Van Gorkom was a very controversial case decided in the Delaware Supreme Court in 1985. It dealt with the duties of the board of directors in a corporation: specifically, their duty to be informed.
Directors unquestionably have this duty. When they pay no attention at all to their business, they can be personally liable as a result. (See Francis v. United Jersey Bank.) Usually, the business judgment rule keeps them safe so long as they don't do something totally stupid. But Van Gorkom expanded directors' duties into a territory where many businesspeople were uncomfortable. Some have gone as far as to call it "the worst decision in the history of corporate law."
Facts of the case
Jerome Van Gorkom was chairman and CEO of the Trans Union Corporation, a public holding company. It made much of its revenue from leasing out railway cars. In the late 1970s, Trans Union wasn't making enough taxable income to claim investment tax credits which were generally available to other companies in that business, and as a result, it couldn't effectively match its competitors' prices.
One solution to the problem, floated at a management meeting in August 1980, was a merger with a larger company. Another proposal was a leveraged buyout—where the managers would buy the company from shareholders using the company as collateral for a loan. Trans Union's CFO presented some calculations based on a share price of $50-60 (the market price was about $40). Van Gorkom rejected the idea but said that he would be willing to sell his own shares within that range.
In September, Van Gorkom sat down with a friend, Jay Pritzker, who specialized in corporate takeovers. He proposed a sale of Trans Union to Pritzker at $55 a share, and Pritzker accepted this offer a couple of days later. They worked out a deal over the next couple of days in which Trans Union's shareholders would receive $55 cash for each of their shares, and Pritzker would have the option to buy one million shares of Trans Union's unissued treasury stock at $38 per share, 75 cents above market price. Pritzker demanded a response from the board by September 21, just three days away.
On September 20, Van Gorkom called a senior management meeting. Almost all of the other managers thought the idea was ridiculous. The CFO objected to the $55 per share price and to the option to buy treasury shares.
Immediately after the management meeting, Van Gorkom summoned the board. He outlined the deal to them without handing over the actual agreement. He brought in a lawyer from an outside firm, who instructed the board that they might face a lawsuit if they didn't take the offer; after all, it was for a shareholder meeting to decide. The CFO told the board that $55 was "at the beginning of the range" of a fair price. The board approved the merger offer after two hours, on the condition that Trans Union would be able to accept any better offer brought within the next 90 days. Van Gorkom signed the merger agreement that night at a party. Neither he nor any members of the board had actually read it.
After the deal was made public on September 22, many officers threatened to resign. Van Gorkom quieted them down by negotiating amendments that would allow Trans Union to solicit other bids through its investment banker, Salomon Brothers. The board approved these amendments on October 8.
Two other offers came in, but neither ultimately led to anything. The first, from General Electric Credit Corporation, couldn't be completed within the 90-day window. The other was a leveraged buyout, which the officers (Van Gorkom excepted) tried to pursue with the help of Kohlberg Kravis Roberts. The KKR deal fell through after Van Gorkom allegedly talked one of the rebel officers out of it; Van Gorkom's story was that the deal was not "firm" because it was contingent on KKR getting outside financing.
On December 19, some dissident shareholders filed a class action suit on behalf of 10,537 shareholders against Trans Union, its directors, and Pritzker. The court refused to preliminarily enjoin the merger, so the shareholder meeting took place on February 10, 1981, and the merger was approved by a substantial majority, many voting based on a proxy sent out by the board (as is usual in big companies).
The trial in the Delaware Court of Chancery led to a judgment for the directors on July 6, 1982. (Pritzker had been eliminated as a defendant by agreement of both sides prior to the verdict.) The court held that that the business judgment rule protected the board's decision to approve the cash-out merger, and that the shareholders had been fairly informed by the board before voting on the merger. The plaintiffs appealed their case to the Delaware Supreme Court, which ordered this verdict thrown out.
The decision
The Supreme Court's opinion lambasted Van Gorkom and the board of directors. Justice McNeilly, in his dissent, claimed that it "reads like an advocate's closing address to a hostile jury... Throughout the opinion great emphasis is directed only to the negative, with nothing more than lip service granted the positive aspects of this case."
The opinion, written by Justice Horsey, stated the law as:
Under the business judgment rule there is no protection for directors who have made "an unintelligent or unadvised judgment." A director's duty to inform himself in preparation for a decision derives from the fiduciary capacity in which he serves the corporation and its stockholders. Since a director is vested with the responsibility for the management of the affairs of the corporation, he must execute that duty with the recognition that he acts on behalf of others. Such obligation does not tolerate faithlessness or self-dealing. But fulfillment of the fiduciary function requires more than the mere absence of bad faith or fraud. Representation of the financial interests of others imposes on a director an affirmative duty to protect those interests and to proceed with a critical eye in assessing information of the type and under the circumstances present here. Thus, a director's duty to exercise an informed business judgment is in the nature of a duty of care, as distinguished from a duty of loyalty.
