ProfessorBainbridge.com

Corporate Governance Panel Question: Caremark and the Board's Duty of Oversight

Question

Over the past few years, the Delaware Courts have been wrestling with the duty of oversight as first set forth in the Caremark case. The exact parameters of that duty, when it is triggered, and what it entails remains somewhat uncertain.

Putting aside Delaware law for a moment, Do you think that good corporate governance requires a board to have a duty of oversight that is part of the duty of loyalty or duty of care?  (If not, why not.)

Stephen, I know that you have been critical of Caremark and the Caremark line of cases. Do you think the duty of care or the duty of loyalty includes within it a duty of oversight at all or do you think it is unnecessary for effective governance.

Answer

First, Caremark was wrong from the outset. Caremark’s unique procedural posture, which precluded any appeal, gave Chancellor Allen an opportunity to write “an opinion filled almost entirely with dicta” that “drastically expanded directors’ oversight liability.” In doing so, Allen misinterpreted binding Delaware Supreme Court precedent and ignored the important policy justifications underlying that precedent.

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

I think we ought to revive Graham v. Allis-Chalmers Manufacturing Co., 188 A.2d 125, 130 (Del. 1963). Consider the old saying: “every dog gets one bite.” This saying was based on the common law principle that a dog’s master was only liable for bites if the master knew or had reason to know the dog had a propensity to bite. Such knowledge could be based either on the breed’s inherently violent propensities or a prior bite. The economic rationale for such a rule is simple—monitoring costs. Keeping an eye on your dog requires costly precautions, such as leashes, fences, and the like. Why require such expenditures if Fido is as gentle as a lamb?

The analogy to Graham should be self-evident, but let’s beat the dead horse anyway. Just as a dog owner does not have liability unless the owner knows the dog has a propensity to bite, directors are liable only if they are on notice that their employees have a propensity for crime. Just as a dog owner is put on such notice by a prior bite, prior criminal violations can put directors on notice. Just as owners have an affirmative duty to control dogs of an inherently vicious breed, directors may not recklessly fail to monitor an obviously untrustworthy employee.

As with the dog bite rule, Graham implicitly rests on a cost-benefit analysis. Law compliance programs are not free. At the very least, a law compliance program requires preparation of a company manual telling employees not to fix prices. It probably also requires training of employees. Beyond that, the firm probably should send lawyers out to do compliance audits from time to time. Programs with real teeth require substantial high-level commitment and review, frequent and meaningful communication to employees, serious monitoring and auditing, and appropriate discipline where violations are discovered. By analogy to the dog bite cases, one reasonably would expect a firm to go through all this only when on notice of a past violation.

Interestingly, the Model Business Corporation Act’s director liability provisions codify a standard closer to Graham than Caremark. Under MBCA § 8.31(a)(2)(iv), a director may be held liable for sustained inattention but only when “particular facts and circumstances materialize that” would put “a reasonably attentive director” on notice of the need for further inquiry. Under this provision, it would seem, proactive vigilance is not required.

Reading

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

Bainbridge, Stephen Mark, Caremark and Enterprise Risk Management (March, 18 2009). UCLA School of Law, Law-Econ Research Paper No. 09-08, Available at SSRN: https://ssrn.com/abstract=1364500 or http://dx.doi.org/10.2139/ssrn.1364500

Bainbridge, Stephen Mark and Lopez, Star and Oklan, Benjamin, The Convergence of Good Faith and Oversight. UCLA School of Law, Law-Econ Research Paper No. 07-09, Available at SSRN: https://ssrn.com/abstract=1006097 or http://dx.doi.org/10.2139/ssrn.1006097

Corporate Governance Panel Question: What do each of you see as the major challenges facing boards beyond the economy?

Question

What do each of you see as the major challenges facing boards beyond the economy? For example: Do you think we will see more pressure from certain state actors on corporate policy a la Florida and Disney? Do you think the large funds (Blackrock, State Street, Vanguard) will continue to pressure companies for certain social change?

Answer

In my book, The Profit Motive: Defending Shareholder Value Maximization, I discuss the question of whether CEOs have become social justice warriors. Some have. Most of the supposedly woke CEOs, however, revert to shareholder primacy when push comes to shove.

