Radicalism v. Respect: The Jurisprudence of VC Laster

The WSJ published an article about J. Travis Laster, one of the Vice Chancellors in Delaware. According to the article, VC Laster "has built a reputation for being as tough on bankers as on the corporate directors they advise.  He has censured boards he viewed as careless, ripped advisers he viewed as conflicted, rejected settlements he viewed as flimsy and halted transactions he viewed as unfair."  

Some described him as having "a moralistic streak" and noting that he is the grandson of a Presbyterian minister whose Bible Mr. Laster used during his swearing-in ceremony."  This has not made everyone happy.  The positions have apparently resulted in disquiet on Wall Street.  Id.  ("The rulings cast unease over Wall Street by promising closer scrutiny of its work.").  As the article noted: "His tenure hasn't been without controversy. Some see in Mr. Laster, who declined to be interviewed, a tendency to second-guess boards with little regard for market realities."

VC Laster's opinions reflect a deep respect for the jurisprudential approach adopted by Delaware courts as a legal matter.  He is suspicious of shareholder law suits (at least those challenging mergers). He has done nothing to alter the process (versus substance) approach to Delaware law.  If directors use the right process, they are free of liability, without worrying about second guessing by shareholders or courts.

His approach is to try to make the process adopted by Delaware courts meaningful.  Thus, when he sees potential conflicts of interest by advisors to boards, he doesn't ignore them but highlights them and their potential impact on the process.  When he sees directors on special committees who may have close personal relations with someone on the other side of the transaction, he declines to simply ignore the relationships.    

This is, in the end, consistent with a management friendly approach to corporate law.  Boards can still obtain complete protection from liability.  They simply have to work harder at making sure the process is actually meaningful.  In many ways, it empowers boards to do what they would prefer anyway.  To the extent friendship with officers/controlling shareholders can impair independence, boards now have a reason to reduce the number of "friends" serving as directors. 

VC Laster’s approach does not reflect a radicalism but instead reflects a deep seated respect for the Delaware approach.  It is an attitude that, if it became prevalent, would likely slow the pace of federal preemption of principles of corporate governance.  


Delaware's Top Five Worst Shareholder Decisions for 2013: Boilermaker Local 154 v. Chevron  (#3)

Delaware is a management friendly jurisdiction.  This is particularly true with respect to the interpretation of fiduciary duties by the Delaware courts.  Perhaps as a result, there has been a much discussed litigation "flight from Delaware," with shareholders increasingly bringing suits in other jurisdictions. 

 This does not give shareholders more favorable law.  With respect to fiduciary obligations, the internal affairs doctrine requires that a court apply the law from the state of incorporation.  As a result, a court in New York or California will still be required to apply Delaware law so long as the company is incorporated in that state.  What shareholders do gain from the flight, however, is a different set of decision makers.  By filing in other states, they have their case reviewed by judges who do not sit on the Delaware Chancery Court or the Delaware Supreme Court.

The decision to bring cases in other jurisdictions is not good news for the Delaware economy.  Cases bring business to Delaware.  They employ lawyers and fill hotels.  They also give Delaware judges control over the outcome of the claim, something that may increase the incentive to incorporate in the state.   

One way to temper the "flight from Delaware" would be to adopt a jurisdictional approach that eliminated much of the benefit associated with the filing of derivative suits outside of Delaware.  For that to occur, the Delaware courts would likely have to make decisions that were less management friendly.  Given the current trend, there is no significant evidence that this approach is underway.  An alternative approach could be the imposition of restrictions on the right of shareholders to bring actions in other states.  

The Chancery Court addressed the ability of management to impose such restrictions in Boilermakers Local 154 v. Chevron (we posted on the case here).  In that case, shareholders challenged a pair of "forum selection bylaws."  One of them provided that exclusive jurisdiction for derivative suits (and certain other fiduciary/internal affairs/DGCL claims) rested with "a state or federal court located within the state of Delaware" so long as the court had "personal jurisdiction over the indispensable parties named as defendants."  The bylaws provided that anyone "purchasing or otherwise acquiring" shares in the company was "deemed to have notice of and consented" to the bylaw. 

Other than a choice between the federal district court in Delaware or the Delaware Chancery Court, the bylaw effectively eliminated the right of shareholders to seek other jurists in other jurisdictions to adjudicate their claims.  Moreover, despite the references to "consent," the requirement was simply imposed on existing shareholders.  See Id.  ("Such a change by the board is not extra-contractual simply because the board acts unilaterally; rather it is the kind of change that the overarching statutory and contractual regime the stockholders buy into explicitly allows the board to make on its own.").   

The bylaw fell far outside the traditional boundaries of the internal affairs doctrine.  The bylaw did not address the relationship between, or the law governing, directors and shareholders, only the forum used to address those issues.  With the legal standards clear, therefore, the bylaws did not implicate the underlying purpose of the "intenal affairs doctrine."  See Vantage Point v. Examen, 871 A.2d 1108 (Del. 2005) ("The inernal affairs doctrine developed on the premise that, in order to prevent corporations from being subjected to inconsistent legal standards, the authority to regulate a corporation's internal affairs should not rest with multiple jurisdictions.").   

The weakness in the court's reasoning was apparent from the lack of limitations that flowed from the analysis.  The court included no analytical restraint on the substance of these bylaws, nothing that suggested there was a "bylaw too far."  The only limitation was on the identity of the person subject to the bylaw.  As the court reasoned:

  • The bylaws would be regulating external matters if the board adopted a bylaw that purported to bind a plaintiff, even a stockholder plaintiff, who sought to bring a tort claim against the company based on a personal injury she suffered that occurred on the company's premises or a contract claim based on a commercial contract with the corporation. The reason why those kinds of bylaws would be beyond the statutory language of 8 Del. C. §109(b) is obvious: the bylaws would not deal with the rights and powers of the plaintiff-stockholder as a stockholder.  

So long as the bylaw applied to shareholders qua shareholders, the analytical rubric allowed companies to rewrite the rules of civil procedure.  They could adopt bylaws requiring shareholders to arbitrate fiduciary duty claims, forego discovery, agree to reduced time periods to litigate and, perhaps, submit to a shorter statute of limitations.  Whatever the merits of these restrictions, they went well beyond the traditional notions of corporate governance and the traditional boundaries of the internal affairs doctrine. 

Shareholders ultimately discontinued the appeal so the reasoning has not yet been examined by the Delaware Supreme Court.  The Supreme Court was likely to affirm and, while there is some truth to the claim that it was due to the "incontestability of the Chancellor’s ruling" a more complete description would be the "incontestability of the Chancellor's ruling" in Delaware.  As a result, the reasoning of the decision will play out not in Delaware but in the other courts that have to determine whether this divested them of jurisdiction.  In those jurisdictions, the "incontestability of the Chancellor's ruling" is likely to be less clear.


Inspection Rights, Delaware Law and the Need for Federal Disclosure Requirements: In re Hershey

There has been considerable criticism of the decision by Congress to assign to the SEC the obligation to develop disclosure requirements concerning conflict minerals and resource extraction.  The disclosure mandates are less about investor protection and more about corporate social responsibility.  As the chair of the SEC recently stated 

  • But other mandates, which invoke the Commission’s mandatory disclosure powers, seem more directed at exerting societal pressure on companies to change behavior, rather than to disclose financial information that primarily informs investment decisions.  That is not to say that the goals of such mandates are not laudable.  Indeed, most are.  Seeking to improve safety in mines for workers or to end horrible human rights atrocities in the Democratic Republic of the Congo are compelling objectives, which, as a citizen, I wholeheartedly share. But, as the Chair of the SEC, I must question, as a policy matter, using the federal securities laws and the SEC’s powers of mandatory disclosure to accomplish these goals.

The requirements are different from the SEC's traditional mission of protecting markets and investors.  One explanation is that they are entirely random examples of congressional intrusion into the disclosure process.  Another is that they portend an expanded  mission for the Commission, one that includes not only disclosure oriented toward the protection of investors but also disclosure with a broader, public purpose.

But another way to look at the trend is to see it as a consequence of state law.  Often when Congress intervenes into the governance process, it does so because of failures under state law.  As an example in the area of corporate social responsibility, take the recent case of  Louisiana Municipal Police Employees' Restirement System v. Hershey

In Hershey, shareholders sought documents designed to shed light on the board's practices with respect to the purchase of cocoa from countries in Africa making widespread use of child labor to raise the product.  Section 220 of Delaware law requires that shareholders have a "proper purpose" to inspect corporate documents.  With rare exceptions (see Axcelis),  courts have equated proper purpose with wrongdoing by the board.  Plaintiffs therefore are fored to allege that the inspection was needed to explore some time of misbehavior by the board.  In this case, shareholders asserted that there was a "reasonable basis to believe that Hershey and its Board, 'through the purchase and use of cocoa and cocoa-related products originating in Ghana and the Ivory Coast, is actively enabling violations of the law in both Ghana and the Ivory Coast”. 

Assuming a proper purpose, shareholders under Delaware law also must demonstrate a "credible basis" for the alleged misbehavior.  Said another way, they have to allege some affirmative evidence that supports the underlying claim for breach of fiduciary obligations.  In trying to fulfill this standard, shareholders asserted that:

  • (i) Hershey is a major player in the chocolate industry that uses cocoa beans and products derived from cocoa beans, (ii) child labor is endemic in two countries that produce a large portion of the cocoa beans, and (iii) some of Hershey's cocoa beans and cocoa-derived products originate in those countries.

