The executive compensation provisions provide for say on pay, clawbacks and increased disclosure.  Relying on listing standards, they require that the compensation committee have independent directors.  The Bill also regulates the compensation consultant and counsel hired by the committee.  It stops short of requiring that they be independent but specifies the factors that must be considered in making the selection.  Presumably consideration of the factors will result in the use of independent consultants and counsel. 

The legislation contains two sleeper provisions, both of which have been mentioned on this Blog before.  First, the directors on the compensation committee must be independent.  The legislation, however, provides that the Commission with the authority to dictate the definition.  Specifically, Section 952 provides that the Commission "shall require" the exchanges to adopt a definition that requires the consideration of "relevant factors" including "compensatory fees" paid by the company to the director.  In other words, unlike the current approach, fees will matter. 

It is also possible that, by giving the Commission the authority to determine "relevant factors," the Commission will further expand the definition to include other relevant factors.  Thus, the Commission could correct the problem that surfaced in connection with the Black & Decker, Stanley Works merger and require the exchanges to consider material relationships among directors (we will revisit this issue next week).  In short, the definition of independence will fall to the Commission and, as a result, it may become more meaningful.

The second sleeper provision, as noted in an earlier post, the legislation authorizes the Federal Reserve Board to adopt rules that prohibit "excessive" compensation paid to executive officers, directors, employees or principal shareholders of bank holding companies.  This is, in short, substantive regulation of executive compensation.  Moreover, by federalizing the issue, it effectively preempts Delaware.   

We've included the text of the compensation provisions.  The entire act is posted on the DU Corporate Governance web site.

Subtitle E—Accountability and Executive Compensation

SEC. 951. SHAREHOLDER VOTE ON EXECUTIVE COMPENSATION DISCLOSURES.
The Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) is amended by inserting after section 14 (15
U.S.C. 78n) the following:

SEC. 14A. ANNUAL SHAREHOLDER APPROVAL OF EXECUTIVE COMPENSATION.

(a) SEPARATE RESOLUTION REQUIRED.—Any proxy or consent or authorization for an annual or other
meeting of the shareholders occurring after the end of the 6-month period beginning on the date of enactment of this section, for which the proxy solicitation rules of the Commission require compensation disclosure, shall include a separate resolution subject to shareholder vote to approve the compensation of executives, as disclosed pursuant to section 229.402 of title 17, Code of Federal Regulations,
or any successor thereto. 

(b) RULE OF CONSTRUCTION.—The shareholder vote referred to in subsection (a) shall not be binding on
the issuer or the board of directors of an issuer, and may not be construed—

(1) as overruling a decision by such issuer or board of directors;
(2) to create or imply any change to the fiduciary duties of such issuer or board of directors;
(3) to create or imply any additional fiduciary
duties for such issuer or board of directors; or
(4) to restrict or limit the ability of shareholders to make proposals for inclusion in proxy materials related to executive compensation.’’.

SEC. 952. COMPENSATION COMMITTEE INDEPENDENCE.
The Securities Exchange Act of 1934 (15 U.S.C. 78 et seq.) is amended by inserting after section 10B, as
added by section 753, the following:

SEC. 10C. COMPENSATION COMMITTEES.

(a) INDEPENDENCE OF COMPENSATION COMMITTEES.—

(1) LISTING STANDARDS.—The Commission shall, by rule, direct the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that does not comply with the requirements of this subsection.

(2) INDEPENDENCE OF COMPENSATION COMMITTEES.—The rules of the Commission under paragraph (1) shall require that each member of the compensation committee of the board of directors of an issuer be—
(A) a member of the board of directors of the issuer; and
(B) independent.

(3) INDEPENDENCE.—The rules of the Commission under paragraph (1) shall require that, in determining the definition of the term ‘independence’ for purposes of paragraph (2), the national securities exchanges and the national securities associations shall consider relevant factors, including—
(A) the source of compensation of a member of the board of directors of an issuer, including any consulting, advisory, or other compensatory fee paid by the issuer to such member of the board of directors; and (B) whether a member of the board of directors of an issuer is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.

(4) EXEMPTION AUTHORITY.—The rules of the Commission under paragraph (1) shall permit a national securities exchange or a national securities association to exempt a particular relationship from
the requirements of paragraph (2), with respect to the members of a compensation committee, as the
national securities exchange or national securities association determines is appropriate, taking into
consideration the size of an issuer and any other relevant factors.

(b) INDEPENDENCE OF COMPENSATION CONSULTANTS AND OTHER COMPENSATION COMMITTEE ADVIS15
ERS.—

(1) IN GENERAL.—The compensation committee of an issuer may only select a compensation
consultant, legal counsel, or other adviser to the compensation committee after taking into consideration the factors identified by the Commission under paragraph (2).

(2) RULES.—The Commission shall identify factors that affect the independence of a compensation consultant, legal counsel, or other adviser to a compensation committee of an issuer, including—
(A) the provision of other services to the issuer by the person that employs the compensation consultant, legal counsel, or other adviser;
(B) the amount of fees received from the issuer by the person that employs the compensation consultant, legal counsel, or other adviser, as a percentage of the total revenue of
the person that employs the compensation consultant, legal counsel, or other adviser;
(C) the policies and procedures of the person that employs the compensation consultant, legal counsel, or other adviser that are designed to prevent conflicts of interest;
(D) any business or personal relationship of the compensation consultant, legal counsel,
or other adviser with a member of the compensation committee; and
(E) any stock of the issuer owned by the compensation consultant, legal counsel, or other
adviser.

(c) COMPENSATION COMMITTEE AUTHORITY RELATING TO COMPENSATION CONSULTANTS.—
(1) AUTHORITY TO RETAIN COMPENSATION CONSULTANT.—

(A) IN GENERAL.—The compensation committee of an issuer, in its capacity as a committee of the board of directors, may, in its sole discretion, retain or obtain the advice of a compensation consultant.

(B) DIRECT RESPONSIBILITY OF COMPENSATION COMMITTEE.—The compensation committee of an issuer shall be directly responsible for the appointment, compensation, and oversight of the work of a compensation consultant.

(C) RULE OF CONSTRUCTION.—This paragraph may not be construed—
(i) to require the compensation committee to implement or act consistently with the advice or recommendations of the compensation consultant; or
(ii) to affect the ability or obligation of a compensation committee to exercise its own judgment in fulfillment of the duties of the compensation committee.

(2) DISCLOSURE.—In any proxy or consent solicitation material for an annual meeting of the
shareholders (or a special meeting in lieu of the annual meeting) occurring on or after the date that is 1 year after the date of enactment of this section, each issuer shall disclose in the proxy or consent
material, in accordance with regulations of the Commission, whether—
(A) the compensation committee of the issuer retained or obtained the advice of a compensation consultant; and
(B) the work of the compensation committee has raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed.

(d) AUTHORITY TO ENGAGE INDEPENDENT LEGAL COUNSEL AND OTHER ADVISERS.—
(1) IN GENERAL.—The compensation committee of an issuer, in its capacity as a committee
of the board of directors, may, in its sole discretion, retain and obtain the advice of independent legal
counsel and other advisers. 
(2) DIRECT RESPONSIBILITY OF COMPENSATION COMMITTEE.—The compensation committee of
an issuer shall be directly responsible for the appointment, compensation, and oversight of the work
of independent legal counsel and other advisers.
(3) RULE OF CONSTRUCTION.—This subsection may not be construed—

(A) to require a compensation committee to implement or act consistently with the advice
or recommendations of independent legal counsel or other advisers under this subsection; or
(B) to affect the ability or obligation of a compensation committee to exercise its own
judgment in fulfillment of the duties of the compensation committee.

(e) COMPENSATION OF COMPENSATION CONSULTANTS, INDEPENDENT LEGAL COUNSEL, AND OTHER ADVISORS.—Each issuer shall provide for appropriate funding, as determined by the compensation committee in its capacity as a committee of the board of directors, for payment of reasonable compensation—

(1) to a compensation consultant; and
(2) to independent legal counsel or any other adviser to the compensation committee.

(f) COMMISSION RULES.—
(1) IN GENERAL.—Not later than 360 days after the date of enactment of this section, the Commission shall, by rule, direct the national securities exchanges and national securities associations to
prohibit the listing of any security of an issuer that is not in compliance with the requirements of this
section.

(2) OPPORTUNITY TO CURE DEFECTS.—The rules of the Commission under paragraph (1) shall
provide for appropriate procedures for an issuer to have a reasonable opportunity to cure any defects
that would be the basis for the prohibition under paragraph (1), before the imposition of such prohibition.
(3) EXEMPTION AUTHORITY.—

(A) IN GENERAL.—The rules of the Commission under paragraph (1) shall permit a national securities exchange or a national securities association to exempt a category of issuers from the requirements under this section, as the national securities exchange or the national securities association determines is appropriate.

(B) CONSIDERATIONS.—In determining
appropriate exemptions under subparagraph (A), the national securities exchange or the national securities association shall take into account the potential impact of the requirements of this section on smaller reporting issuers.’’.

