ProfessorBainbridge.com

Delaware Chancery Court Holds Failure to Disclose "Intrinsic Value" Precludes Corwin Defense

A post from Tyler O'Connell of MorrisJames informs us that:

In In re USG Corp. S’holder Litig., 2020 WL 5126671 (Del. Ch. Aug. 31, 2020), the Court of Chancery granted the director-defendants’ motions to dismiss post-closing money damages claims arising out of the sale of USG Corporation (“USG”) for less than what USG’s directors allegedly thought was its intrinsic value. Although the failure to disclose such “intrinsic value” prevented dismissal under Corwin v. KKR Financial Holdings, LLC, 125 A.3d 304 (Del. 2015), Vice Chancellor Sam Glasscock III held that, in the circumstances, that omission and the directors’ approval of the sale did not suffice to plead a breach of the directors’ fiduciary duty of loyalty.  ...

The Court reasoned that, as recent Delaware appraisal cases have suggested, “intrinsic value” or “fair value” are “nebulous, even illusory, concepts.” With a “but see” cite to Delaware’s appraisal statute, the Court reasoned that “[b]elief in any particular intrinsic value, by any being less than an omniscient god, is necessarily a belief that is subjective in nature.” The Court held, however, that “because the Proxy Statement disclosed that the Board held a view of intrinsic value and frequently referenced such a view during its disclosures about the sales process, USG’s stockholders were entitled to know the Board’s opinion of USG’s intrinsic value, even if it was unachievable due to market forces and Knauf’s threats to launch a hostile takeover.” 

An asset (including a business) has no intrinsic value, of course. Instead, it is worth only what the buyer with the highest reservation price is willing to pay. The Delaware courts have recognized this. But the USG board apparently doesn't understand basic finance and they paid the price for being that dumb.

Professors of a certain age struggling with remote teaching

A dear friend sent this along. I don't know where he got it, so can't give credit:

Lowell Milken Institute Program on Should Boards Have Duties to Stakeholders? Lessons from the COVID-19 Crisis

The Lowell Milken Institute for Business Law and Policy at the UCLA School of Law is sponsoring a Zoom stayconference on CSR during the pandemic today. I'll be speaking, along with David A. Katz, who is a partner at Wachtell, Lipton, Rosen & Katz, and Professor Jeffrey M. Lipshaw of the Suffolk University Law School. Regular readers will recall that Jeff and I have dueling papers on the Business Roundtable's August 2019 statement on corporate purpose:

Bainbridge, Making Sense of the Business Roundtable’s Reversal on Corporate Purpose

Lipshaw, The False Dichotomy of Corporate Governance Platitudes

The moderators (my colleagues Iman Anabtawi and Jim Park) circulated a list of questions, which I'm reposting below along with notes I've prepared to use in answering them:

Question: Let’s begin by having each of the panelists describe their position on the question of whether boards should owe duties to corporate stakeholders other than shareholders.

• There is no such duty under current law and the law should not create one.
• You don’t have to take my word for it. Former Delaware Chief Justice Leo Strine has always been very clear this question: "within the limits of their discretion, directors must make stockholder welfare their sole end, and that other interests may be taken into consideration only as a means of promoting stockholder welfare."[1]

Question: The Business Roundtable issued a statement last year expressing “a fundamental commitment” to corporate stakeholders. Was the corporate response to the pandemic consistent with that statement?

• The BRT statement is just woke-washing. It signaled the CEOs’ advocacy for stakeholders but didn’t change much.
• Lucian Bebchuk and Roberto Tallarita found that the vast majority of signatory CEOs had not gotten board approval to sign it. “Even “imperial” CEOs tend to push major decisions through the board rather than disregard it. … The most plausible explanation for the lack of board approval is that CEOs didn’t regard the statement as a commitment to make a major change in how their companies treat stakeholders.”
• There’s evidence that the CEOs in fact do not walk the walk.
  • Anecdotally, WSJ reported in late August that: “A day after Salesforce.com posted record quarterly sales, the business-software company notified its 54,000-person workforce that 1,000 would lose their jobs later this year.”
    • I don't think even Scrooge would have told his employees that in a few months down the road 2% of them would be fired, leaving them to twist slowly in the wind for months while worrying whether they'll be among those who get fired.
    • What makes all of this especially pertinent is that Saleforce CEOMarc Benioff is one of the leading social justice warrior CEOs, constantly bragging about what a great human being he is.
  • There’s a study by a pair of economists, entitled “Do the Socially Responsible Walk the Talk?,” which found “that Business Roundtable signatories exhibit worse records with respect to labor and the environment than their peers.”

Question: Recently a group of 322 long-term institutional investors with $9.2 trillion in assets under management issued an “Investor Statement on Coronavirus Response” asking corporations to take a variety of steps including providing paid leave to employees, taking measures to maintain employment and exhibiting financial prudence by suspending share buybacks. If shareholders themselves are pushing for greater attention to employee interests, shouldn’t boards respond ?

• The question is whether you think those investors will change their behavior or whether you think this is just more woke washing. I believe that the emphasis on ESG investing that we’re seeing from BlackRock, Vanguard, and State Street is mostly advertising. There is survey data that millennials apparently prefer to work for and purchase from companies that are perceived as socially and environmentally responsible. Accordingly, there is an increasingly widely held view in the investment community that to attract Millennial and Generation Z customers, companies must project an image as social justice activists.
• But none of the Big Three have lived up to their commitments. They devote relatively few personnel and resources to monitoring ESG issues at their portfolio companies. Despite the fact that the Big Three collectively own enough shares to determine the outcome of the vote on pro-ESG proposals made by other shareholders,  they rarely vote in favor of such proposals.

Question: Our health care system was initially overwhelmed during the pandemic because sufficient supplies had not been stockpiled and much of our manufacturing is now offshore. Is this failure evidence that a focus on increasing shareholder wealth is problematic from a public policy perspective?

• It’s not a business’ responsibility to anticipate unknown and unpredictable events that will widely affect society.
  • What incentive does a for-profit business have to invest in a drug that may never be needed?
• It was a series of failures of government policy over a two-decade period:
  • We’ve known about zoonotic diseases at least since the AIDS epidemic began. Ebola looked like a nightmare waiting to happen.
  • There have been many proposals to prepare for pandemics. But the proposals were either never funded, underfunded, or defunded.

Question: In Marchand v. Barnhill, the Delaware Supreme Court held that the failure of the board of Blue Bell Creameries to adopt a monitoring and reporting system that would ensure it was informed about food safety issues could support aCaremark It observed that Blue Bell could “only thrive if its consumers enjoyed its product and were confident that its products were safe to eat.” Does this case recognize that the board must be attentive to the interests of stakeholders such as consumers?

• Marchand was decided by Chief Justice Leo Strine. Strine has explained that “a clear-eyed look at the law of corporations in Delaware reveals that, within the limits of their discretion, directors must make stockholder welfare their sole end, and that other interests may be taken into consideration only as a means of promoting stockholder welfare.”
• The cause of action was a derivative shareholder suit brought to enforce the duty of loyalty owed shareholders. The claim is based on the losses the shareholders suffered as a result of the product recall, shutdown of production, lawsuits, and a dilutive private equity offering necessary to keep the company afloat.

Question: How should the board consider situations where the interests of stakeholders conflict? For example, during the pandemic, keeping businesses operating may benefit consumers while risking the health of employees?

• Obviously, one size will not fit all.
• Boards need discretion to decide what is in the company’s best interest in these unusual circumstances.
• The business judgment rule exists precisely so as to ensure that directors can exercise that discretion without fear of liability.
• What directors should not do is to make tradeoffs between the interests of shareholders and stakeholders.
• The core problem of corporate social responsibility is that directors who are responsible to everyone are responsible to no one.

Leo Strine on Milton Friedman on the Social Responsibility of Business

We recently celebrated the 50th anniversary of the publication by The NY Times of Nobel economics laureate Milton Friedman essay The Social Responsibility of Business Is to Increase Its Profits.

Corporate social responsibility raises two questions that often get bollixed up even 50 years later:

1. Do corporations have a social responsibility, as a matter of law.
2. Should corporations be socially responsible?

This is, of course, an example of the classic is/ought dichotomy. (Not, as you may have thought, the is-ought problem.)

Former Delaware Chief Justice Leo Strine has always been very clear on the "is" question: "Despite attempts to muddy the doctrinal waters, a clear-eyed look at the law of corporations in Delaware reveals that, within the limits of their discretion, directors must make stockholder welfare their sole end, and that other interests may be taken into consideration only as a means of promoting stockholder welfare." Leo E. Strine, Jr., The Dangers of Denial: The Need for A Clear-Eyed Understanding of the Power and Accountability Structure Established by the Delaware General Corporation Law, 50 Wake Forest L. Rev. 761, 768 (2015).

So some might be surprised by his recent NY Times op-ed (with Joey Zwillinger, who is the co-founder and co-C.E.O. of Allbirds), in which Strine has some very harsh words for Friedman and his seminal essay. (I'm going to be going back and forth between the Wake Forest and NYT articles. To avoid confusion, I am marking WFLR quotes in blue and the NYT quotes in red.)

