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.  


The Move to Fee-Shifting By-Laws Begins in Delaware

As discussed in earlier posts (here and here), the Delaware Supreme Court in ATP Tour v. Deutscher recently upheld the use of a fee-shifting by-law by a non-stock company and the Delaware legislature failed to pass legislation that would prohibit their use during the last legislative session. With the window of opportunity open, at least two public companies have already adopted such by-laws. Echo Therapeutics and LGL Group Inc. are among the early adopters. 

          Echo Therapeutics’s by-law reads as follows:

  • Litigation Costs.  To the fullest extent permitted by law, in the event that (i) any current or prior stockholder or anyone on their behalf (“Claiming Party”) initiates or asserts any claim or counterclaim (“Claim”) or joins, offers substantial assistance to, or has a direct financial interest in any Claim against the Corporation and/or any Director, Officer, Employee or Affiliate, and (ii) the Claiming Party (or the third party that received substantial assistance from the Claiming Party or in whose Claim the Claiming Party had a direct financial interest) does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then each Claiming Party shall be obligated jointly and severally to reimburse the Corporation and any such Director, Officer, Employee or Affiliate, the greatest amount permitted by law of all fees, costs and expenses of every kind and description (including but not limited to, all reasonable attorney's fees and other litigation expenses) (collectively, “Litigation Costs”) that the parties may incur in connection with such Claim.

It would not be surprising if other companies follow the lead of Echo Therapeutics and LGL Group. What will be of great interest is what may happen in the near future if many companies go down that path. Will shareholders, who under Delaware law also have the authority to amend by-laws, try to repeal board adopted fee-shifting by-laws? Or consider the following scenario. A company adopts a fee-shifting by-law. A shareholder (or group of shareholders) brings a suit that is covered by the by-law. Before the suit is concluded, the Delaware legislature enacts the proposed change to the DGCL that would make such a by-law void. Is the application of the fee-shifting provision considered at the time the law suit was filed or at the time the effect of the fee-shifting provision would be relevant to the proceeding in issue?

The potential for confusion and inter-corporate conflict is strong. Good for the lawyers but maybe not so much for companies and their shareholders.


Fee-Shifting By-Laws Remain Valid in Delaware For Now

As discussed in earlier posts (here and here) the Delaware Supreme Court in ATP Tour v. Deutscher recently approved the use of a fee-shifting by-law by a non-stock corporation.  The by-law allowed the recovery of "fees, costs and expenses" from any member/owner who brought a claim of any kind against the [entity] or any member/owner where the member/owner did "not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought.”

Fearful that such by-laws would chill litigation, on May 22, 2014, the Delaware Corporate Law Council proposed an amendment to the DCGL that according to the amendment’s synopsis is “intended to limit the applicability of [the Delaware Supreme Court decision in ATP Tours, Inc. v. Deutscher Tennis Bund] to non-stock corporations, and to make clear that such liability may not be imposed on holders of stock in stock corporations.”   

It was widely expected that the Delaware General Assembly would act on the proposed amendment before the end of its June term and it was expected that the amendment would become effective on August 1, 2014.

That is not to be.  In a victory for the US Chamber of Commerce, the Delaware legislature instead adopted a resolution to continue examining the issue, according to Senator Bryan Townsend, the sponsor of the proposed amendment.  The U.S. Chamber Institute for Legal Reform opposed the legislation, writing two letters to state lawmakers requesting delays. The Chamber said the bill would protect frivolous lawsuits intended to "line the pockets of the plaintiffs' trial bar at the expense of national and Delaware companies and their shareholders."

ILR President Lisa A. Rickard wrote that the court’s decision "gives corporations a way to protect their shareholders against these costs of abusive litigation.”  "Why would the Legislature so quickly deprive shareholders of the opportunity to obtain that protection?” she added. The ILR further states that it “will continue to staunchly oppose this legislation, as well as to educate lawmakers on the negative impact this bill would have on Delaware’s business climate.”

The proposed legislation, “takes away a new tool authorized by the Delaware courts … which businesses could use to reduce the amount of unnecessary litigation that accompanies corporate mergers,” wrote ILR's Andrew Wynne.

It is not certain when the bill will finally be considered although it probably will not reach the Delaware legislature before January 2015.  This gives the US Chamber and other business groups opposing the legislation plenty of time to rally their forces.  Proponents of the amendment will also undoubtedly work in the intervening time to shore up support.  It may prove to be an interesting battle.  It will also be interesting to see if any Delaware corporations take advantage of the delay to pass fee-shifting by-laws.  


Delaware General Assembly Asked to Bar Fee Shifting By-Laws

As was discussed in an earlier post (here) the Delaware Supreme Court recently upheld a fee shifting bylaw adopted by a non-stock corporation in ATP Tour v. Deutscher and suggested that it was likely that  the Delaware legislature would take action to overturn portions of the decision, as it did with respect to CA v. AFSCME.

Those actions are well underway.  On May 22, 2014, the Delaware Corporate Law Council proposed an amendment to the DCGL that according to the amendment’s synopsis is “intended to limit the applicability of [the Delaware Supreme Court decision in ATP Tours, Inc. v. Deutscher Tennis Bund] to non-stock corporations, and to make clear that such liability may not be imposed on holders of stock in stock corporations.”   

The amendment affects § 102(b) (6), Title 8 of the Delaware Code and adds a new Section 331.  Under new Section 331 and Section 102(b) (6) as amended, a provision of the certificate of incorporation or bylaws that would purport to require a holder of stock in a stock corporation to pay expenses incurred by the corporation, its directors, officers, employees, agents or controlling stockholders in connection with litigation initiated or claims prosecuted by the stockholder would be facially invalid.   The expansive wording of the proposed Section 331 would prohibit not only fee-shifting provisions in charters and bylaws, but practically all charter and bylaw provisions that would impose liability on stockholders.

The amendments are not intended to limit a court's power to impose sanctions under applicable law or the enforceability of any charter or bylaw provision that binds any person pursuant to any separate contract.

A corresponding amendment proposed to Section 114(b) (2) makes clear that the prohibition in Section 331 would not apply to non-stock corporations. As noted in the proposed amendments' synopsis, these amendments are "intended to limit applicability of [the Court's ATP Tour decision] to non-stock corporations, and to make clear that such liability may not be imposed on holders of stock in stock corporations."

The legislation is expected to be presented to the Delaware General Assembly before the end of its term in June and is slated to become effective on August 1, 2014.

The purported public policy reasoning behind the proposed statute is that fee shifting bylaws unduly chill meritorious claims from being brought, and undermine the limited liability protections afforded to shareholders by Delaware corporate law.   Of particular concern (supposedly) was that a fee shifting provision would chill the willingness of a stockholder to file claims in order to enforce the fiduciary duties of directors. 

Whether you believe that these reasons lie behind the quick proposal of the amendments barring fee shifting bylaws or whether you accept other justifications (set forth here) it seems extremely likely that they will be enacted. 

The rush to pass these amendments is both ironic—Delaware encouraging shareholder litigation!—fiduciary duty suits!—and to some degree unfortunate.  By enacting a blanket prohibition on all fee shifting bylaws, Delaware misses an opportunity to craft a more nuanced approach.  Not all cases are the same.  It may be that fee shifting is appropriate in some but not in others.   The proposed amendments forestall the opportunity to engage in a broader discussion about the appropriate role of fee shifting bylaws specially and the role of stockholder litigation generally.


