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The 11th Edition of what is now Bainbridge's Business Association's casebook is now available for Spring 2022 adoptions

Foundation Press today announced that the 11th edition of my Business Associations casebook is now available for Spring 2022 adoptions. Go here to order.

Celebrating Lucian Bebchuk

New article: Kobi Kastiel, Lucian Bebchuk and the Study of Corporate Governance (October 4, 2021). Forthcoming, University of Chicago Law Review, Vol. 88, No. 7, 2021, Available at SSRN: https://ssrn.com/abstract=3936085

Prepared for an upcoming issue of The University of Chicago Law Review on the most-cited legal scholars, this Essay discusses Lucian Bebchuk’s fundamental contributions to the field of corporate governance, as well as his major impact on scholarship, practice, and policy. Bebchuk is the author of more than one hundred corporate law and finance articles, and is ranked by SSRN as the most-cited corporate law scholar (as well as one of the most-cited among all law professors). However, this ranking only tells part of the story; this Essay seeks to provide a fuller picture.

The first part of the Essay focuses on Bebchuk’s research contributions. I begin by surveying the broad range of corporate governance areas to which Bebchuk has made major contributions. I then identify the aspects of Bebchuk’s research that have made it so consequential, including Bebchuk’s tools and modes of analysis and some overarching themes and approaches shared by his work in disparate areas.

The second part of the Essay focuses on Bebchuk’s impact. I discuss three ways in which Bebchuk’s work has been impactful—by shaping and influencing subsequent academic research, as well as discourse among practitioners and policymakers; through his mentorship of many corporate governance scholars; and by having substantial influence on the evolution of policy and practices in the corporate field.

It's a well-deserved honor for one of the premier scholars of our field over the last several decades.

William Bratton Revisits Team Production but I Remain Wholly Unpersuaded

Bratton, William Wilson, Team Production Revisited (September 29, 2021). U of Penn, Inst for Law & Econ Research Paper No. 21-27, University of Miami Legal Studies Research Paper No. 3935788, Vanderbilt Law Review, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3935788

This Article reconsiders Margaret Blair and Lynn Stout’s team production model of corporate law, offering a favorable evaluation. The model explains both the legal corporate entity and corporate governance institutions in microeconomic terms as the means to the end of encouraging investment, situating corporations within markets and subject to market constraints but simultaneously insisting that productive success requires that corporations remain independent of markets. The model also integrates the inherited framework of corporate law into an economically derived model of production, constructing a microeconomic description of large enterprises firmly rooted in corporate doctrine but neither focused on nor limited by a description of principal-agent relationships among shareholders and managers. This Article shows that the model retains descriptive robustness, despite the substantial accretion of shareholder power during the two decades since its appearance. The Article also shows that the model taught three groundbreaking lessons to corporate legal theory. First, nothing binds microeconomic analysis together with a theory of the firm rooted in shareholder primacy. Second, microeconomics, with its emphases on efficiency and maximization, can be deployed in the service of an allocatively sensitive description of corporate governance, providing a more capacious methodological tent than anyone in corporate law understood prior to Blair and Stout’s intervention. Third, it is not only possible but arguably necessary to take corporate law seriously when articulating a microeconomic theory of corporate production. To the extent an economic model’s description of the appropriate legal framework differs materially from the inherited legal framework, there is a possible, even a probable, infirmity in the model.

I remain unpersuaded. I have never bought team production as either a descriptive or normative model of corporate governance. To the contrary, I think my director primacy model is superior both descriptively and normatively.

What follows is excerpted from my article Director primacy: The means and ends of corporate governance. 97 Northwestern University Law Review, 547-606 (2003). One of these days I'll get around to updating it for subsequent developments.

Blair and Stout contend that corporate law treats directors not as hierarchs charged with serving shareholder interests, but as referees—mediating hierarchs, to use their term—charged with serving the interests of the legal entity known as the corporation.[1]

The Firm as Team

Team production is an important and highly useful concept in neoinstitutional economics. Blair and Stout stretch the team production model to encompass the entire firm. Doing so is unconventional. In my view, stretching team production that far also detracts from the model’s utility.

Production teams are defined conventionally as “a collection of individuals who are interdependent in their tasks, who share responsibility for outcomes, [and] who see themselves and who are seen by others as an intact social entity embedded in one or more larger social systems ....”[2] This definition contemplates that production teams are embedded within a larger entity. As one commentator defines them, teams are “intact social systems that perform one or more tasks within an organizational context.”[3]

Building on the work of Rajan and Zingales, Blair and Stout define team production by reference to firm specific investments.[4] Hence, for example, they describe the firm “as a ‘nexus of firm-specific investments.’” In fact, however, firm specific investments are not the defining characteristic of team production. Instead, the common feature of team production is task nonseparability.

Oliver Williamson identifies two forms production teams take: primitive and relational. In both, team members perform nonseparable tasks. The two forms are distinguished by the degree of firm specific human capital possessed by such members. In primitive teams, workers have little such capital; in relational teams, they have substantial amounts. Because both primitive and relational team production requires task nonseparability, it is that characteristic that defines team production.

Most public corporations have both relational and primitive teams embedded throughout their organizational hierarchy. Self-directed work teams, for example, have become a common feature of manufacturing shop floors and even some service workplaces. Even the board of directors can be regarded as a relational team. Hence, the modern public corporation arguably is better described as a hierarchy of teams rather than one of autonomous individuals. To call the entire firm a team, however, is neither accurate nor helpful.