Strine's oped strikes a left-of-center populist note:

In the past 50 years, instead of gains for stockholders and top management tracking gains for workers — as characterized by the period when Mr. Friedman wrote — the returns of our capitalist system have become skewed toward the haves.

(As I have written elsewhere, of course, this is a concern shared by right-of-center populists. See my essay Conservative Critiques of Capitalism.)

Strine also takes a left-of-center shot at the libertarian views of espoused by Friedman and his allies:

Mr. Friedman sought to weaken the rules of the game by opposing basic civil rights legislation, unions, the minimum wage and other measures that protected workers, Black people, and the environment.

Of course, some folks would call that a 20th Century version of classical liberalism, which advocates a limited role for government so as to promote maximal freedom and responsibility for everyone. But let's not get bogged down with who says what about whom.

Instead, I want to make a couple of points. First, although Strine's op-ed does not suggest a change in his views on the "is" question, it does suggest a shift in his views on the "ought question" In his earlier Wake Forest Law review article, Strine wrote that:

I am more than moderately sympathetic with those who argue that for-profit corporations should behave lawfully, responsibly, and ethically.

... It is more productive to take the legal rules and corporate power structure as it is, and to advance proposals that make sure that corporations operate in a way that encourages more responsible behavior and that maximizes long-term welfare, within the bounds of that structure.

As I have always read that passage, what Strine wanted was for the legislature to set regulatory bounds within which the corporation operates. Instead of asking directors to be socially responsible, he simply wanted to ask them to obey the law--albeit a much more aggressively regulatory body of law than he believes currently exists.

Now, however, it appears Strine has changed his mind and wants boards "embrace an affirmative duty to stakeholders and society." 

By committing to goals of responsible citizenship, companies allow stakeholders, institutional investors and the public to hold them accountable to their inclusive ideals. In doing so, corporate leaders will also set an example that institutional investors should be required to follow in their own investing and voting policies.

This is pretty surprising. Let's go back to the Wake Forest article:

Under the current legal rules and power structures within corporate law, it is naïve to expect that corporations will not externalize costs when they can. It is naïve to think that they will treat workers the way we would want to be treated. It is naïve to think that corporations will not be tempted to sacrifice long-term value maximizing investments when powerful institutional investors prefer short-term corporate finance gimmicks. It is naïve to think that, over time, corporations will not tend to push against the boundaries of whatever limits the law sets, when mobilized capital focused on short-term returns is the only constituency with real power over who manages the corporations. And it is naïve to think that institutional investors themselves will behave differently if action is not taken to address the incentives that cause their interests to diverge from those people whose funds they invest.

One wonders what has changed so that it is no longer naive to "expect that corporations will not externalize costs when they can" and so on? One also wonders how Strine squares his view of what boards ought to do with his view of what the law allows boards to do. Back to WFLR: "Dodge v. Ford and eBay are hornbook law because they make clear that if a fiduciary admits that he is treating an interest other than stockholder wealth as an end in itself, rather than an instrument to stockholder wealth, he is committing a breach of fiduciary duty." 

How do we square that blunt statement with Strine's current embrace of "a stakeholder-centric governance model"? Does he think directors can do the latter without breaching their fiduciary duties? If so, how?

I think Strine's evolution (assuming he is evolving--I would LOVE for him to do a guest post in reply to my comments, but I am not holding my breath) is being driven by his visceral loathing of the Citizens United decision. Strine has written 8 law review articles (by my count) in which Citizens United comes up and none of them have anything good to say about that decision. In particular, he has argued that Citizens United unleaded a flood of corporate money into politics (of course, it also unleashed a food of union money), which has had deleterious effects:

Because corporate wealth far exceeds that held directly by human beings, if corporations are able to act directly to influence who is elected to office, the laws and regulations in our society will increasingly tend to tolerate the imposition of greater externalities, because they will be enacted by politicians who have been elected in an expensive process in which money matters, and in which securing the support of nonhuman corporate money with a monocular focus on profit will be important to electoral competitiveness.

Leo E. Strine, Jr. & Nicholas Walter, Conservative Collision Course?: The Tension Between Conservative Corporate Law Theory and Citizens United, 100 Cornell L. Rev. 335, 389 (2015).

Although Citizens United goes unnamed in the NYT op-ed, we see the same concerns:

Business leaders must ... stop using corporate funds to distort our nation’s political process. That means ending corporate political spending without shareholder consent, and not contributing to dark money or political party committees. It also means ensuring that spending plans recommended to shareholders only allow contributions to candidates whose views on issues like racial inequality, climate change and fairness to workers are consistent with the corporation’s stated values.

In response, I refer you to my essay Corporate Social Responsibility in the Night Watchman State: A Comment on Strine & Walker, from which I'll draw a few quick points. 

As I have observed previously, “in the 2008 election cycle, the total amount spent on all political campaigns by all actors was, according to OpenSecrets.org, $5,285,680,883.” To put that figure in context, it is less than the amount Procter & Gamble alone spent on advertising in 2008. “As a society, we spend much more money selling stuff to wipe our bottoms with than we do deciding who should run the most powerful country in the world,” which perhaps suggests that the amounts at issue are not as unreasonable as Strine and Walter seem to think.

Instead, the more serious objection posed by Strine and Walter goes to the core of their argument; namely, that corporate political spending is deployed to erode regulations necessary to constrain the externalities inherent in corporate business activity… In fact, however, much corporate political spending is likely to be defensive. As The Economist recently observed:

When America was founded, there were only three specified federal crimes-- treason, counterfeiting and piracy. Now there are too many to count. In the most recent estimate, in the early 1990s, a law professor reckoned there were perhaps 300,000 regulatory statutes carrying criminal penalties--a number that can only have grown since then. For financial firms especially, there are now so many laws, and they are so complex (witness the thousands of pages of new rules resulting from the Dodd-Frank reforms), that enforcing them is becoming discretionary.

In this environment, it seems plausible that much corporate political spending goes to stave off additional regulation rather than to repealing existing laws. In the absence of a showing that the benefits of foregone regulations exceed their costs, there is no reason to assume that corporate political spending increases the extent to which corporations can externalize costs. Strine and Walter offer no convincing evidence that corporate political spending in fact has the effect they posit.

Strine and Walter also fail to take into account the likelihood that much corporate political spending will simply cancel out spending by other corporations. It seems intuitively obvious that specific regulations rarely advantage all businesses. If so, spending by opponents of particular laws or rules likely will be countered by those who benefit from them. Accordingly, Citizens United’s alleged anti-regulatory effect will be self-minimizing.

In addition, Strine and Walter fail to explore the implications of the fact that large corporations dominate corporate campaign spending. First, spending by such corporations is highly constrained by reputational considerations due to “the seriousness with which large corporations treat any potential threats to their goodwill arising from ... negative publicity” generated by unpopular contributions. Second, and more important, while Strine and Walter assume corporations use political spending exclusively to externalize the negative costs of their activities, the reality is that large corporations frequently support regulations that force corporations to internalize social costs. They do so because such regulation can create significant costs for smaller competitors and barriers to entry for startups. Because regulatory costs frequently do not scale, they are often borne disproportionately by small businesses and startups. This observation is not offered as a defense of corporate political spending, but solely as a critique of Strine and Walter’s assumption that corporate political spending is inevitably anti-regulation.

I go on to explore reasons why, even if Strine and Walker were right, I would still oppose corporate social responsibility. But that’s a story for another day (and, in any event, has been oft explored in these pages.)

Guest Post by JW Verrett: Forensic Accounting, Corporate Law, The CIA, & The Hunt for Aldrich Ames

J.W. Verret here.

I have recently embarked on a career shift to focus study on accounting, specifically forensic accounting, and how it relates to the core issues in corporate, securities and banking law that have previously been the focus of my scholarship.  That has included getting certified as a CPA and as a CFF (certification in financial forensics).

Along the way I’ve learned a ton about using financial accounting and forensic accounting techniques to catch bad guys.  Forensic accounting is a core tool for financial fraud investigations under the securities laws (10b-5, FCPA, etc.) and banking law.  It is also a core tool used by Delaware companies to meet their Caremark oversight obligations as forensic accountants design internal controls to prevent compliance violations and utilize forensic accounting to catch violators. 

Before digging into issues at the intersection of forensic accounting and corp/securities law, I thought I would introduce readers to forensic accounting through the story of the FBI and CIA’s efforts to catch Aldrich Ames.  This spy hunt was only successful because of evidence put together by a forensic accounting team conducting a net worth analysis, a common tool of forensic accountants which shows that changes in a subject’s net worth cannot be sufficiently explained by their legitimate sources of income.

Aldrich Ames sold information to the KGB about the identity of our intelligence assets within the USSR, and at the time of his arrest he was responsible for the greatest intelligence leak in American history.  He identified at least ten active agents for the US, some of whom were later executed by the Soviets as a result of his tips.