Moreover, documents incorporated into the complaint by reference, according to the court, confirmed "that Hershey cannot certify that all of the 10,000 suppliers from which it sources raw materials produce cocoa without relying on the 'worst forms of child labor.' ”

The court held that this was insufficient evidence to establish a credible basis.  For one thing, the court disputed whether shareholders had sufficiently alleged that Hershey even acquired cocoa from farms that used illegal child labor.   Shareholders tried to do so by making "the undeniable point that child labor continues to be common on cocoa farms in West Africa" and that "the largest percentage of Hershey's supply" came from West Africa. 

Such allegations, however, were not enough.  The assertion was "little more than the logical fallacy that, because some cocoa is produced using child labor, and Hershey purchases a large amount of cocoa or cocoa-derived products, Hershey must use cocoa products tainted by child labor."   Apparently, under the court's reasoning, shareholders were required to show that Hershey bought cocoa from specific farms and that those farms relied upon illegal child labor.

Even assuming this evidence was sufficient, the court found that shareholders had not met the credible basis standard.  "At most, LAMPERS has succeeded in alleging that Hershey purchases cocoa, directly or indirectly, from farms that utilize child labor.  Neither that 'evidence,' or the other sources on which LAMPERS relies, provide any  basis from which the court could conclude that Hershey has violated the law."

The standard was, of course, an almost impossible one to meet.  Allegations of mismanagement or breach of fiduciary duty would depend for the most part on what the board knew and, based upon that knowledge, how the board responded.  By cutting off the inspection request, the court essentially made this information unavailable to shareholders. 

The circumstance involved a natural resource, cocoa.  The facts suggested that the product was often produced in an environment that involved legal and/or human rights violations.  Sound familiar?  The fact pattern has at least a passing familiarity to conflict minerals. 

With state law avenues for disclosure cut off, shareholders wanting information will need to resort to the federal government.  If in the next major instance of federal preemption of state law (see Sarbanes-Oxley and Dodd-Frank), Congress imposes on the SEC the obligation to ensure companies disclose information about their purchase of cocoa, the impetus will be at least in part traceable to Delaware decisions such as this one.    


Southeastern Pennsylvania Transportation Authority v. Volgenau: Eliminating the Fiduciary Obligation of Fairness (Special Committees and the Influence of Controlling Shareholders) (Part 5)

We are discussing Southeastern Pennsylvania Transportation Authority v. Volgenau.

The application of the business judgment rule depended upon the use of the independent special committee and the approval of the shares not beneficially owned by the controlling shareholder.  In forming the special committee, the goal was to implement a process that essentially eliminated the influence of the controlling shareholder. 

The opinion, however, noted that the controlling shareholder potentially played a role in the selection of the directors on the committee.  As the opinion stated:

  • There is some dispute whether the Special Committee members volunteered or whether they were selected by Volgenau. Grafton testified that “Dr. Volgenau proposed the committee members and the chair and gave each director an opportunity to comment . . . .” He later clarified:  "I think that Mr. Klein, Mr. Gilburne, Mr. Barter and myself were proposed by Dr. Volgenau. There was a discussion then of the committee. I think Dr. Volgenau at that point asked the other board members whether any wanted to be on the committee. . ." General Ellis asked to be on the committee, and Ms. Wilensky and Mr. Keevan did not volunteer. Id.

The opinion found that the selection of a "majority of the committee's members was not 'the best practice'" but nonetheless found that the practice was "not fatal to the independence of the Special Committee". 

The fact that the court described the approach as not "the best practice" reflects a judicial understanding that this provides a potential avenue for controlling shareholder influence.  Had the court decided that this was impermissible, future boards would have excluded the controlling shareholder from selecting these directors.  This would have provided additional assurance of the integrity of the process used by special committees.  But the court chose not to do so, avoiding an opportunity to ensure more meaningful process.  

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


Southeastern Pennsylvania Transportation Authority v. Volgenau: Eliminating the Fiduciary Obligation of Fairness (The Immateriality of a $1.3 Million Payment) (Part 4B)

We are discussing Southeastern Pennsylvania Transportation Authority v. Volgenau.

The court held that the entire fairness standard should be replaced by the business judgment rule where the company used an independent special committee and made the transaction contingent upon the approval of a minority of shares.  In other words, process would replace substance. 

For this to have any possibility of working, the process must be meaningful.  What constitutes meaningful is a matter for the Delaware courts.  As noted in a prior post, the decisions suggest that the requirement of minority approval of a transaction will be interpreted to permit the inclusion of shares held by persons "beholden" to the controlling shareholder.  The court in this Volgenau did so by accepting a definition of "minority" that included all shares except those beneficially owned by the controlling shareholders.  This suggests that the court's will not require a "meaningful" process with respect to minority shareholder approval.

Likewise, the decisions indicate that the courts will not impose a meaningful standard with respect to the process used by the special committee.  In reviewing the special committee used in Volgenau, the court considered challenges to the independence of the committee.  Of particular interest was the treatment of a $1.3 million payment allegedly sought by one of the directors serving on the committee.     

According to opinion, one of the directors on the special committee had an “undisclosed expectation” that he would “receive a significant bonus for his work with the Special Committee.”  The board opted to award $75,000 for the director’s service. The amount was later increased to $150,000. The director declined the additional compensation as “premature.” As a result, the board donated the funds to "two charitable organizations supported" by the director.

The director later submitted a “a memorandum in which he expressed disappointment over the meager compensation offered to him for his eight months of work directing the sale process and in light of the nearly $30 million in fees and expenses paid to outside advisors for their help in effectuating the Merger.” The memorandum suggested that reasonable compensation would be at least $1.3 million, "payable to two charities with which" the director was "affiliated."   

The court noted that the subjective expectation of a significant bonus raised “a serious question regarding [the director’s] motivation for completing a deal.” It was possible that the director “may have been subtly motivated to favor [the controlling shareholder’s] interest because he knew that a significant bonus was dependent upon receiving [the controlling shareholder’s] consent.”  The court was clearly concerned by these facts. As the opinion described:

  • [the director]'s request for at least $1.3 million far exceeded what the Board had ever contemplated and what [the law firm] had advised was customary. This type of request or expectation raises serious concerns about the objectivity of a special committee member. One can easily imagine how this practice, if adopted, could be fraught with potential abuse, especially when it is not disclosed to shareholders and directors who might have thought such significant compensation material; if nothing else, it likely would have generated envy.

Nonetheless, the court found that the desired payment was immaterial.  The court relied mostly on the fact that the director requested that the bonus be paid to two charities.  The court noted that there was "no evidence in the record that [the director] would have received any backdoor remuneration, measured in dollars or accolades, for a donation made because of him."   

The analysis illustrates the weakness in the use of process by Delaware courts as a means of ostensibly protecting the interests of shareholders.  In concluding that the desire for a $1.3 million payment was immaterial, the court did not cite any authority.  Indeed, the opinion suggests, oddly, that socially positive acts (the desire to have a bonus paid to charities) are not a sufficient motivation for a director to favor a particular position.  At the same time, the court suggested that a significant payment to a charity could be material if resulting in some undefinded level of accolades.  Yet this tied materiality not to the subjective interests of the director but to the response of the recipient of the donation.  

The court's determination, therefore, does not appear to be based on the needs or interests of shareholders but is more accurately viewed as a policy decision that payments to charities are simply not going to be part of the analysis of a committee's independence.  As a result, a special committee would presumably be considered independent even if all of the directors were promised a substantial bonus for approving the specific transaction favored by the controlling shareholder so long as the substantial bonus went to a charity supported by the directors.  

All of this suggests that the court had decided to replace entire fairness standard with process but intends to take a lax rather than rigorous view of the appropriate process.      

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

Southeastern Pennsylvania Transportation Authority v. Volgenau: Eliminating the Fiduciary Obligation of Fairness (Imposing the Burden of Proper Process on Shareholders) (Part 4A)

 We are discussing Southeastern Pennsylvania Transportation Authority v. Volgenau.

 The court determined that the process employed by the board of SRA justified the elimination of "entire fairness" and the application of the business judgement rule.  In effect, the fairness of the transaction would no longer be part of the analysis.  At the same time, however, the courts have not been willing to ensure that the process employed by the board was meaningful.  This can be seen with respect to the review of the process used by the special committee. 

In reviewing the membership of the special committee, the court in Volgenau noted that the “mere presence of a conflicted director or an act of disloyalty by a director, does not deprive the board of the business judgment rule's presumption of loyalty.”  Instead, shareholders had to show that these directors constituted a majority of the board, dominated the board, or had failed to disclose the conflict.  

In other words, shareholders could not successfully challenge the process by showing a conflicted director or by raising concerns about a director's loyalty.  Instead, shareholders had the additional burden of establishing that the conflict/disloyalty affected the entire committee. 

Yet it is the board that benefits from the special committee and obtains the protection of the business judgment rule as a result.  Once the committee has been shown to be infected with disloyalty or a conflict, logic would suggest that this either eliminates the benefits that come with the special committee process or, at a minimum, imposes on the board the obligation to show that the conflict/disloyalty had no impact.  Only by imposing the standard on the board would there be sufficient incentive to ensure that in fact special committees include directors that are not conflicted or disloyal. 

Yet the court left the burden with shareholder.  This certainly reduces the incentive for board's to ensure that there are no conflicts or instances of disloyalty on a special committee. 

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

Southeastern Pennsylvania Transportation Authority v. Volgenau: Eliminating the Fiduciary Obligation of Fairness (The Mirage of Minority Shareholder Approval) (Part 3)

We are discussing Southeastern Pennsylvania Transportation Authority v. Volgenau

With respect to transactions involving a controlling shareholder, the standard of review in Delaware has long been entire fairness. See Kahn v. Lynch Communications, 638 A.2d, 1110 (Del. 1994) ("the exclusive standard of judicial review in examining the propriety of an interested cash-out merger transaction by a controlling or dominating shareholder is entire fairness”).  

