One objection has not been addressed. The objection is that even if increasing shareholder access to the directorial nominating process and efforts to increase diversity on boards allow the selection of board members who are not beholden to top management, and who do not share the visions and viewpoints of that group, the new board members will be condemned to service as lonely and ineffectual dissenters and completely marginalized. The predicate assumption of the objection is almost certainly correct. Even the most ardent supporters of the reforms do not suggest that they will lead to boards of directors in which a majority of the members are truly independent of the CEO and other top managers. Even if the reforms are fully implemented, the likelihood for the foreseeable future is that the boards of publicly held corporations will continue to be dominated by directors selected by top management who tend to think like top management. However, the conclusion that the presence of one or two directors who do not share the viewpoints of top management will be totally ineffectual is not necessarily correct.
Well established and tested principles of social psychology suggest that the mere presence of even solitary dissenters can have a significant impact on the quality of decision making of groups such as a board of directors. Over sixty years ago, psychologist Solomon Asch demonstrated how group dynamics can lead to erroneous decision making. In Asch’s most famous experiment he placed the subject of his experiments in a room with several other “subjects” who were in fact actors who were collaborating with Asch. The subjects were instructed to pick out a which of three lines was closest in length to a fourth line. The “fake subjects” all sequentially announced their choice of which line, and deliberately chose the same blatantly wrong answer. Three quarters of the subjects were influenced by the fake subjects to choose the same wrong answer in at least one iteration of the experiment.
The ability of a even a lone dissenter to break the hold of group conformity was demonstrated in later experiments by Asch, and even more dramatically by an experiment in the early 1970s by psychologists Vernon Allen and John Levine. Allen and Levine used the same basic framework as Asch but expanded it in several respects. One of those ways was to break the fake subjects into three different groups. In one group, the “fake subjects” all unanimously adhered to the same opinion. In a second group, a fake subject dissented from the group consensus. However, the fake dissenting subjects convinced the real subjects (and the person purportedly “conducting” the experiment) that they were visually impaired and literally guessing at random. The researcher purportedly conducting the experiment “informed” the fake subjects, in front of the real subjects, that the fake subjects’ answers would not be recorded or count in the study. In the third group the dissenter was represented as no different from other members of the group.
Not surprisingly, the third group showed by far the lowest conformity among the real subjects of the experiment to deliberately wrong answers chosen by the majority of fake subjects. What is surprising is that conformity to wrong answers among the real subjects was significantly lower in the second group than in the group where no dissenter was present. The presence of a dissenting person whom the real subjects viewed as physically unable to ascertain a correct answer still seemed to reduce by a meaningful amount group pressure on the real subjects to pick an incorrect answer.
Do these experiments mean that directors who are selected by persons other than the top managers of publicly held corporations will routinely be able to prevent mistakes by directors who are dominated by the top managers of the corporation? Hardly. Unlike the true subjects in the psychological experiments, the continued participation of the board members on the board is usually dependent upon the good graces of top management. Nonetheless, the experiments do give some hope that the presence of shareholder nominated directors may sway some other directors to challenge some of the more irrational or ill considered decisions pushed by top management of publicly held corporations. We may not see a major change in the quality of board decision making, but we may see a decrease in decisions which, when considered in retrospect, cause observers to ask “how could the board possibly have believed that"? or “didn’t anyone see the obvious possible problems"?
Note: For a fascinating application of the above psychological studies to Supreme Court decision making (including very interesting comments on the process by Justice Breyer) see Ori & Rom Brafman, SWAY ch. 8 (2008).
]]>One of the reasons given for striking down the bylaw that reduced the size of the board was that it amounted to a removal of incumbent directors. Because directors had the same bylaw authority as shareholders, it potentially allowed directors to remove other directors by shrinking the size of the board. This in turn conflicted with the proposition that directors cannot remove other directors. As the court noted:
In general, the prohibition on directors removing directors amounts to black letter law. To do so would essentially allow directors to undo the will of shareholders. Yet in fact, matters are not so clear.
First, some states expressly allow it, at least if for cause. See Mass. Gen. Laws ch. 156B §51(c) ("any director, and any officer elected by the stockholders, may be removed from his office for cause by vote of a majority of the directors then in office. A director or officer may be removed for cause only after a reasonable notice and opportunity to be heard before the body proposing to remove him."). Some permit the removal of directors who were appointed by the board. See Minn. Stat. § 301A.223(2)(permitting removal by directors, with or without cause, where the director was appointed by the board to fill a vacancy, "the shareholders have not elected directors in the interval between the time of the appointment to fill a vacancy and the time of the removal" and removal is approved by a majority of the remaining directors). See also ND Cent. Code § 10-19.1-41(2)(same language).
Others allow for the authority if in the articles or a shareholder adopted bylaws. See NY Bus. Corp. Law § 706 ("The certificate of incorporation or the specific provisions of a by-law adopted by the shareholders may provide for such removal by action of the board, except in the case of any director elected by cumulative voting, or by the holders of the shares of any class or series, or holders of bonds, voting as a class, when so entitled by the provisions of the certificate of incorporation.").
