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The SEC's Investor Advisory Committee: The Feb. 2015 Meeting

The SEC's Investor Advisory Committee is meeting on Thursday, Feb. 12.  A creation of Dodd-Frank, the IAC consists of persons appointed by the Commission for four year terms and was authorized to "advise and consult with the Commission."  

Consultation includes regulatory priorities, issues relating to the regulation of securities products, trading strategies, and fee structures, and the effectiveness of disclosure, initiatives to protect investor interest, and initiatives to promote investor confidence and the integrity of the securities marketplace.  In addition, the IAC can "submit to the Commission such findings and recommendations as the Committee determines are appropriate, including recommendations for proposed legislative changes."   

The Commission in turn is required to "review the findings and recommendations of the Committee" and "promptly issue a public statement— (A) assessing the finding or recommendation of the Committee; and (B) disclosing the action, if any, the Commission intends to take with respect to the finding or recommendation." In other words, the Commission is legally required to respond to any recommendations.

The Agenda of the next meeting has been posted. The public meetings include overviews of substantive matters.  At the upcoming meeting on Feb. 12, the IAC will consider one recommendation on T-2 settlement and will discuss a number of substantive matters.  The agenda includes:       


10:35 - 11:05 a.m.


Discussion of Recommendation of Market Structure Subcommittee on Shortening the Trade Settlement Cycle
11:05 - 12:05 p.m. Discussion of Proxy Access

2:00 - 3:00 p.m.


Update on FINRA's CARDS Proposal
3:00 - 4:00 p.m. Update on MSRB and FINRA Proposals for Improved Disclosures for Same-Day, Retail-Size Principal Transactions in Fixed Income Securities

The SEC's Budget: An Enforcement Heavy Agency (Part 2)

As for the specifics of the SEC's budget, the details are here.  How did the divisions fair in the request? The details, however, hold considerable interest. The operating divisions will, if the budget goes through, be funded at levels below fiscal 2014. Thus, CorpFin had a 2014 budget of $186 million, something that would fall to $159 million in 2015 and $162 million in 2016. Trading and Markets? $99 million in 2014; $88 million in 2015; $93 million in 2016.  IM largely stayed flat ($67/$63/$68).  

The increases mostly went two places: enforcement (Enforcement and OCIE) and DERA.  For Enforcement, the proposed increase from 2014 would result in a total increase of around 36% ($349 million in 2014; $442 in 2015 and $474 in 2016).  For OCIE, the numbers were even more significant, reflecting a 71% increase, with the budget almost in parity with the Division of Enforcement ($242/$340/$413).  As for DERA, the office saw a big increase from 2014 to 2015 but nothing much after that.  Nonetheless, over the three years (assuming full funding), DERA's budget will increase by over 100% ($23/$52/$54).  

What overview do these numbers provide?  If you add together the budgets for OCIE and Enforcement and compare it to the three operating divisions (CorpFin, IM and T&M) you see an interesting shift.  Total new obligations in 2014 were $1.336 billion.  Of that amount, OCIE/Enforcement made up 44% of the total; the three operating divisions 26%.  Fast forward to the 2016 proposed budget (total new obligations of $1.647 billion).  OCIE/Enforcement represent 54% and the operating divisions have fallen to 20%.  

Said another way, the SEC is becoming primarily an enforcement agency.  The funds for rulemaking, market oversight, and public disclosure in the three main operating divisions is decreasing and, if the 2016 budget is approved as is, will sink to perhaps record lows, at least when measured as a percentage of the overall budget. 

By the way, the total number of budgeted, full time positions for the agency responsible for overseeing the securities markets?  637 in 2014; 773 in the 2016 request.  Not many people for such a broad set of tasks.  


The SEC's Budget: The Aggregate Numbers (Part 1)

The President's Fiscal Year 2016 Budget addressed "Wall Street Reform."  The Budget Message started with a retrospective on the financial crisis of 2008.     

  • When the President took office in 2009, financial markets were in a tailspin. The crisis left millions of Americans unemployed and resulted in trillions in lost wealth. America’s broken regulatory system was the principal cause of that crisis. To ensure financial stability for Americans and businesses, the President fought to reform Wall Street, ultimately signing a bill that represented the most sweeping financial regulatory legislation since the Great Depression. Since that time, Americans are getting back to work and regaining lost equity in their homes. But there is still work to do to protect American consumers and investors, and maintain fairness in the financial system. 

The statement then noted the importance of reform.   

  • In response to the destabilizing 2008 financial crisis, the Administration achieved landmark reform of the Nation’s financial system in 2010 with enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Wall Street Reform). In the years since enactment, Federal agencies have helped make home, auto, and short-term consumer loan terms fairer and easier to understand for average consumers, improved visibility for investors into the shadowy corners and complex instruments of financial markets, and increased financial firms’ planning for and resilience to future financial downturns.

As a result, the President proposed a budget for the SEC and CFTC that provided for significant increases.

  • The Budget continues to support Wall Street Reform implementation across agencies, including $1.7 billion for the Securities and Exchange Commission and $322 million for the Commodity Futures Trading Commission (CFTC), representing increases over the 2015 enacted level of 15 percent and 29 percent, respectively. These are the only two Federal financial regulators whose budgets are set through annual appropriations. The Budget also reflects continued support for legislation to enable funding the CFTC through user fees like all other financial regulators. The Administration will continue to oppose efforts to restrict the funding independence of the other financial regulators, including the Consumer Financial Protection Bureau, and will fight other attempts to roll back Wall Street Reform.

In the next post, we'll look at some of the specific numbers in the budget and some of the implications.   


Crowdfunding and the "Wisdom of the Crowd"

Congress in the JOBS Act provided an exemption from registration for certain crowdfunding offerings.  The SEC has a rule proposal pending.  The difficulty in this area is balancing the costs of investor protection against the impediments to capital raising.  The issues are exacerbated by the limits ($1 million) on the size of any offering relying on the crowdfunding exemption.

In considering the need for shareholder protection, some suggest that the online community is more sophisticated and better able to identify frauds.  Indeed, the Commission put considerable emphasis on the "wisdom of the crowd."  This has always been a debatable proposition.  As we have noted:

  • There are many reasons to suspect that the “collective wisdom” of the crowd will not adequately protect investors. Fraudulent offerings may be difficult to expose. Bad actors can hide behind others, obscuring their identity and role. Challenging inaccurate or incomplete statements will be difficult given the dearth of public information associated with non-reporting companies. Nor, in many cases, will the “crowd” be the only, or even the loudest, voice in the debate.

See Selling Equity Through Crowdfunding: A Comment.

With that in mind, we note an article in the WSJ that discussed some potential changes on the non-equity crowdfunding sites.  See Should Crowdfunding Sites Do More to Vet Projects?  The article discussed a number of potetial problems with crowdfunding ventures.  In one case, a venture, according to the article, "drew flags online from some in the growing crowdfunding community" but continued to raise funds.  As the article noted: "The campaign stands as an example to those who say crowdfunding platforms should take a more active role in checking out projects on their sites before allowing the public to contribute money that may never be returned."  