A classic tool used by forensic accountants to guide investigations is the “Fraud Triangle.”  Three factors that are nearly universal in frauds studied in an early survey of embezzlers by criminologist Donald Kressey.  Its components are pressure, opportunity, and rationalization.  In Ames’s case, pressure for money came initially from an expensive divorce and then from a lavish spending lifestyle he shared with a new wife (when she was arrested, investigators found 60 purses and 500 pairs of shoes among other items). 

Opportunity (a prong that usually reflects poorly on the organization) was here created by his ability to walk out of headquarters with armloads of documents to give the Soviets (since remedied by the agency).  Opportunity also came a result of his legitimate cover for meeting with handlers, which was often that he was attempting to recruit them in reports he would file with the agency about the meetings. 

Rationalization in his case was a personal grudge over being passed over for promotion because of the impact of his drinking on his work.  He would frequently return from long lunches unable to function.

The Fraud Triangle doesn’t only help to explain an embezzler, financial fraud, or in this case spy’s behavior after being caught.  It informs key aspects of an internal investigation, from the email keywords used in email searches to the questions asked during internal interviews as a fraud investigator attempts to track down the perpetrator.

The fascinating details of the investigation of Aldrich Ames can be found in a Senate Intelligence Committee Report, available here.

The first 40 pages outline an intelligence disaster, a ten-year period during which Ames lived a dangerous double life.  Some of his methods utilized sophisticated tradecraft, code names and the famous “dead-drop” mailbox where he would leave markings to indicate he left intelligence in one of several KGB dead drop locations for pickup.

Near the end of the story, the FBI and the CIA know they have a mole on their hands and have seen entire intelligence networks overseas rolled up by the KGB (and later the FSB) overnight.  The first break they have in the case is a tip that Ames cover for his excessive spending, that he inherited the money from his wife and her family, was bogus.  Subsequent forensic analysis of his spending showed him spending cash amounts of nearly $1.4 million and credit card billings of another $500,000 between 1985 and 1993.  During that 8 year time-frame his aggregate CIA take home pay was $336,000.

Ames covered his tracks in part through the classic money laundering techniques of placement, layering, and integration.  Placement takes illicit cash and enters it into the financial system.  He would make structured cash deposits just below the SARs reporting threshold at which banks must report them to the Treasury Department of $10,000.  He would then move the money overseas between various accounts, and then wire it back to the US to make it appear that the money came from his wife’s family.

One challenge CIA officials faced in investigating Ames was that, despite their tips concerning his strangely lavish spending, they did not have the authority themselves to obtain information from banks where he may have done business.  And, at least early in the investigation, the CIA wasn’t eager to expose their dirty laundry to the FBI to pursue a FISA warrant.

From the initial tip about Ames’ odd spending, until his arrest, Ames was able to continue giving away secrets for four years!  At one point a CIA officer went to Bogota to determine whether Ames’ wife was the source of his money.  His was able to vaguely confirm that her family was successful, and had donated to a local sports stadium for naming rights, but specific details like Ames’ assertion about a windfall of money from his mother-in-law’s insurance policy were never nailed down.

It took some time for the FBI to gain access to his bank accounts to review the cash transactions.  Once they did, the investigation quickly focused on him.  One piece of smoking gun evidence in the case was the fact that roughly $9,000 cash deposits, in amounts at multiple banks appearing to be structuring transactions designed to stay below the suspicious activity reporting (SARs) threshold, seemed to take place just after incidents in which Ames was documented meeting with Soviet officials.  Some of those meetings were documented by Ames as his efforts to “recruit” potential agents who were in fact his handlers.  Some of those meetings were documented by FBI agents tailing the Soviet officials (who recorded Ames’ meeting with them) but suspiciously not documented by Ames in violation of procedure.

Spy stories are fun.  Similar fact patterns play out in corporate internal investigations every day as corporations seek to maintain compliance with the federal securities and banking laws and fulfill their oversight duties under Caremark.  The Fraud Triangle and other techniques of forensic accounting utilized in the mole hunt for Aldrich Ames are also used to design internal controls and to conduct investigations of suspected fraud in corporations.  As a fan of cold war era spy fiction (I’ve probably read Le Carre’s George Smiley series a half dozen times) I think that is pretty cool.

Three nights of Ridge Zinfandel

We had Ridge Vineyard reds every night this weekend (in the PB.com household, Thursdays count as a weekend night).

Up first with Hello Fresh's Brown Sugar Bourbon Pork Chops with Apple Pan Sauce, Scallion Mashed Potatoes & Roasted Green Beans was Ridge Wild Cattle Creek Zinfandel (Dry Creek Valley) 2017. Deep purple-ruby. No sediment to speak of. Not a vin de garde, but offering very enjoyable near-term drinking. Cherry cola. Blackberry and raspberry. Plenty of American oak. On the light side for Ridge. Grade: B+

Friday night was a Caesar salad with skirt steak and air-fried French fries. We drank a Ridge Geyserville (Alexander Valley) 2012. Mature but still in its prime. Would have aged well for a while, but it gave a lot of enjoyment now. Enough sediment to justify decanting. Rich and savory bouquet of dried red and black fruits. Well-balanced. Improved with time in the decanter. A big wine. Cherry, blackberry, and discernible American oak. Grade: A-

Saturday night was quail stuffed with jambalaya (with more jambalaya on the side). We had it with a Ridge Lytton Springs (Dry Creek Valley) 2012. It was very interesting to compare it to our notes of the Geyserville from the same vintage. Both Helen and I strongly preferred the Lytton Springs, which was unusual on Helen's part since she is usually prefers Geyserville (I'm just the opposite).

Still a deep ruby-purple, despite having thrown enough sediment to justify decanting. Rich bouquet suggesting blackberries and plums. Rich and complex on the palate. Blackberry. Black cherry. Prunes. Tobacco. Long finish. Probably would age well for a few more years, but providing plenty of enjoyment now. Grade: A-/A

Three great wines.

Disgraced former Theranos CEO Elizabeth Holmes wants to plead mental disease or defect as a defense to the securities fraud charges against her

Reuters reports:

U.S. District Judge Edward Davila in San Jose, California overruled defense objections to letting a psychologist and psychiatrist chosen by the government examine the 36-year-old Holmes for 14 hours over two days, and having the examinations recorded on video.

Davila authorized the examinations after Holmes’ lawyers said they intended to introduce expert evidence from a clinical psychologist “relating to a mental disease or defect or any other mental condition of the defendant bearing on the issue of guilt.”

The defense expert, Mindy Mechanic, is a California State University at Fullerton professor specializing in psychosocial consequences of violence, trauma and victimization, including violence against women, and often testifies in cases involving interpersonal violence, according to her university biography.

I've been in this business for a long time and this is the first time I've heard of the mental disease or defect defense being used in a securities fraud case. A quick Westlaw search turned up about 3 or 4 similar cases, with the opinions mainly dealing with whether a defendant was competent to stand trial. In contrast, It appears from a CNN report that Holmes wants to plead mental disease or defect as a substantive defense to the charges:

This week, Judge Edward Davila of the US District Court for the Northern District of California granted federal prosecutors the ability to have Holmes examined by two experts -- a psychologist and a psychiatrist -- over two consecutive days and for no more than 14 hours combined. The ruling comes after Holmes' defense team previously notified the government of intent to "introduce expert evidence relating to a mental disease or defect or any other mental condition of the defendant bearing on ... the issue of guilt," according to the filing.

I couldn't find any precedent indicating that the defense would play out differently in a securities fraud case than it would in any other criminal case. 

The Ninth Circuit has held that the following jury instruction on the defense was proper:

A defendant is insane if, but only if, at the time of the crime charged,

1. The defendant had a severe mental disease or defect; and
2. As a result, the defendant was unable to appreciate the nature and quality or the wrongfulness of his acts.

The defendant must prove insanity at the time by clear and convincing evidence—that is, that it is highly probable that the defendant was insane.

U.S. v. Elliott, 91 F.3d 156 (9th Cir. 1996).

It's somewhat hard to predict how things will play out, especially because the court's order is redacted with respect to the scope of Dr. Mechanic's proposed testimony.

At a high level, the testimony would cover [redacted], all during the period of the alleged conspiracy. ...

Mechanic does not propose merely to speak “generally” about “the effects of a particular condition,” ... rather, she intends to offer an opinion as to whether Defendant Holmes [redacted]

UNITED STATES OF AMERICA, Pl., v. ELIZABETH A. HOLMES, Def.., 18-CR-00258-EJD-1, 2020 WL 5414786, at *3 (N.D. Cal. Sept. 9, 2020).

I'll be following this case with interest.

Were Easterbrook and Fischel right that target company boards should remain passive in the face of a hostile takeover bid? A comment on Sharfman and Moore. Part 4

In Part I of this essay, I discussed a new article by Bernard Sharfman and Marc Moore, in which they propose reviving the passivity thesis, which argued that target boards faced with a hostile takeover offer should be passive.

