ProfessorBainbridge.com

Keith Bishop asks "Could The SEC Have Made A Weaker Case For Mandating Enhanced Repurchase Disclosures?"

It's a great question:

As I read the SEC's 102-page rule proposal, I was struck by the SEC's repeated use of "could".   According to my count, the word appears 90 times in the proposing release.   

"Could" is the past participle of "can".  When used as a substitute for "can", "could" implies a greater degree of uncertainty.   When we say that something "could happen" we mean that it might or might not happen.   Essentially, it means that something is possible, not that it necessarily will occur.  Thus, the proposing release's constant use of the word conveys a notable incertitude on the part of the SEC. 

I wonder if one could use that as a challenge to the eventual rule. After all, the SEC's seen a lot of high profile rules go down in flames due to lousy cost-benefit analyses.

23 states file comment opposing DOL's proposed rule that "promotes a social activist agenda over the interests of employees, retirees, and other retirement fund beneficiaries"

H/T: Stefan Padfield:

You can read the full comment letter here.  For additional background on the proposed rule, go here.  An excerpt from the letter:

It is our position that social and political issues should not be considered by fiduciaries in employee retirement savings investment decisions. We are not opposed to any person or entity considering ESG or other social factors when investing their own money; individuals and companies may promote social causes through their investments to the extent they desire. But we are opposed to investment managers and employers being encouraged or mandated to consider ESG factors and protected from legal action when they do. Adopting this Proposed Rule and allowing employers and investment managers to consider ESG factors makes what should be a financial decision into a political one....

Reform Rule 10b5-1 by making executives trade the same amount every day (or week or whatever)

My friend and sometime coauthor Todd Henderson recognizes that SEC Rule 10b5-1 has not prevented use of inside information by corporate executives and has come up with a unique and sensible reform proposal:

The typical big-company CEO makes enough money—more than $24 million in 2020—that he shouldn’t need to sell shares urgently. A CEO can set a goal for the year in dollar or percentage terms and then have those sales spread out evenly over every trading day to diversify his portfolio. No surprises, no allegations of trading in advance of information disclosure, no timing the market and no big risk of front-running.

I think this is an excellent idea, but I would offer what I hope is a friendly amendment: Why not allow CEOs to trade once a week or once a month. For example, the CEO could be obliged to sell the same number of shares on the same day of the week every week of the year. It's not clear to me why allowing the CEO to sell 1000 shares every Wednesday the exchange is open, for example, would not achieve essentially the same result.

Introducing The Profit Motive

2/ Since the title of the book is "The Profit Motive: : Defending Shareholder Wealth Maximization," there doesn't seem to be much point in hiding the ball behind a pretense of academic objectivity. So here's what I've got. Thoughts? #lawtwitter #academictwitter #corpgov pic.twitter.com/5mMk0UVA1h

— Steve Bainbridge (@PrawfBainbridge) December 23, 2021

More on whether Fliegler v. Lawrence was wrongly decided and whether the votes of interested stockholders should count under DGCL 144(a)(2)

About a week ago, I opined that Fliegler v. Lawrence was wrongly decided. 

The court’s reading of § 144 is inconsistent with a plain-meaning approach to statutory construction. Section 144(a)(1) requires approval by “a majority of the disinterested directors,” but § 144(a)(2) requires only approval by a “vote of the shareholders.” The statute’s drafters thus inserted a requirement of disinterest in (a)(1) but not in (a)(2). Presumably, they did not forget the word disinterested in the presumably brief interval between writing (a)(1) and (a)(2). Accordingly, on the face of the statute, shareholder approval ought to be effective even if the shareholders are not disinterested.

Keith Paul Bishop finds support for my argument in an odd place:

Like Section 144(a)(1) of the DGCL, California Corporations Code Section 310(a)(2) requires approval of the board by a vote "sufficient without counting the vote of the interested directors".  Unlike Section 144(a)(2), however, Section 310(a)(1) requires approval of the shareholders with the shares "owned by the interested director or directors not being entitled to vote thereon".    Thus, the California statute illustrates Professor Bainbridge's point - the Delaware legislature could have, but did not, include "disinterested" in Section 144(a)(2).   I agree - haec omissio non praetermitterenda est.

A corporation is not a person in any ontological or metaphysical sense; nor is it a thing capable of being owned. It is a nexus of contracts.