Second, Delaware has no statutory prohibition on directors removing other diretors. The law in this area traced back to Bruch v. National Guarantee Credit Corp., 13 Del. Ch. 180 (Del. Ch. April 10, 1922). As the court in that case concluded:
This is a surprisingly thin reed to draw conclusions about the right of directors to remove directors. First it is only a Chancery Court decision. Second, it is premised on the idea that directors are elected by shareholders. Yet this is not true for directors elected by the board, suggesting that a different rule might be applicable. Third, the court did not deal with circumstances involving removal neither by directors nor shareholders. Thus, if directors were required to leave the board because of disability or the failure to meet board qualifications, the act of removal would be automatic and based upon criteria set forth at the time of election.
Finally, the court left often the possibility that such authority could be inserted into the articles. As the opinion stated: "Whether under the law of this state the certificate of incorporation may confer such power on directors is, of course, not a question involved in this case."
The usual rule that directors cannot remove directors is a sound one. But without a statutory basis, it is not quite as clear as VC Laster suggests. Moreover, the Delaware courts have shown a tendency to abandon black letter law when it is not in the statute and abandonment suits management. Examples? Vote buying and discrimination among shareholders of the same class of shares.
The opinion and a number of primary materials are posted at the DU Corporate Governance web site.
]]>In one case, Crown Emak Partners, a shareholder holding 28% of the voting shares, solicited consents to reduce the size of the Board to three directors. Because Crown had the right to designate two directors on the board, the effect would give Crown a majority. A second bylaw provided that a special meeting would be called to elect the third director. Crown succeeded in obtaining sufficient consents to adopt the bylaws. The consents were executed by DTC on behalf of the beneficial owners.
One group of shareholders (Take Back EMAK or TBE) sought to obtain the consents to replace two of the five directors and fill three of the vacancies, thereby obtaining control. As the soliciation proceeded, the TBE Group obtained consents equal to 48.4% of the common stock. In order to obtain the additional votes. Donald A. Kurz, an incumbent director and member of the TBE Group, agreed to purchase from another shareholder, Boutros.
Because, however, the shares were subject to restrictions on sale, Kurz could only obtained title after the restrictions were lifted. Despite the future date of delivery, Boutros executed an irrevocable proxy. According to the purchase agreement:
The consents apparently provided TBE with enough shares to implement their plan to take control of the board. While the TBE Group appeared to have a majority, a portion of its support came from street name owners. Because an omnibus proxy had not been obtained from DTC, the street name votes were disallowed.
In the litigation that followed, Vice Chancellor Laster had to determine: (1) the legality of a bylaw that reduced the size of an incumbent board; (2) the validity of the purchase of votes by Kurz under vote buying analysis; and (3) the consequence of the failure to obtain the omnibus proxy. We will deal with the issues seriatim.
For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?
The opinion and a number of primary materials are posted at the DU Corporate Governance web site.
]]>Any notion that he would enter the legal fray quietly and gradually was dispelled with his 70 page decision in Kurz v. Holbrook, 2010 Del. Ch. LEXIS 24 (Del. Ch. Feb. 9, 2010). The case is to some degree a tutorial on various aspects of Delaware law. There is a detailed discussion about the appropriate methods of removing directors from the board. The wide ranging discussion, however, likely invalidates certain types of bylaws that mandate the resignation of directors who cease to be qualified after joining the board.
Most interestingly is the discussion of the voting system for owners using street name accounts. In public companies, these shares are typically held by brokers (and sometimes banks) who then place them into a central depository (The Depository Trust & Clearing Corporation or DTC). It is the depository that ultimately holds record title and is treated as the owner under state law. Typically, however, DTC executes an omnibus proxy in favor of the depositing banks and brokers, tranfering voting rights to them.
In this case, the parties engaged in a consent contest. Both, however, failed to obtain the omnibus proxy. The Chancery Court had to determine whether the votes cast by assorted brokers could be counted in the absence of the formalistic but necessary piece of paper. In concluding that they could, VC Laster effectively set aside the obligation to focus on record ownership. The case raises any number of questions about the continued reliance on record ownership in other circumstances.
We will spend a few posts exploring the case and its implications.
For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?
The opinion and a number of primary materials are posted at the DU Corporate Governance web site.
]]>The trial court judge granted summary judgment for the appellees stating that the appellant could not bring a direct action suit because he failed to allege injuries apart from those suffered by the other shareholders. The only issue up on appeal was whether the appellant could bring a direct action for breach of fiduciary duty or whether the claim was derivative.
Shareholders may bring a direct suit only in their own right to redress an injury sustained directly by them individually. Based upon this rule, the Florida Appellate Court stated that none of the appellant’s alleged injuries established the individualized harm necessary to bring a direct action. Furthermore, the court held that all allegations brought by the appellant affected all of the shareholders equally. Thus, the Florida Appellate Court affirmed the trial court’s ruling that in order to pursue the appellant’s claim he must bring a derivative action.
The primary materials for this post are available on the DU Corporate Governance website.
]]>Paolino, the Chairman and Chief Executive Officer of Mace from 1999 until May 20, 2008 was terminated by the company. Upon dismissal, he filed a demand for arbitration, and claimed that he was terminated in retaliation for insisting that the Board publicly disclose certain material facts and events affecting Mace’s business, which the Board refused to do.
Mace filed counterclaims. Mace argued that Paolino refused to follow the Board’s direction, refused to properly inform and/or seek Board approval for Paolino’s actions, refused to comply with Mace’s corporate governance principles and bylaws, refused to reduce corporate overhead and expense as directed by the Board, and inappropriately interfered with the Board’s investigation of matters. Mace alleged that Paolino’s actions constituted willful misconduct, which according to the terms of an employment agreement, negated any severance payment Mace may have owed to Paolino.