ATP Tour v. Deutscher: The Management Friendly Nature of Delaware Law (The Implications)

ATP is a very management friendly opinion. The basic holding that fees can be shifted will reduce the number of actions filed by shareholders.  

Potentially even more momentous, the Court's reading of Section 109 entails an almost unlimited interpretation of the "business of the corporation." Anything that can be done by contract can be done by bylaw as long as it involves the company's business. Thus, a bylaw could presumably require a shareholder to waive the right to a jury trial since these provisions routinely appear in contracts.  

Nonetheless, the broad holding, once it moves to the traditional for profit corporate context (recall that ATP involved a non-stock corporation), will likely be narrowed (or the Delaware legislature will overturn portions of the decision, as it did with respect to CA v. AFSCME). Indeed, the Court left open this possibility by noting that the bylaw at issue "appear[s] to satisfy" Section 109. Appearances can change.  

There are a couple of reasons to expect a change in appearance.

First, the courts have already thrown up substantial barriers to shareholder actions. As a result, even meritorious cases are routinely thrown out because of pleading burdens. Given the high risk of dismissal, a fee shifting bylaw will likely prevent shareholders from bringing legitimate claims.  

Broadly written the provision could also shift fees in appraisal cases. Given the uncertainty of the determinations in these cases, a fee shifting provision applicable where shareholders did not "substantially achieve[]" the full remedy sought could effectively eliminate the statutory right. This consequence will cause shareholders to seek to have the limit overturned. To the extent it does not happen in Delaware, shareholders will have to seek a federal remedy. Preemption in short.  

Second, Delaware thrives on shareholder litigation. It fills the hotels, compensates the bar, and allows the courts to determine national corporate law. The management friendly nature of the Delaware courts has already caused a substantial number of cases to move to other jurisdictions. Forum selection bylaws are an attempt to stem the outflow. To the extent that Delaware courts are willing to rigorously enforce fee shifting bylaws, shareholders will have even more incentive to file suit outside of Delaware. Courts in other jurisdictions would presumably be more likely to narrow the application of these bylaws or invalidate them on public policy grounds.

Delaware, therefore, has an incentive to, and will, narrow the import of the ATP holding.  

Nonetheless, the decision is instructive. As we have noted before, there was a time (the 1980s) when shareholders could occasionally win a major governance case (Van Gorkom) or at least not entirely lose (Unocal). Those days are, however, over. It is, in the end, an unfortunate change. Federal preemption comes at a cost. Yet the decisions of the Delaware courts are causing the benefits of federal preemption to outweigh the costs.

We are discussing ATP Tour v. Deutscher. The Opening Brief of the Appellant is here; the opening brief of Appellees is here; and the reply brief of the Appellant is here.


ATP Tour v. Deutscher: The Management Friendly Nature of Delaware Law (Overview)

Accepting a certified question from the federal district court, the Delaware Supreme Court issued an opinion on a fee shifting bylaw adopted by a non-stock corporation in ATP Tour v. Deutscher.  

The bylaw allowed the recovery of "fees, costs and expenses" from any member/owner who brought a claim of any kind against the "League" (presumably the corporation) or any member/owner where the member/owner did "not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought."  

The provision was extremely broad and unmoored from corporate law principles. First, it applied to actions not only against the corporation but also actions where one member sued another. 

Second, the bylaw was not limited to fiduciary duty claims or actions involving the DGCL but applied whenever a member/owner "initiates or asserts any [claim or counterclaim (“Claim”)]" or, as the Appellant's stated, the provision applied "regardless of the nature of the legal theories asserted." It would, therefore, cover claims for breach of contract.  

Third, to the extent the member/owner won on the merits, fees could still be recovered to the extent the member did not "substantially achieve[]" the remedy sought.     

Fourth, the provision applied even to members who are not parties to the action. Merely offering "substantial assistance" was enough to trigger the fee shifting burden.   

In other words, the bylaw went well beyond the internal affairs of a corporation. Nor did the basis for upholding the bylaw have anything to do with the statutory framework in place for corporations.  

In upholding the right to adopt a fee shifting bylaw, the Court noted that the provision "would also appear to satisfy" Section 109(b) which permitted the adoption of bylaws "relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees." Yet when the Chancery Court relied on this same provision to uphold the forum selection bylaw, it specifically referenced the fact that the bylaw only addressed claims "arising under the DGCL or other internal affairs claims." Boilermakers Local v. Chevron, 73 A.3d 934 (Del. Ch. 2013). The byalw at issue in ATP had no such limit.  

Instead, the Supreme Court upheld the bylaw on the basis of a metaphor (remember nexus of contracts?) that once was, but no longer is, particularly popular among corporate law scholars. (The current adage is "private ordering.") The Court decided that the provision could be upheld due to the contractual nature of bylaws.  

  • Because corporate bylaws are “contracts among a corporation’s shareholders,” a fee-shifting provision contained in a nonstock corporation’s validly-enacted bylaw would fall within the contractual exception to the American Rule. Therefore, a fee-shifting bylaw would not be prohibited under Delaware common law. 

Essentially, therefore, bylaws as a matter of substance could address any issue that could be included in a contract. But contracts also require agreement of the parties.  

No such explicit agreement occurred in this case. The bylaw was not approved by the members. Indeed, the Appellees indicated that they were not put on notice of the fee shifting provision until after the litigation had commenced. See Appellee Brief, at 8 ("The Bylaws provided on June 1, 2007 by the ATP to its tournament members, including the Federations–six weeks after the filing of this litigation and three weeks after the filing of ATP’s Answer–did not contain any Bylaw Article 23, generally; Bylaw 23.3(a), specifically; or any other fee­shifting or attorney’s fee provision.").  

Admittedly, bylaws are binding on shareholders who acquire an ownership interest after adoption. But that is because of statutory fiat, not contractual principles. The Court, therefore, relied only on the portions of contract law that were consistent with the decision to uphold the bylaw and ignored those that were not. 

We will discuss some of the implications of this provision in the next post.   

We are discussing ATP Tour v. Deutscher. The Opening Brief of the Appellant is here; the opening brief of appellees is here; and the reply brief of the Appellant is here


One of Delaware's "Worst" Shareholder Decisions Reversed: LAMPERS v. Hershey

Last year, one of our worst shareholder cases for 2013 was the decision by a Delaware Master to deny shareholders access to documents designed to determine Hershey's knowledge of, or involvement in the purchase of, cocoa produced from child labor. The case really raised the issue of the right of shareholders to explore board awareness of human rights violations in the supply chain.      

In effect, the master found that the plaintiffs had not shown a “credible basis” from which the court “could infer possible mismanagement or wrongdoing at The Hershey Company.” From the Master's perspective, this was not a close case. As the Master reasoned:     

  • The question this case presents is whether illegal conduct within one sector of an industry provides a credible basis from which this Court may infer that wrongdoing or mismanagement may have occurred at a company in that industry. This is not a novel question, having been addressed, for example, in two other cases involving the stockholder who filed this action. In this case, because the stockholder failed to sustain its minimal burden of providing credible evidence from which the Court may infer mismanagement or wrongdoing at Hershey, rather than within the cocoa supply chain, I recommend that the Court dismiss the complaint. 