As for the big three asset managers—BlackRock, State Street, and Vanguard—all claim to have embraced ESG because they believe that ESG factors are positively correlated with firm performance. But I think it’s mostly greenwashing. Case in point: The coal-fired Hardin Generating Station in Montana had been struggling for years. Late last year, a Nasdaq-listed bitcoin miner called Marathon Digital Holdings Inc. partnered with Hardin’s owner to transform the power plant into a hub for mining bitcoin.

The project is in the process of scaling up, with more than 100 megawatts of power capacity planned. Marathon Digital said that by tapping the Montana coal plant, its break-even costs to produce a bitcoin will fall to $4,600, 38% less than previously.

One of Marathon’s biggest shareholders? BlackRock.

Back in March we learned that Vanguard CEO Tim Buckley was backing his massive fund family away from ESG: “Our research indicates that ESG investing does not have any advantage over broad-based investing,” Mr. Buckley said in a recent interview with the Financial Times. Matching word to deed, his comments came after he had withdrawn his firm from the $59 trillion Net Zero Asset Managers initiative, an organization that is part of the $150 trillion United Nations-affiliated Glasgow Financial Alliance for Net Zero. Both alliances are committed to restricting their investments over time to companies that are compliant with the Paris Agreement’s objective of net-zero greenhouse gas emissions by 2050. Mr. Buckley claims the financial world, swept up in climate-change fervor, can’t make such commitments without reneging on its fiduciary duties.

As Delaware contemplates the Match.com case, the court should acknowledge that not all controlling shareholder transactions should require cleansing.

Bloomberg reports:

Delaware’s top court is weighing a potentially groundbreaking ruling that could streamline corporate dealmaking while scaling back protections for minority investors in many transactions that favor insiders.

A case involving dating site Match.com is giving the leading US forum for M&A disputes a chance to reaffirm or rein in enhanced scrutiny of deals involving a potential conflict of interest between a company and its controlling stockholder. ...

The legal framework getting a hard look from the Delaware’s high court is known as the “MFW” doctrine. Named after the court’s seminal 2014 ruling in Kahn v. M&F Worldwide Corp. , it was developed for “squeeze-out” or “freeze-out” transactions that forcibly cash out investors at a price unilaterally set by a controlling stockholder.

But judges on Delaware’s Chancery Court are now applying the standard to a wider range of deals. 

Bloomberg further explains that:

The legal standard facing an unexpected challenge requires corporate leaders to defend a transaction as “entirely fair” unless the board sets up an independent special committee and seeks “majority of the minority” approval from unaffiliated investors, onerous steps that can derail a deal.

IAC is asking the state high court to reject that “belt and suspenders” approach and instead require only one or the other. 

But IAC didn't go far enough. Independent board committees and votes of the disinterested shareholders are what we call cleansing devices. They supposedly "cleanse" the conflicting shareholders' conflict of interest in transactions with the company.

My own view is that not all controlling shareholder transactions need cleansing. I start with the Delaware Supreme Court's decision in Sinclair Oil. v. Levien, 280 A.2d (Del. 1971). Under Sinclair Oil, as I explain in my book Corporate Law (Concepts and Insights):

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

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

Accordingly, the initial question is whether the controlling shareholder “has received a benefit to the exclusion and at the expense of the subsidiary.” Only if that is the case does thee transaction require cleansing. Controlling shareholder transactions that do not involve such a benefit are reviewed under the business judgment rule without the need for cleansing by an independent board committee of disinterested shareholder vote.   (To be sure, Sinclair Oil involved a parent-subsidiary relationship, but the parent by definition is a controlling shareholder and the principles are the same.)

The fact that the controlling shareholder is a party to the transaction is not enough to trigger ckeansing. The controlling shareholder must have gotten a benefit that is both at the expense of and to the exclusion of the minority shareholders.

This is made clear by the court’s treatment of the minority’s objection to the subsidiary’s dividend policy. Sinven (the subsidiary) had adopted at Sinclair Oil’s behest a policy of paying out the maximum lawful dividend. This benefited Sinclair Oil but did not constitute self-dealing by Sinclair Oil because Sinclair received nothing from Sinven to the exclusion of its minority stockholders.” Id. at 772.

