Tyson, Backdating and Some Additional Observations

Vaughn Marshall has posted on Tyson, the second of the backdating cases decided by the Delaware Court of Chancery.  Another of the interesting points concerns the never explained, hard to justify standard used by Delaware courts to dismiss claims for breach of the duty of loyalty.  

The Delaware courts have determined that a conflict of interest transaction will be reviewed under the all but impossible to overturn business judgment rule if it is approved by a board with a majority of independent directors.  The courts have never explained why a transaction is entitled to an almost irrebutable presumption of validity when the conflict of interest is still present in the decision making process (interested and non-independent directors can participate, they just can't be a majority of the board).  Moreover, the courts employ a definition of "independence" that does not ensure that majority is in fact independent.  I discuss all of this in much greater detail in Disloyalty Without Limits:  'Independent' Directors and the Elimination of the Duty of Loyalty. 

The misguided standard also conveniently overlaps with the standard for dismissing a derivative suit.  For demand to be excused under Aronson, shareholders must show reasonable doubt that: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. As we have discussed often on this Blog, the Delaware courts routinely throw out challenges to director independence through the use of inconsistent tests and excessively high pleading standards.  Characterizing the board as independent effectively resolves the duty of loyalty claim.  It means the transaction was approved by a majority of independent directors and therefore a valid exercise of business judgment.  Thus, the courts conflate the finding of an independent board in the context of demand excusal context with the substantive claim of breach of the duty of loyalty.  /as a result, the excessively high pleading standards in the case of demand excusal prevent the underlying claim of breach of the duty of loyalty from ever being reached.  

This came up in Tyson.  Chancellor Chandler concluded that the board was not independent and, therefore, demand was excused.   Defendants, however, also made a motion to dismiss the underlying claim for breach of the duty of loyalty.  The court admitted that the two tests (Aronson and the standard for determining a violation of the duty of loyalty on a motion to dismiss) were similar.  Both required "reason to doubt the independence or interestedness of a majority" of the board.  The two, however, were subject to different pleading standards.  As he noted:

• "In the context of a motion to dismiss under Rule 23.1 [the standard for demand excusal], the Court considers the directors in office at the time a plaintiff brings a complaint, and plaintiffs may not rely upon the notice pleading standards of Rule 8 (a). In the context of a motion to dismiss for failure to state a claim, on the other hand, the directors relevant to the Court's decision will usually be those in office at the time the challenged decision was made, and the standard, while perhaps more rigorous in derivative cases than in some others, does not reach so high a bar as Rule 23.1. In both cases this Court must make all inferences in favor of plaintiffs, but in the Rule 23.1 context such inferences may only be drawn from particularized facts, while in the former case I may draw from general, if not conclusory, allegations." (footnote omitted). 

In this case, however, the different standards only mattered because the court found demand excusal.  With demand excusal, it could apply the separate and lower pleading standard to the substantive claim.  Had it not found demand excusal, the case would have been dismissed without ever applying this standard to the underlying claim. 

The language by Chancellor Chandler is in fact an admission that the courts use the standards for demand excusal to dismiss claims that would otherwise be sustained if reviewed under more reasonable pleading standards.  In other words, as long as you meet the weak standards in Delaware for a majority independent board, there is no need to worry about judicial review of the substance of a duty of loyalty claim.  No wonder conflict of interest transactions -- like executive compensation -- seem so out of control. 

In re Tyson, Spring Loaded Options, and Bad Faith

In a decision handed down on the same day as Ryan, Chancellor Chandler allowed portions of a claim against current and former members of the Tyson Foods board of directors go forward. While there were also allegations of improper compensation to Don Tyson and related-party transactions, this summary will focus on alleged “spring loading” of stock option grants by the board of directors between 1999 and 2001.

In applying Aronson (the case setting out the test for demand excusal), the court concluded that the board was not independent or disinterested, excusing demand. Chancellor Chandler, therefore, devoted most of the opinion to the motion to dismiss the substantive claims.

With respect to the allegations of spring loaded options, the court conceded that the seven defendant directors on the compensation committee accused of improperly issuing the options were not interested in any of the transactions. This forced an analysis under the duty of loyalty and whether the directors aced in good faith. The court went on to hold; “It is inconsistent with such a duty[of loyalty] for a board of directors to ask for shareholder approval of an incentive stock option plan and then later to distribute shares to managers in such a way as to undermine the very objectives approved by shareholders.” The Chancellor went on to hold, “A director who intentionally uses insider knowledge not available to shareholders in order to enrich employees while avoiding shareholder-imposed requirements cannot, in my opinion, be said to be acting loyally and in good faith as a fiduciary.”