In addition to criticizing the “credible basis” analysis, we noted that this approach would only embolden Congress to impose more socially responsible disclosure requirements (e.g., conflict minerals) since decisions like Hershey made clear that there was no meaningful state law avenue for obtaining this type of information. 

Earlier this year, however, that decision was effectively reversed. In La. Mun. Police Employees’ Ret. Sys. v. Hershey Co., 7996-ML, Del. Ch., March 18, 2014, VC Laster authorized access to corporate records. The court noted that shareholders were not obligated to “prove” mismanagement but only provide a “reasonable basis from which” a court could “infer . . . possible mismanagement. . . .” The recommendation of the Master “sadly” focused on “whether actual wrongdoing has occurred.” The court determined that the allegations “read in the doubly plaintiff-friendly manner that is required in this procedural posture, support a reasonable inference of possible violations of law in which Hershey may be involved.”

The court found a number of inferences that were sufficient to find a "credible" basis. The complaint supported "a reasonable inference . . . that the board knows some of its cocoa and cocoa-derived ingredients are sourced from farms that exploit child labor and use trafficked persons."  

Another inference was that: 

  • Hershey's cocoa sustainability efforts, which admittedly and necessarily put Hershey in contact with farmers in West Africa, results in Hershey knowing of instances involving the use of trafficked children on cocoa farms in Ghana that would have triggered the duty to inform. That is not the only possible inference, but it's one possible inference. And at this procedural stage, I have to credit it.

And inferences arose from silence on some matters:  

  • Hershey has not provided any information about its suppliers. One possible inference—not the only inference, but one possible inference is that Hershey's relationships with its suppliers could support a finding of the use of labor for an aiding and abetting claim. Not the only possible inference, but one possible inference.

The decision is a common sense analysis of the allegations. The court allowed the use of public sources, including disclosure by the company, to establish a credible basis. In many ways, it was an easy case. The child labor issue appears to be widely known, Hershey purchases a substantial amount of cocoa, and the company specifically disclosed that it expected suppliers to adhere to their "commitment to legal compliance and business integrity, social and working conditions, environment and food safety."  

One case does not support a trend. But it is a hopeful sign that the Delaware courts are willing to provide shareholders with a state law avenue for exploring knowledge of suspected human rights violations in the supply chain. If the avenue becomes meaningful, the need for federal intervention will be greatly reduced. 

Both the decision of the Master and the transcript of the decision by the Chancery Court are posted on the DU Corporate Governance web site.  


A Loss For Delaware On Arbitration

On March 24, the U.S. Supreme Court dealt the final blow to Delaware’s private arbitration process by declining to review a non-unanimous ruling from the U.S. Court of Appeals in Philadelphia that found that having state court judges rule on arbitration proceedings in private violates the U.S. Constitution.

The controversy stems from a move in 2009, when, in an effort to “preserve Delaware’s pre-eminence in offering cost-effective options for resolving disputes, particularly those involving commercial, corporate, and technology matters,” Delaware amended its code to grant the Court of Chancery “the power to arbitrate business disputes.” The key to the procedure was secrecy; arbitration cases were heard in Chancery courtrooms, in front of judges wearing their robes, but everything was secret, even the filing of cases. Both the statute and rules governing Delaware’s proceedings barred public access. Arbitration petitions were “considered confidential” and are not included “as part of the public docketing system.” Attendance at the proceeding was limited to “parties and their representatives,” and all “materials and communications” produced during the arbitration are protected from disclosure in judicial or administrative proceedings.

The hope was that this procedure would enable Delaware to retain its traditional supremacy in the corporate law area by offering an attractive alternative to traditional arbitration as it would involve a binding decision from a judge on the Court of Chancery.

In 2011, the Delaware Coalition for Open Government sued Leo Strine, then the chief judge of the Court of Chancery, and the court's four other judges for violating the First Amendment of the U.S. Constitution. In the penultimate action in the case, the Third U.S. Circuit Court of Appeals found that the First Amendment required government-sponsored arbitration proceedings be open to the public.

The Court Applied an “experience and logic” test, stating that a proceeding qualifies for the "First Amendment right of public access when 'there has been a tradition of accessibility' to that kind of proceeding, and when access plays a significant positive role in the functioning of the particular process in question.' " See Press-Enter. Co. v. Superior Court, 478 U.S. 1, 10 (1986). In order to qualify for public access, both experience and logic must counsel in favor of opening the proceeding to the public. See N. Jersey Media Grp., 308 F.3d at 213-14. ("Once a presumption of public access is established it may only be overridden by a compelling government interest.").

Under that test, the Court concluded that allowing access to the proceedings would give stockholders and the public a better understanding of how Delaware resolves business disputes and would discourage companies from misrepresenting their activities to the public. Finally, the Court found that “[b]ecause there has been a tradition of accessibility to proceedings like Delaware’s government-sponsored arbitration, and because access plays an important role in such proceedings, we find that there is a First Amendment right of access to Delaware’s government-sponsored arbitrations.”

In its appeal to the Supreme Court  the Delaware Chancery Court argued that that the public enjoys a constitutional right of access only for proceedings in which there is a long history of openness. “That history is completely absent here,” it said. The Supreme Court rejected the Chancery Court’s appeal without comment.

This does not mean Delaware will abandon its arbitration procedure completely. It could keep other central features of the law, such as the ability to customize the proceedings and the rapidity of decision-making while allowing public access. But for now, the “secret courts” sought by some will not be allowed.


Kahn v. M&F Worldwide: The Unfair Fairness Analysis (Part 4)

The Supreme Court in Delaware just upheld a significant change in the law surrounding mergers with controlling shareholders. The case is Kahn v. M&F Worldwide, C.A. No. 6566 (Del. March 14, 2014).  

In any event, approval by disinterested shareholders is supposed to be preceded by the approval of a special committee that is beyond reproach. Part of this standard requires that directors be "independent." The analysis in this case illustrates the weak content of this requirement (for a discussion of the lower court's analysis of the independence of the board, go here).  

Shareholders simply sought to overcome summary judgement and establish a triable issue of fact with respect to director independence. They challenged the independence of three of the four directors on the special committee, alleging that each had prior business and/or social relations with the controlling shareholder. 

One director was alleged to have had, with the controlling shareholder, a “'longstanding and lucrative business partnership' between 1983 and 2002 which included acquisitions of thrifts and financial institutions, and which led to a 2002 asset sale to Citibank in which [the director] made 'a significant amount of money.' ” The precise nature or extent of the dealings was found to be irrelevant since they had occurred years in the past. 

A second director worked at a law firm that allegedly had previously billed MacAndrews & Forbes and a company partially owned by MacAndrew & Forbes $200,000 in fees. The same director was a Professor at the University where the CEO of MFW (who also served as the Vice Chairman and Chief Administrative Officer of MacAndrews & Forbes) served on the Board of Trustees. Moreover, the CEO invited the Professor to serve on the board of Revlon, a company controlled by MacAndrews & Forbes. See Revlon Annual Report on Form 10-K (2014) ("As of December 31, 2013, 52,356,798 shares of Class A Common Stock were outstanding. At such date, 40,669,640 shares of Class A Common Stock were beneficially owned by MacAndrews & Forbes Holdings Inc. and certain of its affiliates.").   