SEC. 953. EXECUTIVE COMPENSATION DISCLOSURES.
Section 14 of the Securities Exchange Act of 1934 (15 U.S.C. 78n), as amended by this title, is amended by adding at the end the following:

(j) DISCLOSURE OF PAY VERSUS PERFORMANCE.—
The Commission shall, by rule, require each issuer to disclose in the annual proxy statement of the issuer a clear description of any compensation required to be disclosed by the issuer under section 229.402 of title 17, Code of Federal Regulations (or any successor thereto), including information that shows the relationship between executive compensation actually paid and the financial performance
of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions. The disclosure under this subsection may in clude a graphic representation of the information required to be disclosed.

SEC. 954. RECOVERY OF ERRONEOUSLY AWARDED COMPENSATION.

Section 16 of the Securities Exchange Act of 1934 (15 U.S.C. 78p) is amended by adding at the end the following:

(h) RECOVERY OF ERRONEOUSLY AWARDED COMPENSATION POLICY.—
(1) LISTING STANDARDS.—The Commission shall, by rule, direct the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that does not comply with the requirements of this subsection.
(2) RECOVERY OF FUNDS.—The rules of the Commission under paragraph (1) shall require each
issuer to develop and implement a policy providing—
(A) for disclosure of the policy of the issuer on incentive-based compensation that is based on financial information required to be reported under the securities laws; and
(B) that, in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, the issuer will recover from any current or former executive officer of the issuer who received incentive-based compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement.

SEC. 955. DISCLOSURE REGARDING EMPLOYEE AND DIRECTOR HEDGING.

Section 14 of the Securities Exchange Act of 1934 (15 U.S.C. 78n), as amended by this title, is amended by adding at the end the following:

(l) DISCLOSURE OF HEDGING BY EMPLOYEES AND DIRECTORS.—The Commission shall, by rule, require each issuer to disclose in the annual proxy statement of the issuer whether any employee or member of the board of directors of the issuer, or any designee of such employee or member, is permitted to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars, and exchange funds) that are designed to hedge or offset any decrease in the market value of equity
securities—

(1) granted to the employee or member of the board of directors by the issuer as part of the compensation of the employee or member of the board of directors; or
(2) held, directly or indirectly, by the employee or member of the board of directors.’’.

SEC. 956. EXCESSIVE COMPENSATION BY HOLDING COMPANIES OF DEPOSITORY INSTITUTIONS.

Section 5 of the Bank Holding Company Act of 1956 (12 U.S.C. 1844) is amended by adding at the end thefollowing:

(h) EXCESSIVE COMPENSATION.—
(1) IN GENERAL.—Not later than 180 days after the transfer date established under section 311
of the Restoring American Financial Stability Act of 2010, the Board of Governors shall, by rule, establish standards prohibiting as an unsafe and unsound practice any compensation plan of a bank holding
company that—
(A) provides an executive officer, employee, director, or principal shareholder of the bank holding company with excessive compensation, fees, or benefits; or
(B) could lead to material financial loss to the bank holding company.
(2) CONSIDERATIONS.—In establishing the standards under paragraph (1), the Board of Governors shall take into consideration the compensation standards described in section 39(c) of the Fed19
eral Deposit Insurance Act (12 U.S.C. 1831p–1(c))

We take a temporary breather from our discussion of Kurz v. Holbrook.  The discussion will resume tomorrow.

Instead, we turn to Senator Dodd's leviathan bill on financial reform.  We take a moment to briefly discuss the corporate governance provisions included in the Bill (the text is below).  They include access (which the SEC almost certainly has the authority to do without the legislation), a provision that requires companies to explain why they have or have not separate the chairman and the CEO positions (the SEC has already done this, more or less), and a requirement for listed companies that directors be elected by majority vote in uncontested elections.

The latter is a disappointment.  These provisions have become common enough, particularly among exchange traded companies.  But the legislation would merely require directors not receiving a majority to resign.  The board would then have the discretion to reject or accept the letter.  As RiskMetrics has noted, somewhere around 100 directors in 2009 did not receive a majority vote and none of them lost their position because of this failure. 

In many cases, companies did not have a majority vote provisions in place.  But where they did (Axcelis and Pulte), the companies did not accept the letters of resignation.  In other words, these provisions do not provide shareholders with any additional rights or protections.  Directors lose but the board doesn't remove them.  The provisions are, therefore, a myth.  For a more in depth discussion of the problems with these provisions, see Majority Voting, Delaware Statutory Reform, and Shareholder Access to the Proxy Statement: A Comment to the Securities and Exchange Commission Real reform would provide that directors who do not receive a majority lose and cannot take office. 

Finally, the Axcelis case illustrated that Delaware will not allow the use of inspection rights to obtain information on the materials considered by the board in deciding not to accept letters of resignation.  There is a serious need for federal law to step in and require disclosure of the information denied under Delaware law.  This legislation may at least address this issue.  It requires companies to make public "together with a discussion of the analysis used in reaching the conclusion, the specific reasons" for declining to accept the letter of resignation.  The value formulation will need to be fleshed out by rulemaking to make certain that companies provide all material information on the matter.

There are also provisions in the Bill that would reform the executive compensation process, including a right of banking agencies to ban excessive compensation.  We have discussed this provision in the past and view it as significant and substantive.  We will return to this subject in a later post.  

The draft legislation is posted on the DU Corporate Governance web site.

SEC. 971. ELECTION OF DIRECTORS BY MAJORITY VOTE IN UNCONTESTED ELECTIONS.
The Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) is amended by inserting after section 14A, as added by this title, the following:

SEC. 14B. CORPORATE GOVERNANCE.

(a) CORPORATE GOVERNANCE STANDARDS.—
(1) LISTING STANDARDS.—
(A) IN GENERAL.—Not later than 1 year after the date of enactment of this subsection,
the Commission shall, by rule, direct the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that is not in compliance
with any of the requirements of this subsection.

(B) OPPORTUNITY TO COMPLY AND CURE.—The rules established under this para5
graph shall allow an issuer to have an opportunity to come into compliance with the requirements of this subsection, and to cure any defect that would be the basis for a prohibition under subparagraph (A), before the imposition of such prohibition.

(C) AUTHORITY TO EXEMPT.—The Commission may, by rule or order, exempt an issuer from any or all of the requirements of this subsection and the rules issued under this subsection, based on the size of the issuer, the market capitalization of the issuer, the number of shareholders of record of the issuer, or any
other criteria, as the Commission deems necessary and appropriate in the public interest or
for the protection of investors.

(2) COMMISSION RULES ON ELECTIONS.—In an election for membership on the board of directors
of an issuer—
(A) that is uncontested, each director who receives a majority of the votes cast shall be
deemed to be elected;
(B) that is contested, if the number of nominees exceeds the number of directors to be
elected, each director shall be elected by the vote of a plurality of the shares represented at
a meeting and entitled to vote; and
(C) if a director of an issuer receives less than a majority of the votes cast in an
uncontested election—
(i) the director shall tender the resignation of the director to the board of di14
rectors; and
(ii) the board of directors—
(I) shall—

(aa) accept the resignation of the director;

(bb) determine a date on which the resignation will take effect, within a reasonable period of time, as established by the Commission; and

(cc) make the date under item (bb) public within a reason able period of time, as established by the Commission; or

(II) shall, upon a unanimous vote of the board, decline to accept the resignation and, not later than 30 days after the date of the vote (or within such shorter period as the Commission may establish), make public, together with a discussion of the analysis used in reaching the conclusion, the specific reasons that—
(aa) the board chose not to accept the resignation; and
(bb) the decision was in the best interests of the issuer and the shareholders of the issuer.

SEC. 972. PROXY ACCESS.
(a) PROXY ACCESS.—Section 14(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78n(a)) is amended—
(1) by inserting ‘‘(1)’’ after ‘‘(a)’’; and
(2) by adding at the end the following:
(2) The rules and regulations prescribed by the Commission under paragraph (1) may include—

(A) a requirement that a solicitation of proxy, consent, or authorization by (or on behalf of) an
issuer include a nominee submitted by a shareholder to serve on the board of directors of the issuer; and
(B) a requirement that an issuer follow a certain procedure in relation to a solicitation described
in subparagraph (A).
(b) REGULATIONS.—The Commission may issue rules permitting the use by shareholders of proxy solicitation materials supplied by an issuer of securities for the purpose of nominating individuals to membership on the board of directors of the issuer, under such terms and conditions as the Commission determines are in the interests of shareholders and for the protection of investors.

SEC. 973. DISCLOSURES REGARDING CHAIRMAN AND CEO STRUCTURES.

Section 14B of the Securities Exchange Act of 1934, as added by section 971, is amended by adding at the end the following:

(b) DISCLOSURES REGARDING CHAIRMAN AND CEO STRUCTURES.—Not later than 180 days after the date of enactment of this subsection, the Commission shall issue rules that require an issuer to disclose in the annual proxy sent to investors the reasons why the issuer has chosen—

(1) the same person to serve as chairman of the board of directors and chief executive officer (or
in equivalent positions); or

(2) different individuals to serve as chairman of the board of directors and chief executive officer
(or in equivalent positions of the issuer).

