ProfessorBainbridge.com

More on "Social Activist CEOs and Their Duties to Shareholders"

Kevin Lacroix has a typically thoughtful post on the issue.

Will social justice warrior CEOs attract the attention of the plaintiff's bar?

Francis Pileggi noted on May 4:

Yesterday’s Wall Street Journal featured a front page article about an apparently increasing number of CEOs of public companies who use their companies’ resources, and wield their companies’ resources as a sword, to advocate in their official corporate capacities to advance their favorite social agendas–or to oppose legislation on social policies that they disfavor. ...

If a stockholder thought that a CEO of a public company was more focused on social activism than observing his or her duty to maintain a focus on maximizing shareholder wealth, one element of a claim would be the measure of damages. If a company is profitable “enough”, the CEO may “get a pass”. But the recent downward trajectory of the stock price of profitable companies like Apple, which recently lost about $73 billion in market value, and an unrelated petition of over one million people who are boycotting Target department stores due to their position on recent gender issues, may gain the attention of a different type of activist: plaintiffs’ lawyers who specialize in stockholder class actions.

The twist, of course, is that many trial lawyers are themselves social justice warriors.

Travel thought for the day

The proxy access debacle: Managers are such wimps

Bloomberg reports:

More than two-thirds of companies that received proxy access proposals this year from the New York City pension funds have agreed to implement the director-nomination mechanism without holding a shareholder vote. ...

For the 2016 proxy season, the New York City pension funds filed proxy access proposals to allow a group of shareholders that collectively own at least 3 percent of the company for three years to nominate up to 25 percent of the board in any given year.

By adopting bylaws with these parameters, some companies have been able to fend off shareholder resolutions that attempt to obtain other concessions, such as allowing loaned shares to be counted toward eligibility (31 CCW 84, 3/16/16). Staff of the Securities and Exchange Commission have concluded that these companies substantially implemented proxy access, giving them a basis to exclude shareholder resolutions that touch on the matter from their proxy materials.

I get that adopting a less intrusive bylaw can stave off more intrusive ones, but I'm disappointed in corporate managers for not trying harder to stop this nonsense in its tracks.

As I explained in my book Corporate Governance after the Financial Crisis:

The SEC offers two explanations for adopting proxy access. First, because shareholders who appear in person at an annual stockholders’ meeting would have the power to nominate a director, the rule simply ensures that shareholders can exercise that right via the proxy system. In other words, the SEC claims, the rule simply effectuates existing state law rights. In fact, however, the SEC’s argument is false. On the one hand, in some respects the rule is more restrictive of shareholder rights than is the state law it supposedly effectuates. On the other hand, however, the rule creates new federal entitlements that do not exist under state law.

As to the former, the proxy system as a whole was already more restrictive than what may be done by a shareholder in person. Rule 14a-11 simply continues that pattern. Under state law, for example, any shareholder could make a nomination at the annual meeting, not just those meeting Rule 14a-11’s criteria on issues like the ownership threshold.[1]

As to the latter, Rule 14a-11 disallows restrictions on the shareholder nominating power that are likely permissible under state law.[2] In Harrah’s Entertainment, Inc. v. JCC Holding Co.,[3] Vice Chancellor Leo Strine addressed the extent to which Delaware law permits restrictions on that power:

Because of the obvious importance of the nomination right in our system of corporate governance, Delaware courts have been reluctant to approve measures that impede the ability of stockholders to nominate candidates. Put simply, Delaware law recognizes that the “right of shareholders to participate in the voting process includes the right to nominate an opposing slate.” And, “the unadorned right to cast a ballot in a contest for [corporate] office... is meaningless without the right to participate in selecting the contestants. As the nominating process circumscribes the range of choice to be made, it is a fundamental and outcome-determinative step in the election of officeholders. To allow for voting while maintaining a closed selection process thus renders the former an empty exercise.”[4]

Vice Chancellor Strine went on to explain, however, that a corporation may in fact opt out of the default voting—and nominating—rules of state law, provided it does so clearly and unambiguously:

When a corporate charter is alleged to contain a restriction on the fundamental electoral rights of stockholders under default provisions of law——such as the right of a majority of the shares to elect new directors or enact a charter amendment—it has been said that the restriction must be “clear and unambiguous” to be enforceable.[5]

Consequently, the SEC’s claim that the shareholder power to nominate and elect directors is imposed by state law and “cannot be bargained away” is likely erroneous.

The extent to which Rule 14a-11 thereby displaces state corporate law with new federal entitlements was a key point in SEC Commissioner Troy Paredes’ dissent from adoption of the rule. He explained that “Rule 14a-11’s immutability conflicts with state law. Rule 14a-11 is not limited to facilitating the ability of shareholders to exercise their state law rights, but instead confers upon shareholders a new substantive federal right that in many respects runs counter to what state corporate law otherwise provides.”[6] On both sides of the equation, Rule 14a-11 thus is hardly a means of facilitating shareholders’ state law rights.

The SEC’s second justification is that proxy access will promote director accountability.[7] In fact, however, because proxy access’ effect will be to increase the number of short slates, albeit to an uncertain extent, its impact on corporate governance likely will be analogous to that of cumulative voting. Both result in divided boards representing differing constituencies. Experience with cumulative voting suggests that adversarial relations between the majority block and the minority of shareholder nominees commonly dominate such divided boards.

