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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. 


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 Invested.in 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.    


Delaware's Top Five Worst Shareholder Decisions for 2014 (#3: ATP Tour v. Deutscher and the Rewriting of the DGCL)

Perhaps more than any other decision by the Delaware Supreme Court in 2014, the one in ATP is the most problematic and concerning.  In 2013, the Chancery Court in Chevron upheld bylaws adopted unilaterally by the board that required shareholders to bring actions in a specified forum, typically Delaware.  The decision ensured that Delaware would be the decision maker in fiduciary duty cases.  The case for the most part was based upon an unprecedented and expansive reading of the board's authority to adopt bylaws under DGCL 109.  

Nonetheless, the case at least purported to retain a nexus with the internal affairs doctrine. The bylaws in that case were said to have involved "litigation relating to Chevron‟s internal affairs" and required that such litgation "be conducted in Delaware".  While the analysis expanded the reach of management adopted bylaws, they were at least ostensibly limited by the need to relate to a corporation's internal affairs.    

That limitation was entirely read out of Section 109 by the ATP decision. In that case, the Court upheld as facially valid a fee shifting bylaw that applied in all actions against the entity or its owners.  In the context of for profit companies, therefore, the provision applies not only to actions involving a company's internal affairs but also to actions under federal law such as the federal securities laws.  The only facial limitation on bylaws in the aftermath of ATP is that it relate to the "business of the corporation," which means it can address almost any issue, irrespective of the connection to a corporation's internal affairs.  

The case also ignored a statutory framework inconsistent with the court's interpretation.  Section 102 of the DGCL provides that limits on shareholders should appear in the articles.  As the provision provides:

  • Any provision for the management of the business and for the conduct of the affairs of the corporation, and any provision creating, defining, limiting and regulating the powers of the corporation, the directors, and the stockholders, or any class of the stockholders, or the governing body, members, or any class or group of members of a nonstock corporation; if such provisions are not contrary to the laws of this State. Any provision which is required or permitted by any section of this chapter to be stated in the bylaws may instead be stated in the certificate of incorporation

Yet limits can now be included in the bylaws, largely writing this provision out of the Delaware Code. 

This represents a significant rewriting of corporate law.  It accedes considerable additional authority to management with respect to unilaterally adopted bylaws.  For example, Section 109 specifically provides that bylaws can regulate the rights of employees.  Under the reasoning in ATP, there is nothing that would facially invalidate a bylaw that shifted fees in suits brought by employees against the corporation.  Bylaws were never intended to reach this type of behavior.  Now they can.    

In the short term, this newly granted authority is likely to result in greater efforts by companies to adopt bylaws that restrict the rights of shareholders.  

In the longer term, the result is likely to continue the erosion of the role of Delaware in determining corporate law.  By allowing bylaws unrelated to a corporation's internal affairs, the courts have put in place a true mechanism for competition among the states.  Oklahoma already put in place a provision that requires fee shifting in derivative cases and has applied it to both domestic and foreign companies.  Other states may follow suit.  At the same time, the approach cements the courts as management friendly and encourages shareholders and investors to seek reforms in other forums, particularly at the federal level (increasing the likelihood of further federal preemption).    

For a more detailed review of the misguided analysis in ATP, see Shifting Back the Focus: Fee Shifting Bylaws and a Need to Return to Legislative Intent.   


Delaware's Top Five Worst Shareholder Decisions for 2014 (#4: C&J Energy Services v. City of Miami General Employees and Repealing Revlon)

Revlon is a vestige of those halcyon days back in the 1980s when the Delaware Supreme Court could be convinced to adjust the law in a manner that at least sometimes benefited shareholders.  See Revlon v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).  Think Unocal or Van Gorkom

Those days are over.  As if there was any doubt, that was made absolutely clear in C&J Energy Services v. City of Miami General Employees' and Sanitation Employees' Retirement Trust, 2014 WL 7243153 (Del. Dec. 17, 2014), a case that brings Revlon duties full circle by effectively overturning the 1986 decision and eliminating any need for boards to even realize they are selling control, much less actually engage in a sales process reasonably designed to ensure that shareholders received the best value in the absence of a competing bidder. 

After a long line of decisions representing that there was no “blue print” for complying with Revlon, the Supreme Court provided a blue print.  Boards pursuing negotiations with a single bidder could meet Revlon by signing an agreement that prohibited other solicitations so long as there was a “fiduciary out” that permitted directors to act in the event “a more favorable deal" happened to  emerge.      