We are discussing Kurz v. Holbrook, 2010 Del. Ch. LEXIS 24 (Del. Ch. Feb. 9, 2010).

In analyzing whether the transaction constituted vote buying, VC Laster indicated that there needed to be either disenfranchisement or fraud.  Disenfranchisement occurred where the acquisition “actually affect[s] the outcome of the vote” or “it alters the voting pattern in a critical way, such as through coercive tactics reminiscent of tender offer strategies from pre-Williams Act days.”

Mostly, though, the court was interested in the possible separation of voting rights from economic ownership.  This has been a growing practical concern.  Those seeking to influence the outcome of an election (perhaps by acquiring control) can enhance the possibility of victory by acquiring votes without actually purchasing the underlying shares.  This can occur, for example, through the borrowing of stock (which is actually a purchase but guarantees that the shares will be sold back to the original owner, perhaps after the record date) or through the use of swaps and other derivatives.

VC Laster used the opinion to strongly emphasize the need for economic interests to align with voting rights, something he found hidden within legislative intent. 

• A Delaware public policy of guarding against the decoupling of economic ownership from voting power can be seen in the 2009 amendment to Section 213(a), which now authorizes a board to set one record date for purposes of giving notice of a meeting of stockholders and a second, later record date for determining which stockholders can vote at the meeting. 8 Del. C. 213(a).  

Thus, were “economic interests are fully aligned with voting rights do not raise concern, Delaware law does not restrict a soliciting party from buying shares and getting a proxy to bolster the solicitation's chance of success.” 

Kurz acquired the economic interests in the shares.  Even though actually title would not be transferred until a future date, he absorbed the economic risk associated with the shares.  In those circumstances, the court concluded that there was no separation of economic ownership and voting rights.  “Because Kurz now holds the economic interest in the shares, Delaware law presumes that he should and will exercise the right to vote.”

The analysis is fair enough.  The mere fact that Boutros could not deliver all of the shares because of transfer restrictions did not prevent Kurz from assuming the economic risks associated with ownership, thereby allowing him to dictate how they were voted.  Yet by emphasizing the negative -- the concern over the exercise of voting rights when the two interests are separated, facts not present in the case -- the opinion provided a clear basis for challenges to voting results where the two interests were not aligned.  This is a tough issue and VC Laster may ultimately be right, but the matter did not have to be reached in such a clear fashion under the facts of this case. 

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?  The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

We are discussing Kurz v. Holbrook, 2010 Del. Ch. LEXIS 24 (Del. Ch. Feb. 9, 2010).

There is often a debate over whether boards are really obligated to engage in profit maximizing behavior.  As commentators sometimes note, corporate statutes don't mention the phrase.  Boards instead are obligated to act in the best interests of shareholders, which may or may not equal profit maximization. 

We note only that VC Laster looks to be squarely in the profit maximization camp, at least from the shareholder perspective.  As he noted in Kurz:  "What legitimizes the stockholder vote as a decision-making mechanism is the premise that stockholders with economic ownership are expressing their collective view as to whether a particular course of action serves the corporate goal of stockholder wealth maximization."  In other words, shareholders do not want companies to engage in philanthropy or socially beneficial behavior unless also maximizing wealth. 

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?  The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

We are discussing Kurz v. Holbrook, 2010 Del. Ch. LEXIS 24 (Del. Ch. Feb. 9, 2010).

Another issue addressed by the court were allegations of vote buying.  These concerns arose because Kurz, a director and member of the TBE Group, acquired shares that could not yet be transferred (due to transfer restrictions) and in the process obtained an irrevocable proxy for the undelivered shares.  The votes were, apparently, outcome determinative. 

The court acknowledged that vote buying “is an incendiary phrase” that “carries connotations of bribery and corruption.”  Nonetheless, as VC Laster rightfully notes, the Delaware courts have, since Schreiber v. Carney, 447 A.2d 17 (Del. Ch. 1982), recognized that vote buying was a permissible practice.

The transaction raised three distinct issues.  First was whether the practice even involved vote buying since there were no corporate assets used in the transaction.  Assuming it did, the second was whether the purchases violated the standards for vote buying set out in Schreiber and its progeny.  The last was whether the acquisition of the votes without actually obtaining the shares was somehow improper. 

The prohibition on vote buying traditionally arose in the context of companies acquiring votes to facilitate shareholder approval.  In Schreiber, the court approved a transaction in which the company made a loan to a shareholder in return for support for a merger.  Moreover, in the HP case, the Chancery Court indicated that the use of corporate assets was a necessary condition in order to separate vote buying from identical behavior that could occur in a shareholder voting agreement.  As that court noted:

• The appropriate standard for evaluating vote-buying claims is articulated in Schreiber v. Carney. Schreiber indicates that vote-buying is illegal per se if "the object or purpose is to defraud or in some way disenfranchise the other stockholders." Schreiber also notes, absent these deleterious purposes, that "because vote-buying is so easily susceptible of abuse it must be viewed as a voidable transaction subject to a test for intrinsic fairness." At first blush this proposition seems difficult to reconcile with the General Assembly's explicit validation of shareholder voting agreements in Sec. 218(c).  Significantly, however, it was the management of the defendant corporation that was buying votes in favor of a corporate reorganization in Schreiber. Shareholders are free to do whatever they want with their votes, including selling them to the highest bidder. Management, on the other hand, may not use corporate assets to buy votes in a hotly contested proxy contest about an extraordinary transaction that would significantly transform the corporation, unless it can be demonstrated, as it was in Schreiber, that management's vote-buying activity does not have a deleterious effect on the corporate franchise.

Hewlett v. Hewlett-Packard Co., 2002 Del. Ch. LEXIS 44  (Del. Ch. April 8, 2002).  The distinction makes sense because directors have fiduciary obligations and, in general, shareholders do not.  In other words, vote buying if improper is a fiduciary duty violation and therefore ought not to be extended to shareholders, other than perhaps controlling shareholders. 

VC Laster saw things differently.  This case did not involve the use of corporate assts but did involve a fiduciary.  Nonetheless, VC Laster disregarded the distinction set out in Hewlett and instead likened the transaction to “third party” vote buying.   

• Vote-buying that does not involve use of corporate resources--which I will call "third party vote buying"--is an undeveloped area of our law. Although dictum in Hewlett-Packard could be read to suggest that there are no restrictions on the buying or selling of votes when corporate resources are not involved, I do not believe that was what Chancellor Chandler intended. Elsewhere in the Hewlett-Packard decision, Chancellor Chandler noted that "the principle that vote-buying is illegal per se if entered into for deleterious purposes survives." Recent scholarship has cast light on shadowy aspects of the voting process and techniques by which voting rights can be manipulated. I regard the concept of vote buying as broad enough to encompass these practices. When they prove deleterious to stockholder voting, this Court can and should provide a remedy.

The result is correct but the analysis suspect.  It’s true that no corporate assets were used in the transaction.  But the analysis ignores the fact that the purchaser was a director who had a fiduciary duty to shareholders.  Reliance on the purchaser’s fiduciary status would have allowed VC Laster to render a decision consistent with Hewlett, rather than try to explain away the inconsistency, and prevented the case from reaching true third party vote buying schemes. 

By characterizing the issue as third party vote buying (and ignoring the purchaser’s fiduciary status), the analysis unequivocally extends vote buying analysis to shareholder voting agreements by all shareholders, even shareholders without any fiduciary obligations.  In other words, ordinary shareholders seeking to organize through the use of shareholder voting agreements will now have to analyze their behavior for possible illegal vote buying. Indeed, as he notes later in the opinion:

• Nothing in Section 218 states or implies that every voting trust or voting agreement is valid, and nothing in Section 218 speaks to arrangements producing voting incentives directly contrary to ownership interests.  Section 218 does not limit this Court's equitable powers to address deleterious practices.

In short, shareholder voting agreements are in play.  It was an unnecessary step to take and arguably in conflict, as the court in Hewlett noted, with “the General Assembly's explicit validation of shareholder voting agreements in Sec. 218(c)." 

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?  The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

We are discussing Kurz v. Holbrook, 2010 Del. Ch. LEXIS 24 (Del. Ch. Feb. 9, 2010).

In many ways, this is an unusual case.  Certainly, bylaws designed to reduce board size between meetings are not common.  Moreover, while VC Laster made his view clear, that these bylaws are invalid, any uncertainly left over by the case may require companies to address the issue more explicitedly.  Some already have.  Thus, for example, the articles at Lockheed Martin include the following language:  "However, no decrease in the number of directors constituting the Board of Directors shall shorten the term of any incumbent director."  This type of language is quite common and appears in hundreds if not thousands of constituent documents of public companies.   

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?

The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

We are discussing Kurz v. Holbrook, 2010 Del. Ch. LEXIS 24 (Del. Ch. Feb. 9, 2010).

We are examining the portion of the decision that struck down the bylaw submitted by Crown that would have reduced the size of the board from seven directors to three.