Robert T Miller: 

This short piece responds to an article by Professor McLeod and argues that, even under strong natural law assumptions about the natural rights of human beings to form associations, there is no reason to think that corporations, churches or other associations of individuals are real persons in any ontological or metaphysical sense. Anything we want to say about the rights and obligations of associations under the natural law is fully explainable in terms of the rights and obligations of the individual human beings who compose such associations.

Miller, Robert T., Corporations, Persons and the Natural Law: A Response to Professor McLeod (November 23, 2021). Anchoring Truths (November 23, 2021), Available at SSRN: https://ssrn.com/abstract=3971735 or http://dx.doi.org/10.2139/ssrn.3971735

Ordinary Course Covenants in M&A Deals

@fpileggi has a most helpful post re AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC, Del. Supr., No. 71, 2021 (Dec. 8 2021), the new Delaware Supreme Court decision on material adverse effect clauses and ordinary course of business covenants. https://t.co/KUUNh48YhS

— Steve Bainbridge (@PrawfBainbridge) December 13, 2021

Should interested shareholders get to vote? A third comment on Hamermesh, Jacobs, and Strine

As regular readers know, I am enjoying parsing the exciting new paper from Lawrence Hamermesh, Jack B. Jacobs, and Leo E.  Strine (hereinafter HJS), Optimizing The World’s Leading Corporate Law: A 20-Year Retrospective and Look Ahead. In a prior post, I discussed their proposals for judicial review of controller transactions. In the course of doing so, I noted that when the conflict of interest transaction is to be cleansed by a shareholder vote, I observed that "I would allow the interested shareholder to vote (but that's a story for another post)." Herewith that other post.

HJS opine that "the cleansing vote must be one of only the disinterested stockholders," citing for that proposition "Fliegler v. Lawrence, 361 A.2d 218, 221-22 (Del. 1976) (failing to accept cleansing effect of a shareholder vote because less than a majority of the votes cast were from disinterested shareholders)."

My objection is that Fliegler was wrongly decided. 

In Fliegler v. Lawrence, the defendants relied on DGCL § 144(a)(2) in arguing that shareholder approval relieved defendants of the common law obligation to prove the transaction’s fairness. DGCL 144(a)(2) provides that a conflicted interest transaction "between a corporation and 1 or more of its directors or officers, or between a corporation and any other corporation, partnership, association, or other organization in which 1 or more of its directors or officers, are directors or officers, or have a financial interest, shall be void or voidable solely for this reason, or solely because the director or officer is present at or participates in the meeting of the board or committee which authorizes the contract or transaction, or solely because any such director’s or officer’s votes are counted for such purpose, if: ... (2) The material facts as to the director’s or officer’s relationship or interest and as to the contract or transaction are disclosed or are known to the stockholders entitled to vote thereon, and the contract or transaction is specifically approved in good faith by vote of the stockholders ...."

The court agreed that shareholder ratification of a conflicted interest transaction shifted the burden of proof from the defendants to the objecting shareholders. On the facts of this case, however, the burden would not shift. A majority of the shares voted in favor of the transaction had been cast by the interested defendants in their capacities as Agau shareholders. In the court’s view, those votes should not count. Instead, only the votes cast by disinterested shareholders count and only the vote of a majority of such disinterested shareholders has the desired burden-shifting effect.

The court’s reading of § 144 is inconsistent with a plain-meaning approach to statutory construction. Section 144(a)(1) requires approval by “a majority of the disinterested directors,” but § 144(a)(2) requires only approval by a “vote of the shareholders.” The statute’s drafters thus inserted a requirement of disinterest in (a)(1) but not in (a)(2). Presumably, they did not forget the word disinterested in the presumably brief interval between writing (a)(1) and (a)(2). Accordingly, on the face of the statute, shareholder approval ought to be effective even if the shareholders are not disinterested.

Turning to policy, even if Fliegler were correctly decided, it applies only to cases under DGCL 144, which applies only to transactions involving a conflict of interest on the part of a director or officer. 

As to controlling shareholders, even Massachusetts--which has gone the furthest in imposing fiduciary duties on controlling shareholders of close corporations--acknowledges that controllers have "certain rights to what has been termed ‘selfish ownership’ in the corporation." Wilkes v. Springside Nursing Home, Inc., 353 N.E.2d 657, 663 (Mass. 1976).