The likely effects of proxy access therefore will not be better governance. It is more likely to be an increase in interpersonal conflict (as opposed to the more useful cognitive conflict). There probably will be a reduction in the trust-based relationships that are the foundation of effective board decision making.[8] There may also be an increase in the use by the majority of pre-meeting caucuses and a reduction in information flows to the board as a whole. Not surprisingly, early research suggests that proxy access reduces shareholder wealth.[9]

In his dissent, Commissioner Paredes pointed to additional pre-Rule 14a-11 studies undercutting the SEC’s position:

The mixed empirical results do not support the Commission’s decision to impose a one-size-fits-all minimum right of access. Some studies have shown that certain means of enhancing corporate accountability, such as de-staggering boards, may increase firm value, but these studies do not test the impact of proxy access specifically. Accordingly, what the Commission properly can infer from these data is limited and, in any event, other studies show competing results. Recent economic work examining proxy access specifically is of particular interest in that the findings suggest that the costs of proxy access may outweigh the potential benefits, although the results are not uniform. The net effect of proxy access — be it for better or for worse — would seem to vary based on a company’s particular characteristics and circumstances.

To my mind, the adopting release’s treatment of the economic studies is not evenhanded. The release goes to some length in questioning studies that call the benefits of proxy access into doubt — critiquing the authors’ methodologies, noting that the studies’ results are open to interpretation, and cautioning against drawing “sharp inferences” from the data. By way of contrast, the release too readily embraces and extrapolates from the studies it characterizes as supporting the rulemaking, as if these studies were on point and above critique when in fact they are not.[10]

In sum, proxy access is bad public policy, unsupported by the empirical evidence, and the pet project of a powerful interest group. In other words, quack corporate governance.

 

[1] Fisch, supra note 603, at 19.

[2] Id.

[3] 802 A.2d 294 (Del.Ch. 2002).

[4] Id. at 310-11 (citations omitted).

[5] Id. at 310.

[6] Troy Paredes, Comm’r, Sec. & Exch. Comm’n, Statement at Open Meeting to Adopt the Final Rule Regarding Facilitating Shareholder Director Nominations (“Proxy Access”) (Aug. 25, 2010), http://www.sec.gov/news/speech/2010/spch082510tap.htm.

[7] Fisch, supra note 603, at 18.

[8] Cf. Stephen M. Bainbridge, Why a Board? Group Decision Making in Corporate Governance, 55 Vand. L. Rev. 1, 35-38 (2002) (discussing how trust and cooperation norms affect horizontal monitoring within the board).

[9] Ali C. Akyol et al., Shareholders in the Boardroom: Wealth Effects of the SEC’s Rule to Facilitate Director Nominations (Dec. 2009).

[10] Id.

Will Trulia Drive “Merger Tax” Suits Out Of Delaware?

Anthony Rickey and Keola Whittaker tackle the titular question in a WLF Backgrounder. It concludes:

While there are some preliminary indications of a short-term decline in merger litigation, this may not last. Trulia’s influence will be clearer once courts outside of Delaware consider its reasoning and explicitly adopt or reject its approach. However, if non-Delaware courts remain willing to approve disclosure-only settlements and generous fee awards, Trulia may simply drive weak claims to other jurisdictions.

Given recent trends, enterprising plaintiff's attorneys may file merger-related shareholder lawsuits outside of Delaware as vehicles for disclosure-only settlements precluded by Trulia. In turn, Delaware defendants may decide not to adopt or enforce a Delaware forum-selection clause so that they may obtain a broad release in a more settlement-friendly jurisdiction.

Corporate Compliance Conference at Rutgers

I've been asked to pass along the following announcement:

Conference Invitation: The Rutgers Center for Corporate Law and Governance is presenting a conference on corporate compliance on Friday, May 20, 2016, from 8:30 AM to 3:30 PM, entitled New Directions in Corporate Compliance. The conference will take place at Rutgers Law School, 217 North Fifth Street, Camden, NJ 08102.

Corporate and regulatory compliance has exploded as an area of importance to a variety of business organizations in recent years. Corporate compliance programs must be well planned and rigorously implemented throughout a business organization. Notwithstanding the importance of corporate compliance, there is disagreement over the best way to implement and enforce a compliance program.

This conference will bring together academics, practitioners, and government officials, who approach compliance from different perspectives. The conference will include sessions on litigating the adequacy of a compliance program, structural issues in the compliance department, and organizational culture and developing a culture of compliance. Andrew Donohue, Chief of Staff of the U.S. Securities and Exchange Commission, will present a keynote luncheon address.

Other speakers include: Catherine Bromilow, Partner, PwC Center for Board Governance; Stephen L. Cohen, Associate Director, Securities and Exchange Commission; James Fanto, Gerald Baylin Professor of Law, Brooklyn Law School; Donald C. Langevoort, Thomas Aquinas Reynold Professor of Law, Georgetown Law; Joseph E. Murphy, Author of 501 Ideas for Your Compliance & Ethics Program; Donna Nagy, C. Ben Dutton Professor of Law, Indiana University Maurer School of Law; Charles V. Senatore, Executive Vice President, Fidelity Investments, Greg Urban, Arthur Hobson Quinn Professor of Anthropology, University of Pennsylvania; and John Walsh, Partner, Sutherland

The conference is free and open to the public. A reception will follow. Reservations are required. To RSVP, please contact Deborah Leak at [email protected]. CLE credit is available for NJ, NY, and PA. For additional information about CLE credit, contact Deborah Leak.

 

Updated: Paramount v. Time and standing of a bidder qua bidder under Delaware takeover law

A user of the Klein Ramseyer Bainbridge casebook recently sent along this question:

I've been using your text for years now and in teaching Paramount v. Time today, it occurred to me - what standing did Paramount have? 

 

The decision talks about the Shareholder claims which sought to invoke Revlon duties, and then the Paramount claims which sought to invoke Unocal duties. 