In many respects, the facts of the case are unique.  C&J sought to  purchase a division from Nabors Corporation.  The combined entities would receive tax benefits by forming in Bermuda.  The twist, however, was that the transaction would result in a shift in control.  Once the acquisition was completed, Nabors would own almost 53% of the shares of the surviving entity, reducing the stockholders of C&J to minority owners in a subsidiary of Nabors.  

The transaction was structured as an asset purchase.  The board of C&J did not, apparently, see itself as selling the company and triggering Revlon duties.  As a result, the board "took no steps to sell or shop the company".  As the Chancery Court found: 

  • "In approving the transaction, the board did not consider alternative transactions. The board did not seek out other potential buyers. The board's review of the merger process was more akin to what one would expect from a board pursuing an acquisition rather than one selling a company, but that is not necessarily fatal to the arguments that C&J makes.” 

Moreover, while the court did not find that the board of C&J had a disabling conflict of interest, it did note that the decision to purchase the subsidiary was surrounded by "noise." Four of the C&J directors would be appointed as a majority of the board of the new entity and would be guaranteed six-year terms.  Management (including the CEO who served on the board) were, according to the Chancery Court, promised "very generous employment packages as a result of the merger, although those agreements were not negotiated until a couple of months after the merger agreement was signed."

Tthe Chancery Court responded to these circumstances with a "relatively modest" solution.  The merger would be enjoined for 30 days so that C&J could "solicit interest" in the company.   

The Supreme Court overturned the injunction.  There was no duty to consider alternative transactions or to consider other means of maximizing shareholder value.  According to the Supreme Court, the Chancery Court opinion: 

  • "rested on the erroneous proposition that a company selling itself in a change of control transaction is required to shop itself to fulfill its duty to seek the highest immediate value. But Revlonand its progeny do not set out a specific route that a board must follow when fulfilling its fiduciary duties, and an independent board is entitled to use its business judgment to decide to enter into a strategic transaction that promises great benefit, even when it creates certain risks. When a board exercises its judgment in good faith, tests the transaction through a viable passive market check, and gives its stockholders a fully informed, uncoerced opportunity to vote to accept the deal, we cannot conclude that the board likely violated its Revlon duties. It is too often forgotten that Revlon, and later cases like QVC, primarily involved board resistance to a competing bid after the board had agreed to a change of control, which threatened to impede the emergence of another higher-priced deal. No hint of such a defensive, entrenching motive emerges from this record.” 

The Court also sharply rebuked the Chancery Court for requiring the C&J board to solicit alternative transactions that could maximize shareholder value pending the 30-day preliminary injunction.  Once a deal was signed, the Chancery Court could do little to remedy any unfairness.   Absent allgations that the bidder aided and abetted the breaches of duty, a contract was, essentially, immutable. 

  • "Mandatory injunctions should only issue with the confidence of findings made after a trial or on undisputed facts. Such an injunction cannot strip an innocent third party of its contractual rights while simultaneously binding that party to consummate the transaction.  To blue-pencil a contract as the Court of Chancery did here is not an appropriate exercise of equitable authority in a preliminary injunction order. That is especially true because the Court of Chancery made no finding that Nabors had aided and abetted any breach of fiduciary duty, and the Court of Chancery could not even find that it was reasonably likely such a breach by C&J‟s board would be found after trial." 

The Court treated the Chancery Court decision as effectively rewriting the contract. 

  • To blue-pencil an agreement to excise a provision beneficial to a third party like Nabors on the basis of a provisional record and then declare that the third party could not regard the excision as a basis for relieving it of its own contractual duties involves an exercise of judicial power inconsistent with the standards that govern the award of mandatory injunctions under Delaware law.  In those cases, plaintiffs were effectively left with after-the-fact monetary damages (notwithstanding that duty of care violations cannot lead to money damages because every public company has an exculpatory provision). 

As for the fact that a majority of the C&J board was offered board seats for five years on the surviving entity, the Supreme Court simply ignored it.  Similarly, the Supreme Court ignored that C&J’s CEO who negotiated the sale of C&J to Nabors had, as the Chancery Court observed, used "some arguably optimistic values and did increase the multipel for EBITDA to get a number that would support the transaction". 

Perhaps most egrigiously, the Court ignored the apparent threat by the CEO of C&J to "not sign [the agreement]. . . and not announce the transaction'" unless Nabors agreed in a side leter to "endors[e] a generous compensation packag".  See Id.  ("When [the CEO of Nabors] hesitated to sign the letter, objecting to some of [the CEO of C&J's] demands, [the CEO of C&J] threatened to 'not sign . . . and not announce the transaction.' . . . But a few hours later, [the CEO of Nabors] agreed to sign the letter with some modifications, and the deal was announced as planned."). 

