Corporate Governance

Delaware's Top Five Worst Shareholder Decisions for 2009 (#5): Pfeffer v. Redstone

By J. Robert Brown

The courts in Delaware claim that the duty of loyalty "demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of his duty." It is the duty of loyalty that applies to transactions involving conflicts of interest, including executive compensation.  The duty is designed to protect shareholders from self dealing by imposing on the board the obligation to establish the fairness of any transaction subject to the standard. 

The language is from Guth v. Loft, 5 A. 2d 503 (Del. 1939), an early case but repeated in a legion of more recent decisions.  Yet the history of the duty of loyalty in Delaware has been one of circumvention.  The courts do so in two ways.  First, they provide that the duty of loyalty does not apply where the board contains a majority of independent directors. 

The other approach is to limit the application of the duty of loyalty through arbitrary standards.   An example occurred in Sinclair Oil Corp. v. Levien, 280 A.2d 717, 721-22 (Del. 1972).  The Court concluded that a dividend approved by the board of a subsidiary entirely dominated by the parent did not implicate the duty of loyalty since the parent did not receive a disproportionate benefit.  Why?  Because a dividend is paid proportionately to all shareholders.  As the Court noted:  "[A] proportionate share of this money was received by the minority shareholders of [the Subsidiary].  [The parent] received nothing from [the Subsidiary] to the exclusion of its minority stockholders. As such, these dividends were not self-dealing."  

In other words, a controlling shareholder can bleed off the cash and assets held by a subsidiary, do great damage to the subsidiary's business, and have as a primary motivation its own need for cash, without implicating the duty of loyalty.  The analysis ignored the Parent's control of the board, the impact on the Subsidiary, or the fact that most of the cash went to the controlling shareholder.  The Supreme Court, in reaching the legal conclusion, cited no authority for the proposition.

The weakness in the rational can be seen clearly in Pfeffer v. Redstone.  In that case, Viacom dominated Blockbuster, owning approximately 82.3% of the equity value and 95.9% of the voting power in Blockbuster.  Blockbuster approved a $5/share dividend that resulted in Viacom receiving over $738 million of the $905 million distributed to Blockbuster shareholders.  Blockbuster, which was already suffering, had to borrow the money needed to pay the dividend.  At the time, at least one analyst described Blockbuster's prospects as "grim."  In other words, the outflow of money was certainly good for Viacom but may have been very bad for Blockbuster.

Despite Viacom's degree of control and the possibility that the control influenced the decision to pay the dividend, the Court refused to apply the entire fairness test.  Why?  As the Court concluded: 

• Pfeffer complains that Redstone, through his company NAI, received an overwhelming majority of the Special Dividend. That may be true, but it does not establish a disqualifying self interest since NAI held a majority of Viacom's stock. What is significant is that Director Redstone and NAI received nothing unique that was otherwise unavailable to the other stockholders.

In other words, the Court made no effort to require that the board approving the dividend show that it was fair.  As a result, the conflict of interest was simply ignored.  It is the law in Delaware but like so many other things, it is in conflict with common sense.

The Delaware courts have severely weakened the duty of loyalty.  The result is that unfair transactions involving a conflict of interest are subject only to the meaningless process requirements of the duty of care.  It allows management to treat shareholders unfairly without allowing them any recourse.

Primary materials can be found at the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on January 01, 2010 (boomark / email).