 

It was not clear from the decision however that Paramount was even a shareholder.

Starting with the general issue of bidder qua bidder standing, there is surprisingly little law on this subject. Let's start with a 1988 Business Lawyer article (vol. 53, pp 767) by Travis Laster (who now, of course, is a Vice Chancellor on the Delaware Chancery Court). Back then my fellow UVa law alum Laster (he was ten years after me in the Class of 1995) argued that Delaware courts had developed "sub silentio a pragmatic approach to standing that permits potential acquirors to raise breach of fiduciary duty claims where resolution of the dispute is supported by other factors, such as the presence of target-stockholder plaintiffs raising the same or similar claims, the amount of resources already expended on the case, and the alignment of the bidder's interests with the interests of the stockholders." J. Travis Laster, The Line Item Veto and Unocal: Can A Bidder Qua Bidder Pursue Unocal Claims Against A Target Corporation's Board of Director's, 53 Bus. Law. 767, 768 (1998). He contended the courts thus recognized that, "in some cases, a potential acquiror's Unocal action should proceed whether or not the potential acquiror is a stockholder." Id. at 796. According to VC Laster,  this "framework thus enables the Delaware Court of Chancery to decide litigable Unocal cases on public interest grounds, while allowing the court to avoid on a combination of standing and public policy grounds those cases where resolution of a potential acquiror's Unocal or Revlon claim is inappropriate." Id. I recommend reading it for its careful analysis of the doctrinal and policy issues.

In the infamous Omnicare litigation, however, then VC Stephen Lamb rejected bidder qua bidder standing:

Omnicare suggests that it nonetheless should be accorded standing to pursue these claims because it is making a bona fide bid for control of NCS. Omnicare argues that the policy limiting the right to initiate litigation relating to the internal affairs of a Delaware corporation to those who were participants in the corporate enterprise at the time of the alleged misconduct is designed to prevent “strike suits” and should not prevent a person such as Omnicare, which has a substantial and legitimate interest in the outcome of the litigation, from filing or prosecuting its suit. Instead, Omnicare urges the court to adopt a policy-based approach and allow standing for bidders without regard to their stock ownership in breach of fiduciary duty cases if failure to do so would disserve the interests of the parties, the stockholders, and the public.20 For the reasons that are briefly discussed hereinafter, the court is unwilling to extend the law in this fashion.

 

... Omnicare is unable to cite any case holding that a bidder that did not own shares at the time of the alleged breach of fiduciary duty by the target board nonetheless had standing to sue. ...

 

... Delaware courts have shown considerable latitude in entertaining fiduciary duty litigation brought by stockholders who are also themselves bidders for control. The only consistent limitation placed on those persons is that they also be stockholders at all relevant times and, thus, among those to whom a duty was owed, even if they only own one share. 

Omnicare, Inc. v. NCS Healthcare, Inc., 809 A.2d 1163, 1170-72 (Del. Ch. 2002). Omnicare's appeal of that ruling was dismissed by the Delaware Supreme Court as moot because NCS shareholders had emerged to bring the same claims that Omnicare would have pressed.

Unfortunately, VA Lamb's Omnicare decision does not discuss VC Laster's article at any length, contenting himself by observing that:

If, as Omnicare suggests, persons external to those relationships are acknowledged to have standing to sue to enforce them, it is not immediately apparent why competing bidders are the only ones to whom such standing might be accorded.

VC Laster's article was also discussed in one of the only other subsequent Delaware cases, In re Gaylord Container Corp. Shareholders Litigation, 747 A.2d 71, 77 n.7 (Del. Ch. 1999), in which the court held that the bidder's standing was “putatively tethered, if only by a bare thread, to its status as a stockholder." As to Laster's argument, the court in Gaylord offered this dicta:

There are very sound practical, value-enhancing reasons for the case law according bidders standing, even though the practice of according bidders standing as stockholders leads to a certain amount of undeniable doctrinal incoherence. See generally J. Travis Laster, The Line Item Veto and Unocal:Can a Bidder Qua Bidder Pursue Unocal Claims Against a Target Corporation's Board of Directors?, 53 Business Lawyer 767 (1998). There are also very sound doctrinal reasons for recognizing that defensive measures primarily affect stockholders as prospective sellers and bidders (regardless of stockholder status) as prospective buyers, and enabling each to bring individual actions to protect their legitimate interests in being able to deal with each other without improper (i.e., not fiduciarily compliant) interference by corporate boards. Such a reality-based approach seems to have little downside and is a more straightforward manner in which to address cases implicating Unocal.

Id. at 81 n.14. Which doesn't really answer the question.

Speaking of policy, the policy arguments have been aptly summarized by Robert Haig as follows:

The general rule is that only a stockholder may assert claims against a director for breach of a fiduciary duty. Whether a potential acquiror also has standing to pursue a breach-of-fiduciary-duty claim against a target's board of directors is an unsettled issue, but one worthy of careful consideration in bringing or defending such claims. The key standing cases in this context were decided under Delaware law. Arguments in favor of an exception to the general rule are that the board's failings adversely affect the potential acquiror's success and that interests underlying a bidder's demand for injunctive relief to remedy alleged misconduct are identical to the stockholders' interests in receiving a higher value for their shares. Arguments against standing in this context include the belief that allowing a bidder to sue for breach is akin to allowing the bidder to “purchase” a lawsuit against the company after the fact, which is generally disfavored and, more generally, that only those with a legitimate relationship with the corporation should be permitted to sue over that corporation's internal affairs. 