Other issues concern missed delays.  See Id.  ("A study last year of crowdfunded projects by professor Ethan Mollick at the University of Pennsylvania’s Wharton School found that more than three-fourths were delayed.").  Delays may arise because of poor planning or unforseen problems.  But delay may also be an explanation used for offers that were fraudulent from the outset.  

As for litigation, there hasn't apparently been much given the small amounts usually involved.  See Id. ("Complaints have also prompted little legal action. With the mean pledge amount at about $64, according to Mr. Mollick’s study, many backers may not think litigation is worth the cost and the hassle.").  

Indiegogo has apparently been testing a solution.  Rather than collectively imposing the costs of investor protection on the companies making the offerings, Indiegogo has begun offering a product that will allow contributors to buy insurance.  See Indiegogo Signals a Blending of Crowdfunding and Commerce ("Indiegogo is testing optional insurance to protect backers against delays and non-delivery.  The insurance, if bought, guarantees a refund for the backer if the product misses its deadline by more than three months. Crowdfunding websites don’t provide refunds for funded projects, leaving them to founders and backers to settle directly.").

In other words, if investors want to avoid caveat emptor, they can pay for it.  All of this suggests that investors investing up to $100,000 a year in crowdfunding offerings, the maximum amount permitted under the JOBS Act, may not be able to rely on the wisdom of the crowd for protection.  


Poison Puts and Fiduciary Obligations and the Irrelevance of the Delaware Courts: Pontiac General Employees Retirement v. Healthways (Part 5)

We are discussing Pontiac General Employees Retirement v. Healthways.  

What makes this case so remarkable?  One possibility is the decision.  By denying the motion to dismiss, the court has announced that boards putting in place dead hand poison puts will confront litigation risk.  The court also emphasized that poison puts, even without a deadhand feature, raise possible fiduciary duty concerns.

Most importantly, however, the decision not to allow dismissal of the aiding and abetting claim raises the specter of liability for the bank or other lender in the transaction. Banks aware of this possibility will now have to determine whether the value of the provision outweighs the litigation risk that will arise from any subsequent challenge by shareholders. One suspects that most banks will decide that this vestige of the 1980s has little real value and that the marginal value does not outweigh the litigation risk.  The provisions are likely to disappear not at the insistence of the board but at the insistence of the lender.

But perhaps the most interesting aspect of this case is the apparent irrelevance of the Delaware courts to issuers and their boards in adopting these provisions.  Amalyin addressed poison puts.  The court in that case gave Amylin a pass on the use of the provision but served warning that the provisions were suspect. Nonetheless, the "warning" did not stop Healthways.  Moreover, a search of the EDGAR data base in the post-Amalyin period reveals that poison puts remain not uncommon. 

The behavior has a number of possible explanations.  One possibility is that issuers simply did not believe the "warning" issued by the Delaware court in Amalyin. In other words, when the next poison put was litigated, the company would get another stern lecture but given the same pass that went to Amalyin.  The reaction of the Delaware courts, therefore, was irrelevant in deciding whether to adopt these provisions.  Given the management friendly nature of the Delaware courts, this is not an unreasonable expectation.   

Delaware courts probably have their greatest influence when they provide management with increased authority and discretion.  Where, however, the courts are seeking to impose limits, their authority appears to be decidedly less robust and, at least in some cases, irrelevant.  

The primary materials in Pontiac General Employees Retirement v. Healthways can be found at the DU Corporate Governanceweb site. 


Poison Puts and Fiduciary Obligations and the Irrelevance of the Delaware Courts: Pontiac General Employees Retirement v. Healthways (Part 4)

We are discussing Pontiac General Employees Retirement v. Healthways, a case that declined to grant a motion to dismiss that challenged a dead hand poison put.   The primary materials in the case, including the transcript, can be found at the DU Corporate Governance web site. Because the full opinion is in a transcript, this post includes the entire version:


COURT:  Thank you all for your presentations today. I appreciate it. I'm going to go ahead and give you my thoughts now. We are here on a motion to dismiss filed by the defendants. There are two groups of defendants.  The individual defendants and the company have moved to dismiss on ripeness grounds. The lender, SunTrust, has moved to dismiss, in addition, on failure to state a claim for which relief can be granted, primarily based on the assertion that the complaint doesn't contain sufficient allegations to support a claim for aiding and abetting.

The plaintiff, Pontiac General Employees Retirement System, is a stockholder of the nominal defendant, Healthways. Pontiac has sued, principally on a classwide basis, on a putative classwide basis, but alternatively it sues derivatively. The individual defendants are the members of the company's board of directors. 

The background facts are as follows: In 2010, the company entered into a fourth amended and restated revolving credit and term loan agreement. That term loan agreement included what the plaintiffs have described as a proxy put that had a continuing director feature. The proxy put at that time would be triggered when, during any period of 24 consecutive months, a majority of the members of the board of directors ceased to be composed of continuing directors. The proxy provision in the 2010 loan agreement did not contain a dead hand feature.

Subsequently, the company came under, and remains under, pressure from stockholders. It faced,
and continues to face, the risk of a proxy contest. In 2012, the New York State Common Retirement Fund submitted a proposal to declassify the board. On May 31, 2012, the company's stockholders overwhelmingly approved that precatory proposal to declassify the board, despite the board's opposition.

Subsequently, on October 10, 2013, the company did, in fact, amend its articles of incorporation to phase out its classified board structure. By 2016, the entire board will be up for reelection.  On June 8th, 2012, days after the stockholder vote that signaled, to at least some degree -- and certainly it's inferable at the pleadings stage -- some degree of stockholder dissatisfaction with the company, the board entered into a fifth amended and restated revolving credit and term loan agreement. That 2012 agreement has been amended three times since then.

The 2012 loan agreement provided the company with a $200 million revolving credit facility, including a $20 million swing-line subfacility and a 75 million subfacility for letters of credit, which terminates on June 8th, 2017, as well as a $200 million term loan facility, which matures on the same date. The 2012 loan agreement contained a dead hand proxy put.

Subsequently, in 2013, the company issued additional debt. That additional debt, one tranche of 125 million and another tranche of 20 million, was wrapped into the dead hand proxy put by stating that it would be an event of default if the company defaulted on any other loans in excess of $10 million.

Stockholder pressure continued. On December 2nd, 2013, North Tide Capital, an 11 percent stockholder, sent a public letter to the board expressing its concern with the board's leadership and the company's performance and called for the board to remove its CEO.  The board rejected that request.

In January 2014, North Tide sent another fight letter and stated its intent to wage a proxy fight. There was ultimately a resolution, where North Tide gained representation on the board. Those directors are treated as noncontinuing directors for purposes of the dead hand proxy put.

In March 2014, Pontiac served the company with a demand under Section 220, seeking documents and records relating to the dead hand proxy put. According to the complaint, the company failed to produce documents showing that there was substantive negotiation about the proxy put and no documents that suggested, to use the language of Amylin, that the company received "extraordinarily valuable economic benefits" that might justify the proxy put.

In this action the plaintiff asserts a claim for a breach of fiduciary duty against the individual defendants, a claim for aiding and abetting against SunTrust, and it also seeks a declaratory judgment that the dead hand proxy put is unenforceable. 

