On this Blog, we enjoy examining assorted issues and developments in signficant detail, often examining the primary materials filed in a case.  Beginning on Monday, we will run two parallel series.  In the morning, each day, the 6:15 am post will be devoted to the materials filed before the Second Circuit in the CSX case.  That case involves the issue of whether a hedge fund can be treated as the beneficial owner of shares held by a counterparty to an equity swap.  Among the material examined in the series are the merit briefs and a number of amicus, including one filed by an assortment of former commissioners from the SEC.

Each day next week, the 11:00 am post will be devoted to proposed changes by US News to the formula for ranking law schools.  US News is talking about ranking law schools based upon a median LSAT and GPA from all students rather than the current system of ranking based on the medians of full time students.  The practical effect of the change will be to force all schools with night divisions to include the night students in the rankings.  Currently about 90 law schools have part time divisions and for all of them the part time division has a lower median LSAT score than for the full time division.  (Median here was imperfectly calculated by averaging the 25th/75th percential lsat).  This suggests that if all other things remain the same, schools with night divisions will take a hit in the rankings.  We will look at this issue and the probable impact on law schools during the week.

Enjoy!

We are discussing In re Transkaryotic, a relatively recent Delaware case that contains bad law and reflect the anti-plaintiff bias of the Delaware courts.  

The Court described some of plaintiffs' description as "sloppy and disingenuous."  The opinion, however, noted the following:  "Products used to treat rare diseases are known as 'orphan drugs.'"  The statement is incomplete.  As the FDA web page notes:  "The term 'orphan drug' refers to a product that treats a rare disease affecting fewer than 200,000 Americans."  Sloppy and disingenuous?  You decide.

We are discussing In re Transkaryotic, a relatively recent Delaware case that contains bad law and reflects the anti-plaintiff bias of the Delaware courts.  

The case opened with a condescending slap at the role of plaintiffs and presumably their lawyers, likening them to  scavengers who concoct theories of misbehavior out of rubble.

• All corporate combinations leave in their wake certain artifacts-documents, e-mails, conversations, and notes.  If one digs through enough of the rubble of a consummated merger, one will almost invariably find something questionable.  A clever corporate archeologist can extrapolate from these suspicious artifacts and concoct a theory of malfeasance, disloyalty, and bad faith.  Yet theories alone cannot lead to liability. 

Now mind you, the Court found in this case that the  "rubble" revealed that the merger may not have been approved by shareholders, hardly requiring plaintiff to "concoct a theory."  It was not accurate about this plaintiff and an unattractive thing to say about plaintiffs in general.     

These aspersions more or less continued throughout the opinion.  When plaintiffs alleged a possible conflict of interest with respect to one of the directors, the Court accused plaintiffs of "misrepresent[ing] and mischaracteriz[ing] the record in their opposition brief."  As if not blunt enough, the Court further noted that "Plaintiffs' sloppy and disingenuous description of the record cannot create a genuine issue of material fact where none exists."  Put aside that some of the evidence used by the plaintiffs was characterized as hearsay.  In other words, it wasn't that the plaintiffs misrepresented the evidence, it was that the Court chose to exclude it on evidentiary grounds.

The sharpness of the approach was particularly apparent given the Court's treatment of the defendants.  Plaintiffs alleged that the vote tally for the merger was incorrect, that in fact shareholders voted down rather than approved the merger.  As part of that argument, plaintiffs asserted that some votes favoring the merger had been double counted, producing as evidence two proxy cards with the same totals.  The Company responded by contending that the same proxy card had "apparently [been] produced twice."  The Court, however, noted that "[e]ven a cursory examination of each card makes clear that the cards are not identical reproductions or photocopies of each other . . . Thus it is obvious that they are not the same card . . . " 

Imagine if the plaintiffs had made an argument that could be dispelled with a "cursory" examination of the evidence. But where the defendants make the argument, there was no reference to sloppy or disingenuous practices, no reference to mischaracterizing the record.  In this opinion, pejorative language and hostile reactions are reserved for the plaintiffs. 

This disparity is not all.  When Plaintiffs succeeded on an argument, the Court made absolutely clear that the decision was grudging.  Examples?

• I conclude that plaintiffs have sufficiently, albeit scarcely, rebutted this presumption to survive the Company;'s motion for summary judgment on the unlawful merger claim . . . 
• I therefore conclude that plaintiffs have adequately, if barely, demonstrated Shire's knowing participation in Langer's assumptive breach of his duty of loyalty to the Company.
• Without such evidence, however, I am forced to conclude that, with respect to the 776,395 votes at issue on the July 25 proxy card, plaintiffs have raised a genuine issue of material fact . . .
• I hasten to add, however, that this conclusion should not in any way imply that I am optimistic that plaintiffs will succeed in carrying their ultimate burden of proof at trial (emphasis added)

There is more.  Take a look at footnote 137, with plaintiffs criticized for failing to attend the meeting while the court hardly has anything to say about the failure of the defendants to preserve documents.  There is a reference to the 110 page brief opposing summary judgment, clearly intended to suggest a wordy (dare we say prolix) written product, coming from a Court that itself took 63 pages to set out its views. 

