". . . Skepticism but Not Cynicism": Chancellor Allen's Scrutiny of Special Committees

• Publication year: 1997
• Citation: Vol. 21 No. 02

SEATTLE UNIVERSITY LAW REVIEWVolume 21, No. 3WINTER 1998

". . . Skepticism But Not Cynicism": Chancellor Allen's Scrutiny of Special Committees

James C. Freund(fn*)

As Chancellor William T. Allen retires from the Delaware Court of Chancery after 12 productive years as its presiding jurist, I want to pay special tribute to the beneficial influence he exerted on business lawyers like myself.

A word of background. In the decade of the eighties, I was practicing law in the mergers and acquisitions (M and A) area, enmeshed in the takeover activity that marked those frenetic years. I was not a litigator, but (like other business lawyers representing clients) was absorbed by what was happening concurrently in the courthouse-in particular, the one in Wilmington, Delaware. As I noted at the time, M and A practice in the 1980s had the following characteristics which, taken together, created a very unstable lawyering environment:- The necessity for clients to take actions which had legal consequences in order to accomplish their business and financial goals-actions which placed a heavy premium on the lawyer's counseling role. - The knowledge that each step would likely be scrutinized by a court while under assault by an implacable, well-financed, intelligent adversary lawyer, poised to characterize one's every move in apocalyptic terms as the ultimate depredation. - The feeling of insecurity rooted in the fact that the "legal" issues tended to be broad ones, the considerations were highly fact-sensitive, and the facts were almost never the same in crucial respects from case to case. It was the edge of the law, with few "bright-lines" existing for appropriate conduct and new judicial decisions or regulatory positions being promulgated on a weekly basis.(fn1)

All of this impacted directly on the lawyer's vital predictive function. The ability to tell a client how something is likely to come out-which is a large part of what separates the professional from the layman-furnishes the cornerstone on which considerations of strategy and approach are based. Those of us who counseled the demanding M and A clients of that turbulent decade had to live with the ever-present fear of not going far enough to accomplish our purpose, or conversely, going so far that we would live to regret it in the courthouse.

What we business lawyers needed was guidance, for which the prime source was the courts. Unfortunately, given the constant state of flux during those years, what guidance we received was often as likely to be puzzling as enlightening.

Chancellor Allen, perhaps more than any other jurist of his day, seemed to appreciate this constant quandary in which practicing lawyers found themselves. I like to think that he saw his function as not only to decide the numerous cases that came before him, but also to provide practitioners with explicit guidance as to what factors he considered acceptable and what he found troubling in the situations that recurred frequently during those years.(fn2) He spoke not only to the litigants, the litigators, and the law professors, but to those of us on the daily firing line-negotiating the next deal which was almost certain to be judicially reviewed.

This educational function was not an easy task for the Chancellor. After all, he wasn't drafting a statute or regulations, or writing a treatise-he was forced to deal with the cases that came before him, warts and all. He had the clarity of vision to realize that the world we inhabited was rarely black-and-white. More frequently, the situations were fact-specific and untidy, with some factors pointing one way, some another, and still others swathed in ambiguity. His approach was to embark on a painstaking journey through those facts, assessing and weighing each of them in turn. His principal goal, of course, was to arrive at a measured conclusion and thus be able to render an overall judgment on the matter, which subsumed all the facts. But, just as important to us, he also recognized that along the way-by expressing candid (and often eminently quotable) reactions to the various patterns he encountered-he could educate practitioners who would be shepherding the next flock as to what was warranted and what missed the mark.

I am sure that the Chancellor must have realized that by doing this he eased our lawyering chores. Anyone who has practiced knows that when a lawyer is advising his or her client to do something that the client finds disagreeable (or to refrain from taking some action that the client wants to take), the advice is much more palatable (and the lawyer has a greater chance of convincing the client to so act or refrain) if the lawyer can point to a specific statement on the point by the Chancellor.

To show the reader how this worked in practice, I've chosen to focus on one specific area-the use of special committees of the board of directors in M and A transactions (such as, but not limited to, management- or parent-initiated buyouts). In doing so, I do not mean to imply that the Chancellor was the only jurist involved with special committees; in fact, Vice Chancellors Jacobs,(fn3) Hartnett(fn4) and Berger(fn5) all dealt with special committee issues, as did the Delaware Supreme Court.(fn6) The Chancellor also passed on the use of special committees in other contexts, such as in deciding on whether to institute derivative litigation.(fn7) Nor do I intend to suggest any limitation on the Chancellor's judicial scope. He also dealt with the full range of thorny M and A issues passing through the Delaware courts (as well as many issues arising in other corporate(fn8) and noncorporate(fn9) contexts), such as board determinations that effectively blocked shareholders from tendering shares to an unfriendly acquirer,(fn10) including the issue of whether and when the board has a fiduciary duty to redeem a "poison pill,"(fn11) and the validity of the grant of lock-up options during the course of an acquisition.(fn12) It has been suggested, in fact, that of all the commercial law judges this century has witnessed, only Learned Hand produced a body of work which equals that turned out by Chancellor Allen.(fn13) But our focus will be narrowed to just the Chancellor and to just this one issue, with the main emphasis on the five key years from 1986 through 1990.

First, here in brief is the backdrop against which this issue played out.(fn14) An important tenet of Delaware corporation law is the business judgment rule, as a result of which courts will not substitute their judgment for the business judgment of boards of directors, provided that certain standards have been satisfied.(fn15) When a corporate board confronts a decision on an issue such as selling the company, one such prerequisite is that the directors reviewing the transaction be disinterested.(fn16) When directors stand on both sides of a deal, they cannot be said to be disinterested.(fn17) If they're not, then they must affirmatively demonstrate the entire fairness of the transaction.(fn18)

That was the situation in the Weinberger v. UOP, Inc. case, involving a cash-out merger of a controlled subsidiary in which a majority of the subsidiary's board were designees of the parent.(fn19) The Delaware Supreme Court considered the majority's failure to share pertinent information they possessed with the subsidiary's outside directors to be a breach of the fiduciary duty they owed to the subsidiary.(fn20) The court noted, however, in a footnote that the result could have been different if the subsidiary had appointed an independent negotiating committee of its outside directors to deal with the parent at arm's length, and suggested that use of such a committee would be considered strong evidence of fairness.(fn21)

In a subsequent decision, where arm's-length negotiations were conducted through a special committee, the Delaware Supreme Court deemed this to be "of considerable importance" and suggested that "it may give rise to the proposition that the directors' actions are more appropriately measured by business judgment standards."(fn22) If so, this would be quite significant, since as a practical matter, in many cases the presumption afforded by the business judgment rule represents the crucial consideration for the court in deciding whether to validate or overturn the corporate action taken.(fn23)

As a result, special committees came into vogue in the 1980s when conflicts existed, especially in management-led buyouts and where the minority shareholders of a controlled subsidiary were being squeezed out. The crucial question in those years was whether the court was satisfied that the formation and performance of the special committee was such that its actions were entitled to the benefits of the business judgment rule.(fn24) (Subsequent to this period, as we shall see, the Delaware Supreme Court ruled that the special committee's sole effect would be to shift the burden of proof on fairness from the defendant to the plaintiff.(fn25)) And this is where Chancellor Allen and the Delaware Chancery Court came into the picture-to scrutinize particular transactions and lay down guidelines for practitioners.

At the outset, the Chancellor appeared to approach the subject a bit gingerly. In a case involving MGM Grand Hotels(fn26) in 1986, where no special committee participated in the key decision of how to apportion consideration received in the...