The Court in Lynch nonetheless provided incentives for boards to rely on process, particularly the use of a special committees consisting of independent directors.   “[A]pproval of the transaction by an independent committee of directors or an informed majority of minority shareholders” shifts the burden of proof to shareholders to show unfairness.  Nonetheless, even with proper process, fairness remained an element of the analysis. 

Lower courts in Delaware have, however, engaged in serious efforts to limit the application of the entire fairness analysis in transactions involving controlling shareholders, replacing it with the impossible to overcome business judgment rule.  In In re MFW Shareholders Litigation (“ MFW”), the Chancery Court held that transactions between a company and a controlling shareholder would not be reviewed under the entire fairness standard where the transaction was approved by an independent special committee and a majority of the minority of shares.  Instead, the standard would be the duty of care.  The court did suggest that approval by minority shareholders had to be non-waivable. 

The court in MFW took the position that shareholders benefited from the double layer of process more than from the higher standard of review.  The analysis is, however, questionable.  The court, for example, largely ignored the impact of arbs on the voting process.  With a short term horizon, these investors have an incentive to approve the transaction even if unfair.  Moreover, the decision ignored the impact of the change in standard of review on the activities of the special committee.  No longer seriously worried about the possibility of liability, the committee had less incentive to adopt and implement exacting standards in reviewing transactions. 

Volgenau continued this trend.  First, the court took the opportunity to include a "note" (read dicta) on MFW. The Volgenau court  reiterated the conclusion from MFW that the combination of an independent special committee and approval by a majority of the minority of investors "had the effect of replicating an arms' length transaction" that "had a 'cleansing' effect on the transaction that justified judicial review under the deferential business judgment rule."  The "note" reflected the reality that in the Delaware Chancery Court there is no longer any need to analyze the consequences of minority approval.  The courts have now accepted that it is beneficial to shareholders and justifies replacing entire fairness with the business judgement rule. 

Unlike MFW, Volgenau did not involve a contract with a controlling shareholder on both sides of the transaction.  Instead, there was a controlling shareholder of SRA but not the buyer.  As the court described:    

  • this case involves a merger between a third-party and a company with a controlling stockholder. Despite SEPTA's attempt to show otherwise, [the controlling shareholder] is not a buyer in this transaction. As a seller, his interest is generally aligned with that of minority stockholders to the extent that he receives equal consideration for his shares. But as this Court has observed before, a controlling stockholder may, even in this context, inappropriately influence the outcome of the sale process

Relying on the analysis in In re JOHN Q. HAMMONS HOTELS INC. SHAREHOLDER LITIGATION, a decision that declined to automatically apply the entire fairness standard in cases involving a controlling shareholder that stood on only one side of the transaction, the court in Volgenau set out procedures that would result in the application of the business judgement rule.  These included that:   

  • (1) the transaction must be recommended by a disinterested and independent special committee, (2) which has “sufficient authority and opportunity to bargain on behalf of minority stockholders,” including the “ability to hire independent legal and financial advisors[;]” (3) the transaction must be approved by stockholders in a non-waivable majority of the minority vote; and (4) the stockholders must be fully informed and free of any coercion.

The key element was the need for approval of a "majority of the minority vote."  The court left unaddressed the meaning of "minority."  Apparently, however, the court was satisfied with the definition used by SRA.  Specifically, the merger agreement defined "Company Stockholder Approval" to include

  • "the adoption of this Agreement by the holders of a majority of the outstanding shares of Class A Common Stock entitled to vote on such matter (excluding all shares of Class A Common Stock beneficially owned, whether directly or indirectly, by [the controlling shareholder]) at a stockholders’ meeting duly called and held for such purpose." 

The proxy statement stated that the "condition may not be waived by any party."  Proxy Statement at 94.  

Thus, the court equated minority shares with those not beneficially owned by the controlling shareholder.   This is not the same as requiring approval of all "disinterested" shares (although the court refers to this as "disinterested" in footnote 147).  Beneficial ownership has a precise definition.  See Rule 13d-3, 17 CFR 240.13d-3.  It would not apply, for example, to shares owned by someone "beholden" to the controlling shareholder, particularly where the relationship arose out of a material financial relationship.  See CSX v. The Children's Investment Fund, 654 F.3d 276 (2nd Cir. 2011).  

As a result, the "process" used by the courts will not inevitably protect shareholders.  Between arbs with their short term horizons and shares held by persons beholden to the controlling shareholder, the outcome of the "minority" approval process will often be preordained, irrespective of the actual fairness of the offer to shareholders. 

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


Southeastern Pennsylvania Transportation Authority v. Volgenau: Eliminating the Fiduciary Obligation of Fairness (The Facts) (Part 2)

We are discussing Southeastern Pennsylvania Transportation Authority v. Volgenau.

The case arose out of the acquisitoin of SRA International.  Ernst Volgenau (“Volgenau”) founded the company in 1978.  Volgenau stepped down as CEO in 2002 but served as chairman of the board.  Although owning only 21.8% of the equity, he held supervoting shares that resulted in control of 71.8% of the voting rights.  Even after stepping down as CEO, he remained influential.  As the court described,

  • "[t]here is no doubt that Volgenau, even after stepping down as SRA's CEO in 2002, exercised considerable influence over the operations of the Company in his capacities as Chairman of the Board and controlling stockholder." 

This, according to the opinion, included involvement in the selection of the CEO, "regularly conferr[ing] with [the CEO] on all 'major decisions'", and active involvement in pursuing a "strategic transaction."  

In the spring of 2010, Volgenau and "senior management of SRA" met with officials from Providence Equity Partners LLC to discuss a possible buyout.  As the court stated:  "As discussions ensued, Volgenau was not only amenable to a transaction with Providence, but he also seemed to have significant interest in completing a deal with it."  Eventually, Volgenau gave a "tacit endorsement" of Providence, noting that it "was the only potential bidder that had ever interested him and that it was committed to maintain the Company's values and culture.”

The board formed a special committee.  A majority of the directors (including the chair) on the committee were selected by Volgenau, something the court described as “not ‘the best practice.’”  The committee hired a financial advisor and legal counsel.  While waiting for a “formal bid” from Providence, the company received an offer from Serco, a strategic competitor.  The chair of the special committee informed Providence of this turn of events in an effort to “elicit a higher offer from Providence”.  Providence did not, however, provide a higher offer. 

As information about the efforts became public, the special committee opened the bidding process to “other strategic sponsors.”  The approach was bifurcated:  The Committee “would exclusively address issues of price and certainty while Volgenau would meet with strategic acquirers to discuss his ‘humanistic concerns.’”  Eventually, the process narrowed to two companies, Providence and Veritas. 

The two companies engaged in a back and forth.  Eventually, Veritas increased its bid to $31.25 and asked for “exclusivity in negotiations until the next business day.”  The offer was not finalized and Providence matched the price. The special committee asked both companies to submit a best and final offer.  Veritas did not.  As the court explained:  “Apparently frustrated by the Special Committee's conduct in dragging the process along, Veritas instead withdrew its $31.25 bid, leaving Providence, which declined to make a higher offer, as the only remaining bidder.” 

Thereafter, the Committee approved the acquisition.  The transaction included a 30 day go shop provision, a $47 million termination fee, a reverse breakup fee of $112.9 million, and the requirement that the agreement be approved by a majority of the minority vote.  The approval requirement was “not waivable by the Special Committee.”  Ultimately, the Board (with Volgenau abtaining) approved the merger. The "minority" shareholders also approved the merger, with 81.3% of the total outstanding minority shares (99.7% of those that actually voted) voting in favor.   

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


Southeastern Pennsylvania Transportation Authority v. Volgenau: Eliminating the Fiduciary Obligation of Fairness (Overview) (Part 1)

The standard of review in a case can be outcome determinative in cases alleging breach of fiduciary duties.  Nowhere is this more clear than with respect to the standards put in place by the Delaware courts.   

To the extent shareholders are limited to a duty of care, the case is all but impossible to bring successfully.  Cases such as Disney demonstrate that the standard of behavior is so low that directors will almost never fall below it.  Even in the exceedingly rare case where this could occur (recall the now mostly discredited decision in Van Gorkom), the ubiquitous nature of waiver of liability provisions all but eliminate liability for damages.  These provisions are discussed here:  Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom.  Shareholders can try to bring a case for waste but under Delaware law, they must show something approaching unconscionable behavior, an all but impossible standard. 

Shareholders, therefore, will only have a chance of succeeding (albeit a small one) if they can convince the court that the standard of review is not the duty of care.  This requires a showing that the behavior was disloyal or constituted a violation of good faith.  A cause of action for disloyalty arising out of a conflict of interest is reviewed under the "entire fairness" standard.  In theory, the burden rests with the board to show the fairness of the transaction.  The need to show fairness means that, unlike the duty of care, the substance of the transaction matters. 

The Delaware courts, however, have consistently narrowed the circumstances where the duty of loyalty applies.  They have done so by holding that boards with a majority of independent directors are entitled to the presumption of the business judgment rule even when the conflict of interest remains in the board room.  Thus, for example, compensation paid to the CEO is reviewed under the duty of care despite the fact that the CEO typically sits on the board and is therefore in a position to influence the decision.  By using the duty of care with respect to executive compensation, Delaware courts have allowed process to control.  As a result, the type and amount of compensation paid to a CEO sitting on the board is largely irrelevant to any analysis of fiduciary responsibilities.  For a more extended discussion of this approach, see Returning Fairness to Executive Compensation

There are, however, a few places where the entire fairness standard has been preserved. This is true, for example, with respect to transactions between the company and a controlling shareholder.  Given the potential for influence by the controlling shareholders, the board retains the obligation to show that such a transaction was fair. 