Perhaps anticipating that principle, it was said in Ringling Bros-Barnum & Bailey Combined Shows v. Ringling, 53 A.2d 441, 447 (Del.1947) that:

Generally speaking, a shareholder may exercise wide liberality of judgment in the matter of voting, and it is not objectionable that his motives may be for personal profit, or determined by whims or caprices, so long as he violates no duty to his fellow shareholders.... 

My friend and mentor, the great corporate law scholar Michael Dooley, cited that case for the proposition that "shareholder autonomy [is] an independently important value in corporate law." Michael P. Dooley, Two Models of Corporate Governance, 47 Bus. Law. 461, 495 (1992).

Reforming the Delaware case law on controlling shareholders by resurrecting Sinclair Oil: A second comment on Hamermesh, Jacobs, and Strine

A few days ago I mentioned an exciting new paper from Lawrence Hamermesh, Jack B. Jacobs, and Leo E.  Strine (hereinafter HJS), Optimizing The World’s Leading Corporate Law: A 20-Year Retrospective and Look Ahead. They offer seven proposed reforms of Delaware case law, two of which apply to controlling shareholders:

Extending the inherent coercion theory expressed in Kahn v. Lynch beyond freezeout mergers to all controller transactions, thereby (i) making the procedural requirements specified in MFW applicable to decisions for which they were not designed and do not rationally pertain, and (ii) inappropriately expanding the range of full discovery and judicial review for fairness. We advocate abandoning Lynch‘s inherent coercion rationale and limiting the reach of MFW to transactions in which a controlling stockholder seeks to acquire the minority's shares, or a statute requires the approval of both the board and the stockholders.

What's interesting about their proposal is that they don't quite have the courage of their convictions. They point out, for example, "that (i) independent directors and stockholders can exercise real leverage and make informed choices when faced with a conflict transaction involving a controller, and (ii) Delaware law is vibrant enough to protect minority stockholders from retribution by a controller that did not get its way." 

Later in the article they expand on those points:

[When Jacobs and Strine's earlier article] was published, independent directors had already shown themselves capable of standing up to corporate managers, and CEO tenure had been declining as a result. Independent directors increasingly owed their continued access to directorships not to ties to management, but to their willingness to support policies that powerful institutional investors liked. These same institutional investors had shown themselves willing to criticize companies — including those with controlling stockholders — and to dissent at the ballot box. Moreover, Delaware courts had proven vigilant in policing electoral manipulation and coercion of stockholders in the voting process, and would readily address any controller who reacted to a negative vote with retribution. Likewise, even controllers had to be sensitive to the prospect that replacing independent directors who said no to a conflict transaction with ones who would do their bidding would impair their ability to raise debt and other capital. ...

Market activity since then has only strengthened that argument. Institutional investors have a powerful voice, no fear of controlling stockholders or corporate management. Stockholders challenge them &equently, and they have hedge funds and the media to help them. Independent directors are under great scrutiny too, and are expected to act aggressively in M&A situations to make sure that the public investors get a good deal. Proxy advisors and analysts scrutinize deals and help institutional investors decide how to vote.

The logic of their argument is that judicial review of a controlling shareholder transaction should not automatically be subject to entire fairness review. Yet, as we have seen, HJS would retain fairness review in cases in which "a controlling stockholder seeks to acquire the minority's shares, or a statute requires the approval of both the board and the stockholders." Why not go all the way?

Which brings us to the question of when entire fairness should be the standard. As HJS explain, there has been a trend towards expanding the scope of entire fairness to include cases beyond freeze-outs and other events in which the statute requires the approval of both the board and the stockholders. They criticize that trend:

[Delaware law is I]nsufficiently distinguishing between transactions involving classic self-dealing and transactions in which a fiduciary (whether a director or controlling stockholder) receives an additional benefit only because of being differently situated, thereby extending entire fairness review to a context where it does not fit. We advocate restoring that distinction, at the injunctive stage, by applying Unocal and Revlon intermediate judicial review to transactions where a fiduciary merely receives (but does not force) a benefit, such as a post-merger compensation package, not received by other stockholders. In a post-closing damages case, the review standard should require the plaintiff to prove a breach of the duty of loyalty and resulting damages.

Hence, they "acknowledge the many cases stating that any conflicted self-dealing transaction with a controlling stockholder is subject initially to the entire fairness standard." In light of the reality of independent director and institutional investor developments they discussed in the excerpts above, however, they deplore that trend.