I'm going to start with the individual defendants and the company who have moved to dismiss on grounds of ripeness. Courts in this country generally, and in Delaware in particular, decline to exercise jurisdiction over cases in which a controversy has not yet matured to a point where judicial action is appropriate, to paraphrase the Stroud case. When considering a declaratory judgment application, for an actual controversy to exist, the issue must be ripe for judicial determination. That's a paraphrase of the XL Specialty Insurance case.

"In determining whether an action is ripe for a judicial determination, a 'practical judgment is required.'" That's the Stroud case quoting this Court's decision in Schick. This practical judgment has been described as a common-sense assessment of whether the interests of the party seeking relief outweigh the concerns of the Court in postponing review until the question arises in some more concrete and final form.

Here, the defendants argue that the dispute is not ripe because a variety of additional events must take place before the proxy put with its dead-hand feature is actually, in fact, triggered and does actually accelerate the debt.  The plaintiffs, however, have cited two different injuries. The first is the deterrent effect of the proxy put. Namely, because the proxy put exists, it necessarily has an effect on people's decision-making about whether to run a proxy contest and how to negotiate with respect to potential board representation.

As with other defensive devices, such as rights plans, one necessarily bargains in the shadow of a defensive measure that has deterrent effect. A truly effective deterrent is never triggered. A really truly effective deterrent is one you don't even have to point the other side to because they know it's there. If the deterrent is actually used, it has failed its purpose.

Delaware courts have consistently recognized that disputes are ripe when challenging defensive measures that have a substantial deterrent effect. For example, we regularly allow stockholder plaintiffs to litigate defensive measures in merger agreements in the absence of an actual topping bid. Why?

Because if truly effective, those defensive measures will deter the topping bid and it won't emerge.  Delaware courts, likewise, have held that a similar deterrent effect is sufficient to establish a ripe dispute when dealing with another classic defensive measure that is adoptable in a quite similar format by a board; namely, a rights plan.

In Moran, it was the deterrent effect on proxy contests that made the dispute ripe. Now, as the defendants point out, the Court in Moran ultimately held post-trial that the rights plan, in fact, did not interfere with the proxy contest in that case, based on the nature of the plan, the level of its trigger, and other evidence that was presented. That was a merits-stage ruling as to whether the rights plan should be permanently enjoined or otherwise invalidated. It was not an analysis of the ripeness issue. The ripeness issue was decided based on the deterrent effect.

The same is true in Leonard Loventhal Account. Most importantly, to my mind, the same is true in Carmody vs. Toll Brothers. I am unable to distinguish Carmody vs. Toll Brothers from this case, and I don't think the defendants have offered any credible justification on which the two cases can be distinguished for ripeness purposes.  The problem in Toll Brothers was that a rights plan containing a dead hand feature in a pill would have a chilling effect on, among other things, potential proxy contests such that the stockholders would be deterred, they would have the Sword of Damocles hanging over them, when they were deciding what to do with respect to a proxy contest. There wasn't a requirement that an actually proxy contest be underway.

That's exactly what the effect is of the dead hand proxy put in this case. The same analysis, in my view, applies. The same reasoning was followed in KLM Royal Dutch Airlines vs. Checchi and, again, I think it's on all fours here. 

The second present injury that the plaintiffs have cited, as Mr. Lebovitch reminded me of, is that the noncontinuing directors currently serving on the board are currently designated as such. And hence,  they are currently suffering an injury in the form of being treated differently than the other directors on the board. And that was another injury of a type that then-Vice Chancellor, later-Justice Jacobs allowed the stockholders to sue for in Toll Brothers. And he ultimately held on the motion to dismiss that, in fact, it stated a claim for a 141(d) violation. So that is another present injury that's happening now.

I do think there is a distinction -- as Mr. Lafferty ably identified -- between the potential future invocation or triggering of the dead hand put, the nonwaiver of the dead hand put, and its adoption now.

What I think is ripe now is a claim that, based on the facts of this case, the board of directors breached its duties in a factually-specific manner by adopting this poison dead hand put arrangement -- however you want to call it -- I guess proxy -- you guys have too much jargon -- dead hand proxy put arrangement in the context of the facts and circumstances here, including the rise of stockholder opposition, the identified insurgency, the change from the historical practice in the company's debt instruments, the lack of any document produced to date suggesting informed consideration of this feature, the lack of any document produced to date suggesting negotiation with respect to this feature, etc.

This is not a per se analysis. No one is suggesting that. Nor does the denial of the motion to dismiss depend on any theory that entering into an agreement that contains a proxy put is a per se breach of fiduciary duty.  Procedurally, that's inaccurate. All we're here on right now is a motion to dismiss. As to one of the motions, we're just asking if the claim is ripe, we're not making any per se adjudication. And as to the other motion to dismiss, all we're asking is has a claim been pled under the Central Mortgage notice pleading standard. We're not asking whether there is some ultimate relief to be granted as a matter of law.

And substantively it's inaccurate as well, because a ruling in this case will be based on the facts of this case; namely, what the board did or didn't do or knew or didn't know and what the back and forth was, if there was any, with SunTrust.

So in my view, I do think that the dispute is sufficiently ripe to state a claim as to the entry into a credit agreement with the proxy put. It may be that there is another claim down the way based on the potential nonwaiver of the proxy put for future directors, just like there might be a potential claim on down the way regarding the use of a rights plan. But that doesn't mean there's not a claim surrounding the adoption of a rights plan or a claim surrounding the entry into the proxy put. So I think that the dispute is ripe.

In terms of whether Pontiac has standing, I think this is a flip side of the ripeness argument. The primary purpose of standing is to ensure the plaintiff has suffered a redressable injury.  Standing is the requisite interest that must exist in the outcome of the litigation at the time the action is commenced. The test of standing is whether there is a claim of injury, in fact; and that the interest sought to be protected is arguably within the zone of the interest to be protected or regulated by the -- and I'm going to say -- the legal protection in question. That's a paraphrase of the Gannett case. The concepts of standing and ripeness are, indeed, related. 

So what I've tried to explain is I think this dispute is ripe as a practical matter because the stockholders of the company are presently suffering a distinct injury in the form of the deterrent effect, the Sword-of-Damocles concept, as well as in the form of the fact that they have directors on the board, some of whom are noncontinuing directors and some of whom are continuing directors.

What we know from those cases that I cited on ripeness grounds -- namely, Moran, Leonard Loventhal, Carmody, KLM -- those were all brought by stockholders. Stockholders had standing to bring those claims. So I think the same is true here. So I'm denying the motion to dismiss that was brought by the individual defendants and the company on ripeness grounds.

I'm now going to turn to the question of whether the complaint adequately states a claim for aiding and abetting. To state a claim for aiding and abetting, the plaintiff must plead the existence of a fiduciary relationship, a breach of a fiduciary duty, knowing participation in the breach, and damages proximately caused by the breach. That's a paraphrase of the Malpiede case. SunTrust has focused its motion to dismiss on the knowing participation element.

It is certainly true, and I agree, that evidence of arm's-length negotiation negates claims of
aiding and abetting. In other words, when you are an arm's-length contractual counterparty, you are permitted, and the law allows you, to negotiate for the best deal that you can get. What it doesn't allow you to do is to propose terms, insist on terms, demand terms, contemplate terms, incorporate terms that take advantage of a conflict of interest that the fiduciary counterparts on the other side of the negotiating table face.