In Part II of this essay, I discussed my article, Unocal at 20: Director Primacy in Corporate Takeovers,[1] in which I explained why I disagree with the passivity thesis. My analysis grew directly out of my director primacy model of corporate governance. Because I still think a board-centric approach to corporate governance is appropriate, even in the context of a hostile takeover bid, let me summarize my argument here. I encourage you to go read the whole thing, however.

In Part III, I discussed the final and perhaps most important argument for treating negotiated and hostile acquisitions differently with respect to the scope of the target board’s authority, which rests on the conflicted interests inherent in corporate takeovers.

In this Part, I defend Delaware's approach to takeovers against one aspect of Sharfman & Moore's passivity thesis.

In their discussion of the UK system, which adopts a variant of the passivity thesis, and which they support, Sharfman and Moore point out that (at 32):

Notably, the board passivity rule is an effect- rather than intention-based doctrine, which enables the United Kingdom’s non-judicial Takeover Panel to enforce the rule against target directors and other relevant parties in an administratively straightforward manner, unencumbered by the vexing questions of factual inference and fiduciary duty conformance that typically confront U.S. trial and chancery courts.

In contrast, I think Delaware’s motive-based analysis gets it exactly right.

In its takeover jurisprudence, Delaware has balanced the competing claims of authority and accountability by varying the standard of review according to the likelihood that the actions of the board or managers will be tainted by conflicted interests in a particular transactional setting and the likelihood that nonlegal forces can effectively constrain those conflicted interests in that setting. In other words, the Delaware cases suggest that motive is the key issue. As former Delaware Chancellor Allen explained in the closely related context of management buyout transactions: “The court’s own implicit evaluation of the integrity of the . . . process marks that process as deserving respect or condemns it to be ignored.” Assuming that a special committee of independent directors would be appointed to consider the proposed transaction, Allen went on to explain: “When a special committee’s process is perceived as reflecting a good faith, informed attempt  to approximate aggressive, arms-length bargaining, it will be accorded substantial importance by the court. When, on the other hand, it appears as artifice, ruse or charade, or when the board unduly limits the committee or when the committee fails to correctly perceive its mission—then one can expect that its decision will be accorded no respect.”[1] Our claim is the same is true with respect to board resistance to unsolicited tender offers. If the conflict of interest inherent in such resistance has matured into actual self-dealing, the court will invalidate the defensive tactics. If the board acted from proper motives, even if mistakenly, however, the court will leave the defenses in place.

Former Delaware supreme court Justice Moore argued, for example, that his court’s “decisions represent a case-by-case analysis of some difficult and compelling problems.”[2] He later elaborated:

We did not approach [takeover] cases with the question of whether to allow the corporation to continue in its present form or to permit someone else to acquire the company. . . . [T]he question before the Court was whether the directors acted properly in accepting or rejecting the competing offers. . . . As long as the directors adhered to their fiduciary duties, it would have been most inappropriate for any court to intrude upon a board’s business decision. No court has a role in disciplining directors for the proper exercise of business judgment, even if it turns out to be wrong.[3]

Former Delaware Chancellor Allen made much the same point in RJR Nabisco, where he indicated that the basic question is whether the board acted with due care and in good faith:

Surely the board may not use its power to exercise judgment in [an auction of control] as a sham or pretext to prefer one bidder for inappropriate reasons. . . . But the board of directors continues, in the auction setting as in others, to bear the burden imposed and exercise the power conferred by Section 141(a). Assuming it does exercise a business judgment, in good faith and advisedly, concerning the management of the auction process, it has, in my opinion, satisfied its duty.[4]

A federal court similarly described the Unocal standard as asking “whether a fully informed, wholly disinterested, reasonably courageous director would dissent from the board’s act in any material part.”[5]Motive is the consistent theme throughout these summations of Delaware law.

In light of Sharfman and Moore’s description of Delaware law as not being administratively straightforward and being encumbered by vexing questions, they presumably would agree with those who argue that the difficulty of distinguishing between proper and improper motives is so great in this context that courts should simply eschew a motive-based analysis.

Granted, motive analysis is always difficult, but in every other conflicted interest context the board’s authority to act depends upon the validity of the directors’ mo­tives.[6] Unless we are to accept the passivity model and strip the board of decision-making authority in the takeover context, a motive-based inquiry is inescapable.[7]

The Delaware Supreme Court’s leading decision in Paramount Communications Inc. v. QVC Network Inc.,[8]explained that the enhanced scrutiny test Delaware courts use to review takeover defenses is basically a reasonableness inquiry to be applied on a case-by-case basis: “The key features of an enhanced scrutiny test are: (a) a judicial determination regarding the adequacy of the decision-making process employed by the directors, including the information on which the directors based their decision; and (b) a judicial examination of the reasonableness of the directors’ action in light of the circumstances then existing.” The burden of proof is on the directors with respect to both issues. They need not prove that they made the right decision, but merely that their decision fell within the range of reasonableness.

The new reasonableness standard is a logical culmination of our argument that motive is what counts. While a cynic might argue that it is merely a way of justifying a particular result, the reasonableness test in fact is well-calibrated to preventing improper motives from skewing the competition for control. Notice that the reasonableness test parallels the definition of fairness used in the former Revised Model Business Corporation Act provisions governing interested director transactions, namely, whether the transaction in question falls “within the range that might have been entered into an arms-length by disinterested persons.”[9] Both standards seem designed to ferret out board actions motivated by conflicted interests by contrasting the decision at hand to some objective standard. The implicit assumption is that a reasonable decision is unlikely to be motivated by conflicted interest or, at least, that improper motives are irrelevant so long as the resulting decision falls within a range of reasonable outcomes. The operating norm seems to be “no harm, no foul,” which seems sensible enough.

QVC, moreover, strongly indicated that a court should not second-guess a board decision that falls within the range of reasonableness, “even though it might have decided otherwise or subsequent events may have cast doubt on the board’s determination.” In Interco, Chancellor Allen had warned that “Delaware courts have employed the Unocal precedent cautiously. . . . The danger that it poses is, of course, that courts—in exercising some element of substantive judgment—will too readily seek to assert the primacy of their own view on a question upon which reasonable, completely disinterested minds might differ.”[10] QVC made clear that, so long as the board’s conduct falls within the bounds of reasonableness, Delaware courts will not second-guess the board’s decisions.

If that point was insufficiently clear after QVC, it was driven home in unmistakable terms by the Delaware supreme court’s subsequent decision in Unitrin v. American General Corp., in which the court approved an everything but the kitchen sink array of defensive tactics.[11] Unitrin’s board adopted a poison pill, amended the bylaws to add some shark repellent features, and initiated a defensive stock repurchase. The chancery court found the latter “unnecessary” in light of the poison pill. The supreme court reversed. The court deemed “draconian” defenses—those which are “coercive or preclusive”—to be invalid. (Note the parallel to our discussion of the post-Time status of the just say no defense.) Defenses that are not preclusive or coercive are to be reviewed under QVC’s “range of reasonableness” standard. On the facts before it, the court concluded that the shareholders were not foreclosed from receiving a control premium in the future and that a change of control was still possible. Accordingly, the defensive tactics were neither coercive nor preclusive. More important, the supreme court held that the chancery court had “erred by substituting its judgment” for that of the board. The court explained:

The ratio decidendi for the “range of reasonableness” standard is a need of the board of directors for latitude in discharging its fiduciary duties to the corporation and its shareholders when defending against perceived threats. The concomitant requirement is for judicial restraint. Consequently, if the board of directors’ defensive response is not draconian (preclusive or coercive) and is within a “range of reasonableness,” a court must not substitute its judgment for the board’s.

Note, once again, how the balance tips towards authority values even in a context charged with conflicts of interest. Given the significant conflicts of interest posed by takeovers, courts recognize the need for some review. But the Delaware courts also seemingly recognize that their power of review easily could become the power to decide. To avoid that unhappy result, they are exercising appropriate caution in applying the range of reasonableness standard.

In sum, the search for conflicted interests reflects the Delaware courts’ solution to the irreconcilable tension between authority and accountability. Concern for accountability drives the courts’ expectation that the board will function as a separate institution independent from and superior to the firm’s managers. The court will inquire closely into the role actually played by the board, especially the outside directors, the extent to which they were supplied with all relevant information and independent advisors, and the extent to which they were insulated from management influence. Only if the directors had the ultimate decisionmaking authority, rather than incumbent management, will the board’s conduct pass muster. But if it does, respect for authority values will require the court to defer to the board’s substantive decisions. The board has legitimate authority in the takeover context, just as it has in proxy contests and a host of other decisions that nominally appear to belong to the shareholders. Nor can the board’s authority be restricted in this context without impinging on the board’s authority elsewhere. Authority thus cannot be avoided anymore than can accountability; the task is to come up with a reasonable balance. Properly interpreted, that is precisely what the Delaware cases have done.