Extending Lynch's inherent coercion doctrine after MFW had effectively rejected it, thereby dooming to failure any motion to dismiss unless the controller employs the costly MFW procedures, will not generate systemic value for diversified stockholders. Instead, it is more likely to result in excessive transaction costs, increased D&O insurance costs, and contrived settlements designed only to avoid the costs of discovery and justify the attorneys' fee that motivates most corporate representative suits.

They are particularly critical of cases in which Delaware courts have been "expanding the use of non-ratable benefits as a basis for expanding the scope of the definition of self-dealing transactions."

If the goal is to limit the situations in which a transaction involving a controlling shareholder is subject to entire fairness review, which seems the right goal for the reasons they so eloquently explain, it is curious to me that they ignore a tool lying close at hand; namely, the Delaware Supreme Court's decision in Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971), which they cite but once and in a string cite for the proposition that "the fact that a controlled company makes a decision benefiting its parent should not invoke the entire fairness standard absent harm to the corporation or the minority stockholders."

In my view, Sinclair Oil should be foundational case for analysis of controlling shareholder cases. I discuss it at length in my book Corporate Law (Concepts and Insights):

The Delaware supreme court identified two standards potentially applicable in such situations: the business judgment rule and the intrinsic fairness rule. Under the business judgment rule, the directors of Sinven get the benefit of a rebuttable presumption of good faith. Under the intrinsic fairness test, the burden of proof is on the directors to show, subject to close scrutiny, that the transactions were objectively fair to Sinven. In this case, as in most, it mattered quite a lot which standard applied. As is often the case, the party bearing the burden of proof on a given dispute lost.

Under Sinclair Oil, a court will apply the intrinsic fairness standard, as opposed to the business judgment rule, when the parent has received a benefit “to the exclusion and at the expense of the subsidiary.” In other words, the fiduciary obligations owed by a parent corporation are limited to self-dealing. The more exacting intrinsic fairness standard comes into play only when the parent is on both sides of the transaction and, moreover, used its position to extract non-pro rata benefits from a transaction to the minority shareholders’ detriment. (Page 210)

So here's how I think controlling shareholder transactions should be reviewed: Does the corporation have a controlling shareholder? If yes, does the transaction, contract, or other event result in the controller getting a benefit “to the exclusion and at the expense of the" minority? This question is essential because it ensures that courts will only get involved where there is a real conflict in the sense of a detriment to the minority, not just a benefit to the controller.

If there is no benefit to the controller at the expense of and to the exclusion of the minority, the business judgment rule should apply. This should be a full stop with no further judicial review, as I agree with HJS that the "vestigial waste" standard should be retired.

If there is such a benefit, however, then entire fairness should be the standard of review with the burden of proof on the defendant. If the transaction was approved either by a majority of the disinterested directors or a majority of the shareholders, then the burden of proof should be on the plaintiff to show that the transaction was not fair to the corporation. If the transaction complies with the full set of MFW conditions, then again the business judgment rule should be invoked to preclude any further judicial review.

Notice that my proposal goes one step beyond HJS in that I would apply the above formula to all transactions involving a controlling shareholder, including going private transactions and ones in which the board and shareholders must vote. Notice also that I would allow the interested shareholder to vote (but that's a story for another post).

My proposal has two hard stops: If there was no non-ratable benefit gained by the controller, the BJR applies and--unlike current law--judicial review is precluded. The vestigial waste theory dies. There is precedent for this. Under the MBCA, where conflict of interest transactions are properly approved by the board or shareholders, there is no further judicial review. Likewise, if there was a non-ratable benefit, the controller can still get a hard stop--i.e., application of an irrefutable BJR--if it complies with both MFW conditions. In addition, I could be persuaded that complying with either disinterested director or shareholder approval should invoke the BJR.

Having hard stops available is critical; because the problem with a burden shift approach Ii.e., Lynch and MFW insofar as the latter retains the vestigial waste review), is that it does not reduce rent-seeking in a game where the plaintiffs are not real parties in interest, and the game is about attorneys’ fees. If there is no dismissal option, there will be excessive litigation costs.