Despite the "noise," despite the failure to shop the company, despite, for the most part, the board's apparent lack of awareness that Revloneven applied, the blue brint for meeting the requirements of Revlon required only a passive market test and fiduciary out.

In Revlon, the Supreme Court announced boldly that, once a company was for sale, the "directors' role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company." The decision tasked the board with an active role in auctioning the company and maximizing the return for shareholders.  After C&J, however, that is no longer the case.  The Court reduced these duties to "an effective market check" that allowed another bidder a reasonable opportunity to provide an offer but without any "active solicitation" by management.  

In short, active auctioneer has been reduced to passive mannequin. 

The transcript and the opinion by the Delaware Supreme Court is posted on the DU Corporate Governance web site. 


Delaware's Top Five Worst Shareholder Decisions for 2014 (#5: Kahn v. M & F Worldwide Corp. and the Elimination of Fairness in Controlling Shareholder Cases)

Beware anytime the Delaware courts claim they are making decisions because the result are good for shareholders.  This is one of them. 

Shareholders have few advantages in challenging board behavior.  One of the few had been in connection with transactions involving controlling shareholders.  For reasons best explained as a matter of historical accident, the Delaware courts provided benefits to boards that used what they deemed to be appropriate process when approving a transaction with a controlling shareholder.  

Boards relying on a special committee consisting of independent directors did not have to establish the "entire fairness" of the transaction.  Instead, the burden shifted to shareholders to establish the unfairness of the transaction.  The burden shift could be constrasted with the law with respect to the approval of a conflict of interest transaction between the company and a director (often the CEO).  In those circumstances, a board with a majority of independent directors received the protection of the business judgment rule.  All of this is discussed in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.  

The differences in the two standards are stark.  In the case of the shift of the burden, the substantive terms of the transaction matter.  In the case of the application of the BJR, only process matters.  It is enough that the board was independent and informed; for the most part, the substantive terms are irrelevant.  

In Kahn, however, the Delaware Supreme Court began the process of eliminating this vestige of shareholder protection.  In a case involving a controlling shareholder, the Court gave the board the benefit of the business judgment rule 

  • if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.

With process on top of process, the business judgment rule applied.  And the value of the new process, particularly the addition of the requirement that approval be by a majority of disinterested shareholders? Without citation, the Court had this to say: 

  • The simultaneous deployment of the procedural protections employed here create a countervailing, offsetting influence of equal—if not greater—force. That is, where the controller irrevocably and publicly disables itself from using its control to dictate the outcome of the negotiations and the shareholder vote, the controlled merger then acquires the shareholder-protective characteristics of third-party, arm’s-length mergers, which are reviewed under the business judgment standard. 

In fact, that is not likely to be true.  The assumption is that disinterested shareholder approval is another method of determining fairness.  The Court, however, did not discuss the shift in ownership configuration that takes place after a transaction has been announced.  Risk averse shareholders sell; risk taking shareholders (hedge funds and arbitrageurs) buy.  The buyers have every incentive to see the transaction close.  As a result, they will favor the transaction, irrespective of the fairness of the offering price.  Disinterested shareholder approval is not a categorical substitute for fairness.

So, there are traditional statements that ought to put the listener on alert.  "The check is in the mail" is one of them.  This will be a "benefit to minority stockholders" is another, at least if spoken by the Delaware courts.    


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

We are running a bit late this year, usually starting the countdown on the first day of the new year.  Nonetheless, the tradition continues, even if a bit tardy. 

For the eighth year in a row (for prior listings, see 2013, 2012,  2011201020092008, and 2007), we ring in the new year with a retrospective on the decisions from the prior year that were the least favorable to shareholders.  There are, as usual, a bounty of choices.  Nonetheless, as in prior years, we narrow the list to five.  Anyway, on with the countdown of the five worst shareholder decisions by the Delaware courts for 2014.


NAM Files Its Supplemental Brief in Conflict Minerals Rule Case

On December  29, the National Association of Manufactures (NAM) et al. filed their supplemental brief asking a panel of the U.S. Court of Appeals for the District of Columbia to reaffirm its holding that the SEC's conflict minerals rule violates the First Amendment by compelling corporations to label their products “not DRC conflict free.” The brief follows one filed earlier by the SEC (discussed here). At issue in the pending action is the reach of the American Meat Institute decision which found that Zauderer v. Office of Disciplinary Counsel does not apply unless the government-mandated statements are “of ‘purely factual and uncontroversial information’ about the good or service being offered.”  Thus, if the label “not DRC conflict free” is found to be “purely factual and uncontroversial information” it will likely withstand First Amendment scrutiny under Zauderer and the portion of the Court of Appeals panel decision holding to the contrary will be reversed. 

