ProfessorBainbridge.com

What makes directors independent? And how does one distinguish social circle friendships from close ones?

Some weeks ago, Usha Rodrigues tagged me in a post about  Del. County Emples. Ret. Fund v. Sanchez, asking:

What's not to love about this opinion?  First, it's a Delaware Supreme Court opinion.  Second, it's short and sweet--clocking in at a mere 13 pages (I'm looking at you, Steve Bainbridge).  Third, it takes on a topic of interest to law professors and law students alike: friendship.  Fourth, it makes human one of the most challenging topics for the new student of corporate law: the derivative suit.

I actually think there's much to not love about it as a principal case. First, it is almost devoid of facts--especially interesting ones. Out of Klein, Ramseyer, and myself, I am most willing to teach factually boring cases but even I balked at this one. And for folks who like to play with the facts, there is almost nothing to work with here. Second, the procedural posture of the case is sort of odd. CJ Strine's opinion fails to join issue with the Chancery Court's discussion of the role of the audit committee and basically ignores the Chancery Court's analysis of the thinness of the allegations relating to friendship. Finally, as an essay on friendship, it pales in comparison to Oracle.

So it will not be going into KRB as a principal case. Despite Bill and Mark's aversion to textual notes, however, I have persuaded the to include the following as a question following Grimes v. Donald:

The question whether corporate directors and officers are “independent” comes up in many contexts, such as:

• Independent and disinterested decision makers are a key precondition to application of the business judgment rule.
• Whether demand is excused as futile, as illustrated by Grimes.
• Whether courts should defer to the recommendation of a special litigation committee to dismiss a derivative lawsuit.
• Determining which standard of review to apply to various duty of loyalty cases.
• Adoption of defenses against hostile takeover bids by the target company’s board of directors.

In Aronson v. Lewis, 473 A.2d 805 (Del. 1984), the chief wrongdoer owned 47% of the corporation’s stock and allegedly had personally selected each board member. The Delaware supreme court held that this did not render the board per se incapable of exercising independent judgment. Instead, to show that the directors were not independent of the controlling shareholder, the plaintiff must “demonstrate that through personal or other relationships the directors are beholden to the controlling person.” Subsequent decisions held that that standard required "a careful analysis of why the directors, on an individual basis, might need to curry favor with (or otherwise consider their obligations to) the majority shareholder is necessary. For example, the Court must consider what material benefits (or detriments) the majority shareholder can bestow (or impose) upon each of the directors, other than, as a general matter, the majority shareholder's capacity to deny them their continuing status as directors.” Zimmerman v. Braddock, 2005 WL 2266566, at *9 (Del. Ch. Sept. 8, 2005) rev’d on other grounds, 906 A.2d 776 (Del. 2006). Accordingly, courts tended to focus on economic relationships between the defendant and the directors whose independence was being questioned.

In Delaware County Employees Retirement Fund v. Sanchez, 2015 WL 5766264 (Del. 2015), however, the Delaware supreme court held that:

When, as here, a plaintiff has pled that a director has been close friends with an interested party for a half century, the plaintiff has pled facts [sufficient to show a lack of independence]. Close friendships of that duration are likely considered precious by many people, and are rare. People drift apart for many reasons, and when a close relationship endures for that long, a pleading stage inference arises that it is important to the parties.

The Court distinguished such friendships from a "thin social-circle friendship,” which would not be enough to establish that a director lacked independence.

Does adding personal friendships and, presumably, family relationships to the independence inquiry make good policy sense? If so, how would one distinguish between mere social friendships and enduring close relationships?

Which leads me to a question that really does puzzle me: How the [expletive deleted] are trial courts supposed to distinguish between mere social friendships and enduring close relationships? Especially because the issue will often be decided on the pleadings before discovery.

In the case at bar, the issue was easy because there was both an enduring friendship and close economic ties (at least according to Strine's version of the facts as opposed to that of the Chancery Court). But what if all you have are ties of friendship? (I checked the lyrics to Springsteen's Ties that Bind but they were no help.)

Would a First Amendment Challenge to the SEC's Pay Ratio Disclosure Rule Work?

A WLF Legal Backgrounder poses the titular question and points out the potential for massive expansion of SEC-mandated corporate social responsibility disclosures if the answer to that question is no. Go read the whole thing.

What did Luther want? Reform or Reformation?

Apropos of my earlier post on The Economics of the Protestant Reformation, there was an interesting op-ed in today's WSJ on whether Luther wanted reform or Reformation:

When an obscure German monk hammered his indictments to the door of All Saints’ Church at Wittenberg on Oct. 31, 1517, he did not intend to impugn the authority of the Catholic Church, or malign its leaders, or rupture the spiritual unity of medieval Europe. Martin Luther wanted reform, not a Reformation.

