasizing that the directors were independent and did not expect to have a role in the surviving entity, the court held that the board had presented a compelling justification under Blasius when it postponed the meeting in order to give shareholders additional time to consider the merits of the transaction and to prevent them from irretrievably losing a deal that the disinterested board in good faith believed to be in the shareholders' best interests. (14)

This Note analyzes the state of the Blasius doctrine after Inter-Tel. Part I reviews the basic structure of the doctrine. It identifies two broad categories of board action that have been found to trigger Blasius review: (1) acts designed to thwart the ability of shareholders to replace the incumbent board, which I refer to as entrenchment cases, and (2) acts designed to thwart a vote on a business transaction that requires shareholder approval as a matter of law. The first category goes to the heart of Blasius, but the second category has historically been within its scope as well.

Part II examines Vice Chancellor Strine's opinion in Inter-Tel, a case that falls into the second category. It argues that the opinion departs from traditional Blasius analysis in two ways. First, it openly seeks to replace Blasius with Unocal review in the context of a contest for corporate control. More subtly, it attempts, at a minimum, to confine Blasius to entrenchment cases. The combined effect of these two doctrinal changes would have been to effectively eliminate Blasius as a separate doctrine. When the board interferes with the shareholder franchise in a situation implicating control of the corporation, Unocal would govern. Unocal would completely displace Blasius in this context whether or not the board is allegedly motivated by a desire to entrench itself, although the outcome of Unocal review would be heavily influenced by the presence of such a motive. (15) With respect to board action interfering with a vote that involves an ordinary business proposal rather than the composition of the board or control of the corporation, Unocal does not apply and, moreover, board entrenchment will not be at issue; thus, Inter-Tel suggests that the board's action would be evaluated under the business judgment rule. (16) However, Inter-Tel cannot be read to completely nullify Blasius review because Vice Chancellor Strine expressly recognized that stare decisis foreclosed the possibility of replacing Blasius with Unocal in the corporate control context. (17) Instead, the practical import of Inter-Tel is to quietly but substantially alter the content of Blasius review in nonentrenchment cases so that it bears little resemblance to the doctrine of strict scrutiny announced by Chancellor Allen two decades ago.

Part III offers a normative analysis of the court's decision in Inter-Tel. It argues that while the decision may seem reasonable ex post insofar as shareholders would have voted down the Mitel merger on the basis of potentially incomplete information but for the postponement, it is less defensible when certain ex ante agency cost considerations are taken into account. In particular, it suggests that a strong presumption against board action designed to thwart an imminent shareholder vote is an optimal default rule. Although such a rule imposes a monitoring cost on the firm by reducing the discretion of the board to respond to contingencies, it also reduces residual agency costs (18) to the extent that there is a heightened risk of abuse or error when the board acts to disenfranchise shareholders in the context of a fundamental business transaction, assuming that courts may not always be able to detect such mismanagement. (19) Even if it is uncertain whether on balance the reduction in residual agency costs outweighs the increase in monitoring costs, a benefit of such a default rule is that it may force the board to reveal ex ante the possibility that it might try to thwart a vote, and thereby enable shareholders to decide in advance whether to endow the board with this power. (20) Indeed, in Inter-Tel the board had initially sought shareholder authorization to postpone the vote in the event that approval of the merger appeared unlikely, and shareholders voted to deny that authorization.

1. AN OVERVIEW OF THE BLASIUS DOCTRINE

   1. Board Action Desired To Entrench Itself

      When directors act for the primary purpose of thwarting the ability of shareholders to determine the composition of the board, they bear the heavy burden of producing a compelling justification to defend their actions. Cases involving board entrenchment have historically formed the core of the Blasius doctrine. (21) Although Chancellor Allen's discussion in Blasius of the allocation of power between the principal and agent applied to all shareholder votes, (22) he noted that the issue is particularly implicated in cases "deal[ing] with the question who should constitute the board of directors of the corporation." (23) Within this category of entrenchment cases, there are three main subcategories of board action that have been found to impermissibly impede the exercise of the shareholder franchise. The first subcategory, and the one most analogous to the situation in Inter-Tel, involves board action that interferes with the election process in order to thwart an upcoming proxy contest or consent solicitation. (24) The second involves unilateral corporate governance changes designed to erect obstacles to shareholders seeking to replace the board at the next election. (25) The third type of entrenchment action that Delaware courts have on rare occasion invalidated is a share issuance designed to dilute a dissident shareholder.

      1. Board Action Interfering with the Electoral Process

         The first type of entrenchment case implicating Blasius involves...