Moreover, the need for cleansing is not triggered even if the controlling shareholder get a benefit or even if that the benefit is not shared. The controlling shareholder must get a benefit not only that excludes the minority but comes at their expense. This is made clear by the court’s treatment of the minority’s complaint that Sinclair Oil had denied Sinven opportunities to develop oil properties outside of Venezuela. “From 1960 to 1966 Sinclair purchased or developed oil fields in Alaska, Canada, Paraguay, and other places around the world. The plaintiff contends that these were all opportunities which could have been taken by Sinven.” Id. But the court rejected that claim: “Sinclair usurped no business opportunity belonging to Sinven. Since Sinclair received nothing from Sinven to the exclusion of and detriment to Sinven's minority stockholders, there was no self-dealing.” Id. Again, you must have both exclusion AND detriment.

I will grant you that some recent Chancery Court cases appear to assume that any “interested” transaction involving a controller is subject to intrinsic fairness analysis (unless cleansed as per below). But that is not the law, at least in Delaware. Under Sinclair Oil, there are two standards of review. If the plaintiff can carry the burden of proof of showing that the controlling shareholder benefited itself at the expense and exclusion of the minority, then entire fairness is the standard. But if the plaintiff cannot, the business judgment rule is the standard of review. The requirement that the controller receive a benefit “to the exclusion and at the expense of the" minority is essential because it ensures that courts will only get involved where there is a real conflict in the sense of a detriment to the minority, not just a benefit to the controller.

The rule thus is not: Controlling shareholder > was controlling shareholder connected to transaction > fairness unless cleansing.

The rule is: Controlling shareholder > did controlling shareholder benefited at the expense of and to the exclusion of minority shareholders > if yes, fairness unless cleansed; if no, business judgment rule.

In other words, If the plaintiff can't carry the burden of proof of showing that the controlling shareholder benefited itself at the expense and exclusion of the minority, then no cleansing--whether ordinary Kahn v. Lynch or MFW--is required.

As been ably said by a court otherwise quite protective of minority shareholder rights, “The majority . . . have certain rights to what has been termed ‘selfish ownership’ in the corporation which should be balanced against the concept of their fiduciary obligation to the minority.” Wilkes v. Springside Nursing Home, Inc., 353 N.E.2d 657, 663 (Mass. 1976). This seems to be the principle animating Sinclair Oil, which allows some controlling shareholder transactions the protection of the business judgment rule even without the sort of cleansing envisioned by either Kahn v. Lynch or MFW.

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

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

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

To be sure, the Sinclair Oil approach does not explain the law in freeze-out mergers. As a policy matter, I think that it makes sense to go immediately into an entire fairness review--and thus to require cleansing--in this context. tThe potential conflict of interest is especially pronounced in this context. After all, “a merger in which it is bought out is the most important event that can occur in a small corporation's life, to wit, its death . . ..” SEC v. Geon Industries, Inc., 531 F.2d 39, 47 (1976). In a freeze out merger, the transaction takes on even greater significance than in the ordinary case because the controlling shareholder is buying the company and thus has a strong incentive to minimize the price at the expense of the minority. Freeze out mergers thus have long been the subject of especially close review.

Julian Velasco's "A Catholic Defense of Corporate Law and Practice"

As regular readers know, exploring the implications of Catholic social teaching for corporate law and governance is one of my principals areas of interest. I just read a wonderful contribution to that literature by Notre Dame Law Professor Julian Velsco. Here's the abstract:

In this essay, I provide a defense of corporate law and of pursuing a career therein from the perspective of Catholic teaching. I argue that Catholicism is not incompatible with the pursuit of wealth as such, but rather insists upon the appropriate use of wealth. I also argue that it is appropriate for corporate actors to pursue the interests of shareholders, provided that they do not break the law or otherwise sin in doing so. I also explain why I found transaction practice personally fulfilling.