Haig continues:

Because of the uncertainty regarding “bidder standing,” companies contemplating a potential hostile acquisition often acquire a small position in the potential target company, which generally permits them to bring claims as a stockholder rather than as a potential acquiror.

4C N.Y.Prac., Com. Litig. in New York State Courts § 89:28 (4th ed.). See also Sean J. Griffith, Correcting Corporate Benefit: How to Fix Shareholder Litigation by Shifting the Doctrine on Fees, 56 B.C. L. Rev. 1, 59 n.275 (2015) ('The ability of an intervening bidder as such to sue on the basis of fiduciary duty is unclear. However, intervening bidders are likely also to be shareholders with standing to sue on that basis.") (citation omitted).

Turning to the Paramount case, our edit of the case refers to the "Shareholder Plaintiffs" (747) as bringing a Revlon claim. As edited (same page) the text states "Paramount asserts only a Unocal claim in which the shareholders plaintiffs join." As that suggests, there were two sets of plaintiffs in the suit. In an introductory paragraph to the unedited opinion, the Delaware Supreme Court in fact explained that:

Paramount Communications, Inc. (“Paramount”) and two other groups of plaintiffs (“Shareholder Plaintiffs”), shareholders of Time Incorporated (“Time”), a Delaware corporation, separately filed suits in the Delaware Court of Chancery seeking a preliminary injunction to halt Time's tender offer for 51% of Warner Communication, Inc.'s (“Warner”) outstanding shares at $70 cash per share. The court below consolidated the cases and, following the development of an extensive record, after discovery and an evidentiary hearing, denied plaintiffs' motion.

Paramount Commc'ns, Inc. v. Time Inc., 571 A.2d 1140, 1141-42 (Del. 1989). It probably would have been helpful to have left that in, but some of us have very sharp editorial pencils.

Curiously, however, neither the full Supreme Court nor the lower Chancery Court decision discusses Paramount's standing to sue. Was it essentially ignored because the shareholder plaintiffs were bring the same claims (although that would argue for tossing Paramount's suit)?

My guess is that Paramount owned some Time Inc. stock. So I have been looking for any of the following, which might shed light on the issue: Paramount's Schedule 13D filing(s), Paramount's Schedule 14d-1 filing(s), Paramount's complaint against Time-Warner. So far with no luck.

Any readers know where we could get them?

Update: Through the hard work of the incredible reference staff at the UCLA Law Library, we got a copy of the Paramount complaint. It states:

Plaintiff KDS is a Delaware corporation, an indirect wholly-owned subsidiary of Paramount, and the owner of one hundred shares of Time common stock.

Presumably that's our answer. But there is still one curiosity: Paramount itself was also a plaintiff and there's no evidence in the complaint that Paramount itself owned Time stock. Did the court impute the subsidiary's ownership to Paramount to allow the latter to also have standing?

I'd like to get Salesforce CEO Marc Benioff together with Chief Justice Leo Strine

In today's WSJ, we learn that Salesforce CEO Marc Benioff is using his position--and company resources--to advance a variety of liberal causes:

“Marc rallies CEOs when business and trade groups are much slower to act, particularly on noneconomic issues,” says Dow Chemical Co. chief Andrew Liveris, who weighed in against the North Carolina law and says Mr. Benioff’s influence led him to get personally engaged in social activism.

The 51-year-old Mr. Benioff earlier this year helped push Georgia’s governor into vetoing that state’s bill that would have let faith-based organizations decline services or fire employees over religious beliefs after the U.S. Supreme Court ruling that backed same-sex marriage. Last year, he and other CEOs were instrumental in persuading Indiana’s governor to revise a similar law. He is now pressing cohorts to back measures to close the gender pay gap.

He argues that:

“The next generation of CEOs must advocate for all stakeholders—employees, customers, community, the environment, everybody,” Mr. Benioff says, “not just for shareholders.”

Granted, if advocating for non-shareholder stakeholders redounds to shareholder benefit, that's fine. But the implication here is that Benioff is willing to make trade-offs between stakeholder and shareholder interests. If so, we must flag him.

Salesforce is a Delaware corporation, so let's see what Delaware's Chief Justice Leo Strine thinks:

It is not only hollow but also injurious to social welfare to declare that directors can and should do the right thing by promoting interests other than stockholder interests. ...

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. ...

The understanding in Delaware is that [our decisions] could not have been more clear that directors of a for-profit corporation must at all times pursue the best interests of the corporation's stockholders, and that the decision highlighted the instrumental nature of other constituencies and interests. Non-stockholder constituencies and interests can be considered, but only instrumentally, in other words, when giving consideration to them can be justified as benefiting the stockholders.

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, 767 (2015).

Of course, as Strine acknowledges that:

... it is true that the business judgment rule provides directors with wide discretion, and thus enables directors to justify--by reference to long-run stockholder interests--a number of decisions that may in fact be motivated more by a concern for a charity the CEO cares about, the community in which the corporate headquarters is located, or once in a while, even the company's ordinary workers, rather than long-run stockholder wealth. But that does not alter the reality of what the law is.

Yet, the bottom line is that Benioff is on the verge of admitting that he'll put his own political and policy preference ahead of the interests of Salesforce's shareholders.

Somehow, however, I doubt whether the folks who have been complaining about corporate influence in politics will start criticizing Benioff's activism the way they do, say, that of the Koch Brothers.

Facebook's proposed issuance of nonvoting stock challenged in Delaware Chancery Court

NBC reports:

A Facebook shareholder filed a proposed class action lawsuit on Friday in a bid to stop the company's plan to issue new Class C stock, calling the move an unfair deal to entrench Chief Executive Mark Zuckerberg as controlling shareholder. ...