Few could read this opinion without detecting a noticeable hostility or dislike towards plaintiffs.  The disparate treatment of the two sides makes this impression even more pronounced.  Could this opinion have been written in a manner that avoided the harsh remarks and grudging references while still conveying the same legal principals?  Of course.  But in the Delaware, such neutrality is apparently not required, at least when it comes to the plaintiffs. 

We have posted a copy of the opinion and many of the primary documents involved in the case  on the DU Corporate Governance web site. 

We are discussing In re Transkaryotic, a relatively recent Delaware case that contains bad law and reflects the anti-plaintiff bias of the Delaware courts.  

We have noted numerous times on this Blog how Delaware courts use excessively high pleading standards to dismiss meritorious cases.  This is another example.  Plaintiffs alleged that the votes in the election were miscounted.  The motion for summary judgment was decided about three years after completion of the merger.  This "delay" caused the Court great consternation.

• Given the peculiar facts and history of this case, the Court must acknowledge its reluctance to allow this claim to continue. . . . the Court is not unaware that allowing this claim to advance beyond TKT's motion for summary judgment implicates important policy concerns regarding the need for finality in corporate transactions.  Thus, as with a delayed challenge to an election vote, the Court will demand clear and convincing evidence -- not merely raising a genuine issue of material fact with the benefit of all reasonable inferences -- that the vote was invalid.  

Indeed, the Court was "reluctant to permit even the specter of undermining the finality of this merger, which was consummated nearly three years ago. . . "  In other words, the Court was troubled by the lateness of the suit relative to completion of the merger.  But in the Complaint, the Plaintiffs noted that it was only because of the discovery in the appraisal action.  See Complaint, at para. 77 ("Thus, based on the discovery provided during the appraisal action, there is substantial doubt that TKT actually obtained the necessary votes in favor of the merger.").   Moreover, the Complaint is replete with allegations that the discovery process in the appraisal action was subjected to delay.

• TKT's conduct in the appraisal litigation (conduct that was controlled by Shire, its new corporate parent) was underscored these substantive breaches of duty.  It utterly failed to comply with the Court's discovery orders and then waited until after fact depositions had ended to produce tens of thousands of pages of relevant documents.  These violations of Court orders and rules certainly suggest that TKT and Shire were in no hurry to conclude the litigation or to have evidence of their wrongdoing finally come to light.

Complaint, at para. 7.  In other words, at least according to the Complaint, a portion of the delay resulted from the behavior of some of the Defendants.  In the course of the fiduciary duty case, the Plaintiffs filed a motion to compel, arguing that:

• Rather than provide the requested information, however, defendants assumed an aggressively non-responsive posture that has affected discovery at macro level.  They sidestepped straightforward financial inquiries.  They ignored or recharacterized questions about the core issues in this case.  And with one limited exception, they insisted that they were under no obligation to disclose any information about their affirmative defenses.

Motion to Compel, July 10, 2007, at para. 4.  Plaintiffs noted that "if this case is to stay on-track for trial," there was a need for "judicial intervention." 

While these are only allegations, the record suggests that at least some of the delay in bringing and resolving the matter can be attributed to the behavior of the Defendants.  The Court makes no mention of this, merely referring to the "peculiar facts" in the case.  Yet the Court relies on the delay to raise the bar on Plaintiffs.  From now on, they will need to show not genuine issues of material fact but clear and convincing evidence.  Thus, there is a possibility in this case that the Defendants caused delay and then benefited through the imposition of a higher evidentiary standards.  In other words, the Court used this case as an excuse to try to lift the procedural bars imposed on Plaintiffs. 

We have noted repeatedly that the Delaware courts do this.  This is another example.  As for the requirement of clear and convincing, the Chancery Court relied on an opinion that imposed the standard in a challenge to a corporate election that took place 37 years after the election.  See Opinion at note 125.  First, this case involved an action filed approximately 19 months after the challenged behavior.  This is in no way comparable to a case where the gap was 37 years.  Second, as noted, the 19 month delay (and the three year delay in resolving the matter) may have been a result, at least in part, of the behavior of some of the Defendants. 

We have posted a copy of the opinion and many of the primary documents involved in the case  on the DU Corporate Governance web site. 

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We have often wondered about the appropriate label for this Blog.  We have received an occasional suggestion (particularly "sensational") but are more than happy to accept the judgment of the Library of Congress and go with "authoritative." 

In the area of director independence, Delaware courts routinely ignore evidence of obvious conflicts of interest.  In this case, the largest shareholder of Transkaryotic was Warburg Pincus, a private equity fund.  At one point, the fund owned 14% of the shares.  As the Court noted, the ownership "entitled" Warburg to a seat on the board.  In addition, a second Warburg "professional" who was a founding investor of Transkaryotic also sat on the board. 

When the shares of Transkaryotic fell dramatically in 2003, Warburg "lost over $100 million" and in 2004 considered the investment "problematic."  Plaintiffs alleged that the two Warburg directors had divided loyalties, favoring the interests of Warburg over Transkaryotic.  The Court summarily dismissed the argument.   