This is the premise that is true in third-party deal cases. The acquirer is perfectly able to negotiate for the best deal it can get, but as soon as it starts offering side benefits, entrenchment benefits, other types of concepts that create a conflict of interest for the fiduciaries with whom it's negotiating, that acquirer is now at risk. Is the acquirer necessarily liable? No. But does that take the acquirer out of the privilege that we afford arm's-length negotiation? It does.

Here, the plaintiffs are not challenging the loan agreement as a whole. They are not challenging the interest rate or other financial terms. They are challenging a proxy put with recognized entrenching effect. There was ample precedent from this Court putting lenders on notice that these provisions were highly suspect and could potentially lead to a breach of duty on the part of the fiduciaries who were the counter-parties to a negotiation over the credit agreement.

Given the facts here, as alleged, including that there was a historic credit agreement that had a proxy put but not a dead hand proxy put, and then that under pressure from stockholders, including the threat of a potential proxy contest, the debt agreements were modified so that the change-in-control provision now included a dead hand proxy put, and considering that all of this happened well after Sandridge and Amylin let everyone know that these provisions were something you ought to really think twice about, I believe that, as pled, this complaint satisfies the requirement to survive a motion to dismiss.

It may well be that there's ultimately no claim and that SunTrust wins. It may well be that they didn't aid and abet anything. But for pleading-stage purposes, what they are is they're a party to an agreement containing an entrenching provision that creates a conflict of interest on the part of the fiduciaries on the other side of the negotiation. And that provision arose in the context of a series of pled events and after decisions of this Court that should have put people on notice that there was a potential problem here such that the inclusion of the provision was, for pleading-stage purposes, knowing.

At the risk of stating what I hope is obvious, I am not making any findings of fact on that, and I do not know if, in fact, these things were responsive to stockholder pressure or if some other driver generated them. All I know is that for pleading-stage purposes, I think that the complaint states a claim. So for that reason I am also denying the SunTrust motion.


Poison Puts and Fiduciary Obligations and the Irrelevance of the Delaware Courts: Pontiac General Employees Retirement v. Healthways (Part 3)

We are discussing Pontiac General Employees Retirement v. Healthways.  Although the case involved a dead hand poison put, the trial judge also discussed more traditional poison puts, including a bit of a history lesson on the provisions.     

  • they are great for the two sides of the negotiation who are at the table. So, I mean, that's what we know from the history of the '80s. These things come out of the '80s. And both sides of the negotiation at the table, both the banker and -- both the lender and the fiduciaries, had benefit from the entrenching effect. It's a win-win for them. The person for whom it's not a win is the person not at the table, who then has to actually expend resources to monitor, to bring suit, etc. So, I mean, it's not surprising that these things would proliferate, because for the people in the room, it's great.

So true.  The only way for shareholders to have a say in the matter is to bring a legal action after the fact. Fee shifting bylaws, however, can effectively deny this role to shareholders, leaving the "people in the room" with exclusive decision making authority and no need to worry about the interests of shareholders.  For more on those bylaws, see Shifting Back the Focus: Fee Shifting Bylaws and a Need to Return to Legislative Intent

The primary materials in Pontiac General Employees Retirement v. Healthways can be found at the DU Corporate Governance web site. 


Poison Puts and Fiduciary Obligations and the Irrelevance of the Delaware Courts: Pontiac General Employees Retirement v. Healthways (Part 2)

Shareholders brought an action for breach of fiduciary duty against the board and one for aiding and abetting against the creditor.  In addition, the shareholder sought declaratory relief that the dead hand proxy put was invalid.  The company sought dismissal primarily on the grounds of ripeness. 

With respect to ripeness, the court found the matter ready for adjudication. 

  • Here, the defendants argue that the dispute is not ripe because a variety of additional events must take place before the proxy put with its dead-hand feature is actually, in fact, triggered and does actually accelerate the debt.  The plaintiffs, however, have cited two different injuries. The first is the deterrent effect of the proxy put. Namely, because the proxy put exists, it necessarily has an effect on people's decision-making about whether to run a proxy contest and how to negotiate with respect to potential board representation.

The "substantial deterrent effect" of the provision was, therefore, enough to make the matter ripe.  It was, as the trial judge observed, a "sword of Damocles" theory of ripeness.  See Transcript, at 10.  Or, perhaps, more colorfully, its the "loaded artillary" theory of ripeness.  As the court described: 

  • Like, if somebody's got a piece of artillery sitting on a hill overlooking my town, it is definitely true that before a shell can land on my town, people have to go up there, people have to load the weapon, you know, people have to go through the firing sequence, somebody actually has to pull the cord, the shell actually has to fire, the shell has to arc through the air, it has to land, and it actually has to go off. But that's a different thing from how I change my behavior driven by the fact that somebody has a piece of artillery on a hill over my town.

Transcript, at 16.   

As to whether the complaint stated a cause of action for aiding and abetting against the creditor, the court concluded that it did.  The creditor asserted that there had not been "knowing participation" in any breach of fiduciary duty.  While acknowledging that creditors had the right to negotiate at arms length and obtain "the best deal", they could not "propose terms, insist on terms, demand terms, contemplate terms, incorporate terms that take advantage of a conflict of interest that the fiduciary counterparts on the other side of the negotiating table face." 

The court emphasized that lenders had been put "on notice that these provisions were highly suspect".  As the court reasoned:   

  • Given the facts here, as alleged, including that there was a historic credit agreement that had a proxy put but not a dead hand proxy put, and then that under pressure from stockholders, including the threat of a potential proxy contest, the debt agreements were modified so that the change-in-control provision now included a dead hand proxy put, and considering that all of this happened well after Sandridge and Amylin let everyone know that these provisions were something you ought to really think twice about, I believe that, as pled, this complaint satisfies the requirement to survive a motion to dismiss.

The court, therefore, denied the motion to dismiss. 

The primary materials in Pontiac General Employees Retirement v. Healthways including the transcript can be found at the DU Corporate Governance web site. 


Poison Puts and Fiduciary Obligations and the Irrelevance of the Delaware Courts: Pontiac General Employees Retirement v. Healthways (Part 1)

Debt instruments, at least in the past, commonly included poison puts.  These are clauses that define, as an event of default, the replacement of a majority of the board.  The clauses often have a provision that alleviates the event of default if the incumbent board approves the new directors.  The provisions can also, however, have a dead hand provision that provides for immediate acceleration of the loan principal by the company, with no discretion by the board to avoid the consequences. 

Needless to say, these provisions can have a significant impact on the shareholder franchise.  Shareholders may be unwilling to support an insurgent slate of directors to the extent doing so will result in an event of default and cause financial hardship (even insolvency) for the company. 