The lawsuit contends that a Facebook board committee which approved the share deal "did not bargain hard" with Zuckerberg "to obtain anything of meaningful value" in exchange for granting Zuckerberg added control. ...

Facebook plans to create a new class of shares that are publicly listed but do not have voting rights. Facebook will issue two of the so-called "Class C" shares for each outstanding Class A and Class B share held by shareholders. Those new Class C shares will be publicly traded under a new symbol. 

Zuckerberg "wishes to retain this power, while selling off large amounts of his stockholdings, and reaping billions of dollars in proceeds," the lawsuit said. 

"The issuance of the Class C stock will, in effect, have the same effect as a grant to Zuckerberg of billions of dollars in equity, for which he will pay nothing," it said. 

Actually, there have been two complaints filed. One is a class action filed on April 29 by a Facebook shareholder named Eric McGinty represented by local counsel Michael P. Kelly and Benjamin A. Smyth of MCCARTER & ENGLISH and LEVI & KORSINSKY, LLP (DC). The other is a class action was filed today by a Facebook shareholder named Eric Levy (what are the odds of them both being named Eric?) represented by local counsel Blake A. Bennett of COOCH AND TAYLOR, PA, with Lynda J. Grant of THEGRANTLAWFIRM, PLLC (NY) and Laurence D. Paskowitz of THE PASKOWITZ LAW FIRM P.C. (also NY). Both complaints allege the the defendants--Zuckerberg and the Facebook board--breached their "fiduciary duties of loyalty, good faith and candor." They also emphasize that the transaction would have a significant entrenchment effect, allowing Zuckerberg to profit by selling his Class C stock while maintaining his control.

First, why are these class actions rather than derivative suits? The Delaware courts have held that whether a suit is derivative or direct is determined by asking "(1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?" Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031, 1033 (Del. 2004). prior cases have indicated that entrenchment claims and claims involving dilution of minority voting rights may be brought directly. See, e.g., Wells Fargo & Co. v. First Interstate Bancorp., No. CIV. A. 14623, 1996 WL 32169 (Del. Ch. Jan. 18, 1996).

What standard of review will Chancery apply on these facts? Surely there is an argument that this is a case for entire fairness review:

Under current law, the entire fairness framework governs any transaction between a controller and the controlled corporation in which the controller receives a non-ratable benefit. This is because “Delaware is more suspicious when the fiduciary who is interested is a controlling stockholder.” Leo E. Strine, Jr., The Delaware Way: How We Do Corporate Law and Some of the New Challenges We (and Europe) Face, 30 Del. J. Corp. L. 673, 678 (2005). A controlling stockholder occupies a uniquely advantageous position for extracting differential benefits from the corporation at the expense of minority stockholders. See id. There is also “an obvious fear that even putatively independent directors may owe or feel a more-than-wholesome allegiance to the interests of the controller, rather than to the corporation and its public stockholders.” Id.

[T]he underlying factors which raise the specter of impropriety can never be completely eradicated and still require careful judicial scrutiny. This policy reflects the reality that in a transaction such as the one considered ..., the controlling shareholder will continue to dominate the company regardless of the outcome of the transaction. The risk is thus created that those who pass upon the propriety of the transaction might perceive that disapproval may result in retaliation by the controlling shareholder.

 

*12 Tremont II, 694 A.2d at 428 (citations omitted).

 

In re Ezcorp Inc. Consulting Agreement Derivative Litig., No. CV 9962-VCL, 2016 WL 301245, at *11-12 (Del. Ch. Jan. 25, 2016).

 

Facebook seems to have anticipated the risk of the transaction being subjected to entire fairness review, since they had a special committee of the board approve the transaction rather than leaving it to the full board. The proxy statement states:

The Special Committee was established in August 2015 as a committee of our board of directors to (i) review, analyze, evaluate, and negotiate a potential reclassification of our capital or voting structure in order to maintain our founder-controlled structure, (ii) make a recommendation to our board of directors regarding such a reclassification, and (iii) to the extent delegable by our board of directors to the Special Committee under applicable law, approve or disapprove such a reclassification on behalf of the board of directors.

 

Among other things, our board of directors authorized the Special Committee to retain, at our expense, such legal, financial, and other advisors, consultants, and experts as the Special Committee determined to be necessary or appropriate to assist and advise the Special Committee in performing its responsibilities, and to enter into contracts with such advisors, consultants, and experts for their compensation, reimbursement of expenses, and indemnification. The board of directors also resolved that the Special Committee would have the power to authorize and direct the appropriate officers of the company to provide such information and assistance as may be requested by the Special Committee in the exercise of its responsibilities.

 

Our board of directors (with the employee directors abstaining) appointed Susan Desmond-Hellmann , Marc Andreessen, and Erskine B. Bowles as members of the Special Committee. Following the establishment of the Special Committee, the members of the Special Committee appointed Dr. Desmond-Hellmann as Chairperson of the Special Committee. Our board of directors (with the employee directors abstaining) determined that the members of the Special Committee (i) were not members of our management, (ii) were independent of Mr. Zuckerberg, and (iii) were disinterested with respect to a reclassification, except with respect to any interest they may have by virtue of their ownership of shares of our Class A common stock (subject to obtaining their (and any affiliated funds') irrevocable commitment to cause any of their shares of, or securities convertible into or exchangeable for, our Class B common stock to be converted to Class A common stock to the extent that they beneficially owned shares of, or securities convertible or exchangeable into, our Class B common stock as further described in "Background" below).