• Clearly, the mere fact that Leff was affiliated with a large stockholder does not disable the business judgment rule.  On the contrary, in fact, "[a] director who is also a shareholder of his corporation is more likely to have interest that are aligned with the other shareholders of that corporation as it is in his best interest as a shareholder to negotiate a transaction that will result in the largest return for all shareholders."  Warburg owned about fifteen percent of Transkaryotic, and this substantial stake gave Leff "powerful economic (and psychological) incentives to get the best available deal.  Plaintiffs have failed to show that this normal presumption is inapplicable here because they have not and cannot on this record make "a strong factual showing" that Leff and Warburg "were willing to leave a substantial sum of money on the table -- simply to rid themselves of [Transkaryotic]." 

Several thoughts on this.  First, the quote refers to directors who are also shareholders.  While one of the two directors did own shares, the allegations by Plaintiffs had nothing to do with direct ownership by the directors.  It was an allegation of a conflict of interest because the directors represented the company's largest shareholders.  The issue, therefore, is whether directors representing a large shareholder can have interests that differ from other shareholders, particularly where the large shareholder pays the director a salary (or other compensation).  That issue was entirely ignored by the Court.

Representing a large shareholder can easily create a conflict of interest with other investors.  There are two reasons.  First, there are different types of shareholders with different motivations that can easily be at odds with other investors.  VC Strine has more or less said this.  Thus, the Court apparently treated Warburg as a typical shareholder, all but ignoring its status as a private equity fund.  While it is true that any large shareholder would likely want to maximize the price received for its shares, shareholders that routinely redeploy assets like private equity funds have other temporal concerns.  If there is a better use for the funds, they may be willing to forgo the possibility of a higher offer in the future for an acceptable one now.  In other words, it is not only about whether Warburg would be willing to leave a "substantial sum" on the table but also about what Warburg's alternative uses for the funds.  

Second, size matters.  Large shareholders do not necessarily have the same interests as other shareholders.  This is why, for example, that the Combined Code of Corporate Governance for the United Kingdom provides that a director is presumptively not independent if he or she "represents a significant shareholder."  In other words, this Code (and others) recognizes that a representative on the board of a large shareholder may well have interests that differ from other shareholders.

None of this mattered to the Court.  It was enough that the directors represented a shareholder and, apparently, all shareholders have the same goals irrespective of the nature of their investment history and the size of their investment.    

We are discussing In re Transkaryotic, a relatively recent Delaware case that contains bad law and reflects the anti-plaintiff bias of the Delaware courts.  

When the Delaware Supreme Court held that friendship with an interested party could result in the loss of independence in Brehm v. Stewart, 845 A.2d 1040 (Del. 2004), we noted that the test was one almost impossible to meet, particularly when coupled with the excessively high pleading standards used by the Delaware courts.  Thus, plaintiffs had to show that “the non-interested director would be more willing to risk his or her reputation than risk the relationship with the interested director.”  And, despite the inherently subjective nature of the test, they had to do so on a motion to dismiss, without the benefit of any discovery.  So the courts would claim that friendship could be a disqualifying relationship in theory but in practice would ensure that it never was.

This case illustrates the point.  In seeking to acquire Transkaryotic, the CEO of Shire, Matthew Emmens, contacted Wayne Yetter, the chairperson of the board.  Plaintiff alleged that the two had a relationship that went back 20 years, that they knew each other "extremely well" and were "very friendly," and that Emmens and Yetter "worked closely together."  At the time when Emmens was using the "back-channel approach" to contact Yetter, Yetter was using Emmen's as a reference for a job as CEO of Odyssey Pharmaceuticals.  The Court treated the reference almost with derision.

• The actual record evidence, however, shows that Yetter merely included Emmen's name on a list of references submitted in connection with an application for a position with Odyssey Pharmaceuticals.  There is no evidence that Emmens was actually contacted by Odyssey or any affiliates.  In fact, there is no evidence whatsoever that Emmens even knew he was listed as a reference.  Moreover, the suggestion that Yetter would sell his vote for a positive job references is belied by the fact that Yetter . .  . voted affirmatively to reject the initial Shire offer of $31 per share.

The Court's explanation is full of assertion and little reasoning.  That Yetter would choose to use Emmens as a reference at the very time Emmens was seeking information on behalf of Shire creates at least the appearance of a conflict of interest.  The fact that there is no evidence that Odyssey contacted Emmens is irrelevant.  Yetter presumably knew that Emmens might be contacted and presumably knew that an unsuccessful interaction in connection with the Shire/Transkaryotic acquisition might impair the value of the reference. 

Moreover, the fact that there was no evidence that Emmens knew he was listed as a reference cuts against the Court's position.  If Yetter included Emmens without informing him, that suggests that he didn't need permission, indicia of a close relationship.  The Court also omitted to mention that Yetter was hired by Odyssey in November 2004, suggesting that the references may have had some value (whether or not actually contacted).  See Wayne Yetter Profile, Forbes.com ("From November 2004 to September 2005, he served as the Chief Executive Officer of Odyssey Pharmaceuticals, Inc., the specialty pharmaceutical division of Pliva d.d.").   

But in addition, there's at least arguable evidence that Emmens and Yetter thought their relationship close.  The proxy statement for the merger disclosed Emmens approached Yetter for the first time in November 2005.  See Proxy Statement, June 27, 2005 ("On November 15, 2004, Mr. Emmens communicated to Wayne Yetter, who was the chairman of our board of directors at the time, Shire’s interest in pursuing an acquisition of our company.").  Plaintiffs alleged that the proxy statement was misleading because it failed to disclose that "Emmens had secretly approached Yetter about the merger in early October 2004."  To the extent true, the failure to disclose the earlier contact could have been accidental.  But it also could have been an effort to hide the preexisting relationship.   