In any case, I go on in Corporate Law (Concepts and Insights) to explain that you can understand many controlling shareholder doctrines through the Sinclair Oil lens. I argue for example, that sale of control cases like Perlman v. Feldmann can be understood as an application of Sinclair Oil:

Perlman does not stand for the proposition that a controlling shareholder must give all other shareholders an equal opportunity to sell their stock on a pro rata basis. Instead, it simply stands for the proposition that a controlling shareholder may not usurp an opportunity that should be available to all shareholders. One could have reached the very same result under a Sinclair Oil-style analysis. The controlling shareholder received a benefit “to the exclusion and at the expense” of the minority. Not only were the minority excluded from the opportunity to sell at a premium, they were left worse off as a result.

Beyond Perlman’s unique facts, where are corporate opportunity issues most likely to arise? Probably in connection with structuring of acquisitions. Suppose Lorraine Looter approaches Susan Stockholder with an offer to buy Stockholder’s control block at a premium. Should there be liability? Not if we adopt the Sinclair Oil analogy. The majority shareholder can do whatever she wants as long as she does not deprive the minority shareholders of something to which they are entitled. On these facts, there is no corporate opportunity to be usurped. (Pages 218-19)

Later in the book I explain how you could use Sinclair Oil to explain cases involving refusal by a controlling shareholder to allow payment of a dividend.

Do You Remember Sherron Watkins? Or Just The Myth?

Corporate Counsel reports:

While Frances Haugen and Tyler Shultz/Erika Cheung are currently top of mind, there was a time – 20 years ago! – when the world was abuzz about Sherron Watkins, who raised concerns internally at Enron and later testified before Congress about those warnings.

A recent Bloomberg article checks in on where the major Enron players are today, and reports that Watkins now teaches business ethics. Here’s a Houston news outlet with a couple of short video interviews in which Sherron shares what the company’s collapse looked like from the inside – and how it still feels like yesterday to her.

Personally, I think Watkins gets way too much credit:

Part of the Enron mythology is that former Enron VP Sherron Watkins blew the whistle on Ken Lay, Jeff Skilling, and their fellow miscreants. In fact, however, so-called “Enron whistle-blower” Sherron Watkins never really blew a whistle. A real whistle-blower would have reported the misconduct to the SEC or the cops. Watkins simply reported it to Ken Lay, and even warned him that potential real whistle-blowers were lurking among within the company.

Indeed, there is a school of thought that Watkins got away with insider trading:

Watkins’ testimony was downright bizarre regarding her $47,000 in insider trades of Enron stock that she made after delivering her memo to Lay and prior to the company’s announcement of the charge to earnings. Despite having certified in a 2002 Enron employment agreement and sworn in Congressional testimony that she had not engaged in any illegal insider trading while at Enron, Watkins yesterday conceded on direct examination that the trades were not “proper” because “I had more information than the marketplace did.”

Extending Caremark to Climate Change Risk Management and Other ESG Issues Would Simply Compound the Original Mistake

Alex Cooper, Cynthia Williams, Ellie Mulholland, Robert Eccles, and Sarah Barker argue that directors of Delaware corporations face Caremark liability for climate change risk management failures.

As discussed in detail in a new paper published in October 2021 by the Commonwealth Climate and Law Initiative (CCLI), climate change has therefore evolved from an “ethical, environmental” issue to one that presents foreseeable financial and systemic risks (and opportunities) over mainstream investment horizons. This evolution has substantially changed the relevance of climate change to the governance of corporations, which has implications for the fiduciary duties of directors and officers under Delaware law. ...

Climate change is likely to significantly increase the risks facing a corporation’s operations, and through government’s efforts to halt climate change and protect economies and communities from its impacts, increase its regulatory obligations. Therefore, in the context of climate-related risks, oversight liability may arise where directors and officers:

• • fail to consider or oversee the implementation of climate-related legal risk controls;
  • fail to monitor mission-critical regulatory compliance, either specific climate change-related regulations or existing regulations which require consideration or disclosure of climate change risks. This latter category is likely to include a broad range of regulations, but may include: securities laws, which require listed companies to disclose material risks; environmental laws, as the physical effects of climate change catalyze infrastructure failure; and health and safety laws for companies with employees are exposed to increasingly hostile conditions; or
  • fail to monitor climate-related mission-critical operational and business risks.

It's not entirely clear whether they think that's a good thing or not. But their descriptive analysis is spot on. The precautions they urge boards to take seem advisable. Those precautions might even help save the planet, which would be a good thing.