Paolino sought indemnification and advancement of fees and expenses incurred in defending against counterclaims. Mace moved to dismiss the complaint alleging that Paolino was not entitled to advancements because Paolino was not defending against the counterclaims, a carve-out in the provision barred recovery, and the counterclaims did not arise out of Paolino’s role as a director or officer of Mace.
The court stayed the action to the extent it sought indemnification pending final disposition of the arbitration, but continued Paolino’s action to enforce the mandatory advancement right granted to him under Mace’s Bylaws. Under Section 145(e) of Delaware’s General Corporation Law, corporations may pay expenses incurred by directors and officers in defending any civil, criminal, administrative or investigative action, suit or proceeding “in advance of the final disposition of such action.” Pursuant to this authority, Mace adopted Bylaws that entitled current and former directors and officers of Mace to broad and mandatory indemnification and advancement rights. As the Bylaws provided:
Because Paolino was defending against the counterclaims, he was entitled to advances under the Bylaws.
Mace argued, however, that Delaware precedents did not require the advancement of expenses. Mace alleged that where a covered person initiated a proceeding and a corporation asserted counterclaims defensively, those claims were not defensive. Mace further argued that the counterclaims were part of the covered person’s offensive proceeding and did not qualify for advancements.
The Vice Chancellor held that Mace’s argument contradicted the core public policies underlying Section 145. The Section was intended (a) to allow corporate officials to resist unjustified lawsuits so that the corporation will bear the expenses of litigation in the event the Plaintiffs are successful; and (b) to encourage capable candidates to serve as corporate officers and directors because the corporation will absorb the cost of defending their honesty and integrity. The court held that the procedural posture of the claim wasn't important, only whether the office or director was placed in a posture of having to defend.
The court also stated that the carve-out within the Bylaw did not bar Paolino from receiving advancements. Mace argued that the carve-out in Section 6.01 foreclosed advancement because Paulino initiated the proceeding. The carve-out provided that payments would not be made where the officer or director "initiated" the proceeding unless "authorized by the Board of Directors of the Corporation.” Furthermore, Section 6.02 provided that “the right to indemnification conferred by Article 6 shall include the right to be paid by the Corporation the expenses incurred in defending any such proceeding in advance of its final disposition.” The court held that Paolino was not seeking advancements or indemnification in connection with a proceeding initiated by him. Rather, the counterclaims were part of the proceeding that Mace initiated because the counterclaims were a separate cause of action for purposes of Section 145 analysis.
Lastly, the court stated that the employment agreement between Paolino and Mace did not alter his right to recover. Mace argued that Paolino was not entitled to recover because the counterclaims did not arise “by reason of the fact” that Paulino was CEO and Chairman of Mace, but rather out of his employment agreement. Plaintiff needed only to show the existence of a "nexus or casual connection between a claim and [the officer's] official capacity." The court concluded that the counterclaims broadly asserted that Paolino breached his fiduciary obligations and contractual, statutory, and common law duties owed to Mace. Thus, the counterclaims implicated his duties as an officer and director.
Additionally, the requisite connection was established “if the corporate powers were used or necessary for the commission of the alleged misconduct.” Under this test, a claim against a director or officer for matters that related to a corporation would fall within Section 145, even if the individual was a party to an employment agreement. The court further stated that in order for the corporation to avoid advancements, the claim must involve a specific and limited contractual obligation without any nexus or casual connection to official duties.
The primary materials for this post are available on the DU Corporate Governance website.
]]>According to the SEC, Assurant Solutions, a subsidiary of Assurant, entered into an Aggregate Stop Loss Reinsurance treaty with American Re-Insurance Company (“American”) dating back to 1992 and renewed annually. The treaty consisted of a written policy shifting the risk of losses from Assurant Solutions to American in certain conditions and an oral verbal agreement on the side known as a “handshake” agreement. The handshake agreement conveyed that if American paid more in claims than Assurant Solutions paid in premiums, then Assurant Solutions would reimburse American for the difference. The handshake agreement also stipulated that if Assurant Solutions paid more in premiums than American paid in claims, then American would pay the difference to Assurant Solutions.
Pursuant to the handshake agreement, American made a payment of $10 million to Assurant Solutions in 2004. Assurant accounted for the $10 million using reinsurance accounting, whereas under generally accepted accounting principles (“GAAP”), Assurant should have accounted for the payment using deposit accounting.
Under GAAP, the deposit accounting method treats the payment as a return of a deposit or loan payment. The deposit accounting method is used where there is no risk transfer and only affects the balance sheet of a company’s financials. The reinsurance accounting method is used when risk has been transferred to the reinsurer under a reinsurance treaty. This method allows the company to offset losses with the recovery payment and reduces the amount of losses on a company’s income statement. Since the handshake agreement contained a reimbursement provision, under GAAP this would negate the transfer of risk and require deposit accounting.
Assurant’s agreed upon civil penalty of $3.5 million also takes into account failure to comply with subpoenas in a timely manner.
The primary materials for this case may be found on the DU Corporate Governance Website.
]]>Shareholder Rights Plan: An effort to Control eBay’s Interest in Craigslist?