As among shop floor workers organized into a self-directed work team, for example, team production is an appropriate model precisely because their collective output is not task separable. In a large firm, however, the vast majority of tasks performed by the firm’s various constituencies are task separable. The contribution of employees of one division versus those of a second division can be separated. The contributions of employees and creditors can be separated. The contributions of supervisory employees can be separated from those of shop floor employees. And so on. Accordingly, the concept of team production is simply inapt with respect to the large public corporations with which Blair and Stout are concerned. [5]

The Domain of the Mediating Hierarchy

John Coates argues that Blair and Stout’s mediating hierarch model fares poorly whenever there is a dominant shareholder. If so, the model’s utility is vitiated with respect to close corporations, wholly-owned subsidiaries, and publicly held corporations with a controlling shareholder. In addition, Coates argues, Blair and Stout’s model also fares poorly whenever any corporate constituent dominates the firm. Many of publicly held corporations lacking a controlling shareholder are dominated one of the constituents among which the board supposedly mediates—namely, top management. Although the precise figures disputed, a substantial minority of publicly held corporations have boards in which insiders comprise a majority of the members. Even where a majority of the board is nominally independent, the board may be captured by insiders.

I more skeptical than Coates of board capture theories, having argued elsewhere that independent board members have substantial incentives to buck management. On balance, however, Coates makes a persuasive case that the mediating hierarch model has a relatively small domain. In contrast, the domain of director primacy, which merely requires the absence of a controlling shareholder, seems considerably larger.

The Foundational Hypothetical

Blair and Stout develop the mediating hierarchy model by telling the story of a start-up venture in which a number of individuals come together to undertake a team production project. The participating constituents know that incorporation, especially the selection of independent board members, will reduce their control over the firm and, consequently, expose their interests to shirking or self-dealing by other participants. They go forward, Blair and Stout suggest, because the participants know the board of directors will function as a mediating hierarch resolving horizontal disputes among team members about the allocation of the return on their production.

On its face, Blair and Stout’s scenario is not about established public corporations. Instead, their scenario seems heavily influenced by the high-tech start-ups of the late 1990s. Yet, even in that setting, the model seems inapt. In the typical pattern, the entrepreneurial founders hire the first factors of production.[6] If the firm subsequently goes public,[7] the founding entrepreneurs commonly are replaced by a more or less independent board.[8] The board thus displaces the original promoters as the central party with whom all other corporate constituencies contract. It is due to my empirical impression that this is the typical pattern that director primacy assumes the board of directors—whether comprised of the founding entrepreneurs or subsequently appointed outsiders—hires factors of production, not the other way around.[9]

Lest the foregoing seem like an argument for shareholder primacy, I think it is instructive to note the corporation—unlike partnerships, for example—did not evolve from enterprises in which the owners of the residual claim managed the business. Instead, as a legal construct, the modern corporation evolved out of such antecedent forms as municipal and ecclesiastical corporations.[10] The board of directors as an institution thus pre-dates the rise of shareholder capitalism.[11] When the earliest industrial corporations began, moreover, they typically were large enterprises requiring centralized management. Hence, separation of ownership and control was not a late development but rather a key institutional characteristic of the corporate form from its inception.[12] At the risk of descending into chicken-and-egg pedantry, the historical record thus suggests that director primacy emerged long before shareholder primacy. Directors have always hired factors of production, not vice-versa.

The Board’s Role

In Blair and Stout’s model, directors are hired by all constituencies and charged with balancing the competing interests of all team members “in a fashion that keeps everyone happy enough that the productive coalitions stays together.” In other words, the principal function of the mediating board is resolving disputes among other corporate constituents. This account of the board’s role differs significantly from the standard account.

The literature typically identifies three functions performed by boards of public corporations:[13] First, and foremost, the board monitors and disciplines top management. Second, while boards rarely are involved in day-to-day operational decision making, most boards have at least some managerial functions. Broad policymaking is commonly a board prerogative, for example. Even more commonly, however, individual board members provide advice and guidance to top managers with respect to operational and/or policy decisions. Finally, the board provides access to a network of contacts that may be useful in gathering resources and/or obtaining business. Outside directors affiliated with financial institutions, for example, apparently facilitate the firm’s access to capital. In none of these capacities, however, does the board of directors directly referee between corporate constituencies.

To be sure, institutional economics acknowledges that dispute resolution is an important function of any governance system. Ex post gap-filling and error correction are necessitated by the incomplete contracts inherent in corporate governance. Those functions inevitably entail dispute resolution. As we’ve seen, the firm addresses the problem of incomplete contracting by creating a central decisionmaker authorized to rewrite by fiat the implicit—and, in some cases, even the explicit—contracts of which the corporation is a nexus.

As the principal governance mechanism within the public corporation, the board of directors is that central decisionmaker and, accordingly, bears principal dispute resolution responsibility. Yet, in doing so, the board “is an instrument of the residual claimants.” Hence, if the board considers the interests of nonshareholder constituencies when making decisions, it does so only because shareholder wealth will be maximized in the long run.

Blair and Stout posit that the legal mechanisms purporting to ensure director accountability to shareholder interests—such as derivative litigation and voting rights—benefit all corporate constituents. Conceding that shareholder and nonshareholder interests are often congruent, it nevertheless remains the case that some situations present zero-sum games. Further conceding the weakness of those accountability mechanisms, shareholder standing to pursue litigation and/or the exercise of shareholder voting rights nevertheless give shareholders rights that potentially can be used to the disadvantage of other constituencies.