But the ultimate evidence of the importance of the relationship was the board's response.  Plaintiffs assert on brief that, at a board meeting on January 17, 2005: 

• "Yetter was forced to admit generally his 'past association' with Emmens and to acknowledge that 'they were very close . . .  Those admissions fell far short of full disclosure, but they were troubling enough that the board's 'confidence was shaken' by the news.  Even TKT's counsel stated that Yetter was not 'appropriately ' representing TKT and that there was 'ample reason for [the] board to get rid of [Yetter] based on bad judgment alone.'  It therefore agreed that Yetter should step down as Chairman. (citations to record omitted).

The Court acknowledged that Yetter disclosed that "he had a preexisting relationship" with Emmens at the January 17 meeting but did not disclose "the initial October call from Emmens and did not disclose that he listed Emmens as a reference on his resume."  In other words, Yetter did not make full disclosure about the relationship but from what he did say, the information apparently played a role in the decision to have him step down as chairman.  (The Court is unclear on this point, noting only that "the board expressed that its confidence had been shaken in Yetter" but does not specifically relate it to the discovery of the relationship with Emmens).  If so, it would suggest that the board thought that the information was important. 

Plaintiffs don't have to prove a conflict of interest, but need only show the existence of a factual issue requiring resolution by the jury.  The evidence presented by Plaintiffs would seem to suggest at least a jury question over the issue.  There was evidence of a disqualifying relationship.  There was evidence that suggested others thought the relationship significant.  But not in Delaware, where despite protestations to the contrary, friendship does not result in the loss of independence or a finding of a conflict of interest.  It is another reason why the concept of independence in Delaware is flawed. 

We have posted a copy of the opinion and many of the primary documents involved in the case  on the DU Corporate Governance web site. 

We are discussing In re Transkaryotic.  In this case, shareholders approved a merger by a very close vote.  In the immediate aftermath, plaintiffs filed appraisal actions.  Approximately eighteen months later, after the benefit of discovery in the appraisal action, plaintiffs filed an action for breach of fiduciary duty. 

Among other claims, plaintiffs alleged that the proxy materials were incomplete and inaccurate.  The material omissions included "material facts" about the relationship between a director on the Transkaryotic Board and the CEO of Shire, the acquirer.  

The Chancery Court's response?  It "need not determine whether the purported facts are material . . . because all of plaintiffs' disclosure claims are barred."  Why were they barred?  Without any support, the Court determined that disclosure claims could only be cured through equitable relief.  As the opinion stated:

• [T]his Court has explicitly held that a breach of the disclosure duty leads to irreparable harm. On account of this, the Court grants injunctive relief to prevent a vote from taking place where there is a credible threat that shareholders will be asked to vote without such complete and accurate information.  The corollary to this point, however, is that once this irreparable harm has occurred -- i.e., when shareholders have voted without complete and accurate information -- it is, by definition, too late to remedy the harm.  If the Court could redress such an information injury after the fact, then the harm, by definition, would not be irreparable, and injunctive relief would not be available in the first place. . . 

As a result, actions brought after the merger had been consummated would be dismissed because there was no remedy.  "I  hold that this Court cannot grant monetary or injunctive relief for disclosure violations in connection with a proxy solicitation in favor of a merger three years after the merger has been consummated and where there is no evidence of a breach of the duty of loyalty or good faith by the directors who authorized the disclosures." 

There are a number of observations that can be made about this holding.  First, even the Court knows it is going far out on a limb in the case because of the way it confusingly couches the holding.  While concluding that it is "too late to remedy the harm," the Court also found, alternatively, that the case must be dismissed under the waiver of liability clause adopted by the Company.  In other words, the holding that disclosure claims brought post-merger could not be remedied was entirely unnecessary. 

Second, the Court was wrong that the disclosure claims were subject to the waiver of liability provision since they arose out of allegations that implicated the duty of loyalty.

Third, after having said that a disclosure claim cannot be remedied, the Court concluded that this was only true in cases  "where there is no evidence of a breach of the duty of loyalty or good faith."  The quote suggests that disclosure violations can be remedied if they involve bad faith or breach of the duty of loyalty.  Yet this is entirely inconsistent with the Court's reasoning that once the irreparable harm occurs, there can be no remedy. 

Fourth, the reasoning is not by any stretch of the imagination limited to mergers.  Essentially, the same reasoning would apply to any disclosure case involving a shareholder vote.  In other words, once the vote occurs and the matter cannot be undone, there can be no monetary or injunctive action.  The holding, therefore, threatens to eviscerate entirely suits seeking recovery "after the fact" for false disclosure.

Fifth, the complaint alleged that had the disclosure been accurate, "the stockholders of TKT would never have approved the merger."  See Paragraph 90.  In other words, the harm was not some amorphous impairment of voting rights in a matter that passed overwhelmingly; the harm was the approval of a merger as a result of a close vote that otherwise would not have passed.  Moreover, plaintiffs alleged that appraisal did not "provide them a full remedy."