Defendants also adopted a Rights Plan (“Rights Plan” or “Poison Pill”) designed to address the threat of a potential hostile takeover, specifically in the event of a “death problem." They explained that, so long as defendants, the majority stakeholders, held their shares and did not sell them, eBay could not acquire the company. However, the death of either majority stakeholder would result in automatic liquidation of their shares, which in turn would make Craigslist more susceptible to a hostile takeover. Therefore, while the threat of a hostile takeover was not imminent, defendants argued that implementing a Rights Plans was justified because it mitigated against a potential future threat.
eBay contended that this Plan was an unnecessary measure and that effective estate planning could cure the “death problem." Further, composition of the Plan benefited the defendants to the detriment of eBay. Under the Plan’s terms, Newmark and Buckmaster could freely transfer shares to each other, whereas eBay would be limited to transfers of stock to a successor in interest by merger. Moreover, the right of directors to veto or waive the Plan at their discretion creates an unfair disadvantage for eBay.
Defendants responded that Craigslist created a plan that protected the company from eBay and any acquisition. Furthermore, the Rights Plan only took affect when eBay or one of the other shareholders decided to sell their respective shares. The Plan allowed Newmark and Buckmaster the power to veto; however, defendants argued that long-term interests of the company, and not the personal interests of Newmark or Buckmaster, would guide use of the veto.
eBay argued that defendants’ power to waive the poison pill accentuated the defendants' control and disadvantaged eBay. In response, defendants brushed aside eBay’s concern by concluding that sale of a director’s shares was not an imminent concern. They added that eBay’s complaints about the Plan were based on speculation that future actions would trigger the Plan and that defendants would inevitably breach fiduciary duties. Defendants’ also noted that because eBay had not submitted to the company’s Right of First Refusal agreement, it is currently able to sell its entire stake without triggering the Rights Plan and without Board approval, provided it does not sell more than 15% of the company to a single purchaser.
Company ROFR: Cornering eBay to Surrender Liquidity of Shares?
eBay’s complaint alleged that Newmark and Buckmaster approved a plan to authorize and implement a stock issuance program premised on a ROFR Agreement executed in early 2008 without financial advice, third-party expertise, or notice to and involvement of eBay.
The ROFR, once accepted by a stockholder, provided Craigslist with the right of first refusal in the event that a stockholder desired to transfer its shares to a third party. In return, the company would issue one “reorganization share” of common stock in Craigslist for every five shares of common stock owned by that stockholder. According to defendants’ pretrial brief, the ROFR agreement allowed Craigslist to purchase shares whenever the Board determined the sale was below market price or to a purchaser that was hostile or incompatible with Craigslist.
The complaint asserted that because Craigslist was a privately held company comprised of only three stockholders, the ROFR was an effort to strip eBay of the ability to sell its interest to anyone not controlled by Newmark or Buckmaster. Moreover, if either Newmark or Buckmaster exercised the ROFR with respect to the other's shares, they would own over 50% of the Craigslist shares.
Exercise of the ROFR also unfairly disadvantaged eBay because Newmark and Buckmaster maintained the ability to waive the implication of the company ROFR. Ed Wes, counsel hired by Craigslist to act on these transactions, was also hired by the insider directors in their personal capacity for estate planning matters. Both the ROFR and the poison pill contained “carve out” provisions allowing the insiders to transfer shares for estate planning reasons without triggering the restrictions contained in either documents.
Thirdly, there was little cost to Newmark and Buckmaster because they were already subject to personal refusal rights held over each other’s shares, while eBay had no such obligation. Finally, because eBay was a competitor of Craigslist, eBay argued it deserves a higher premium for submission to the company ROFR.
In contrast, defendants argued the ROFR encouraged full participation and achieved the greatest benefit for the corporation as opposed to diluting eBay’s shares. eBay was offered the same opportunity to submit to the ROFR. Moreover, eBay was not unfairly burdened by implementation of such a governance measure. As eBay admitted, any acquisition of control by Newmark or Buckmaster under the ROFR was due to the equity stake of the shareholders at the time of exercising the ROFR and not inequitable treatment. Secondly, defendants argued that their ability to veto ROFR would be guided by the best interests of the company and not their personal interests.
Thirdly, while the defendants previously held personal refusal rights over each other’s shares, by submitting to the company ROFR they have in fact incurred a greater cost than eBay through the loss of those refusal rights by transferring them to the company. On the other hand, eBay would not be giving up any such right.
Finally, with respect to eBay’s assertion that its status as a competitor entitled eBay to a higher premium for the ROFR , the defendants stated this further supported the need for the ROFR. Overall, eBay was given the option to (1) submit to the ROFR, surrendering its right to control the liquidity of its shares; or (2) refuse to accept the ROFR agreement and face substantial dilution of its interest while losing important minority shareholder protections.
The arguments on both sides are strong and the outcome is expected to shed light on rights of minority shareholders. In its article, “Judge urges eBay, Craigslist to resolve dispute,” Associated Press highlighted the judge’s stance on the issue. Chancellor William Chandler III, the presiding judge, urged the parties to settle the dispute amongst themselves before he issues a ruling. The judge stated that such a resolution would benefit both parties, much more than what he may decide.
The pleadings and other primary materials for the post are available on the DU Corporate Governance website.