Velasco, Julian, A Catholic Defense of Corporate Law and Practice (August 25, 2023). 38 Notre Dame J.L. Ethics & Pub. Pol’y ___ (Forthcoming), Available at SSRN: https://ssrn.com/abstract=4552281 

I was very flattered by footnote 114:

As for the actual benefits that flow from the use of the corporate form, I point the reader to the works of Michael Novak and Stephen Bainbridge in particular. See, e.g., MICHAEL NOVAK, TOWARD A THEOLOGY OF THE CORPORATION (AEI Press, rev. ed. 1990); Stephen M. Bainbridge, Community and Statism: A Conservative Contractarian Critique of Progressive Corporate Law Scholarship, 82 CORNELL L. REV. 856, 898-99 (1997); Stephen M. Bainbridge, In Defense of the Shareholder Wealth Maximization Norm: A Reply to Professor Green, 50 WASH. & LEE L. REV. 1423, 1446 (1994) (“That rule [i.e., the shareholder wealth maximization norm] has helped produce an economy that is dominated by public corporations, which in turn has produced the highest standard of living of any society in the history of the world.”). They have argued that the corporate form is not only morally acceptable, but positively beneficial. According to them, it has led to unprecedented levels of prosperity and the alleviation of incredible amounts of suffering. Their arguments, which I find generally persuasive, should help to destigmatize corporations and corporate law.

But I would strongly recommend readuing the paper even if he had left out that part. 

Adapting corporate law for a non-bricks and mortar world

The latest long form Chancery Daily observes: 

We briefly observe that Delaware business entity law has overwhelmingly developed in what might be called the bricks-and-mortar corporate paradigm, where companies had offices and people worked there, doing physical tasks having some form of tangible representation -- if only on paper (or an electronic file simulating paper) -- that evidenced their existence. Today, to a much greater degree than even just a few years ago, business operations are virtual, decentralized, and even ephemeral -- and as TCDrecently noted in its September 27, 2023 edition, we begin to see questions regarding whether entities or individuals actually exist.

The question of virtual firms was one that fascinated my friend and colleague Bill Klein. In his most complete treatment of the issue, Bill and two coauthors wrote:

This Article proposes the metaphor "connected contracts" for understanding collaborative economic activity. Connected contracts refers to the interrelating agreements and relationships among the participants in a business venture. From the perspective offered by this metaphor, there are no firms, no predetermined hierarchies, no organizations with personalities of their own, and no a priori notions of ownership or control; there is no shareholder or managerial primacy and no centralizing "nexus." The view is from the bottom up rather than from the top down. Boundaries and governance are neither central issues, nor do they loom in the background. There are no boundaries and there is nothing to govern. The connected contracts perspective is applied to an important aspect of joint activity?the putative bargain over control. Looking at business activity as bargains among individuals who agree to undertake a specific project leads to the insight that control of the venture is not automatically allocated to equity. The concept of an "owner" has little value. The connected contracts perspective suggests, among other things, that, all else equal, different capital structures can be viewed as representing different bargains over control. Capital structure is not irrelevant, but reflects unique bargains over control in general and future decisions about projects in particular. The inquiry then broadens to encompass more participants and types of contributions and to speculate on how the connected contracts metaphor might affect thinking about a variety of topics in corporate and tax law, including piercing the corporate veil, insider trading, executive compensation, the taxation of corporations, and the differential taxation of debt and equity. Finally, and tentatively, the essay offers a list of criteria that might be used to judge the value of models and metaphors and, by offering the list, suggests that scholars should be more conscious of the risks and rewards of reliance on models and metaphors.

Gulati, Mitu and Klein, William A. and Zolt, Eric M., Connected Contracts. Available at SSRN: https://ssrn.com/abstract=217590 or http://dx.doi.org/10.2139/ssrn.217590

You should also check out:

Klein, William A. and Gulati, Mitu, Economic Organization in the Construction Industry: A Case Study of Collaborative Production Under High Uncertainty (July 16, 2003). Available at SSRN: https://ssrn.com/abstract=428600 or http://dx.doi.org/10.2139/ssrn.428600

 

Gulati, Mitu and Isaac, Thomas M. and Klein, William A., When a Worker's Cooperative Works: The Case of Kerala Dinesh Beedi (April 24, 2002). Available at SSRN: https://ssrn.com/abstract=308759 or http://dx.doi.org/10.2139/ssrn.308759

More on Chancellor McCormick and the future of Caremark: We still need to call a halt to the "'disintegrating erosion' of particular exceptions"

Apropos a preceding post, my friend GWU law professor Lawrence Cunningham sent along the following email, which he has kindly authorized me to post:

I didn't see the Bloomberg report, but just to clarify, Chancellor McCormick did not make a speech yesterday. We were on a Caremark panel together at the Delaware Governance Institute. The remarks she made about reducing concern around Caremark were responses to my opening and closing comments on the panel about directors' concerns on Caremark. She said "don't worry Larry" and explained how the law has not changed since Bill Allen wrote.