Reminder: If you want much more detail, be sure to check out my article Unocal at 20: Director Primacy in Corporate Takeovers, 31 DEL. J. CORP. L. 769 (2006), on which the posts have drawn.

Were Easterbrook and Fischel right that target company boards should remain passive in the face of a hostile takeover bid? A comment on Sharfman and Moore. Part 3

In Part I of this essay, I discussed a new article by Bernard Sharfman and Marc Moore, in which they propose reviving the passivity thesis, which argued that target boards faced with a hostile takeover offer should be passive.

In Part II of this essay, I discussed my article, Unocal at 20: Director Primacy in Corporate Takeovers,[1] in which I explained why I disagree with the passivity thesis. My analysis grew directly out of my director primacy model of corporate governance. Because I still think a board-centric approach to corporate governance is appropriate, even in the context of a hostile takeover bid, let me summarize my argument here. I encourage you to go read the whole thing, however.

In this Part, I discuss the final and perhaps most important argument for treating negotiated and hostile acquisitions differently with respect to the scope of the target board’s authority, which rests on the conflicted interests inherent in corporate takeovers.

The conflicted interest argument

Put in my director primacy terminology, the conflicted interest argument is that accountability concerns are so severe in this context that they must trump authority values. Unsolicited tender offers implicate accountability concerns in at least two ways, which might be referred to respectively as transactional and systemic. The former relates to the effect of a hostile takeover on the target in question, while the latter relates to the effect resistance to hostile takeovers can have on public corporations as a whole. Neither justifies wholly barring authority values from playing a part in developing the governing legal rules.

Transactional accountability. As with business judgment rule scholarship generally, a failing of the academic literature on takeovers is the almost universal tendency to conflate the roles of corporate officers and directors. The legal literature speaks of “management resistance” and “management defensive tactics,” rarely recognizing any separate institutional role for the board. Most commentators simply assume that even independent directors are in thrall to senior managers and will ignore shareholder interests if necessary to preserve their patrons’ jobs.[2]

In contrast, the Delaware courts take the board’s distinct role quite seriously, especially with respect to its independent members. As a doctrinal matter, the board’s burden of proof is more easily carried if the key decisions are made by independent directors.[3] As a practical matter, the court’s assessment of the outside directors’ role often is outcome-determinative.[4]

Why have the Delaware courts insisted on drawing such sharp distinctions between the board’s role and that of management? Because while the conflict of interest unsolicited tender offers pose for the target company’s managers is inescapable, the independent director’s conflict of interest is merely a potential problem. For the independent directors, the conflicts posed by unsolicited tender offers are no different than those posed by freezeout mergers, manage­ment buyouts, interested director transactions, or a host of similar situations. Corporate law neither prohibits these transactions, nor requires complete board passivity in connection with them, simply because they potentially involve conflicts of interest. Instead, it regulates them in ways designed to constrain self-interested behavior. Unless one makes a living on the buy-side of corporate takeovers, it is not clear why hostile takeovers should be treated differently.

Consider, for example, the somewhat analogous case of management-sponsored leveraged buyouts. Like unsolicited tender offers, these transactions inherently involve a strong risk of management self-dealing. While management is acting as the sellers’ agents and, in that capacity, is obliged to get the best price it can for the shareholders, it is also acting as a purchaser and, in that capacity, has a strong self-interest to pay the lowest possible price. Like unsolicited tender offers, management buyouts also create conflicts of interest for the independent directors. Just as an independent director may resist an unsolicited tender offer to avoid being fired by the hostile bidder, he may go along with a management buyout in order to avoid being fired by the incumbent managers. Alternatively, if an independent director is inclined to resist a hostile takeover because of his friendship with the insiders, why should he not go along with a management-sponsored buyout for the same reason? Strikingly, however, the empirical evidence indicates that shareholder premiums are essentially identical in management-sponsored leveraged buyouts and arms-length leveraged buyouts.[5] This evidence suggests that the potentially conflicted interests of independent directors are not affecting their ability to successfully constrain management misconduct. Accordingly, while judicial review of management buyouts tends to be rather intensive, courts have not prohibited such transactions, but have addressed the problem of conflicted interests by encouraging an active role for the firm’s independent directors in approving a management buyout proposal.[6] Why should the same not be true of the board’s response to unsolicited tender offers?

In sum, the conflict of interest present when the board responds to an unsolicited tender offers thus differs only in degree, not kind, from any other corporate conflict. Although skepticism about their motives is thus appropriate, their conflict of interest does not necessarily equate to blameworthiness. Rather, it is simply a state of affairs inherently created by the necessity of conferring authority in the board of directors to act on behalf of the shareholders. To be sure, proponents of the no resistance rule will respond that such a state of affairs could be avoided by declining to confer such authority on the board in this context. Yet, if the legal system deprives the board of authority here, it will be hard-pressed to decline to do so with respect to other conflict transactions. As has been the case with other situations of potential conflict, we therefore would expect the courts to develop standards of review for takeover defenses that are designed to detect, punish, and deter self-interested behavior. Because the risk may be greater in this context, stricter than normal policing mechanisms may be required, but this does not mean that we must set aside authority values by divesting the board of decisionmaking authority.

Systemic accountability. Because the incumbent directors and management’s transactional conflict of interest is neither so severe nor unusual as to justify a wholly new governance system for tender offers, opponents of target resistance to tender offers must find some other basis for depriving the board of its normal decisionmaking authority. For most critics of takeover defenses, such a basis is to be found in the systemic agency cost effects of management resistance. Sharfman and Moore, for example, make this point at pp. 22-23.

In agency cost theory, disciplinary actions against employees and mid-level managers are expected to take the form of dismissals, demotions, or salary adjustments imposed by senior management. Where it is senior management that requires discipline, however, alternative mechanisms become necessary. According to the standard academic account, hostile takeover bidders provide just such a mechanism. Making the standard efficient capital market assumption that poor corporate performance will be reflected in the corporation’s stock price, opponents of target resistance claim that a declining market price sends a signal to prospective bidders that there are gains to be had by acquiring the corporation and displacing the incumbent directors and managers. Of course, the signal will not always be correct. Sometimes the firm’s market price may be declining despite the best efforts of competent management, as where some exogenous shock—such as technological change or new government regulation—has permanently altered the corporation’s fundamentals. If close examination by a prospective bidder reveals that the declining market price is in fact attributable to shirking by senior management, however, a disciplinary takeover could produce real gains for division between the target’s shareholders and the successful acquirer. This prospect creates positive incentives for potential bidders to investigate when the market signals a firm is in distress. Conversely, because keeping the stock price up is the best defense managers have against being displaced by an outside searcher, the market for corporate control—more specifically, the unsolicited tender offer—is an important mechanism for prevent­ing manage­ment slacking. Indeed, some would argue, the market for control is the ultimate monitor that makes the modern business corpora­tion feasible.

By making possible target resistance to unsolicited takeover bids, so the theory goes, takeover defenses thus undermine the very foundations of corporate governance. The first prospective bidder to identify a prospective target incurs significant search costs, which become part of the bidder’s overall profit calculation. By announcing its offer, however, the first bidder identifies the prospective target to all other potential bidders. Subsequent bidders thus need not incur the high search costs carried by the first bidder, perhaps allowing them to pay a higher price than is possible for the first bidder. If target resistance delays closing of the offer, subsequent bidders have a greater opportunity to enter the fray. At the very least, target resistance may force the initial bidder to raise its offer, reducing the gains to search. Target resistance therefore reduces bidders’ incentives to search out takeover targets. Reductions in bidders’ search incentives results in fewer opportuni­ties for shareholders to profit from takeover premia. More important, a reduction in search incentives also reduces the effectiveness of interfirm monitor­ing by outsiders. In turn, that reduces the market for corporate control’s disciplinary effect. A rule prohibiting target resistance is therefore likely to decrease agency costs, and increase stock prices, benefiting shareholders of all firms, even those whose companies are never targeted for a takeover bid.[7]

All well and good, but who died and left the unsolicited tender offer in charge? A no resistance rule in effect creates a kind of private eminent domain: bidders can effectively “condemn” target shares by offering even a slight premium over the current market price.[8] Awarding the lion’s share of the gains to be had from a change of control to the bidder, however, only makes sense if all gains from takeovers are created by bidders through the elimination of inept or corrupt target managers and none are attributable to the hard work of efficient target managers. Unfortunately for proponents of the no resistance rule, the evidence is that takeovers produce gains for a variety of reasons that are likely to differ from case to case.[9]

In order for a no resistance rule to make sense, the unsolicited tender offer also must be the critical mechanism by which incumbents are disciplined. In fact, however, unsolicited tender offers are so rare and sporadic that a director or manager who shirks his responsibilities by playing golf when he should be working is undoubtedly more likely to be struck by lightening while on the course than to be fired after a hostile takeover. As a result, the disciplinary effect of takeovers has been grossly overstated by proponents of the no resistance rule. Instead, as our analysis of Delaware’s takeover jurisprudence will suggest, the critical disciplinary mechanism is the board of directors, especially the independent directors. In turn, the tenure and reputation of outside board members are determined by the performance of the inside managers, which gives indepen­dent directors incentives to be vigilant in overseeing management’s conduct.