The decision went too far in determining that Section 141 was the exclusive method of removing directors.  Moreover, even if exclusive, dicta in the case went too far in concluding that directors forced out of office for not meeting board qualifications were subject to Section 141 and therefore could not be removed until their term expired.  

It would have been much cleaner and raise fewer questions about existing practice to simply hold that  directors "hold office until such director's successor is elected and qualified or until such director's earlier resignation or removal" and that this provision does not contemplate removal through a reduction in board size. See Section 141(b)

The conclusion is bolstered by the problems that would otherwise result from a different interpretation.  As the opinion pointed out, reducing board size leaves unanswered how to determine which directors are to be removed should that be necessary.  While Crown proposed a bylaw to resolve the issue, it does not address the circumstances where there is no bylaw or the bylaw is defeated.  In other words, to allow for removal by reducing board size would require the courts to create an entire framework for dealing with the consequences. 

To the extent the bylaw somehow leaves "seatless" directors (in other words, no one is actually removed), the court correctly noted that the quorum requirements would be impossible to meet in at least some cases.  See Section 141(b)(imposing a board quorum of a majority unless reduced to no less than one-third).  Because quorums depend upon directorships rather than directors, a board could be reduced to the point where a quorum is impossible. 

Moreover, the MBCA makes this restriction explicit, suggesting that the general practice is to not allow for director removal through a reduction in board size.  See RMBCA § 8.05(c)("A decrease in the number of directors does not shorten an incumbent director’s term."). 

In short, the conclusion was correct.  Directors cannot be removed through bylaws that reduce the size of the board.  The need to find that Section 141 was exclusive and that it applied to directors failing to meet board qualifications was not necessary in arriving at this conclusion. 

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?

The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

VC Laster, in invalidating a bylaw that would reduce the size of the board and remove incumbent directors, concluded that Section 141 (which gives shareholders the right to remove directors) was the exclusive method of removing directors under Delaware law.  As we noted, the import of this conclusion is to invalidate bylaws that provide for mandatory removal upon a director becoming disabled.  This is not the only type of bylaw arguably invalidated by the court's reasoning. 

VC Laster concluded that a director meeting board qualifications at the time of election could not be removed if, after the election, he/she ceases to meet those qualifications.   

• For similar reasons, my reading of Section 141(b) is not affected by the possibility that a corporation might establish qualifications for directorship and provide that a director who ceased to meet them could no longer serve. This Court has upheld a limited example of such a provision that appeared in the certificate of incorporation.   In light of the three procedural means for ending a director's term in Section 141(b), I do not believe a bylaw could impose a requirement that would disqualify a director and terminate his service.  Section 141(b)'s  recognition of the bylaws as a locus for director qualifications instead contemplates reasonable qualifications to be applied at the front end, before a director's term commences, when the director is "elected and qualified." 8 Del. C. 141(b). The concept of a bylaw that would end a director's service through disqualification thus lends no support to a bylaw that would accomplish the same thing through board shrinkage. Neither is valid under Section 141(b) (citations omitted)

In fact, however, bylaws are commonly written to require directors to submit a letter of resignation in the event that they cease, after election, to continue to meet certain specified qualifications necessary to be elected in the first place.  This bylaw from Sachs Inc. is an example:  

• Mandatory Resignation. Directors who are also officers of the Corporation shall submit a letter of resignation as such to the Board of Directors upon any termination of employment as an officer of the Corporation, and directors who are not officers of the Corporation shall likewise submit a letter of resignation upon any change in that directors principal business or other activity in which the director was engaged at the time of his or her election.

Similarly, the bylaws of Harley Davidson provide:  

• Retirement . Notwithstanding that directors are elected for a three year term, a director shall automatically cease to be a director of the corporation effective upon the commencement of the Annual Meeting immediately following such director's seventy-second (72 nd ) birthday. Each director, other than a director who is serving or has served as the Chief Executive Officer of the corporation, whose position of principal employment, occupation or affiliation changes substantially, and each director who develops a conflict of interest with the corporation as a result of changes in the business of the corporation, such director's personal interests or such director's principal employer, after his or her most recent election to the Board of Directors shall submit his or her resignation as a director of the corporation promptly following such change, and the Board of Directors (without such director present if the Board of Directors so chooses) shall consider whether to accept such resignation in the interests of the corporation.

Presumably under VC Laster's analysis, these types of bylaws are invalid.  They essentially extend to the board the authority to remove directors who fail to meet specified qualifications during their term. 

This could be a significant problem where, for example, a director of an exchange traded company ceases to be independent and, as a result, the board violates the listing requirements.  Perhaps the director could be induced to resign or the board expanded and additional independent directors appointed.  Nonetheless, in at least some cases, directors may refuse to resign and the company may find itself in violation of the listing requirements.

This portion of the opinion was dicta and unnecessary.  Even assuming Section 141 contains the exclusive method of removing directors, mandatory resignation for failing to meet mandatory qualifications is not removal, at least not in the way contemplated by Section 141.  Section 141 contemplates volitional acts by shareholders.  No longer meeting qualifications seems more like death, a form of removal not influenced by directors or other groups.  Nonetheless, the dicta in the case throws these types of bylaws into doubt.

The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

We are discussing Kurz v. Holbrook, 2010 Del. Ch. LEXIS 24 (Del. Ch. Feb. 9, 2010).

One issue in the case was whether shareholders could adopt a bylaw that would reduce the size of the existing board from seven directors to three, effectively forcing off the board as many as four incumbent directors (because there were two vacancies and only five incumbents the bylaw actually threatened to unseat two directors).  The effect of the bylaw was to remove existing directors.

VC Laster struck down the bylaw, concluding that it conflicted with Section 141(b) of the Delaware General Corporation Law.  The Section provided that directors would hold office "until such director's successor is elected and qualified or until such director's earlier resignation or removal."  Removal, in turn, was set out in Section 141(k), which gave shareholders the right to remove directors, with or without cause, by majority vote.   

A sound enough conclusion (for reasons we will note in a later post), VC Laster used some unnecessary analysis that raise questions about existing practice.  He arrived at his conclusion by determining that Section 141 provided the exclusive means of removing directors.  The Section only explicitly allowed for removal by shareholders.  Because the bylaw added an additional form of removal, it violated the exclusive nature of Section 141. 

In reaching this conclusion, the opinion discussed whether in fact Section 141 was the exclusive method of removing directors.  VC Laster conceded that directors could be removed by reason of death, a form of removal not considered by Section 141.  Nonetheless, it was an exception that proved the rule.  As he noted:  "death is a not procedural means by which a director’s term can be brought to a close under a corporation’s constitutive documents and the DGCL. To impose death on a director is not a legitimate method of effecting board change. It is a felony."

True enough but he failed to address bylaws, which seem common enough, that provide a director will be removed if disabled.  See Bylaws of JetBlue ("Any person elected to a newly-created director position or any person elected to fill a vacancy on the Board of Directors shall serve until the next annual meeting of stockholders and until a successor has been elected and qualified, subject to such director's prior death, disability, resignation, retirement, disqualification or removal from office."). 

While disability may, like death, seem involuntary, it puts in the hands of existing directors considerable discretion to determine the onset of disability.  This is particularly true where the bylaws (and the statute) do not define disability.  By concluding that Section 141 is exclusive, VC Laster has at least raised doubts about every bylaw that provides for mandatory replacement upon a director becoming disabled.

The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

             One of the topics that this blog has followed on a regular basis is the effort to allow shareholders to nominate candidates for positions on corporate boards of directors in publicly held corporations.  Another subject which has been explored on this blog is the struggle to obtain gender and ethnic diversity on such boards of directors.  One of the most important objectives of these reforms is to break the stranglehold of top management (particularly the CEO) over the boards that are supposed to be supervising them.  Other posts on this blog have ably rebutted the arguments against such changes, e.g., that enhancing shareholder access to the board selection process will enable “special interest” groups to get directors elected to the board who are only interested in furthering their particular special interest.

            One objection has not been addressed.  The objection is that even if increasing shareholder access to the directorial nominating process and efforts to increase diversity on boards allow the selection of board members who are not beholden to top management,  and who do not share the visions and viewpoints of that group, the new board members will be condemned to service as lonely and ineffectual dissenters and completely marginalized.  The predicate assumption of the objection is almost certainly correct.  Even the most ardent supporters of the reforms do not suggest that they will lead to boards of directors in which a majority of the members are truly independent of the CEO and other top managers.  Even if the reforms are fully implemented, the likelihood for the foreseeable future is that the boards of publicly held corporations will continue to be dominated by directors selected by top management who tend to think like top management.  However, the conclusion that the presence of one or two directors who do not share the viewpoints of top management will be totally ineffectual is not necessarily correct.

             Well established and tested principles of social psychology suggest that the mere presence of even solitary dissenters can have a significant impact on the quality of decision making of groups such as a board of directors.  Over sixty years ago, psychologist Solomon Asch demonstrated how group dynamics can lead to erroneous decision making.  In Asch’s most famous experiment he placed the subject of his experiments in a room with several other “subjects” who were in fact actors who were collaborating with Asch.  The subjects were instructed to pick out a which of three lines was closest in length to a fourth line.  The “fake subjects” all sequentially announced their choice of which line, and deliberately chose the same blatantly wrong answer.  Three quarters of the subjects were influenced by the fake subjects to choose the same wrong answer in at least one iteration of the experiment.