Delaware decisions, however, are rapidly eliminating this protection, replacing substance with process.  They have done so by providing that boards using certain procedural protections can obtain the benefit of the business judgment rule.  Specifically, the board must assign approval of the transaction to an independent committee of the board.  In addition, the transaction must be approved by a majority of the shares not beneficially owned by the controlling shareholder.  

Shareholders only benefit from this approach if the process is sufficient to provide greater protection than the reduction in the standard of review.  As we will illustrate in our analysis of SPTA v. Volgenau, this is likely not the case.  Whatever value process might have, the Delaware courts do not intend to ensure that it will be sufficiently rigorous to adequately protect the interests of shareholders.   

With this introduction in mind, we turn to Southeastern Pennsylvania Transportation Authority v. Volgenau. Primary materials on this case can be found at the DU Corporate Governance web site.


In re Plains Exploration & Prod. Co. Stockholder Litig: The Problem of Process and the "Numerous Board Meetings" Defense

As we have discussed often on ths Blog, Delaware courts have for the most part transformed fiduciary obligations into a process standard.  Ignoring the substantive terms of the transaction, the courts limit their analysis to the process used by the board.

In theory, this approach can be beneficial.  Courts are removed from the substance, leaving those matters to management.  Shareholders are protected by a rigorous set of procedures that ensure the board acts in their best interest.  Process can fail but for the most part shareholders are protected by an informed, independent and vigilant board.

The problem with the approach is that the Delaware courts do not ensure that boards employ sufficiently rigorous process.  In those circumstances, process does not adequately protect shareholders.  Yet because the courts refuse to engage in substantive review, the decision remains unreviewed.  In these circumstances, management benefits. 

An example of this approach occurred in In re Plains Exploration & Production Co. Stockholder Litigation, 2013 Del. Ch. Lexis 118 (Del. Ch. May 9, 2013).  In that case, Freeport-McMoRan ("Freeport") sought to acquire Plains Exploration through a merger.  The court reviewed the transaction under the Revlon standard.

In challenging the transaction, plaintiffs pointed to a number of factors that suggested inadequate process.  For one thing, the board failed to form a special committee and instead allowed the CEO/Chairman to conduct the negotiations.  With the CEO "expected to become Vice Chairman of Freeport and CEO of Freeport’s newly acquired oil and gas operations," he was treated as interested.  Thus, an interested director was allowed to conduct the negotiations.

Second, the board did not "shop Plains or engage in a pre-agreement market check".  It was enough that the board had "experienced" directors.  The fact that it was "difficult from the record to assess" their knowledge of the company was of no moment.  As the court reasoned: 

  • its directors, most of whom had significant experience in the oil and gas industry and as directors of Plains, were fully capable of making an informed decision. Although it is difficult from the record to assess whether the Board possessed impeccable knowledge of Plains’ business, the directors’ relevant expertise and experience support a reasonable inference that they were informed and competent to make an appropriate decision.

The reasoning shows how far the courts in Delaware have retreated from Van GorkomSee Smith v. Van Gorkom, 488 A.2d 858, 880 (Del. 1985) (finding that "collective experience and sophistication [of the board] was [not] a sufficient basis for finding that it reached its September 20 decision with informed, reasonable deliberation.").  In any event, the reasoning would apply to any board with industry experienced directors, providing a ready justification by any board to dispense with an actual auction.  

Plaintiffs also pointed to a number of terms that seemed favorable to Freeport.  There was the absence of a collar on the price (something significant since half of the consideration was in stock and Freeport's shares apparently declined in value). 

And the merger agreement contained a number of deal protection devices.  They were not, according to the court, "onerous" and did not "unduly impede a competing bid".  These non-onerous provisions included a no solicitation provision with a fiduciary out.  In other words, the board could not solicit bids but could respond to "unsolicited bids if the Board determined in good faith that the bid would reasonably be expected to lead to a superior proposal."  In addition, the agreement provided for a 3% termination fee ($207 million) that the court characterized as "not unreasonable."  Finally, the agreement gave Freeport the right to match a competing offer.  

These provisions collectively would not "have prevented either a serious bidder from putting forth a higher bid or the Board from  entertaining and accepting a bona fide superior proposal."  Yet the court provided no authority for this proposition.  It did no analysis of how the deal protection devices worked in tandem or how they might affect actual bidders.

Thus, according to the allegations made by plaintiff:  the deal was negotiated by an interested director; the board never considered alternative bidders, giving the one purchaser a monopoly on the acquisition process; and the agreement contained terms favorable to the bidder.   

The court, however, viewed these allegations as inadequate.  The reason?  The board, excluding the CEO, contained independent and disinterested directors.  This board acted with sufficient vigilance to protect shareholders.  As the court stated:

  • the remaining Plains’ directors are disinterested and independent. They participated in numerous board meetings involving the Merger, and, where appropriate, authorized Flores to take specific action.

Similarly, in addressing the concern that an interested director was allowed to oversee the negotiations, the court again pointed to the "numerous board meetings" attended by directors.  Id.  ("The Plaintiffs essentially argue that the remaining directors completely abdicated their responsibilities in the negotiations to Flores. Perhaps the other directors could have done more, but the Plaintiffs' allegations are inconsistent with the numerous board meetings that the directors attended during which they discussed the proposed merger and participated in the decision-making process.").  

Thus, shareholders were protected as a result of "numerous board meetings."  In concluding that these meetings occurred, the court cited pages 38-45 in the proxy statement.  There are, a the court notes, a description of a number of meetings of the board of Plains.  Yet the role of the board in the transaction is very difficult to discern from the description.  Some of the meetings involved:


  •  On August 1, 2012, the PXP Board held a teleconference during which they received an update on a potential combination with FCX and MMR. During this teleconference, the PXP Board discussed the financial and operating characteristics of the combined company.
  • On November 30, 2012, . . . representatives of Barclays reviewed Barclays’ preliminary financial analyses regarding a strategic combination with FCX with the PXP Board. Additionally, Jefferies updated the PXP Board on the status of FCX’s proposed transaction with MMR, including Jefferies’ analysis of the proposed consideration.


  • On October 31, 2012, the PXP Board held a regularly scheduled meeting at which it discussed the possible transaction with FCX. 
  • The PXP Board met with its legal and financial advisors on November 28, 2012 to discuss the proposed transaction with FCX, including the proposed range of consideration. Barclays provided an overview of the mining industry in general and the copper industry in particular, the strategic benefits that could be expected to be realized and the strategic rationale of the transaction with FCX.
  • On December 4, 2012, the PXP Board met with certain members of management and representatives of Barclays and Latham & Watkins to discuss FCX’s proposed transactions with PXP and MMR. Mr. Flores described the proposed consideration to be paid by FCX for MMR. The PXP Board also discussed the proposed terms of the transaction between FCX and PXP. Latham & Watkins described the terms of the merger agreement (including the no-shop and termination provisions), the voting and support agreement, the letter agreements to be entered into by certain of PXP’s officers and the FCX commitment letter. Representatives of Barclays then reviewed the Barclays fairness opinion analyses with respect to the transaction and confirmed that Barclays was in a position to issue its fairness opinion.
  • The PXP Board discussed the conflict of interest with respect to Mr. Flores as a result of his position as the Chairman of the PXP Board and the possibility that he would be retained as part of the combined company’s senior management. Notwithstanding this conflict, the PXP Board determined that, because Mr. Flores’ significant beneficial ownership of PXP common stock aligned his interests with those of PXP’s other stockholders and because he had the most experience with and deepest knowledge of PXP’s assets and business, Mr. Flores was in the best position to advance the interests of PXP stockholders by continuing discussions with FCX regarding this matter and that he would do so under the PXP Board’s supervision.

"updates" and "discussions"

  • The PXP Board held a special telephonic meeting on November 14, 2012, with certain members of PXP management and representatives of Barclays and Latham & Watkins present. During the meeting, Mr. Flores provided an update on the potential transaction with FCX. The PXP Board discussed with its legal and financial advisors the proposed terms of the transaction with FCX, including FCX’s proposed consideration of $49 – $50 per share of PXP common stock, FCX’s proposal to pay the consideration half in cash and half in FCX common stock, and the need to retain PXP’s senior management to provide strong operating results for the combined company. The PXP Board also discussed for the first time the need to retain a number of PXP directors to maintain continuity on the combined company’s board. The PXP Board did not believe that this discussion presented any potential conflicts of interest for any member of the PXP Board since a decision had not yet been made as to which members, if any, would be designated as directors of the combined company. Following the discussions, the PXP Board agreed that PXP should continue negotiations with FCX and refine the terms of the draft merger agreement provided by Wachtell Lipton.

The board took a number of actions.  It "authorized" the CEO to respond to an offer and ultimatley aproved the transaction.

  • On November 6, 2012, the PXP Board met with its legal and financial advisors to consider the FCX special committee’s proposal. At that meeting, the PXP Board authorized Mr. Flores to respond to Mr. Allison that PXP would potentially be interested in a transaction at $55 per share with one-third of the consideration in cash and two-thirds of the consideration in FCX common stock. The PXP Board also discussed the potential role of PXP’s senior management in the management of the combined company.
  • On the morning of December 5, 2012, . . . the PXP Board approved the merger agreement with FCX and the related transactions.

In other words, the court only had limited information before it on the role actually played by the board in the transaction.  Yet this was enough to conclude that shareholders were adequately protected.  The court, therefore, opted for an analysis that looked more quantitative (numerous meetings) than qualitative (the actual degree of board oversight). 