A third director worked with Perelman in the 1990s while she was at Citibank. Later she allegedly performed advisory work for a company partially owned by MacAndrews & Forbes. The company paid the advisory firm $100,000, an amount deemed by the court to be immaterial. No explicit mention was made in the case of allegations at the trial level that a friendship existed between the director and the controlling shareholder although the court noted abstractly that "[b]are allegations that directors are friendly with, travel in the same social circles as, or have past business relationships with the proponent of a transaction or the person they are investigating are not enough to rebut the presumption of independence".  

The case did not mention the $130,000-$150,000 in fees received by the directors.  

Whatever the outcome of the independence test used for directors in Delaware, there was no missing the fact that a majority of the special committee allegedly had some kind of relationship with the controlling shareholder (or companies controlled by the controlling shareholder). Yet the special committee received deference from the Court as if these relationships did not exist.  

Nothing in the Court's analysis provided boards with an incentive to include on special committees directors lacking in these types of relationships. In fact, the decision did the contrary. It made absolutely clear that these sort of relationships, irrespective of their seriousness, were irrelevant to any analysis of independence as long as they were sufficiently in past.

The decision illustrates that Delaware courts have opted for process over substance and then declined to interpret the process in a manner that provides confidence to shareholders. Disinterested approval by shareholders may well proceed along the same course.    


Kahn v. M&F Worldwide: The Unfair Fairness Analysis (Part 3)

The Supreme Court in Delaware just upheld a significant change in the law surrounding mergers with controlling shareholders. The case is Kahn v. M&F Worldwide, C.A. No. 6566 (Del. March 14, 2014).  

There is a temporal component to the need for approval by minority shareholders. The elimination of the duty of loyalty was premised upon the controlling shareholder "condition[ing] the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders." In other words, the decision to seek shareholder approval has to be made early in the process.  

The language, therefore, suggests that the controlling shareholder must, early in the process, take something of a calculated risk and, as a result, may not inevitably agree to the requirement. A special committee will always be formed in these circumstances so any risk that the offer will be rejected by this body is already present. Conditioning the offer on approval by disinterested shareholders, however, is a new risk. A controlling shareholders may not always agree to this requirement ab initio, at least to the extent a negative vote may have consequences.  

The Court, however, made clear that a negative vote has no consequences. As the Court reasoned: "A controller that employs and/or establishes only one of these dual procedural protections would continue to receive burden-shifting within the entire fairness standard of review framework. Stated differently, unless both procedural protections for the minority stockholders are established prior to trial, the ultimate judicial scrutiny of controller buyouts will continue to be the entire fairness standard of review." 

So the offer has to be conditioned upon both ab initio but if minority shareholders vote down the transaction, it may still go forward. Moreover, the controlling shareholder still gets the benefit of the shift in the burden of proof. As a result, there is nothing to weigh. Controlling shareholders will routinely agree to a vote of the minority investors, aware that it may help and can never hurt.   


Kahn v. M&F Worldwide: The Unfair Fairness Analysis (Part 2)

The Supreme Court in Delaware just upheld a significant change in the law surrounding mergers with controlling shareholders. The case is Kahn v. M&F Worldwide, C.A. No. 6566 (Del. March 14, 2014).  

The most disappointing thing about the decision is the way the Court simply ignored, rather than addressed, the direct challenge to the claim that approval by disinterested shareholders did not support the conclusion that the price was "fair."   

The Court noted that "the underlying purposes of the dual protection merger structure utilized here and the entire fairness standard of review, both converge and are fulfilled at the same critical point: price." In other words, the question for the Court was to determine the value of disinterested approval in determining the fairness of the price.  

Shareholders asserted that approval did not provide evidence of fairness. They argued that "because majority-of-the-minority votes may be unduly influenced by arbitrageurs that have an institutional bias to approve virtually any transaction that offers a market premium, however insubstantial it may be," a majority-of-the-minority does not demonstrate a fair price. The Court never really addressed the issue, except to include a quote from the Chancery Court opinion. Id. ("[Plaintiffs] just believe that most investors like a premium and will tend to vote for a deal that delivers one and that many long-term investors will sell out when they can obtain most of the premium without waiting for the ultimate vote. But that argument is not one that suggests that the voting decision is not voluntary, it is simply an editorial about the motives of investors and does not contradict the premise that a majority-of-the-minority condition gives minority investors a free and voluntary opportunity to decide what is fair for themselves.").  

In other words, the Court deftly turned the issue away from fairness and substituted coercion. But even in an offer that lacked coercion, the price could still be unfair. Arbitrageurs that bought at a price below the sale price will profit if the deal closes at the sale price, irrespective of fairness. As a result, fairness is irrelevant to their economic interest.

The Court could easily have made this process meaningful by, for example, limiting the approval process to long term shareholders. After all, Delaware courts have often indicated that companies can ignore the interests of "short-term" investors. They have also noted the dynamic of arbitrageurs selling shares even when the price is unfair. See Air Products and Chemicals, Inc. v. Airgas, Inc., 16 A.3d 48 (Del. Ch. 2011) ("The articulated risk that does exist, however, is that arbitrageurs with no long-term horizon in Airgas will tender, whether or not they believe the board that $70 clearly undervalues Airgas.").  


Kahn v. M&F Worldwide: The Unfair Fairness Analysis (Part 1)

The Supreme Court in Delaware just upheld a significant change in the law surrounding mergers with controlling shareholders. The case is Kahn v. M&F Worldwide, C.A. No. 6566 (Del. March 14, 2014).  

The lower court had found that mergers with controlling shareholders were to be reviewed under the all but impossible to challenge duty of care standard so long as the transaction was approved by an independent special committee and a majority of the disinterested shareholders. The new approach eliminated the duty of loyalty and consideration of "substantive fairness" when reviewing the transaction.

As the case was heading to the Delaware Supreme Court, we made this prediction: 

  • [The approach] 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.

As predicted, the Court upheld the approach. 

  • To summarize our holding, in controller buyouts, the business judgment standard of review will be applied if and only if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.

It took no great skill to predict the outcome of the case. The management friendly nature of the Deleware courts provides a relatively straight line in determining most outcomes. We will provide a few comments on the decision over the next few posts.  


OTK Associates, LLC v. Friedman: Delaware Chancery Opinion Raises Host of Issues (Part 4)

Forum Selection Clause. Defendants argued that a forum selection clause in the Transaction Documents selecting New York as the exclusive jurisdiction for “all actions and proceedings arising out of or relating to [the Transaction Documents]," meant that Delaware did not have jurisdiction to hear any action relating to the recapitalization. The court found otherwise, stating that while forum selection clauses are presumptively valid and should be specifically enforced when the claims at issue relate to contractual duties, when the issue at hand is a breach of fiduciary duties, the internal affairs doctrine means that the issue is governed by the law of the state of incorporation rather than the terms of deal documents. 