If directors suddenly began behaving as mediating hierarchs, rather than shareholder wealth maximizers, an adaptive response would be called forth.[14] Shareholders would adjust their relationships with the firm, demanding a higher return to compensate them for the increase in risk to the value of their residual claim resulting from director freedom to make trade-offs between shareholder wealth and nonshareholder constituency interests. Ironically, this adaptation would raise the cost of capital and thus injure the interests of all corporate constituents whose claims vary in value with the fortunes of the firm.

Revised Version of "Don’t Compound the Caremark Mistake by Extending it to ESG Oversight" Now Online

Bainbridge, Stephen Mark, Don’t Compound the Caremark Mistake by Extending it to ESG Oversight (October 11, 2021). Business Lawyer (September 2021), UCLA School of Law, Law-Econ Research Paper No. 21-10, Available at SSRN: https://ssrn.com/abstract=3899528

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.

A little self-promotion

.@PrawfBainbridge's take (https://t.co/WJ9wmhUWCz) on Sen. @marcorubio's "Mind Your Own Business Act" is cited by @jonsskolnik in @Salon. https://t.co/nEa7Kclqi3

— UCLA School of Law (@UCLA_Law) October 4, 2021

Wachtell Lipton Discusses Delaware Supreme Court’s New Demand Futility Test

Regular readers will recall that I offered a long post on United Food & Commercial Workers Union v. Zuckerberg, which set out Delaware's new-is demand futility standard. One week later, Wachtell Lipton catches up with a short post on the case:

To excuse demand under the new test, a complaint must allege with particularity that at least half of the members of the current board (1) received a material personal benefit from the misconduct alleged in the complaint; (2) face a substantial likelihood of liability on any of the claims in the complaint; or (3) lack independence from someone who received a material personal benefit from the misconduct alleged in the complaint or who would face a substantial likelihood of liability for any of the claims in the complaint.  The Court took care to note, however, that because its new test was conceptually consistent with Aronson and Rales, earlier precedents properly applying those rulings remain good law.

The decision reaffirms that directors are presumed to exercise their business judgment in the best interests of the corporation—even when they are named as defendants.  The law will therefore supplant board authority over corporate litigation only if a stockholder makes a detailed showing that at least half of the directors face a substantial threat of actual liability.

 

California Board of Director Gender Quota Law Going to Trial

Keith Paul Bishop reports:

California Superior Court Judge Maureen Duffy-Lewis issued her ruling yesterday on the parties' respective motions for summary judgment in Crest v. Padilla (Cal. Super. Ct. Case No. 19STCV27561).  In this case, the plaintiffs are seeking a judgment declaring that any and all expenditures of taxpayer funds to enforce and carry out the provisions of California's female director quota law (SB 826) are illegal.   SB 826 is codified at Sections 301.3 and 2115.5 of the California Corporations Code.   The basis for the plaintiffs' claim is Art. I, Section 31 of the California Constitution which forbids the state from discriminating against, or granting preferential treatment to, any individual or group on the basis of race, sex, color, ethnicity, or national origin in the operation of public employment, public education, or public contracting.

Judge Duffy-Lewis denied both motions on the grounds that there are triable issues of material facts.  While the fundamental question presented by the case appears to be legal, the ruling notes that each side provided with their moving papers "substantial amounts of extrinsic evidence" and that each side disputed facts presented by the other. 

The Chancery Daily on Delaware's New Demand Futility Standard (UFCWU v. Zuckerberg)

I blogged yesterday about United Food and Commercial Workers Union v. Zuckerberg, et al., No. 2018-0671-JTL, 2021 WL _______ (Sep. 23, 2021), in which the Delaware Supreme Court established a new standard for deciding whether demand is excused in derivative litigation. It's a long post, which situates the case in its context.

The Chancery Daily immediately blasted out a note about the case to its email subscribers. I suspect a longer form analysis of the case will be forthcoming. In the meanwhile, I note TCD's closing observation:

TCD notes that, earlier this week, the Supreme Court overruled John A. Gentile, et al. v. Pasquale David Rossette, et al., No. 573, 2005, opinion (Del. Aug. 17, 2006), which recognized dual-natured direct and derivative claims for “corporate-overpayment-to-a-controlling-stockholder,” finding that under Patrick Tooley, et al. v. Donaldson, Lufkin & Jenrette, Inc., et al., No. 84, 2003, opinion (Del. Apr. 2, 2004), claims for overpayment or dilution are solely derivative. The Chancery Salvo - Monday, September 20, 2021. TCD can confidently say that the week of September 20, 2021 has been the most significant during its publication lifetime in terms of the development of Delaware law governing stockholder assertion of claims on behalf of a corporation during its publication lifetime, and sympathizes with its many subscribers who are corporate law professors to the extent they are teaching corporate law this semester and suddenly find themselves having to modify lesson plans and syllabi -- presumably this happened well before you reached derivative claims, so at least there’s some runway.

FWIW, I regard The Chancery Daily as essential reading for anyone with an interest in corporate law and governance. I strongly encourage you to subscribe.

