LexisNexis Corporate & Securities Law Community 2011 Top 50 Blogs

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Padfield on The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases (Updated Draft)

I've posted an updated draft of my article, The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases, 15 U. Pa. J. Const. L. __ (forthcoming), on SSRN (here).  The abstract reads as follows:

In Citizens United v. Federal Election Commission, a 5-4 majority of the Supreme Court held that corporate political speech could not be regulated on the basis of corporate status alone. In support of that conclusion, the majority characterized corporations as mere “associations of citizens.” The dissent, meanwhile, viewed corporations as state-created entities that “differ from natural persons in fundamental ways” and “have been effectively delegated responsibility for ensuring society’s economic welfare." I have argued previously that these two competing conceptions of the corporation implicate corporate theory, with the majority adopting an aggregate/contractarian view, and the dissent an artificial entity/concession view. Even if one understands Citizens United to be primarily about listeners’ rights, this stark contrast of competing theories of the corporation is difficult to ignore. At the very least, what the majority and dissent thought about corporate speakers was relevant to the question whether the campaign finance restrictions challenged in Citizens United should fall within that narrow class of speech restrictions justified on the basis of the speaker’s identity due to “an interest in allowing governmental entities to perform their functions.” Somewhat surprisingly, however, the majority was silent, and the dissent expressly disavowed, any role for corporate theory. I have previously offered some explanations for this apparent inconsistency, and concluded that an active “silent corporate theory debate” was indeed integral to the outcome of Citizens United - despite protestations to the contrary. In this project, I examine the key Supreme Court cases leading up to Citizens United to see whether a similar silent corporate theory debate is evident in those cases. I find that there is indeed such an on-going debate, and proceed to argue that in future cases involving the rights of corporations the justices should make their views regarding the proper theory of the corporation express. This will allow for a more meaningful discussion of the merits of those decisions, and impose an additional layer of intellectual accountability on the jurists.


The Election and Corporate Governance: Political Contributions and the Role of the SEC

In the aftermath of the election, attention is likely to return to the need to impose greater transparency on corporate campaign contributions.  While Citizens United ruled out most types of substantive regulation, the case specifically approved an approach  premised around greater disclosure. 

The DISCLOSURE (‘‘Disclosure of Information on Spending on Campaigns Leads to Open and Secure Elections Act of 2012’’) Act, HR 4010, seeks to do this.  The premise of the legislation is that corporations (and other organizations such as unions) must file a report with the Federal Election Commission that discloses campaign contributions. Presumably, in the aftermath of the election, this provision will again return to the forefront. 

The SEC presumably has the regulatory authority to require disclosure of this information.  Moreover, there is a strong regulatory reason for the SEC to do so.  The DISCLOSURE 2012 ACT leaves execution of these requirements to the FEC, not the SEC.  In other words, congressional intervention would largely give control over the disclosure process to another agency.  This is not an appropriate outcome and perhaps explains stories floating around that the SEC is prepared to act in this area.   


The Election and Corporate Governance: The Pressure on Dodd Frank Eased

After the election, the press noted statements by one prominent Republican that Obamacare is the law of the land.  So, in the aftermath of the election, is Dodd Frank. 

A victory for Governor Romney would likely have put pressure on Congress to repeal significant portions of Dodd Frank.  As the WSJ reports, this hope has largely evaporated.  The article noted the possibility of "small changes . . . in the next couple of years."  In other words, Dodd Frank is going nowhere and at most there may be some modest fixes, something always possible with such a long and complex piece of legislation. 

The election cycle also provided some evidence that opposition to Dodd Frank was costly at the ballot box.  One of the people defeated in this cycle was Nan Hayworth from New York.  Hayworth sponsored a number of efforts to repeal portions of Dodd Frank, including the disclosure of pay ratios.  Arguments were made that Scott Brown in Massachusetts acted to undercut provisions in Dodd Frank

With Dodd Frank no longer in doubt, certain provisions in the governance area will need to be implemented.  One is Section 952(b) and the requirement that companies disclose compensation ratios.  In addition, the Commission ought to reconsider shareholder access, the provision struck down by the DC Circuit.  With Congress having affirmed the SEC's authority to adopt a shareholder access rule, the post election cycle may be the right time to consider another effort at implementing the requirement. 


The Election and Corporate Governance: The Impact on the Courts

One place where there may be a change in the legal regime associated with corporate governance is the role played by the federal courts.  As this Blog has often discussed, the federal courts have not been particularly friendly toward corporate governance related issues. 

The Supreme Court has embarked on a deliberate policy to restrict the use of Rule 10b-5 in the context of private actions.  Janus is an example; so is Morrison.

The DC Circuit has been striking down SEC and other administrative rules while evidencing little concern with the requirement of agency deference.  Shareholder access is the obvious example.  Moreover, the trend has the potential to continue with industry challenges to the Conflict Minerals and Resource Extraction Rules.  The use of cost-benefit analysis as a basis for striking down rules such as the access rule has effectively forced agencies to direct resources away from rule writing and enforcement to economic analysis.  There is no evidence that this is the best use of agency resources and in any event it is not for a court to determine.

