ProfessorBainbridge.com

The State of Shareholder Inspection Rights under Delaware Law

Friend of the blog (and of yours truly) Francis Pileggi has a great post on the state of the law under section 220.

Reassessing the Empirical Evidence on U.S. Dual-Class Stock

Bobby Reddy has a post at CLS' blog, in which he reports that:

I review an array of empirical studies on U.S. dual-class firms, which embrace a range of performance measures – not just Tobin’s Q or derivatives thereof.  I find that, on average, dual-class firms do show lower firm valuations than one-share, one-vote firms.  However, when assessed from the perspective of accounting measures of performance, dual-class firms show greater operating performance than matched one-share, one-vote firms.  Furthermore, investors in notional portfolios of inferior voting stock of dual-class firms earn at least equal, and possibly greater, returns than investors in notional portfolios of similar one-share, one-vote firms.

If dual-class firms are valued less than one-share, one-vote firms, but perform better financially and generate higher buy-and-hold stock returns than one-share, one-vote firms, it would suggest that the market is excessively discounting dual-class firms.  There is no evidence that, on average, dual-class structure is used to exploit public stockholders, at least not to the extent that it outweighs the structure’s positive impact on operating performance.  The market appears to discount dual-class firms on the assumption that public stockholders will be harmed, but that harm is not, on the whole, born out in practice.

Go read the whole thing.

One huge reason Delaware corporate law is preferable to, say, California's

Contrary to the nattering of anti-Delaware fanatics, with their "race to the bottom" nonsense, I tell my students that one of the big reasons Delaware is the state of choice for incorporation is that the volume of Delaware law is sufficiently high that most questions have answers. In contrast, to pick the state with the biggest economy, you cannot say the same thing about California. Keith Paul Bishop offers what I regard as a case in point:

Although Caremark was decided more than a decade ago, no California appellate court has adopted it in a published decision.  The Court of Appeal cites Caremark in Leyte-Vidal v. Semel, 220 Cal. App. 4th 1001 (2013).  Caremark also makes an appearance in Robbins v. Alibrandi, 127 Cal. App. 4th 438 (2005) but the court cites it with respect to the standard of review to be applied to settlements.  Superior Court Judge Peter H. Kirwan did sustain a demurrer to Caremark claims in In re Apple E-Book Deriv. LItig., 2015 Cal. Super. LEXIS 2655.  Apple is a California corporation and Judge Kirwan did not explain why he believed that a claim fashioned by a trial court in another state was the law in California.

Should corporations owe fiduciary duties to bondholders?

If we may allude to the biblical injunction that no one can serve two masters, for example, fiduciary duties to bondholders would create a two masters problem. When shareholder and bondholder interests conflict, which interests do the directors pursue? A closely related concern is the potential that directors would camouflage self-interested decisions by aligning themselves with the affected group whose interests mirror their own.

In addition, the underwriting process ensures that the indenture will contain efficient protections for bondholders. Some argue that the underwriters have a pecuniary interest in pleasing the issuer, not the bondholders,^[1] but the relationship between underwriters and bondholders is a classic repeat transaction phenomenon. Underwriters will not sully their reputation with bondholders for the sake of one issuer.^[2] In a firm commitment underwriting, moreover, the underwriters buy the securities from the issuer. If the indenture does not provide adequate levels of protection, the underwriters will be unable to sell the bonds.^[3]

Portfolio theory further suggests that bondholders are fully compensated for the risks posed by potential breaches of fiduciary duty. Arguably such risks are unsystematic in nature, so that the bondholders can eliminate them by holding a diversified portfolio. Even if such risks are characterized as systematic risks, moreover, the pricing mechanism will ensure a rate of interest that compensates the bondholders for those risks.

Consequently, the better view is that neither the corporation itself nor its officers and directors owe fiduciary duties to bondholders, as the leading cases hold.^[4] Instead, “the relationship between a corporation and the holders of its debt securities, even convertible debt securities, is contractual in nature.”^[5] The indenture thus both defines and confines the scope of the corporation’s obligations to its bondholders.

Internal Affairs, the California Board Gender Quota Law, and Chin v. CH2M Hill Companies, Ltd.

Regular readers know that I am working on a forthcoming (with Foundation Press Book) Advanced Corporation Law: A Practical Approach to Corporate Governance. The book is almost done and I have started working on the teachers manual. Today, I tackled the section dealing with California's 2018 board gender quota statute, SB 826 [codified at California Corporations Code § 301.3], which imposed gender diversity quotas on all public corporations whose principal executive offices are located in California. If the corporation has six or more directors, it must have at least three female directors. If it has five board members, it must have at least two female members. If the board has four or fewer members, it must have at least one female director. 

Regular readers will recall that I wrote a briefing paper for The WLF Legal Pulse, in which I argued that the so-called internal affairs doctrine is not just a choice of law doctrine but also makes it "unconstitutional for a state other than the state of incorporation to attempt to regulate a corporation’s internal affairs." 

I excerpt the briefing paper in the forthcoming text and then pose this question:

Is board diversity an internal corporate affair? Does it matter whether one is applying the internal affairs doctrine as a rule of conflicts of law or one of constitutional law?

I am not aware of any case squarely on point, but—unfortunately, only after I published the briefing paper excerpted in the main text—I found a potentially relevant decision; namely Chin v. CH2M Hill Companies, Ltd.[1]

Plainitff Chin was kicked off defendant CH2m Hill Companies, Ltd. (“LTD”)’s board of directors. (More precisely, her term expired and she was not nominated for re-election.) She claimed “that she was not re-nominated to LTD's board of directors because Defendants discriminated against her on the basis of her sex, race, and disability and because Plaintiff had complained of gender discrimination in connection with a female employee whose employment had been terminated.” She brought suit under NY state civil rights statutes.