Alison Frankel on Delaware's New Demand Futility Standard (UFCWU v. Zuckerberg)

I blogged yesterday about United Food and Commercial Workers Union v. Zuckerberg, et al., No. 2018-0671-JTL, 2021 WL _______ (Sep. 23, 2021), in which the Delaware Supreme Court established a new standard for deciding whether demand is excused in derivative litigation. It's a long post, which situates the case in its context.

Top legal journalist Alison Frankel has also weighed in on the new case. It's a concise and useful summary of the decision.

Senator Marco Rubio's "Mind Your Own Business Act" would make bad law and is premised on dumb policy grounds

On Thursday, Marco Rubio announced that he had "introduced the Mind Your Own Business Act, which would enable shareholders to hold woke corporations accountable." (HT: Stefan Padfield)

Specifically, the legislation would require corporate directors to prove their “woke” corporate actions were in their shareholders’ best interest in order to avoid liability for breach of fiduciary duty in shareholder litigation over corporate actions relating to certain social policies. It would also incentivize corporate management to stop abusing their positions to advance left-wing social policies by increasing their personal liability to shareholders for breaches of fiduciary duty resulting from those policies.

“Patriotic Americans who love their country and the opportunity it provides should be able to fight back against the growing tyranny of the woke elites running corporate America,” Rubio said.

...

“No more legal tricks that shield these corporate executives from accountability,”Rubio continued. “If they really believe that being woke is good for business, they should have to say so—and prove it—under oath in court.”

[Insert world weary sigh and eyeball here.]

As regular readers know, I am not a fan of woke capitalism--particularly when committed by social justice warrior CEOs. But the Rubio proposal is a lousy response to woke capitalism.

First, it would represent a further step towards the federalization of corporate law. I address the arguments against expanding the federal role in corporate governance in my book, Corporate Governance After the Financial Crisis at 261-70. The supremacy of federal law and the uniform opposition of Congress and the SEC to private ordering eliminates opportunities for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law. As Justice Brandeis pointed out many years ago, “It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of country.” New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting). So long as state legislation is limited to regulation of firms incorporated within the state, as it generally is, there is no risk of conflicting rules applying to the same corporation. Experimentation thus does not result in confusion, but instead may lead to more efficient corporate law rules.

In contrast, the uniformity imposed by federal law precludes experimentation with differing modes of regulation. As such, there will be no opportunity for new and better regulatory ideas to be developed—no “laboratory” of federalism. Likewise, the persistent refusal to accommodate private ordering eliminates solutions from emerging from competition in the market. Instead, the federalization of corporate governance has resulted in rules that were wrong from the outset or may quickly become obsolete, but are effectively carved into stone with little prospect for change.

I would also draw the reader's attention to an older article, The Creeping Federalization of Corporate Law, Regulation, Spring 2003, at 26. In it, I explain that:

The corporation is a creature of the state “whose very existence and attributes are a product of state law.” States have an interest in overseeing the firms they create. States also have an interest in protecting the shareholders of their corporations. Finally, as the Court noted in CTS v. Dynamics, a state has a legitimate “interest in promoting stable relationships among parties involved in the corporations it charters, as well as in ensuring that investors in such corporations have an effective voice in corporate affairs.” In other words, state regulation not only protects shareholders, but also protects investor and entrepreneurial confidence in the fairness and effectiveness of the state corporation law.

According to the Supreme Court’s CTS decision, the country as a whole benefits from state regulation in this area. As Justice Powell explained, the markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that corporations generally are organized under, and governed by, the law of the state of their incorporation. . . .

Competitive federalism promotes liberty as well as shareholder wealth. When firms may freely select among multiple competing regulators, oppressive regulation becomes impractical. If one regulator overreaches, firms will exit its jurisdiction and move to one that is more laissez-faire. In contrast, when there is but a single regulator, exit is no longer an option and an essential check on excessive regulation is lost.

Second, we know that much derivative litigation is meritless. Unless the legislation is extremely narrowly focused, changes intended to “increase stockholder plaintiff’s chances of making it pass the pleading stage” will simply increase the settlement value of such suits. Suppose, for example, in the wake of a tragic mass shooting Walmart decides to stop selling firearms. Do we really want some plaintiff lawyer filing suit against Walmart in that instance? Especially since trial lawyer political contributions primarily go to Democrats?

Third, unless the legislation is extremely narrowly drafted, it will likely involve delegating substantial discretion to a Democrat-dominated SEC.

Fourth, it takes a procedural approach to a substantive problem. A derivative suit is a procedural device mainly used to allow shareholders to bring suit against the firm’s directors and officers for breaching a fiduciary duty owed to the corporation. At present, the sort of woke decisions to which I object almost certainly would be insulated from judicial review by the business judgment rule. See my post Can Tim Cook Ignore ROI When Deciding How to Design an iPhone? So the law would have to create an underlying cause of action.  Which would make the intrusion on state corporate law even greater.

Finally, such proposals are just slapping a Band-Aid on a deep systemic problem. I address the underlying problem in my article Corporate Purpose in a Populist Era at pages 568-577. In short,  I think the rise of CEO social justice warriors resulted from a combination of virtue signaling, the business world equivalent of the Linda Greenhouse effect, and the Ivy League/Upper East Side bubble most of them live in. Most large corporation CEOs these days live in families and social circles where social conservatism is regarded as moronic, retrograde, trailer trash, flyover country nonsense. Acting out as SJWs keeps their spouses and kids off their backs, ensures that the NY Times will say nice things about them, gets their pictures on the society pages, and gets them invited to all the best parties. It lets them hobnob with Hollywood elites and hang out with at Clinton Foundation functions. And it differentiates them from the proles in the GOP base. Tinkering with corporate law at the margins is unlikely to do much until the dynamics of the underlying social phenomena change.

