The WSJ reports that:
On the morning of Sunday, April 8, Facebook Inc.'s youthful chief executive, Mark Zuckerberg, alerted his board of directors that he intended to buy Instagram, the hot photo-sharing service. It was the first the board heard of what, later that day, would become Facebook's largest acquisition ever, according to several people familiar with the matter. Mr. Zuckerberg and his counterpart at Instagram, Kevin Systrom, had already been talking over the deal for three days, these people said.
Negotiating mostly on his own, Mr. Zuckerberg had fielded Mr. Systrom's opening number, $2 billion, and whittled it down over several meetings at Mr. Zuckerberg's $7 million five-bedroom home in Palo Alto. Later that Sunday, the two 20-somethings would agree on a sale valued at $1 billion.
It was a remarkably speedy three-day path to a deal for Facebook—a young company taking pains to portray itself as blue-chip ahead of its initial public offering of stock in a few weeks that could value it at up to $100 billion. Companies generally prefer to bring in ranks of lawyers and bankers to scrutinize a deal before proceeding, a process that can eat up days or weeks.
Mr. Zuckerberg ditched all that. By the time Facebook's board was brought in, the deal was all but done. The board, according to one person familiar with the matter, "Was told, not consulted."
Ah, the hubris of youth.
Many of the facts call to mind the classic corporate law case, Smith v. Van Gorkom, about which I wrote an essay you can download here.
Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), was on of the most important corporate law decisions of the 20th century. The supreme court of a state widely criticized for allegedly leading the race to the bottom held that directors who make an uninformed decision are unprotected by the business judgment rule and, accordingly, face substantial personal liability exposure:
To summarize: we hold that the directors of Trans Union breached their fiduciary duty to their stockholders (1) by their failure to inform themselves of all information reasonably available to them and relevant to their decision to recommend the Pritzker merger …. We hold, therefore, that the Trial Court committed reversible error in applying the business judgment rule in favor of the director defendants in this case.
Our story begins on Saturday, September 20, 1980, when Trans Union CEO Jerome Van Gorkom hosted a gala party at the 25th floor penthouse of the Trans Union building in Chicago to celebrate the opening of the Lyric Opera’s 26th season at Chicago’s Civic Opera House. Van Gorkom was a long time supporter of the Lyric Opera, and his annual opening night parties were a major feature of the Chicago social circuit.
Financier Jay Pritzker was one of Van Gorkom’s guests at the party. At some point in the course of the evening, Van Gorkom and Pritzker slipped out of the party and signed an agreement under which Pritzker would buy out Trans Union’s shareholders at $55 per share in cash. At that point in time, only two of Van Gorkom’s subordinates and none of Trans Union’s outside board members were even aware that a sale to Pritzker was in the works.
According to the court’s opinion, Pritzker had imposed a tight time deadline on the negotiations in order to prevent leaks and the increased stock price that usually follows such leaks. According to Robert Pritzker’s subsequent account, however, the timetable was initiated by Van Gorkom.
In any case, the process in fact went quite quickly and many decisions were made under significant time constraints. All of which evidently troubled the court, as it several times noted that there was no crisis or emergency justifying such speed.
Sounds a lot like the Facebook deal, doesn’t it?
In the Trans Union case, a disgruntled shareholder brought suit, claiming that the board of directors had violated its duty of care in approving the deal. The court agreed, stating that, of all the preconditions that must be satisfied in order for the business judgment rule to insulate a board of director decision from judicial review the most important is the requirement that the decision be an informed one. Put another way, the board of directors must exercise what has been called “process due care.” Accordingly, the Van Gorkom opinion explained that “[i]n the specific context of a proposed merger of domestic corporations, a director has a duty … along with his fellow directors, to act in an informed and deliberate manner in determining whether to approve an agreement of merger before submitting the proposal to the stockholders.” The court further explained that “[t]he determination of whether a business judgment is an informed one turns on whether the directors have informed themselves ‘prior to making a business decision, of all material information reasonably available to them.’”