The defendants argued “that this case must be governed by the law of the state of incorporation and that New York City cannot regulate the internal affairs of a foreign corporation.” The court rejected that argument:

The cases cited by Defendants deal squarely with issues that “closely affect the organic structure or internal administration of the corporation.” Restatement (Second) of Conflict of Laws § 309 cmt. c (1971); see, e.g., In re BP P.L.C. Deriv. Litig., 507 F.Supp.2d 302 (S.D.N.Y.2007) (applying English corporate law to claims of breach of fiduciary duty to shareholders, waste of corporate assets, and commodities trading activities); Prescott v. Plant Indus., Inc., 88 F.R.D. 257 (S.D.N.Y.1980) (applying the internal affairs doctrine where seven individuals received equal votes for three open positions on the board of directors). While undoubtedly set in the context of a board election, our case is less about the validity of the election, or even the nomination of board members, than it is the “existence of groups prejudiced against one another and antagonistic to each other because of their actual or perceived differences, including those based on race, color, ... gender, [or] disability....” N.Y.C. Admin. Code § 8–101. One part of the relief Plaintiff seeks does directly implicate the internal administration of the corporation; reinstatement to the board. The case at bar, however, is concerned with matters that are far broader than the organic structure or internal administration of LTD. Reinstatement to the board may (or may not) be available to Plaintiff, but that does not render impossible the prospect of collecting damages. The aims of the internal affairs doctrine—to save a corporation from conflicting demands—are not necessarily frustrated by the potential requirements of the NYCHRL. This raises the questions of whether there is even a conflict to begin with and whether, if compliance with the NYCHRL is in tension with the demands of Delaware corporate law, this is sufficient (in consideration with other factors) to find that Delaware has a greater interest.

The interest expressed by New York City is, in no uncertain terms, significant. See N.Y.C. Admin. Code § 8–101 (“[T]here is no greater danger to the health, morals, safety and welfare of the city and its inhabitants than the existence of groups prejudiced against one another and antagonistic to each other because of their actual or perceived differences.... [P]rejudice, intolerance, bigotry, and discrimination ... threaten the rights and proper privileges of its inhabitants and menace the institutions and foundation of a free democratic state.”).

I see no reason why a defender of the California statute could not make the same argument. Having said that, the Chin case is dealing not with the constitutionality of the statutes in question, but solely with a choice of law problem. as such, it does not resolve the statute of board diversity laws for purposes of the dormant Commerce Clause, which is the issue to which my briefing paper was addressed. Still, it adds an interesting wrinkle.

Why Have a Board of Directors?

Fortune editor-at-large Justin Fox once asked: "Why do companies have boards of directors, anyway?" Why aren't corporations run using "direct democracy—putting all major corporate decisions, including the choice of a new CEO, to a shareholder vote"? Or by "absolute corporate monarchy—allowing management to make all the decisions without oversight"? Good questions, all. On close examination, however, the modern system of corporate governance in which the corporate hierarchy is topped by a small committee of independent board members, who typically lack both day-to-day management power and any significant equity stake in the corporation, turns out to be a highly efficient solution to the problems of making decisions in complex organizations.

Why Not Direct Shareholder Democracy?

Nobel laureate economist Kenneth Arrow's seminal work on organizational decision making identified two basic decision-making structures: "consensus" and "authority." Consensus is utilized where each member of the organization has identical information and interests and will therefore select the course of action preferred by all the other team members. In contrast, authority-based decision-making structures arise where team members have different interests and amounts of information. They are characterized by the existence of a central agency to which all relevant information is transmitted and which is empowered to make decisions binding on the whole.

It is very hard to imagine a modern public corporation that could be effectively run using consensus-based decision-making mechanisms. At the most basic level, the mechanical difficulties of achieving consensus amongst thousands of shareholders impede direct democracy.

Even if those collective action problems could be overcome, however, active shareholder participation in corporate decision making still would be precluded by the shareholders' widely divergent interests and distinctly different levels of information. As to the former, while neoclassical economics assumes that shareholders come to the corporation with wealth maximization as their goal, and most presumably do so, once uncertainty is introduced it would be surprising if shareholder opinions did not differ on which course will maximize share value. As to the latter, shareholders lack incentives to gather the information necessary to actively participate in decision making and thus are rationally apathetic.

Consequently, it is hardly surprising that, among public companies, corporate governance precisely fits Arrow's model of an authority-based decision-making system. Shareholders lack the information and the incentives necessary to make sound decisions on either operational or policy questions. Under these conditions, Arrow predicts, it is "cheaper and more efficient to transmit all the pieces of information to a central place" and to have the central office "make the collective choice and transmit it rather than retransmit all the information on which the decision is based," which is precisely what a board-centered system of corporate governance does.[1]

Why Not Monarchy?

The more interesting question Fox poses can be rephrased as: Why a board rather than an individual autocrat? In theory, corporate governance has always been board-centered. As the Delaware General Corporation Law, for example, has long put it: the corporation's "business and affairs . . . shall be managed by or under the direction of the board of directors." The statutory model of corporate governance thus contemplates not a single hierarch, but rather a multi-member body that typically will act by consensus.

In practice, however, corporations were de facto run by an imperial CEO or a team of senior managers, with little or no interference from other stakeholders. Shareholders were essentially powerless and typically quiescent. Boards of directors were little more than rubber stamps.

Today, corporate governance looks very different. In recent years, several trends coalesced to encourage more active and effective board oversight. Much director compensation is now paid in stock, for example, which helps align director and shareholder interests. Courts have made clear that effective board processes and oversight are essential if board decisions are to receive the deference traditionally accorded to them under the business judgment rule, especially insofar as structural decisions are concerned (such as those relating to management buy-outs). Third, director conduct is constrained by an active market for corporate control, ever-rising rates of shareholder litigation, and, some say, activist shareholders. As a result, modern boards of directors typically are smaller than their antecedents, meet more often, are more independent from management, own more stock, and have better access to information. Real world practice thus increasingly has come into line with the statutory model of board primacy.