At somewhat greater length, I suggest that what we’re seeing is the culmination of what Christopher Lasch called The Revolt of the Elites. In his 1995 classic, Lasch identified an emergent split between what he called the New Elites and the rest of society. The changes Lasch spotted became trends that accelerated in subsequent years. In particular, Lasch explained that “the new elites . . . regard the masses with mingled scorn and apprehension.”  They dismissed the masses’ values as “mindless patriotism, religious fundamentalism, racism, homophobia, and retrograde views of women.”  This tension was perhaps nowhere more pronounced than with respect to religion. When Lasch wrote over two decades ago, he opined that “[a] skeptical, iconoclastic state of mind is one of the distinguishing characteristics of the knowledge classes. . . .  The elites’ attitude to religion ranges from indifference to active hostility.”

If anything, today’s elites have become even more hostile to religious values. As Samuel Gregg observes, the Davos Man’s moral creed is “a mélange of social liberalism, environmentalism, and a new order of a borderless world. . . . [R]eligion is considered the refuge of fanatics and anyone stupid enough to be skeptical of gender ideology and techno-utopianism.”

A quarter-century later, Lasch’s new elites have risen to the top of corporate hierarchies. They brought their values into the C-suite. CEOs increasingly reflect the values of the Blue state coastal bubbles in which they are embedded, especially on environmental and social issues. No Fortune 100 CEOs contributed to Donald Trump’s 2016 presidential campaign, for example, but eleven gave to Hillary Clinton. More generally, “liberal groups accounted for eight of the top ten ideological causes of the ultra-rich, and seven of the ten congressional candidates most dependent on money from such people were Democrats.” Even one of the progressive movement’s favorite whipping boys—David Koch—publicly self-identifies as “a social liberal.”

As a result, as a Slate essay observed, “Fortune 500 companies today are socially liberal, especially on areas surrounding diversity, gay rights, and immigration; they are unabashedly in favor of free trade and globalization, express concern about climate change, and embrace renewable energy.” In doing so, they are simply reflecting the changing values of their CEOs.

Tinkering with corporate law at the margins is unlikely to do much until the dynamics of the underlying social phenomena change.

Major Delaware Corporate Law Development: Delaware Supreme Court "Revises" Aronson Standard for Demand Futility

United Food and Commercial Workers Union v. Zuckerberg, et al., No. 2018-0671-JTL, 2021 WL _______ (Sep. 23, 2021)

Background

Shareholder litigation comes in two possible forms. Direct” shareholder suits arise out of causes of action belonging to the shareholders in their individual capacity. It is typically premised on an injury directly affecting the shareholders and must be brought by the shareholders in their own name. In contrast, a “derivative” suit is one brought by the shareholder on behalf of the corporation. The cause of action belongs to the corporation as an entity and arises out of an injury done to the corporation as an entity. The shareholder is merely acting as the firm’s representative. Our focus here is on derivative litigation.

The law governing derivative litigation has many complexities, most of which result from the collision of two basic principles. On the one hand, the derivative cause of action belongs to the corporation. The board of directors is charged with running the corporation and therefore ought to control corporate litigation. On the other hand, when it is the directors or their associates who are on trial, we may not trust them to make unbiased decisions.

Because the derivative suit is premised on a cause of action belonging to the corporation, one might assume that the corporation would simply bring the lawsuit itself. Derivative suits in fact are relatively rare; most corporate lawsuits are brought by the entity, rather than its shareholders. The derivative suit, of course, was devised so as to permit shareholders to seek relief on behalf of the firm in those cases where the corporation’s management for some reason elected not to pursue the claim. Logically, however, it would seem that the corporation should be given an opportunity to decide whether to bring suit before a shareholder is allowed to file a derivative suit.

Accordingly, both Delaware Rule of Civil Procedure 23.1 and the essentially identical Federal Rule 23.1 provides that shareholders may not bring suit unless they first make demand on the board of directors or demand is excused.[1] The requisite demand can take any form, although most jurisdictions require that it be in writing. The demand need not be in the form of a pleading nor a detailed as a complaint, but rather simply must request that the board bring suit on the alleged cause of action.

Although the demand requirement looks like a mere procedural formality, it has evolved into the central substantive rule of derivative litigation.[2] The foundational question in derivative litigation is the extent to which the corporation, acting through the board of directors or a committee thereof, is permitted to prevent or terminate a derivative action. Put another way, who gets to control the litigation—the shareholder or the corporation’s board of directors? Curiously, the answer to that question depends mainly on the procedural posture of the particular case with respect to the demand requirement. More precisely, it depends on whether demand is required or excused as futile.