How important is the DC Circuit?  According to an editorial in the WSJ, the DC Circuit:

provides the only check on the burgeoning regulatory state. Congress tends increasingly to write ambiguous laws, precisely to give regulators the discretion to impose far-reaching costs on the economy without the legislators having to take responsibility for the vote.

There are currently no vacancies on the Supreme Court but some could come open in the next four years.  There are three vacancies on the DC circuit, with eight active judges.  The Obama Administration has nominated two judges to fill some of the vacancies.

Four more years of the Obama Administration means four more years of judicial appointments.  No one can predict with certainty what judges appointed for life will do.  But new appointees will change the mix of views and opinions and, in the area of corporate governance, may result in more investor friendly decisions. 


The Election and Corporate Governance: A Lesson in Demographics

If there has been a single common subject in the analysis of the 2012 presidential election, it has been the role of demographics.  Apparently something like 45% of President Obama's votes came from people of color.  He rolled up huge margins with Latinos, African Americans and, less discussed, Asians (Asians favored the President 73% to 26%). 

Then there were women, with the President chalking up a double digit lead (12%) with that group as well.  As one study noted:  "Since 1964 women have comprised a majority of the eligible electorate, but it was not until 1980 that the percentage of eligible women who actually voted surpassed the percentage of qualified men casting ballots . . . "

These demographics caused Politico to ask whether the Republican Party was Too old, too white, too male and whether this amounted to a "glaring structural weaknesses in the GOP".  See also Vote Data Show Changing Nation.

In the area of corporate governance, the exact same question can be asked about corporate boards and about the judiciary in Delaware.  Corporate boards of public companies consist of about 15% women (one study of the 1500 largest public companies put it at 12.7%) and 10% people of color.  For the most part, this means one woman and one person of color on a corporate board.

Similarly, Delaware determines the corporate law for an entire nation.  Yet, as we have noted, it is a remarkably undiverse group of judges.  There is, among the 10 jurists on the Chancery Court and the State Supreme Court, a single woman.  They often have similar backgrounds and attend similar law schools.  Moreover, as we have also noted, this lack of diversity can increasingly be contrasted with a more diverse federal judiciary. 

Corporate boards and the Delaware courts should consider whether they also have a "glaring structural weakness" that should be seriously considered.  For the Delaware courts, the lack of diversity provides another argument for preempting state statutes and transferring matters to the federal government. 

For public companies, the lack of diversity raises concerns over the quality of the board.  Companies that figure out the importance of diversity before the others may well obtain a competitive advantage in the market place.  See Essay: Neutralizing the Board of Directors and the Impact on Diversity


The Election and Corporate Governance: The Role of Citizens United

The reelection of Barak Obama has a number of explanations that are best left to the pundits and sages to point out.  Corporate governance, however, played a small but potentially important role.

How was that the case?  The answer is Citizens United.  Put aside the unleashing of contributions as a result of the decision.  Right or wrong, the decision was perceived as permitting corporations to have a more accentuated influence during the election cycle.  The Supreme Court indicated that corporate contributions were a matter between companies and shareholders and expressly approved of disclosure regimes designed to inform shareholders and the public of these contributions.  Despite efforts in Congress, however, no such disclosure regime was put in place.

Thus, the election cycle occurred with few meaningful limits on corporate contributions.  As a result, the issue of corporate contributions became part of the debate.  With Governor Romney having strong roots in the corporate world, the debate likely increased voter focus on this fact.  Moreover, the debate engendered by Citizens United was likely responsible for the much repeated statement by Governor Romney that "corporations are people, my friend."  The phrase made its way into campaign commercials, was the subject of a spoof in an ad sponsored by the Colbert Super Pac, and came up constantly in the campaign. 

Exit polls showed that a majority of voters perceived Governor Romney as supporting policies that favored the wealthy.  Whatever the merits of the perception, candidates for national office probably prefer to be perceived as supporting policies that favor the middle class.  The Citizens United debate and statements like "corporations are people, my friend" probably in the end made the middle class orientation a more difficult perception for Governor Romney to achieve.   


Non-Reviewability of Directors' Fees: In re Huron Consulting Group, Inc. Shareholder Deriv. Litig., 971 NE 2d 1067 (Ill App. 2012)

In re Huron Consulting Group, Inc. Shareholder Deriv. Litig., 971 NE 2d 1067 (Ill App. 2012) involved a derivative suit filed in Indiana.  In considering the standard for demand futility, the courts applied Delaware law since the corporation had been formed under the laws of that state.  As part of the analysis, the court had to determine whether a majority of the board was disinterested and independent.  

Shareholders sought to show a lack of independence by pointing to the fees paid to directors.  As the plaintiff alleged:  "the members of the board of directors earned an average of $330,438 in annual salary."  Shareholders asserted that the fees were "materially higher" than those paid to directors of other corporations.  The court, however, found that the allegation, standing alone, did not establish a lack of disinterest or independence. 