Poison puts were challenged in San Antonio Fire & Police Pension Fund v. Amylin, 983 A.2d 304 (Del. Ch.), aff'd, 981 A.2d 1173 (Del. 2009).  In a case we ranked as one of the five worst shareholder decisions in 2009, the court expressed concerned over the use of the provisions but declined to find that a board's approval of the debt agreement without awareness of the poison puts violated its fiduciary obligations.  Nonetheless, the Chancery Court had this to say: 

  • This case does highlight the troubling reality that corporations and their counsel routinely negotiate contract terms that may, in some circumstances, impinge on the free exercise of the stockholder franchise. . . . Outside counsel advising a board in such circumstances should be especially mindful of the board’s continuing duties to the stockholders to protect their interests. Specifically, terms which may affect the stockholders’ range of discretion in exercising the franchise should, even if considered customary, be highlighted to the board. In this way, the board will be able to exercise its fully informed business judgment.

Moreover, the court essentially served a warning to companies that these provisions were highly problematic and required a substantial (essentially impossible) showing to justify.

  • The court would want, at a minimum, to see evidence that the board believed in good faith that, in accepting [a Proxy Put], it was obtaining in return extraordinarily valuable economic benefits for the corporation that would not otherwise be available to it.

We posted the primary materials in the case here.  The court, therefore, gave the Amylin board a pass but seemed to put counsel and companies on notice that the provisions were not favored.  What affect did this "guidance" have on Delaware corporations? 

Fast forward to 2012.  In Pontiac General Employees Retirement v. Healthways, the Complaint alleges the following:

  • Numerous times prior to 2012, Healthways had entered into credit agreements and amendments to those agreements. Those agreements did not include a “Dead Hand Proxy Put” that would prevent the Board from approving directors initially nominated in connection with a proxy context or threatened
    proxy contest. But in 2012, the New York State Common Retirement Fund (“NYSCRF”), one of Healthways large institutional investors, submitted a stockholder proposal to declassify the Board. The Healthways Board opposed the proposal, but the stockholders nonetheless voted by a ten-to-one margin in support of the proposal. On June 8, 2012, barely a week after stockholders voted to destagger the Board, Healthways entered into a new amended revolving credit and term loan agreement, with a $200 million revolving credit facility and a $200 million term loan (the “2012 Loan Agreement”). This 2012 Loan Agreement bound Healthways to a Dead Hand Proxy Put.

How did the provision work?  As the Complaint alleged:

  • Pursuant to the Loan Agreement, if more than half of the incumbent Board is replaced through a contested election or threatened contested election, the lenders under the Loan Agreement may, through the administrative agent, declare a default and cause the principal and any accrued interest on any outstanding loans made pursuant to the Loan Agreement immediately due and payable.

The complaint alleged that the board had "disabled itself from avoiding this Event of Default."  As a result, it would be entirely the decision of creditors to decide whether to waive the event of default and forego repayment of the loans.  As the Complaint asserted: 

  • Thus, at a minimum, the price to the Company of stockholders launching a proxy fight would be a payment to the lenders for waiving such an Event of Default. It is both wasteful and bad faith for the Board to impose this cost on the Company. . . Moreover, there can be no assurance that lenders will agree to a waiver of their default rights for any fee. Indeed, a proxy contest is most likely when a company’s financial performance is at its nadir. So, too, lenders’ desire to enforce default provisions or extract significant concessions in exchange for a waiver is at its greatest when a company’s financial performance is at its nadir. Thus, the Board has approved a Dead Hand Proxy Put that will predictably have the greatest deterrent effect when the likelihood of stockholder efforts to exercise their franchise rights is at its peak.

In other words, three years after the decision in Amylin criticizing the use of poison puts, the company chose to amend an existing loan agreement (at least according to the allegations in the opinion) and add one in a dead hand provision. 

The provision was, however, challenged.  We'll discuss the outcome of that challenge in the next posts. 

The primary materials in Pontiac General Employees Retirement v. Healthways can be found at the DU Corporate Governance web site. 


Jones v. Martinez: Delaware Demand Rules Supersede California Discovery Rules

In Jones v. Martinez, 230 Cal. App. 4th 1248 (App. 2d Dist. 2014), the court held that Delaware discovery rules applied to cases in other states involving Delaware corporations.

On August 27, 2012, Jones, a shareholder in Deckers Outdoor Corporation (“Deckers” or “Company”), a Delaware corporation based in California, sent Deckers a “First Request for Production of Documents.” Deckers objected to the discovery request contending that Jones lacked standing to bring the shareholders derivative action.  Jones then filed a “Consolidated Shareholder Derivative Complaint” against Deckers’ current and former officers and board members (collectively, “respondents”).  The court dismissed the claim, finding that the complaint  “was internally inconsistent and that its allegations of false or misleading statements were disproved by required regulatory filings and that the complaint failed to allege particularized facts showing that a pre-filing demand on the board for action would have been futile.”  The court also found that Jones had not established demand futility and therefore denied a motion to compel discovery. 

Jones appealed.  He did not challenge the basis for the demur but did challenge the denial of discovery.  Jones asserted that the trial court erred by applying Delaware law to the procedural aspects of the case and should have, instead, applied California’s policy of “broad access to discovery.”

In a derivative suit, demand requirements are “determined by the law of the state of incorporation.” Because directors are presumed to manage a corporation, a plaintiff must “establish [his] right to bring a derivative action on behalf of the corporation” before issuing discovery requests. In order to establish the right to bring suit, a putative plaintiff must make a demand for relief from a board of directors or demonstrate that such demand was futile. Putative plaintiffs are not allowed to use discovery to demonstrate the futility of a demand.

Jones sought to establish demand futility through discovery. The court, however, reasoned that discovery served to unveil “additional facts” about well pleaded claims, “not to find out whether such a claim exists.”  As a result, Jones was “not entitled to discovery to assist his compliance with the particularized pleading requirement of Rule 23.1.” 

The primary materials for this post can be found on the DU Corporate Governance website.


The Latest on Fee Shifting Bylaws

Fee shifting bylaws arise out of an interpretation of DGCL 109 that essentially removes all limits on the board of directors.  As long as the bylaw relates to the "business of the corporation," it is facially permitted under Delaware law. 

The Delaware Supreme Court has read out of the provision any limit imposed by the internal affairs doctrine.  For a discussion of these bylaws, see Shifting Back the Focus: Fee Shifting Bylaws and a Need to Return to Legislative Intent.  For a discussion of this piece by Bloomberg BNA, see Professor Lambasts Delaware’s ‘ATP Tour,’ Arguing That it Overturns Core Corporate Law


Management, Activists, and Long-Term Shareholders

The WSJ article discussing a hedge fund funded in part by CEOs had a number of interesting observations with respect to the relationship between management and shareholders.   

  • the dynamic between shareholder activists and companies has evolved in recent years. Companies were once loath to entertain the suggestions of shareholder activists. More recently, managements have generally become more receptive to, or at least resigned to, these investors’ influence. Also, traditionally long-term shareholders, such as pension and mutual funds, have become more supportive of activist campaigns.

For the most part, hedge funds labeled activists do not purchase a controlling block of stock.  To implement their ideas, therefore, they must successfully convince management to do so.  To the extent that management declines, implementation may require a new board (or at least a portion of the board).    

Shareholders with a large but not controlling block can only achieve this goal if they convince other shareholders, particularly long term shareholders, to go along.  Thus, in companies where shareholders "have become more supportive" of activists, the threat of replacing at least some of management is real.