The court was, however, careful to narrow its decision. The court created a two part test that a plaintiff must sufficiently plead in order to survive a motion to dismiss.

• “First, a plaintiff must allege that options were issued according to a shareholder-approved employee compensation plan. Second, a plaintiff must allege that the directors that approved spring-loaded (or bullet-dodging) options (a) possessed material non-public information soon to be released that would impact the company’s share price, and (b) issued those options with the intent to circumvent otherwise valid shareholder-approved restrictions upon the exercise price of the options.”

This, Chancellor Chandler added, would be sufficient to show at the pleadings stage that “a director acted disloyally and in bad faith and is therefore unable to claim the protection of the business judgment rule.” In other words, the essence of the violation was a deliberate circumvention of the requirements of the terms of the plan.

There are two more points that are noteworthy. First, the court did contemplate a scenario where shareholders “expressly empower” the board to engage in improper options granting practices, which would presumably defeat a claim of disloyalty on the part of the board. The court likewise described a hypothetical scenario where a compensation committee determined that a spring loaded options grant was the most appropriate compensation for the person in question, and properly disclosed it. These situations served to further narrow the court’s holding.

The pleadings and the opinion for this case can be found on the DU Corporate Governance website.

Backdating: Ryan v. Gifford (Continued)

Vaughn Marshall has written a nice post on Chancellor Chandler's decision in Ryan v. Gifford. Let's draw some conclusions that will become more relevant, particularly as we get to the last of the three backdating cases, Desimone v. Barrows. First, Chancellor Chandler shows no patience for backdating. The opinion contains no tone of acceptance. He emphasizes the inherently deceptive nature of the practice.

• "Commonly known as backdating, this practice involves a company issuing stock options to an executive on one date while providing fraudulent documentation asserting that the options were actually issued earlier. These options may provide a windfall for executives because the falsely dated stock option grants often coincide with market lows. Such timing reduces the strike prices and inflates the value of stock options, thereby increasing management compensation."

Second, the court had no problem accepting a fairly Spartan complaint. The complaint is on the DU Corporate Governance web site. The complaint contained no specific information about backdating, no allegation about documents changed or people involved. The complaint relied entirely on statistics produced from a study by Merrill Lynch. As Chancellor Chandler noted:

• "Defendants argue repeatedly that plaintiff's allegations ultimately rest upon nothing more than statistical abstractions. Nevertheless, this Court is required to draw reasonable inferences and need not be blind to probability. True, the Merrill Lynch report does not state conclusively that Gifford's options were actually backdated. Rather, it emphatically suggests that either defendant directors knowingly manipulated the dates on which options were granted, or their timing was extraordinarily lucky. Given the choice between improbable good fortune and knowing manipulation of option grants, the Court may reasonably infer the latter, even when applying the heightened pleading standards of Rule 23.1."

In other words, the statistical data was compelling enough to at least let the case go to discovery. Similarly, the complaint contains no specifics about the role of the compensation committee in the backdating scheme. The complaint noted that the board "could designate a Committee to approve the options" and that the Compensation Committee "approved the option grants". The complaint contained no dates, no references to minutes or meetings, no facts demonstrating actual knowledge on the part of the compensation committee.

In other words, it did not take much to get past a motion to dismiss. It was enough that options were issued, that evidence of backdating existed (even if only statistical), that the board (or relevant committee) approved the options (with a mere assertion enough), and that there had been false disclosure. As we will see, Desimone takes a very different approach.

Delaware and Backdating: Ryan v. Gifford

Ryan v. Gifford, 918 A.2d 341 (Del. Ch. 2007) is the first of the three Delaware backdating cases. The case arose in the context of demand excusal.

The suit arose following a study released by Merrill Lynch in May of 2006 examining the timing of stock options grants to executives in the semiconductor industry. The study found that executives at Maxim Integrated Products Inc. realized extraordinary returns of 249% annually, compared with the market average of 29%.

Plaintiff brought suit, focussing mainly on options issued to defendant, John F. Gifford, founder, chairman of the board, and chief executive officer pursuant to shareholder approved stock option plans. The complaint sought to show backdating mostly by emphasizing the coincidence that the exercise price was usually determined at lows for the months or year. As the Complaint noted:

• "The Merrill Lynch report . . . shows that most of the option grants in question were purportedly granted at the low market price of the month, or year, in which the stock was traded.

• "Many of the other grants occurred from one day to one week before a major rise in the market price of Maxim common stock. As the charts in the Merrill Lynch SOX report show . . . each trade was made in a 'valley' on the chart. The timing is too favorable on a repeated basis to be mere coincidence."