The economic advantages associated with board primacy vis-à-vis CEO primacy come into play when we consider the three major functions of the board of directors: (1) providing an in-house set of specialists and access to a network of outside resources; (2) broad policy making; and (3) monitoring and disciplining top management. A sizeable body of research suggests that groups are superior to individuals in all three areas.

Networking is the easiest context in which to make the case for groups, of course. Unlike a single CEO, who often came up through the ranks, specializing in a particular area of the firm's business, a diverse board comprised mainly of outsiders links the firm to a network of other companies who may be useful suppliers or customers. Likewise, such a board often includes persons with specialized expertise, such as lawyers or bankers, who can bring valuable outsider perspectives to the table.

As for policy making and monitoring, both of these involve the exercise of critical evaluative judgment. A wealth of research in psychology, sociology, and behavioral economics confirms that groups often make better decisions than individuals. Even more strikingly, the conditions under which groups outperform individuals in laboratory settings have important similarities to board decision making.

Two examples might suffice. In the 1930s, Marjorie Shaw conducted a classic experiment in which four-person teams of undergraduates solved various problems with single, self-confirming solutions (so-called "Eureka" problems.) One set of problems involved three variants on the classic missionaries and cannibals game.[2] The other set of problems required subjects to solve two word puzzles and another involving spatial relationships. The proportion of correct solutions in a sample of groups was significantly higher than a sample of individuals working alone.

Some 50 years later, Frederick Miner devised another classic experiment to test the ability of groups to exercise evaluative judgment vis-à-vis that of individuals. Miner's experiment required 69 self-selected groups, each composed of 4 undergraduate business students, to solve the so-called winter survival exercise. This exercise, which is variously attributed, has become something of a benchmark standard in the field. The subject group is told that they are survivors of an airplane crash at a remote location. They first must decide whether to walk out or remain at the crash site. They then must rank the utility of 15 survival aids. Miner found that group rankings were more accurate than those of the average individual subject.[3]

Although Miner's experiment may not seem relevant to corporate governance, it has certain instructive features. First, it used business students, who presumably resemble corporate directors more closely than other plausible experimental subjects. Second, the subjects knew one another before becoming members of the group and were allowed to form their own groups, both of which somewhat replicate the process by which boards form. Finally, and most importantly, the subjects shared a single goal (i.e., survival). Granted, the experiment thus did not require them to aggregate preferences as to which there might be value differences, but rather to pool their collective knowledge and use that knowledge to evaluate alternatives in light of the shared goal. If we assume that directors generally share a primary goal of shareholder wealth maximization, however, this experimental condition also replicates corporate governance.

Even the limitations of Miner's study bear some resemblance to corporate boards, at least insofar as outsider dominated boards are concerned. Students subjects bring to the task only general human capital, and the experimental design cannot capture any equivalent to firm-specific human capital. Yet, outside directors accumulate significant firm-specific knowledge and human capital only after very long tenure. The subjects also had relatively little stake in the outcome, but many outside directors likewise lack a direct economic stake in the firm.

A wealth of other studies confirm these results, suggesting that decision making by groups will generally be preferable to decision making by an individual autocrat when it comes to the sort of critical evaluative judgments boards are asked to make. This is not to say that group decision making is always preferable. The old joke about the camel being a horse designed by a committee captures the valid empirical observation that individuals are often superior to groups when it comes to matters requiring creativity. But while individuals may well be better at devising a brilliant plan, individuals often become wedded to their plans and fail to see flaws that others might identify. As such, you may want an individual to write a symphony, but a group to evaluate it. Group decision making checks individual overconfidence by providing critical assessment and alternative viewpoints.

As we have seen, most of what boards do requires the exercise of critical evaluative judgment, but not creativity. Even the board's policymaking role entails judgment more than creativity, because the board is usually selecting between a range of options presented by subordinates. The board thus serves to constrain subordinates who have become wedded to their plans and ideas, rather than developing such plans in the first instance.[4]

Why Not a Management Team?

Fox points out that "the chief decisionmaking group at most large corporations is top management, not the board." True, day-to-day decision making may be vested in the hands of a top management team, but ultimate power to hire and fire remains with the board.

In theory, the CEO could be monitored by his or her subordinates. Indeed, economist Eugene Fama contends that lower level managers in fact monitor more senior managers. Such up-stream monitoring, however, does not take full advantage of specialization. One response to the agency costs inherent in the corporate separation of ownership and control is separation of "decision management"—initiating and implementing decisions—from "decision control"—ratifying and monitoring decisions. Such separation is a defining characteristic of the central office typical of M-form corporations. The M-form corporation replaces the simple pyramidal hierarchy with a more complex structure in which the central office has certain tasks and the operating units have others, which allows for more effective monitoring through specialization, sharper definition of purpose, and savings in informational costs. In particular, the central office's key decision makers—the board of directors—specialize in decision control. Because executives specialize in decision management, expecting them to monitor the CEO thus calls on the former to perform a task for which they are poorly suited.

A different critique of Fama's hypothesis is suggested by evidence with respect to meeting behavior from research on group decision making. In mixed status groups, higher status persons talk more than lower status members. Managers, for example, talk more than subordinates in business meetings. Such disparities result in higher status group members being more inclined to propound initiatives and having greater influence over the group's ultimate decision.

One function of the board of directors thus is providing a set of status equals for top managers. As such, corporate law's insistence on the superiority of the board to management begins to make sense. To the extent law shapes social norms, corporate law empowers the board to constrain top management more effectively by creating a de jure status relationship favoring the board.