But in that statement rests management's best strategy.  The view that management has become more receptive to activist influence has two possible causes:  First, the activist is correct and management agrees with the approach.  Second, management does not agree but knows that it has already lost the long term investors, thereby giving hedge funds the room to successfully change some or all of the board.  

In the latter case, therefore, the best strategy would be to maintain strong relationships with long term shareholders.   To the extent that they do so, the ability of hedge funds and other similar investors to change management is reduced. In Britain, the chair of the board acts as a communication channel with institutional investors. The chair in this country has no similar role.  Moreover, too many boards still view shareholders collectively as a nuisance, a group that should be seen but not heard.    

The recent efforts to defeat shareholder access proposals by putting up bylaws that effectively prevented shareholder access is an example of this arguably self-defeating approach.  Shareholder access is designed to provide a modest opportunity for long term shareholders to have access to the company proxy statement for their nominees.  Few long term investors will ever actually exercise the authority.  They don't want to incur the costs of a contest and, in fact, they don't really want to participate in the active management of the company.  The authority is at its best as an unused threat, causing directors to be more aware of the interests of long term shareholders as a means of avoiding an actual contest.  

Yet rather than support the efforts of these investors, many companies have opposed them and sought to introduce proposals that effectively negate shareholder access.  When the activist shareholder arrives and long term shareholders prove "more supportive" of their views, the reason will not be difficult to figure out.   


Hedge Funds, Management, and a Cooperative Approach

The WSJ has an article about a hedge fund started with capital from CEOs.  The fund is intended to have a "collaborative approach to management".  The fund, according to the article, "doesn’t plan on launching proxy fights or releasing shareholder letters".  The hope is that the approach will "open more doors than the combative stances and sharp missives favored by other activists."

The interesting thing is that the approach intimates that other hedge funds do not favor a "collaborative approach" with management.  One suspects that most if not all of them do.  The funds have ideas for the future direction of the company and want to see those ideas implemented.  There is no immediate benefit to conflict if the same result can be accomplished through collaboration.  As a result, funds, even those with reputations for short term investment horizons, typically approach management quietly to discuss and negotiate possible changes.  

Conflict does arise.  This occurs when collaboration doesn't work and management declines to sufficiently accept the advice provided by the hedge fund.  In those circumstances, additional pressure may be necessary, something that often requires a public campaign and can include a proxy contest.    

To the extent that this characterization is accurate, the difference between hedge funds that announce an intent to take a "collaborative approach to management" and funds that do not make this announcement is not the investment horizon or the desire to pressure management for change.  It is the willingness to relinquish up front tactics that are designed provide additional leverage in the event the negotiations break down.  

One suspects that management of most public companies doesn't want advice from outside players as to the direction of the company.  The advice is likely to be unwelcome whether the hedge fund is financed by CEOs or by other types of investors.  Funds may, therefore, discover that the unthreatening approach can in fact open more doors. But success is not based upon the number that open but the number that close and without the traditional means of applying pressure, funds may find the success rate not what they had hoped. 


Special Projects Segment: An Overview of the Proposed Crowdfunding Rules

We are discussing possible rulemaking for equity crowdfunding under the JOBS Act.

On October 23, 2013 the Securities and Exchange Commission (“SEC”) unanimously voted to propose a set of crowdfunding rules under the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”). Title III of the JOBS Act created an exemption under the securities laws to allow for crowdfunding and directed the SEC to create a set of rules implementing that exemption. The ultimate goal of the proposed rules is to provide a method whereby an issuer can offer and sell securities to both accredited and unaccredited investors pursuant to Section 4(a)(6) of the Securities Act of 1933 (the “Securities Act”), which acts as an exemption from the registration requirements.

Under the proposed rules, an issuer must comply with four main requirements in order to undertake a Section 4(a)(6) offering. Those requirements are as follows: (i) the issuer can only sell an aggregate of $1 million pursuant to the exemption during a twelve month period; (ii) an investor, during a 12 month period, can only invest (a) the greater of $2,000 or 5% of his annual income or net worth if both annual income and net worth are less than $100,000 or (b) the greater of 10% of his annual income or net worth not to exceed $100,000 if either his annual income or net worth equals or exceeds $100,000; (iii) the sale is conducted through a regulation compliant intermediary and that intermediary’s platform; and (iv) the issuer complies with Section 4A(b) of the Securities Act.

Pursuant to Section 4A(b), only certain issuers can take advantage of the 4(a)(6) exempt offering. The issuer must be a company organized under the laws of a state or territory of the U.S. or the District of Columbia. Additionally, the issuer cannot utilize the exemption if it is required to file reports under the Securities Exchange Act of 1934, is an investment company, is otherwise disqualified, has not met previous 4(a)(6) filing requirements, or has no specific business plan.

In order to utilize the 4(a)(6) exemption, the issuer must file a Form C: Offering Statement with the SEC that provides various disclosures to investors and relevant intermediaries. The issuer must also make those same disclosures available to potential investors. Some of the significant disclosures include the names of those persons who own 20% or more of the issuer’s equity voting securities; a description of the business and its proposed business plan; material factors that may cause the investment to be risky; the targeted offering amount, subscription deadline, plans for oversubscriptions, and use of the proceeds; the underlying terms and rights of the offered securities; and a description of the issuer’s financial condition. In the case of an offering that is less than $100,000, the issuer must provide tax returns for the most recent year certified by its principle executive officer. Where the offering exceeds $100,000, but is less than $500,000, the issuer must provide financial statements reviewed by an outside public accountant. An issuer must provide audited financial statements when the offering exceeds $500,000.

A key component of the proposed rules is that the crowdfunding offering must occur through the use of an intermediary and its online platform. The intermediary must be registered with the SEC as a broker or as a funding portal. Additionally, the intermediary must be a member of FINRA or another registered national securities association. Intermediaries must undertake measures to reduce the risk of fraud such as having a reasonable belief that the issuer is complying with 4(a)(6) and that the issuer is maintaining accurate records of holders of its securities, as well as denying access to its platform to any issuer that it believes presents the potential for fraud. Intermediaries are responsible for making information about the offering available to investors, qualifying investors, creating communication channels, and providing investors with educational materials. Funding portals acting as intermediaries are prohibited from offering investment advice or recommendations, soliciting purchases, and handling the investors’ funds, which must be handled through a qualified third party.

The proposed rules also address such issues as the early completion of an offering, investor cancellation of a subscription, reconfirmations of subscriptions as a result of material changes, uncompleted offerings, advertising restrictions, promoter compensation, and funding portal regulations.

As of the date of this posting, the proposed crowdfunding rules are still just that – proposed. To date, the SEC has not finalized the crowdfunding rules and recently indicated that it will not finalize the rules until at least October 2015. 


Long Term Profit Maximization and Shareholder Access

Marty Lipton just sent around a study that emphasizes the need for corporate governance to help orient companies towards a long term, rather than short term, perspective on profit maximization.  The study (from the Center for American Progress) is here.  As the study states: "To provide greater macroeconomic and financial stability and to raise productivity, it is essential that markets work in the public interest and for the long term rather than focusing only on short-term returns." 