Sixth, the case is internally inconsistent.  Later in the case, the Court concedes that plaintiffs have sufficiently alleged that the votes were miscounted and the merger in fact did not pass.  But if this is true, the Court must understand that there is a remedy for plaintiffs who were subjected to a merger that they didn't approve.  The same remedy would be applicable to shareholders who were subjected to a merger that they wouldn't have approved had they been given proper disclosure. 

We have posted a copy of the opinion and many of the primary documents involved in the case  on the DU Corporate Governance web site. 

The WSJ just ran an article on what it describes as "a new breed of directors," those members of the board who actually reach out to large shareholders and listen to their concerns.  Big news in the United States but common practice in the United Kingdom.  The UK has in place the Combined Code, a set of non-mandatory corporate governance practices.  Among other things, the Code provides for the separation of chairman and CEO.  Among other assignments, the chairman is given the task of maintaining "sufficient contact with major shareholders to understand their issues and concerns."  In other words, dialogue among owners and managers is common practice in the UK and not, as it is here, a newsworthy event.

It is tough to be a plaintiff's lawyer in Delaware, as the decision in In re Transkaryotic Therapies illustrates.  The case is full of tendentious tone and criticism of the plaintiff.  

But worse than attitude, the case contains very bad law and demonstrates once again that the Delaware courts have no interest in imposing meaningful standards on boards of directors.  First, the Court, without authority, held that it could not grant injunctive or monetary relief for false disclosure in connection with a merger once the merger was consummated.  This was apparently true even where the false disclosure was only discovered after the merger closed and the vote was "close" (the merger passed "by less than a million votes.").  While this is only the opinion of one person on the Chancery Court, if it becomes controlling, it is tantamount to a holding that companies can issue false disclosure that affects the vote of shareholders and escape any consequence so long as the false disclosure remains undisclosed until after the merger closes.

Second, the Court arbitrarily lifted the standard of proof for plaintiffs challenging the vote to approve a merger, requiring clear and convincing evidence.  The opinion implied that this was necessary in cases of excessive delay between the date of the merger and the date of the law suit.  In this case, the delay was about 19 months, hardly an excessive time period, and the Plaintiffs alleged that the delay occurred at least in part because of the actions of the Defendants.  The Court ignored both and used the case as a vehicle to impose the higher standard.

We will spend a few days examining this opinion.  As usual, we have posted many of the primary documents involved in the case  on the DU Corporate Governance web site. 

We offer one final comment on CA v. AFSCME.  The Court noted that those who "believe that CA’s shareholders should be permitted to make the proposed Bylaw as drafted part of CA’s governance scheme" could, among other things, accomplish the result by seeking "to amend the Certificate of Incorporation to include the substance of the Bylaw."  In other words, the Court all but held that a mandatory repayment scheme, with no board discretion, was valid if in the articles. 

But as we have noted, the offer is an empty one.  As we pointed out in Opting Only In: Contractarians, Waiver of Liability Provisions and the Race to the Bottom, management entirely dominates the process of drafting and amending the certificate. Amendments cannot be introduced by shareholders, only managers. Managers, therefore, introduce what they want, not what shareholders want. Moreover, as the paper empirically shows, management drafts the amendments and uses language most advantageous to its own interests.

The Court pretends that there is a solution to the problem created by its decision to strike down the bylaw but the solution is entirely in the control of the board.  Shareholders have no ability to obtain these types of amendments to the articles.  In other words, the Court would have us believe that its decision only forecloses one method of obtaining mandatory reimbursement for proxy expenses, that others are available.  But in fact there are no avenues available to shareholders and the Court's decision practically forecloses shareholders from obtaining these types of provisions.   

This is a result oriented decision designed to minimize shareholder participation in the nomination process.  It is not compelled by the law but by philosophy, a race to the bottom philosophy.

We have posted a copy of the opinion and many of the primary documents involved in the case  on the DU Corporate Governance web site. 

The case has considerable consequences.  Most immediately, shareholder proposed bylaws that call for the reimbursement of proxy expenses will be considered invalid unless they include a fiduciary out.  This all but spells the death knell for the proposals. A fiduciary out means that reimbursement is not guaranteed but will require the affirmative consent of those opposed in the proxy contest.  In other words, most shareholders wanting to run a short slate will view reimbursement as unlikely.  The fiduciary out, therefore, eliminates most if not all of the added incentive to run a competing slate of directors. 

The broader impact, however, will be felt under Rule 14a-8.  The Court provided a basis for arguing that any proposal addressing substance (as opposed to process) is an improper subject for shareholders under Section 141(a).  But even in the area of process (shareholder elections), the Court essentially invalidated anything that would result in mandatory impositions on the board.  A strong argument will now exist that any shareholder proposal without a fiduciary out will be invalid. 

The Commission denied shareholders access to the proxy statement for its nominees.  In so doing, however, the Commission stated that the amendments to Rule 14a-8 would not undo any prior interpretations of the rule.  But by referring the matter to the Delaware Supreme Court, the effect has been the same.  The Commission has made it harder for shareholders to participate in any meaningful way in the nomination process.