New Institutional Economics has taught us that the firm must be viewed as an institution—more precisely, as a set of institutions—rather than as a mere production function. Specifically, the corporation consists of a set of production teams embedded within a hierarchical structure. At the apex of that hierarchy stands not an individual, but yet another team—the board of directors.

Team production is imperfect, whether the product is a manufactured good or a corporate decision. Teams are subject to unique cognitive biases, such as groupthink, and unique sources of agency costs, such as social loafing. With respect to the exercise of critical evaluative judgment, however, groups have clear advantages over autonomous individuals. Not only do groups clearly outperform average individuals in a given sample, there is considerable evidence that the process of group interaction has synergistic effects allowing groups to outperform even the best decision makers in the sample.

The author teaches law at UCLA and is a TCS Contributing Editor.

---

[1] [1] For more on this topic, see my article The Case for Limited Shareholder Voting Rights, 53 UCLA Law Review 601 (2006).

[2] In this game, subjects were given three disks representing missionaries and three disks representing cannibals. The missionaries and cannibals are on one side of a river. The decision maker must get all six to the other side of the river using a boat that can only carry two discs at a time. All missionaries and one cannibal can row. Cannibals must never outnumber missionaries in any location for obvious reasons, albeit politically incorrect ones. See Marjorie E. Shaw, Comparison of Individuals and Small Groups in the Rational Solution of Complex Problems, 44 Am. J. Psych. 491, 492-93 (1932) (describing problems).

[3] Frederick C. Miner, Jr., Group v. Individual Decision Making: An Investigation of Performance Measures, Decision Strategies, and Process Losses/Gains, 33 Org. Beh. and Human Performance 112 (1984).

[4] For more on the merits of group decision making, see my article Why a Board? Group Decision Making in Corporate Governance, 55 Vanderbilt Law Review 1 (2002).

More on the latest Caremark claim to survive a motion to dismiss

In an earlier post, I discussed Hughes v. Hu, which is the latest in a set of cases in which Caremark claims survived a motion to dismiss. Kevin La Croix has also written about the case, with a typically detailed and thoughtful post. (My thanks to Counselor LaCroix for kindly linking my post.) As LaCroix points out, the facts in this case are especially egregious:

The three recent Delaware decisions taken collectively serve to underscore the conclusion that under Delaware law corporate directors have a fiduciary duty to oversee their companies by creating and implementing systems of control and by monitoring the company’s management and operations, and that the failure to take these steps could result in the imposition of personal liability.

In analyzing the issues presented in the most recent case, it is clear that Vice Chancellor was most concerned about the defendants’ response to previously revealed problems. As the company’s 2013 10-K disclosed, the company and its directors and officers were already on notice that the company had problems with its internal controls and financial reporting, particularly with respect to related party transactions.

As Vice Chancellor Laster noted, despite these prior developments, “the allegations in this case support inferences that the board members did not make a good faith effort to do their jobs.”

The take home lesson I draw from that observation is that if you have problems big enough to warrant mentioning in your 10-K, FIX THEM!

LaCroix also points out the case has COVID-19 implications:

These developments may be particularly relevant now, as we anticipate claims that may arise in connection with the current coronavirus outbreak. The possibility that adverse company developments might result in breach of the duty of oversight claims has been a topic of discussion, particularly with respect to the first of the three recent Delaware duty of oversight cases, Marchand v. Barnhill.

Marchand involved a food manufacturer whose operations were shut down after a listeria outbreak resulted in the deaths of three customers. Because of the health related aspect of the underlying business problem and because of the resulting shut down, some commentators have suggested that the case might point toward future oversight breach cases arising out of the pandemic. The Duane Morris Business Law Blogto which I linked at the outset of this post notes that in light of these oversight duty concerns during the current coronavirus outbreak, “directors and officers have created and are implementing adequate controls and monitoring to avoid the potential that unforeseen events” might arise and lead to their potential liability.

But go read the whole thing.

Can a breach of fiduciary duty suit be brought directly?

A friend and fellow corporate law professor (one of those wise folks that use Klein, Ramseyer & Bainbridge) sent along this question:

On the issue of direct versus derivative claims, there is some language on pp. 360-61 of the casebook (and in the accompanying slides) that may be confusing.  We start with a general proposition that "a claim for breach of fiduciary duty can only be brought as a derivative suit" ( https://tremblylaw.com/difference-shareholder-derivative-suit-vs-direct-claim/ ) because fiduciary duties are generally understood run to the corporation, and thus any harm to the shareholders from breach thereof is derivative.  However, we are told on the bottom of p. 361 that "the Tooley test [for direct claims] has been limited to claims asserting breach of fiduciary duty."  If fiduciary claims are always derivative claims, why would we need a test for whether they can be brought as direct claims?  

Put another way, there seems to be an apparent conflict between a general rule that says fiduciary claims are always derivative and a test that at least implies some fiduciary claims can be brought as direct claims. 

My answer starts with rejecting the premise of the question; i.e., I don't agree that "a claim for breach of fiduciary duty can only be brought as a derivative suit.” To be sure, you can find opinions claiming that “cases are legion that a shareholder may not sue directly for breaches of duties by officers and directors of a company because those injuries are actually suffered by the corporation.”[1] It’s not clear when or where this belief took hold, but the weight of authority is to the contrary.

