In re EZCORP: Entire Fairness Framework and Independent Boards

When the board of a Delaware corporation has established—and follows—specific policies and procedures for approval of related party agreements, the directors should be mindful that a related party agreement, if challenged, would nonetheless be subject to the court’s “entire fairness” framework of review.

In re EZCORP Inc. Consulting Agreement Derivative Litigation (Jan. 25, 2016) serves as a reminder that the court generally will review claims alleging fiduciary breach relating to agreements between a corporation and its controller under the “entire fairness” framework (rather than the more deferential business judgment rule). This will be the case even for agreements that relate to business transactions other than a squeeze-out merger and even when the agreements have been approved by independent and disinterested directors through a board-established process for the consideration of related party transactions. While not the subject of the decision, EZCORP also serves as a reminder that, in the context of initial public offerings and spin-offs, proper advance planning should significantly reduce or even eliminate any breach of fiduciary duty issues with respect to agreements between the newco (i.e., the corporation that will become public) and its controller.

Background

In EZCORP, the plaintiff-stockholder challenged a series of consulting agreements between EZCORP Inc. and affiliates of its controlling stockholder, contending that they were “not legitimate contracts for services but rather a means by which [the controller] extracted a non-ratable cash return from EZCORP.” The audit committee of the EZCORP board had approved the agreements. The plaintiff claimed that the committee directors had rubber-stamped the agreements “to preserve their cozy positions” (including significant pay) as directors of EZCORP and of other companies affiliated with the controller. Vice Chancellor J. Travis Laster held that the “entire fairness” framework would apply to the court’s review of the challenged agreements.

Key Points

“Entire fairness” framework applies to commercial agreements (not only merger agreements) with a controller. The “entire fairness” framework generally applies to the court’s review of any transaction between a corporation and its controller in which the controller extracts a benefit not available to the minority stockholders on a pro rata basis. This standard applies not only to transformative transactions with a controller (such as a merger), but also to consulting, compensation, service, license, or other business transaction agreements between a corporation and its controller.

Procedures for approval of controller transactions by an independent committee have significant advantages, but will not prevent application of the “entire fairness” framework. A corporation will be meaningfully advantaged by establishing and utilizing clear procedures for negotiating and approving controller transactions (e.g., through an independent conflicts, related-party transactions, audit, or other special committee, as discussed below). Indeed, the establishment and use of such procedures are necessary for good corporate governance, important to a company’s public stockholder base, and critical in connection with the defense of any related shareholder litigation. However, these procedures will not prevent a controller transaction, if challenged, from being reviewed by the court under the entire fairness framework—even though, under that framework, board and/or stockholder ratification can result in a shift in the burden of proof or a shift to the business judgment rule standard of review, as described below.

Advance planning for related party commercial arrangements in the context of IPOs and spin-offs. Although not the situation in EZCORP, the decision serves as a reminder that protective planning can avoid review of controller arrangements entered into in the context of an initial public offering or spin-off. If a company is going to effect an IPO or a spin-off, the newco (i.e., the company that will go public or be spun-off) should consider putting into place in advance of the IPO or spin-off any commercial arrangements it intends to enter into with the controller. If these arrangements are properly disclosed in connection with the IPO or spin-off, they will not be subject to later review (unless they are amended or modified), as they would be pre-existing stockholder-approved agreements. In addition, to the extent the newco may want to enter into agreements with the controller after the IPO or spin-off, the company should consider including in the charter of the newco (before the IPO or spin-off) a process for approval of related party transactions. If the approval process to be utilized is properly disclosed, those arrangements should pass judicial muster so long as the process specified in the charter is closely followed and the terms of the agreement are fully disclosed. The impact of these arrangements on the value of the IPO or spin-off would have to be evaluated.

“Entire fairness” framework. In connection with an agreement under which a controller or its affiliates receive a non-ratable return from the corporation, the “entire fairness” framework of review would apply as follows:

• Defendants’ burden to prove fairness—The defendants have the burden of proving that (i) the process was fair—for example, that the agreement was approved by independent and disinterested directors after full consideration, based on their reasoned view of what would be in the best interests of the company; and (ii) the economic terms of the agreement were fair—for example, the amount paid and other terms reflected what would have been standard or reasonable if the agreement had been entered into with a non-affiliated third party.
• Shift of burden to plaintiffs—If either a fully authorized and effectively functioning committee of independent and disinterested directors, or a majority of the minority stockholders in a fully informed vote, approved the agreement, then the burden would shift to the plaintiffs to prove that the transaction was unfair as to price or process.
• Change to business judgment rule review—If the agreement satisfies the prerequisites established in the Delaware Supreme Court’s 2014 MFW decision for review of controller transactions under the business judgment rule—i.e., from the outset, the agreement was subject to approval by a fully authorized and effectively functioning committee of independent and disinterested directors and by a majority of the minority stockholders in a fully informed vote, and both approvals were obtained then the deferential business judgment rule should apply. (As shareholder agreements with a controller are not generally subject to a shareholder vote, it is rare that a shareholder vote is sought and the MFW prerequisites satisfied in this context.)