Among other possible reforms, the study provided: 

  • There are a number of potential ideas that could be implemented, including making directors more independent of company staff, moving away from quarterly reporting, taking measures to reduce the ease with which hostile takeovers can take place, and promoting greater information disclosure from brokers and other market participants.  

Marty Lipton concludes by stating that "Implementation of recommendations made in the report is critical to the American economy and a fairer distribution of prosperity."

There is much to be said for the position that favors a long term perspective.  But the focus of the reforms in this report suggest that management should have a monopoly on determining the perspective.  Yet in fact the perspective would benefit from the inclusion of the views of long term shareholders. 

For the most part, long term shareholders prefer steady rather than short term growth and prefer sustainable growth.  Moreover, in what can only be described as an unsubstantiated opinion, long term shareholders generally understand that a corporation's contributions to the common good (community, environment, employees) also provides reputational benefits and contributes to the sustainability of long term growth.

Yet the interests of long term shareholders are often ignored.  Thus, for example, most companies (and Wachtell) opposed the shareholder access rule (Rule 14a-11) when it was proposed in 2009.  This was true even though it provided access only to long term shareholders.  The comment letters are here

Admittedly, the proposal defined long term as those holding shares for one year.  The final rule, however, ratcheted that number up to three years, allowing only long term shareholders with 3% of the shares to submit nominees.  Yet the provision was still challenged by the Business Roundtable and ultimately invalidated by the DC Circuit in a poorly reasoned opinion.  (For a discussion of this case, see Shareholder Access and Uneconomic Economic Analysis: Business Roundtable v. SEC).   

By opposing shareholder access, these participants suggested that in fact they did not want a shareholder presence in the board room.   Long term interests should not be a monopoly of management but should involve the participation of managers and long-term owners.  Shareholder access provides the promise of such participation.  


Scott v. General Motors Co.: Dismissing Retrospective Pleading Under Section 11 of the Securities Act of 1933

In Scott v. General Motors Co., No. 12CV5124–LTS–JLC, 2014 BL 245298, (S.D.N.Y. Sept. 4, 2014), the United States District Court for the Southern District of New York granted defendants’ motion to dismiss plaintiffs’ amended class action complaint against General Motors Company (“GM”). The court found GM’s Shareholders’ (“Plaintiffs”) failed to plead facts that, if found to be true, would establish a material misstatement or omission in GM’s Registration Statement as required under Section11 of the Securities Act of 1933 (“Securities Act”).

In June 2009, General Motors Corporation, GM’s predecessor, filed for bankruptcy.  When GM emerged from the bankruptcy as a new entity, it began preparations for a public offering. GM filed monthly inventory levels in a Form 8-K filed with the Securities and Exchange Commission (“SEC”). In November 2010, GM filed a final amended Registration Statement for its IPO. In its Registration Statement, GM affirmatively expressed its goal to increase profitability through a strengthened product portfolio and through active management of production levels by monitoring dealer inventory levels. The Registration Statement provided information about facility shut downs to reduce dealer inventory and strategies to strengthen the brand’s reputation and sales. During the IPO, 470 million shares GM common stock and 87 million shares of Series B preferred stock were sold, raising roughly $20 billion in proceeds.

On June 29, 2012, Plaintiffs filed a complaint alleging GM, the individual members of GM's board of directors, and the eleven underwriters of GM’s IPO violated Sections 11 and 15 of the Securities Act. Plaintiffs’ alleged that GM disclosed that it would reduce inventory levels while in fact the company was “purposefully increasing inventory” through channel stuffing, a practice whereby dealers were sold excess inventory so that the manufacturer could report increased revenues. The approach affected future sales. See Id. (“Because the vehicles "stuffed" into a dealership do not increase the demand for a company's vehicles, the company may recognize less revenue during future periods as a result of the increased dealer inventory that must be sold before new revenue is recognized.”).   

Section 11 allows shareholders to recover for material misstatements or omissions in an effective registration statement. Shareholders must, therefore, sufficiently allege the materiality of the statement. Additionally, to be successful under Section 11, a plaintiff must "’at a minimum, plead facts to demonstrate that allegedly omitted facts both existed, and were known or knowable, at the time of the offering.’"

The court found that Plaintiffs failed to plead facts that, even if found true, were sufficient to demonstrate  material misstatements. Some of the alleged misstatements were treated as “puffery.” See Id. (distinguishing cases that involved “existing facts” and therefore were “in a wholly different category from GM's forward-looking, aspirational statements regarding inventory management.”). In other cases, statements were not considered false because the public was aware of the concerns alleged to have been omitted. See Id. (“Any excess of inventory was therefore a matter of public record. GM's public filings preceding the IPO demonstrate that these sales and inventory figures were public information at the time the Registration Statement became effective.”). 

With respect to the assertion that “channel stuffing” constituted a negative trend subject to disclosure under Item 303 of Regulation S-K (“Regulation S-K”), the court acknowledged that the provision required the disclosure of “trends.” Companies, however, were not required to disclose negative trends in “’most unflattering light possible.’"  Having sufficiently disclosed the negative trend, GM did not make a misstatement by failing to “characterize events in the most negative way possible.”

For the above reasons, the United States District Court for the Southern District of New York granted GM’s motion, dismissing Plaintiffs’ complaint with prejudice. 

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


Special Projects Segment: Crowdfunding

The Race to the Bottom is happy to announce its launch of a special projects editorial section, which will focus on prominent issues concerning corporate governance and securities laws. The first project will focus on crowdfunding.

Crowdfunding is an evolving alternative form of capital raising that typically involves seeking small individual contributions from the general public. These campaigns generally have a specific fundraising goal to support a project, cause, idea, or business within a specific time period. Individuals who wish to contribute to a crowdfunding campaign can communicate on the crowdfunding platform about its credibility and whether it should be funded.

A number of entities facilitate crowdfunding campaigns by utilizing website platforms. Crowdfunding websites vary by interest and industry. According to Forbes, Kickstarter, Indiegogo, Quirky, Crowdrise, Tilt, and were a few of the leading crowdfunding websites in 2014. Kickstarter and Indiegogo are perhaps the best known of these websites. Each of these websites offers its own twist on crowdfunding. For example, Kickstarter focuses more on creative projects, which require project approval to be launched, while Indiegogo operates an expansive international platform that funds almost anything. Others allow users to: collaboratively develop a product or prototype pitched by inventors and makers; fund charitable causes, and focus on smaller fundraising campaigns.

Crowdfunding exists in two models: rewards and equity. All of the above listed platforms operate on the rewards based model, meaning individuals contribute money to a campaign and do not receive any interest in the project – other than feeling involved. The equity based model, on the other hand, provides an ownership interest in the project for invested capital.

The Jumpstart Our Business Startups Act of 2012 (“JOBS Act”) is credited with providing a framework for equity crowdfunding. Title II of the JOBS Act currently regulates general solicitations to accredited investors for private equity crowdfunding. Title III of the JOBS Act, which has not yet been implemented, addresses regulating general solicitations to non-accredited investors for private equity crowdfunding. The Securities and Exchange Commission (“SEC”) has issued its proposed Crowdfunding rules (the "Proposed Rules") and received public comment. The Proposed Rules are on the SEC’s rulemaking agenda, scheduled for final action in October 2015.