In so deciding, the court drew on the reasoning in Parfi Holding AB v. Mirror Image Internet, Inc, that held that an arbitration clause would not be enforced to cover a claim that did not “touch on contract rights or contract performance” under the agreement containing the clause. The court contrasted arbitration or other forum selection clauses that appear in the document that gives rise to the fiduciary relationship—noting that in such a case the clause would govern fiduciary claims. So for instance, an arbitration clause in a LLC agreement would govern claims for breach of fiduciary duty by a manager of the LLC. See Elf Atochem N Am,, Inc. v. Jaffari.

To justify its results, the court used the analogy of a non-Delaware forum selection clause in a merger agreement, stating that such a clause would not restrict shareholders suing sell-side fiduciaries in Delaware for breach of fiduciary duty claims based on that merger agreement. When claims raised in the complaint relate to matters of corporate governance and not deal document terms a contractual forum selection clause will not apply.

Of course, it is interesting to note that Delaware courts are quick to not enforce forum selection clauses when they stipulate non-Delaware courts (as in the OTK case), but very much in favor of them when the forum of choice is Delaware—to the extent that Delaware favors forum selection clause unilaterally adopted by boards of directors selecting Delaware as in Boilermakers Local 154 Retirement Fund. Go figure.

Section 102(b)(7). Two of the defendant directors moved to dismiss on the grounds that the Complaint at most alleged a breach of the duty of care for which they would be exculpated because Morgans' COI contained a standard exculpatory provision. The court noted the oft-cited fact that that the exculpatory provisions shielded directors only from breaches of the duty of care, not of the duty of loyalty as per Stone v. Ritter and then launched into a fascinating discussion of the interplay between care and loyalty claims. It stated:

  • Defendants seeking exculpation under such a provision will normally bear the burden of establishing each of its elements. The degree to which a court can classify claims as falling only within the duty of care and enter judgment based on the statutory immunity conferred by Section 102(b)(7) depends on the stage of the case, the standard of review, and the allegations or evidence to be considered at that procedural stage. In a breach of fiduciary duty case, at the pleadings stage, when the business judgment rule provides the operative standard of review, a court can apply a Section 102(b)(7) provision summarily to enter judgment in favor of defendant directors unless the complaint pleads sufficient facts to rebut the business judgment rule and call into question the existence of a disinterested and independent board majority that acted in good faith.

Here, because the plaintiff had pled sufficient facts to call into question the disinterestedness and independence of enough members of the Board and of the Special Committee such that neither could muster a disinterested and independent majority, the directors actions were not judged under the business judgment rule but instead under entire fairness. Under that standard each of the two directors seeking dismissal on grounds of the application of the exculpatory clause lost because “it is not possible to hold as a matter of law that the factual basis for the plaintiff's claims solely implicates a violation of the duty of care.”

Without being explicit, the court was forced to confront the challenging issue of how to parse the duties of care and loyalty when considering the application of exculpatory clauses. Delaware precedent is not at all clear on this point. In an earlier case Chancellor Lasker noted a potential in Delaware jurisprudence, pointed specifically to In re Santa Fe Pacific Corporation Shareholder Litigation, and Emerald Partners v. Ronald P. Berlin, et al., which suggest that the duties cannot be easily parsed and Lu V. Malpiede, et al. v. George W. Townson, et al., and Lyondell Chemical Company, et al. v. Walter E. Ryan, Jr., each suggesting that  separation of the duties is simple.

  • ". . . [N]obody has cited this. So this is something I'm raising with you, but I do not know the continuing validity of In re Santa Fe Pacific Corporation Shareholder Litigation, No. 224, 1995, opinion (Del. Nov. 22, 1995). . .  there's a quote in here that says, ‘Revlon and Unocal and the duties of a Board when faced with a contest of corporate control, do not admit an easy categorization as duties of care or loyalty.’ 
    So the idea that they can all be muddled together and they're dealing with it in terms of ratification; but the same thing happens with Emerald Partners v. Ronald P. Berlin, et al., No. 96, 2001, opinion (Del. Nov. 28, 2001) in terms of the entire fairness and 102(b)(7). Similar type ideas. 
    But then you got, you know, Lu V. Malpiede, et al. v. George W. Townson, et al., No. 80, 2000, opinion (Del. Aug. 27, 2001) and Lyondell Chemical Company, et al. v. Walter E. Ryan, Jr., No. 401, 2008, opinion (Del. Mar. 25, 2009; rev. Apr. 16, 2009) that seem to say you can parse these things really clearly. Like, do I still listen to this, or has this been implicitly overruled? 
    . . . [E]verybody is always throwing Santa Fe in my face because Santa Fe is one of the ones about the number of shares, the percentage of shares that it takes to trigger Revlon scrutiny. I read the whole case. There's this stuff in here about you can't untie them. It's very hard to disentangle them. And then you get Malpiede a few years later that says, ‘Oh, no, you can actually disentangle them really, really easily.’ But it doesn't overrule this case. 
    . . . [H]ow do I rationalize this? What do I do with that? Which one do I pick? I can't just pick one. They're both Delaware Supreme Court cases. I got to follow both of them somehow. 
    . . . We're in a post-close damages setting where you have raised disclosure claims about the validity of the vote that otherwise might shift the standard of review to business judgment. So given that, is the standard of review still enhanced scrutiny? In which case Santa Fe seems to say it's really hard to disentangle these things, or is the standard of review something more business judgment-ish as Malpiede and Lyondell seem to suggest? In which case we can just basically call it and say care, care, care, loyalty, loyalty, loyalty. 
    . . . [A]nother thing that I think . . . is hard about this Santa Fe thing . . . Chancellor Strine has suggested--and makes a lot of sense to me--that once you have a fully informed stockholder vote, it ought to go down to business judgment. If it goes down to business judgment, then I get why you would be able to say care, care, care, loyalty, loyalty, loyalty, because the burden then is back on the plaintiff to articulate the claim and show what it is and to call into question the supposed motives. But as long as you're in enhanced scrutiny, Santa Fe seems to say it's not that easy, and it also seems to say the vote doesn't change it. 

In this case the court punted somewhat and found that because the allegations against the directors claiming the protection of the exculpatory clause were sufficient to show some possibility of a breach of the duty of loyalty dismissal on the basis of that clause was inappropriate. 

What will happen when the case is fully heard on the merits (currently scheduled to happen in June) is anyone’s guess, but it is certain that the opinion will be interesting—we’ll pay particular attention to what the court does with regard to questions of independence of directors and the relationship of the duties of care and loyalty and how that plays out in various stages of the proceedings.


OTK Associates, LLC v. Friedman: Delaware Chancery Opinion Raises Host of Issues (Part 3) 

A month after the injunction was issued, the annual meeting of Morgans’ shareholders was held as directed by the court. At that meeting Morgans’ shareholders voted overwhelmingly in favor of OTK’s slate and removed the board members that had supported the deal with Yucaipa with the result that the recapitalization did not go through. But the litigation continued apace. In an action worth noting, but not the topic of this discussion, Yucaipa filed suit in New York against Morgans for breach of the Transaction Documents, which if successful with allow it to collect a $9 million break-up fee among other damages. 