In sum, I agree that there is a risk here. But insofar as the ought questions are concerned, I think courts should not allow that risk to materialize. I elaborate in my paper Don’t Compound the Caremark Mistake by Extending it to ESG Oversight (September 2021), which is forthcoming in The Business Lawyer. In it, I argue that:

Since the foundational decision in In re Caremark Intern. Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996), Delaware corporate law has required boards of directors to establish reasonable legal compliance programs. Although Caremark has been applied almost exclusively with respect to law and accounting compliance, the original Caremark decision contemplated applying the oversight duty to the corporation’s “business performance.” Accordingly, there is no doctrinal reason that Caremark claims should not lie in cases in which the corporation suffered losses, not due to a failure to comply with applicable laws, but rather due to lax risk management.

The question thus arises as to whether Caremark should be extended to board failures to exercise oversight with respect to environmental, social, and governance (ESG) factors. Obviously, where existing legislation or regulations impose compliance obligations in ESG-related areas, such as human resources, the environment, or worker safety, Caremark already applies. As such, boards must “ensure that compliance and monitoring systems are in place” to oversee corporate compliance with those laws.

Many ESG issues are not yet the subject to legal requirements, however. The question addressed in this Article is whether the board’s Caremark obligations should be extended to encompass oversight of corporate performance with such issues. In other words, should the board face potential liability not just for failing to ensure that the company has adequate reporting and monitoring systems in place to insure compliance with ESG-related legal requirements, but also to monitor ESG risks in areas where corporate compliance would be voluntary or aspirational.

As I explained in a summary version of article at CLS Blue Sky Blog, such an extension would be highly undesirable. First, Caremark was wrong from the outset. Caremark’s unique procedural posture, which precluded any appeal, gave Chancellor Allen an opportunity to write “an opinion filled almost entirely with dicta” that “drastically expanded directors’ oversight liability.” In doing so, Allen misinterpreted binding Delaware Supreme Court precedent and ignored the important policy justifications underlying that precedent.

Second, Caremark was further mangled by subsequent decisions. The underlying fiduciary duty was changed from care to loyalty, with multiple adverse effects. In recent years, moreover, there has been a steady expansion of Caremark liability. Even though the risk of actual liability probably remains low, there is substantial risk that changing perceptions of that risk induces directors to take excessive precautions.

Finally, applying Caremark to ESG issues will undermine Delaware’s clear law of corporate purpose by extending director oversight duties to areas of social responsibility unrelated to corporate profit. Caremark can be justified as ensuring that a corporation complies with applicable laws, but ESG compliance remains voluntary. Advocates of extending Caremark to encompass ESG compliance thus likely hope doing so will push companies to adopt what they regard as socially responsible policies but which they have not been able to mandate through the political process.] Asking corporate executives to take on governmental functions not only asks them to undertake tasks for which they are untrained and for which their enterprise is unsuited, it also subverts the basis of a liberal democracy. Government efforts to solve social problems are inherently limited by the checks and balances baked into the American political system. Mandated board attention to ESG risks would erode those checks and balances by asking unelected executives to undertake solving social ills.

Taken together, these negatives—the errors embedded in the original Caremark decision, the recharacterization of the oversight obligation as a duty of loyalty, and its potential extension to aspirational rather than binding obligations—add up to a whole that is much worse than the individual elements. There has long been a risk that expansive readings of Caremark will “undermine the long established protections of the business judgment rule.”

Expanding Caremark to ESG issues would continue the process of undermining those protections and, more generally, threaten the board-centric model of corporate governance that lies at the heart of Delaware’s dominance of the market for corporate charters. In practice, extending Caremark to ESG considerations would subordinate the board’s view of how much it should measure and manage to the views of external standard setters or consultants. The likely result would be a regime in which following “best practices” as defined by expert bodies would be the only sure-fire protection against duty of loyalty suits.

Note to adopters of Bainbridge's Business Associations Cases and Materials

The book's website has an update memo with UFCW v. Zuckerberg and notes, which updates the Delaware law of demand excusal.

Francis Pileggi said some nice things about yours truly

I very much appreciated his kind words:

Professor Stephen Bainbridge, a leading corporate law scholar whose many publications are cited in opinions of Delaware’s Court of Chancery and Supreme Court, recently provided learned commentary about the latest guidance by the SEC on Rule 14a-8 regarding shareholder proposals.