If independent directors were the sole bulwark against managerial shirking, concerns about structural and actual bias might be troubling, but they do not stand alone. Although monitoring by institutional investors is weak, and problematic given our theory of the firm, it likely has some effects on the margins. Whatever one makes of institutional investor activism as a monitoring device, important accountability mechanisms continue to be supplied by the product market in which the firm operates and the internal and external job markets for the firm’s managers.[10] Corporate directors and managers do not get ahead by being associated with sub-par performance in the product markets. Indeed, as between shareholders and managers, it is the latter who have the greatest incentives to ensure the firm’s success. Shareholders can and should hold diversified portfolios, so that the failure of an individual firm will not greatly decrease their total wealth, while managers cannot diversify their firm-specific human capital (or their general human capital, for that matter). If the firm fails on their watch, it is the incumbent directors and managers who suffer the principal losses.

It is for this reason that the capital markets also have a disciplinary function. Incompetent or even unlucky management eventually shows up in the firm’s performance. These signs are identified by potential debt or equity investors, who (if they are willing to invest at all) will demand a higher rate of return to compensate them for the risks of continued suboptimal performance. In turn, this makes the firm more likely to flounder—taking the incumbent managers down with it.

Our point is not that the tender offer has no disciplinary effect, but merely that the tender offer is only one of many mechanisms by which management’s behavior is constrained. Once we view corporate governance as a system in which many forces constrain management behavior, the theory of the second best becomes relevant. In a complex, interdependent system, it holds that inefficiencies in one part of the system should be tolerated if “fixing” them would create even greater inefficiencies elsewhere in the system as a whole.[11]Even if we concede the claim that a no resistance rule would reduce agency costs, such a rule would still be inappropriate if it imposes costs in other parts of the corporate governance system. By restricting the board’s authority with respect to tender offers, the various academic proposals impose just such costs by also restricting the board’s authority with respect to the everyday decisions upon which shareholder wealth principally depends. Accordingly, it is not surprising that Delaware has rejected the academic approach to the unsolicited tender offer. This half of Delaware’s takeover jurisprudence, like that regulating negotiated acquisitions, is best explained as implicitly concluding that the benefits of preserving authority outweighs the costs of doing so.

Reminder: If you want much more detail, be sure to check out my article Unocal at 20: Director Primacy in Corporate Takeovers, 31 DEL. J. CORP. L. 769 (2006), on which the posts have drawn.

Were Easterbrook and Fischel right that target company boards should remain passive in the face of a hostile takeover bid? A comment on Sharfman and Moore. Part 2

In Part I of this essay, I discussed a new article by Bernard Sharfman and Marc Moore, in which they propose reviving the passivity thesis, which argued that target boards faced with a hostile takeover offer should be passive.

A long time ago, in my article, Unocal at 20: Director Primacy in Corporate Takeovers,[1] I explained why I disagree with the passivity thesis. My analysis grew directly out of my director primacy model of corporate governance. Because I still think a board-centric approach to corporate governance is appropriate, even in the context of a hostile takeover bid, let me summarize my argument here. I encourage you to go read the whole thing, however.

Given the Delaware courts’ normal sensitivity to conflicts of interests, the clear evidence that management resistance to unsolicited tender offers is at best a risky proposition for shareholders and at worst economically disastrous (note that I do not quibble with the empirical evidence Sharfman and Moore rehearse at 38-55, I'm just not persuaded it overcomes the arguments herein), and the undeniable fact that the no resistance rule does a more thorough job of removing management’s conflicted interests from the tender offer process than does Unocal, is it not surprising that Delaware courts adopted a standard that permits target resistance? The Delaware courts’ consistent rejection of the no resistance rule suggests that the courts have perceived some dimension to the puzzle that has escaped the attention of academics.

Analysis should begin with the proposition that all doctrinal responses to corporate conflict of interest transactions have two features in common. First, so long as the board of directors is disinterested and independent, it retains full decision-making authority with respect to the transaction.[2] Second, the board’s indepen­dence and decision-making process is subject to judicial scrutiny. Here, as ever, we see the competing influences of authority and accountability.

In a sense, Delaware’s takeover cases do no more than to simply bring this traditional corporate governance system to bear on target resistance to tender offers.[3] Admittedly, the form of review is unique, but so too is the context. Just as has been the case with all other corporate conflicts of interest, Delaware decisions in the unsolicited tender offer context strive to find an appropriate balance between authority and accountability. We see the courts’ concern for accountability in, for example, Unocal’s explicit recognition of the conflict of interest that target directors and officers face in an unsolicited takeover bid. Of course, it is one thing to recognize this conflict of interest and quite another to do something about it. As a doctrinal matter, the Delaware supreme court concretely demonstrated its sensitivity to management’s conflicted interests by placing the preliminary burden of proof on the board. This action demonstrated considerable judicial sensitivity to the board’s conflicted interests, because outside of areas traditionally covered by the duty of loyalty, putting the initial burden of proof on the board of directors is a very unusual—indeed, essentially unprecedented—step.

At the same time, however, we see the value of authority reflected in, for example, Unocal’s express rejection of the passivity model. Even plainer evidence of the Delaware courts’ concern for authority came when Chancellor Allen wrote that unless Unocal was carefully applied “courts—in exercising some element of substantive judgment—will too readily seek to assert the primacy of their own view on a question upon which reasonable, completely disinterested minds might differ.”[4] Is it not striking how precisely Allen echoes our argument that one cannot make an actor more accountable without simultaneously transferring some aliquot of his decision-making authority to the entity empowered to hold him to account?

In contrast, virtually all of the policy prescriptions to emerge from the academic accounts of the tender offer’s corporate governance role would create an entirely corporate governance system, in which the board is stripped of some or all of its normal decision-making authority. Recast in our terminology, the academic proposals reflect an overriding concern with accountability. There is no room in the academic account for the value of authority. Indeed, the academic proposals reject the very notion that authority has any legitimate role to play in developing takeover doctrine. Deciding whether the judiciary or the ivory tower has the better argument is the task to which the remainder of this section is devoted.

We approach the problem by asking whether the unsolicited tender offer differs in kind, not just degree, from any other conflicted interest transaction. If so, perhaps a special governance scheme applicable only to unsolicited tender offers can be justified. If not, however, we would expect the law to treat unsolicited tender offers just as it treats other conflicted interest transactions. In other words, the law can be expected to develop mechanisms for policing incumbent conflict of interests, but cannot be expected to deny incumbents a role in the process.

The question of comparative advantage

According to most critics of Delaware’s takeover jurisprudence, corporate law gives the board decision-making authority because in most situations the directors have a competitive advantage vis-a-vis the shareholders in choosing between competing alternatives. They then argue that directors have no such competi­tive advantage when it comes to making tender offer decisions and, accordingly, reject granting the board decision-making authority in the tender offer context. Certainly, it is true that even the most apathetic investor is presumably capable of choosing between an all-cash bid at $74 per share and an all-cash bid at $76. This analysis, however, obscures two important rationales for granting the board decision-making authority in the tender offer context.

At the outset, it is important to recognize that unsolicited tender offers and negotiated acquisitions have a good deal in common. From a practical perspective, it is often increasingly difficult to tell the two apart. In today’s market place most takeovers follow a fairly convoluted path. They start out quasi-hostile, but end up as quasi-friendly, or vice-versa. They start out as a merger proposal, which is restructured as a tender offer for tax or other business reasons, or vice-versa. The problem is usefully illustrated by Chancellor Allen’s opinion in TW Services v. SWT Acquisition.[5] SWT’s unsolicited partial tender offer for TW Services was subject to a number of conditions, including a requirement that the transaction be approved by TW Services’ board of directors. The TW Services’ board saw the tender offer as a ruse designed to extort greenmail or to put the company into play. Accordingly, the board declined to redeem the company’s outstanding poison pill. SWT filed a lawsuit seeking invalidation of the pill. Because SWT conditioned its offer on the TW Service board’s support, the case presented a problem of characterization that the legal literature largely ignores. If the transaction is characterized as a merger, then most commentators would permit the board an active decision-making role. Conversely, if the transaction is characterized as a tender offer, they would preclude the board from exercising decision-making authority. Categorizing this transaction, however, is a non-trivial task.[6] Attempting to define the scope of the board’s authority by the nature of the transaction at hand thus quickly proves an unsatisfactory resolution.