This is a lesson that will not be lost on law professors teaching students or the practicing bar advising clients. 

they mad
e a
perfect decision, only a reasonable one.
On a preliminary injunction
motion, the Plaintiffs bear the burden of
establishing a reasonable probability
at trial
Director Defendants
would be unable to show
Revlon Claim Lacks a Reasonable
Probability of Success
The Plaintiffs
and theory of the case
must overcome
s. W
ith the exception of Flores, the remaining Plains’
and independent
They participated in numerous board mee
involving the Merger, and,
where appropriate
, authorized Flores to take specific
action. With Flores
as the lead negotiator,
they negotiated Freeport’s initial offer
of $47 per share
in cash
upwards to $50 per share with a
stock election subject to proration.
As Freeport was conducting its due
acquired a $6.1 billion asset (the
Gulf of Mexico
asset) without
even notifying Freeport
acting on the B
oard’s behalf,
at least for a time
the Freeport transaction. And
relied upon
sophisticated legal and financial advisors to guide them in the sales process.
(“If a board selected one of several reasonable alternatives, a court should not second
that choice even though it might have decided otherwise or subsequent events may have cast
on the board’s determination. Thus, courts will not substitute their business judgment for
that of the directors, but will determine if the directors’ decision was, on balance, within a range
of reasonableness.”).
In addition, all of the Plains’ directors had substantial stock holdings in Plains, which
presumably aligned their interest
the interests of
all other stockholders.
Proxy at 84.
In stark contrast, the Plaintiffs
paint the picture that Flores was bent on
pushing through a merger with his buddy Moffett to sit at the top of a premier
natural resources company and
obtain a financial windfall from the Merger.
their attempt to
color the Board’s actions
, the Plain
plethora of
the Board breached its
fiduciary duty to maxim
ize Plains’
sales price
contend that the Board acted unreasonably by:
(1) permitting Flores to control the
process and failing to establish a special committee; (2) failing to shop Plains
consenting to onerous deal protection devices
(3) failing to negotiate a collar,
an increased
Exchange Ratio
, or a royalty trust
Perhaps tellingly, while the
criticize the Board’s actions, they ultimately fail to explain
“why the disinterested and independent directors would disregard their fiduciary
help Flores achieve his self
ted objectives
highlighting various ways in which the Board might
have obtained a higher price,
the Plaintiffs
nonetheless fail to establish a reasonable probability that the Board’s
making process was inadequate or that its
actions were
light of the circumstances
In re BJ’s Wholesale Club, Inc. S’holders Litig.
, 2013 WL 396202, at
*10 (Del. Ch. Jan. 31,
Although the Merger will net
Flores a $900,000 salary increase,
no longer
will be
CEO of an entire company. Given that a higher price would have
Flores substantially more
(or Freeport stock)
, it is diffi
cult to understand, under the circumstances, why he
have been
to obtain the best deal possible.
Leads the Negotiations;
Special Committee
is Formed
The formation of a special committee can serve as “powerful evidence of
fair dealing,”
but it is
every time a board makes a
offered only
conclusory allegations unsupported by facts
statement that the
Board has never disapproved a transaction that Flores recommended
Plaintiffs have not
come close to demonstrating
that Flores dominated and
ed the Board.
Where, as here, s
even of the eight directors
the Board
independent and disinterested
, the need to establish a special committee
under the circumstances,
the Board’s decision not to form a
special committee was reasonable.
the Board’s decision to allow Flores to run the negotiations
was not
unreasonable either.
“While a board cannot completely
abdicate its role in a change of cont
rol transaction, Delaware law is clear that in
certain circumstances it is appropriate to enlist the efforts of management in
negotiating a sale of control.”
Even though Flores
may have been
interested, t
Gesoff v. IIC Indus., Inc
., 902 A.2d 1130, 1145 (Del. Ch. 2006).
Talbert Dep.
at 173.
That the Board has consistently followed Flore
s’ recommendations does not necessarily raise
an inference that the Board is beholden to Flores.
Wayne Cnty. Empls.’
Ret. Sys. v. Corti
, 2009 WL 2219260, at *
13 (Del. Ch. July 24, 2009),
, 996 A.2d 795 (Del. 2010).
circumstances here were appropriate.
could have
reasonably believed
Flores, as CEO of Plains
was in the “best position to advance the interests of
’] stockholders
because he had the
most experience
and deepest
knowledge of
The Board also
was aware
Flores’ conflict of interest
with respect to his future employment at Freeport. First,
noted that Flores
significant ownership of Plains
which aligned h
interests with
of stockholders generally
partially mitigated th
Second, the Board properly
conflict by overseeing the
The Plaintiffs essentially argue that the
remaining directors
abdicated the
ir responsibilities in the
negotiations to Flores.
Perhaps the
could have done more, b
the Plaintiffs’
allegations are
inconsistent with
the numerous board meetings that the directors attended
which they
discussed the pro
posed merger
and participated in the decision
making process
The Plaintiffs
ave not established a reasonable probability that the
See In re OPENLANE, Inc.
, 2011
WL 4599662, at *5 (Del. Ch. Sept. 30, 2
011) (noting that
even if a director is conflicted, his involvement in the negotiations does not necessarily taint the
Proxy at 42.
As evidence that Flores
improperly controlled the negotiation p
ess, the Plaintiffs assert:
controlled the selection of the investment bankers; (2) Flores handled all the
communications between Plains and Freeport; (3) Flores controlled all of t
he information about
Gulf of Mexico
transaction that went
to Freeport;
(4) Flores, not Freeport, reeng
discussions with Freeport regarding the M
erger; and (5) the Board has a history of acquiescing to
Flores’ recommendations.
Without more, t
hese allegations do not show that the merger process
was tainted.
making process was inadequate or that the
Director Defendants
their fiduciary duties so that Flores could obtain future employment at Freeport.
The Failure to
Shop Plains
The Plaintiffs challenge the Board’s decision not to shop Plains at all.
course of action can make it more difficult
or less likely
to obtain the best
available price. But
is no bright
line rule that directors must conduct a pre
agreement ma
rket check
or shop the company
. “When . . . the directors possess a
body of reliable evidence with which to evaluate the fairness of a transaction, they
may approve that transaction without conducting an active survey of the market.”
Moreover, as long a
s the
Board retained “significant flexibility to deal with any
emerging bidder and ensured that the market would have a healthy period of
time to digest the proposed transaction,”
and no other bidder emerged,
the Board
could be as
sured that it had ob
tained the best transaction reasonably attainable.
the record reflects
, t
did not
shop Plains or
in a pre
agreement market check
because they were focused on completing a deal
with Freeport or going forward as a stand
alone company.
Both options were
financially attractive.
buyer negotiation strategy is
it requires a board to rely more extensively on its own knowledge and the
knowledge of
its financial advisor
in determining whether the
Barkan v. Amsted Indus., Inc
., 567 A.2d 1279, 1287 (Del. 1989).
In re Pennaco Energy, Inc.
, 787 A.2d 691, 707 (Del. Ch. 2001).
priced fairly.
Arguably, n
either option provides a robust determination of
market value.
ains has
that its directors,
of whom had significant
ce in the oil and gas
industry and as directors of Plains
, were fully capable
of making an informed
it is difficult from the record
to assess
whether the Board
possessed impeccable knowledge of
and experience
a reasonable inference that
informed and
competent to make
In addition
so long as
company has not agreed to onerous deal protection devices that would
impede a competing bid, a
agreement market
can be an effective
way to
that a company obtains the best price reasonably available
agreed upon
deal protection
devices were not onerous.
The no
solicitation clause combined with a fiduciary out
the Board
to respond to
unsolicited bids if the Board determined in good faith that the bid would
reasonably be expected to lead to a superior proposal.
termination fee ($207 million) was also not unreasonable. Termination fees in
, 567 A.2d at 1287 (noting that “
advice [of an investment banker] is frequently a pale
substitute for the dependable
information that a canvas of the relevant market can provide”)
(internal quotation marks omitted).
See Lyondell Chem. Co.
, 970 A.2d at 243.
Proxy at A
42 (Merger Agreement)
excess of
three percent
have been deemed reasonable
by this Court before
matching rights provision
which provides the modest benefit of the right to
match a
competing offer
would not deter “a fervent bidder intent on paying a
materially higher price for the
, t
hese deal protection
would not have prevented
a serious bidder from putting forth a
or the Board
from entertaining and accepting a
bona fide
The Merger Agreement was executed on December 5, 2012.
More than five
months later,
the market
no doubt fully digested the Merger, and
bids have emerged
perhaps for good
reason. Freeport’
s $50 per share offer
a 39
premium to Plains’ closing price on December 4, 2012
and a 42
premium to the
month average closing price.
In light of
the fact that the Board
a sufficient time for
competing acquirers to
negotiated Freeport’s initial offer upwards, and obtained a substantial
premium for the Company, the Plaintiffs have not established that the Board’s
See, e.g., In re 3Com S’holders Litig.
, 2009 WL 5173804, at *7 (De
l. Ch. Dec. 18, 2009)
(upholding a 4
termination fee).
See, e.g.
In re Toys “R” Us, Inc. S’holder Litig
., 877 A.2d 975, 1019 (Del. Ch. 2005).
The date for submitting approval of the Merger to the stockholders has been delayed beyond
the date initially expected by the Board. Nonetheless, the Board allowed for a reasonable period
of time during which competing acquirers could emerge.
In re
Pennaco Energy, Inc.
, 787
A.2d at 707 (finding that post
agreement market check of roughly three weeks over the holidays
was enough time for potential acquirers to emerge).
failure to undertake a market check or obtain a go
shop period raises a r
likelihood that their claim will be successful on the merits.
or Royalty Trust
The Plaintiffs next complain about what
deal terms the
should have
obtained from an arms
length negotiation between Freeport and Plains.
In doing
realities of a
n arms
, where
essions tend to come at a price
guess the
reasonable business judgments of the Board.
The decision to
or not
for a collar
is within the
business judgment of the Board.
As this Court has observed before, “i
t is not
reasonable to infer that the Board was unaware of the potential benefits (or costs)
that a collar might have.”
may have believed
conventional wisdom
stock would increase as a result of the
, which
why the Board did not
even attempt to secure
But even if the decision in hindsight was a “bad” one, it does not
follow that the decision was unreasonable at the time
was made an
in any event, the Plaintiffs
have not demonstrated that here.
In re NYMEX S’holder Litig.
, 2009 WL 3206051,
at *8 (Del. Ch. Sept. 30, 2009).
. at *8 n.73.
at *8.
ome of the participants in the
, i
ncluding Freeport’s Allison and its bankers
believed that Freeport’s stock price would fall upon announcement of the
Andrews Decl.
Ex. 9
(Weinberger Dep.
) at 193
Andrews Decl. Ex. 6 (Watson Dep.) at 280.
For similar reasons, the Board’s failure to secure an equity “kicker”
a royalty trust)
also does not suppor
A board
has discretion
in deciding what
consideration to seek
in neg
otiating a merger. The
Board sought both a cash and stock component as consideration. Apparently,
Flores attempted to add a royalty
the one
obtained by McMoRan, but
dropped his request when Allison informed him that adding a
result in a lower price per share.
The decision to maximize the sales price in lieu
of obtaining an equity
is one that falls squarely in the busi
ness judgment
of the Board.
Moreover, that decision was not unreasonable because Freeport
stock may outperform any royalty trust that might have
been obtained for
light of
the Board
obtaining a
stock component,
which enables
ins’ stockholders to share in the upside potential of the combined company,
Plaintiffs have failed to
establish a reasonable probability that the Board’s
not to pursue an equity
was unreasonable.