The options were issued pursuant to plans approved by shareholders. Under the plan, options were to be issued at fair market value on the date granted by the board. The board had the authority to delegate responsibility to a committee. The responsibility was, therefore, vested in the compensation committee consisting of three independent directors. Plaintiff alleged that the compensation committee "approved the option grants to Defendant Gifford."

Chancellor Chandler concluded that Aronson, rather than Rales, provided the applicable standard, although he ended up applying both. In determining whether the backdating allegations transgressed the business judgment rule, the court concluded that they did.

• "Plaintiff alleges that the challenged transactions raise a reason to doubt whether the option grants were a valid exercise of business judgment. Specifically, plaintiff states that the terms of the stock option plans required that '[t]he exercise price of each option shall be not less than one hundred percent (100%) of the fair market value of the stock subject to the option on the date the option is granted.' The board had no discretion to contravene the terms of the stock option plans. Altering the actual date of the grant so as to affect the exercise price contravenes the plan. Thus, knowing and intentional violations of the stock option plans, according to the plaintiff, cannot be an exercises of business judgment. I conclude that the unusual facts alleged raise a reason to doubt that the challenged transactions resulted from a valid exercise of business judgment." (footnote omitted).
  

As for whether plaintiff had pled reasonable doubt about the independence and disinterest of the board, the court again agreed that he had.

• "A director who approves the backdating of options faces at the very least a substantial likelihood of liability, if only because it is difficult to conceive of a context in which a director may simultaneously lie to his shareholders (regarding his violations of a shareholder-approved plan, no less) and yet satisfy his duty of loyalty. Backdating options qualifies as one of those 'rare cases [in which] a transaction may be so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists.' Plaintiff alleges that three members of a board approved backdated options, and another board member accepted them. These are sufficient allegations to raise a reason to doubt the disinterestedness of the current board and to suggest that they are incapable of impartially considering demand." (footnote omitted).

In addition to the demand excusal issue, defendants contended that plaintiff has failed to state a claim for breach of fiduciary duty. Plaintiff had not sufficiently alleged that a majority of the board had "personal interests potentially adverse to the interests of the company and its shareholders" or that directors had acted "intentionally, in bad faith, or for personal gain." Chancellor Chandler had no patience with the contention. "I am unable to fathom a situation where the deliberate violation of a shareholder approved stock option plan and false disclosures, obviously intended to mislead shareholder into thinking that the directors complied honestly with the shareholder-approved option plan, is anything but an act of bad faith. . . Well pleaded allegations of such conduct are sufficient, in my opinion, to rebut the business judgment rule and to survive a motion to dismiss."

Footnote 31 of the opinion did take the time to remind the plaintiff of the "procedural posture of the case." As a motion to dismiss, plaintiff had received certain "presumptions of the truth." As a result, the complaint could rely upon empirical evidence to raise the possibility of backdating. At trial, however, plaintiffs would have to establish "1) specific instances of backdating; 2) violations of shareholder-approved plans or some other legal obligation; and 3) fraudulent disclosures regarding compliance with that plan."

Primary materials (including the complaint and relevant motions) and the Chancery Court opinion can be found on the DU Corporate Governance website.

Delaware Courts and Backdating

We are pleased, over the next several days, to have posts from Vaugn Marshall, one of the students working on The Race to the Bottom.  He will be writing posts about the three backdating cases that have emerged from the Delaware Court of Chancery.  The first is below.

Option Grant Practices and the Delaware Courts: an introduction

We will be examining some of the recent cases in the Delaware Court of Chancery that involved allegations of improper option granting practices by boards of directors. The three major decisions thus far have been Ryan v. Gifford, In re Tyson Foods, and Desimone v. Barrows.  In order to better understand the issues involved in challenges to options grants, it is helpful to first define some of new jargon being used. An excellent breakdown of the three scenarios that have thus far received judicial scrutiny is provided by Chancellor Strine in Desimone v. Barrows, No. 2210-VCS, 2007 WL 1670255, at *6 (Del. Ch. June 7, 2007).

The most commonly known practice, and the one receiving nearly all of the recent media attention, is backdating. Backdating occurs when a company issues options to an employee or director on a particular date and falsely records the grant date as being at an earlier time when the company’s stock price was lower. While the company attempts to give the appearance that the options were granted at the current market price, they are in fact issued “in the money” through the false recording of the grant date. Id.

Another options granting practice has been dubbed spring loading. This occurs when a company is in possession of positive, material, non-public information that will most likely lead to an increase in the stock price once it is disclosed. Id. Before disclosing the information, the company will grant options to an employee or director.

Bullet dodging is essentially the opposite of spring loading.  In those circumstances, issuance of the options are delayed until after the disclosure of negative information to the market and reflected in stock prices.  