His allegations that individual directors lacked independence is merely a comparison of the fees Huron paid its directors and fees awarded to directors of other Fortune 500 companies he selected. He then concludes that "[b]ecause of the sheer size of the atypical director fees" awarded to each director in this case, "there is reason to doubt [their] independence from other directors, rendering [them] incapable of impartially considering a demand to commence and vigorously prosecute this action." Plaintiff cannot survive dismissal based on such conclusory statements. . . .

Significant fees, standing alone, will not result in the loss of director independence.  The court did not provide any insight into the method of showing that fees were excessive and impaired independence.  The court, however, added an additional element to the analysis.  "More importantly, plaintiff failed to allege that any director has used his influence to pressure the others to do his bidding to further his personal interests, as the test for 'independence' requires under Rales." 

The element suggests that a loss of independence requires some affirmative evidence of actual pressure by the interested director.  Putting aside the merits of the requirement, this is an almost impossible burden to meet at the pleading stage.  Thus, non-independent boards would be treated as independent not because they were but because of the insurmountable pleading burden.   


Davidoff & Hill on the Limits of Disclosure

Steven Davidoff and Claire Hill have posted “The Limits of Disclosure” on SSRN (here).  The abstract concludes that “underlying the rationale for disclosure are common sense views about how people make decisions — views that turn out to be importantly incomplete.... Disclosure’s limits reveal yet again the need for a nuanced view of human nature that can better inform policy decisions.”

Davidoff has also posted an accompanying piece on DealBook: “Reading the Fine Print in Abacus and Other Soured Deals.”  After describing a fascinating series of examples that seriously call into question the ability of disclosure to carry the weight our regulatory regime places upon it, Davidoff concludes:

This is a problem. Sophisticated investors are supposed to read the documents. We all know that retail investors don’t often take the time to read disclosure, but the securities laws are based on the idea that information is filtered into the markets through disclosure to sophisticated investors who then set the real price of the security.

This is a form of the efficient market hypothesis. If sophisticated investors can’t be bothered to read the documents and act on them, then we have a real gap in the entire disclosure regime and asset pricing generally.

Unfortunately, this is what the evidence from the C.D.O. market before the financial crisis shows. And because of this, the idea that requiring still more, better or clearer disclosure is likely to be unfruitful in many cases.

So perhaps it won’t be such a bad thing after all if the Supreme Court eventually guts our securities law disclosure regime in the name of the First Amendment.


South v. Baker and the Race to the Courthouse in Caremark Actions (Part 2)

So what are the implications of this approach?

The decision is thoughtful in limiting the analysis to Caremark actions.  Those claims are tough to bring under the best of circumstances.  The court clearly believes that if the race to the courthouse can be slowed, shareholders (and their counsel) will proceed in a more deliberate fashion and, at least sometimes, will opt not to file Caremark claims. 

That is not, however, the likely outcome.  Shareholders still have an incentive to file quickly.  They will argue that they have alleged sufficient facts to withstand a motion to dismiss.  Assuming they are correct, they benefited from the fast filing.  Assuming they are wrong, they suffer nothing more than the usual consequence of a dismissal (although their dismissal will be with prejudice).  

To the extent representation is deemed inadequate, shareholders who do not file quickly but instead conduct a meaningful investigation (presumably by invoking their inspection rights).  They can then  file a claim in the same action.  Thus, derivative actions involving Caremark allegations are likely to produce a class of plaintiffs who file quickly and a class of plaintiffs who invoke their inspection rights.  The former will presumably succeed sometimes, albeit in rare circumstances, and when they do not, the latter will be in a position to file a follow up action.

It is possible that the second group of plaintiffs will decide not to file once they have completed the inspection process.  They may not uncover sufficient additional facts to allow them to adequate differentiate their complaint from the one filed by the first group of shareholders.  This seems to be what the Vice Chancellor hopes will happen.  Yet this "discretion" is for the most part unlikely.  Given the existing predilection to file even without significant investigation, it presumably will not be difficult for subsequent plaintiffs to find enough additional evidence to justify a second complaint. 

The effort by the Vice Chancellor is a worthy one.  He was careful to limit the approach to Caremark actions.  Moveover, he did not require shareholders to invoke inspection rights.  Instead, he more broadly required a "meaningful investigation," something that will often but not always mean the use of inspection rights.  

The real consequence of the risk of plaintiffs who file without adequate homework is a dismissal that ultimately bars other shareholders who do engage in the requisite investigation.  The Vice Chancellor has left open the door for those shareholders.  Morover, as the practice develops, the more sophisticated firms may opt increasingly to represent shareholders who prefer to conduct a more thorough investigation before filing an action. 


South v. Baker and the Race to the Courthouse in Caremark Actions (Part 1)

South v. Baker, 2012 Del. Ch. LEXIS 229 (Del. Ch. Sept. 25, 2012) represents another step in VC Laster's efforts to slow the race to the courthouse at least in cases involving Caremark allegations.  It is in many ways a refinement of the analysis in Pyott

In this case, he created a presumption that counsel filing derivative claims containing Caremark allegations would be subjected to a presumption of inadequate counsel unless the suit was preceded by an effort to obtain documents under Section 220.  The analysis was an attempt not only to slow the race to the courthouse but also to reduce the number of lawsuits filed.  There may be some impact on the latter but not on the former. 