What's interesting, however, is that Facebook decided not to avail itself of the newly approved mechanisms for insulating conflicted transactions from fairness review:

If a controller agrees up front, before any negotiations begin, that the controller will not proceed with the proposed transaction without both (i) the affirmative recommendation of a sufficiently authorized board committee composed of independent and disinterested directors and (ii) the affirmative vote of a majority of the shares owned by stockholders who are not affiliated with the controller, then the controller has sufficiently disabled itself such that it no longer stands on both sides of the transaction, thereby making the business judgment rule the operative standard of review. M & F Worldwide, 88 A.3d at 644. If a controller agrees to use only one of the protections, or does not agree to both protections up front, then the most that the controller can achieve is a shift in the burden of proof such that the plaintiff challenging the transaction must prove unfairness.

In re Ezcorp Inc. Consulting Agreement Derivative Litig., No. CV 9962-VCL, 2016 WL 301245, at *11 (Del. Ch. Jan. 25, 2016). Here Zuckerberg gave the minority the protection of a special committee (although both complaints allege significant failures by the committee), but not approval by a majority of the minority. So fairness would remain the applicable standard.

 

Indeed, the proxy statement rubs the minority shareholders' impotence in their face:

As a result of his beneficial ownership of more than a majority of each of our total outstanding voting power and the outstanding voting power of the Class B common stock as of the record date, Mr. Zuckerberg has the power to approve the adoption of the New Certificate without the affirmative vote of any other stockholder.

I'm hoping this case goes the distance (unlike the Google case from a couple of years ago), as it would make a great addition to our case book.

Hodak to Facebook shareholders: You made your bed, now lie in it

Marc Hodak on Facebook's plan to issue non-voting stock:

I’ve been hearing a lot of angst about Facebook’s decision to issue a new class of non-voting shares for the express purpose of preventing dilution of Mark Zuckerberg’s control over Facebook. Mainly, the complaints are of the nature, “It’s undemocratic!” The best response I can offer: Get over it.

God did not ordain that all companies need to be governed in any particular way. Yeah, I get the benefits of a more diverse shareholder influence over the board. I get that he might abuse the outsized authority he has gained from dual class (now triple class?) shares, and act in ways that hurt minority shareholders. I would be willing to grant all that and ignore that Zuckerberg’s influence has so far been very beneficial to all shareholders, and that his board is as good as one might hope for to restrain his potential excesses.

But here’s the deal with Facebook: Zuckerberg is in control. Every current shareholder bought into that premise. There is no moral principle that says we need to adjust the charter or capital structure to accommodate our personal or collective preferences on what “good governance” ought to look like after the fact.

What about the fact that Zuckerberg has now added another layer of anti-dilution protection that wasn’t there when current shareholders bought into Facebook? Well, they bought into that, as well. They bought into the current change insofar as Facebook is, basically, the charter that enables that change and everything else that Facebook is. When you date a paranoid, you can’t complain when they add another alarm system to the house.

Go read the whole thing.

I tend to agree with Mr Hodak. But I wonder if the Delaware courts would agree. What standard of review would a court apply if a Facebook shareholder challenged the issuance? Would the court regard this as a controlling shareholder conflict of interest transaction subject to entire fairness review?

 

Rerunning the 1980s Takeover Debate in the Hedge Fund Activism Space

Back in the 1980s there was a vigorous debate as to whether the merger mania of that era was creating new value. We are now starting to see the same issue being raised in the context of hedge fund activism, as in a recent study by Felix Zhiyu Feng, Qiping Xu and Heqing Zhu:

The objective of our recent study is precisely to investigate what happens to bondholders when caught in the crossfire between managers and activist hedge funds. Specifically, we want to know whether managerial actions to boost equity value in effort to avert hedge fund intervention involve compromising the interest of bondholders. The answer to this question would bring new and important insight into our understanding of hedge fund activism as a mechanism for corporate governance.

To carry out our investigation, we use a comprehensive sample of hedge fund activism events from 1994 to 2011 to help us determine the degree of firms’ exposure to HFA threat. We find that firms with greater (relative to those with less) ex-ante exposure to intervention threat experience higher bond yields, greater default probability, and worse bond and overall firm ratings, after their industries are hit with an abnormal degree of intervention activity. These can be explained by the tendency of such firms to increase leverage through share repurchases funded by using up cash reserves and selling assets. While these policy changes tend to be viewed as in governance-improving directions and therefore lead to positive stock market reactions, they could potentially jeopardize bondholders’ interests in the event of bankruptcy and therefore induce negative credit market reactions.

Finally, we find that the transfer of wealth from bondholders to shareholders is more serious in poorly governed firms, in firms that experience greater improvement to equity value, in years with more industry-wide interventions, and in years when a greater proportion of the industry-wide interventions are more hostile in nature, meaning the activist hedge funds deploy more aggressive engagement tactics. These results suggest that the extent to which the manager-bondholder agency problem is permitted to exist in the firm affects the degree to which bondholders’ interest is sacrificed when managers face intervention threat.

As regular readers know, I'm skeptical of hedge fund activism. Yet, I'm also skeptical of these sort of wealth transfer analysis. In my book Mergers and Acquisitions, I argue that:

There is a widely shared assumption that takeovers leave nonshareholder constituencies, especially employees, significantly worse off. Admittedly, a fair bit of anecdotal evidence supports the claim. The AFL–CIO estimated, for example, that 500,000 jobs were lost as a direct result of takeover activity between 1983 and 1987 alone. Acquiring companies also supposedly use funds taken out of the target company's pension plans to help finance the acquisition. In light of such stories, prominent management author Peter Drucker spoke for many when he observed that "employees, from senior middle managers down to the rank and file in the office or factory floor, are increasingly being demoralized—a thoughtful union leader of my acquaintance calls it 'traumatized'—by the fear of a takeover raid."