As the Delaware Supreme Court has explained:

Tooley and its progeny … deal with a different subject: determining the line between direct actions for breach of fiduciary duty suits by stockholders and derivative actions for breach of fiduciary duty suits subject to the demand excusal rules set forth in § 327 of the Delaware General Corporation Law, Court of Chancery Rule 23.1, and related case law.[2]

Obviously, it would be necessary to draw such a line only if there are two distinct categories that need to separated.[3]

Consider the classic business judgment rule case, Smith v. Van Gorkom, which was brought as “a class action”—not a derivative suit.[4] Likewise, in Omnicare, Inc. v. NCS Healthcare, the shareholders brought “a class action brought by NCS stockholders seeking to invalidate the merger primarily on the ground that the directors of NCS violated their fiduciary duty of care in failing to establish an effective process designed to achieve the transaction that would produce the highest value for the NCS stockholders.”[5]

In fact, most litigated cases fall into the direct category. Professors Black, Cheffins, and Klausner conducted a study of litigation involving outside directors, which found “136 hits for derivative suits and 235 hits for direct suits” in Westlaw’s MBUS-CS directory. They specifically identify “twelve post-1980 direct suit trials … involving fiduciary duty claims against outside directors of public companies, compared to “five post-1980 derivative suits … where there was a trial involving a claim for damages against outside directors of a public company.”[6]

Many scholars have read the law similarly. O’Neal and Thompson’s treatise, for example, opines that “A challenge to action taken by controlling shareholders or directors based on breach of fiduciary duty traditionally was brought as a derivative suit, but now is more likely to be brought as a direct suit.”[7]Deborah Demott asserts that “cases permit individual shareholders to sue directly when the directors misuse their powers,” resulting in a breach of fiduciary duty.[8] Nadelle Grossman states that “Stockholders can enforce directors' fiduciary duties through either a direct suit on behalf of that stockholder, where there is damage personal to that stockholder, or through a derivative suit to enforce the directors' duties on behalf of the corporation.”[9]

Is Caremark still the hardest claim for plaintiffs to win in corporate law?

Yet another Caremark claim has survived a motion to dismiss. One is reminded of the aphorism that once is a happenstance, two is a coincidence, and three is enemy action.

The case is Hughes v. Hu. VC Travis Laster summarized the company's deficiencies:

The Company has struggled persistently with its financial reporting and internal controls, encountering particular difficulties with related-party transactions. The complaint describes problems dating back to 2010. In March 2014, the Company publicly announced the existence of material weaknesses in its financial reporting and oversight system, including a lack of oversight by the Audit Committee and a lack of internal controls for related-party transactions. The Company pledged to remediate these problems. Instead, in March 2017, the Company disclosed that its preceding three years of financial statements needed to be restated. In connection with the restatement, the Company disclosed that it lacked:

• Sufficient expertise relating to technical knowledge of US GAAP requirements and SEC disclosure regulations;
• Sufficient expertise to ensure the completeness of the disclosure of financial statements for equity investments;
• Sufficient expertise to ensure the proper disclosure of related-party transactions;
• Effective controls to ensure the proper classification and reporting of certain cash and non-cash activities related to accounts receivable, accounts payable, and notes payable; and
• Sufficient expertise to ensure the accuracy of the accounting and reporting of income taxes and related disclosures.

Despite having pledged three years earlier to get its house in order, the Company had none of these necessary competencies.

The opinion has an extended analysis of how Rales v. Blasband and Aronson v. Lewis apply to Caremark claims.

As to the merits, Laster reported that:

A plaintiff can state a Caremark claim by alleging that “the company had an audit committee that met only sporadically and devoted patently inadequate time to its work, or that the audit committee had clear notice of serious accounting irregularities and simply chose to ignore them or, even worse, to encourage their continuation.” Guttman, 823 A.2d at 507. The mere existence of an audit committee and the hiring of an auditor does not provide universal protection against a Caremark claim. Compare Ash v. McCall, 2000 WL 1370341, at *15 n.57 (Del. Ch. Sept. 15, 2000) (concluding that audit committee and independent auditor were “some evidence” that the requisite systems existed), with Rich ex rel. Fuqi Int’l, Inc. v. Yu Kwai Chong, 66 A.3d 963, 983 (Del. Ch. 2013) (concluding that despite existence of audit committee and independent auditor, the company “had no meaningful controls in place”).

The complaint alleges facts that support an inference that the Company’s Audit Committee met sporadically, devoted inadequate time to its work, had clear notice of irregularities, and consciously turned a blind eye to their continuation. ...

The complaint in this case depicts directors who acted similarly to their counterparts in Marchand, who failed “to make a good faith effort—i.e., try—to put in place a reasonable board-level system of monitoring and reporting.” Marchand, 212 A.3d at 821. The allegations in this case support inferences that the board members did not make a good faith effort to do their jobs. The Audit Committee only met when spurred by the requirements of the federal securities laws. Their abbreviated meetings suggest that they devoted patently inadequate time to their work. Their pattern of behavior indicates that they followed management blindly, even after management had demonstrated an inability to report accurately about related-party transactions.

For blog commentary see Lynn Jokela, Steve Quinlivan, and Oderah Nwaeze. The latter helpfully focuses on the role the company's poor responses to plaintiffs Section 220 request:

• In Hughes, the Court of Chancery drew some negative inferences about the conduct of the Company’s board because the Company failed to produce exculpating information in response to the plaintiff’s demand under Section 220 of the Delaware General Corporation Law. Those negative inferences then were used to justify denying the defendants’ motion to dismiss.
  • Given this reality, companies should be strategic about what information they withhold in response to a Section 220 demand. Recognizing that most companies are reluctant to produce sensitive business information that could be used to support meritless claims, entities faced with a Section 220 demand must make sure to produce documents, communications, and other materials that may stop the Court of Chancery from crediting a plaintiff’s allegations against the company’s board and/or officers.