            The ability of a even a lone dissenter to break the hold of group conformity was demonstrated in later experiments by Asch, and even more dramatically by an experiment in the early 1970s by psychologists Vernon Allen and John Levine.  Allen and Levine used the same basic framework as Asch but expanded it in several respects.  One of those ways was to break the fake subjects into three different groups.  In one group, the “fake subjects” all unanimously adhered to the same opinion.  In a second group, a fake subject dissented from the group consensus.  However, the fake dissenting subjects convinced the real subjects (and the person purportedly “conducting” the experiment) that they were visually impaired and literally guessing at random.  The researcher purportedly conducting the experiment “informed” the fake subjects, in front of the real subjects, that the fake subjects’  answers would not be recorded or count in the study.   In the third group the dissenter was represented as no different from other members of the group.

            Not surprisingly, the third group showed by far the lowest conformity among the real subjects of the experiment to deliberately wrong answers chosen by the majority of fake subjects.  What is surprising is that conformity to wrong answers among the real subjects was significantly lower in the second group than in the group where no dissenter was present.  The presence of a dissenting person whom the real subjects viewed as physically unable to ascertain a correct answer still seemed to reduce by a meaningful amount group pressure on the real subjects to pick an incorrect answer.

            Do these experiments mean that directors who are selected by persons other than the top managers of publicly held corporations will routinely be able to prevent mistakes by directors who are dominated by the top managers of the corporation?  Hardly.  Unlike the true subjects in the psychological experiments, the continued participation of the board members on the board is usually dependent upon the good graces of top management.  Nonetheless, the experiments do give some hope that the presence of shareholder nominated directors may sway some other directors to challenge some of the more irrational or ill considered decisions pushed by top management of publicly held corporations.  We may not see a major change in the quality of board decision making, but we may see a decrease in decisions which, when considered in retrospect, cause observers to ask “how could the board possibly have believed that"? or “didn’t anyone see the obvious possible problems"?

Note: For a fascinating application of the above psychological studies to Supreme Court decision making (including very interesting comments on the process by Justice Breyer) see Ori & Rom Brafman, SWAY ch. 8 (2008).

We are discussing Kurz v. Holbrook, 2010 Del. Ch. LEXIS 24 (Del. Ch. Feb. 9, 2010).

One of the reasons given for striking down the bylaw that reduced the size of the board was that it amounted to a removal of incumbent directors.  Because directors had the same bylaw authority as shareholders, it potentially allowed directors to remove other directors by shrinking the size of the board.  This in turn conflicted with the proposition that directors cannot remove other directors.  As the court noted:

• If a bylaw amendment reducing the size of a board could eliminate sitting directors, then directors suddenly would have the power to remove other directors. For 89 years, Delaware law has barred directors from removing other directors. Bruch v. Nat’l Guar. Credit. Corp., 116 A. 738, 741 (Del. Ch. 1922); accord Robert Pennington, Pennington on Delaware Corporations 117 (1925) (“A director being an officer chosen by the stockholders cannot be removed by his fellow directors.”). In 1974, when the stockholders’ power to remove directors was confirmed and addressed through the adoption of Section 141(k), two leading authorities on the DGCL wrote that “by negative implication intended by the draftsmen, directors do not have the authority to remove other directors.” S. Samuel Arsht & Lewis S. Black, The 1974 Amendments To The Delaware Corporation Law 378 (1974). I do not believe the DGCL contemplates a bylaw amendment could overturn this rule.

In general, the prohibition on directors removing directors amounts to black letter law.  To do so would essentially allow directors to undo the will of shareholders.  Yet in fact, matters are not so clear.

First, some states expressly allow it, at least if for cause.  See Mass. Gen. Laws ch. 156B §51(c) ("any director, and any officer elected by the stockholders, may be removed from his office for cause by vote of a majority of the directors then in office.  A director or officer may be removed for cause only after a reasonable notice and opportunity to be heard before the body proposing to remove him.").  Some permit the removal of directors who were appointed by the board.  See Minn. Stat. § 301A.223(2)(permitting removal by directors, with or without cause, where the director was appointed by the board to fill a vacancy, "the shareholders have not elected directors in the interval between the time of the appointment to fill a vacancy and the time of the removal" and removal is approved by a majority of the remaining directors).  See also ND Cent. Code § 10-19.1-41(2)(same language). 

Others allow for the authority if in the articles or a shareholder adopted bylaws.  See NY Bus. Corp. Law § 706 ("The certificate of incorporation or the specific provisions of a by-law adopted by the shareholders may provide for such removal by action of the board, except in the case of any director elected by cumulative voting, or by the holders of the shares of any class or series, or holders of bonds, voting as a class, when so entitled by the provisions of the certificate of incorporation."). 

Second, Delaware has no statutory prohibition on directors removing other diretors.  The law in this area traced back to Bruch v. National Guarantee Credit Corp., 13 Del. Ch. 180 (Del. Ch. April 10, 1922).  As the court in that case concluded:

• But I am of the opinion that directors of an industrial corporation, such as is the defendant, cannot be removed by his fellow members. A director is an officer chosen by the stockholders. His title to the office is as good as the title of his fellows. His right to the office is quite different from that of those officers of the corporation who are selected not by stockholders but by the directors themselves. If the power of amotion of a director exists, it is reasonable to hold that it shall be exercised by the power that elected him, viz., by the stockholders. To allow directors to frame charges against one of their fellows and then to try and expel him, would open the door to possibilities of fraud which designing men might use to wrest control of corporate affairs from the stockholders, or their sympathetic representatives on the board, and transfer it to those who might seek to grasp the corporation for their own ends.

This is a surprisingly thin reed to draw conclusions about the right of directors to remove directors.  First it is only a Chancery Court decision.  Second, it is premised on the idea that directors are elected by shareholders.  Yet this is not true for directors elected by the board, suggesting that a different rule might be applicable.  Third, the court did not deal with circumstances involving removal neither by directors nor shareholders.  Thus, if directors were required to leave the board because of disability or the failure to meet board qualifications, the act of removal would be automatic and based upon criteria set forth at the time of election.

Finally, the court left often the possibility that such authority could be inserted into the articles.  As the opinion stated:  "Whether under the law of this state the certificate of incorporation may confer such power on directors is, of course, not a question involved in this case."

The usual rule that directors cannot remove directors is a sound one.  But without a statutory basis, it is not quite as clear as VC Laster suggests.  Moreover, the Delaware courts have shown a tendency to abandon black letter law when it is not in the statute and abandonment suits management.  Examples?  Vote buying and discrimination among shareholders of the same class of shares.

The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

The Board of EMAK consisted of five directors and two vacancies.  The fact pattern involved two separate consent solicitations, with each having the goal of acquiring control of the board. 

In one case, Crown Emak Partners, a shareholder holding 28% of the voting shares, solicited consents to reduce the size of the Board to three directors.  Because Crown had the right to designate two directors on the board, the effect would give Crown a majority.  A second bylaw provided that a special meeting would be called to elect the third director.  Crown succeeded in obtaining sufficient consents to adopt the bylaws.  The consents were executed by DTC on behalf of the beneficial owners. 

One group of shareholders (Take Back EMAK or TBE) sought to obtain the consents to replace two of the five directors and fill three of the vacancies, thereby obtaining control.  As the soliciation proceeded, the TBE Group obtained consents equal to 48.4% of the common stock.  In order to obtain the additional votes.  Donald A. Kurz, an incumbent director and member of the TBE Group, agreed to purchase from another shareholder, Boutros. 

Because, however, the shares were subject to restrictions on sale, Kurz could only obtained title after the restrictions were lifted.  Despite the future date of delivery, Boutros executed an irrevocable proxy.  According to the purchase agreement:

• Proxies.As a material part of the consideration for this Agreement, and an express condition precedent to the effectiveness hereof, Seller agrees to execute and deliver to Buyer by facsimile transmittal on the date hereof, time being of the essence, with originals to follow immediately by express delivery, (a) this Agreement, (b) an Irrevocable Proxy, (c) the Revocation, and (d) the White Consent Card solicited by Take Back EMAK LLC, each in the form attached hereto.

The consents apparently provided TBE with enough shares to implement their plan to take control of the board.  While the TBE Group appeared to have a majority, a portion of its support came from street name owners.  Because an omnibus proxy had not been obtained from DTC, the street name votes were disallowed.

In the litigation that followed, Vice Chancellor Laster had to determine:  (1) the legality of a bylaw that reduced the size of an incumbent board; (2) the validity of the purchase of votes by Kurz under vote buying analysis; and (3) the consequence of the failure to obtain the omnibus proxy.  We will deal with the issues seriatim. 

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility? 

