Fairness Opinions: Session 2 - US Rules
Smith v Van Gorkom (1985)
In a landmark decision, the Delaware Supreme Court case of Smith v. Van Gorkom (1985) held corporate directors personally liable for a breach of their duty of care.
This ruling sent shockwaves through the corporate world, fundamentally altering the standards for board decision-making and highlighting the importance of a diligent and informed process.
Background of the Case
The case centered on the leveraged buyout of Trans Union Corporation. The company’s chairman and CEO, Jerome Van Gorkom, sought to sell the company in order to address its tax-related issues. Without consulting the board or outside financial experts, he unilaterally fixed a sale price of $55 per share—a 48% premium over the market price at the time—based on a rough calculation with his CFO. Van Gorkom then met with Jay Pritzker, a prominent corporate acquirer, and secured an offer at that price.
Van Gorkom presented the proposal to his board of directors at a two-hour meeting that was scheduled with no prior notice of the topic. The directors received no written materials, did not read the merger agreement, and were advised by the company’s lawyer that they could be sued if they did not accept the offer. Relying almost entirely on Van Gorkom's oral presentation, and with no independent valuation of the company's worth, the board approved the merger. The shareholders later approved the deal, but a class action lawsuit was filed alleging the directors were grossly negligent.
The Court's Ruling
The Delaware Supreme Court reversed the lower court's finding in favor of the directors. The court held that the board was "grossly negligent" in its decision-making process. The court concluded that the directors failed to exercise an "informed business judgment" because they:
Did not adequately inform themselves of the intrinsic value of the company before approving the sale.
Relied solely on the uninformed representations of Van Gorkom and did not seek advice from outside financial experts or obtain a formal fairness opinion.
Approved the merger agreement after only two hours of deliberation and without ever having read the document.
Failed to disclose all material information to the shareholders, thereby preventing a fully informed vote.
Most importantly the Supereme Court's ruling pierced the protection of the business judgment rule, which normally shields directors from liability for honest mistakes. The court determined that the board's lack of due diligence in their process was so egregious that the business judgment rule did not apply.
Significance and Impact on Corporate Law
Smith v. Van Gorkom is a landmark case for its profound impact on the corporate duty of care. Its legacy is seen in several key areas of corporate law and governance:
The Business Judgment Rule: The decision clarified that the business judgment rule is not a blank check for directors. Its protection only applies when a board has acted in an "informed" manner. The court established that a director’s decision-making process, not just the outcome, is subject to judicial scrutiny.
The Rise of Fairness Opinions: The case is widely credited with making fairness opinions a standard practice in corporate transactions. Boards now routinely hire independent financial advisors to provide a formal valuation and opinion to demonstrate they have acted with due care (although the actual “fairness” of transactions from a resultant opinion has been recently challenged in the Delaware Court of Chancery).
The Importance of Process: The ruling underscored that the "how" of a decision is as important as the "what." Board meetings for major transactions must now be structured to allow for thorough review, access to all material information, and sufficient time for deliberation.
Legislative Response
The decision sparked such an outcry over the potential for personal liability that the Delaware legislature enacted Section 102(b)(7) of the Delaware General Corporation Law.
This statute allows a company to include a provision in its corporate charter that exculpates directors from monetary liability for breaches of the duty of care, provided the breach does not involve a lack of good faith, a breach of the duty of loyalty, or other specific misconduct. While this provision offers a shield against personal liability, the case's core message—the importance of a diligent and informed process—remains a cornerstone of good corporate governance.
Implications for Executives and Boards (Our take)
Gorkum is the pre-eminent case describing the need for boards to seek counsel on related party or perceived related party transactions that affect the shareholders they represent. As a result, many boards whose executives or companies with majority shareholders are seeking to use the “fairness opinion” as the shield against actions taken against them in these types of transactions. But there is little prescription as to what comprises an accurate or appropriate fairness opinion.
Recent cases in Canada and the US have begun to look the role that advisors have played in completing said fairness opinions, their inherent conflicts and the components found within a completed fairness opinion.
In the Small and Mid Cap company market (Private & Public), where controlling shareholders are abound and boards are often conflicted, many boards ignore or choose to ignore the completion of a fairness opinion.. But those who choose to ignore this work, do so at their own legal peril as small institutional shareholders become more active in defending their minority rights.