COVID-19 as a Force Majeure in Corporate Transactions

Timely new article:

This paper surveys the use of pandemic-related provisions in Material Adverse Effects ("MAE") provisions in a large data set of publicly disclosed M&A transactions spanning the years 2003-2020. We document a trend towards greater use of such provisions, taking off particularly after the H1N1 crisis in 2009, and spiking again in late 2019 and early 2020. These terms are invariably located in the exclusions/carve-outs to the MAE, and they are overwhelmingly accompanied by "disproportionate effects" language that tends to dampen the effect of the carve out. There is little discernible statistical relationship between the inclusion of a pandemic-related carve-out and the inclusion of a reverse termination fee ("RTF") granting optionality to the buyer; but when an RTF is present, its magnitude tends to be smaller in the absence of any pandemic-specific carve-out, suggesting some degree of observational complementarity between these terms.

Jennejohn, Matthew and Nyarko, Julian and Talley, Eric L., COVID-19 as a Force Majeure in Corporate Transactions (April 1, 2020). Available at SSRN: https://ssrn.com/abstract=3577701 or http://dx.doi.org/10.2139/ssrn.3577701

Are there any corporate law cases that deserve a book all to themselves?

At Public Discourse, Matthew Franck comments on a number of books each of which focuses on a single constitutional law case: 

... as I look around my shelves, I see a great many books on American political thought and constitutional law that have influenced my own work as a teacher and scholar of those subjects. The books I describe below have something in common: each is a deep reconsideration of a famous U.S. Supreme Court decision, with unexpected insights not only about the law but about the shape of our political order.

Which got me to wondering whether one could write similar books about cases from an important area of the law, such as corporate law. Any suggestions?

Who is in control? Delaware corporate law's answer

Under Delaware law, a shareholder is deemed to have control if the shareholder either owns a majority of the voting stock or exercises control over corporate decision making.[1] If the shareholder owns less than 50 percent of the voting stock, plaintiff must show evidence of actual control of corporate conduct.[2] Consequently, for example, the Delaware supreme court in Kahn v. Lynch Communication Systems, Inc.,[3] held that a 43.3 percent shareholder exercised control, not based on the number of shares it owned, but because the board of directors deferred to the shareholder’s wishes.

In an interesting new case, Voigt v. Metcalf,[4] plaintiffs claimed that private equity firm Clayton, Dubilier & Rice (“CD&R”) controlled  NCI Building Systems, Inc. (the “Company”), pointing to such factors as CD&R’s control of 34.8% of the Company’s voting power, the presence of four CD&R insiders on the Company’s twelve-member board of directors (the “Board”), CD&R’s relationships of varying significance with another four directors, and a stockholders agreement that gave CD&R contractual veto rights over a wide range of actions that the Board could otherwise take unilaterally. Plaintiffs who were minority shareholders of the Company claimed CD&R had used its control of the Company to effect a merger between the Company and a CD&R affiliate.

The defendants moved to dismiss, arguing that CD&R did not have control of the Company and, accordingly, owed no fiduciary duties to the minority. The court noted that because CD&R’s 34.8% ownership stake was than a majority, plaintiffs could only prevail if they “allege facts that support a reasonable inference that the defendant in fact ‘exercise[d] control over the business affairs of the corporation.’”

A plaintiff can plead that a defendant had the ability to exercise actual control by alleging facts that support a reasonable inference of either (i) control over the corporation’s business and affairs in general or (ii) control over the corporation specifically for purposes of the challenged transaction.

To plead that the requisite degree of control exists generally, a plaintiff may allege facts supporting a reasonable inference that a defendant or group of defendants exercised sufficient influence “that they, as a practical matter, are no differently situated than if they had majority voting control.” One means of doing so is to plead that the defendant, “as a practical matter, possesses a combination of stock voting power and managerial authority that enables him to control the corporation, if he so wishes.”

To plead that the requisite degree of control existed for purposes of a particular transaction or decision, a plaintiff does not have make such a pervasive showing. Rather, the plaintiff must plead facts supporting a reasonable inference that the defendant in fact exercised actual control “with regard to the particular transaction that is being challenged.”

“The question whether a shareholder is a controlling one is highly contextualized and is difficult to resolve based solely on the complaint.” “[T]here is no magic formula to find control; rather, it is a highly fact specific inquiry.”

Under the Company’s shareholders agreement, CD&R had a right to appoint four out of the Company’s twelve directors. Even though CD&R’s representatives were less than a majority of the board, the power to appoint them was “an indication of control.” In addition, CD&R has various business relationships with four of the nominally independent directors, which were sufficient to infer at this stage of the proceeding that those directors were beholden to CD&R, which gave CD&R effective control over two-thirds of the board.

In discussing CD&R’s stock ownership, the court acknowledged that there is no “linear, sliding scale approach where by a larger share percentage makes it substantially more likely that the court will find the stockholder was a controlling stockholder.” Nevertheless, “a relatively larger block size should make an inference of actual control more likely, even though the interplay with factors makes the correspondence difficult to perceive.” This is so not only because a large blockholder only needs pick up the votes of a small number of shareholders to prevail, but also because a large blockholder is likely to have significant influence on the board,

In addition to various other minor factors, the court noted that the stockholder agreement contained provisions that cut in opposite directions. On the one hand, the agreement ensured board representation for the minority shareholders. On the other hand, the agreement gave CD&R a de facto video over a number of corporate actions that ordinarily would be left to the discretion of the board.

The consent rights encompassed both significant corporate and financing transactions, as well as more basic corporate governance issues like increasing the size of the Board or amending the bylaws. These blocking rights weigh in favor of an inference that CD&R exercised control over the Company generally by giving CD&R power over the Company beyond what the holder of a mathematical majority of the voting power ordinarily could wield.

Contractual rights that do not amount to a significant source of general control can, depending on the circumstances, give rise to an inference of transaction-specific control, because the holder of the contract rights can use them to channel a corporation into a particular outcome by blocking other paths. Although a blocking right standing alone is unlikely to support a reasonable inference of control, in the context of a particular factual scenario, it can be a highly effective form of control. The paradigmatic example involves a cash-burning, asset-light company that does not yet generate sufficient revenue to finance its business plan and has reached the point where it requires external financing. Under those circumstances, a party that has a veto right over the company’s access to financing can “sit on the company’s lifeline, with the ability to turn it on or off.” When cash is like oxygen, the ability to choke off the air supply is a strong indicator of control, particularly if there are factual allegations (and later evidence) that the party holding the veto right used it to force the company into a vulnerable position.

