At Francis Pileggi's Delaware Corporate & Commercial Law Blog, Aimee Czachorowski reports "that a controlling stockholder must formally ratify a self-dealing transaction by a vote at a meeting of stockholders or by written consent in order to shift the standard of review from entire fairness to the business judgment rule."
In Espinoza v. Zuckerberg et al., C.A. No. 9745-CB (Del. Ch. Oct. 28, 2015), Chancellor Bouchard stated that: “The controlling stockholder of a Delaware corporation wields significant power, including the power in some circumstances to ratify interested directors’ decisions and thereby limit judicial scrutiny of such actions. But a controlling stockholder should not, in my view, be immune from the required formalities that come with such power.” This case involved Mark Zuckerberg, the controlling stockholder of the popular social media site Facebook, Inc.
At Jay Brown's Race to the Bottom blog, Celia Taylor reports that the Delaware Chancery Court addressed a question of first impression:
Can a disinterested controlling stockholder ratify a transaction approved by an interested board of directors, so as to shift the standard of review from entire fairness to the business judgment presumption, by expressing assent to the transaction informally without using one of the methods the Delaware General Corporation Law prescribes to take stockholder action?
As we know, the court held that Zuckerberg had to comply with the requisite statutory formalities.
This case called to mind a couple of cases from the casebook I coauthor with Bill Klein and Mark Ramseyer: First, Bayer v. Beran, 49 N.Y.S.2d 2 (Sup. Ct. 1944), which involved a shareholder challenge to a board decision to begin a radio advertising program in which the wife of the CEO performed:
It is urged that the expenditures were illegal because the radio advertising program was not taken up at any formal meeting of the board of directors, and no resolution approving it was adopted by the board or by the executive committee. The general rule is that directors acting separately and not collectively as a board cannot bind the corporation. There are two reasons for this: first, that collective procedure is necessary in order that action may bedeliberately taken after an opportunity for discussion and an interchange of views; and second, that directors are the agents of the stockholders and are given by law no power to act except as a board. Liability may not, however, be imposed on directors because they failed to approve the radio program by resolution at a board meeting.
It is desirable to follow the regular procedure, prescribed by law, which is something more than what has, at times, thoughtlessly been termed red tape. Long experience has demonstrated the necessity for doing this in order to safeguard the interests of all concerned, particularly where, as here, the company has over 1,375,000 shares outstanding in the hands of the public, of which about 10% are held by the officers and directors.
But the failure to observe the formal requirements is by no means fatal. The directorate of this company is composed largely of its executive officers. It is a close, working directorate. Its members are in daily association with one another and their full time is devoted to the business of the company with which they have been connected for many years. In this respect it differs from the boards of many corporations of comparable size, where the directorate is made up of men of varied interests who meet only at stated, and somewhat infrequent, intervals. The same informal practice followed in this transaction had been the customary procedure of the directors in acting on corporate projects of equal and greater magnitude. All of the members of the executive committee were available for daily consultation and they discussed and approved the plan for radio advertising. While a greater degree of formality should undoubtedly be exercised in the future, it is only just and proper to point out that these directors, with all their loose procedure, have done very well for the corporation.
The other is Broz v. Cellular Information Systems, Inc., 673 A.2d 148 (Del.1996), in which director Broz was sued by the corporation for having usurped a corporate opportunity. Broz did not get formal board rejection of the opportunity, but did informally run his taking the opportunity past several of the board members. The court held that:
We assume arguendo that informal contacts and individual opinions of board members are not a substitute for a formal process of presenting an opportunity to a board of directors. Nevertheless, in our view such a formal process was not necessary under the circumstances of this case in order for Broz to avoid liability. These contacts with individual board members do, however, tend to show that Broz was not acting surreptitiously or in bad faith.
All of which raises the question of when formal procedures can be regarded as mere best practice as opposed to a mandatory requirement.
Two candidates come to mind: (1) Formal action is required when shareholders act but not when boards act. (2) Formal procedures are required when complying with statutory mandates.
There is language in Espinoza to support an argument that formalities are mandatory in either setting. First, the court discusses case law involving shareholder ratification in cases where the ratification is required by prior judicial precedent rather than by statute:
One foundational case is Gantler v. Stephens. As the Supreme Court recently noted, Gantleris “a narrow decision focused on defining a specific legal term, ‘ratification.’ ” In Gantler, the Supreme Court held that the scope of “the shareholder ratification doctrine must be limited ... to circumstances where a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective.” In my view, Gantler's use of the phrase “fully informed shareholder vote” in defining the concept of ratification was deliberate and was not intended to mean something less formal than an actual stockholder vote (or an action by written consent in lieu thereof).