The case arose following statements by Hecla Mining Company that lowered projections for silver production and a statement by the United States Mine Safety and Health Administration ("MSHA") that disclosed safety violations by Hecla.  The statement was quickly followed by two securities cases alleging violations of Rule 10b-5 and seven derivative suits.  Some were filed in Delaware and some in Idaho, both in state and federal court.  Two stockholders who did not file suit sought documents under Section 220.  With respect to the case in Delaware, plaintiffs alleged a Caremark claim. 

Defendants sought dismissal and the court found that the complaint lacked "particularized facts supporting a reasonable inference that a majority of the Board faces a substantial risk of liability".  As a result, plaintiffs had not sufficiently alleged demand futility.  The court then addressed the consequences of the dismissal. 

The Vice Chancellor had a point to make.  In his court, those who did not precede a Caremark claim with the exercise of inspection rights risked punishment, at least where the failure was unexplained . "Wholly missing was any explanation as to why the Souths did not use Section 220 before filing suit, as the Delaware Supreme Court has recommended repeatedly."  As a result, "dismissal of the complaint with prejudice as to the Souths is a fitting consequence that does not seem likely to work any prejudice on the corporation."

A dismissal with prejudice, however, did little to slow the race to the courthouse.  Plaintiffs still had an incentive to file quickly, even if they risked dismissal.  The Vice Chancellor, however, addressed this incentive.  He noted that dismissal with prejudice of someone who filed quickly essentially penalized the shareholders that took steps to invoke their inspection rights. 

As noted, good faith disagreements exist over the extent to which a dismissal with prejudice as to the named plaintiff could have preclusive effect on the efforts of other stockholders to bring suit, including those stockholders who have attempted to use Section 220. After considering the Souths' pleading, it concerned me that if a different stockholder carefully investigated the events at the Lucky Friday mine, uncovered a meritorious claim, and wished to pursue it, the potential combination of a broad preclusion rule together with all-too-predicable results of the Souths' litigation strategy could bar the diligent stockholder from suing.

He ultimately decided that the dismissal with prejudice applied only to the existing plaintiffs, not to other possible plaintiffs.  To reach that result, he concluded that "another stockholder still can sue if the first plaintiff provided inadequate representation."  He then made a "finding of inadequacy" and, as a result, determined that the dismissal of the complaint "should not have preclusive effect on the litigation efforts of more diligent stockholders".  

The finding of inadequacy was grounded on the failure of plaintiffs to first seek to inspect documents under Section 220.  The failure, according to the court, created a presumption that the shareholder had acted in a disloyal fashion. See Id. ("When a stockholder rushes to file a Caremark claim without first conducting an adequate investigation to determine whether or not there is a connection between the corporate trauma and director action or conscious inaction, the stockholder acts contrary to the interests of the corporation but consistent with the interests of the plaintiffs' firm that files the suit. This recurring scenario supports a presumption that the plaintiff has acted disloyally and is not an adequate fiduciary for the corporation.").

The presumption was limited to Caremark claims.  Id.  ("This requirement differentiates a Caremark claim from other types of derivative actions in which a plaintiff challenges a specific and identifiable board decision. In such a case, a plaintiff may well be able to plead particularized allegations without using Section 220 that are sufficient to survive a Rule 23.1 motion to dismiss"). 

The court left open the possibility that the presumption could be rebutted.  The shareholder could either produce "evidence that calls into question the requisite facts giving rise to the presumption" or could rebut the presumption by "producing evidence directly contrary to the presumptive inference."  The former could be accomplished by alleging facts "showing that the plaintiff did not file hastily and conducted a meaningful and thorough investigation."  The latter could be accomplished by adducing facts demonstrating that a quick filing "benefited the corporation and not just the plaintiffs' law firm."  Plaintiffs, however, were unable to rebut the presumption. 

We will discuss the implications of this decision in the next post.


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 7)

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits.

We would be remiss if we did not consider the Caremark analysis employed by the court in Pyott.  In what has to be more unusual than a finding that the board violated the Blasius standard, the court concluded that the shareholders in Pyott sufficiently alleged a Caremark violation.  Such a claim could arise where the alleged conduct involved conscious behavior to cause a violation of the law.  As the court explained:

by consciously causing the corporation to violate the law, a director would be disloyal to the corporation and could be forced to answer for the harm he has caused. Although directors have wide authority to take lawful action on behalf of the corporation, they have no authority knowingly to cause the corporation to become a rogue, exposing the corporation to penalties from criminal and civil regulators. Delaware corporate law has long been clear on this rather obvious notion; namely, that it is utterly inconsistent with one's duty of fidelity to the corporation to consciously cause the corporation to act unlawfully. The knowing use of illegal means to pursue profit for the corporation is director misconduct.