The Management Friendly Nature of Delaware Decisions: In re MFW Shareholders Litigation (The Future) (Part 9)  

What predictions can we make about this case?

First, it needs to be approved by the Delaware Supreme Court.  Although described as pro-shareholder, it is a management friendly decision that reduces the risk of liability on directors.  As a result, the Supreme Court, which is probably more management friendly than the Chancery Court (look at the decisions in the Air Products case), is likely to view the reasoning with considerable sympathy.  The Supreme Court may, however, want to limit or reverse the Chancery Court's view of dicta but will otherwise be likely to leave the reasoning in place. 

Second, the law can be expected to develop in a manner that will make the process less and less rigorous.  The most obvious mechanism for doing so is for the courts to adopt a broad definition of minority shareholders.  To the extent that the minority includes shareholders predisposed towards the controlling shareholder, a majority will be easier to attain.  Thus, for example, the minority shareholders will likely include not only arbs and other short term investors but also management and the shares owned by entities or persons with considerable contact with the controlling shareholders. 

Third, the offer in this case was conditioned upon approval of the unaffiliated shares. This was important to the court's analysis. 

  • From inception, the controlling stockholder knows that it cannot bypass the special committee's ability to say no. And, the controlling stockholder knows it cannot dangle a majority-of-the-minority vote before the special committee late in the process as a deal-closer rather than having to make a price move. From inception, the controller has had to accept that any deal agreed to by the special committee will also have to be supported by a majority of the minority stockholders.

Yet future decisions will likely eliminate this requirement.  Controlling shareholders may seek approval of minority shareholders to obtain the shift in the burden but not condition the transaction on a successful vote.  In those circumstances, the Delaware courts will likely still give them the advantages associated with the use of a special committee.  Thus, entire fairness will be the applicable standard but the burden will shift to shareholders.

This approach means that controlling shareholders will ultimately obtain all of the advantages that can arise from seeking a majority of the minority but none of the disadvantages.  Shareholders will receive something like an advisory vote, able to register opposition to the transaction but having no actual authority to stop it from going forward.

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


Metcalf v. Zoullas: Derivative Action for Excessive Director Compensation

In Metcalf v. Zoullas, No. 11 Civ. 3996 (S.D.N.Y. Jan. 19, 2012), the plaintiffs, John Metcalf et al., brought a derivative shareholder action on behalf of Eagle Bulk Shipping Inc. (“Eagle”), against Eagle’s Board of Directors (“Board”) and certain executive officers, including Eagle’s CEO, Sophocles Zoullas.  Eagle is a Delaware corporation located in the Marshall Islands.  The court denied the defendants’ motion to dismiss under Federal Rule of Civil Procedure (“FRCP”) 23.1 and 12(b)(6). 

The plaintiffs alleged a quid pro quo arrangement in which Eagle’s Board excessively increased director compensation and executive compensation following a change in ownership.  plaintiffs described the amount of   director compensation as  “reach[ing] levels that were generally three to four times” previous amounts despite the absence of  any corresponding change in duties.  They likewise alleged that “hand in hand with the extraordinary rise in director compensation came skyrocketing executive compensation awards, bearing no relationship to Company performance”.  In addition, Eagle allegedly entered into a service agreement with Delphin, a company run by Eagle’s CEO, and Delphin did not provide Eagle with reasonable compensation for its services.  The defendants moved to dismiss the plaintiffs’ complaint on two grounds. First, the defendants claimed the plaintiffs failed to plead demand futility with particularity in accordance with FRCP 23.1.  Second, the defendants argued that they were protected by the business judgment rule, and they moved to dismiss the complaint for failure to state a claim under FRCP 12(b)(6).  

The defendants moved to dismiss the plaintiffs’ complaint on two grounds. First, the defendants claimed the plaintiffs failed to plead demand futility with particularity in accordance with FRCP 23.1.  Second, the defendants argued that they were protected by the business judgment rule, and they moved to dismiss the complaint for failure to state a claim under FRCP 12(b)(6).  

The court first analyzed the defendants’ motion to dismiss under FRCP 23.1.  Under Delaware law, a derivative action allows an individual shareholder to sue directors and executives on behalf of the corporation so long as the shareholder first demands action from the board and executives.  Absent a sufficient demand, the shareholder must prove the demand would be futile.  To prove futility, the court must find a reasonable doubt that either “the directors are disinterested and independent [or] the challenged transaction was otherwise the product of a valid exercise of business judgment.”  It is also possible for the court to treat a related sequence of transactions as a single transaction in order to find reasonable doubt.

In examining the independence and disinterest of the board, the court considered the plaintiffs  “quid pro quo” allegations.  In alleging a sufficient inference of a causal link between the director self- compensation and the compensation paid to the executives, plaintiffs were not limited to a single board meeting.  “If an inference of a quid pro quo arrangement could never arise from non-contemporaneous transactions, those engaged in such misdeeds could too easily render their malfeasance immune from the disinfecting sunlight of shareholder derivative actions, simply by spreading the transactions across multiple board meetings.”

The court found that plaintiffs had alleged the requisite inference.  “Considering the Directors' decisions together and given the particularized factual allegations in Plaintiffs' Complaint, the quid pro quo arrangement alleged by Plaintiffs is a reasonable inference and creates a reasonable doubt as to the disinterestedness of a majority of the Directors with respect to their decisions regarding executive compensation and Delphin.”  Therefore, the court denied the defendants’ motion for dismissal under FRCP 23.1.

The court then analyzed the defendants’ motion to dismiss under FRCP 12(b)(6).  In order to survive a FRCP 12(b)(6) motion to dismiss, a claim must be “plausible on its face” and must allow “the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.”  With respect to claims concerning director compensation, plaintiffs must allege “compensation rates excessive on their face or other facts which call into question whether the compensation was fair to the corporation when approved, the good faith of the directors setting those rates, or that the decision to set the compensation could not have been a product of valid business judgment”. 

The court found that the allegations were sufficient to “call into question whether the compensation was fair to the corporation when approved, the good faith of the directors setting those rates, or that the decision to set the compensation could not have been a product of valid business judgment.”  Moreover, the court noted that  “[l]ike any other interested transaction, directoral self-compensation decisions lie outside the business judgment rule’s presumptive protection….”  As a result, the “’initial burden’” of establishing fairness rested with defendants.  As a result, the court declined to dismiss the case under Rule 12(b)(6). 

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


Saginaw Police & Fire Pension Fund v. Hewlett Packard Company: Derivative Action Alleging Knowledge of Illegal Activity

In Saginaw Police & Fire Pension Fund v. Hewlett Packard Company, No. 5:10 CV 4720 EJD, 2012 WL 967063 (N.D. Cal. Mar. 21, 2012), the district court dismissed the plaintiff’s derivative action with leave to amend. The plaintiff, Saginaw Police & Fire Pension Fund, brought a shareholders’ derivative action alleging that current and former Hewlett Packard Company (“HP”) officers and board members violated provisions of the federal False Claims Act (“FCA”), the Anti Kickback Act of 1986 (“AKA”), the Truth in Negotiations Act (“TINA”), and the Foreign Corrupt Practices Act (“FCPA”).

According to the plaintiff,  HP paid $55 million to settle a qui tam action alleging violations of the FCA, AKA, and TINA  but  did not admit liability.   The complaint alleged that HP “allowed violations to continue until December 2009.” Plaintiffs further alleged that HP’s Board of Directors (“Board”) approved compensation to the CEO in the amount of $30,332,527, even though there were “allegations that [the CEO] actively participated in the kickback scheme.”

