Corporate Governance

Limiting the Duty of Loyalty: Pfeffer v. Redstone (The Evisceration of the Duty of Loyalty)

By J. Robert Brown

We are discussing Pfeffer v. Redstone, a recent Delaware Supreme Court opinion involving the spin off of Blockbuster by Viacom.

Delaware courts purport to apply a higher standard when it comes to transactions that implicate the duty of loyalty.  But in fact this would interfere with managerial discretion and potentially cause corporations to eschew Delaware as the jurisdiction of choice.  This is particularly the case since CEO compensation is typically a duty of loyalty issue and supposedly subject to these exacting standards. 

So Delaware courts say one thing but do something else.  Rather than apply exacting standards (in the form of the entire fairness test), they instead allow companies to rely on process, particurly approval by independent directors, then apply the business judgment rule to the conflict of interest transaction.  Putting aside, as we have noted often, that "independent" directors are in fact not necessarily "independent" under the Delaware approach, the standard entirely ignores the presence of the interested director in the process.  All of this is discussed in much greater length in Returning Fairness to Executive Compensation.

The approach, however, is not the only way to limit the application of the duty of loyalty.  Another is to conclude on spurious grounds that the doctrine does not apply, despite a clear conflict of interest.  The poster child for this approach was Sinclair Oil Corp. v. Levien, 280 A.2d 717, 721-22 (Del. 1972).  There the Court found that a dividend approved by the board of a subsidiary entirely dominated by the parent did not implicate the duty of loyalty since the controlling shareholder did not receive a disproportionate benefit.  As the Court noted:  "However, a proportionate share of this money was received by the minority shareholders of Sinven. Sinclair received nothing from Sinven 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 do so because it needs the subsidiary's cash, without implicating the duty of loyalty.  Note that when the Supreme Court set out the analysis in Sinclair, it 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?  Let us have the Court tell us.

• 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.

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

Full post as published by The Race to the Bottom on February 23, 2009 (boomark / email).