Ten best securities and corporate law articles of 2019

The list is out. Congratulations to the winners, especially Elizabeth Pollman who had two articles make the list: the rare double!

Have you used my Concepts and Insights treatise on Corporate Law?

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Conducting the Annual Shareholder Meeting during the COVID19 Pandemic

The season for annual shareholder meetings is now well underway, but many states have stay-at-home mandates or suggestions limiting the size of public meetings. So how will corporations safely and legally conduct a shareholder meeting during the pandemic? And what will the changes made this year bode for the future?

In 2000, Delaware amended the General Corporation Law to permit virtual shareholder meetings. Section 211(a)(1) thus provides that:

Meetings of stockholders may be held at such place, either within or without this State as may be designated by or in the manner provided in the certificate of incorporation or bylaws, or if not so designated, as determined by the board of directors. If, pursuant to this paragraph or the certificate of incorporation or the bylaws of the corporation, the board of directors is authorized to determine the place of a meeting of stockholders, the board of directors may, in its sole discretion, determine that the meeting shall not be held at any place, but may instead be held solely by means of remote communication as authorized by paragraph (a)(2) of this section.

Section 211(a)(2) provides an alternative, pursuant to which the board may authorize shareholders who are not present at a physical meeting of the shareholders to participate in such a meeting by "remote communication." Until recently, this sort of hybrid meeting was far more common than a purely virtual meeting. But there was a trend towards virtual meetings: "Broadridge Financial Solutions, Inc. (Broadridge), has reported a dramatic increase in the prevalence of virtual-only meetings, going from hosting just one virtual-only meeting in 2009, to 53 meetings in 2014, and then increasing to 90 and 155 meetings in 2015 and 2016, respectively." Lisa A. Fontenot, Public Company Virtual-Only Annual Meetings, 73 Bus. Law. 35, 35–36 (2018). And, as noted, the novel coronavirus may change all of that.

Delaware Governor John Carney yesterday (4/6/2020) issued an emergeny order intended to substantially facilitate the use of virtual shareholder meetings. The order notes that:

WHEREAS, § 222(c) of Title 8 of the Delaware Code allows for adjournments of stockholder meetings, but does not address the method of adjournment of a meeting noticed for a physical location in the case of a public health threat and concomitant restrictions on personal mobility and travel; and

WHEREAS, § 232 of Title 8 of the Delaware Code provides that notice of stockholder meetings may be given by mail, courier service or electronic mail, but also suggests that there may be other means by which notice may be given effectively to stockholders; and

WHEREAS, during the COVID-19 pandemic, the Securities and Exchange Commission is allowing reporting companies to provide certain notices to stockholders via the companies’ required public filings and a press release.

The order then provides that:

With respect to a corporation subject to the reporting requirements of § 13(a) or § 15(d) of the Securities Exchange Act of 1934, as amended, and the rules and regulations promulgated thereunder:

i. if, as a result of the public health threat caused by the COVID-19 pandemic or the COVID-19 outbreak in the United States, the board of directors wishes to change a meeting currently noticed for a physical location to a meeting conducted solely by remote communication, it may notify stockholders of the change solely by a document publicly filed by the corporation with the Securities and Exchange Commission pursuant to § 13, § 14 or § 15(d) of such Act and a press release, which shall be promptly posted on the corporation’s website after release; and

ii. if it is impracticable to convene a currently noticed meeting of stockholders at the physical location for which it has been noticed due to the public health threat caused by the COVID-19 pandemic or the COVID- 19 outbreak in the United States, such corporation may adjourn such meeting to another date or time, to be held by remote communication, by providing notice of the date and time and the means of remote communication in a document filed by the corporation with the Securities and Exchange Commission pursuant to § 13, § 14 or § 15(d) of such Act and a press release, which shall be promptly posted on the corporation’s website after release.

As K&L Gates observes, a corporation wishing to take advantage of this option must:

• Implement reasonable measures to verify that each person deemed present and permitted to vote at the virtual meeting is a stockholder or proxyholder;
• Implement reasonable measures to provide stockholders and proxyholders a reasonable opportunity to participate in the virtual meeting and vote on matters, including an opportunity to read or hear the proceedings of the meeting substantially concurrently with such proceedings; and
• Maintain a record of a stockholder or proxyholder’s vote or other action taken at such meeting.

K&L Gates also notes that:

• If the corporation has already mailed the notice of meeting, and the corporation has sufficient time to give its stockholders 10 days’ notice of the virtual meeting, a new notice ordinarily must be distributed to stockholders by a physical mailing or by e-mail [1]. However, pursuant to the Order, any Delaware corporation that is subject to the reporting requirements of §13(a) or §15(d) of the Exchange Act may notify stockholders of the change of the format of the meeting solely by filing a document with the SEC and issuing a press release, which shall be promptly posted on the corporation’s website after release. The notice should contain the information required for a notice of a virtual meeting described above.
• If the corporation has mailed the notice of the annual meeting and there are fewer than 10 days’ before the meeting or it is otherwise impracticable to convene a currently noticed meeting, the meeting could be held but adjourned to another place (i.e., a virtual location). Ordinarily, notice of an adjourned meeting is not required so long as the date, time and place or means of remote communications by which stockholders and proxyholders may be deemed to be present in person and vote at such adjourned meeting are announced at the meeting at which the adjournment is taken and the adjournment is for no more than 30 days. Pursuant to the Order, a public company also may adjourn the meeting by providing notice of the date and time of the virtual meeting and the means of remote communication by which stockholders may participate in the meeting solely by filing a document with the SEC and issuing a press release, which shall be promptly posted on the corporation’s website after release.
• Where there is insufficient time to send out a new notice and/or it is impracticable to adjourn or postpone the meeting, another option for corporations is to simply hold the physical meeting as planned, but to stream the meeting over the internet so that stockholders have the opportunity to hear or view the meeting remotely. Because the meeting is considered a meeting held at a physical place, stockholders, who do not come to the physical meeting but participate in the webcast, must submit their proxies in advance of the meeting according to the instructions set forth in the original proxy materials in order to have their votes count for quorum and voting purposes.