The Board sought dismissal alleging plaintiff’s failure to make demand.  Plaintiff argued that demand would be futile.  In order for demand to be excused,  the complaint must contain  “particularized factual allegations sufficient to establish that either (1) any of the directors are interested and that other directors are compromised in their ability to act independently of the interested directors, or (2) that at least half of the directors face a sufficiently substantial threat of personal liability.” [cite]

The plaintiff argued that the initial demand was properly excused because the Board was not protected by the business judgment rule.  Plaintiff asserted that the Board became aware of illegal conduct through the 2007 DOJ suit, yet “failed to take action to stop the illegal conduct [until December 2009].” The plaintiff further argued that Board members were interested because they could face personal liability.

The court held that the fact a board is subject to investigation or “the mere threat of personal liability” is insufficient to allege a breach of fiduciary duties. The plaintiff must show that the directors “face a ‘substantial likelihood’ of personal liability” through “detailing the precise roles that these directors played at the company, the information that would have come to their attention in these roles, and any indication as to why they would have perceived [the alleged violation].” The court reasoned that the Board actually did take action in 2007 because it hired a consultant to investigate the allegations. HP also had a company policy in place prohibiting bribery, and the Board received regular reports regarding compliance.

The court also held that the plaintiff failed to show how the Board was “not adequately informed” or acted in bad faith when exercising its business judgment to award the CEO’s compensation.  As the court reasoned:

In the Complaint, Plaintiff does not show that Hurd's compensation was egregious or irrational. Plaintiff notes that the Board based Hurd's compensation on HP's 'superior financial results, as well as significant achievement on a broad range of non-financial goals, including strategic acquisition, talent management, and succession planning.' These standards of evaluation indicate that the Board did, in fact, act in good faith in determining Hurd's compensation.

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


The Flawed System for the Election and Nomination of Directors (The Fiduciary Obligations of Directors)

We are discussing the recent election of directors at Sirius XM Radio.  Shareholders overwhelmingly voted against one of the candidates nominated by the Board.  According to the proxy statement, the director had missed at least a quarter of board and committee meetings.  The WSJ article went further and indicated that the director did not attend any board or committee meetings in 2011.  Id.  ("Sirius XM Radio Inc. held seven meetings for its 13-person board during 2011.  [The Director], a well-known private-equity player, attended none of them."). 

The proxy statement contained no explanation of the attendance record.  Quite the contrary. The proxy statement noted that the director's "experience in the private equity industry brings a long-term strategic perspective to the board’s deliberations."  This "perspective" apparently did not require actual attendance at meetings to be delivered. 

Nor was the attendance issue an isolated event.  In 2010, the same director also failed to attend 75% of the meetings.  This time, however, the proxy statement at least provided some additional information about his role in the governance process.   

[The Director] has regularly advised our directors and executive offices on various matters of significance, including financings and strategic transactions. [The Director] has also made arrangements to have a colleague observe board meetings he has been unable to attend personally and brief him on the proceedings of the board.

That year he received a majority of the votes cast by shareholders.

He did not meet the 75% threshold in 2009, see Sirius Proxy Statement, March 2010 ("During 2009, there were eighteen meetings of our board of directors and two written consents in lieu of a meeting. Each director, other than [the Director] attended more than 75% of the total number of meetings of the board and meetings held by committees on which he or she served."), and again failed to receive a majority of the votes cast.  See Current Report on Form 8-K,  June 1, 2010 (408,528,344 votes for,458,481,167 votes against). 

The Directors did not attend at least 75% of the meetings in 2008, see Proxy Statement, at 14 ("During 2008, there were nine meetings of our board of directors and one written consent in lieu of a meeting. Each director, other than [the Director], attended more than 75% of the total number of meetings of the board and meetings held by committees on which he or she served."), or in 2007.  See Proxy Statement, at 10. 

All of this raises serious questions about the board's fiduciary obligations.  In Business Roundtable v. SEC, the case that struck down the shareholder access rule, the court essentially noted that board had a fiduciary obligation to oppose candidates for the board that were not the most "appropriate."  While the court noted the obligation in the context of the board's "duty" to resist a shareholder nominee, the same obligation presumably applies to the nomination of directors in the first instance. 

In other words, the board has an obligation to show how the nomination of a director who has not attended at least 75% of the board meetings for years was in the best interests of shareholders. 


Narrowing the Scope of Inspection Rights: Espinoza v. HP (Part 3)

In addressing the disclosure of the Covington Report, the Supreme Court was to some degree hemmed in.  It could not find the absence of a proper purpose.  As the opinion noted:  "It is uncontested that, as a matter of law, Espinoza has stated a proper shareholder purpose under Section 220 —to investigate possible wrongdoing."  Similarly, the plaintiff provided a credible basis for the claim.  Id.  ("Nor is it contested that he has made the required factual showing of a credible basis to infer possible mismanagement.").  As a result, "entitlement to inspection relief is not at issue."

Then there was the reason given by the lower court -- that plaintiff "had not demonstrated a need to inspect the Covington Report sufficient to overcome the attorney-client privilege and work product immunity protections."  The lower court's reasoning had two problems.  First, it was hard to justify a finding of an absence of need.  The Report went to both the informed nature of the decision and the "red flags" available to the Board, something that implicated good faith. 

Second, the opinion was narrow.  It allowed for the withholding of the Report only when it conflicted with privilege.  Given that Chancery Court's characterization of the Report as potentially "helpful" to plaintiffs, cases dealing with similarly sensitive material that did not implicate privilege would likely be subject to disclosure. 

The Supreme Court, therefore, did not rely on the lower court's analysis.  Instead, it relied on common law standards designed to allow courts to limit the scope of an inspection.  In effect, the court concluded that "scope" was limited to those documents that were "essential" to the alleged purpose (corporate wrongdoing) and that plaintiff had not made a sufficient showing to justify disclosure of the Report.  See Id.  (Plaintiff has not "shown that the Covington Report is essential to his stated purpose, which is to investigate possible corporate wrongdoing."). 

The Court gave three reasons for affirming the right of the Company to withhold the Report.  First, the Report, according to defendants, "does not discuss the 'for cause' issue."   

  • If the Covington Report discussed the "for cause" termination issue, then Espinoza's claim would stand on a significantly different footing. But, as HP represented to both the Court of Chancery and this Court, the Covington Report contains no discussion or analysis of the "for cause" issue.

In other words, the Court considered the absence of any specific language about a "for cause" dismissal to be outcome determinative.

Second, plaintiff had not shown "by a preponderance of the evidence" that the Report was "central" to the Board's decision to enter into the separation agreement, rather than terminate [the CEO] for cause."

  • It is conceivable that the Board consulted the Covington Report when it deliberated whether or not to terminate Hurd "for cause." Even if that were so, it is undisputed that the Report was not prepared for the purpose of the Board considering the "for cause" issue. Nor does it otherwise appear from the record what role, if any, the Report actually played in the Board's termination decision.

The third reason given by the Court was that HP had already "disclosed the information contained in the Covington Report that is essential to Espinoza's Section 220 stated purpose."  This included "considerable documentation of the circumstances of [the CEO's] departure." The "considerable documentation" included records documenting much, if not all, of the misconduct that the Board's investigation uncovered and that the Covington Report chronicled." 

We will discuss the implications of the decision in the next post.  Primary materials for the case at the trial level can be found at the DU Corporate Governance web site.


Narrowing the Scope of Inspection Rights: Espinoza v. HP (Part 2)

So what happened in this case?  According to the opinion, the CEO at HP eceived a letter from an employment lawyer that claimed that the CEO "had sexually harassed her client . . . over the two-year period".  The letter, as the Court set out, "threatened legal action against both [the CEO] and HP" but also "suggested the possibility of reaching a confidential settlement." 

The CEO informed the general counsel of the letter and the company initiated an investigation.  As the opinion described:

  • The Board retained Covington & Burling to conduct the inquiry and, based on that firm's findings, to advise the Board accordingly. On July 28, 2010, the Board was presented with the Covington Report, which contained interim factual findings and analysis arising out of the Covington firm's investigation.

A week later, the CEO agreed to a confidential settlement.  The next day, the company announced the CEO's departure.  In the announcement, the board noted that the "internal investigation did not show that [the CEO] had committed sexual harassment" but did "reveal that [the CEO] had breached HP’s Standards of Business Conduct." The board approved a separation agreement that provided for "among other benefits, severance payments estimated as worth over $30 million."

Plaintiff sought documents to determine whether execution of the separation agreement violated the board's fiduciary obligations.  The company made some documents available, "subject to a confidentiality agreement". The disclosure (which the court described as "extensive documentation") did not include the Covington Report.   

Plaintiff sought to compel disclosure of the Covington Report.  According to the Court:

  • Espinoza’s complaint alleged that he was entitled to relief because the Covington Report “uniquely detail[s] . . . the bases for the possible courses the Board evaluated and why it chose not to terminate Hurd for cause,” and that “[t]his information is unavailable from any other source.” Espinoza further claimed that that Report “contained the scope of the investigation, the investigative activities undertaken, findings of possible violations, and potentialdisciplinary options for HP.”

The Company declined to turn over the Report asserting that it was "protected from disclosure under the attorney-client privilege and work product immunity doctrine."

The Chancery Court sided with HP.  The Chancery Court conceded that the report contained information that "might be helpful to the plaintiff in that it is something the board considered in making its decision" but because it did not contain "the thought process of the board or any committee" it was "not necessary to the plaintiff's investigation into the board's thought process in deciding not to fire" the CEO for cause.  The lower court, therefore, took the position that, in failing to show necessity, plaintiff had not met its burden of overcoming the privilege.

As we will see in the next post, the Court found a way to allow the company to withhold the report but declined to follow the reasoning of the Chancery Court. 

Primary materials for the case at the trial level can be found at the DU Corporate Governance web site.