 

Hamermesh, Jacobs, and Strine on "Optimizing The World’s Leading Corporate Law": Part 1 Controlling Shareholders--Plus Lipton

There is an exciting new paper from Lawrence Hamermesh, Jack B. Jacobs, and Leo E. Strine (hereinafter HJS), Optimizing The World’s Leading Corporate Law: A 20-Year Retrospective and Look Ahead. Here we have two prominent and respected ex-members of the Delaware Chancery and Supreme Courts plus a highly respected academic expert on Delaware corporate law evaluating the state of Delaware corporate law.

Here's the abstract:

In a 2001 article (Function Over Form: A Reassessment of Standards of Review in Delaware Corporation Law) two of us, with important input from the other, argued that in addressing issues like hostile takeovers, assertive institutional investors, leveraged buyouts, and contested ballot questions, the Delaware courts had done exemplary work but on occasion crafted standards of review that unduly encouraged litigation and did not appropriately credit intra-corporate procedures designed to ensure fairness. Function Over Form suggested ways to make those standards more predictable, encourage procedures that better protected stockholders, and discourage meritless litigation, by restoring business judgment rule protection for transactions approved by independent directors, the disinterested stockholders, or both.

This article examines how Delaware law responded to the prior article’s recommendations, concluding that the Delaware judiciary has addressed most of them constructively, thereby creating incentives to use procedures that promote the fair treatment of stockholders and discourage meritless litigation. The continued excellence and diligence of the Delaware judiciary is one of Delaware corporate law’s core strengths.

But some recent cases have articulated standards of review that involve greater than optimal litigation intensity and less than ideal respect for decision-making in which independent directors and disinterested stockholders have potent say. Those standards also impair the integrity of Delaware’s approach to demand excusal in derivative cases and the identification of controlling stockholders. We also propose eliminating concepts like substantive coercion that do not provide a legitimate basis for resolving cases. Finally, we urge action to correct new problems such as the unfair targeting of corporate officers for negligence claims in representative actions and the frustrating state of practice under Delaware’s books and records statute.

There is so much in this article to discuss that I expect to get a number of blog posts out of it. Today, I'm starting with their discussion of controlling shareholders because there is also an important new article out from my Twitter friend Ann Lipton, The Three Faces of Control. Herewith her abstract:

Controlling shareholders are subject to distinct legal obligations under Delaware law, and thus Delaware courts are routinely called upon to distinguish “controlling shareholders” from other corporate actors. That is an easy enough task when a person or entity has more than 50% of the corporate vote, but when a putative controller has less than 50% of the vote – and is nonetheless alleged to exercise control over corporate operations via other means – the law is shot through with inconsistency.

What is needed is a contextual approach that recognizes that the meaning of control may vary depending on the purpose of the inquiry. Under Delaware doctrine, the controlling shareholder label subjects that entity to unique legal treatment along three distinct dimensions. First, controlling shareholders – unlike minority shareholders – have fiduciary duties to the corporation. Second, interested transactions with controlling shareholders – unlike interested transactions with other fiduciaries – are subject to a unique cleansing regime in order to win business judgment deference from reviewing courts. Third, when certain transactions involving sales of control are challenged in court, they may be treated as direct rather than derivative actions, even when similar transactions that do not involve control sales would be treated as purely derivative.

By teasing out these three aspects of the legal framework and analyzing them separately, courts can more closely attend to the reasons why control carries special significance, and ultimately develop a more rational and consistent set of definitions. Most critically, courts may properly designate someone a controlling shareholder for some purposes, but not others.

Herewith HJS' summary of their argument with the controlling person standard:

[They object to the way courts have enlarged] the definition of “controlling stockholders” to include persons having little or no share voting power, and to lump together unaffiliated stockholders into a “control bloc,” so that a different standard of review applies, thereby expanding the range of full discovery and judicial review for fairness. To address this concern, we propose limiting the concept of “controlling stockholder” to the situation where a stockholder’s voting power gives it at least negative power over the company’s future, in the sense of acting as a practical impediment to any change of control.