The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

Vice Chancellor Laster only recently joined the bench of the Delaware Chancery Court.  He had considerable experience practicing before the Delaware courts, something that shows in his decision making on the Chancery Court to date.  He has already written a number of opinions, some lengthy, that are generally thorough but accessible in their prose.   Take a look at Paolino v. Mace Security, for example, a case involving advancement of attorneys fees by a CEO subjected to counterclaims in an action arising out of his dismissal. 

Any notion that he would enter the legal fray quietly and gradually was dispelled with his 70 page decision in Kurz v. Holbrook, 2010 Del. Ch. LEXIS 24 (Del. Ch. Feb. 9, 2010).  The case is to some degree a tutorial on various aspects of Delaware law.  There is a detailed discussion about the appropriate methods of removing directors from the board.  The wide ranging discussion, however, likely invalidates certain types of bylaws that mandate the resignation of directors who cease to be qualified after joining the board.

Most interestingly is the discussion of the voting system for owners using street name accounts.  In public companies, these shares are typically held by brokers (and sometimes banks) who then place them into a central depository (The Depository Trust & Clearing Corporation or DTC).   It is the depository that ultimately holds record title and is treated as the owner under state law.  Typically, however, DTC executes an omnibus proxy in favor of the depositing banks and brokers, tranfering voting rights to them.

In this case, the parties engaged in a consent contest.  Both, however, failed to obtain the omnibus proxy.  The Chancery Court had to determine whether the votes cast by assorted brokers could be counted in the absence of the formalistic but necessary piece of paper.   In concluding that they could, VC Laster effectively set aside the obligation to focus on record ownership.  The case raises any number of questions about the continued reliance on record ownership in other circumstances.

We will spend a few posts exploring the case and its implications. 

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?

The opinion and a number of primary materials are posted at the DU Corporate Governance web site. 

In Karten v. Woltin, 23 So.3d 839 (Fla. Dist. Ct. App. 2009), the parties were shareholders in 201 East Atlantic, Inc., which controlled a restaurant called Louie Louie Too.  The appellant owned a 25% stake in the company while the appellees owned 50% and 25% respectively.  In the Spring of 2006, the appellant brought a suit against the other two shareholders for opening a competing restaurant and diverting funds from 201 East Atlantic, Inc., solely for the use of the new competing restaurant.  The appellant also alleged that he was prevented from entering Louie Louie Too, that the appellees voted at a shareholder meeting to deprive him of profits, and that the appellees decided to pay Woltin an extravagant salary. 

The trial court judge granted summary judgment for the appellees stating that the appellant could not bring a direct action suit because he failed to allege injuries apart from those suffered by the other shareholders.  The only issue up on appeal was whether the appellant could bring a direct action for breach of fiduciary duty or whether the claim was derivative.  

Shareholders may bring a direct suit only in their own right to redress an injury sustained directly by them individually.  Based upon this rule, the Florida Appellate Court stated that none of the appellant’s alleged injuries established the individualized harm necessary to bring a direct action.  Furthermore, the court held that all allegations brought by the appellant affected all of the shareholders equally.  Thus, the Florida Appellate Court affirmed the trial court’s ruling that in order to pursue the appellant’s claim he must bring a derivative action.     

The primary materials for this post are available on the DU Corporate Governance website.

In Paolino v. Mace Security International Inc., Louis D. Paolino, Jr. sought indemnification and advancement of fees and expenses incurred in defending against counterclaims asserted against him by Mace Security International (“Mace”).  On December 14, 2010, the Delaware Court of Chancery denied Mace’s motion to dismiss the claim for advancement.   

Paolino, the Chairman and Chief Executive Officer of Mace from 1999 until May 20, 2008 was terminated by the company.  Upon dismissal, he filed a demand for arbitration, and claimed that he was terminated in retaliation for insisting that the Board publicly disclose certain material facts and events affecting Mace’s business, which the Board refused to do. 

Mace filed counterclaims.  Mace argued that Paolino refused to follow the Board’s direction, refused to properly inform and/or seek Board approval for Paolino’s actions, refused to comply with Mace’s corporate governance principles and bylaws, refused to reduce corporate overhead and expense as directed by the Board, and inappropriately interfered with the Board’s investigation of matters.  Mace alleged that Paolino’s actions constituted willful misconduct, which according to the terms of an employment agreement, negated any severance payment Mace may have owed to Paolino.

Paolino sought indemnification and advancement of fees and expenses incurred in defending against counterclaims. Mace moved to dismiss the complaint alleging that Paolino was not entitled to advancements because Paolino was not defending against the counterclaims, a carve-out in the provision barred recovery, and the counterclaims did not arise out of Paolino’s role as a director or officer of Mace.

The court stayed the action to the extent it sought indemnification pending final disposition of the arbitration, but continued Paolino’s action to enforce the mandatory advancement right granted to him under Mace’s Bylaws.  Under Section 145(e) of Delaware’s General Corporation Law, corporations may pay expenses incurred by directors and officers in defending any civil, criminal, administrative or investigative action, suit or proceeding “in advance of the final disposition of such action.”  Pursuant to this authority, Mace adopted Bylaws that entitled current and former directors and officers of Mace to broad and mandatory indemnification and advancement rights.  As the Bylaws provided:  

• §6.01—Each person who was or is made a party…in any action, suit or proceeding, whether civil, criminal, administrative or investigative, by reason of the fact that he or she…is or was a director or officer of the Corporation…shall be indemnified and held harmless by the Corporation to the fullest extent authorized by the Delaware General Corporation Law…provided, however, that except as provided in paragraph (b) hereof, the Corporation shall indemnify any such person seeking indemnification in connection with a proceeding (or part thereof) initiated by such person only if such proceeding (or part thereof) was authorized by the Board of Directors of the Corporation.
• §6.02—The right to indemnification conferred by Article 6 shall include the right to be paid by the Corporation the expenses incurred in defending any such proceeding in advance of its final disposition, including without limitation, attorney’s fees, expert's fees and all costs of litigation.

Because Paolino was defending against the counterclaims, he was entitled to advances under the Bylaws. 

Mace argued, however, that Delaware precedents did not require the advancement of expenses.  Mace alleged that where a covered person initiated a proceeding and a corporation asserted counterclaims defensively, those claims were not defensive.  Mace further argued that the counterclaims were part of the covered person’s offensive proceeding and did not qualify for advancements. 

The Vice Chancellor held that Mace’s argument contradicted the core public policies underlying Section 145.  The Section was intended (a) to allow corporate officials to resist unjustified lawsuits so that the corporation will bear the expenses of litigation in the event the Plaintiffs are successful; and (b) to encourage capable candidates to serve as corporate officers and directors because the corporation will absorb the cost of defending their honesty and integrity.  The court held that the procedural posture of the claim wasn't important, only whether the office or director was placed in a posture of having to defend.  

• For purposes of determining whether someone is “defending” a proceeding, the operative question is not “who started the lawsuit?” as Mace suggests, but rather “has a claim been asserted against the covered person?” If a claim has been asserted, whether as an initial claim, counterclaim, or third party claim, then the covered person is “defending.”

The court also stated that the carve-out within the Bylaw did not bar Paolino from receiving advancements.  Mace argued that the carve-out in Section 6.01 foreclosed advancement because Paulino initiated the proceeding.  The carve-out provided that payments would not be made where the officer or director "initiated" the proceeding unless "authorized by the Board of Directors of the Corporation.”  Furthermore, Section 6.02 provided that “the right to indemnification conferred by Article 6 shall include the right to be paid by the Corporation the expenses incurred in defending any such proceeding in advance of its final disposition.”  The court held that Paolino was not seeking advancements or indemnification in connection with a proceeding initiated by him.  Rather, the counterclaims were part of the proceeding that Mace initiated because the counterclaims were a separate cause of action for purposes of Section 145 analysis. 

Lastly, the court stated that the employment agreement between Paolino and Mace did not alter his right to recover.  Mace argued that Paolino was not entitled to recover because the counterclaims did not arise “by reason of the fact” that Paulino was CEO and Chairman of Mace, but rather out of his employment agreement.  Plaintiff needed only to show the existence of a "nexus or casual connection between a claim and [the officer's] official capacity."  The court concluded that the counterclaims broadly asserted that Paolino breached his fiduciary obligations and contractual, statutory, and common law duties owed to Mace.  Thus, the counterclaims implicated his duties as an officer and director. 

Additionally, the requisite connection was established “if the corporate powers were used or necessary for the commission of the alleged misconduct.”  Under this test, a claim against a director or officer for matters that related to a corporation would fall within Section 145, even if the individual was a party to an employment agreement.  The court further stated that in order for the corporation to avoid advancements, the claim must involve a specific and limited contractual obligation without any nexus or casual connection to official duties.

The primary materials for this post are available on the DU Corporate Governance website.

In a complaint filed January 21, 2010, the SEC asserts Assurant used improper accounting methods to record payments that the company received. The SEC charges Assurant with violating Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Securities Exchange Act of 1934 and Rules 12b-20, 13a-11, and 13a-13.  As a result, the SEC claims Assurant overstated its reported net income by nearly 10% for the third quarter in 2004.  Assurant has agreed to pay a civil penalty of $3.5 million without admitting or denying the charges. 