But that’s what he got. On Reformation Sunday, nearly 500 years after Luther published his 95 Theses, Protestants will celebrate his revolution to recapture the meaning of the gospel and the authority of the Bible against that of popes or princes.

Author Joseph Loconte goes on to draw a parallel between Luther's revolution and Islam, asking:

Given the failed revolutions of the Arab Spring, can Islam undergo a similar reformation? One hopeful sign is the outrage at the atrocities carried out under the banner of Islam. Another is Pakistan’s Malala Yousafzai, the teenager shot in the head by the Taliban for campaigning that women be allowed to attend school. She has launched an educational movement—call it a revolution for rationality—as egalitarian as anything the Muslim world has seen in centuries.

The Economics of the Protestant Reformation

An interesting new paper argues that:

Adam Smith characterized the medieval Roman Catholic Church as a force impeding Europe’s process of development. The Church was, in Smith words, “the most formidable combination that ever was formed against the authority and security of civil government, as well as against the liberty, reason, and happiness of mankind.” In many ways, the Church’s survival seems — as it probably did to Smith — “miraculous” (Minowitz 1993,176). How did the Church maintain this position, especially as the monopoly provider of religious services for several centuries; and how did that monopoly break down in the Reformation? Further, given that the secular lords had a comparative advantage in violence relative to the Church, how did the Church survive and maintain its power? And why did it prevent development?

Smith developed a rich and systematic approach to the incentives, institutions, and competition surrounding the medieval Church. To understand the relationship between the secular and ecclesiastic lords, Smith raises the importance of a third group, the masses. According to Smith, the secular lords were unable to pacify the masses; but the Church could do so. The ability to influence the masses granted the Church a credible threat over the secular lords: were the latter to challenge the Church and attempt to appropriate some of its revenue, assets and control, the Church would turn against them. Given this setting, each of the two sets of elites had incentives to cooperate to exploit the masses. To maintain this equilibrium, the Church had to prevent economic growth. Growth would have granted the masses wealth, power, and independence, undermining the Church’s ability to mobilize the masses in times of threat from the secular lords. It therefore suppressed growth and liberty in order to maintain the peasants’ dependency.

As to the Reformation, Smith argues that the masses gradually became less dependent on the Church. Independence meant that they were less responsive to the Church’s direction. This change, in turn, removed the Church’s credible threat over the secular lords, allowing them to force considerable concessions from the Church or to remove the Church altogether in favor of newly established sects. I develop a simple game theoretic model to demonstrate the logic of Smith’s equilibrium and comparative static claims.

Weingast, Barry R., Adam Smith's Industrial Organization of Religion: Explaining the Medieval Church's Monopoly and Its Breakdown in the Reformation (October 18, 2015). Available at SSRN: http://ssrn.com/abstract=2675590

 

"Professors in the Boardroom" add lots of value

New paper argues that boards ought to include academics (like, say, yours truly):

Directors from academia served on the boards of around 40% of S&P 1,500 firms over the 1998-2011 period. This paper investigates the effects of academic directors on corporate governance and firm performance. We find that companies with directors from academia are associated with higher performance and this relation is driven by professors without administrative jobs. We also find that academic directors play an important governance role through their advising and monitoring functions. Specifically, our results show that the presence of academic directors is associated with higher acquisition performance, higher number of patents and citations, higher stock price informativeness, lower discretionary accruals, lower CEO compensation, and higher CEO forced turnover-performance sensitivity. Overall, our results provide supportive evidence that academic directors are valuable advisors and effective monitors and that, in general, firms benefit from having academic directors.

Francis, Bill and Hasan, Iftekhar and Wu, Qiang, Professors in the Boardroom and Their Impact on Corporate Governance and Firm Performance (2014). Bank of Finland Research Discussion Paper No. 15/2014. Available at SSRN: http://ssrn.com/abstract=2676983

Beringer Vineyards Cabernet Sauvignon Private Reserve (Napa Valley) 2004

My dear wife is out tonight with some of her lady friends, so the pups and I revived an old PB.com tradition: Bachelor night. Long time readers will recall that this involves steak, potatoes, and a small dose of the obligatory green vegetable. Tonight, however, the green vegetable component was limited to the tarragon that went into the Béarnaise sauce that topped my filet mignon and boiled baby yukon gold potatoes.