The AFSCME bylaw was unlikely to have much impact.  Few would pass and those that did would probably not encourage many shareholders to incur the risk of a proxy contest.  In other words, it was a way for the Delaware Courts (and the Commission) to provide some semblance of shareholder involvement in the nomination process without really changing the dynamics of director elections.  The same was true of the access proposal considered by the Commission. 

With the unwillingness to accept even this modest proposals, the Delaware courts simply make the case for preemption.  In the aftermath of the November 2008 elections, pressure will build on the Commission to return to the issue of access.  But shareholders will not want the access bylaw considered last year.  The pressure will build for direct access for shareholder nominees to the company's proxy statement.  When this occurs, it will render decisions like CA v. AFSCME largely irrelevant. 

The Delaware Supreme Court all but admitted its bias but professed to have no choice.  As the opinion noted: 

• In arriving at this conclusion, we express no view on whether the Bylaw as currently drafted, would create a better governance scheme from a policy standpoint. We decide only what is, and is not, legally permitted under the DGCL. That statute, as currently drafted, is the expression of policy as decreed by the Delaware legislature. Those who believe that CA’s shareholders should be permitted to make the proposed Bylaw as drafted part of CA’s governance scheme, have two alternatives. They may seek to amend the Certificate of Incorporation to include the substance of the Bylaw; or they may seek recourse from the Delaware General Assembly.  

In other words, the Court recognized that the opinion might well be bad policy and bad governance but asserted that its hands were tied and recourse would need to be to the legislature.  Its hands were not tied.  The opinion ultimately found that the language of the relevant statutes did not control and instead relied entirely on principals of common law.  In other words, the Court could easily have come out the other way.  Instead, the Court sought to blame the legislature for a state of affairs that it created. 

The opinion is posted on the DU Corporate Governance web site.

We are discussing the Delaware Supreme Court's decision in CA v. AFSCME, an opinion that severely restricted the scope of shareholder bylaws and facilitated the ability of companies to exclude proposals under Rule 14a-8.

The second issue concerned the impact of the bylaw on the board's fiduciary obligations.  The bylaw made repayment mandatory, providing no express fiduciary out.  Relying on Quickturn, the Court concluded that this would violate "the prohibition, which our decisions have derived from Section 141(a), against contractual arrangements that commit the board of directors to a course of action that would preclude them from fully discharging their fiduciary duties to the corporation and its shareholders."

How might the expenditures result in a violation of fiduciary obligations?  The Court reaffirmed the holding of a 1934 case and noted that "where the proxy contest is motivated by personal or petty concerns, or to promote interests that do not further, or are adverse to, those of the corporation, the board’s fiduciary duty could compel that reimbursement be denied altogether."  But what about the fact that the bylaw only allowed for payment where a director actually won the election?  In other words, whatever the motive for the nomination, the nominees could only win by making the case that on policy grounds they were the best candidates.  Despite discussion on the very topic at oral argument, the Court simply ignored the argument. 

Moreover, in illustrating the type of harm that could befall a company if there was no fiduciary out, the Court engaged in bait and switch.  The opinion noted the following:  

• Such a circumstance could arise, for example, if a shareholder group affiliated with a competitor of the company were to cause the election of a minority slate of candidates committed to using their director positions to obtain, and then communicate, valuable proprietary strategic or product information to the competitor.

There are many many problems with this example.  Foremost, the behavior is an outright violation of the elected directors' fiduciary obligations.  Moreover, for directors to be elected with this motive, they would almost certainly violate the duty of candor and Rule 10b-5.  In other words, the fiduciary out was entirely unnecessary to put a stop to this type of behavior. 

In addition, however, was the bait and switch approach.  The Court struck down the bylaw relying on cases that prohibited repayment in the case of nomination made for "personal or petty concerns."  In other words, the focus was not on what the directors did once in office (fiduciary obligations addressed that) but on the reasons for the nomination.  The example by the Supreme Court, however, does the opposite, addressing not so much the motivation of the shareholder but what the nominees will do once in office.  In other words, the Court could not really justify the need for a fiduciary out where a director, nominated for personal reasons, nonetheless won the election.  This is a slight of hand, not consistent with the earlier case law, and difficult to justify given the fiduciary obligations applicable to all directors, even those nominated by a competitor.   

More importantly, however, the Court flatly ignored arguments that the bylaw already contained what essentially amounted to a fiduciary out.  During oral argument, a colloquy took place where it was suggested that reimbursement would be "unreasonable" if it cause the board to engage in illegal conduct.  The Court never addressed why, when addressing a short slate nominated for "personal or petty" concerns, the board couldn't simply conclude that any reimbursement was not unreasonable.  

In addition, at oral argument, counsel for AFSCME conceded that the reimbursement bylaw could be repealed by the board if repeal was consistent with the board's fiduciary duties.  If confronted with the need to reimburse for illegal activity (nominations made for "personal and petty" reasons), the board could have repealed the bylaw.  The Court never addressed this argument either. 

Indeed, avoidance can be seen from the care taken by the Court in addressing the issue.  The opinion concluded that the bylaw "contains no language or provision that would reserve to CA’s directors their full power to exercise their fiduciary duty to decide whether or not it would be appropriate, in a specific case, to award reimbursement at all."  This was careful drafting by the court.  True enough there was no language in the bylaw but there didn't have to be.  Under Delaware law, a board confronted with the possibility of an illegal payment could have undone the bylaw in its entirety.  In other words, the fiduciary out was in the statute.  But the Court never addressed the point.