This series will examine the comments received by the SEC regarding the Proposed Rules, the likelihood that the SEC will implement the rules, and the response by some states to the approach taken by the SEC and required under the JOBS Act.

Additional posts will cover interviews with business entrepreneurs who have utilized the crowdfunding platforms for capital formation, the ins and outs of a successful crowdfunding campaign, and procedural safeguards individuals should consider when raising capital through crowdfunding campaigns in both rewards and equity. 


Delaware's Top Five Worst Shareholder Decisions for 2014 (A Review)


Delaware's Top Five Worst Shareholder Decisions for 2014 (#1: The Delaware Courts and the Continuing Lack of Diversity)

With the actions of the Delaware Supreme Court, it was a tough decision as to what should be the worst development for shareholders in 2014.  The continued lack of meaningful diversity, however, still has to top the list.  

At the beginning of 2014, the Chancery Court and Supreme Court in Delaware had no meaningful diversity. Of the 10 jurists, only one was a woman.  There were no minorities.  The judges for the most part had a similar background, including attendance at private law schools (or pseudo private schools such as UVA) and experience at firms that mostly defended management.  National corporate law fell to this undiverse pool of judges.

There was a fair amount of turnover during the year, including one opening on the Chancery Court and three on the Supreme Court.  The opportunity existed, therefore, for an increase in diversity.  It didn't happen.

Chancellor Strine was elevated to the Supreme Court and confirmed in January 2014 (replacing Myron Steele). In April, Andre Bouchard replaced Leo Strine as Chancellor.  Later in the year, Justices Carolyn Berger and Jack Jacobs stepped down from the Supreme Court.  In July, Justice Jacobs was replaced by Karen L. Valihura, a former partner at Skadden Arps who received her law degree from the University of Pennsylvania.  For a brief and shining moment, the Supreme Court included two women.  

That, however, did not last.  Justice Berger left the Court in September and was replaced by James T. Vaughn Jr., a judge from the state's Superior Court (and a Georgetown Law graduate).  The Delaware courts were back to where they started at the beginning of 2014.  

Nor does that look to change.  Justice Ridgely has announced that he will retire from the Court in 2015. Speculation on possible candidates indicates that the ultimate appointment will add no racial or gender diversity to the Court.  

Delaware courts set the corporate law for the nation.  They frequently issue management friendly decisions. In many ways, they resemble the management of the companies that they routinely see in their courts.  Boards of large public companies lack meaningful racial/gender diversity.  Women represent about 14% of these directors, minorities represent around 10%.  Companies have been criticized for this lack of diversity yet the Delaware courts are even less diverse.  

What about other benchmarks?  The Delaware courts do not compare well on diversity with the federal bench. According to a recent study, as of March 2014:  "Of the active U.S. circuit court judges, 51.2% are white men, 25.3% are white women, 16.7% are non-white men, and 6.8% are non-white women."  

What about diversity in the state?  There is, of course, no shortage of women in Delaware.  The population of state is 51.6% women.  How about minorities?  About 30%, including 22.1% African American; 8.7% Hispanic; and 3.6% Asian.  In other words, the bench in Delaware is nowhere near as diverse as the state's population.

Who knows what difference, if any, greater diversity would make on the decisions of the Delaware courts.  At a minimum, it would at least create the appearance of a more inclusive decision making process, providing some additional credibility to the decisions of these courts.     


Delaware's Top Five Worst Shareholder Decisions for 2014 (#2: The Radicalization of Corporate Law by the Delaware Supreme Court)

Delaware is a management friendly state.  The courts are management friendly in their decisions.  We have written on these themes often.  Management friendly, however, represents a leaning.  It does not mean that shareholders always lose.  In the Chancery Court, in particular, 2014 saw a number of cases that, while operating within a management friendly set of legal principles, applied them with appropriate rigor.  

Thus, in In re Orchard, the Chancery Court for the first time found a set of facts that warranted a trial over whether non-family personal relationships resulted in a loss of director independence.  In In re Rural Metro, the court provided additional content to the duty of care, essentially requiring boards to take a more active role in hiring and supervising financial advisors.  In In re Hershey, the court overturned recommendations from a Master indicating that shareholders could not inspect records relating to information about possible violations of child labor restrictions in the cocoa market.  

While the Chancery Court was making these decisions, the Delaware Supreme Court swung sharply in the opposite direction, radically revising corporat law.  In the three cases discussed in this series of posts (C&J, ATP & Kahn), the Supreme Court either rewrote statutes or effectively abrogated longstanding principles of common law, all in a shareholder unfriendly fashion.  

ATP is perhaps the most radical departure, rewriting the DGCL and eliminating any effective ability to facially challenge management adopted bylaws.  The decision eliminated any need for a connection to the company's internal affairs, allowing bylaws that, for example, applied to actions brought under the federal securities laws.

To get there, the Court had to ignore explicit language in the DGCL indicating that limits on the rights of shareholders were to be in the certificate of incorporation.  See DGCL 102.  The bylaws also threatened statutory rights that had long been viewed as incidents of ownership.  Thus, fee shifting bylaws arguably apply to inspection and appraisal right actions filed by shareholders, thereby throwing up non-statutory barriers to the exercise of these basic rights.  

The decision did not, however, just rewrite the statute.  It effectively gave the courts enormous additional authority.  By eliminating facial challenges to most bylaws, the decision left courts as the arbiter of bylaws through the application of equity.  

For a more detailed discussion of the case, see Shifting Back the Focus: Fee Shifting Bylaws and a Need to Return to Legislative Intent.  

C&J and Kahn both rewrote the common law, eliminating shareholder friendly vestiges that had been in place since the 1980s.  Revlon is gone, at least to the extent it required boards to actually act as an auctioneer and ensure that shareholder received the best price when selling the company.  Also gone, for the most part, is the ability to test for fairness of transactions with controlling shareholders.  As long as there is enough process (process on top of process), the business judgment rule is the applicable standard and the terms of the transaction no longer matter.   

We shall see what other positions that benefit shareholders are rewritten in 2015.  The Blasius standard is presumably at risk, with the possibility that the shareholder friendly "compelling justification" standard will be replaced by a management friendly standard of reasonableness.  

As the Court rewrites the law and the shareholder unfriendly nature of the positions become more apparent, responses designed to minimize the role of Delaware in the corporate governance process become more viable. Federal preemption is one possibility.  

There is also, arguably, room for a race to the top. The primary limit in the past on states that attempted to impose stricter requirements on corporations was the ability to reincorporate in management friendly jurisdictions, effectively neutering any such standards.  But Delaware, through the allowance of bylaws not limited by the internal affairs doctrine, has provided other states with an opening.   

States can now adopt a different interpretation of management's authority and apply it to domestic and foreign companies.  Oklahoma has already done this.  New York or California could easily provide that fee shifting bylaws are invalid for actions filed in the state (by any company, whether or not incorporated in the state).  The ability of a company to reincorporate in Delaware wouldn't change that result.  If that happened, New York and California would be the main site of derivative suits and their courts, not the Delaware courts, would determine national corporate law.