The plaintiffs in Pyott sufficiently alleged this type of behavior.  The plaintiffs alleged that the board approved business plans "premised on illegal activity."  According to the court:  "The Board kept Allergan's business plan in place even after the . . . FDA inquiries illustrated the extent of Allergan's regulatory exposure."  These and other allegations were sufficient to "reasonably infer that the Board knowingly approved and monitored a business plan that contemplated illegality." As the court concluded:  "At the pleadings stage, I believe the plaintiffs are entitled to the reasonable inference that the Board oversaw company-wide efforts to promote off-label use of Botox for treating migraine headaches, which was not an FDA-approved use at the time."

The facts, therefore, look to be unusual.  It will be a decidedly rare case where plaintiffs can present sufficient allegations that a board knowingly approved a business plan that "contemplated illegality."   Nonetheless, the court took the same allegations examined by the California court and reached a different outcome.  Moreover, the court did so in a manner that benefited shareholders.  Were there to be a few more cases with similar outcomes, this Blog might have a harder time justifying the management friendly appellation usually given to the Delaware courts. 

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


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 6) 

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits.

What are the implications of the decision?  First, the case could be criticized because it was not limited on its face to Caremark actions.  The decision seemed to impose a duty to inspect in all derivative actions.  A subsequent case, as we will discuss tomorrow, however, made clear that the analysis was limited to Caremark actions, circumstances where the need to inspect may be stronger than in other types of derivative suits.  Moreover, the subsequent case also clarified that the presumption against rapid filing of Caremark actions could be rebutted.  So we will put those criticisms aside. 

The clear intent of the opinion is to force counsel for shareholders to slow down the race to the courthouse, be more deliberative in formulating a case, and, ideally, actually deciding in some cases not to bring an action.  Will this occur?  Yes and no.

Clearly, counsel bringing these cases in Delaware will know that they will receive short shrift in VC Laster's courtroom if they do not first invoke inspection rights.  Whether the other jurists in Delaware will follow his approach remains to be seen. 

But invoking inspection rights will delay the filing only in Delaware.  Unless courts in other jurisdictions apply the same approach, there will be no impediment to filing a quick action in a non-Delaware jurisdiction.  To the extent that these plaintiffs survive a motion to dismiss, they will control the litigation and gain everything in discovery that the Delaware shareholders tried to obtain through an inspection demand.  As a result, this approach may in fact encourage litigation outside of Delaware.  See 2012 COLUM. BUS. L. REV. 427, 491 (2012) ("As we document elsewhere, since the mid-1990s, the rate of corporate litigation involving Delaware companies has increased, and the proportion of cases filed in Delaware courts has fallen.").

To the extent the non-Delaware court dismisses the action, Pyott makes clear that in at least one courtroom, shareholders will suffer the same fate unless they have invoked inspection rights.  At the same time, this obligation will at least in some cases result in a stronger complaint being filed in Delaware than in the non-Delaware jurisdiction.  It is possible that a few of them might survive a motion to dismiss, something that occurred in this case.     

That possibility depends upon the Delaware courts.  To the extent that Pyott effectively mandates the use of inspection rights as a precondition to a Caremark action in Delaware, it is effectively imposing on plaintiffs additional cost and additional delay.  The costs and delay will only be beneficial if in fact they sometimes result in a case surviving a motion to dismiss that otherwise would not have. 

This occurred in Pyott.  But as we noted, counsel for shareholders in the California action received all of the material obtained from the inspection request by other shareholders.  In other words, the Delaware case was allowed to go forward but there was no evidence that the complaint was any better than the one dismissed in California.  To the extent the Delaware courts continue to dismiss almost all of the Caremark claims brought by shareholders, Pyott potentially makes the process more expensive without providing any compensatory benefit to make up for these additional costs.

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


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 5)

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits.

Having identified the idealized version of the shareholder derivative suit (at least in a Caremark context), the court sought to turn this version into the reality. 

In reviewing the facts of the case at hand, the Chancery Court concluded that the firms filing the California actions "failed to provide adequate representation."  As a result, the dismissal in California was not determinative of the motion to dismiss the action in Delaware.

The characterization of California counsel was not, in the end, based upon the merits of the complaint but solely from the decision to file quickly.  The case, the court reasoned, "exemplif[ied] the race-to-the-courthouse problem."  Within 48 hours of the settlement between Allergan and the Department of Justice, a derivative suit was filed in Delaware.  Three additional complaints were filed within weeks of the initial suit in California. 

The complaints were "filed hastily for one reason only: to enable the specialized law firms to gain control of a case that could generate legal fees."  As a result, the company was forced to "fund the teams of the lawyers hired by the individual defendants to respond in each jurisdiction, address coordination issues, and brief parallel motions to dismiss." The court viewed the actions of the California law firms as a failure to "fulfill the fiduciary duties they voluntarily assumed as derivative action plaintiffs." 

Presumably California counsel should have delayed filing and invoked inspection rights.  Had they done so, they would have had additional information to use in deciding whether to bring the action.  Yet in fact, they had that very information.  A shareholder in Delaware had successfully made a demand to inspect records at Allergan and the materials were given to the plaintiffs in the California actions.  California plaintiffs "used the materials to file an amended complaint. and used in the amended complaint."