I stressed that the string of cases denying motions to dismiss got huge coverage and encouraged the 200 Delaware lawyers/judges present and more listening to put as much emphasis on ProAssurance and Solar Winds. She agrees and it makes me less worried. There were many Delaware judges in the audience, including 4 of 5 Supreme Court justices and several VCs. I think I got the message across.

My conclusion emphasized the intersection of the proposed Noclar rule from the PCAOB and asked the judges to be careful with red flags about legal violations. The real danger today is from Washington not Wilmington.

Several thoughts. First, I would be the first to concede that Gary Gensler's SEC and Congress folk like Elizabeth Warren pose a far greater danger to good corporate governance than the Delaware judiciary.

Second, ProAssurance and Solar Winds were important cases that provide some reassurance about Caremark being constrained. In the former, VC Will stated: "Oversight claims should be reserved for extreme events." As for the latter, the estimable Kevin LaCroix has written that:

A claim alleging a board’s breach of duty of oversight has long been regarded as one of the most difficult for a plaintiff to sustain. But after the Delaware Supreme Court’s 2019 opinion in Marchand v. Barnhill, breach of the duty of oversight claims (or Caremark claims, as they are sometimes called) have in recent years, as Vice Chancellor Sam Glasscock put in in his recent opinion in the SolarWinds case, “bloomed like dandelions after a warm spring rain.” Some commentators questioned whether oversight breach claims were in fact as difficult to sustain as is so often said. However, in his recent opinion, the Vice Chancellor emphasized the oversight breach claims remain “one of the most difficult claims” to sustain and granted the defendants’ motion to dismiss the cybersecurity-related oversight breach claims asserted against the board of Solar Winds.  A copy of Vice Chancellor Glasscock’s September 6, 2022 opinion in the SolarWinds case can be found here.

Again, good news for those of us who have questioned the direction Caremark has taken.

Third, however, on the other side of the scales one can stack up Marchand, Boeing, and McDonald's. Taken together, these cases and their ilk call to mind Judge Cardozo's reference--albeit, of course, in a very diffent context--in Meinhard v. Salmon to the "'disintegrating erosion' of particular exceptions."

I would feel better about the direction of Delaware law if we started seeing some opinions drawing clear redlines beyond which Caremark cannot reach. This far shall it go and no farther.

A new The Profit Motive video

Delaware Chancellor McCormick is not worried that Caremark is evolving into the chicken heart

I have observed before that Arch Oboler was an American entertainer perhaps best known for running the 1930s radio drama Lights Out. One of his most famous stories was The Chicken Heart. In brief, a mad scientist keeps a disembodied chicken heart alive and beating. Until one day the apparatus is overturned and smashed. And disaster followed:

That apparatus—robot-heart or whatever you want to call it—was accidentally smashed and over the week-end, in some miraculous manner, that little chicken heart no larger than my thumb-nail grew into a mass of pulsing flesh a thousand times its original size! ...

When those women knocked over the apparatus - it fell against that rack of chemicals! Is it not possible that some unknown combination of those reagents acting upon the tissue resulted in what you choose to call a "miracle"—the super-growth of this heart, this independent existence of an organ outside its own bodily environment?

And the chicken heart kept growing. And started moving:

With my own eyes I saw it! It moved out until it reached that case of white mice there and then it—it wrapped itself around one of the mice! ... Then—then the tentacle retracted itself and the mass of flesh engulfed the mouse!

And still it grew:

That little piece of flesh has grown until now it's jamming that building with flesh! All inside the space of an hour!

Until:

The end has come for humanity—not in the glory of interstellar combustion—not in the peace of white cold silence—but with that - creeping, grasping flesh below us! It is a joke, eh, Lewis? A great joke! The joke of the Cosmos! The end of mankind - because of a chicken's heart!

That tale of horror came to mind when I read Delaware Vice Chancellor Travis Laster's opinion in In re McDonald's Corp. Stockholder Deriv. Litig., in which the VC held that Caremark's oversight duty applies to officers as well as directors. McDonald's generated two posts:

In re McDonald's Corp. Stockholder Litig.: Caremark is the Chicken Heart

and

VC Laster Disposes of Shareholder Suit over McDonald's Corporate Culture

As I explained in the former, I have two longstanding concerns about Caremark.