Even if one were wholly confident of one’s ability to appropriately characterize transactions, however, the comparative advantage argument still would not justify precluding the board from exercising decision-making authority in tender offers. Consider transactions like the defensive restructuring at issue in City Capital Associates v. Interco. In the face of an all-cash hostile bid at $74 per share, Interco’s board of directors proposed to sell certain assets and to borrow a substantial amount of money. The joint proceeds of those transactions would then be paid out to Interco’s shareholders as dividends. The dividends would be paid in three forms: cash, bonds, and preferred stock. The dividends’ total value was said to be $66 per share. Interco’s investment banker opined that, after this series of transactions, Interco’s stock would trade at no less than $10 per share. The proposed defensive measures thus purportedly would give Interco’s shareholders a total value of $76—$2 more than the hostile bid. In rebuttal, the bidder’s investment bankers valued the defensive plan at $68-$70 per share.[7] It is precisely because passive, widely dispersed shareholders have neither the inclination nor the information necessary to decide between these sort of alternatives that the corporate law in other contexts allocates the decision to the board.[8] Only compelling accountability concerns can justify treating tender offers differently. The comparative advantage argument thus collapses into a variant of the agency cost arguments discussed below.

The bypass argument

An alternative justification for treating the tender offer differently than negotiated acquisitions rests on the former’s elimination of the need for target management’s cooperation. As we saw above, the target board’s gatekeeper role in negotiated acquisitions creates a conflict of interest, which is constrained principally by the ability the tender offer gives a bidder to bypass the target’s board by purchasing a controlling share block directly from the stockhold­ers. According to some academics, authority values thus are only appropriate in the negotiated acquisition context if the board is denied the ability to resist tender offers.[9]

This argument looks good on paper, but ultimately is unpersuasive. In the first place, it too ignores the problem of characterization alluded to in the preceding section. In addition, tender offers are not the only vehicle by which outsiders can appeal directly to the shareholders. Proxy contests similarly permit a would-be acquirer to end-run management. How a shareholder votes in director elections seems just as an individual decision as that of whether to tender to a hostile bidder. Yet, nobody expects a board to be passive in the face of a proxy contest. To the contrary, the incumbent board’s role is very active indeed. Why? Because the incumbent board members remain in office and therefore also continue to be legally responsible for the conduct of the business until they are displaced. Complete passivity in the face of a proxy contest thus would be inconsistent with the directors’ obligation to determine and advance the best interests of the corporation and its shareholders.[10]

The same is true of a tender offer. While the analogy between tender offers and proxy contests is unconvincing for most purposes, the courts may have correctly sensed a fit at this most basic level. The directors will remain in office unless the offer succeeds and they thereafter resign or are removed by the new owner. As a doctrinal matter, the board of directors has a “fundamental duty” to protect shareholders from harm, which can include an unsolicited tender offer that the directors truly believe is not in the shareholders’ best interests. As Unocal recognized, complete passivity in the face of such an offer would be inconsistent with their fiduciary duties.[11] To the contrary, their on-going fiduciary duty obliges them to seek out alternatives. At the bare minimum, it thus would be appropriate for the board to use takeover defenses to delay an inadequate bid from going forward while the board seeks out an alternative higher-valued offer, because until the board has time to arrange a more attractive alternative there is a risk that the shareholders will “choose an inadequate tender offer only because the superior offer has not yet been presented.”[12]

The structural argument (a.k.a. shareholder choice)

A more substantial argument against authority values in the unsolicited tender offer context contrasts the board’s considerable control in negotiated acquisitions with the board’s lack of control over secondary market transactions in the firm’s shares. Corporate law generally provides for free alienability of shares on the secondary trading markets. Mergers and related transfers of control, however, are treated quite differently. As we saw above, corporate law gives considerable responsibil­ity and latitude to target directors in negotiating a merger agreement. The question then is whether unsolicited tender offers are more like secondary market trading or mergers.

The so-called structural argument—also known as the shareholder choice argument—asserts that the tender offer is much more closely analogous to the former. According to its proponents, an individual shareholder’s decision to tender his shares to the bidder no more concerns the institutional responsibilities or prerogatives of the board than does the shareholder’s decision to sell his shares on the open market or, for that matter, to sell his house.[13] Both stock and a home are treated as species of private property that are freely alienable by their owners.

The shareholder choice argument actually cuts against one of Sharfman and Moore’s arguments. They suggest (at 23-24) that some hostile bids are motivated by private information asymmetrically held by the bidder. I doubt that happened very often even in the hostile takeover’s heyday, but if true would not allowing a bidder to act on that information be inconsistent with shareholder choice? After all, we no longer live in a world of caveat emptor. Major purchases these days come with masses of disclosure (I vividly recall the mountain of information I reviewed at my house closing). Assume the law requires the bidder to disclose its private information. Would the passivity thesis preclude management from undertaking changes in response to learning that information?

In any case, none of the normative bases for the structural argument prove persuasive. That shareholders have the right to make the final decision about an unsolicited tender offer does not necessarily follow, for example, from the mere fact that shareholder have voting rights. While notions of shareholder democracy permit powerful rhetoric, corporations are not New England town meetings. Put another way, we need not value corporate democracy simply because we value political democracy.[14]

Indeed, we need not value shareholder democracy very much at all. In its purest form, our authority-based model of corporate decision making calls for all decisions to be made by a single, central decision-making body—i.e., the board of directors. If authority were corporate law’s sole value, shareholders thus would have no voice in corporate decision making. Shareholder voting rights thus are properly seen not as part of the firm’s decisionmaking system, but as simply one of many accountability tools—and not a very important one at that.

Nor is shareholder choice a necessary corollary of the shareholders’ ownership of the corporation. The most widely accepted theory of the corporation, the nexus of contracts model, visualizes the firm not as an entity but as a legal fiction representing a complex set of contractual relation­ships. Because shareholders are simply one of the inputs bound together by this web of voluntary agreements, ownership is not a meaningful concept under this model. Each input is owned by someone, but no one input owns the totali­ty. A shareholder’s ability to dispose of his stock thus is not defined by notions of private property, but rather by the terms of the corporate contract, which in turn are provided by the firm’s organic documents and the state of incorporation’s corporate statute and common law. The notion of shareholder ownership is thus irrelevant to the scope of the board’s authority. As Vice Chancellor Walsh observed, “shareholders do not possess a contractual right to receive takeover bids. The shareholders’ ability to gain premiums through takeover activity is subject to the good faith business judgment of the board of directors in structuring defensive tactics.”[15]

Finally, and most importantly, the structural argument also ignores the risk that restricting the board’s authority in the tender offer context will undermine the board’s authority in other contexts. Even the most casual examination of corporate legal rules will find plenty of evidence that courts value preservation of the board’s decision-making authority. The structural argument, however, ignores the authority values reflected in these rules. To the contrary, if accepted, the structural argument would necessarily undermine the board’s unquestioned authority in a variety of areas. Consider, for example, the board’s authority to negotiate mergers. If the bidder can easily by-pass the board by making a tender offer, hard bargaining by the target board becomes counter-productive. It will simply lead to the bidder making a low-ball tender offer to the shareholders, which will probably be accepted due to the collective action problems that preclude meaningful shareholder resistance. Restricting the board’s authority to resist tender offers thus indirectly restricts its authority with respect to negotiated acquisitions.[16]

Indeed, taken to its logical extreme, the structural argument requires direct restrictions on management’s authority in the negotiated acquisition context. Suppose management believes that its company is a logical target for a hostile takeover bid. One way to make itself less attractive is by expending resources in acquiring other companies. Alternatively, the board could effect a preemptive strike by agreeing to be acquired by a friendly bidder. In order to assure that such acquisitions will not deter unsolicited tender offers, the structural argument would require searching judicial review of the board’s motives in any negotiated acquisition.

To take but one more example, it is quite clear that managers can make themselves less vulnerable to takeover by eliminating marginal operations or increasing the dividend paid to shareholders and thus enhancing the value of the outstanding shares. A corporate restructuring thus can be seen as a preemptive response to the threat of takeovers. It is hard to imagine valid objections to incumbents securing their position through transactions that benefit shareholders.[17] Why then should it matter if the restructuring occurs after a specific takeover proposal materializes? The structural argument not only says that it does matter, but taken to its logical extreme would require close judicial scrutiny of all corporate restructurings.

Were Easterbrook and Fischel right that target company boards should remain passive in the face of a hostile takeover bid? A comment on Sharfman and Moore. Part 1

In 1965, my friend and mentor the late Henry Manne published the seminal article on the market for corporate control, Mergers and the Market for Corporate Control.[1] As my friend Bill Carney explains, Manne “rejected the received wisdom: ‘Take-overs of corporations are too expensive generally to make the ‘purchase’ of management compensation an attractive proposition.’”[2] “The returns from acquiring control, Manne argued, were from improving management. Improving management would, in turn, increase cash flows that would be capitalized by the market.”[3]

As a result, Manne argued, a market for corporate control exists because outsiders can profit by buying control of a poorly managed company, firing the incompetent or venal incumbent managers, and replacing them with competent managers who would focus on shareholder wealth maximization:

The market for corporate control is really to be understood in consumer-protection terms, with “consumers” in that market being shareholders. In the pre-Manne era, the prevailing academic paradigm treated shareholders--that is, consumer-purchasers of corporate shares--as chumps. They were routinely, and so predictably, bamboozled by managers supposedly advancing shareholder welfare but really maximizing their own welfare. Management operated seemingly without constraints in bilking shareholders.