Relevant to this discussion, after successfully getting its slate on Morgans’ board and blocking the recapitalization, OTK filed a complaint alleging that Yucaipa--and three entities related to Yucaipa, Burkle, and the other Morgans directors who approved the recapitalization--had breached their fiduciary duties, aided and abetted others in breaches of fiduciary duties, and violated both the by-laws of the Company and the charter of the Special Committee in pursuing and approving the recapitalization.

The heart of the claims:

Defendants moved to dismiss asserting, among other things, that the claims were moot because the recapitalization never took place. The Yucaipa defendants further alleged that the suit should be dismissed because it was a derivative claim and OTK did not make a pre-suit demand pursuant to Federal Rule of Civil Procedure 23.1 and that a forum selection clause in the Transaction Documents stipulated choice of New York law and New York forum. Two of the directors also claimed that the exculpatory provision in the Company’s charter meant that claims must be dismissed. 

In arguing for dismissal the defendants did not challenge the legal grounds asserted by OTK and therefore the court assumed the underlying claims were true for the purposes of weighing the motion to dismiss.

  1. Mootness:  The court quickly dismissed the mootness argument, finding that “the absence of transactional damages arising out of [an] abandoned deal does not necessarily render the underlying claims moot. When directors have breached their fiduciary duties pursuing the abandoned transaction, '[e]quity may require that the directors of a Delaware corporation reimburse the company for the time spent pursuing such faithless ends.' ” (citing In re INFOUSA Inc. S’holder Litig.). 
  2. Rule 23.1  The court noted that the claim that the recapitalization was invalid belonged to Morgans and as such any claim challenging the validity was derivative and subject to Rule 23.1. As OTK had not made demand on Morgans’ board prior to bringing their action, the outcome of the Rule 23.1 challenge turned on which board is the operative board for purposes of demand futility—the board in office when the complaint originally was filed (which because that board was dominated by Morgans interests would render demand futile) or the current, OTK dominated board—which was in place when the amended complaint was filed thereby rendering demand not futile. Relying on Braddock v. Zimmerman, the court noted that “there are three elements that excuse a derivative plaintiff from making demand on the board in place at the time an amended complaint is filed: 'first, the original complaint was well pleaded as a derivative action; second, the original complaint satisfied the legal test for demand excusal; and third, the act or transaction complained of in the amendment is essentially the same as the act or transaction challenged in the original complaint.' ” 

Using this test, the court refused to dismiss the claim that the recapitalization was invalid because it was entered into through fiduciary breaches by the Board because those claims were “sufficiently bound up with the facts originally alleged to constitute a part of the original claim.” Conversely, claims that one contractual party to the recapitalization (Yucaipa) repudiated the recapitalization by imposing new conditions on the deal were not part of the original claim and could have been brought by the Board. Therefore, that portion of the motion for declaratory judgment was granted. 


OTK Associates, LLC v. Friedman: Delaware Chancery Opinion Raises Host of Issues (Part 2)

Kalisman and OTK immediately began legal action against the recapitalization, challenging the postponement of the annual meeting, the resetting of the record date, and the completion of the recapitalization. In May 2013, the Delaware Chancery Court granted an injunction requiring that Morgans (a) reinstate its annual meeting and shareholder voting record dates and (b) refrain from moving forward with the recapitalization until the board approved the transaction pursuant to a proper process. As part of the suit the court also addressed the issue of whether a company can assert the attorney-client privilege or work product doctrine against onw of its directors as Morgans attempted to do to block Kalisman’s access to information.

First important take-away: In the first major take-away from this convoluted litigation, the Chancery Court found that Morgans had no right to deny Kalisman access to information, stating that a “director’s right to information is ‘essentially unfettered in nature . . . . [And] extends to privileged material.’ ” Therefore Morgans could not “pick and choose which directors get information by asserting the attorney-client privilege against Kalisman but not against the defendant directors” unless a recognized limitation on the right to access could be established. 

Three such limitations exist: 1) parties may enter into an ex ante agreement limiting access, 2) access may be limited pursuant to 8 Del. C. § 141(c) if a board acts “openly [and] with the knowledge of [the excluded director] to appoint a special committee,” or 3) access may be denied once “sufficient adversity exists between the director and the corporation such that the director could no longer have a reasonable expectation that he was a client of the board’s counsel.” Finding none of these limitations to be present the court granted Kalisman access.


OTK Associates, LLC v. Friedman: Delaware Chancery Opinion Raises Host of Issues (Part 1)

The recent Delaware Chancery opinion in OTK Associates, LLC v. Friedman raises a host of interesting issues.  The decision is just one of many in an on-going battle revolving around a challenged recapitalization of Morgans Hotel Group by investor Ron Burkle.    First some background—as condensed as possible but necessary to understand the legal issues.

First the players.  Morgans Hotel Group (“Morgans” or the “Company”) is a Delaware corporation that owns and operates boutique hotels. The Yucaipa Companies LLC (“Yucaipa”) is an entity controlled by Ronald Burkle that, while not a majority owner of Morgans on straight numbers of shares held, controlled the Company through a combination of shares held and contract rights that “together with Yucaipa’s board representation and close relationships with management," gave Yucaipa effective control over Morgans.  OTK Associates was a stockholder of Morgans.  Morgans’ board of directors at the relevant time consisted of ten individuals, including Burkle, Gross, the CEO, who earlier had worked for Yucaipa for three years, Gault, who was “described in an email by Yucapia’s financial advisor as ‘essentially [one] of Burkle’s directors' ” and who in January 2012 became the president and CEO of a Yucaipa portfolio company, and Sasson who had ties to Burkle and who “owed Burkle” due to Burkle’s help with related businesses.  The other five had no “readily identifiable” ties to Burkle.  

In December 2011, the Morgans Board of Directors (“Board”) began to consider how to restructure Yucaipa’s investment in the Company.  Because of the conflicts of many of the directors, the Board established a special committee consisting of the five “unconflicted” directors (the Special Committee") to evaluate potential transactions with Yucaipa and the members of the Special Committee believed that their mandate was limited to that charge; that they had to “figure out a way to do the deal that Yucaipa wanted” or “say no.”

Negotiations with Yucaipa stalled and the Special Committee met with a financial advisor who suggested that the Company either engage in a rights offering or sell one of its prime hotels.  Upon receiving this advice, a member of the Special Committee communicated it--and all of the details about the discussions--to Burkle who was not happy with the plan.  Regardless, the full Board voted to move forward on the financial advisor’s suggestions.

In response, Burkle worked behind the scenes to tank any plans (threatening to send troubling disclosures to any potential deal partners, holding up other Company transactions etc.) and Yucaipa proposed that it would buy certain of Morgans' assets in exchange for Yucaipa’s holdings in the Company.  Yucaipa ultimately sweetened this offer with an offer to backstop a $100 million rights offering—designed to maximize the possibility that Yucaipa would gain effective control.

While the Special Committee was considering this proposal, Gault, a director who was not a member of the Special Committee, but who had inside information about the Committee processes, leaked inside information to Burkle.  Burkle at the same time dangled carrots before a member of the Special Committee, offering help in finding jobs to the point that the directors said he would “like to partner with Burkle in the future.” 