First, Caremark was wrong from the outset. In the original Caremark decision, the unique procedural posture of the case, which was such that it would not be appealed, gave Chancellor Allen an opportunity to write “an opinion filled almost entirely with dicta” that “drastically expanded directors' oversight liability.” In doing so, Allen misinterpreted binding Delaware Supreme Court precedent and ignored the important policy justifications underlying that precedent.

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

All of which came to mind when I read a report from Bloomberg about a speech in which Delaware Chancellor Kathaleen St. Jude McCormick. Noting the "rising number of Caremark claims being filed in Chancery Court," McCormick called that increase “interesting but not alarming.”

The report continues:

Caremark claims historically are among the hardest cases for shareholders to win, but a series of Laster’s rulings over the past year—involving AmerisourceBergen Corp., McDonald’s, and Walmart Inc.—potentially have smoothed the path forward.

There’s also been a notable rise in the number of lawsuits seeking corporate books and records concerning board decisions for investigations that may lead to Caremark claims or M&A cases, she said.

Unlike the Chancellor, I find this trend alarming. Caremark should have been nipped in the bud. At the very least, it should have been constrained to its fact pattern. Instead, like the chicken heart of fable, it seems destined to swallow increasing swaths of corporate law.

UPDATE: Larry Cunningham was at the Institute and offers a take in which Caremark is not the chicken heart. As I note, however, I’d like to see Chancery draw some red lines beyond which Caremark will not be allowed to go  

For more detailed critiques of Caremark, see:

Bainbridge, Stephen Mark, Caremark and Enterprise Risk Management (March, 18 2009). UCLA School of Law, Law-Econ Research Paper No. 09-08, Available at SSRN: https://ssrn.com/abstract=1364500 or http://dx.doi.org/10.2139/ssrn.1364500

The financial crisis of 2008 revealed serious and widespread risk management failures throughout the business community. Shareholder losses attributable to absent or poorly implemented risk management programs are enormous.

Efforts to hold corporate boards of directors accountable for these failures likely will focus on so-called Caremark claims. The Caremark decision asserted that a board of directors has a duty to ensure that appropriate "information and reporting systems" are in place to provide the board and top management with "timely and accurate information." Although post-Caremark opinions and commentary have focused on law compliance programs, risk management programs do not differ in kind from the types of conduct that traditionally have been at issue in Caremark-type litigation.

Risk management failures do differ in degree from law violations or accounting irregularities. In particular, risk taking and risk management are inextricably intertwined. Efforts to hold directors accountable for risk management failures thus threaten to morph into holding directors liable for bad business outcomes. Caremark claims premised on risk management failures thus uniquely implicate the concerns that animate the business judgment rule's prohibition of judicial review of business decisions. As Caremark is the most difficult theory of liability in corporate law, risk management is the most difficult variant of Caremark claims.

Bainbridge, Stephen Mark, Don’t Compound the Caremark Mistake by Extending it to ESG Oversight (September 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.

"Beyond Profit Motives": A Review of my Book "The Profit Motive"

In Beyond Profit Motives, ___ Michigan Law Review ___ (forthcoming), available at https://tinyurl.com/29pyycxb, Maryland Law Professor William Moon writes:

Generations of legal scholars have debated both the origins of business corporations and their purpose. Professor Stephen Bainbridge’s new book is a substantial contribution to this literature and an essential read for anyone who wishes to better understand a controversy that has an immense impact on how movers and shakers of today’s largest corporations make decisions.

Bainbridge, one of the most prolific and influential corporate law professors in the United States, throws cold water on burgeoning scholarly literature calling for corporations to embrace corporate social responsibility. . . .

Bainbridge synthesizes familiar policy arguments, while teeing up some more novel arguments. We see in these chapters that Bainbridge is far from an ideological zealot. He carefully deconstructs several theoretical building blocks supporting the shareholder value maximization paradigm and abandons ones he finds unpersuasive. . . .

The essay then goes on to offer an alternative framework based a new approach to concession theory the author believes might provide a stronger foundation for stakeholder capitalism, but concludes:

For those committed to stakeholder capitalism, the book is a powerful reminder that a different theoretical foundation is needed to build a house that justifies infusing social responsibility into business corporations.