The opinion (and the briefs) are posted on the DU Corporate Governance web site.

The Delaware Supreme Court ruled yesterday on the two questions certified by the SEC.  It should have dismissed the case for lack of jurisdiction but ignored the inconvenient fact in order to come down firmly on the side of management and all but prohibit meaningful bylaws that provide for reimbursement in the event of a successful proxy solicitation.  Bad enough the result, worse that the reasoning was unbalanced and incomplete.  We will explore these points in subsequent posts.  But one thing is for certain, the result was entirely predictable, dictated by notions of the race to the bottom.

Mostly though we again note that as a matter of policy it was a serious mistake for the Commission to refer this case to the Delaware Supreme Court.  Rather than resolve a straightforward legal issue, the Delaware Supreme Court took the opportunity to use reasoning that will allow companies to challenge even more proposals submitted under Rule 14a-8.  It will, ultimately, put pressure on the Commission to sidestep the anti-shareholder nature of Delaware law and allow access to the company's proxy statement.  In other words, the decision will backfire on the Commission and backfire on companies.  We will explore this in later posts.

The opinion is posted on the DU Corporate Governance web site.

The SEC certified two questions.  The first was whether the bylaw as a proper subject for action by shareholders.  The Court concluded that it was, an apparent victory for shareholders.  But this is Delaware and things are not as they always seem.  In doing so, the Court distinguished between procedural and substantive bylaws. 

• The process-creating function of bylaws provides a starting point to address the Bylaw at issue. It enables us to frame the issue in terms of whether the Bylaw is one that establishes or regulates a process for substantive director decision making, or one that mandates the decision itself.

Having framed the issue in that manner, the Court then agreed that the bylaw, although "infelicitously couched as a substantive-sounding mandate to expend corporate funds, has both the intent and the effect of regulating the process for electing directors of CA."  It was, therefore, a proper subject for shareholders.

While AFSCME won the argument, shareholders lost the war.  The need to have the bylaw involve process meant that any decision, no matter how small, that was not process oriented, would be invalid.  Bylaws requiring boards to undertake steps to curb global warming, to disinvest from companies doing business with terrorists, or to withdraw poison pills would, under the Court's reasoning in this case, to be on their face invalid. 

In other words, the Court used the case to dramatically broaden the types of bylaws that now must be excluded under Rule 14a-8.

The opinion is posted on the DU Corporate Governance web site.

The decision is in.  AFSCME loses (as predicted).  The opinion will be posted shortly. 

We are discussing Wood v. Baum, a recent Delaware Supreme Court upholding the dismissal of a derivative claim. Plaintiff alleged demand excusal because the directors signed false reports, authorized certain self interested transactions, served on the audit committee and ignored certain red flags.

Delaware courts impose excessive pleading standards, as we have noted often on this blog.  As a result, they ignore evidence and decline to allow potentially meritorious cases to go to discovery.  But in so doing, they often blame the plaintiffs for the state of affairs.  This case was no different.  After ignoring or recasting most of plaintiff's argument, the Court chided the plaintiff for not seeking to inspect the corporate records.  As the Court noted:

• This case is but another replay of other similar cases where the plaintiff failed to allege with particularity any facts from which it could be inferred that particular directors knew or should have been on notice of alleged accounting improprieties, and any facts suggesting that the board knowingly allowed or participated in a violation of law. In such cases, the failure to allege particularized facts is frequently compounded by a failure to make a statutory “books and records” request concerning the matters alleged and the Board’s consideration of such matters. Here, plaintiff could have, but chose not to, make a books and records request pursuant to the LLCA.

But as we have noted, this is nothing more than a requirement that plaintiffs add cost and delay to their action, sometimes without gaining access to the required documents and with little chance that the effort will turn up anything useful.  Even the Delaware judges, in a frank moment, have admitted this.  See Khanna v. McMinn, 2006 Del. Ch. LEXIS 86 (May 9, 2006)("Indeed, even after using the "tools at hand" to develop particularized facts (e.g., public filings and Sec. 220), certain information may be restricted due to the fact that it is held by entities with no public disclosure obligations. Although the burdens presented by such obstacles have been recognized, . . .  the pleading standard under which the Court examines allegations for requisite particularity remains unaltered, even for plaintiffs who employed the "tools at hand."). 

Our criticism of the excessive standards used in these cases drew the umbrage of the Delaware Chancery Court.   The reliance in inspections rights is a rationalization.  Courts confronted with evidence on a motion to dismiss sufficient to allow the case to go to discovery can nonetheless ignore it and blame any dismissal on plaintiffs.   

Primary materials from the Chancery Court can be found at the DU Corporate Governance web site.

We are discussing Wood v. Baum, a recent Delaware Supreme Court upholding the dismissal of a derivative claim. Plaintiff alleged demand excusal because the directors signed false reports, authorized certain self interested transactions, served on the audit committee, and ignored certain red flags.