]]>In a complaint filed on April 30, 2008 (“Complaint”), eBay Domestic Holdings, Inc. (“eBay”) alleged that Craig Newmark (“Newmark”) and James Buckmaster (“Buckmaster”), the only two directors and majority stockholders of Craigslist, Inc. (“Craigslist” or “Company”), breached their fiduciary duties of care, loyalty, and good faith to eBay, the third stockholder, when they (1) approved a plan to implement a Right of First Refusal (“ROFR”) agreement; (2) adopted a Shareholder Rights Plan; and (3) amended Craigslist’s Charter and Bylaws to create a staggered board. Defendants denied such allegations and further stated in their pre-trial brief that adoption of such governance measures was protected by the business judgment rule. In addition, they asserted that eBay’s misconduct precluded it from obtaining an equitable relief.
In August 2004, a former Craigslist executive sold his 28% share to eBay. Newmark, Buckmaster, and eBay entered into a Shareholders' Agreement ("SHA") that imposed certain rights and obligations on the parties. Among other things, the SHA imposed: "(i) certain transfer restrictions and rights of first refusal on the shares held by eBay, Newmark and Buckmaster; and (ii) granted eBay informational, reporting and inspection rights and the right to approve certain transactions directly or through a director designated by eBay."
The agreement further provided that some rights and obligations of the parties would terminate upon eBay engaging in competitive activity. These included: "(i) eBay's right of first refusal to purchase equity securities sold or issued by the Company or to purchase the shares of Newmark or Buckmaster should either attempt to sell his shares, and (ii) Newmark and Buckmaster's right of first refusal to purchase eBay's shares should eBay attempt to sell its shares."
In 2005, eBay started Kijiji.com, an overseas company marketing classified ads. In 2007, eBay began marketing the services in the United States. Viewing the site as competition, the Board of Craigslist implemented protective measures, in addition to those outlined in the SHA, to ward off potential threats presented by eBay. These threats allegedly included the risk of future misuse of Craigslist’s confidential information; impairment of board functions by having an agent of a direct competitor influence Board decisions; and the threat of a future hostile takeover when the defendants' pass away and their respective shares become liquid.
The matter ultimately ended up in litigation, with eBay challenging the actions by Craigslist. The litigation raised a number of issues:
Standard of Review: Entire Fairness v. Business Judgment
In its pretrial brief, eBay urged that the court should use the stricter “Entire Fairness” standard because the majority shareholders, Newmark and Buckmaster, stood on both sides of the transactions when they authorized governance measures that unfairly benefited them to the detriment of eBay. eBay asserted this standard applies “unless the transaction is (1) recommended by a disinterested and independent special committee; and (2) approved by stockholders in a non-waivable vote of the majority of all the minority stockholders.”
Conversely, defendants’ pretrial brief stated that the business judgment rule applied here because the Board did not implement the governance measures by a unilateral action, a necessary prerequisite for enhanced scrutiny of their actions. The governance measures required and received proper shareholder approval. The defendants added that even if the shareholders are impacted differently under the measures, Delaware law did not require equal treatment of all shareholders in all circumstances, especially in situations where a shareholder poses a future threat to the enterprise.
Staggered Board: Staggered Board Squeezing Out eBay’s Directors?
Craigslist amended the certificate of incorporation to provide for a staggered board upon receiving notice of eBay’s competitive activity. eBay asserted that this action effectively removed eBay’s right to elect any director by cumulative voting as all shareholders would vote for one director instead of three at each election. Defendants contended the measure restricted eBay’s ability to unilaterally place conflicted eBay agents on the Craigslist Board. Furthermore, this measure protected (1) the company against further misuse of its confidential information and plans, and (2) the Board’s ability to function properly. Defendants further stated that eBay would still have the right to nominate directors.
eBay directly attacked the implementation of the staggered board by stating that the amendment required approval of directors’ actions by disinterested shareholders. In this case, the directors constructed this measure and authorized it as the shareholders. eBay further claimed the action imposed an unfair disadvantage because Newmark and Buckmaster owned the majority of Craigslist stock and are parties to a voting agreement under which each has agreed to vote for the other’s nominee.
Defendants replied that such a measure prevented any shareholder from unilaterally seating a nominee without support from other shareholders. They further argued that eBay understood that any competitive activity on its part would result in surrendering its claim to a Board seat. As a consequence, eBay would have to propose an acceptable independent board nominee in order for that person to be elected.
The pleadings and other primary materials for the post are available on the DU Corporate Governance website.
]]>According to an editorial in the WSJ, the SEC tried, in connection with the proposed settlement with BofA, to get the Bank's agreement to provide shareholders with access to the company's proxy statement for nominees. The Bank refused and it did not make it into the settlement. The editorial, however, described the efforts this way:
This comment warrants a response. It is an attempt to use scare tactics in place of analysis.
First, the comment suggests that access will unleash special interest groups, particularly, apparently, unions. We wonder in fact how many union pension plans will actually nominate directors. Indeed, we wonder how many union pension plans own more than 2% of the shares of a large public company, the apparent threshold for submitting a nominee. Thus, for example, the institutional ownership of ExxonMobile shows no unions among the top ten institutional investors (with the tenth largest owning under 1% of the company's stock).