On the facts of the case before it, the court concluded that the board had abdicated its responsibilities in these areas and, instead, had allowed itself to be railroaded by management to so great an extent that deference became inappropriate.
Sounds a lot like the Facebook deal, doesn’t it?
By so focusing its opinion, the Van Gorkom court established a set of legal rules that disfavors agenda control by senior management and penalizes boards that simply go through the motions. The decision encourages inquiry, deliberation, care, and process. The decision strongly encourages boards to seek outside counsel and financial advice. None of which was done by the Trans Union board.
And, apparently, none of which was done by the Facebook board.
The WSJ seems to think that the Facebook board faces no legal liability because Zuckerberg holds a controlling stake in Facebook:
Mr. Zuckerberg owns 28% of Facebook's stock, and controls 57% of its voting rights, giving him the freedom to act independently if he wants. Mr. Systrom, similarly, owns about 45% of his company. That control means investors must accept the fact that the CEOs can move quickly.
I do not believe that's true, however. as Eugene Levy explains (106 W. Va. L. Rev. 305):
In McMullin v. Beran, plaintiff-minority shareholder filed a putative class action against ARCHO Chemical, Inc.'s management, alleging breach of their fiduciary duties in connection with the sale of their company to a third party at the behest of 80% controlling stockholder. The importance and precedential value of McMullin lies in its examination of the fiduciary responsibilities owed by directors to minority shareholders in evaluating a sale proposed by the controlling stockholders. The court found that the directors owed minority stockholders fiduciary duties of care, loyalty, and good faith in recommending the sale, notwithstanding the inability of the directors to negotiate or halt the sale given the controlling shareholder's majority holding status.
In other words, a board is not excused from exercising its fiduciary duties just because there is a controlling shareholder. To the contrary, judges will be especially skeptical of transactions railroaded through the decision-making process by “an imperial CEO or controlling shareholder with a supine or passive board."
In other words, if I had been his legal counsel, I would have advised Zuckerberg to be a lot more respectful of his board and the legal niceties.
Having said that, of course, there is a critical difference between the Facebook deal and the Trans Union deal. Unlike the former, the latter involved a major transaction having final period consequences. The Trans Union board was supine in the face of a proposal to sell the company to a private buyer. As Judge Henry Friendly once explained, "a merger in which it is bought out is the most important event that can occur in a small corporation’s life, to wit, its death ....” SEC v. Geon Industries, Inc., 531 F.2d 39, 47-48 (1976).
This matters a lot.
In repeat transactions, the risk of self-dealing by one party is constrained by the threat that other party will punish the cheating party in future transactions. In a final period transaction, this constraint disappears. Because the final period transaction is the last in the series, the threat of future punishment disappears.
Just so, the various extrajudicial constraints imposed on management in the operational context break down when the corporation is being sold. Target management is no longer subject to shareholder discipline because the target’s shareholders will be bought out by the acquirer. Target management is no longer subject to market discipline because the target by definition will no longer operate in the market as an independent agency. As a result, management is no longer subject to either shareholder or market penalties for self-dealing. Accordingly, there is good reason to be skeptical of management claims to be acting in the shareholders’ best interests. In turn, the resulting need in this context to hold the board accountable for its mistakes appropriately trumps the more usual tendency towards judicial deference to the board’s authority.
In contrast, a purchase (such as the Facebook deal) is a repeat transaction. Zuckerberg will still be running the company and his shareholders will still own stock in the company. Granted, because he's a controlling shareholder, the opportunities for punishing him are somewhat limited. Even so, however, the case for legal liability remains weaker where the disputed transaction is a purchase rather than a sale.
Of course, while the WSJ and yours truly have focused here on Zuckerberg and the supine Facebook board of directors, young Mr Systrom was a seller. As such, his lawyers may want to send him a copy of my essay on Smith v. Van Gorkom, because Systrom and Van Gorkom seem to have a lot in common.