We have already noted that the case is little more than a summary dismissal of plaintiff's allegations (on a motion to dismiss, before discovery occurs), with each allegation dismissed seriatim and no effort to consider them in toto. Thus, the Court notes that the "Board’s execution of MME’s financial reports, without more, is insufficient to create an inference that the directors had actual or constructive notice of any illegality." Similarly, the Court describes plaintiff as asserting "that membership on the Audit Committee is a sufficient basis to infer the requisite scienter. That assertion is contrary to well-settled Delaware law."

But of course, plaintiff doesn't allege that mere membership on the audit committee is enough. Instead, it's about what the directors learned by virtue of their position on the audit committee. Thus, in the opposition to the motion to dismiss at the Chancery Court, plaintiff noted: "While the entire Board was apprised of virtually all alleged actions and inactions because of their related party nature, the Audit Committee also was apprised of failures to take other-than temporary impairment charges on non-related party transactions and assets as well as the gross accounting incompetence and mismanagement."  In other words, a far cry from membership alone is enough.

Similarly, plaintiff alleges that the board "ignored red flags." The Court did not discuss the red flags that the board allegedly missed but merely noted that "the Court of Chancery correctly concluded that there were no cognizable 'red flags' from which it could be inferred that the defendants knew that FAS 115 was being improperly applied, or that the defendants otherwise consciously and in bad faith ignored the improprieties alleged in the complaint."  It was a thin discussion of an important issue.

So what were these undiscussed red flag? A list from the opposition to the motion to dismiss at the Chancery Court include the following:

• The timing of foreclosure/resale transactions of non-performing assets with related parties that served to smooth and inflate earnings;
• The issuance of dividends unsupported by actual operating cash flow and despite the poor performance of a material amount of the Company’s assets;
• The maintenance of under-performing assets held by related-parties despite deteriorating performance and market conditions, precluding redeployment of corporate assets;
• The Company’s payment of charitable contributions to borrowers in order to keep loans of the Company in current status;
• The repeated transfers by deed in lieu of foreclosure transactions from one Joseph-controlled entity to another accompanied by the Company’s obligation to make delinquent debt service payments;
• The routine positive statements issued concerning the Company’s performance despite the severe issues with its portfolio of loans;
• The failure to properly value non-performing assets pursuant to the Company’s own valuation policies as well as accounting guidelines, including insisting on the
• Company’s ability and intent to hold assets when the Company had, in fact, relinquished both ability and intent through its syndications;
• The results from the MMA Portfolio Offering, the subsequent cancellation, and the failure to disclose this material information to shareholders which indicated
• the Company was significantly over valuing a material portion of its assets;
• The Company failing to establish and enforce adequate accounting controls and procedures that have resulted in serial restatements, investigations and review by the SEC and NYSE, with the Company having to halt substantial business operations and lose access to important sources of capital;

Perhaps these were insufficient, although at least a few of them seem serious (the payment of charitable contributions to borrowers in order to keep loans current) but they deserved more than a summary statement that the Chancery Court was right (the Chancery decision, by the way, was issued from the bench and was not reduced to a written opinion, so the more extended reasoning of the trial judge is not readily available). 

The case does little to address the standards that boards ought to employ in making decisions.  And, rather than address difficult issues head on the opinion mostly ignored plaintiff's arguments, refashioning them into something approaching a caricatures. 

We've got one more post on this case.  Primary materials from the Chancery Court can be found at the DU Corporate Governance web site.

As the CSX case awaits oral argument, we note a private sector solution of sorts.  The WSJ reported that companies have been adopting bylaws designed to elicit greater amounts of information from insurgents.  The article represented Pfizer as a company that had done this.  In Pfizer's bylaws, the company has in place an advance notice bylaw.  The bylaw requires the shareholder submitting the name of a nominee to include background about the shareholder and the nominee.  Among other information, the shareholder must reveal: 

• (d) a description of any agreement, arrangement or understanding (including any derivative or short positions, profit interests, options, hedging transactions, and borrowed or loaned shares) that has been entered into as of the date of the Proponent's notice by, or on behalf of, the Proponent or any of its affiliates or associates, the effect or intent of which is to mitigate loss to, manage risk or benefit of share price changes for, or increase or decrease the voting power of the Proponent or any of its affiliates or associates with respect to shares of stock of the Corporation, and a representation that the Proponent will notify the Corporation in writing of any such agreement, arrangement or understanding in effect as of the record date for the meeting promptly following the later of the record date or the date notice of the record date is first publicly disclosed,

The article quotes one lawyer as stating that around 40 NYSE companies have adopted these types of provisions.  The language appears broad enough to have picked up the equity swap positions entered into by the hedge funds in connection with their investment in CSX.  The bylaw at least puts the company on notice of these transactions at the time a nominee is submitted.  The bylaw is not, of course, a substitute for required disclosure under the securities laws.  The information provided under the bylaw only goes to the company, not to the public, and is only disclosed when a nominee is submitted, not when the positions are actually executed.

What this language shows is that advance notice bylaws are becoming more complex and more critical.  With hostile tender offers all but eliminated, proxy contests have become the focal point for control contests.  Advance notice bylaws provide management with notice of an impending contest.  Take Two did not have this type of bylaw in place and was, as a result, caught unaware when insurgents seized control at the shareholder meeting. 

We will see increased creativity in the drafting of these bylaws, the first line of defense by companies against proxy contests.  This is the most recent example.