Second, "special interest," whatever that means exactly (beyond union nominated directors apparently), is a pejorative slap at the identity of the shareholder nominating the director. It ignores the fact that it is not the nominating shareholder who is elected to the board but the nominating shareholder's candidates. Even if a nominating shareholder fits within someone's definition of "special interest" (a definition that will likely vary depending upon the background of the particular critic), their candidates for the board will only win if they can convince enough of the other shareholders of the candidate's superiority over those nominated by management. And, in this battle, management had a decided advantage. It can use the corporate treasury to convince shareholders not to elect the insurgent candidate.
In other words, its not about the identity of the nominating shareholder. Its about the right of shareholders to choose among competing candidates rather than be forced to accept, without meaningful choice, those nominated by management. Those raising the "special interest" shibboleth are effectively trying to prevent shareholder choice by preventing the nominations in the first instance. Ought it be that a decision is better made by the shareholders based upon the relative qualifications of the candidates?
Finally, the use of the "special interest" rubric also ignores the fact that the phrase rightfully ought to apply with equal strength to management nominated directors. These are directors who are nominated by management and often have preexisting ties with the CEO. They are likely, as we have written often on this blog, to have a predisposition in favor of the CEO.
The irony in all of this in the end is that had access been included in the proposed settlement with BofA, the likely result would have been no change in the board and no increase in nominations by shareholders for the board. Even with access, shareholders still must incur expense in connection with the proxy contest, something that discourages nominations. In fact, the only two companies with access bylaws (Cryo-Cell and Comverse) have yet, as far as this Blog knows, to receive a shareholder nominee.
For more on this topic, see The SEC, Corporate Governance, and Shareholder Access to the Board Room.
]]>Robert Bentley formed Bentley Financial Service, Inc. (BFS) to broker bank issued certificates of deposit (CD’s) with depositors. Brokers generally offered the CD’s at rates lower than what the banks paid, thereby earning the difference, or “spread.”
Brokers also sold CD’s with differing maturities than those offered by the bank. Brokers were obligated to inform investors of this “mismatching” of maturities. Moreover, when an investor purchased a CD with a shorter maturity, the broker was required to produce the funds needed to liquidate the investor's position at the expiration of the shorter maturity. The broker could either find a new investor for a short term CD, temporarily sell the long term CD to a bank with an agreement to repurchase, or require the investor to stay invested for the duration.
When Bentley began having cash flow problems to meet the demands of his customers he started selling fictitious CD’s to investors. Bentley would use the proceeds from the sale of fictitious CD’s to pay out prior investors in a typical Ponzi scheme structure. Bentley also employed the services of two other individuals, Ted Benghiat, owner of SFG Financial, Inc, (Benghiat) and Joseph Marzouca, Vice President of Peninsula Bank (Marzouca). On at least three occasions, both men provided Bentley with cash that helped keep "Bentley’s operation afloat."
After the SEC filed a civil action against Bentley, the court appointed David H. Marion as receiver for BFS. Marion then brought an action against Benghiat and Marzouca alleging that they aided and abetted or conspired in Bentley’s fraud. The jury found both Benghiat and Marzouca liable and awarded combined damages of almost $33 million. Benghiat and Marzouca moved for judgment as a matter of law, arguing that Marion, as the receiver for BFS, lacked standing because it was the investors, not BFS that suffered injury from Bentley’s fraud.
Marion argued, conversely, that Benghiat’s and Marzouca’s actions allowed Bentley to perpetuate his fraud further, causing the BFS to incur even greater losses than would have been otherwise possible. The court accepted the argument ("This claim, if plausible (and for purposes of this opinion we assume it is), steps over the relatively low standing threshold.") and concluded that the receiver had standing against those third parties who helped the management of that corporation perpetuate the fraud.
Despite the fact that Marion, as receiver, had standing to bring a claim against Benghiat and Marzouca, the court ultimately ruled that there was no liability. The defendants could not be liable to the extent they engaged in practices that increased the company's short-term liquidity, even when doing so allowed the company to "stay afloat long enough to put itself in a worse position than it was in prior to the cash infusion."
While the aid and financing that Benghiat and Marzouca provided to Bentley may have caused BFS to suffer additional harm by increasing its losses, those actions did not rise to the level of proximate causation. Bentley’s intervening act, how he used the financing, stood between the act of injecting cash into the business and the ultimate harm suffered by investors.
The primary materials in this case can be found at the DU Corporate Governance Web Site.
]]>On February 2, 2010, the Securities and Exchange Commission (“SEC”) published an interpretive release (available at http://www.sec.gov/rules/interp/2010/33-9106.pdf) intended to provide guidance on certain existing disclosure rules that may require a company to disclose the impact that business or legal developments related to climate change may have on its business. The release states that it is not intended to create new disclosure obligations, but rather is designed to clarify already existing SEC disclosure rules that require public companies to describe impacts of climate change and climate change related issues.
SEC Deliberation
The interpretive release was approved by a narrow 3-2 vote; drawing dissent from Commissioners Kathleen Casey[1] and Troy Paredes.[2] Commissioner Casey expressed concern that, by issuing this interpretive release, the SEC was indirectly taking a position on the debate over global warming.[3] Commissioner Paredes, on the other hand, noted concern with the requirement that registrants take into account reputational damage resulting from climate change matters. In his opinion such a requirement would only “foster confusion and uncertainty about a company’s required disclosures.”[4] In an SEC press release, Chairman Mary Schapiro reiterated that the SEC has not taken a stance on the issue of global warming, and that this release is intended to assist public companies in satisfying their existing disclosure obligations as they apply to climate change.