So it wasn't about the inadequacy of the complaint.  It was about the decision of the California plaintiffs to file quickly.  As the Vice Chancellor opined:

the fast-filing plaintiffs already had shown where their true loyalties lay. Asking for and receiving the benefit of another lawyer's work did not rehabilitate them. It rather evidenced their continuing desire to control the case. In this regard, I disagree that the policy goal of encouraging plaintiffs to use Section 220 will not be undercut by a rule that affords priority to fast filers if the corporation gives them the same books and records that a diligent stockholder fought to obtain. . . . Under the rule enunciated in King I, the issue would not arise because stockholders like the California plaintiffs would not be able to file fast, suffer dismissal, and then ask for books and records to try again.

In other words, the case amounted to a warning.  Counsel bringing a Caremark action without first invoking inspection rights (and presumably undertaking some kind of deliberative process over whether to bring the case) incurred the risk that a Delaware court would view them as failing to provide adequate representation.

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


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 4) 

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits.

What about derivative suits from the shareholder perspective?  As the court described, shareholders seek to "displace the board's authority."  Particularly in Caremark style cases, they have a difficult burden of showing a relationship between some type of corporate calamity and the board of directors. Ideally, shareholders would benefit from this type of suit only "if there was a risk-adjusted prospect of a net-positive recovery."  

To accurately engage in this calculation takes time.  Shareholder would need to "hire well-qualified counsel" who would need to "conduct an investigation and seek books and records".  With the requisite documents in hand, they could "evaluate whether it made sense to sue." 

The books and records might show that the board had an appropriate monitoring system in place, but that the system did not alert the board. Or the books and records might show that despite their good faith efforts, the directors were misinformed or misled. Under these or other circumstances, the hypothetical stockholder collective logically might decide not to sue, preferring to leave their elected fiduciaries to the task of remedying the harm suffered by the corporation and dispensing with expensive litigation that likely would founder on Rule 23.1. 

There also might be information obtained in the inspection request that strengthened the suit.

if the books and records showed director misconduct, then the stockholders could decide to pursue a claim. Their counsel at that point would be well positioned to plead demand futility and survive a motion to dismiss. Importantly for all concerned, the costly process of briefing and arguing motions to dismiss would take place once, based on the stockholders' post-inspection complaint.

In other words, a more deliberative process might result in a determination that a suit should not be filed.

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


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 3)

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits.

The harm from fast filing of complaints in derivative suits is, according to the court in Pyott, the filing of meritless cases.  These filings impose on companies unnecessary defense costs.  This in turn imposes costs on shareholders.  The problem is apparently limited to shareholder initiated actions.  It does not apply to the process used by the board in deciding whether to bring an action. 

Absent "doubt" about the "directors' ability to make disinterested and independent decisions about litigation," the court reasoned, the board is "optimally positioned to make decisions on behalf of the corporation and, if appropriate, pursue litigation."  Directors are in a position to investigate, to access internal information, and "[p]erhaps most significantly, the board can take into consideration and balance the interests of multiple constituencies when determining what outcome best serves the interests of stockholders."

This analysis gives too much credit to the system of board review.  It is in fact accurate to suggest that the board has more information and is potentially in a better position to weigh all of the competing interests.  But what it can do and what it does are two different things.  In fact, boards invariably seek dismissal of derivative suits.  See La. Mun. Police Emples. Ret. Sys. v. Morgan Stanley & Co., 2011 Del. Ch. LEXIS 42 (Del. Ch. March 4, 2011) (noting that directors "typically" refuse demand for litigation in derivative context).

In other words, the analysis in this case deals with the costs associated with an excessive number of derivative suits brought by shareholders.  What it does not address are the costs associated with an inadequate number of suits brought by management.  

rimary materials can be found at the DU Corporate Governance web site.


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 2)

We are discussing La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) and its potential impact on Caremark style derivative suits. 

The case involved derivative suits filed against Allergan following a guilty plea to a criminal misdemeanor and the payment of $600 million in civil and criminal fines.  Multiple suits were filed, including one in Delaware (filed by the Louisiana Municipal Police Employees' Retirement System) and another in California.  The California action was dismissed without prejudice and then dismissed a second time with prejudice. 

In Delaware, the action was stayed pending an attempt to inspect the books and records under Section 220 by a shareholder, UFCW Local 1776.  UFCW eventually intervened and, along with other plaintiffs, filed a second amended complaint (consisting of 84 pages and 241 paragraphs). 

Defendants sought dismissal.  In part, they based their argument on the actions of the California court.  They asserted that the decision had collateral estoppels effect.  The Chancery Court in the end said it did not but in the course of the opinion took a swipe at the "race to the courthouse" dynamic that apparently takes place with respect to derivative suits.    

The court acknowledged that the race was a product of the structural nature of derivative suits.  Derivative suits were, as the court reasoned, often brought by firms with expertise in the area.  Id.  ("For publicly traded Delaware corporations, the enforcement of fiduciary obligations is largely carried out by specialized plaintiffs' firms who bring claims on a contingent basis.").  These firms were compensated in the form of fees but only if they achieved results. 