...In the specific context of a proposed merger of domestic corporations, a director has a duty under (the law), along with his fellow directors, to act in an informed and deliberate manner in determining whether to approve an agreement of merger before submitting the proposal to the stockholders. Certainly in the merger context, a director may not abdicate that duty by leaving to the shareholders alone the decision to approve or disapprove the agreement. Only an agreement of merger satisfying the requirements of (the law) may be submitted to the shareholders.
Among the findings that led the court to conclude that the directors were liable for gross negligence:
- The board accepted the $55 price without question. "No director sought any further information. No director asked (the CFO) why he put $55 at the bottom of his range. No director asked him for any details as to his study, the reason why it had been undertaken or its depth. No director asked to see the study; and no director asked him whether Trans Union's finance department could do a fairness study within the remaining 36-hour period available under the Pritzker offer. Had the Board, or any member, made an inquiry of him, he presumably would have responded as he testified: that his calculations were rough and preliminary; and, that the study was not designed to determine the fair value of the Company, but rather to assess the feasibility of a leveraged buy-out financed by the Company's projected cash flow, making certain assumptions as to the purchaser's borrowing needs."
- While the board claimed to have provided a 90-day "market test" to ensure the fairness of the deal, the court didn't buy this argument. "There is no evidence that the Merger Agreement was effectively amended to give the Board freedom to put Trans Union up for auction sale to the highest bidder, or that a public auction was in fact permitted to occur. The minutes of the Board meeting make no reference to any of this. Indeed, the record compels the conclusion that the directors had no rational basis for expecting that a market test was attainable, given the terms of the Agreement as executed during the evening of September 20."
- The court refused to take the directors' high level of business experience into account, adopting an earlier precedent that "found those factors denoting competence to be outweighed by evidence of gross negligence."
- As for the lawyer, who allegedly "advised (the Board) that Delaware law did not require a fairness opinion or an outside valuation of the Company before the Board could act on the Pritzker proposal," the court ruled that such advice would have been correct. Nonetheless, "unless the directors had before them adequate information regarding the intrinsic value of the Company, upon which a proper exercise of business judgment could be made, mere advice of this type is meaningless; and, given this record of the defendants' failures, it constitutes no defense here." The court also said that "we cannot conclude that the mere threat of litigation, acknowledged by counsel, constitutes either legal advice or any valid basis upon which to pursue an uninformed course."
"We do not suggest that a board must read in haec verba every contract or legal document which it approves," the court said in a footnote, "but if it is to successfully absolve itself from charges of the type made here, there must be some credible contemporary evidence demonstrating that the directors knew what they were doing, and ensured that their purported action was given effect."
Curiously, the Boston Consulting Group had apparently provided a study to Trans Union, which concluded that $55 was a fair price for the company's stock. The dissent pointed this out as evidence that the board was adequately informed, but the opinion dismissed the study because "no one even referred to it at the September 20 meeting" and because it did "not represent valuation studies."
The resolution
The Supreme Court sent the case back to the Court of Chancery with instructions to determine the fair market value of the plaintiffs' shares in Trans Union. Once the fair value was determined, the plaintiffs were to receive damages to the extent that the fair value exceeded $55 per share.
This determination was never made. Instead, the directors agreed to settle the claim for $23.5 million. $10 million was paid from liability insurance taken out by the directors, and the remaining $13.5 million was paid by Jay Pritzker, on condition that the directors would pay ten percent of that amount to charity. Robert Pritzker, a relative of Jay's and an associate in the family business, explained this deal at a Chicago-Kent College of Law forum in 2001:
We didn't think the directors had done anything wrong. They were a very knowledgeable group; as I recall, four of them were CEOs of conglomerates that had been put together by buying companies. They surely knew what they were doing...
So we felt that we were the beneficiaries of the whole event. The directors didn't do anything wrong, why should they bear the responsibility? They had nothing to gain and everything to lose. Our feeling was that morally we owed it to them. So, our deal was we would pay 90 percent of that $1.35 million for each one, and they would pay 10 percent to charity. We felt they ought to have something, but not so gross a number. And, incidentally, Van Gorkom paid three or four of their charity contributions. He was about as high class as you could be. He asked for nothing, he didn't want any final settlement or bonus. He made one request of us, and that was that we give him some office space for the Chicago Public School Finance Authority. A very decent guy—stubborn as hell—but very honorable.
Chicago school academics were up in arms over the case. How could directors be liable for approving a deal where shareholders got a 50% premium over the market price of their stock? And what business did the court have second-guessing the directors' judgment? Ira Millstein contended that "99% of boards didn't think that anything wrong had happened. Most everybody wrote about the decision as 'the Delaware courts are going nuts.'"
On the other hand, the decision put board members on notice that they had to be careful not to rush to judgment, especially in deals where there's a lot of money involved. Millstein again: "If you went into a board room before Van Gorkom and tried to talk about legal obligations, they'd say 'We have more important things to do...' When it came down, you were able to walk into a boardroom for the first time and really be heard."
Sources
- Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985)
- Bauman, Corporations: Law and Policy (5th ed., West 2003)
- Roundtable Discussion: Corporate Governance, 77 Chi.-Kent L. Rev. 235 (2001)