According to the SEC, Assurant Solutions, a subsidiary of Assurant, entered into an Aggregate Stop Loss Reinsurance treaty with American Re-Insurance Company (“American”) dating back to 1992 and renewed annually.  The treaty consisted of a written policy shifting the risk of losses from Assurant Solutions to American in certain conditions and an oral verbal agreement on the side known as a “handshake” agreement.  The handshake agreement conveyed that if American paid more in claims than Assurant Solutions paid in premiums, then Assurant Solutions would reimburse American for the difference.  The handshake agreement also stipulated that if Assurant Solutions paid more in premiums than American paid in claims, then American would pay the difference to Assurant Solutions. 

Pursuant to the handshake agreement, American made a payment of $10 million to Assurant Solutions in 2004.  Assurant accounted for the $10 million using reinsurance accounting, whereas under generally accepted accounting principles (“GAAP”), Assurant should have accounted for the payment using deposit accounting. 

Under GAAP, the deposit accounting method treats the payment as a return of a deposit or loan payment.  The deposit accounting method is used where there is no risk transfer and only affects the balance sheet of a company’s financials.  The reinsurance accounting method is used when risk has been transferred to the reinsurer under a reinsurance treaty.  This method allows the company to offset losses with the recovery payment and reduces the amount of losses on a company’s income statement.  Since the handshake agreement contained a reimbursement provision, under GAAP this would negate the transfer of risk and require deposit accounting. 

Assurant’s agreed upon civil penalty of $3.5 million also takes into account failure to comply with subpoenas in a timely manner. 

The primary materials for this case may be found on the DU Corporate Governance Website. 

The following post concludes the main arguments by plaintiff eBay, Inc. and defendants Newmark, Buckmaster, and Craigslist, Inc. presented in their pretrial briefs.

Shareholder Rights Plan: An effort to Control eBay’s Interest in Craigslist?

Defendants also adopted a Rights Plan (“Rights Plan” or “Poison Pill”) designed to address the threat of a potential hostile takeover, specifically in the event of a “death problem."  They explained that, so long as defendants, the majority stakeholders, held their shares and did not sell them, eBay could not  acquire the company.  However, the death of either majority stakeholder would result in automatic liquidation of their shares, which in turn would make Craigslist more susceptible to a hostile takeover.  Therefore, while the threat of a hostile takeover was not imminent, defendants argued that implementing a Rights Plans was justified because it mitigated against a potential future threat.

eBay contended that this Plan was an unnecessary measure and that effective estate planning could cure the “death problem."  Further, composition of the Plan benefited the defendants to the detriment of eBay.  Under the Plan’s terms, Newmark and Buckmaster could freely transfer shares to each other, whereas eBay would be limited to transfers of stock to a successor in interest by merger.  Moreover, the right of directors to veto or waive the Plan at their discretion creates an unfair disadvantage for eBay.

Defendants responded that Craigslist created a plan that protected the company from eBay and any acquisition.  Furthermore, the Rights Plan only took affect when eBay or one of the other shareholders decided to sell their respective shares.  The Plan allowed Newmark and Buckmaster the power to veto; however, defendants argued that long-term interests of the company, and not the personal interests of Newmark or Buckmaster, would guide use of the veto.

eBay argued that defendants’ power to waive the poison pill accentuated the defendants' control and disadvantaged eBay.  In response, defendants brushed aside eBay’s concern by concluding that sale of a director’s shares was not an imminent concern.  They added that eBay’s complaints about the Plan were based on speculation that future actions would trigger the Plan and that defendants would inevitably breach fiduciary duties.  Defendants’ also noted that because eBay had not submitted to the company’s Right of First Refusal agreement, it is currently able to sell its entire stake without triggering the Rights Plan and without Board approval, provided it does not sell more than 15% of the company to a single purchaser. 

Company ROFR: Cornering eBay to Surrender Liquidity of Shares? 

eBay’s complaint alleged that Newmark and Buckmaster approved a plan to authorize and implement a stock issuance program premised on a ROFR Agreement executed in early 2008 without financial advice, third-party expertise, or notice to and involvement of eBay. 

The ROFR, once accepted by a stockholder, provided Craigslist with the right of first refusal in the event that a stockholder desired to transfer its shares to a third party.  In return, the company would issue one “reorganization share” of common stock in Craigslist for every five shares of common stock owned by that stockholder.  According to defendants’ pretrial brief, the ROFR agreement allowed Craigslist to purchase shares whenever the Board determined the sale was below market price or to a purchaser that was hostile or incompatible with Craigslist.

The complaint asserted that because Craigslist was a privately held company comprised of only three stockholders, the ROFR was an effort to strip eBay of the ability to sell its interest to anyone not controlled by Newmark or Buckmaster.  Moreover, if either Newmark or Buckmaster exercised the ROFR with respect to the other's shares, they would own over 50% of the Craigslist shares.  

Exercise of the ROFR also unfairly disadvantaged eBay because Newmark and Buckmaster maintained the ability to waive the implication of the company ROFR.  Ed Wes, counsel hired by Craigslist to act on these transactions, was also hired by the insider directors in their personal capacity for estate planning matters.  Both the ROFR and the poison pill contained “carve out” provisions allowing the insiders to transfer shares for estate planning reasons without triggering the restrictions contained in either documents. 

Thirdly, there was little cost to Newmark and Buckmaster because they were already subject to personal refusal rights held over each other’s shares, while eBay had no such obligation.  Finally, because eBay was a competitor of Craigslist, eBay argued it deserves a higher premium for submission to the company ROFR. 

In contrast, defendants argued the ROFR encouraged full participation and achieved the greatest benefit for the corporation as opposed to diluting eBay’s shares.  eBay was offered the same opportunity to submit to the ROFR.  Moreover, eBay was not unfairly burdened by implementation of such a governance measure.  As eBay admitted, any acquisition of control by Newmark or Buckmaster under the ROFR was due to the equity stake of the shareholders at the time of exercising the ROFR and not inequitable treatment.  Secondly, defendants argued that their ability to veto ROFR would be guided by the best interests of the company and not their personal interests. 

Thirdly, while the defendants previously held personal refusal rights over each other’s shares, by submitting to the company ROFR they have in fact incurred a greater cost than eBay through the loss of those refusal rights by transferring them to the company.  On the other hand, eBay would not be giving up any such right. 

Finally, with respect to eBay’s assertion that its status as a competitor entitled eBay to a higher premium for the ROFR , the defendants stated this further supported the need for the ROFR.  Overall, eBay was given the option to (1) submit to the ROFR, surrendering its right to control the liquidity of its shares; or (2) refuse to accept the ROFR agreement and face substantial dilution of its interest while losing important minority shareholder protections.

The arguments on both sides are strong and the outcome is expected to shed light on rights of minority shareholders.  In its article, “Judge urges eBay, Craigslist to resolve dispute,” Associated Press highlighted the judge’s stance on the issue. Chancellor William Chandler III, the presiding judge, urged the parties to settle the dispute amongst themselves before he issues a ruling.  The judge stated that such a resolution would benefit both parties, much more than what he may decide.

The pleadings and other primary materials for the post are available on the DU Corporate Governance website.

Toward the end of 2009, a case brought by Internet auction giant eBay against Craigslist went to trial in the Delaware Court of Chancery.  See eBay Domestic Holdings Inc. v. Newmark et al., No. 3705-CC.  The case featured testimony from top officials from both companies, including the ex-CEO of eBay and current Republican gubernatorial candidate Meg Whitman.  In anticipation of the Chancery Court’s decision, the Race to the Bottom will cover the main legal arguments presented in the pretrial briefings by both parties.   

In a complaint filed on April 30, 2008 (“Complaint”), eBay Domestic Holdings, Inc. (“eBay”) alleged that Craig Newmark (“Newmark”) and James Buckmaster (“Buckmaster”), the only two directors and majority stockholders of Craigslist, Inc. (“Craigslist” or “Company”), breached their fiduciary duties of care, loyalty, and good faith to eBay, the third stockholder, when they (1) approved a plan to implement a Right of First Refusal (“ROFR”) agreement; (2) adopted a Shareholder Rights Plan; and (3) amended Craigslist’s Charter and Bylaws to create a staggered board.  Defendants denied such allegations and further stated in their pre-trial brief that adoption of such governance measures was protected by the business judgment rule.  In addition, they asserted that eBay’s misconduct precluded it from obtaining an equitable relief.   

In August 2004, a former Craigslist executive sold his 28% share to eBay.  Newmark, Buckmaster, and eBay entered into a Shareholders' Agreement ("SHA") that imposed certain rights and obligations on the parties.  Among other things, the SHA imposed: "(i) certain transfer restrictions and rights of first refusal on the shares held by eBay, Newmark and Buckmaster; and (ii) granted eBay informational, reporting and inspection rights and the right to approve certain transactions directly or through a director designated by eBay." 

The agreement further provided that some rights and obligations of the parties would terminate upon eBay engaging in competitive activity.  These included: "(i) eBay's right of first refusal to purchase equity securities sold or issued by the Company or to purchase the shares of Newmark or Buckmaster should either attempt to sell his shares, and (ii) Newmark and Buckmaster's right of first refusal to purchase eBay's shares should eBay attempt to sell its shares." 