This evening's principal libation was the 2004 Beringer. I had bought a half case when it was released and tonight was the first to be opened. I decanted it about an hour before dinner and sampled a glass throughout the cooking process. Purple shading into a deep ruby. Modest sediment. The bouquet took a while to open up, but eventually developed some seriously complex associations. Cedar, leather, cassis, and black cherry. On the palate, it was medium to full bodied with a long finish. Again, cedar, leather, cassis, and black cherry were the dominant flavor associations, as well as blackberry and mocha java. Well balanced. Still has plenty of structure to support aging, but is drinking well now. I'll probably space out the remaining bottles over the next 8-10 years. Grade: 93

Followed, of course, by our old friends tawny port and a Dunhill Peravia.

The boundary of firms

There's a very interesting article in the latest Economist on the reinvention of the company. Here's a core part of the argument:

Early in a company’s life, the founders and first recruits own a majority stake—and they incentivise people with ownership stakes or performance-related rewards. That has always been true for startups, but today the rights and responsibilities are meticulously defined in contracts drawn up by lawyers. This aligns interests and creates a culture of hard work and camaraderie. Because they are private rather than public, they measure how they are doing using performance indicators (such as how many products they have produced) rather than elaborate accounting standards.

New companies also exploit new technology, which enables them to go global without being big themselves. Startups used to face difficult choices about when to invest in large and lumpy assets such as property and computer systems. Today they can expand very fast by buying in services as and when they need them. They can incorporate online for a few hundred dollars, raise money from crowdsourcing sites such as Kickstarter, hire programmers from Upwork, rent computer-processing power from Amazon, find manufacturers on Alibaba, arrange payments systems at Square, and immediately set about conquering the world. Vizio was the bestselling brand of television in America in 2010 with just 200 employees. WhatsApp persuaded Facebook to buy it for $19 billion despite having fewer than 60 employees and revenues of $20m.

Reading this, I was reminded of a 2003 article by my friends Bill Klein and Mitu Gulati on the boundary of the firm. They argued that:

A central question of law and economics is how complex productive activity is initiated, organized, and carried out successfully without central planning. What are some of the most important organizational devices and what is their function? The effort to respond to this type of inquiry has led, among other things, to the dichotomy between transactions within firms and transactions across markets - also referred to as the make-or-buy decision or the outsourcing decision. This dichotomy, leading to explanations of the functions of firms and markets, has proved to be a powerful tool in analysis of economic organization. As with most simple descriptions of complex reality, however, it emphasizes some aspects of reality at the expense of others and is not a good fit in certain settings. One such setting is construction, where the organization of the economic activity (the construction project) is mostly contractual (technically, across markets), but where vital organizational ingredients are networks of relationships as well as collaboration and teamwork, generated in large part by pride, commitment, and reputation. The present paper is a case study that examines those ingredients and others that play, at most, a minor role in traditional thinking about firms and markets. This study also illustrates the notion that bilateral contracts are part of a mosaic of such contracts, with the performance of each dependent on the performance of the others, and contractual relationships exist within an industry in which individual projects are of limited duration but the participants are in for the long haul. Perhaps an even more interesting and important observation is that in construction, and no doubt in other economic activities as well, it is not the firm that is the locus for production. Nor does the idea of market exchanges between firms properly describe the productive process. Instead, production is in the hands of teams of people who are associated with various firms but who operate autonomously with respect to their firms. The teams may perform the functions of firms but they lack the critical firm attribute of hierarchical control. Related to this and also important in at least some settings is the manner of selection of team members: the client/owner may contract with, say, an architectural firm but expects to be working with particular, identified individuals within that firm. This raises the question: when a person contracts for services, what is the role of the individual (e.g., an architect or a lawyer) and what is expected of the firm of which that individual is a member? And what does this tell us about the nature and the boundaries of firms? We also offer some observations about fixed fees versus hourly rates and other contingent compensation.

Klein, William A. and Gulati, G. Mitu, Economic Organization in the Construction Industry: A Case Study of Collaborative Production Under High Uncertainty (July 16, 2003). Georgetown Law and Economics/Public Law Research Paper No. 428600; UCLA School of Law, Law & Econ Research Paper No. 03-17. Available at SSRN: http://ssrn.com/abstract=428600

It would be most interesting to compare the model Klein and Gulati studied to the models which The Economist discusses. How do they differ and how are they similar? It's not the sort of project I would take up, so I offer it up to the reader as a possible research project and ask only that you spell my name correctly.

Tatomer Meeresboden Grüner Veltliner (Santa Barbara County) 2014 & Salade Niçoise

For dinner tonight, I made a simple Salade Niçoise: butter lettuce (untraditional but sue me) topped with heirloom cherry tomatoes, baby yukon gold potatoes (cooked 18 minutes in heavily salted boiling water and then chilled in an ice water bath), haricot verts (cooked 4 minutes in modestly salted boiling water and then ditto), hard boiled eggs, finely sliced green onions (mostly the green parts), Nettuno anchovy filets and Tonnino Tuna Ventresca. All of which was topped with a light Briannas Lemon Tarragon Dressing.