HJS note that "Under Delaware law, it was historically difficult to establish that a stockholder having less than majority ownership was a controlling stockholder." (35) Yet, as Lipton points out, the definition has evolved to include "so many factors and considerations that it allows for a great variety of actors to be designated as controllers." (3) HJS would agree, attributing that development to "the revival of Lynch’s inherent coercion theory has created pressure to expand the definition of controlling stockholder to reach persons having far less than a voting majority, but are either critically important to the company or associated with other stockholders as a group." (36)

There are some key differences in their analyses. Lipton is much more open to the idea that contract rights can make one a corporate controller, at least for purposes of deciding whether they owe fiduciary duties to the entity and the fellow shareholders: 

... if control over another’s assets is the hallmark of a fiduciary – and if it is the controlling shareholder’s dominion over corporate assets that gives rise to fiduciary duties on its part – then it follows that no particular level of stock ownership should be necessary before one can be deemed a controller. Indeed, there is no reason that stock ownership, specifically, should be required at all. This is particularly so because in a world where control rights are often allocated not through equity interests directly, but through shareholder agreements, the distinction between control emanating from stock holdings and control emanating from contractual rights is difficult to parse. (7)

In contrast, HJS argue that:

Another troublesome issue arises where a court accepts the claim (at least for purposes of a motion to dismiss) that a person is a controller, with concomitant fiduciary obligations, despite owning no shares of stock at all. ... Our concern, however, is that the amorphous concept of “soft power” not arising out of stock ownership could be applied to trigger the entire fairness standard and preclude dismissal, where the premise of control involves circumstances that reflect garden variety commercial dealings, such as “the exercise of contractual rights to channel the corporation into a particular outcome by blocking or restricting other paths, ... the existence of commercial relationships that provide the defendant with leverage over the corporation, such as status as a key customer or supplier, [or] [l]ending relationships, [which] can be particularly potent sources of influence.”The courts should heed doctrinal guardrails against overuse of this “soft power” concept: “authority [that] takes the form of a contractual right ... must give the nonstockholder power akin to ‘operating the decision-making machinery of the corporation’ (a ‘classic fiduciary’), rather than ‘an individual who owns a contractual right, and who exploits that right,’ forcing a corporation to 'react' (which does not support a fiduciary status).” (39-40)

It will often be the case that creditors, for example, have contractual rights that, if exercised, sharply limit corporate decision-making freedom but I don't think that should result in them being treated as a controller for any purpose. I'm thinking here of classic Business Association cases like A. Gay Jenson Farms Co. v. Cargill, Inc., 309 N.W.2d 285 (Minn. 1981), or Martin v. Peyton, 158 N.E. 77 (N.Y. 1927). Both involved situations in which contract creditors had certain contractual rights that allegedly resulted in the defendants having sufficient control rights to be deemed a principal of an agent in the former case and a partner in the latter. I think Coppola v. Bear Stearns & Co., Inc., 499 F.3d 144, 150 (2d Cir. 2007),got it right when the court explained that "the dispositive question is whether a creditor is exercising control over the debtor beyond that necessary to recoup some or all of what is owed, and is operating the debtor as the de facto owner of an ongoing business."

There seems to be a consensus, however, that where there is no majority shareholder courts should focus on whether the alleged controller's "degree of entrenchment and ... ability to retaliate against disobedient shareholders" (Lipton at 16) and "the potential to use affirmative voting power to unseat directors and implement transactions that the minority stockholders do not like, and use blocking voting power to impede other transactions." (HJS at 37)

I would love to see HJS and Lipton sit down to hash all this out.

In any case, both of these articles are well worth reading.

 

New and Continuing Challenges to California's Board Diversity Quota Laws

Keith Paul Bishop has the details:

Tomorrow, a trial is scheduled to begin in California Superior Court on the constitutionality of SB 826, California's female director quota law.  Crest v. Padilla (Cal. Super. Ct. Case No. 19STCV27561).   ...

In addition, there is a separate challenge to the law pending in the U.S. District Court for the Eastern District of California.  Meland v. Padilla (Case No. No. 2:19-cv-02288-JAM-AC). ...

Last week, the National Center for Public Policy Research filed a complaint in U.S. District Court challenging both SB 826 and AB 979.  The complaint has a single claim for relief based on the Fourteenth Amendment of the U.S. Constitution and 42 U.S.C. § 1983. 

I'll remind readers that I have taken the position that these laws are unconstitutional under the internal affairs doctrine, which is a penumbra formed by the emanations of the dormant Commerce Clause and the Full Faith and Credit Clause.