In 2005, eBay started Kijiji.com, an overseas company marketing classified ads.  In 2007, eBay began marketing the services in the United States.   Viewing the site as competition, the Board of Craigslist implemented protective measures, in addition to those outlined in the SHA, to ward off potential threats presented by eBay.  These threats allegedly included the risk of future misuse of Craigslist’s confidential information; impairment of board functions by having an agent of a direct competitor influence Board decisions; and the threat of a future hostile takeover when the defendants' pass away and their respective shares become liquid. 

The matter ultimately ended up in litigation, with eBay challenging the actions by Craigslist.  The litigation raised a number of issues:

Standard of Review: Entire Fairness v. Business Judgment

In its pretrial brief, eBay urged that the court should use the stricter “Entire Fairness” standard because the majority shareholders, Newmark and Buckmaster, stood on both sides of the transactions when they authorized governance measures that unfairly benefited them to the detriment of eBay.  eBay asserted this standard applies “unless the transaction is (1) recommended by a disinterested and independent special committee; and (2) approved by stockholders in a non-waivable vote of the majority of all the minority stockholders.” 

Conversely, defendants’ pretrial brief stated that the business judgment rule applied here because the Board did not implement the governance measures by a unilateral action, a necessary prerequisite for enhanced scrutiny of their actions.  The governance measures required and received proper shareholder approval.  The defendants added that even if the shareholders are impacted differently under the measures, Delaware law did not require equal treatment of all shareholders in all circumstances, especially in situations where a shareholder poses a future threat to the enterprise.

Staggered Board: Staggered Board Squeezing Out eBay’s Directors?

Craigslist amended the certificate of incorporation to provide for a staggered board upon receiving notice of eBay’s competitive activity.  eBay asserted that this action effectively removed eBay’s right to elect any director by cumulative voting as all shareholders would vote for one director instead of three at each election.  Defendants contended the measure restricted eBay’s ability to unilaterally place conflicted eBay agents on the Craigslist Board.  Furthermore, this measure protected (1) the company against further misuse of its confidential information and plans, and (2) the Board’s ability to function properly.  Defendants further stated that eBay would still have the right to nominate directors.

eBay directly attacked the implementation of the staggered board by stating that the amendment required approval of directors’ actions by disinterested shareholders.  In this case, the directors constructed this measure and authorized it as the shareholders.  eBay further claimed the action imposed an unfair disadvantage because Newmark and Buckmaster owned the majority of Craigslist stock and are parties to a voting agreement under which each has agreed to vote for the other’s nominee. 

Defendants replied that such a measure prevented any shareholder from unilaterally seating a nominee without support from other shareholders.  They further argued that eBay understood that any competitive activity on its part would result in surrendering its claim to a Board seat.  As a consequence, eBay would have to propose an acceptable independent board nominee in order for that person to be elected.  

The pleadings and other primary materials for the post are available on the DU Corporate Governance website.

As a kind of denoucement to the BofA, we note an opportunity lost.

According to an editorial in the WSJ, the SEC tried, in connection with the proposed settlement with BofA, to get the Bank's agreement to provide shareholders with access to the company's proxy statement for nominees.  The Bank refused and it did not make it into the settlement.  The editorial, however, described the efforts this way:

• According to a Bloomberg report on Thursday, the SEC chairman or her staff also wanted BofA to change the way it runs proxy elections for seats on the company's board. The chairman's office called for BofA to embrace "proxy access." This is the buzzword for allowing special-interest groups like union pension funds to promote dissident board candidates in the company's own proxy materials, even if these interests own as little as 2% of the company.

This comment warrants a response.  It is an attempt to use scare tactics in place of analysis. 

First, the comment suggests that access will unleash special interest groups, particularly, apparently, unions.  We wonder in fact how many union pension plans will actually nominate directors.  Indeed, we wonder how many union pension plans own more than 2% of the shares of a large public company, the apparent threshold for submitting a nominee.  Thus, for example, the institutional ownership of ExxonMobile shows no unions among the top ten institutional investors (with the tenth largest owning under 1% of the company's stock). 

Second, "special interest," whatever that means exactly (beyond union nominated directors apparently), is a pejorative slap at the identity of the shareholder nominating the director.   It ignores the fact that it is not the nominating shareholder who is elected to the board but the nominating shareholder's candidates.  Even if a nominating shareholder fits within someone's definition of "special interest" (a definition that will likely vary depending upon the background of the particular critic), their candidates for the board will only win if they can convince enough of the other shareholders of the candidate's superiority over those nominated by management.  And, in this battle, management had a decided advantage.  It can use the corporate treasury to convince shareholders not to elect the insurgent candidate.

In other words, its not about the identity of the nominating shareholder.  Its about the right of shareholders to choose among competing candidates rather than be forced to accept, without meaningful choice, those nominated by management.  Those raising the "special interest" shibboleth are effectively trying to prevent shareholder choice by preventing the nominations in the first instance.   Ought it be that a decision is better made by the shareholders based upon the relative qualifications of the candidates?  

Finally, the use of the "special interest" rubric also ignores the fact that the phrase rightfully ought to apply with equal strength to management nominated directors.  These are directors who are nominated by management and often have preexisting ties with the CEO.  They are likely, as we have written often on this blog, to have a predisposition in favor of the CEO.  

The irony in all of this in the end is that had access been included in the proposed settlement with BofA, the likely result would have been no change in the board and no increase in nominations by shareholders for the board.  Even with access, shareholders still must incur expense in connection with the proxy contest, something that discourages nominations.  In fact, the only two companies with access bylaws (Cryo-Cell and Comverse) have yet, as far as this Blog knows, to receive a shareholder nominee.

For more on this topic, see The SEC, Corporate Governance, and Shareholder Access to the Board Room.

In Marion v. TDI, Inc., 2010 WL 6189 (3d Cir. Jan. 4, 2010), the United States Court of Appeals  for the Third Circuit held that the receiver from a defunct broker involved in a Ponzi scheme had standing to bring suit against third parties who allegedly assisted the scheme.  In order to prevail on a claim to recover damages from the third party affiliates, however, the receiver needed to establish that the actions of the third parties were the proximate cause of losses, not simply enabling the losses to continue.

Robert Bentley formed Bentley Financial Service, Inc. (BFS) to broker bank issued certificates of deposit (CD’s) with depositors.  Brokers generally offered the CD’s at rates lower than what the banks paid, thereby earning the difference, or “spread.” 

Brokers also sold CD’s with differing maturities than those offered by the bank.  Brokers were obligated to inform investors of this “mismatching” of maturities.  Moreover, when an investor purchased a CD with a shorter maturity, the broker was required to produce the funds needed to liquidate the investor's position at the expiration of the shorter maturity.  The broker could either find a new investor for a short term CD, temporarily sell the long term CD to a bank with an agreement to repurchase, or require the investor to stay invested for the duration. 

When Bentley began having cash flow problems to meet the demands of his customers he started selling fictitious CD’s to investors.  Bentley would use the proceeds from the sale of fictitious CD’s to pay out prior investors in a typical Ponzi scheme structure.  Bentley also employed the services of two other individuals, Ted Benghiat, owner of SFG Financial, Inc, (Benghiat) and Joseph Marzouca, Vice President of Peninsula Bank (Marzouca).  On at least three occasions, both men provided Bentley with cash that helped keep "Bentley’s operation afloat."

After the SEC filed a civil action against Bentley, the court appointed David H. Marion as receiver for BFS. Marion then brought an action against Benghiat and Marzouca alleging that they aided and abetted or conspired in Bentley’s fraud.  The jury found both Benghiat and Marzouca liable and awarded combined damages of almost $33 million.  Benghiat and Marzouca moved for judgment as a matter of law, arguing that Marion, as the receiver for BFS, lacked standing because it was the investors, not BFS that suffered injury from Bentley’s fraud. 

Marion argued, conversely, that Benghiat’s and Marzouca’s actions allowed Bentley to perpetuate his fraud further, causing the BFS to incur even greater losses than would have been otherwise possible.  The court accepted the argument ("This claim, if plausible (and for purposes of this opinion we assume it is), steps over the relatively low standing threshold.") and concluded that the receiver had standing against those third parties who helped the management of that corporation perpetuate the fraud.  

Despite the fact that Marion, as receiver, had standing to bring a claim against Benghiat and Marzouca, the court ultimately ruled that there was no liability.  The defendants could not be liable to the extent they engaged in practices that increased the company's short-term liquidity, even when doing so allowed the company to "stay afloat long enough to put itself in a worse position than it was in prior to the cash infusion." 

While the aid and financing that Benghiat and Marzouca provided to Bentley may have caused BFS to suffer additional harm by increasing its losses, those actions did not rise to the level of proximate causation.  Bentley’s intervening act, how he used the financing, stood between the act of injecting cash into the business and the ultimate harm suffered by investors. 

The primary materials in this case can be found at the DU Corporate Governance Web Site.