Corporate takeovers also affect the communities in which the corporation has plants and other facilities. In the wake of Boone Pickens' raid on Phillips Petroleum, for example, Phillips eliminated 2,700 jobs in its Bartlesville, Oklahoma headquarters. Because Bartlesville's population was only 36,000, this downsizing devastated the local community. Similar tales of woe doubtless could be told of many communities affected by takeover related corporate restructurings.

Highly leveraged takeovers may adversely affect the interests of bondholders and other corporate creditors. As the theory goes, pre takeover creditors assessed the corporation's creditworthiness and set their loan terms based on the corporation's existing assets and debt equity ratios. In a highly leveraged acquisition, the bidder finances the acquisition by borrowing against target corporation assets and/or selling target assets. This significantly lowers the corporation's creditworthiness, yet pre takeover creditors are not compensated for this loss. Bondholders are particularly hard hit by this phenomenon. Bond rating agencies routinely downgrade a corporation's pre takeover bonds to reflect the firm's increased riskiness post takeover, which immediately reduces those bonds' market value.

A number of commentators have advanced theoretical bases for the claim that takeovers are detrimental to nonshareholder corporate constituents. As the basic argument goes, many of the contracts making up the corporation are implicit and therefore judicially unenforceable. Some of these implicit contracts are intended to encourage stakeholders to make firm specific investments. Consider an employee who invests considerable time and effort in learning how to do his job more effectively. Much of this knowledge will be specific to the firm for which he works. In some cases, this will be because other firms do not do comparable work. In others, it will be because the firm has a unique corporate culture. In either case, the longer he works for the firm, the more difficult it becomes for him to obtain a comparable position with some other firm. An employee will invest in such firm specific human capital only if rewarded for doing so. An implicit contract thus comes into existence between employees and shareholders. On the one hand, employees promise to become more productive by investing in firm specific human capital. They bond the performance of that promise by accepting long promotion ladders and compensation schemes that defer much of the return on their investment until the final years of their career. In return, shareholders promise job security. The implicit nature of these contracts, however, leaves stakeholders vulnerable to opportunistic corporate actions.

As the theory goes, this vulnerability comes home to roost in hostile takeovers. In all hostile acquisitions, the shareholders receive a premium for their shares. Where does that premium come from? Recall that the employees' implicit contract involved delaying part of their compensation until the end of their careers. If the bidder fires those workers before the natural end of their careers, replacing them with younger and cheaper workers, or if the bidder obtains wage or other concessions from the existing workers by threatening to displace them or to close the plant, the employees will not receive the full value of the services they provided to the corporation. Accordingly, a substantial part of the takeover premium consists of a wealth transfer from stakeholders to shareholders. Or so the story goes.

There are any number of problems with this thesis, however. For one thing, there is no credible evidence that takeovers transfer wealth from nonshareholder constituencies to shareholders. The theoretical justification for protecting nonshareholders is equally unpersuasive. Many corporate constituencies do not make firm specific investments in human capital (or otherwise). In contrast, the shareholders' investment in the firm always is a transaction specific asset, because the whole of the investment is both at risk and turned over to someone else's control. Consequently, shareholders are more vulnerable to director misconduct than are most nonshareholder constituencies. Relative to many nonshareholder constituencies, moreover, shareholders are poorly positioned to extract contractual protections. Unlike bondholders or unionized employees, for example, whose term limited relationship to the firm is subject to extensive negotiations and detailed contracts, shareholders have an indefinite relationship that is rarely the product of detailed negotiations. In general, nonshareholder constituencies that enter voluntary relationships with the corporation thus can protect themselves by adjusting the contract price to account for negative externalities imposed upon them by the firm. Many nonshareholder constituencies have substantial power to protect themselves through the political process. Public choice theory teaches that well defined interest groups are able to benefit themselves at the expense of larger, loosely defined groups by extracting legal rules from lawmakers that appear to be general welfare laws but in fact redound mainly to the interest group's advantage. Absent a few self appointed spokesmen, most of whom are either gadflies or promoting some service they sell, shareholders—especially individuals—have no meaningful political voice. In contrast, cohesive, politically powerful interest groups represent many nonshareholder constituencies. As a result, the interests of nonshareholder constituencies increasingly are protected by general welfare legislation.

Christina Hurt on "The Hostile Poison Pill"

Christine Hurt weighs in on NOL pills with a skeptical analysis:

Whether one ascribes to the agency theory of shareholder primacy or the contractarian theory of director primacy, boards of directors have great discretion in determining whether, when, and how to sell the corporation.  Defensive tactics, like poison pills, can be tools in wielding that discretion in the service of creating shareholder value.  However, a poison pill designed either to oppress a minority shareholder, as in eBay v. Newmark,[1] or to minimize the impact of activist shareholders, as in Versata Enterprises, Inc. v. Selectica, Inc.,[2] seems to exceed the “maximum dosage” of the pill.  The “tax benefits preservation plan,” or net operating loss (NOL) poison pill, while facially plausible as a tool to protect tax assets from impairment caused by a Section 382 “ownership change,” may be a low-trigger anti-shareholder wolf tactic in Unocalsheep’s clothing.  ...  A brief look at issuers that adopted NOL poison pills between 1998 and 2014 and an analysis of how Section 382 of the Internal Revenue Code works suggests that preserving NOLs may not be the chief concern of boards adopting tax benefits preservation plans.

She goes on to say: "Instead of warding off uninvited potential acquirers, the [NOL] pill could ward off even low-level shareholder voice," as if that were a bad thing.