Delaware requires demand in all cases except those in which it is excused on grounds of futility. In the seminal Aronson v. Lewis decision, the Delaware Supreme Court set forth the following test for demand futility:

[T]he Court of Chancery in the proper exercise of its discretion must decide whether, under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.[3]

The Court’s use of a reasonable doubt standard has been the subject of much criticism:  

The reference to “reasonable doubt” summons up the standard applied in criminal law. It is a demanding standard, meaning at least a 90% likelihood that the defendant is guilty. If “reasonable doubt” in the Aronson formula means the same thing as “reasonable doubt” in criminal law, then demand is excused whenever there is a 10% chance that the original transaction is not protected by the business judgment rule. Why should demand be excused on such a slight showing? Surely not because courts want shareholders to file suit whenever there is an 11% likelihood that the business judgment rule will not protect a transaction. Aronson did not say, and later cases have not supplied the deficit. If “reasonable doubt” in corporate law means something different from “reasonable doubt” in criminal law, however, what is the difference?, and why use the same term for two different things?[4]

In defense of the reasonable doubt standard, the Delaware Supreme Court rather weakly argued that “the term is apt and achieves the proper balance.”[5] Somewhat more helpfully, the court rephrased the test by reversing it: “the concept of reasonable doubt is akin to the concept that the stockholder has a ‘reasonable belief’ that the board lacks independence or that the transaction was not protected by the business judgment rule.”

The Aronson standard proved awkward in some cases, such as when there had been a turnover in board composition, where the complaint alleged inaction rather than action, and so on. In Rales v. Blasband, Plaintiff brought a double derivative suit on behalf of a parent corporation with respect to the sale of subordinated debentures by its wholly owned subsidiary. Because the derivative suit did not challenge a decision by the parent corporation’s board, the court held that the Aronson standard did not apply:

Instead, it is appropriate in these situations to examine whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations. Thus, a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand. If the derivative plaintiff satisfies this burden, then demand will be excused as futile.[6]

The court noted three scenarios in which this test is to be used in lieu of the Aronson standard: (1) where a majority of the board that made the challenged transaction has been replaced by disinterested and independent members; (2) where the litigation arises out of some transaction or event not involving a business decision by the board; and (3) where the challenged decision was made by the board of a different corporation.

As former Delaware Chief Justice Leo Strine explained in an opinion written earlier in his career during his stint as a Vice Chancellor:

At first blush, the Rales test looks somewhat different from Aronson . . .. [The Rales] inquiry makes germane all of the concerns relevant to both the first and second prongs of Aronson. For example, in a situation when a breach of fiduciary duty suit targets acts of self-dealing committed, for example, by the two key managers of a company who are also on a nine-member board, and the other seven board members are not alleged to have directly participated or even approved the wrongdoing (i.e., it was not a board decision), the Rales inquiry will concentrate on whether five of the remaining board members can act independently of the two interested manager-directors. This looks like a first prong Aronsoninquiry.

When, however, there are allegations that a majority of the board that must consider a demand acted wrongfully, the Rales test sensibly addresses concerns similar to the second prong of Aronson. To wit, if the directors face a “substantial likelihood” of personal liability, their ability to consider a demand impartially is compromised under Rales, excusing demand.[7]

In United Food and Com. Workers Union v. Zuckerberg,[8] the Delaware Chancery Court (per Vice Chancellor J. Travis Laster), took note of the criticism that Aronson has been subject to over the years and proposals that the courts should abandon Aronson and adopt Rales as the general standard. In UFCWU, VC Laster proposed just such a move:

Both [the Aronson and Rales] tests remain authoritative, but the Aronson test has proved to be comparatively narrow and inflexible in its application, and its formulation has not fared well in the face of subsequent judicial developments. The Rales test, by contrast, has proved to be broad and flexible, and it encompasses the Aronson test as a special case.[9]

VC Laster went on to explain that:

In using the standard of review for the challenged transaction as a proxy for the risk of director liability and hence the test for demand futility, Aronson was a creature of its time. Subsequent jurisprudential developments severed the linkage between these concepts. Under current law, the application of a standard of review that is more onerous than the business judgment rule does not render demand futile. Similarly, the availability of exculpation means that a standard of review that is more onerous than the business judgment rule may not result in a substantial likelihood of liability.[10]

Laster reviewed these changes in detail, explaining how they had called into question the continuing utility of Aronson.

In addition to its declining doctrinal relevance, the Aronson test has always been an awkward way of getting at the core problem in the derivative suit context. Recall that we are dealing here not with a lawsuit brought to redress an injury done to the shareholder but rather one done to the corporate entity. The board of directors is charged with running the corporation and therefore ought to control corporate litigation. On the other hand, when it is the directors or their associates who are on trial, we may not trust them to make unbiased decisions. Consequently, the law governing derivative litigation must balance the competing policies of deference to the board’s decision-making authority and the need to hold erring directors accountable.

The core question thus is: Do we trust the board of directors to make a good faith decision about the merits of the lawsuit in question. If so, the board should be allowed to control the case. If not, the shareholder should be allowed to go forward.

Aronson gets at that question only indirectly. In contrast, as Laster explained, Rales does so directly:

The significant advance made by Rales was to refocus the inquiry on the decision regarding the litigation demand, rather than the decision being challenged. . . . The Rales decision thus asked directly “whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations.”

