Avoiding The ‘Entire Fairness’ Trap

Recent years have seen derivative-suit scope creep. Now there may be a workaround.

“Entire fairness review” is a phrase that should strike fear into the heart of any corporate director. It’s the Delaware equivalent of a root canal without anesthetic. 

Entire fairness kicks in when plaintiff lawyers convince a judge that board members are so conflicted there’s no point in even asking them whether to approve a derivative lawsuit on behalf of the corporation against insiders accused of engaging in self-interested transactions.

As the Delaware Supreme Court put it in 1952: “Human nature being what it is, the law, in its wisdom, does not presume that directors will be competent judges of the fair treatment of their company where fairness must be at their own personal expense.” With entire fairness, the court decides—at a cost the Delaware Court of Chancery has estimated can run $10 million to $30 million.

Suitable Solutions

One enterprising lawyer may have come up with a hack around entire fairness, however. Relying on Delaware law and prior court rulings, attorney Robert B. Greco of Richards, Layton & Finger suggests in a recent article that companies could amend their corporate charter to give a committee of independent directors exclusive power over decisions involving derivative lawsuits.

It’s an intriguing idea, not least because it tears a page out of the strategy book plaintiff lawyers have used to earn tens of millions of dollars in fees over the years. 

First, an explanation. Unlike when shareholders sue a company for fraud, in derivative suits shareholders are asking the corporation to file a lawsuit on behalf of itself, usually against insiders they accuse of enriching themselves at shareholders’ expense. Delaware courts expanded the scope of derivative suits in recent years to include all sorts of transactions, including Elon Musk’s $56 billion pay package.

In order to proceed with a derivative suit, plaintiff lawyers must demonstrate demand futility, usually by convincing the court that directors have conflicts that prevent them from acting fairly. Once over that hurdle, lawyers are holding most of the cards. Defense lawyers and experts must be hired, millions of documents must be examined and directors must turn over years of emails and electronic messages. Then, there’s the risk of losing at trial.

“Just to avoid the costs of discovery and trial, it may be worth paying millions of dollars in settlements,” Greco says.

Deriving Decisions

Truly independent directors might offer a way around what some call the “entire fairness tax.” Companies already use special litigation committees to review derivative cases after demand futility has been established. Greco’s idea is to empower an independent committee on the front end, leaving all decisions about litigation to them. This committee could be as small as two or three directors but powerful enough to convince a judge they have independently assessed the risks and rewards of proceeding with a derivative suit.

Given the long history of plaintiff lawyers negotiating—and getting paid—for establishing independent committees at the companies they sue, it would be hard for them to argue against giving independent directors the sole power to make decisions about derivative suits, Greco says. And because they are only deciding whether the corporation should sue insiders, not whether shareholders can sue the company, investors can’t claim they are being deprived of their rights.

“I don’t think it’s going out on a limb by saying it could work,” he says of handing authority over derivative suits to such a committee. “They’re really best situated to manage these types of derivative claims.”

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