Christine also makes the apt observation that:

NOL poison pills do not work.  Traditional pills work:  the deterrence value of diluting a 15% or 20% shareholder keeps that shareholder at bay.  The deterrence value of diluting a 5% shareholder who wants to acquire the company eventually is very small.  That shareholder values the NOLs at zero because an acquisition will trigger Section 382 anyway, and that shareholder, particularly in the microcap space, will not find dilution a large loss.  And of course, an NOL pill does not deter either an accidental share purchase or a saboteur.  In fact, the only shareholder that the NOL poison pill effectively deters is the activist shareholder, suggesting that the use of the poison pill in these cases may be “hostile.”

It's an important contribution to the literature.

Choi and Spier on "Taking a Financial Position in Your Opponent in Litigation"

Should a plaintiff suing a public corporation be allowed to take a short position in the company's stock? Choi and Spier explore that issue in an interesting analysis:

With a long position, the plaintiff would benefit if the defendant’s stock price goes up, and with a short position the plaintiff would benefit if the defendant’s stock price falls.  By selling the stock short, the plaintiff is actively betting against the firm, and will reap higher financial gains when the defendant suffers greater litigation losses.  If the capital market is unaware of the lawsuit at the time that the plaintiff takes the short position, then the plaintiff can of course profit from the financial investment.   If the capital market is aware of the lawsuit and has rational expectations, , the plaintiff does not capture any systematic, direct benefit from the financial position.  However, the plaintiff can secure indirect strategic benefits because, by the time of settlement or trial, the initial expenditure the plaintiff has incurred in taking the financial position is sunk and the plaintiff has an interim incentive to maximize the aggregate return from both litigation and the financial position.

Somewhat counter-intuitively (at least counter to my intuition), they conclude that "the plaintiff’s optimal short position can actually benefit the defendant and lower the rate of litigation."

You'll need to go read the whole thing.

Should we allow piercing the corporate veil in criminal law cases?

Josh Fershee recently flagged an Illinois case in which the court invoked veil piercing in a criminal case:

See People v. Abrams, 47 N.E.3d 295, ¶¶ 57-61, 399 Ill. Dec. 790 (2015) ( slip op. PDF here ).  In my view, not quite right, either.

In the case, the defendant (Abrams) stole $1.87 million from the victim (Lev), which led to a restitution order for that amount and a twelve-year prison sentence for Abrams.  The conviction was for a Class 1 felony, for the the theft of property exceeding $500,000.  Id.¶ 23 (citing 720 Ill. Comp. Stat. Ann. 5/16-1(a(2) (West 2012)).  The statute provides, "Theft of property exceeding $500,000 and not exceeding $1,000,000 in value is a Class 1 non-probationable felony." 720 Ill. Comp. Stat. Ann. 5/16-1(b)(6.2). 

On appeal, the defendant argued the indictment was wrong in that it stated the money was stolen from Lev, when most of the money actually belonged to Lev's company, The Fred Lev Company (presumably a corporation, but that is not stated expressly).   Abrams claimed: 

the State did not prove he obtained “unauthorized control” of more than $500,000 of Lev’s property. Abrams recognizes the evidence presented at trial established that over $1.8 million was taken. Abrams contests the finding that the entire amount was taken from Lev and not The Fred Lev Company. 

Abrams, 47 N.E.3d 295 ¶ 57.  The court countered: "This is a distinction without a difference. Two separate doctrines of law guide our decision." Id. Although I think the court is probably right on the outcome, one of the rationales is wrongly explained.

The court's first assertion is as follows: 

First, the alter ego doctrine of corporate law was developed for and has been traditionally used by third persons injured due to their reliance on the existence of a distinct corporate entity. In re Rehabilitation of Centaur Insurance Co., 158 Ill. 2d 166, 173 (1994). “The doctrine fastens liability on the individual or entity that uses a corporation merely as an instrumentality to conduct that person’s or entity’s business.” Peetoom v. Swanson, 334 Ill. App. 3d 523, 527 (2002). In the context of “piercing the corporate veil,” an alter ego analysis starts with examining the factors which reveal how the corporation operates and the particular party’s relationship to that operation. A.G. Cullen Construction, Inc. v. Burnham Partners, LLC, 2015 IL App (1st) 122538, ¶ 43. Generally, did the corporation function simply as a facade for the dominant shareholder? Id. Here, without question, the corporate entity, The Fred Lev Company, served as the alter ego or business conduit of Lev, and Abrams’ own testimony confirmed it. 

Id.¶ 58. This is an overreach, as far as I am concerned, and I don't like the ease with which the court uses veil piercing without a detailed analysis. 

Go read the whole thing, for more detail on this interesting case.

Using veil piercing in criminal cases is not unprecedented, but it is very rare. In his seminal study, Professor Robert Thompson reported that:

Robert B. Thompson, Piercing the Corporate Veil: An Empirical Study, 76 Cornell L. Rev. 1036, 1058 (1991).

 

So less than 1% of the surveyed veil piercing cases arose in the criminal context. That number is sufficiently tiny, by the way, that I don't think we should read too much into the fact that courts pierced in ⅔ of the cases.

 

I do agree with Josh, however, on two points. First, the court's analysis in this particular case seems pretty shoddy. Second:

...as to the judgment for restitution to Lev, it is wrong. That money (or some portion of it) belongs to The Fred Lev Company.  Suppose there are creditors out there who have gone unpaid.  Or they are unpaid down the road.  At a minimum, the funds stolen from the company should go back through the company so it could be clear what funds were there and should have been available.