“Twice Tested” and Still Fair, and the Ongoing Relevance of Schnell
This blog recently discussed the Delaware Supreme Court’s decision in Coster v. UIP Companies, Inc., wherein the Court held that a stock sale that satisfied the entire fairness standard — the most rigorous in Delaware’s corporate law — should undergo still further review to assess the board’s motivations in approving the sale. The Court reversed the decision of the Court of Chancery, which had assumed that entire fairness was the “end of the road” for judicial review, and instead invoked the seminal 1971 decision in Schnell v. Chris-Craft to explain that “inequitable action does not become permissible merely because it is legally possible.” Under Delaware law, therefore, board actions are “twice tested”: first for legal authorization, and second to determine whether such action was equitable.
On remand, Chancellor McCormick had the opportunity to revisit this framework and, in particular, opine on whether the standard of review in Schnell or Blasius Industries v. Atlas Corporation controls. Under Blasius, a board must provide a compelling justification when actions are taken for the “primary purpose of thwarting” the stockholder franchise. Schnell is similar to Blasius, but more broadly prohibits board action taken for “inequitable purposes.” Of these, the Chancellor’s opinion minced few words in embracing the Blasius standard of review and characterizing Schnell as both inscrutable and a relic. The post-remand Coster opinion serves as a call to Delaware’s high court to do the same.
The Court of Chancery first critiqued Schnell as laying down a rule that is both vague and seemingly inflexible — that is, it appears to create a per se prohibition on a board’s inequitable conduct without defining the contours of what constitutes such conduct. For example, the Chancellor queried whether Schnell applies to “board actions lacking any good faith basis,” or rather “all board actions having any bad faith motivation.” In turn, how relevant (if at all) is the directors’ subjective intent to this inquiry? The court noted that Blasius, on the other hand, creates a more flexible, two-step test that looks at (i) the primary purpose of board action, and (ii) whether that action has a compelling justification.
Next, the Chancellor explained that these shortcomings in Schnell are likely a product of the time it was decided, predating by a decade the Delaware Supreme Court’s principal decisions on intermediate standards of review. According to the court, this accounts for Schnell’s relative inflexibility in comparison to “modern” equitable tests, explaining that “[h]ad Schnell been litigated after the creation of intermediate standards, the high court easily could have applied an intermediate standard, rather than an elliptical and seemingly per se rule.”
Finally, while the Court of Chancery lamented that Blasius had yet to displace Schnell as the operative standard, it nonetheless had to determine how each should be applied. Recognizing their similarities, the court suggested viewing Blasius as a carve-out of Schnell, the latter of which should only be applied “in the limited scenario wherein the directors have no good faith basis for approving the disenfranchising action.” Blasius, on the other hand, should apply where “disenfranchising actions [are] taken in good faith.”
With these principles in mind, the Chancellor found that the stock sale at issue satisfied both Schnell and Blasius, relying heavily on certain factual findings that had not been sufficiently emphasized in the prior opinion. While the Court of Chancery found that the stock sale was “significantly motivated” by a desire to dilute plaintiff’s voting power and thus moot legal proceedings in which she sought to appoint a custodian, the board did so because, among other reasons, it concluded that litigation could trigger termination provisions in key contracts for the company. Because the plaintiff’s actions very likely could damage the company’s business, the board had “good faith bases” for approving the challenged sale. Therefore, Schnell was not applicable because the board’s action was not exclusively inequitable; and while the sale was “significantly motivated by a desire to moot” the custodial proceedings, Blasius was not applicable due to the board having a compelling justification for the sale.
It remains to be seen what further guidance (if any) Delaware’s Supreme Court will offer on the application of Schnell and Blasius in this context. While that Court has only sparingly touched on Blasius over the last decade, Coster potentially suggests a renewed interest in the doctrine. In particular, we may expect to see guidance on how Schnell and Blasius fit with other standards of review, most importantly, Unocal’s enhanced scrutiny.