Under Rales, a director is disqualified from exercising judgment regarding a litigation demand if the director was interested in the alleged wrongdoing, such as when the director received a personal benefit from the wrongdoing that was not equally shared from the stockholders. A director also is disqualified from exercising judgment regarding a litigation demand if another person was interested in the alleged wrongdoing, and the director lacks independence from that person. Although these aspects of the Rales inquiry look to the relationship between the alleged wrongdoing and the directors considering the litigation demand, they do so for purposes of analyzing the directors’ ability to evaluate the litigation demand, not to determine the standard of review that would apply to the alleged wrongdoing.[11]

On appeal, the Delaware Supreme Court (per Justice Montgomery-Reeves) affirmed.[12]

Facts

In 2016, Facebook proposed a stock reclassification that would allow founder and controlling shareholder Mark Zuckerberg to dispose a substantial amount of his shares while still retaining voting control of the company. Numerous shareholder suits were challenging the proposal, which were consolidated into a single class action. Shortly before the trial was scheduled to begin, Facebook withdrew the proposal and settled the case. Facebook spent almost $22 million defending the class action, including over $17 million on attorneys’ fees. The settlement included payments to the plaintiffs’ lawyers of over $68 million.

A Facebook shareholder, the United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund (UFCWU), filed a derivative suit claiming that Facebooks’ board of directors “breached their fiduciary duties of care and loyalty by improperly negotiating and approving” the reclassification. The new suit was brought derivatively on behalf of the corporation to recover the money Facebook had spent defending and settling the original class action.

The plaintiff did not make demand before filing the derivative suit. When the defendants moved to dismiss the suit for failure to do so, plaintiff claimed that demand should be excused as futile. VC Laster granted the motion. Plaintiff appealed.

Held

Affirmed.

Reasoning

The Supreme Court emphasized the centrality of a demand requirement with teeth as a gateway to derivative litigation:

[T]he demand requirement is not excused lightly because derivative litigation upsets the balance of power that the DGCL establishes between a corporation’s directors and its stockholders. Thus, the demand-futility analysis provides an important doctrinal check that ensures the board is not improperly deprived of its decision-making authority, while at the same time leaving a path for stockholders to file a derivative action where there is reason to doubt that the board could bring its impartial business judgment to bear on a litigation demand.[13]

(This is, by the way, a point I made at some length in my book Corporation Law and Economics at 399-404, in which I discussed the application of my director primacy theory to derivative litigation.)

In operationalizing that policy, the Court noted that there had been an important doctrinal shift since Aronsonwas decided; namely, the adoption of FGCL § 102(b)(7), which allows corporations to adopt provisions in their articles of incorporation exculpating monetary liability for duty of care claims against directors. Almost all public Delaware corporations have adopted such provisions.

Accordingly, this Court affirms the Court of Chancery’s holding that exculpated care claims do not satisfy Aronson’s second prong. This Court’s decisions construing Aronson have consistently focused on whether the demand board has a connection to the challenged transaction that would render it incapable of impartially considering a litigation demand. When Aronson was decided, raising a reasonable doubt that directors breached their duty of care exposed them to a substantial likelihood of liability and protracted litigation, raising doubt as to their ability to impartially consider demand. The ground has since shifted, and exculpated breach of care claims no longer pose a threat that neutralizes director discretion.[14]

After disposing of plaintiff’s various objections to that conclusion, the Court turned to the question “whether the three-part test for demand futility the Court of Chancery applied below is consistent with Aronson, Rales, and their progeny.”[15] VC Laster’s version of the Rales test stated:

(i) whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;

(ii) whether the director would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand; and

(iii) whether the director lacks independence from someone who received a material personal benefit from the alleged misconduct that is the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand.[16]

Oddly, although the test is phrased in the conjunctive (“and”), it seems clear that the court intends it to be applied in the disjunctive: “If the answer to any of the questions is ‘yes’ for at least half of the members of the demand board, then demand is excused as futile.”[17]

The Supreme Court adopted “the Court of Chancery’s three-part test as the universal test for assessing whether demand should be excused as futile,”[18] explaining:

The purpose of the demand- futility analysis is to assess whether the board should be deprived of its decision-making authority because there is reason to doubt that the directors would be able to bring their impartial business judgment to bear on a litigation demand. That is a different consideration than whether the derivative claim is strong or weak because the challenged transaction is likely to pass or fail the applicable standard of review. It is helpful to keep those inquiries separate.[19]

The court concluded by denying that this amounted to a dramatic change in the law, arguing that “because the three-part test is consistent with and enhances Aronson, Rales, and their progeny, the Court need not overrule Aronson to adopt this refined test, and cases properly construing Aronson, Rales, and their progeny remain good law.”[20]

Kevin LaCroix on Boeing and Caremark

As regular readers know, I regard Kevin LaCroix's D&O Diary blog as essential corporate governance reading. So I was interested to see his take on the new Boeing decision and its implications for the future of Caremark claims. In a post a couple of days agp, I took a rather alarmist view of the opinion. Mr. LaCroix's view is less alarmist, but he does agree that we'll be seeing more oversight claims in the future.

He argues that:

... while there have been several significant recent cases in which breach of the duty of oversight claims have been sustained, even the rulings allowing these kinds of claims to go forward have emphasized pleading requirements that may not be satisfied in many circumstances. The holdings in these cases emphasize that to state a claim, the plaintiff must be able to allege that the company operation is “mission critical” for the oversight duty to be triggered. In order to establish that the board failed in its oversight, the plaintiff must allege the absence of any board committee function or board processes to supervise the critical operation. And while Vice Chancellor Zurn concluded here that the Boeing board acted with scienter, establishing that a board acted with awareness of its oversight shortcomings is going to be a significant pleading hurdle for plaintiffs in many instances.