In support of their position that “not DRC conflict free” is not purely factual and uncontroversial information” NAM makes three primary arguments.   

  • First, the compelled statement is not factual in nature, but rather constitutes an ideological judgment that companies who cannot confirm where the minerals in their products originated bear some “moral responsibility for the Congo war.”  Nat’l Ass’n of Mfrs. v. SEC, 748 F.3d 359, 371 (D.C. Cir. 2014).  As the panel explained, the government is forcing companies to “confess blood on [their] hands” and “tell consumers that [their] products are ethically tainted.” Id.
  • Second, the compelled statement is both non-factual and controversial because it is highly misleading, susceptible to interpretations that are not factually accurate. In many cases, issuers forced to make the compelled statement will have no connection to the region at all, but will be simply unable to identify the source of their minerals due to the length and complexity of their supply chains, making their compelled association with the armed conflict misleading and inaccurate.  
  • Third, the compelled use of the government’s “DRC conflict free” slogan is controversial because it forces companies to inject themselves into a contentious debate over the causes of a foreign conflict, to adopt the government’s loaded terminology classifying products as not “conflict free” depending on the minerals they contain, and to appear thereby to endorse the government’s view that the mineral trade is responsible for the conflict. This is a highly controversial position, with which many policy experts disagree.  

The brief stresses the importance of the First Amendment aspect of the argument:  

  • The Supreme Court has emphasized the importance of independent appellate review of First Amendment issues, “to make sure that the judgment does not constitute a forbidden intrusion on the field of free expression.” Bose Corp. v. Consumers Union of U.S., Inc., 466 U.S. 485, 499 (1984). This “rule of independent review assigns to judges a constitutional responsibility that cannot be delegated to the trier of fact,” id. at 501, even if “in other contexts application of such a legal standard would likely be considered a mixed question of law and fact,” FEC v. Christian Coal., 52 F. Supp. 2d 45, 62 (D.D.C. 1999). Indeed, while the appellees variously describe the “uncontroversial information” requirement as a “mixed question of law and fact,” SEC Br. 4, or a “question of law” “in most instances,” Amnesty Br. 13, all parties agree that the Court should resolve the issue here de novo.  

Battle lines have clearly been drawn.  The ultimate decision will have important things to say about the reach of Zauderer and the ability of various governmental agencies to use disclosure regulation.   


SEC v. Estate of Vincent James Saviano and Palmetto Investments- The Complaint

In a complaint filed October 9, 2014 (the “Complaint”), the Securities and Exchange Commission announced an enforcement action against the estate of Vincent James Saviano and his firm, Palmetto Investments LLC.  The Complaint alleged that “Saviano defrauded advisory clients who invested in a private fund that purportedly executed a day trading program.” According to the Complaint, Saviano and Palmetto Investments allegedly violated Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act, and Rule 10b-5 thereunder, as well as Sections 206(1), 206(2), and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-8 thereunder.

The Complaint made the following assertions:

Saviano marketed and operated an investment program called the Palmetto Investment Portfolio (the “PIP”), which allegedly made money through “extreme” day trading of stocks. Saviano attracted more than one hundred clients to invest by representing the PIP as an unqualified success. He informed prospective investors, both orally and in a written prospectus, that the PIP had experienced monthly gains ranging from “five to ten percent per month” and that these gains were continuing.  Based on these representations, Saviano was able to raise at least $2 million for the PIP. 

According to the Complaint, the PIP was actually a failure. Saviano’s day trading regularly lost money instead of producing the “consistent monthly gains that he advertised.” Saviano concealed his trading losses by reporting consistent gains in performance statements and informing investors that their principal was intact. From January 2011 to September 30, 2014, Saviano lost approximately 81% of the funds invested with him. Additionally, prior to his death, Saviano admitted to a group of PIP investors that he “misappropriated an unidentified portion of investor funds to feed his gambling habit.”

Based on these allegations, the SEC is pursuing this enforcement action against Saviano’s estate and Palmetto Investments. The purpose of the action is to secure investor funds that remain in defendants’ names as a result of securities fraud. The SEC is seeking disgorgement of these funds so that any remaining amounts can be returned to investors who were victims of Saviano’s scheme.

The Complaint seeks final relief in the form of a “permanent injunction against Palmetto Investments”, as well as “disgorgement and prejudgment interest from both the Saviano estate and Palmetto Investments.” 

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