Benefits of established process for approving related party transactions. Regardless of the judicial standard applied to review related party agreements, established policies and procedures for a fair and reasonable process nonetheless offer the following potential advantages:

• increased confidence of the unaffiliated stockholders’ that conflict situations will be dealt with in a manner that provides reasonable protection of their interests;
• avoiding a negative response by proxy advisory firms; and
• as noted, a shift in the burden of proof to the plaintiffs to prove unfairness of the agreement if the procedures include approval by a committee of independent and disinterested directors or by the unaffiliated stockholders.

Court’s rationale. The Vice Chancellor outlined different ways that controllers can attempt to obtain non-ratable benefits from a company—including (i) “cash flow tunneling,” where the controller “removes a portion of the current year’s cash flow, but does not affect the remaining stock of long-term productive assets”; (ii) “asset tunneling,” where the controller transfers “major long-term (tangible and intangible) assets” to or from the company, often not at market value; and (iii) “equity tunneling,” in which the controller “increases [its] share of the firm’s value, at the expense of minority shareholders, but does not directly change the firm’s productive assets or cash flows.” The Vice Chancellor reasoned that, as the court has been consistent in applying entire fairness review in cases involving “equity tunneling” (e.g., going private transactions), heightened scrutiny should apply also to the other forms of potential value extraction so that a controller will not be encouraged to utilize one method over another based on the judicial standard of review that would apply.

Factual context supported reasonable inference of unfairness. The Vice Chancellor concluded, at the pleading stage of litigation, that the plaintiff’s complaint supported a reasonable inference that the challenged agreements were not entirely fair and represented a means by which the controller extracted a non-ratable return from EZCORP. Specifically:

• The court viewed six of the seven EZCORP directors as not independent and disinterested because of their ties to the controller.
• The court was influenced by the fact that, under EZCORP’s dual-class capitalization structure, the controller owned 100% of the voting power but only a 5.5% economic stake—which, according to the court, created a disincentive for the company to pay dividends and a strong incentive for the controller to obtain returns through non-ratable direct transfers.
• At least according to the plaintiff’s pleadings:
  • the company’s audit committee had ultimately terminated the contracts at issue in 2014, apparently based on a concern as to their validity;
  • in response to the committee’s termination of the contracts, the controller replaced the directors on that committee;
  • the controller had a history of “retributive behavior” with respect to directors who he perceived to be disloyal to him;
  • the affiliated consulting company was thinly staffed, had no other publicly traded clients, and was not in a position to offer the services contracted for;
  • the consulting services were for advice relating to EZCORP’s “business and long term strategic planning”services that no peer firms obtained and as to which the consulting company had no expertise that EZCORP’s experienced and highly compensated management itself did not already possess;
  • the company had a long history of entering into agreements with affiliates of the controller, involving significant payments (and sometimes overpayments);
  • the consulting company received significant compensation through the agreements—with the annual fee remaining the same even when EZCORP’s income declined (with the result that the fee represented between 5% and 20% of EZCORP’s net income); and
  • the company had not paid dividends and had consistently stated that it did not intend to pay dividends.

Possibility of appeal. The Vice Chancellor acknowledged that there are a small number of Delaware precedents involving consulting or compensation agreements with controllers—through which the controller extracted a non-ratable benefit, but that had been approved by a board or a duly empowered committee with an independent majority of outside directors—in which the entire fairness framework was not applied. However, after citing a long list of decisions that took the contrary view and applied entire fairness, the Vice Chancellor concluded that “the weight of authority” favored applying the entire fairness framework whenever there was a non-ratable benefit to the controller. The Vice Chancellor acknowledged that “[t]here is considerable tension between these lines of authority,” and characterized the choice between them as “both fundamental and consequential” because “the scope of a controller’s influence has implications for a range of legal doctrines” (including not only the substantive standard of review, but also, for example, demand futility, how the law treats a controller’s take-private tender offer, and the degree to which stockholder approval can ratify or change the standard of review for a controlling stockholder transaction). The Vice Chancellor noted that the decisions that did not apply entire fairness relied primarily on the reasoning of the Delaware Supreme Court’s 1984 Aronson decision. The Vice Chancellor characterized his conclusion that Aronson should be read as limited to the issue of demand futility (which was the subject of that case) as “the view of just one trial court judge” and stated that the issue ultimately can be resolved only by the Delaware Supreme Court.

On February 22, 2016, the Vice Chancellor denied EZCORP’s request that the court certify interlocutory appeal to the Supreme Court. At that hearing, the Vice Chancellor commented that there is “an awful lot of law” that supports application of an entire fairness standard of review to agreements with a controller, but acknowledged that the Supreme Court may want to clarify the issue. Also at that hearing, the Vice Chancellor permitted the plaintiff stockholder to submit an amended complaint to add (to the breach of fiduciary duty claims already made against the company and its directors) breach of fiduciary duty claims against the controller and his affiliated companies.