The SEC guidance referred to above is available here.

Some companies have hesitated about moving to virtual meetings, because shareholder advisory service Glass Lewis and some large institutional investors opposed virtual-only meetings. However, Glass Lewis has suspended that policy for the duration (2020 WL 1430493):

The firm, which is the second-largest advising institutional investors on proxy votes, said in a blog post that online-only meetings offer "compelling advantages" to both companies and shareholders given the situation regarding COVID-19. Its approval of the option extends to June 30.

"We do not believe discouraging virtual-only meetings during this time serves the interests of shareholders or companies," Glass Lewis said in the post on its website, noting that moving meetings online will offer certainty and continuity in timing, agendas, and voting.

Some investors, including the Council of Institutional Investors, oppose virtual-only shareholder meetings as lacking the same opportunities to hold management accountable and ask questions as in-person gatherings. ...

Glass Lewis's policy update says the firm will take the pandemic into account during the 2020 proxy season when applying its virtual-only meeting policy and generally refrain from voting against governance committee members for this reason as long as the company says it moved the meeting online because of COVID-19 or similar rationale. Reviews will be case-by-case and note whether companies say they'll return to in-person or hybrid meetings in the future. 

The Council of Institutional Investors (CII) has likewise suspended its opposition to virtual only meetings, albeit only for the current proxy season:

“Given coronavirus concerns,” said CII Executive Director Ken Bertsch, “it is entirely reasonable that some companies will go to virtual-only annual meetings.”

Bertsch added that CII hopes that companies “will make it clear that this decision is a one-off, tailored for current circumstances.” He also urged companies to follow best practices “for making virtual meetings participatory, replicating as much as possible the experience of an in-person meeting.” And he said that “companies that do hold in-person meetings should be flexible with shareholder proponents on presentation of shareholder proposals, accommodating travel restrictions that they may face.”

CII generally has opposed virtual-only shareholder meetings, in favor of a hybrid approach.

How will it work? Broadridge is the principal stockholder service company and had been active in both virtual and hybrid meetings for many years. They provide online platforms for conducting a virtual meeting:

They also provide a useful white paper on best practices for conducting a virtual meeting. Some key best practices are also available from CII:

CII’s October 2017 publication, Build a Better Meeting, offers guidance on creating shareholder-oriented meetings, including virtual components. The publication urged that virtual meetings include:

• • A live audio and video feed of all key company representatives in attendance, including, at a minimum, the chair, CEO, any lead/presiding director, chairs of key board committees and the corporate secretary.
  • A continuously updated list of all shareholder questions submitted both before and during the meeting, accompanied by clear indication of any subsequent deletion or re-ordering in the queue.
  • A comprehensive Q&A tool allowing the shareholder to:
    • Submit a question
    • Track its prioritization in the queue
    • Present the question virtually, including through the use of a shareholder-provided webcam or phone
    • Instructions or a link to written responses to unanswered shareholder questions, made available within 72 hours of the meeting’s conclusion.
    • Basic information about the meeting known to the company, which may include a list of attendees, the number of shares represented at the meeting and preliminary vote counts.

One key issue will be the requirement in Rule 14a-8 that proponents of a shareholder proposal must be present at the meeting. David Hooper and Lynne McMahan explain that 

The SEC guidance also provides direction to companies and shareholders regarding the presentation of shareholder proposals at annual meetings for the 2020 proxy season. Under Exchange Act Rule 14a-8(h), shareholders or their representatives are required to appear in person and present their proposals at the annual meeting. In light of the possible difficulties of appearing in person to present their proposals (whether because of COVID-19-related travel concerns or because of a change to a virtual meeting), the SEC encourages companies, to the extent feasible under state law, to provide shareholders or their representatives with the ability to present their proposals through alternative means, such as by phone, during the 2020 proxy season. Companies in this situation should coordinate and communicate in advance with shareholders regarding the means of presenting their proposals and any necessary technical requirements or limitations.

Furthermore, to the extent a shareholder or representative is not able to attend the annual meeting and present the proposal due to the inability to travel or other hardships related to COVID-19, the SEC considers this to be “good cause” under Rule 14a-8(h), and therefore, issuers cannot assert a shareholders’ absence as a basis under Rule 14a-8(h)(3) to exclude a proposal submitted by the shareholder for any meetings held in the following two calendar years.

Hooper and McMahon also offer some best practices:

• Companies should engage an experienced remote communication services provider (such as Broadridge or Computershare) to host the virtual or hybrid meeting.

• Companies must ensure that the remote communication method allows shareholders to vote, ask questions and make comments, hear answers to questions, and otherwise exercise all of the rights shareholders have under state law for participation in shareholder meetings.

• Companies should develop protocols for facilitating the process for shareholder proposal proponents to present their proposals.

• Companies must also ensure that the technology platform used to conduct the virtual meeting will accommodate all of the shareholders, board members, members of management, and other persons participating in the meeting.

• Companies also should make shareholders aware of the procedures necessary to access and participate in the virtual meeting.

Finally, blog friend Keith Paul Bishop has a useful discussion of the state of the issue in California.