Also while the Special Committee was considering Yucaipa’s proposal, two other suitors came forward.  One offered to purchase all of the outstanding shares of Morgans for a substantial premium over what was being offered in the rights offering and another offering to make a $100 million equity investment in the Company.  Neither of these was pursued (and in the case of the equity investment was barely discussed). 

Frustrated with the lack of progress, Jason Kalisman, a Company director, and the founder of OTK Associates, caused OTK Associates to announce that it was launching a proxy contest with the intent of electing seven candidates (including Kalisman)  and making certain business proposals at the Company’s next annual meeting,  scheduled for May 15 with a record date of March 22.

According to Kalisman, the rest of the Board “sprang into action after OTK’s announcement” but kept their activities secret from Kalisman. Morgans’ outside counsel devised a strategy to delay the annual meeting (to permit the rights offering to happen prior to the meeting) and issued an opinion that no shareholder vote approving the recapitalization was required under DGCL Section 271.

Negotiations with Deutsche Bank resulted in a commitment letter from that Bank to finance Yucaipa’s backstop of Morgans’ rights offering.  Finally, on March 27 the Special Committee’s counsel recommended that the Committee and the Board hold meetings to consider the recapitalization on March 29. That meeting was ultimately held on March 30.

Throughout this time, Kalisman (who recall was a member of the Special Committee) asked to be informed about any developments relating the proposed recapitalization, but was not, instead being told that “nothing was in the works” despite the fact that much was in the works and that all directors other than Kalisman were being informed on the progress.   On March 28 Kalisman delivered a formal books and records request pursuant to Section 220(d) of the DGCL.

On March 29 Kalisman received an email with eleven attached documents consisting of hundreds of pages of transaction documents (“Transaction Documents") and notifying him that a special board meeting was scheduled for the next day to “review, consider, and approve a recapitalization.”  The Board had normally given at least a week’s notice of meetings.

At the Board meeting the directors approved the recapitalization over the objections of Mr. Kalisman. Shortly after approving the recapitalization, the Board announced that it was postponing the annual meeting until July 10 and deferring the record date until May 29. Morgans stated that the purpose of the postponement was to enable stockholders who purchased shares in the rights offering to vote at the annual meeting. The rights were scheduled to begin trading on April 18 with the subscription period to end on May 8. 

Litigation ensued.  We will address that in the next posts.


Delaware Federal Courts and Fiduciary Obligations

We have noted that the "forum selection bylaws" upheld by the Delaware Chancery Court required that  actions for breach of fiduciary duty be brought either in the Chancery Court or in the federal district court in Delaware.  We further noted that the federal court in that jurisdiction does not appear to have the same degree of management friendly approach present in the state court system and therefore may represent a preferable forum for shareholder litigation. 

With that in mind, we turn to Lee v. Pincus, Civ. No. 13-834-SLR., 2013 BL 353897 (D. Del. Dec. 23, 2013), a fiduciary duty case brought in the Chancery Court but removed to the federal district court under SLUSA. 

According to the claim, Zynga, in connection with an IPO, obtained a lock-up agreement that "barred sales by substantially all of Zynga's shareholders, including all of its officers and directors, for 165 days following the December 16, 2011 IPO."  Zynga, according to the complaint, waived the lock up for its CEO and "other senior executives and private equity investors" so that they could participate in a secondary offering.  "[T]he same opportunity was not extended to Zynga's non-executive and former employees."  Plaintiffs alleged that the behavior violated state fiduciary duties.

SLUSA permits the removal of state claims that are really securities class action fraud cases.  SLUSA was not intended to interfere with traditional fiduciary duty claims. The federal court, therefore, had to determine the nature of the claims brought by plaintiff.  As the court reasoned:

  • Despite defendants' attempts to recast plaintiff's complaint to be preempted by SLUSA, the court finds that plaintiff has pled a core breach of the fiduciary duty of loyalty claim---whether executives can discriminate in favor of their own interests in waiving post-IPO lockup agreements that equally affect their share and the shares of other employees and outside investors. As the complaint shows, defendants told plaintiff and the world exactly what they were doing in the registration statement for the second offering---the only issue in the case is whether defendants were in fact entitled to favor their own interests in the manner they did under Delaware law. The court agrees with plaintiff that "fully disclosed trading" does not constitute "manipulation," "deceptive conduct," or a misrepresentation or omission.

As a result, the case was remanded back to the Chancery Court. 

The case wasn't about the quality of the case but about the nature of the claim.  Nonetheless, the court seemed to speak favorably about a somewhat unique fiduciary duty claim.  Now that it is back in state court, it remains to be seen whether the Chancery Court will share the same view. 


Delaware's Top Five Worst Shareholder Decisions for 2013 (A Recap)

It was neither a particularly good or bad year for shareholders in Delaware in 2013.  The cases discussed in this series of posts can be described as management friendly.  This reflects a consistency in interpretation rather than any significant change.

The Top Five Worst Shareholder decisions for 2013 were:


#1:   Chancery Court Domination of the Delaware Supreme Court

#2:   In re MFW Shareholders Litigation (Rendering duty of loyalty inapplicable in some cases involving a   controlling shareholder)

#3:   Boilermaker Local 154 v. Chevron (Upholding forum selection bylaws)

#4:   Freedman v. Adams (Evidence of the impossibility of establishing waste with respect to executive compensation)

#5:   Louisiana Municipal Police v. The Hershey Company (Reaffirmation on limitations imposed on shareholder inspection rights)



Delaware's Top Five Worst Shareholder Decisions for 2013: Chancery Court Domination of the Delaware Supreme Court  (#1)

Delaware has long been a management friendly jurisdiction, particularly with respect to the interpretation of fiduciary duties by the courts.  At the same time, however, the degree of friendliness has varied.  Back in the 1980s, the Delaware Supreme Court decided a number of landmark cases where shareholders occasionally won (think Van Gorkom) or at least didn't entirely lose (think Unocal). 

Today, however, this no longer seems to be the case.  Shareholders routinely lose most major cases that make their way to the Delaware Supreme Court.  Admittedly, this is a feeling more than matter of empirical data.  Yet the examples are there.  In cases such as Airgas v. Air Products, the Supreme Court reversed a well reasoned and somewhat shareholder friendly decision from the Chancery Court.  In a later decision in the same case, the Chancellor chaffed over standards imposed by the Supreme Court that obligated him to uphold a poison pill.   

To the extent that the courts have become more friendly to the positions of management over time, the search for an explanation represents a useful function.  One possibility is the background and makeup of the Supreme Court.  The existence of a Supreme Court in Delaware is a relatively new phenomena.  The Court was created in 1951, the last state to put one in place.  See Henry R. Horsey and William Duffy, THE SUPREME COURT OF DELAWARE After 1951:  The Separate Supreme Court (“The climax came in 1951 when Delaware became the last state in the union to create a separate Supreme Court.”).  At the time, only three Justices served on the Court, a number increased to five in 1973.  Id.  (noting that until then, "the Delaware Supreme Court was the only court of last resort in the nation with fewer than five members."). 