But then the court went on to discusses cases in which the shareholder vote was required by statute:
Another example is 8 Del. C. § 144(a)(2), which prevents the voiding of a director's interested transaction if the “transaction is specifically approved in good faith by vote of the stockholders.” In describing that process, this Court stated in Wheelabrator that “[a]pproval by fully informed, disinterested shareholders pursuant to § 144(a)(2) invokes the business judgment rule and limits judicial review to issues of gift or waste with the burden of proof upon the party attacking the transaction.” Although the statutory language plainly refers to the need for a “vote of the stockholders,” Wheelabrator simply uses the word approval to indicate this formal requirement, suggesting again that Delaware courts naturally assume that stockholder approval requires adherence to formalities.
Precedent also suggests that compliance with statutory formalities is necessary even for an individual controlling stockholder.
Is there a reason to think board decision-making processes would be treated differently? One hint is provided by the court's observation that:
... the policies underlying the DGCL provisions governing the taking of stockholder action further support the conclusion that stockholders—including controlling stockholders like Zuckerberg—must observe statutory formalities when seeking to ratify director action. Doing so will avoid ambiguity and misinterpretation by ensuring that actions taken by stockholders are defined with precision and—where a single controlling stockholder is not present—that the requisite level of approval was obtained, and will promote transparency for the benefit of all stockholders. As the Delaware Supreme Court recently stated, “[c]ertainty and efficiency are critical values when determining how stockholder voting rights have been exercised.”
Where you have a small number of decision makers the risk of imprecision seems less significant.
Having said that, however, maybe Broz and Bayer are outliers. After all, there are cases holding that boards must also follow formal procedures:
Corporate law requires that a board of directors must act through meetings of its directors, and not simply collect their opinions, unless the charter or by-laws of a company provide differently. Del.Code. Ann. Tit. 8 § 141(b)(f); N.Y. Bus. Corp. Law § 708(a)-(b); Douglas Dev. Corp. v.. Carillo, 64 N.Y.S.2d 747 (N.Y.Sup.Ct.1946) (citing Hauben v. Morris, 291 N.Y.S. 96 (N.Y.Sup.Ct.1936) (procedures for formal board action cannot be bypassed).
Woods v. Boston Sci. Corp., 2007 WL 754093, at *6 (S.D.N.Y. Feb. 9, 2007).
O'Neal & Thompson's close corporation treatise suggests that the case law is all over the map, especially with respect to close corporations:
Even in the absence of a statute expressly sanctioning informal action, courts frequently give effect to informal action taken by persons managing a close corporation if its directors and shareholders are the same people. The courts will treat action by the participants as having been taken in whichever capacity (as shareholders or as directors) is appropriate to give it validity. Courts are also likely to sustain informal action if a corporation has a pattern or custom of informal action. As was said by a New York court in sustaining informal action by the board of directors of a close corporation,
[A]ction, concurred in by all [the directors, who owned all the shares], although separately, and not as a body, binds the corporation. We must recognize the fact … that they [close corporations] are, in perhaps the majority of instances, conducted by officers and directors little informed in the law of corporations, who often act informally, sometimes without meetings or even bylaws. To hold that in all instances technical conformity to the requirements of the law of corporations is a condition to a valid action by the directors would be to lay down a rule of law which could be used as a trap for the unwary who deal with corporations, and to permit corporations sometimes to escape liability to which an individual in the same circumstances would be subjected.
The same court pointed out that the reasons usually given as supporting the requirement of formal director action do not apply, at least not in full vigor, to unanimous director action in a close corporation, because (1) if all the directors are of one mind, discussion is futile, and (2) if the directors own all the corporate stock, they are both principals and agents and their unanimous acts as directors carry their consent thereto as shareholders. A close corporation has been held to be bound by the informal action of directors who hold all the common stock, even though some of the preferred shareholders were not represented on the board. ...
If less than all the directors undertake to act informally, the decisions are in conflict on whether the action is valid.
2 Close Corp and LLCs: Law and Practice § 8:3 (Rev. 3d ed.). O'Neal and Thompson also suggest that the result may depend on whose ox is being gored:
The decisions which uphold informal director action by less than all directors frequently invoke legal doctrines such as ratification, estoppel, or unjust enrichment to support the result. Some courts embrace these doctrines in fact situations in which an insistence on corporate formalities would enable the corporation to escape legitimate obligations. ...
In many instances effect must be given to such informal action to avoid injustices to persons dealing with the corporation and relying on informal acts of its shareholders or directors, and most courts will probably continue to validate informal corporate action in circumstances similar to those in which they have done so in the past.
Perhaps we thus might identify a multi-factor test:
- Board versus shareholder action
- Taking action under a statute?
- Public or close corporation?
- Pattern of taking informal action?
Zuckerberg would seem to lose on at least 3 of the 4 factors.