I need to ponder the neo-concession theory a bit more, but overall I'm very honored. 

Shareholder Wealth Maximization and Securities Fraud

My friend and UCLA colleague James Park has posted a very interesting new article, Shareholder Wealth Maximization and Securities Fraud (September 27, 2023). DePaul Law Review, Vol. 72, No. 10, 2023, UCLA School of Law, Law-Econ Research Paper No. 23-07, Available at SSRN: https://ssrn.com/abstract=4586004:

Government enforcers are often criticized for failing to identify and prosecute individual executives responsible for corporate misconduct.

N.B.: I used to be of the critics. But Jim's article is very persuasive.

This essay contends that the failure to prosecute individuals can be partly explained by the difficulty of disentangling individual and corporate incentives for wrongful corporate acts. For example, in securities fraud cases, it can be difficult to determine whether corporate managers issued a materially misleading disclosure to further shareholder wealth or to enrich themselves. It is more difficult to justify prosecuting individuals in the absence of a clear agency costs story.

Recommended reading.

Does the business judgment rule apply to a board's choice of expert?

A friend sent along this question:

In a DGCL § 141 (e) situation (board relying on an expert), does the choice of an expert qualify for the business judgment rule’s safe harbor? Leaving the question of the expert being disinterested aside, can courts second-guess the suitability of the expert (for instance as to his qualifications to answer the question at hand)?

DGCL § 141(e) provides that:

A member of the board of directors, or a member of any committee designated by the board of directors, shall, in the performance of such member’s duties, be fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporation’s officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other person’s professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation.

You'll note that the statute divides the individuals upon whom the board may rely into two categories:

1. "any of the corporation’s officers or employees, or committees of the board of directors" and
2. "any other person"

Only the latter category is subject to the proviso requiring that the board member reasonably believe that the matters on which the expert is being consulted "are within such other person’s professional or expert competence" and that the expert was "selected with reasonable care by or on behalf of the corporation."

On its face the statute seems to preclude application of the business judgment rule to the board's choice of an outside expert. This reading arguably is supported by Brehm v. Eisner:

To survive a Rule 23.1 motion to dismiss in a due care case where an expert has advised the board in its decisionmaking process, the complaint must allege particularized facts (not conclusions) that, if proved, would show, for example, that: (a) the directors did not in fact rely on the expert; (b) their reliance was not in good faith; (c) they did not reasonably believe that the expert's advice was within the expert's professional competence; (d) the expert was not selected with reasonable care by or on behalf of the corporation, and the faulty selection process was attributable to the directors ...

Brehm v. Eisner, 746 A.2d 244, 262 (Del. 2000). The court thus apparently will explore the reasonableness of the director's selection of the expert, which is something that the business judgment rule would preclude. See Michael P. Dooley, Two Models of Corporate Governance, 47 Bus. Law. 461, 478-79 n.58 (1992) (arguing that the term “rational is to be equated with conceivable or imaginable and means only that the court will not even look at the board's judgment if there is any possibility that it was actuated by a legitimate business reason. It clearly does not mean, and cannot legitimately be cited for the proposition, that individual directors must have, and be prepared to put forth, proof of rational reasons for their decisions.”

Update: Keith Paul Bishop notes key differences between the Delaware statute and the comparable California statute.

Joseph Coletti reviews my book The Profit Motive

From behind a paywall at Journal of Markets and Morality:

In his review of precedent, corporate performance, and management incentives Bainbridge provides the legal, economic, and empirical justification for putting shareholders first. It is the law and should be the law. “Pursuit of shareholder value maximization,” Bainbridge concludes, “leads to more efficient resource allocation, creates new social wealth, and promotes economic and political liberty.”

Complying with M&A ordinary course of business covenants in times of global disasters

As I explain in my guide, Mergers & Acquisitions, merger agreements usually include an ordinary course of business covenant:

Covenants are a series of promises about how the parties will behave during the interim (usually two to four months) between the time the agreement is signed and the closing. A key covenant is that governing the target’s conduct of the business during the pendency of the merger agreement. Usually, the target is prohibited from doing anything other than engaging in ordinary course transactions that are consistent with past practice. Typically, certain major acts will be expressly forbidden, such as changes to the articles or by-laws, dividends, stock repurchases, and the like. Conversely, a target friendly version will allow various deviations from past practice, such as those that are immaterial or would not constitute a MAC.