Narrowing the Scope of Inspection Rights: Espinoza v. HP (Part 5) 

We have often discussed the use in Delaware of pleading standards that impose onerous burdens on plaintiffs that in effect interfere with determinations on the merits.  The "credible basis" standard is an example.  The same is true with respect to director independence (or non independence).  See Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty

This case illustrates the approach.  The obligation to show that a document is "essential" or "central" falls on shareholders.  As the Court noted:

  • Espinoza’s specific investigatory purpose is to “investigate why the Board paid tens of millions of dollars rather than dismiss [Hurd] for ‘cause.’” Espinoza bears the burden of proving that the information contained in the Covington Report is essential to that purpose, taking into account the books and records HP has previously furnished.

Shareholders are, of course, at a disadvantage.  They do not have a copy of the relevant documents and do not, therefore, precisely know their contents, making it harder to meet this requirement.  The companies know the contents and know the relative importance of the requested material but they do not have the burden.

One way to address this disparity is to have the document inspected by the court.  An in camera review can determine the overall importance of the contents. In that way, the courts do not have to rely on barriers imposed by difficult pleading standards but can actually resolve the matter on the merits. 

In Espinoza, however, there is no evidence in either opinion, the one by the Chancery Court or the one by the Supreme Court, that either court ever actually examined the Covington Report.  They were therefore prepared to make findings about the "essential" nature of the document without ever actually examining the contents. 

The Supreme Court in Espinoza hinted that this was problematic.  As the Court stated:  "In a dispute over the contents of the demanded materials, in camera inspection by the trial court may be appropriate to reach a decision."  Id. at n. 20.  Presumably this is designed to encourage trial courts to actually examine the relevant document in these sorts of circumstances. 

Nonetheless, as this case illustrates, in camera inspections are not required.  In these circumstances, it will be the pleading standards rather than the actual merits that determine the outcome of the issue. 


Narrowing the Scope of Inspection Rights: Espinoza v. HP (Part 1)

Shareholders have the right, under state law, to "inspect" corporate records.  In Delaware, the right appears in Section 220Like most states, the statute requires shareholders to have a "proper purpose" for any request.  The statute defines proper purpose broadly.  As Section 220 provides:  "A proper purpose shall mean a purpose reasonably related to such person's interest as a stockholder." 

The Delaware courts, however, have generally interpreted "proper" in a narrow fashion.  Rare exceptions aside (see City of Westland v. Axcelis), they require shareholders to mostly allege that the records are necessary to investigate possible wrongdoing.  Wrongdoing in turn means breach of fiduciary obligations. 

That by itself limits the availability of inspection rights.  Shareholders cannot inspect matters that are simply important, whether a major shift in business or a material acquisition.  They cannot look at compensation matters unless the purpose is to investigate wrongdoing. 

In addition, the courts have grafted onto the statute a requirement that shareholders present a "credible basis" for any purpose alleged.  Delaware courts represent that the "credible basis" standard is a low one but in fact it is a common basis for dismissing claims.  This is because, as Seinfeld illustrates, the courts do not permit shareholders to obtain documents when the facts speak for themselves (that case involved allegations that the company paid $200 million in compensation to three officers over a three year period).

Instead, they require affirmative evidence of a breach of fiduciary duties.  Given that a breach often requires a showing of a procedural deficiency, this type of evidence can be difficult to allege at a pre-discovery stage. 

Finally, if plaintiffs want to inspect and the company declines, Delaware does not automatically permit shareholders to recover litigation costs.  Instead, they must assert and establish "bad faith" by the company, a standard that makes recovery of fees very difficult. 

Nonetheless, sometimes shareholders succeed in presenting a proper purpose and in producing the requisite "credible basis."  In those circumstances, they can typically obtain such antiseptic documents as board minutes and meeting agendas.  Because these documents are often "thoroughly advised," they are likely to be written in a manner that reveals as little as possible.  See Mercier v. Inter-Tel (Del.), Inc., 929 A.2d 786, 797 (Del. Ch. 2007) ("The meeting was clearly and thoroughly "advised," shall we say, and the meeting minutes do not reflect the obvious reality driving the need for the meeting: the Merger was going down to defeat the next day.").

There are other documents, however, that may be exceedingly sensitive and important.  Investigative reports are an example.  Often when the board has concern with possible misbehavior inside the corporation it will commission an investigation.  This is sometimes necessary to meet the board's fiduciary obligation of good faith.  The investigations are commonly conducted by lawyers and may well be written in a manner that is "thoroughly advised."  Nonetheless, while one cannot generalize about all reports, it is likely the case that they will at least sometimes contain highly sensitive information about the behavior under investigation. 

In Espinoza v. HP, the Delaware courts confronted an inspection request for an investigative report.  Plaintiffs had a proper purpose for seeking the report and met the "credible basis" standard.  Both the Court of Chancery and the Delaware Supreme Court nonetheless concluded that shareholders could not obtain the report, although the two courts did not agree on the basis for the determination. The Supreme Court in the end denied access by imposing onerous standards that plaintiffs must meet in describing the relevant records that ought to be disclosed once a proper purpose and credible basis has been established. 

We will examine the Supreme Court's decision in the next few posts. 

Posts on the Chancery Court decision begin here.  Primary materials for the case at the trial level can be found at the DU Corporate Governance web site.


Judicial Encouragement of Uninformed Directors: J&J Derivative Litigation (Part 4)

Plaintiffs also alleged that the board became aware of "red flags" by virtue of disclosure in the annual report on Form 10-K of a settlement between the DOJ and a J&J subsidiary.  The settlement resolved a criminal complaint (see P. 273 of the Complaint) and involved the execution of a corporate integrity agreement (CIA), a deferred prosecution agreement (DPA), and an $85 million fine. 

The court held that this was not a sufficient red flag to put the board on notice that the subsidiary “systematically and continuously engaged in illicit conduct.”  In doing so, the court emphasized language in the settlement disclaiming wrongdoing.  The court pointed to a statement that the company "denies that any of the payments, services, or renumeration were illegal, improper, or resulted in any false or fraudulent claims."  Similarly, the agreement stated that it was "neither an admission of any facts or liability by DePuy nor a concession by the United States that its claims are not well founded."

As a result, the court concluded that it was "not clear whether the settlement itself suggested to the Board that DePuy had engaged in illegal behavior.”  As for the amount of the settlement, the court also found this ambiguous.  

  • Of course, one could argue that the Board should have known from the large amount of the settlement—$85 million— that DePuy must have engaged in illicit conduct. But, on the other hand, the Board may have reasonably concluded that the settlement reflected nothing more than a business decision on DePuy's part. Even if the directors assumed that the settlement was merely a business decision, and that the directors' assumption was erroneous, nonetheless they would not be subject to liability if they made that assumption in good faith.

As a result, "the Court cannot infer from Plaintiffs' allegations that the Board knew that the DPA related to an Anti-Kickback Statute violation."

Plaintiffs, therefore, successfully alleged that the board knew about the settlement with the government and the $85 million payment but the court found that this did not amount to a "red flag."  In other words, the board had no duty to investigate or otherwise become informed even when learning of these developments. 

For primary materials on this case, go to the DU Corporate Governance web site.


Judicial Encouragement of Uninformed Directors: J&J Derivative Litigation (Part 3)

We are discussing In re Johnson & Johnson Derivative Litigation, 2011 US Dist. Lexis 112292 (D NJ Sept. 29, 2011).

Plaintiffs did more than attribute knowledge to the board through a committee.  Plaintiffs also asserted that the board was aware of "red flags" by virtue of the information disclosed by the company in its annual report on Form 10-K.   Plaintiffs pointed out the annual report disclosed the receipt of a subpoena from the United States Attorney's Office, District of Massachusetts “seeking documents related to sales and marketing of eight drugs to Omnicare, Inc., a manager of pharmaceutical benefits for long-term care facilities.”

The court more or less accepted that disclosure in the annual report was sufficient to put the board on notice of the subpoena.  Instead, however, to be a red flag, "the pertinent question is not whether the Board knew about the subpoena but whether the subpoena is a determination of wrongdoing."  The disclosure in the annual report did not mention kickbacks “nor does it suggest that J&J or its subsidiaries acknowledged wrongdoing.”  As the court summarized:

  • At least one court has suggested that subpoenas, and other forms of preliminary matters in an investigation of corporate misconduct, do not shed light on whether the corporation actually engaged in misconduct.  I find this reasoning persuasive because such red flags do not suggest that a board was aware of corporate misconduct—they suggest only that the board was aware that the company was under investigation.

Similarly, the plaintiffs also alleged that the board was aware of the violations because of the disclosure of two qui tam suites in the annual report on form 10-K.  The court, however, held that disclosure in the annual report alone was not enough. 

  • “Noticeably absent from Plaintiff's allegations, however, are any facts indicating that the Board received copies of the qui tam complaints. To the extent the existence of the suits is reported in a 10-K form, that does not communicate to the directors anything about the nature of the claims asserted.  Without that information, the Court cannot discern whether the Board knew that . . . kickback behavior [continued] after the 2005 subpoenas were issued.”

The court, therefore, held that directors have no duty to inquire or investigate when they learned that a subpoena had been issued by a regulatory body capable of bringing criminal charges. In other words, notice of a potential criminal investigation was not enough to trigger a duty by the board to look into the matter. 

The holding demonstrates a central weakness in the board's fiduciary obligations.  Even when aware of an investigation there is no duty to investigate.  The approach encourages a "head in the sand" approach to management.  Moreover, the court's decision also encourages the company (and the board) to make minimal disclosure whenever an investigation occurs.  The less disclosed, the less likely knowledge will be attributed to the board. 

For primary materials on this case, go to the DU Corporate Governance web site.