Lots of wine options with Salade Niçoise. The classic is a Provençale rose, of course, but I had none on hand. I often like a rose sparkling wine, but ditto. A light Pinot Noir might work, but I'd be more likely to go that direction if I had grilled fresh tuna steaks for the topping. Skimming through the white wines in my cellar (about 5%), the Tatomer Meeresboden Grüner Veltliner jumped out as a wine I wanted to try and a potentially interesting match.

Grüner Veltliner is a major Austrian variety, of course, but this rare Central Coast example could go toe to toe with any from Austria. At this stage, the bouquet is modest but suggests white nectarines and canned pineapple. On the palate, I tasted pineapple, Meyer lemon, peaches, and honeydew melon. It's a lively wine with high acidity, which made it refreshing against the salt and oil in the salad. Highly recommended. Grade: 90

 

Behrens Family The Dark Place (California) 2010

On my palate, this blend of Tempranillo, Grenache, Cinsault and Cabernet Franc is dominated by the Grenache. It's spicy, with pepper (lots) and anise, plus black cherry, raspberry jam, and licorice. Big, dense, chewy. Drinkable now but should age well. Grade: 90

Creamers and Sepe on "The Shareholder Value of Empowered Boards"

Cremers, Martijn and Sepe, Simone M., The Shareholder Value of Empowered Boards (October 2015). Stanford Law Review, Vol. 68, 2016. Available at SSRN: http://ssrn.com/abstract=2674679

Abstract:  In the last decade, the balance of power between shareholders and boards has shifted dramatically. Changes in both the marketplace and the legal landscape governing it have turned the call for empowered shareholders into a new reality. Correspondingly, the authority that boards of directors have historically held in U.S. corporate law has been eroded. Empirical studies associating staggered boards with lower firm value have been interpreted to favor this shift of authority, supporting the view that protecting boards from shareholder pressure is detrimental to shareholder interests. 

This Article presents new empirical evidence on staggered boards that not only exposes the limitations of prior empirical studies, but also, and more importantly, suggests the opposite conclusion. Employing a unique and comprehensive dataset covering thirty-four years of board staggering and destaggering decisions — from 1978 to 2011 — we show that staggered boards are associated with a statistically and economically significant increase in firm value. In light of these novel empirical results, we then show theoretically that a corporate model with staggered boards emerges as a rational institutional response to market imperfections that are more complex and more significant than shareholder advocates have realized. Boards that retain their historical authority — empowered boards — benefit, rather than hurt, shareholders. This Article concludes with a normative proposal to revitalize the authority of U.S. boards.

 

Anabtawi on "Predatory Management Buyouts"

My friend and UCLAW colleague Iman Anabtawi has posted a great article on management buyouts:

Abstract: In a management buyout (MBO), the managers of a company typically partner with a financing source, such as a private equity firm, to acquire the firm that employs them. MBOs raise an important corporate governance concern not present in other corporate acquisitions: managers act as fiduciaries to target shareholders at the same time that they act as acquirors. According to corporate law fiduciary duty principles, managers must always privilege the interests of the corporation and its shareholders over their own personal interests. In direct opposition to those fiduciary duties are managers’ incentives to acquire the company on the best terms possible. Corporate law’s prevailing answer to questions of conflicts of interest, including in MBOs, is to rely on procedural safeguards to sanitize otherwise tainted transactions. Federal securities law further applies special disclosure requirements to MBOs. This article demonstrates that neither body of law produces the desired equivalent outcome of arm’s-length bargaining and suggests mechanisms for protecting shareholders from predatory managerial behavior in MBOs, in which managers underpay for their targets.

Recommended. 

Anabtawi, Iman, Predatory Management Buyouts (2015). 49 U.C. Davis Law Review, 2016, Forthcoming; UCLA School of Law, Law-Econ Research Paper No. 15-12. Available at SSRN: http://ssrn.com/abstract=2649192

Congratulations to Lisa Fairfax on her nomination to the SEC

The WSJ reports that:

Lisa Fairfax, a professor at George Washington University Law School and an expert on shareholder activism, is the nominee for the open Democratic seat [on the SEC].

Ms. Fairfax is favored by many Democratic lawmakers and activist groups. Her name surfaced earlier this year on a list of candidates that Sen. Elizabeth Warren (D., Mass.) urged liberal groups to consider. Ms. Warren’s aides say she didn't directly express an opinion about Ms. Fairfax to the White House. Ms. Fairfax became a contender after left-leaning groups criticized the White House for considering a corporate attorney to fill the post.