An Overview of the SEC’s Guidance on Climate Change Related Disclosures
The interpretive release states that it is intended only to clarify already existing disclosure rules and prefaces the guidance with a lengthy description of existing legislative and regulatory developments related to climate change. The release then goes on to briefly discuss current disclosure rules under Regulation S-K that could require an issuer to discuss climate change matters, including: Item 101 (Description of Business); Item 103 (Legal Proceedings); Item 303 (Management’s Discussion and Analysis); and Item 503(c) (Risk Factors). The interpretive release follows with a discussion of four topic areas that may trigger climate change disclosures pursuant to these existing requirements.
1. Impact of legislation and regulation. The interpretive release states that public companies should disclose the effects of both existing and pending environmental legislation and regulation on their business.
2. International accords. Although the United States is not a signatory to the Kyoto Protocol, some American companies or their subsidiaries may operate in signatory countries. Registrants are advised to consider, and disclose the impact of international accords relating to climate change, to the extent material.
3. Indirect consequences of regulation or business trends. Legal, technological, political and scientific developments regarding climate change may create new opportunities or risks by either creating demand for new products or services, or reducing demand for existing products or services. Such trends or risks may require disclosure in the description of business, MD&A or risk factors. The SEC provides the following examples of developments for consideration by registrants:
4. Physical impacts of climate change. The fourth topic addressed by the release is the physical impact of climate change such as increased storm severity, rising sea levels, changes in arability of farmland, and changes in water availability and quality. The SEC provides the following as examples of these impacts:
Conclusion
The SEC emphasized that it was adopting this interpretive guidance to remind companies of their existing obligations to consider climate change and its consequences as they prepare disclosure documents to be filed. Although the SEC had been petitioned by advocacy groups to specifically require disclosure of an issuer’s “carbon footprint,” the SEC declined to adopt such a requirement. However, the SEC reminds issuers that such disclosure may be necessary, however, to the extent that it is material. The SEC also reminds registrants that where there is a close question as to materiality, registrants should decide in favor of those whom the regulation was designed to protect. Finally, the SEC reminds issuers that climate change regulation is a rapidly developing area and registrants need to regularly assess their potential disclosure obligations given new developments.
The SEC is planning to hold a public roundtable on disclosure regarding climate change matters in the Spring of 2010. The results of the roundtable will be used by the SEC in determining whether additional guidance or rulemaking is appropriate.
[1] Speech by SEC Commissioner: Statement at Open Meeting – Interpretive Release Regarding Disclosure of Climate Change Matters by Commissioner Kathleen L. Casey, dated January 27, 2010 (http://www.sec.gov/news/speech/2010/spch012710klc-climate.htm).
[2] Speech by SEC Commissioner: Statement at Open Meeting – Interpretive Release Regarding Disclosure of Climate Change Matters by Commissioner Troy A. Paredes, dated January 27, 2010 (http://www.sec.gov/news/speech/2010/spch012710tap-climate.htm).
[3] Commissioner Casey states, “this guidance assumes that man made global warming and climate change are occurring as a result of greenhouse gas emissions and are likely to result in physical effects that will affect the businesses of registrants.”
[4] Commissioner Paredes states, “reputational damage… can be quite speculative” and such a requirement will encourage disclosures “that are unlikely to improve investor decision making and may actually distract investors from focusing on more important information.”
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In accepting comments, the Commission heard from a wide array of constituencies. That is not particularly surprising. But what was noticeable was the firm divisions between constituencies, without much in the way of middle ground. It was not unlike the democratic and republican divide on health care.
This could be seen with respect to the proposals concerning disclosure of risks associated with compensation policies for employees. As the Commission noted: "Individual investors, trade unions, institutional investors and pension funds supported the proposals." And the opposition? "Most companies, law firms and bar groups opposed the proposal." It is not unlike access, where the same groups more or less stack up on opposite sides. The result? The Commission "consider[ed] the comments," promptly adopted the "disclosure requirement substantially as proposed with some modifications."
As we have noted, there is increased polarization at the Commission, with the recent guidance on climate change passing by a 3-2 vote. In the debate over corporate governance reform before the Securities and Exchange Commission, there likewise appears to be increased evidence of polarization.
The approach is short sighted. As we noted, the opposition to access ultimately succeeded in getting the Commission to ban access bylaws in December 2007. Access bylaws required a two step process for shareholders to elect directors to the board. First they had to prevail upon shareholders to pass the bylaw. Then, a year later, they could nominate directors but had to again prevail upon shareholders to support them. It was a slow cumbersome process that was likely to rarely result in the election of shareholder nominated directors. Indeed, three companies in 2007 voted on access bylaws and in two cases they failed (passing only at the relatively small company, Cryo-Cell). These instances are discussed in The SEC, Corporate Governance, and Shareholder Access to the Board Room.
The result of polarized opposition was that the membership of the Commission changed and an access proposal was quickly issued that would, if adopted, provide shareholders with the right to insert directly their nominees into the company's proxy statement. In other words, the two step process was eliminated for something much more blunt, and much more direct, than what has originally been proposed. While it will probably not have a material impact on board membership, the current access proposal will have far more than the access bylaw proposal.
Had there been a compromise on the access bylaw process, the Commission likely would not have made this current proposal. The polarization in the end is unfortunate. It entails a reduction in the consensus over the SEC's regulatory approach and leaves open the possibility that regulatory requirements will shift more dramatically each time regime change occurs at the Commission.