He then identifies some facts that admittedly make Boeing an unusually strong case for plaintiffs:

I think there are important and distinct circumstances involved here that have a lot to do with the outcome. The exceptional occurrence of two tragic air disasters not only dramatically highlight the critical importance of safety issues for Boeing (just as the deaths from the listeria outbreak did the same in Marchand), but put the actions and inactions of the board in a particularly harsh light. The way Zurn’s opinion is written suggests that she was troubled by the plaintiffs’ allegations, a perspective that undoubtedly has something to do with the two fatal air crashes only five months apart. I emphasize this because it is going to be a relatively rare set of circumstances where board actions are subjected to this kind of harsh light.

I take his point. But I still think Boeing at the very least is chumming the litigation waters. As Mr. LaCroix observes "the recent spate of breach of the duty of oversight cases will encourage plaintiffs to pursue these kinds of claims and to include claims of breach of the duty of oversight in cases in which companies have experienced significant adverse circumstances in important operations." I concur.

He concludes with some good advice for what boards should be doing on a going forward basis. Go read the whole thing.

After Boeing, Caremark is no longer "the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment"

“It has become among the hoariest of Chancery clichés for an opinion to note that a derivative claim against a company’s directors, on the grounds that they have failed to comply with oversight duties under Caremark, is among the most difficult of claims in this Court to plead successfully.” Teamsters Local 443 Health Servs. & Ins. Plan v. Chou, 2020 WL 5028065, at *1 (Del. Ch. Aug. 24, 2020).

As I explained in my post, Is Caremark still the hardest claim for plaintiffs to win in corporate law?, there has been a steady erosion of that principle in the Delaware courts. Indeed, it is getting easier and easier for a plaintiff to at the very least get past the motion to dismiss stage of the litigation (at which point the pressure on defendants to settle becomes almost unbearable).

Yesterday's opinion in In re The Boeing Company Derivative Litigation by  Delaware Vice Chancellor Zurn is the latest nail in that cliche's coffin. 

To be sure, VC Zurn's opinion includes the right quotes about how difficult it is to win on a Caremark claim. But I see a number of reasons to doubt whether those quotes mean all that much anymore.

Zurn relies heavily on Marchand. But Marchand involved an ice cream maker--a mono-line company--whose entire operations were shut down after a listeria outbreak resulted in the deaths of three customers. But here any alleged deficiencies went solely to the board's alleged lack of oversight with respect to one of Boeing's many products (namely the 737 MAX). Boeing never shut down its entire operation.

Now it is true that, as Zurn observes, "Like food safety in Marchand, airplane safety 'was essential and mission critical' to Boeing’s business, and externally regulated." But you could say the same thing about any manufacturer. After all, how many products these days come without safety warnings? How many production lines are not extensively regulated? Zurn's approach leaves every manufacturer vulnerable to Caremark claims.

Zurn echoes Marchand in complaining that Boeing had no board-level committee to supervise airline safety risk. But, prior to Marchand, it was hardly obvious that a board-level committee with respect to every major risk a company faces was a Caremark requirement. To the contrary, Caremark required that there be a process by which the board as a whole was kept informed.

Zurn also echoes Marchand in opining that the board didn't promptly discuss the first 737 MAX crash. But so what? Caremark requires ongoing supervision and the defendants apparently offered plenty of evidence that the board regularly discussed safety. 

Zurn's dismissal of that evidence is really the key part of the opinion:

The Board and management’s passive invocations of quality and safety, and use of safety taglines, fall short of the rigorous oversight Marchand contemplates. (emphasis supplied)

If courts are going to examine board decisions about oversight with a microscope and mandate that oversight "be rigorous" then it is no longer true that Caremark claims will be the most difficult corporate law claims to prove. Indeed, that will no longer be a cliche but a falsehood.

Zurn condemns the board's post-crash effort to draw lessons learned, arguing that they evidence the board's pre-crash oversight failures. One wonders what that will do to the incentives of future boards to commission rigorous after-action reports? A board that does so will be shooting itself in the foot.

I am not claiming that Boeing's board was perfect. Far from it. But Zurn's opinion reads like a brief for the plaintiffs rather than an effort to hold plaintiffs to what is supposed to be an “onerous pleading burden.” At every turn, evidence favorable to the defendants is rubbished and evidence favorable to the plaintiffs is accepted. Granted, we're at the motion to dismiss stage. But Caremark claims are supposed to be disposed of at the motion to dismiss stage. See Elizabeth Pollman, Corporate Oversight and Disobedience, 72 VAND. L. REV. 2013, 2021-25 (2019) (finding that few cases alleging director-oversight failures survive the motion to dismiss stage).

I may be overreacting. If so, it is because I firmly believe Marchand was wrongly decided. Boeing seems like another step towards making Marchand the general standard and thereby continuing the evisceration of the supposed limits that remain on Caremark.

Those beliefs coupled with the trend in the Delaware courts towards making Caremark claims the easiest claims to prove in corporate law prompted me to write Don’t Compound the Caremark Mistake by Extending it to ESG Oversight (August 4, 2021). Business Lawyer (September 2021), UCLA School of Law, Law-Econ Research Paper No. 21-10, Available at SSRN: https://ssrn.com/abstract=3899528. If I may say so, Boeing makes that article's argument even more timely and essential.

Update: Kevin LaCroix is less alarmist, but concurs that we'll be seeing more of these cases.

Valuation of a Business in Legal Settings I: Discounting to Present Value

The Reader's Digest Condensed Version of my Article, Don’t Compound the Caremark Mistake by Extending It to ESG Oversight, is Up

Here