Hester Peirce, who used to work at the SEC and the Senate Banking committee, is the nominee to fill the open Republican seat.

I don't know anything about the GOP candidate. But I have no Lisa for a long time and like her very much. She's a great person, a thoughtful and insightful scholar, with sound judgment. As such, I'm setting aside my presumption that anything Liz Warren supports is per se a bad idea. After all, even a stopped clock is right twice a day.

I expect Lisa to be open minded and not the sort of knee-jerk partisan that some SEC members (on both sides) have been lately.

So kudos!

Is shareholder activism a triumph for director primacy?

Apparently Columbia Law Professor Jeffrey Gordon so argued in his Pileggi Lecture:

Prof. Gordon said investments by hedge funds, pension funds and other institutional investors often result in pressure on corporate boards to change, but Delaware law specialists should “celebrate,” rather than worry about, the latest evolutionary changes that activist investors bring to the role of corporate directors.

In comparison to the corporate raiders and takeover specialists who gained notoriety for buying and breaking up companies by circumventing target boards of directors with a direct-to-shareholders offer for a bare majority of the stock, activists use a minority position to leverage change, Gordon said.

Their usual tactic is to press their issues in a proxy battle, making the board the focus of the contest, he said. ” And this is a triumph for the board-centric form of corporate government that Delaware has promoted” (i.e., directors have the edge in corporate decision-making.)

That's a provocative claim. I am going to be very interested to read the article when it is available.

On a personal note, I had the privilege of giving one of the Pileggi lectures, which is where I had the privilege of meeting Francis Pileggi and his father. They're wonderful lawyers and people and this series is a highlight of the corporate law year.

Has the sun set on disclosure only settlements?

Our friend Francis Pileggi  reports that:

In a recent bench ruling, the Delaware Court of Chancery refused to approve a proposed class action settlement in which the benefit to the class was “disclosures only”, and the court dismissed the case as to the named plaintiff. The court was also critical of the broad release that was proposed. This case was filed in connection with Hewlett-Packard’s $2.7 billion acquisition of Aruba Networks. The case is styled In Re Aruba Networks, Inc. Stockholder Litigation, Cons. C.A. No. 10765-VCL (Del. Ch. Oct. 9, 2015)(Transcript). My gratitude is owed to Kyle Wagner Compton, the editor of the unparalleled scholarly publication called The Chancery Daily, for alerting me to the transcript, as well as for the TCD’s exemplary coverage of all things relating to the Court of Chancery.

The Aruba decision has already been explained in such extensive detail by Kevin LaCroix on his blog called The D&O Diary, that I encourage readers to review his treatment of the case at the foregoing link.

We concur with his recommendation of The D&O Diary's excellent analysis:

Stating his belief that the merger objection litigation dynamic represents a “systemic” problem that has resulted in a “misshapen legal system,” Delaware Chancery Court Vice Chancellor Travis Laster rejected the proposed disclosure-only settlement of litigation that had been filed objecting to Hewlett-Packard’s $2.7 billion acquisition of Aruba Networks. In an October 9, 2015 settlement hearing in the case, Laster cited the “inadequacy of the representation” of plaintiffs’ counsel for the shareholder class as the basis for his rejection of the settlement, as well as for the outright dismissal of the case. Liz Hoffman’s October 10, 2015 Wall Street Journal article about Laster’s ruling can be found here.

As I said at the time following Glasscock’s rulings in the Riverbed Technology case, it would only be a matter of time before a judge at the Delaware Court of Chancery rejected a settlement on the basis that the value the plaintiff shareholders’ received in a disclosure only settlement was insufficient to support the breadth of the release that the defendants received in exchange. That is exactly what happened in connection with the proposed settlement of the H-P/Aruba Networks merger objection lawsuit.

Apparently there was a very typical Laster moment in the ruling (should we start referring to Lasterisms?):

Laster also acknowledged in the hearing that because his concerns about these kinds of settlements are well known, that parties  have started dismissing the merger objection cases pending in his court in order to enter settlements in other jurisdictions where perhaps there might not be as many questions asked. (He noted parenthetically that it was fine with him if the parties took these kinds of cases to other courts; he observed that “I actually don’t like dealing with junky things, and I would prefer to devote judicial resources to real litigation, not pseudo-litigation.”)

Do go read the whole thing.

SEC Enforcement Proceedings Against Outside Directors

The D&O Diary has a useful review of recent SEC actions involving  “significant departure[s] from normal corporate governance and appropriate director conduct.”