]]>Plaintiff James River Group, Inc. (“JRG”) was a Delaware corporation and defendant Michael Kehoe was its sole director. Plaintiff James River Insurance Company (“JRIC”) was incorporated in Ohio. All defendants, Kinsale Management, Inc. and Kinsale Capital Group (“Kinsale”), William Kenney, Brian Haney, Ann Marie Marson, Edward Desch (“James River Individual Defendants”), Greg Share, and Michael Kehoe, were on JRIC’s board of directors, and all defendants sought advancement from JRIC.
Plaintiffs JRG and JRIC filed suit against defendants alleging misappropriation of trade secrets, breach of contract, and breach of fiduciary duty. Plaintiffs claimed that defendants used their positions to form the knowledge and expertise to start a competing company. Defendants subsequently moved for an order requiring JRG and JRIC to advance all fees and expenses, including attorneys’ fees, incurred by defendants in connection with this litigation.
A corporation can make the right to advancement of expenses mandatory through either its certificate of incorporation or through its bylaws. When this is the case, the recipient’s right is enforced as a contract. A director’s right to advancement is not dependent upon the likelihood that he will ultimately be entitled to indemnification. The two notions are distinct. The right to advancement also does not depend on the likelihood of repayment if the litigant loses.
Section 145 of the Delaware Code provides that indemnification is available for actions brought against officers and directors, even if the defendant does not ultimately prevail. Additionally, the statute provides that a corporation may "advance" fees and expenses in advance upon receipt of an undertaking by such director or officer to repay the corporation if the director or officer is ultimately not entitled to indemnification. Advancement and indemnification rights, however, may only extend to legal proceedings incurred “by reason of the fact” of the director’s position as a director, and not resulting from activities that a director pursues in his personal capacity. There needs to be a nexus or causal connection between the underlying proceedings and one’s official corporate capacity in order for those proceedings to be “by reason of the fact.”
The JRG bylaws include mandatory advancement and indemnification provisions that state
[E]xpenses incurred by a present or former director, officer, employee, or agent… shall be paid by the corporation in advance of the final disposition of such action… upon receipt of an undertaking by or on behalf of the director or officer to repay the amount if it shall ultimately be determined that [the director or officer] is not entitled to be indemnified by the corporation.
The court found that nexus existed between the claims against Kehoe and his corporate capacity, thereby entitling him to the advancement of expenses. The claim asserted that he used his “entrusted corporate powers” to misappropriate JRG’s trade secrets and form a competing company. If Kehoe had any liability, it would rise directly out of his former position as a director of JRG, and thus would satisfy the requisite nexus between the proceedings and his official corporate capacity.
With respect to advancement from JRIC, the issue turned on Ohio law. Section 1701.13 of the Ohio Code contained language slightly different from Delaware. Like the Delaware Code, the Ohio Code provides that a corporation may indemnify its management. The Ohio Statute also states that “expenses incurred by a director in defending an action or proceeding shall be paid by the corporation as they are incurred, in advance of the final disposition of the action.” As the court noted:
The District Court held that the latter view was correct. Reading the statute as a whole, the court concluded that the plain meaning of the statute indicated that the advancement provision devolved from the decision made under the indemnification provision. Ohio corporations were not, therefore, always required to advance fees to its director-litigants, but rather only when the corporation had chosen to make indemnification available.
Because JRIC did not opt in to the indemnification and advancement provisions under the Ohio Code, the defendants were not entitled to advancement for fees and expenses incurred while litigating the claims brought by JRIC.
The court held JRG must advance Kehoe’s expenses for its claims against him under the Delaware Code, but JRIC was not required to advance expenses to the defendants under the Ohio Code.
The primary materials in this case can be found at the DU Corporate Governance Web Site.
]]>Board diversity can be an important societal concern. It can also affect the decision making process. Greater diversity may result in a wider range of views that can be shared with the CEO and other officers in making important decisions. Some countries, such as Norway, have addressed the dearth of diversity (at least with respect to gender) through legal mandate. The country requires that boards of large public companies include at least 40% of each gender, effectively forcing companies to increase the number of women on the board.
Boards in the US are not particularly diverse. They consist of about 13% for women and about 11% for people of color.
As the issue grows in importance, the Commission has delved into the area in a tentative fashion. In suggesting the need to disclose these types of policies, commentators “noted that there appears to be a meaningful relationship between diverse boards and improved corporate financial performance, and that diverse board can help companies more effectively recruit talent and retain staff.”
Companies must now disclose whether and how the nominating committee “considers diversity in identifying nominees” for director. See Item 407(c)(2)(vi). The term was undefined but broadly construed.
The language has two problems. First, by specifically mentioning race, gender and national origin, it omits sexual orientation, even in the category of "expansive." Second, it suggests that diversity is an either/or situation. In fact, companies ought to be required to report their policies with respect to race and gender and have the option of reporting other policies as well.
In any event, this is a first for the Commission. It creates a disclosure requirement that puts the agency in the middle of the debate over board diversity. It will be the data disclosed as a result of this requirement that causes shareholders and investors to put pressure on boards to change the policy and take a more active approach in the diversification of boards.
For more on the SEC and its use of disclosure to affect the corporate governance process, see Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure.
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