When Van Gorkom was decided in 1985, the decision was heard en banc by all five justices.  The members of the Court consisted of:  Chief Justice  Herrmann, and Justices McNeilly, Horsey, Moore and Christie.  Herrmann, Horsey and Moore were in the majority; McNeilly and Christie in dissent.  Before arriving at the Supreme Court, both McNeilly and Christie came from the bench, having served on the Superior Court.  The court has broad jurisdiction but does not hear cases in equity.  See Superior Court of Delaware:  Legal jurisdiction ("Superior Court has statewide original jurisdiction over criminal and civil cases, except equity cases, over which the Court of Chancery has exclusive jurisdiction, and domestic relations matters, which jurisdiction is vested with the Family Court.").  

Horsey, Moore and Herrmann, in contrast, came out of private practice (although Herrmann had served on the Superior Court six years earlier before resigning and going back into private practice).  So the Court consisted of a majority of members from private practice.  Moreover, the Court had no one who was "promoted" from the Chancery Court.  

Jump ahead to 2010 and the shareholder unfriendly decision in Airgas v. Air Products (Nov. 23, 2010).  The decision, like Van Gorkom, was heard by all five members of the Delaware Supreme Court.  They consisted of Chief Justice Steele, and Justices Holland, Berger, Jacobs, and Ridgely (the author of the opinion).  Before coming to the Supreme Court, three of the Justices served on the Chancery Court (Berger:  (1984-1994);  Jacobs (1985-2003);  Steele (1994-2000) ).  A list of the Chancery Court Chancellors and Vice Chancellors is hereSteele also served on the Superior Court as did  Justice Ridgely.  Only Justice Holland came out of private practice, having worked for a significant Delaware law firm.     

So, 25 or so years later, the makeup of the Court has changed significantly.  No longer are lawyers from private practice routinely placed on the Supreme Court.  Moreover, while courts in both eras had some members with prior judicial experience, the lower court of choice has changed significantly.  Instead of the Superior Court serving as a stepping stone to the Supreme Court, as was the case in the 1980s, the Chancery Court has become the stepping stone in the new millennium.    

The relationship between the background of the Justices and the degree of friendliness (or unfriendliness) toward shareholders is a matter of speculation.  Moreover, the domination of the Supreme Court by former Chancellors/Vice Chancellors is recent and may be temporary. 

Nonetheless, the issue is worth following.  As we have observed on this Blog, those serving on the Chancery Court offer a robust body of information about their judicial temperament and philosophy, particularly in connection with business related cases.  In contrast, those coming out of private practice have had less opportunity to demonstrate their judicial disposition.  For politicians trying to assess the judicial disposition of a possible appointee to the Supreme Court (uncertain though that may be), experience on the Chancery Court rather than in private practice arguably provides a better basis for doing so.    


Delaware's Top Five Worst Shareholder Decisions for 2013: In re MFW Shareholders Litigation (#2)

With the effective reversal of Van Gorkom (see Disney) and the universal adoption of waiver of liability provisions (see Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom), the duty of care has largely become an entirely process driven standard that imposes no real substantive obligations on directors.  

Substantive duties do arise out of the application of the duty of loyalty.  In those cases, the board has the obligation to show that a transaction was fair.  Unlike the process driven standard of the duty of care, fairness requires an analysis of the substantive terms of the transaction. 

The duty of loyalty can come up in a number of circumstances but most often applies where a conflict of interest is present in the boardroom.  This occurs where a director materially benefits from the decision.  In these circumstances, the courts cannot presume that the board acted in the best interests of shareholders.   

The trend in Delaware, however, has been to reduce the application of the duty of loyalty.  A conflict of interest analysis does not even apply so long as all shareholders received the same benefit.  Thus, even if a controlling shareholder induces a board to pay a dividend that it shouldn't pay, the analysis is the duty of care since all shareholders receive the same per share payment.  The controlling shareholder's potential interest in inducing a dividend for its own benefit is, for the most part, irrelevant.  

Similarly, the courts in Delaware made clear in recent decades that a conflict of interest will generally be neutralized if the board consists of a majority of independent directors.  Given that exchange traded companies are required to have a majority of independent directors, Deleware courts have effectively rendered the duty of loyalty inapplicable to transactions involving the CEO of publicly traded companies.  This is particularly true with respect to the determination of CEO compensation.  This erosion is discussed at greater length in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.

One place, however, where the duty of loyalty was preserved, at least in part, was in connection with transactions involving a controlling shareholder.  The duty of loyalty required the board to show that the transaction was fair.  Boards could lessen this burden by relying on a special committee consisting of informed and independent directors.  In those circumstances, the board obtained a shift in the burden of proof.  Shareholders were obligated to demonstrate that the transaction as "unfair."  Nonetheless, even with this shift in the burden, fairness still mattered.  Courts could not resolve the case entirely through an analysis of the process but had to consider the fairness of the substantive terms of the transaction.  

In 2013, however, this redoubt of the duty of loyalty crumbled.  In In re MFW Shareholders Litigation (we posted on it here), the Chancery Court considered the impact of a transaction involving a controlling shareholder where the board used a special committee of independent directors and conditioned acceptance of the transaction upon the approval of a majority of the disinterested (or minority) shares.  Given the double layer of procedural protections, the court concluded that the applicable standard of review would be the duty of care.  In other words, fairness and the substance of the transaction became irrelevant.  Only the process mattered.

Rigorous process could justify a change in the standard of review. But in Delaware, process is not rigorously enforced (the analysis of the independence of the Special Committee in MFW illustrates this).  There is no guarantee that the courts will ensure that the added process (approval of disinterested or minority shares) will in fact operate to protect shareholders. Already, the courts seem to be taking a lax view toward the meaning of "disinterested" shares. 

Moreover, the decision operated under a mistaken premise.  The court essentially viewed shareholder approval as something akin to proof of fairness.  As the opinion reasoned:   

  • [M]arket realities provide no rational basis for concluding that stockholders will not vote against a merger they do not favor. Stockholders, especially institutional investors who dominate market holdings, regularly vote against management on many issues, and do not hesitate to sue, or to speak up. Thus, when such stockholders are given a free opportunity to vote no on a merger negotiated by a special committee, and a majority of them choose to support the merger, it promises more cost than benefit to investors generally in terms of the impact on the overall cost of capital to have a standard of review other than the business judgment rule. That is especially the case because stockholders who vote no, and do not wish to accept the merger consideration in a going private transaction despite the other stockholders' decision to support the merger, will typically have the right to seek appraisal.

The implication is that traditional institutional investors will be in a position to make a reasoned decision about the fairness of the transaction and if they determine it is unfair will vote against it. Perhaps. But they are not the only investors that will be voting on the transaction.  

Once a merger has been announced, the ownership configuration of a company commonly undergoes substantial change.  Risk averse shareholders sell to professional investors such as arbitrageurs.  So long as the professional investors purchased shares at an amount below the offering price, they profit through completion of the transaction, irrespective of its actual fairness.  Thus, a merger may be approved by "disinterested" shareholders but still be unfair. 

The Delaware courts show no interest in taking this change in the ownership configuration into account.  They have shown little willingness to police the use of the record date when used to enfranchise arbitrageurs and other investors that purchase after the announcement of the merger.  

On the other hand, the courts in Delaware have shown a willingness to reduce the instances where management decisions are subject to review under the duty of loyalty.  In re MFW is the latest example.