As I also explain:

The COVID-19 pandemic strained ordinary course covenants to their limits. In AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC, for example, the Chancery Court reportedly observed that:

The real question is whether an ordinary course covenant means ordinary course on a clear day or ordinary course based on the hand you’re dealt. In other words, if you have flooding, is it the ordinary course of what you do consistent with past practice when you are in a flood, or is it ordinary course on a clear day when there hasn’t been any rain? Here, we obviously have a colossal and viral-based rainstorm.

The court opted the clear day rule, holding that “when faced with an extraordinary event,” the target’s management may not “take extraordinary actions and claim that they are ordinary under the circumstances.” Not surprisingly, in the immediate aftermath, ordinary course covenants increasingly included a pandemic exception allowing the target to take such actions as are reasonably necessary in response to such an event.

All of which leads me to Kevin Bishop's post Nevada Supreme Court Holds That Temporary Closing During Pandemic Did Not Violate This "Ordinary Course" Covenant:

When Lucky Lucy D, LLC agreed to sell its hotel and casino to LGS Casino LLC in 2019, the parties included a covenant pursuant to which Lucky Lucy agreed to maintain the property and conduct related business "in a manner generally consistent with the manner in which [Lucky Lucy] has operated and maintained the [p]roperty and [a]ssets prior to the date hereof."    COVID-19 arrived before the sale was consummated and Lucky Lucy temporarily closed the casino and laid off employees in response to gubernatorial directive ordering the closure of non-essential businesses.   The buyer then sent a notice of breach, which Lucky Lucy was unable to cure in light of the Governor's emergency directive.  Needless to say, litigation ensued.

... The Nevada Supreme Court ... held that "[i]n closing the casino and hotel pursuant to the emergency directive, the seller was merely following the law so as to maintain its gaming licenses and thus did not materially breach the agreement".  Lucky Lucy D LLC v. LGS Casino LLC, 139 Nev. Adv. 26 (2023).

Oddly, as Bishop explains, the court thought the result might have been different if the provision had not included the word "generally." It's another valuable lesson in the point that words do work and the transaction planner must carefully consider the meaning of every word, even those that seem generally mundane.

On losing interest in politics

As I get older, I find myself giving less of a [mild scatalogical expletive omitted] about politics. Which is sort of odd for somebody who once was very engaged. I’ve more or less dropped out of The Federalist Society. I vote American Solidarity. But without enthusiasm. I can’t remember the last time I read a book about politics. I can’t remember the last really political blog post I wrote; I.e., one that was unrelated to corporate and securities law.

Of course, it may not just be part of the aging process, but rather the times. Certainly, the major parties aren’t helping. Each in its own way is just awful. They offer up uninspiring candidates with serious flaws. They each have adopted many policies I regard as deal breakers. They accomplish nothing.

The good news, I suppose, is that it frees up time for the things I really enjoy: Devotional life. Scholarship. Maintaining my aquaria. Meal planning.

But it’s still sort of odd to see posts from my politically engaged friends over on X and think “oh, who cares?”

Marc Benioff embraces The Profit Motive

In my book, The Profit Motive, I predicted that a lot of social justice warrior CEOs were really just greenwashing and that, when push comes to shove, they will put profits and shareholder value first. Salesforce CEO Marc Benioff now stands as a prime example that I was right.

2/ In The Profit Motive, I pointed out that Benioff's actions have not always matched his rhetoric. But it now seems as though even his rhetoric is changing.

— Steve Bainbridge (@PrawfBainbridge) September 2, 2023

4/ Benioff is also taking an increasingly hard line on the deteriorating conditions in San Francisco. https://t.co/usHPAPk130

— Steve Bainbridge (@PrawfBainbridge) September 2, 2023

6/ But it is the rhetorical shift that is most striking. The WSJ Benioff told an earnings call: "I am quite addicted to the bottom line as well.” This from a guy who used to say "I need to embrace all of my stakeholders, not just all of my shareholders." https://t.co/wFFIHOD4HD

— Steve Bainbridge (@PrawfBainbridge) September 2, 2023