In order to obtain the requisite "results," these firms had to obtain control over the litigation.  Control, however, often went to the first to file. This imposed pressure on counsel to file suits quickly.  As the Vice Chancellor put it:  "No role, no result, no fee."

Rapid filing could be beneficial but only, according to the court, in a narrow set of circumstances where expedited action is called for.  Id.  ("When fast-filed complaints follow the announcement of a transaction or other event that likely will require expedited litigation, they at least perform the beneficial function of identifying the firms who wish to compete for leadership status. In a quickly evolving deal setting, fast-filing enables a leadership structure to be put in place so that expedited litigation can begin in earnest."). 

Where, however, expedited action was not required, "any administrative benefit [from fast filing] disappear[ed]."  The reason?

[H]astily filed complaints have little chance of surviving a Rule 23.1 motion, yet the defendant fiduciaries must respond, and the corporation must underwrite the costs of defense, either directly through indemnification and advancement or indirectly through insurance.

In other words, the presumption is that quick filed cases will be meritless.  Rapid filing, therefore, requires companies to incur defense costs in connection with meritless cases.   

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


The Race to the Courthouse: La. Mun. Police Emples. Ret. Sys. v. Pyott (Part 1)

It has been a long time coming but the decision by VC Laster in La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012) deserves some comments.   

The case turns mostly on the right of Delaware courts to decide whether the dismissals of derivative suits in other jurisdictions have preclusive effect within the state.  At least where the action was brought by different shareholders, the Chancery Court concluded that an earlier dismissal by California courts was entitled to some weight but otherwise did not bind the Delaware judiciary.  Unsurprisingly for a proud and talented judiciary, they would make up their own mind. 

Yet the opinion contains much more than a discussion of this one issue.  The decision strongly encourages shareholders to bring their action in Delaware and strongly encourages them to avoid filing until after having made a demand to inspect corporate records, at least in cases alleging a Caremark violation.  The court also showed the benefits of this approach by upholding a Caremark claim. 

The case is an effort to slow down the race to the court house in certain types of derivative suits.  It is trying to impose on plaintiffs a more deliberative process that fundamentally pushes shareholders to inspect documents before deciding whether to file an action.  We will assess the likely effectiveness of this approach in subsequent posts. 

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


Delaware Law, Voidable Transactions, and the Implications for the Duty of Loyalty: SPTA v. Volgenau 

One classic example of a shift in Delaware law to the detriment of shareholders occurred in connection with a misapplication of Section 144 of the DGCL.  The provision deals with transactions involving director conflicts of interest and provides that no agreement shall be "shall be void or voidable" as a result of the conflict where the transaction is approved by shareholders, disinterested shareholders, or is otherwise fair. 

The meaning of the provision is plain.  It was intended to prevent conflict of interest transactions from being voidable (something that was possible under the old common law standard).  Nonetheless, Delaware courts have misapplied the provision and used it to significantly change the standard of review for conflict of interest trnasactions.  The courts have concluded that Section 144, if properly used, results in the application of the duty of care rather than the duty of loyalty to a conflict of interest transaction.

The incorrect nature of the interpretation is clear from the language of the statute (it speaks only to voidability) and from the standards set out in the statute.  Voidability is avoided through a showing of fairness, approval by disinterested directors, or approval by shareholders.  Despite suggestions by the Delaware courts to the contrary, the statute does not require approval of the transaction by disinterested shareholders.  Thus, if Section 144 were read to change the standard of review (instead of addressing only voidability), it would effectively be allowing a change in the standard in the unjustifiable circumstances of approval by interested shareholders.  For a more detailed discussion of this issue, see Returning Fairness to Executive Compensation

We note all of this because of the recent decision by the Chancery Court that shows how Section 144 ought to work.  In Southeastern Pennsylvania Transportation Authority v. Volgenau, 2012 Del. Ch. Lexis 206 (Del. Ch. Aug. 31, 2012), the court had to interpret Section 124, the ultra vires provision.  The provision provided that "[n]o act of a corporation . . . shall be invalid by reason of the fact that the corporation was without capacity or power to do such act" but provided that the lack of authority could only be raised in certain circumstances, including "a proceeding by a stockholder against the corporation to enjoin the doing of any act or acts".

Plaintiffs challenged a merger approved by the board and argued that the transaction was ultra vires because it violated the articles of incorporation.  Defendants sought dismissal of the action alleging that plaintiffs had not met the requirements of the statute because the action was for damages, not an injunction.

The court declined to dismiss the action, however.  It noted that Section 124 spoke to voidability, that is a claim "that the act could not occur."  Actions by corporations that are not voidable under the statute could still be challenged as a violation of the board's fiduciary obligations.  The court noted that the Section did not speak to fiduciary obligations.

The General Assembly could have stated in 8 Del. C. 124 that a director's decision to cause a corporation to take an act in violation of the corporation's certificate of incorporation shall not constitute a breach of that director's fiduciary duties. But the General Assembly did not do that. Instead, it enacted a statute directed solely to the acts of corporations that are beyond challenge or that may only be challenged in a limited manner.