But, Manne noted, the corporate control needed to undertake such machinations is subject to market forces. And if markets ordinarily operate reasonably competitively, would not shareholder sovereignty emerge in this market, just as consumer sovereignty emerges in competitive markets generally? So, Manne wrote, mergers “are of considerable importance for the protection of individual non-controlling shareholders . . . .” Thus, … for the first time the famous Berle-Means concern about the separation of ownership and control was seen for what it truly is: an undeniable fact but one that invites, and has elicited, a market solution because it offers manager-entrepreneurs individual gains while protecting other shareholders as well.[4]

The chief difficulty with Henry’s thesis was that the principal acquisition technique of the time—the merger—is ill-suited to play a role in hostile takeovers, because approval of a proposed merger by the target’s board of directors is an essential prerequisite to the accomplishment of a merger.

The solution was coming down the tracks of history at high speed, however. One piece of the puzzle was the emergence of the tender offer. Tender offers were possible in 1965—the first hostile tender offer reportedly took place in 1956[5]—but two barriers had to be overcome before they could become commonplace.

First, as Carney explains, new sources of financing were necessary:

Remarkably, the article predicted leveraged buyouts, noting that any gains from efficient management could be leveraged through borrowed funds, “although American commercial banks are generally forbidden to lend money for this purpose.” It took development of other sources of funds--notably junk bond markets and non-bank institutional lenders--for this leveraging to flower two decades later.[6]

Second, as I have explained elsewhere, there needed to be a major cultural shift on Wall Street:

Given the tender offeror's comparative advantages, it is somewhat surprising that they were relatively rare before the 1960s. Although there are various explanations for that phenomenon, I suspect that the social mores of the business, financial, and legal communities played a major role. Before the 1960s, hostile tender offers were regarded as bad form by most of the key players. See David Halberstam, The Reckoning 674-75 (1986).[7]

Once those pieces were in place, sometime in the mid-1970s,[8] the short-lived era of the hostile takeover began.

In response to the emergence of the hostile takeover, incumbent managers hired talented lawyers to develop an array of defenses—such as the shark repellent, the poison pill, and the Pac-man defense—that allowed the target board to assert a gatekeeping function in the tender offer comparable to the one it long played in the merger.[9]

That development led to one of the most famous of all corporate law review articles; namely, Easterbrook and Fischel’s The Proper Role of a Target's Management in Responding to a Tender Offer.[10] As John Coffee summarizes their argument:

Viewed through the lens supplied by the “market for corporate control” thesis, the role of the tender offer is to replace inefficient management. The bidder, it is argued, pays a premium over the market price because it believes that the target's assets have not been optimally utilized and that under superior management they would earn a higher return, thereby justifying the tender offer premium. In this light, the higher the premium, the greater the degree of mismanagement that the bidder must perceive. So viewed, the hostile tender offer appears a benign and socially desirable phenomenon, which benefits both the bidder and the target's stockholders, who simply divide among themselves the value that the incumbent management's inefficiency denied them.

The Disciplinary Hypothesis places special weight on the target management's resistance to the takeover to demonstrate that the anticipated gain that motivated the acquisition was probably predicated upon the displacement of an inefficient target management. … [According to Easterbrook and Fischel, managerial] resistance is comprehensible only if the interests of the target's management deviated from those of its shareholders. Such a conflict would arise either because the management of the target expected to be replaced by the bidding firm, or because it saw an opportunity to demand a side payment for its acquiescence. The significance of this perspective then lies in its clear implication that “hostile” acquisitions are disproportionately motivated by the bidder's desire to realize enhanced value through replacing an inferior management while “friendly” acquisitions are typically motivated by other business considerations that pose less of a threat to the incumbent management. This logic also leads to the conclusion that hostile bids have a unique role in corporate governance as a policing mechanism.[11]

In turn, those insights led Easterbrook and Fischel to advance what became known as the passivity thesis:

They propose that the management of a corporation subject to a tender offer, the target, should be prohibited from resisting the offer in any fashion. The authors view hostile takeovers as a significant means of displacing poor managers and argue that facilitating tender offers increases the incentive of all managers to perform in the best interests of their shareholders. The passivity thesis has found a sympathetic audience. Many legal scholars have accepted the basic claim that most defensive tactics are undesirable, although some authors would preserve management's right to engage in some limited responses.[12]

Despite their success in the academic arena, Easterbrook and Fischel lost where it matters; namely, in the real world. The passivity thesis developed no traction in the courts. In particular, the one court system that really matters in corporate law—that of Delaware—summarily dismissed the passivity thesis:

It has been suggested that a board's response to a takeover threat should be a passive one. Easterbrook & Fischel, supra, 36 Bus.Law. at 1750. However, that clearly is not the law of Delaware, and as the proponents of this rule of passivity readily concede, it has not been adopted either by courts or state legislatures. Easterbrook & Fischel, supra, 94 Harv.L.Rev. at 1194.[13]

Now, however, come Bernard Sharfman and Marc Moore—two respected and thoughtful corporate law commentators with whom I have frequently corresponded to my benefit—to argue for a restoration of the passivity thesis:

Unfortunately, while a vibrant hostile takeover market did exist in the United States during the 1960s, 70s, and 80s, this has not been the case for many years. By contrast, the United Kingdom, despite having a broadly similar capital market environment and corporate governance system to the U.S., has gone down the path of allowing its hostile takeover market to flourish. Thus, the U.K. has been able to successfully retain the hostile takeover as a corrective mechanism in corporate governance.

We find the current domestic state of affairs unacceptable. Without a vibrant hostile takeover market, a significant corrective mechanism has been lost. Therefore, with a view to correcting this inefficiency, we use as our primary authority the core principles identified in the U.K.’s regulatory legal framework, and especially its longstanding board passivity (or “non-frustration”) rule. More than any other element of the British framework, the board passivity rule has allowed for the creation of an enduring and successful hostile takeover market in the U.K. Accordingly, this Article recommends that domestic state corporate law statutes be amended to include a safe harbor for a hostile bidder when making an all-cash, all-shares tender offer that includes a guarantee of the same or higher price if a back-end or squeeze-out merger occurs.

The use of the above safe harbor would effectively disallow a board’s use of the poison pill as a takeover defense unless a specific takeover defense, such as a poison pill, is provided for in the corporate charter. In this way, private ordering can always be used to trump the statutory safe harbor.[14]

I strongly encourage you to read their article. It is an excellent, yet concise, history of the evolution of the market for corporate control, the academic theorizing about that market, and the development of the law. It also provides a very useful and insightful comparative law treatment of the problem by contrasting US and UK law. In addition, they offer a very helpful review of the empirical literature on the costs and benefits of hostile takeovers. They also make a unique contribution by tying the Delaware courts’ resistance to the passivity thesis to the Delaware courts’ resistance to private ordering in the corporate context, which leads them to proffer a private ordering solution, as noted above.

In Part II, however, I will explain why I don't buy the passivity thesis.

James Copland's new book The Unelected

Our friend James Copland of the Manhattan Institute has a new book out The Unelected: How an Unaccountable Elite is Governing America. It got a positive review from the Law & Liberty blog:

The Founders’ constitutional design, Copland reminds us, “was predicated on accountability to the voting public.” This was essential to ensure the “consent of the governed.” Since the Constitutional Convention was held in 1787, and particularly in the wake of the New Deal, we have significantly departed from this ideal. Government has greatly expanded in size and power, and—more importantly—“governmental accountability to the public has been substantially eroded.” In Copland’s telling, the unelected, unaccountable entities exercising control over the polity consist of four components: rulemakers, enforcers, litigators, and what he calls the “new antifederalists.” ...

Unlike some public law scholars, Copland (who is Director of Legal Policy at MI) does not overlook the role of our legal system in the transformation of our self-governing republic into a caste-like society ruled by an unaccountable clerisy. Copland criticizes “litigators” as an elite group of unelected actors, on par with the administrative state. Defenders of litigation sometimes try to justify it as a form of “private enforcement,” akin to the free market, but Copland correctly notes that our litigation system is far removed from markets: “Markets involve consensual transactions, in which each party to the transaction agrees to a deal. A lawsuit, in contrast, entails one party taking from another, unwilling party, who is engaged with the plaintiff only because the government forces the issue.” ...

Copland’s engaging critique is thorough and thoughtful enough to satisfy policy wonks, but is also laced with interesting vignettes about actual Americans whose lives have been affected by the unaccountable elites. We read about the travails of Bobby Unser, John Rapanos, USC football star Matt Boermeester, and other Americans whose lives were disrupted—and in some cases ruined—by unaccountable elites. These real-life stories may broaden the appeal of The Unelected, and make its message resonate with a popular audience in a way that a purely scholarly tome could not. Toggling back and forth between The Federalist Papers and yesterday’s headlines, Copland brings the concepts to life, energizing them further with pop culture references and allusions to movies and television shows not often seen in legal books.

I am looking forward to reading my copy, which is teed up on Kindle.