The same paragraph could have been written about Section 144.  The provision references voidability but says nothing about fiduciary duties.  Nothing in Section 144 addressed the right of shareholders to challenge transactions that were found not to be voidable.  In other words, the standard of review for these transactions is a matter of common law, not a matter of statutory mandate. 

The inapplicability of Section 144 matters.  To the extent that the courts want to provide benefits to boards that use a disinterested approval mechanism, they have the flexibility as a matter of common law to decide those benefits.  Delaware courts already provide that disinterested approval of transactions with controlling shareholders (a type of transaction not expressly covered by Section 144) will not result in a shift from the duty of loyalty to the business judgment rule but simply results in a shift of the burden of showing unfairness to the challenging shareholders. 

A shift in the burden would mean that fairness still mattered.  The terms of the transaction would be relevant to the analysis.  Shareholders would not be limited to the impossible standard of waste.  The result would be a more exacting standard of review by directors and, in the case of executive compensation, downward pressure on amounts.  Yet as long as the courts point to Section 144, they can lay the blame for an inadequate standard of review at the feet of the Delaware legislature. 

Primary materials are posted on the DU Corporate Governance web site


Special Committees and the "Controlled Mindset" -- Americas Mining Corp. v. Theriault (Part 3)

As for the "controlled mindset" analysis of the Chancery Court, the Supreme Court had little specific to say about it. The Court mentioned it a few times and noted that an analysis of entire fairness required the Chancery Court to apply "a disciplined balancing test".  The Court concluded that the record reflected that this "balancing" in fact had occurred. 

The record reflects that the Court of Chancery applied a "disciplined balancing test," taking into account all relevant factors. The Court of Chancery considered the issues of fair dealing and fair price in a comprehensive and complete manner. The Court of Chancery found the process by which the Merger was negotiated and approved constituted unfair dealing and that resulted in the payment of an unfair price.

The case demonstrates that the traditional safeguards -- independent directors and independent advisors -- do not invariably protect shareholders.  Special committees can still be subject to excessive influence of the controlling shareholder. 

Nothing in the opinion, however, suggested any meaningful method of determining when this untoward influence existed.  The use of the term "controlled mindset" was really a conclusion rather than an analytical framework.  Indeed, the determination was reminiscent of Potter Stewart's famous analytical framework, "I know it when I see it."

The case does demonstrate that the special committee approach used by the Delaware courts has significant problems.  Yet the practice of replacing substantive fairness with process is a continuing trend in the development of Delaware law. 

Some primary materials from the Chancery Court are posted on the DU Corporate Governance web site.


Special Committees and the "Controlled Mindset" -- Americas Mining Corp. v. Theriault (Part 2)

The Supreme Court affirmed the approach taken by the trial court with respect to the burden shifting nature of the Special Committee.  The trial court was found to have been correct in assigning the burden of proof only after the trial had occurred.  As the Court reasoned:

The Court of Chancery could not decide whether to shift the burden based upon the pretrial record. After hearing all of the evidence presented at trial, the Court of Chancery found that, although the independence of the Special Committee was not challenged, "from inception, the Special Committee fell victim to a controlled mindset and allowed Grupo Mexico to dictate the terms and structure of the merger." The Court of Chancery concluded that "although the Special Committee members were competent businessmen and may have had the best of intentions, they allowed themselves to be hemmed in by the controlling stockholder's demands."

The inability to resolve the burden until after the trial resulted in "practical problems for litigants".  Nonetheless, it was an inevitable consequence of the standard.  

In affirming the lower court, the justices tried to minimize the impact of their decision.  The Court described the shift in the burden to the shareholders as a "modest procedural benefit" (emphasis in original).  In other words, boards gained only a modest value in seeing the burden shift.  Moreover, the assignment of the burden was not invariably outcome determinative as the facts in Americas Mining illustrated.  See Id.  ("The Court of Chancery concluded that this is not a case where the evidence of fairness or unfairness stood in equipoise. It found that the evidence of unfairness was so overwhelming that the question of who had the burden of proof at trial was irrelevant to the outcome."). 

In fact, a "modest" benefit probably overstated the value that came with the shift in the burden.  Defendants asserted that the failure to determine the burden shifting issue prior to trial would discourage boards from using special committees.  The Court disagreed, citing the value of special committees. 

That argument underestimates the importance of either or both actions to the process component—fair dealing—of the entire fairness standard. This Court has repeatedly held that any board process is materially enhanced when the decision is attributable to independent directors. Accordingly, judicial review for entire fairness of how the transaction was structured, negotiated, disclosed to the directors, and approved by the directors will be significantly influenced by the work product of a properly functioning special committee of independent directors.

In other words, the benefits of a "properly functioning special committee" weren't modest, they were insurmountable.  If the committee was properly functioning, the burden wouldn't merely shift.  IN effect, shareholders would be subject to an irrefutable presumption of fairness.   In effect, the standard of review was not really entire fairness but the business judgment rule. 

Some primary materials from the Chancery Court are posted on the DU Corporate Governance web site.

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