While all three practices differ in various ways, the goal is the same; obtain the lowest possible exercise price for the recipient.  

Backdating law suits have proliferated.  The WSJ  Law Blog reported on June 19 that around 150 cases alleging backdating have been filed against companies so far.  A number of them have been brought under the federal securities laws and involve allegations of non-disclosure.  These cases often turn upon materiality.  See In re UnitedHealth Group Inc. PSLRA Litigation, No. 06-CV-1691, 2007 WL 1621456 order issued (D. Minn. June 4, 2007).  Some have moved into the criminal arena.  On June 18, the trial of former Brocade CEO Gregory Reyes began; which includes 10 felony counts of securities fraud.  Similarly, the former CEO of Take-Two has pled guilty to backdating charges.  

Most cases, however, have been brought as violations of the board's fiduciary obligations.  They turn, therefore, on state (read Delaware) law.  More specifically, they depend upon resolution of the demand excusal issue.  The three cases in Delaware deal with this issue. 

The Race to the Bottom

The Blog is named the Race to the Bottom for a reason.  It is a way of telegraphing that a principal philosophy of the Blog is the belief that much of corporate law has been on a downward spiral, weakening standards of behavior for directors to the detriment of shareholders.  It is a topic that I have in my article, The Irrelevance of State Corporate Law in the Governance of Public Companies.  Sometime later in the summer or the early fall, we will illustrate this proposition through a study of the evolution of waiver of liability provisions under state law and their almost universal adoption among companies in the Fortune 500.   

The race to the bottom does not explain all changes in corporate law.  There is a genuinely dynamic process among states, with Delaware often at the forefront.  Delaware, for example, became the first state to adopt a provision allowing for virtual shareholder meetings (although the provision was criticized by some shareholder rights advocates).  See 8 Del. C. § 211(a)(2).  The provision has been adopted in other jurisdictions, including Kansas, K.S.A. § 17-6501, and Wyoming, Wyo. Stat. § 17-16-701.  ICU Medical held a virtual shareholder meeting in May.  The proxy statement is here.  In this case, the existence of 50 state laboratories may well result in updated and more modern corporate law provisions.

But no corporation will reincorporate in Delaware solely because it permits virtual shareholder meetings.  What causes companies to move to Delaware (or other states to adopt conforming provisions) are reforms that do not arise out of experimentation or modernization but out of a desire to benefit management.  As my article above points out (at p. 331), the type of "reforms" that will encourage management to shift its state of incorporation are those designed to increase the discretion of the board (and executive management), are designed to reduce liability for management, and are designed to facilitate job preservation.  So, management cares less about virtual shareholder meetings (other states are adopting them slowly) but cares a great deal about waiver of liability provisions (something like 40 states adopted provisions allowing them within a few years after the first was adopted). 

It is here where the race to the bottom occurs most vigorously.  Delaware continuously reduces the rights of shareholders and increases the discretion of management.  While providing additional discretion, Delaware reduces the standards that subject management to liability.  In other words, it is discretion without accountability.

In this context, we will explore over the next few days (no doubt interrupted by current developments) the efforts by, of all places, North Dakota, to demonstrate whether it is possible for other states to engineer a race to the top.  The North Dakota legislature has adopted the Publicly Traded Corporations Act, a law that imposes on companies that opt in a number of pro-shareholder provisions.  

Weakening Corporate Governance: Delaware Courts and the Contorted Exception to the Demand Requirement

We have been focused of late on the role of the SEC in the regulation of corporate governance. Part of the explanation for the stepped up involvement by the SEC is the declining substantive standards under state law. We explore today a relatively recent case that demonstrates the consequences of these weakening standards and the contortions that the Delaware courts must undertake in order to circumvent their own doctrines.

One of the ways that Delaware courts have debased substantive standards has been the use of "independent" directors to terminate derivative claims and eliminate judicial review of fiduciary behavior. Approval by a majority of “independent” directors results in the application of the business judgment rule to transactions involving a conflict of interest. A majority of “independent” directors on the board is a basis for finding that demand is not futile. Delaware courts use a variety of mechanisms, ranging from pleading standards to inadequate definitions to inconsistent application of relevant tests to avoid examination of the independence of directors. In other words, they use this approach to prevent meritorious derivative claims from going forward. This topic is discussed in my article on the subject, Disloyalty without Limits and a number of posts on this blog, including a top 10 list of ways Delaware courts accomplish this approach.

The consequence of this approach is that the Delaware courts sometimes run into circumstances involving unfair behavior by the board that cannot be ignored but is otherwise not actionable given the various hurdles and doctrines used to prevent judicial review. In other words, the courts confront the limits of their own legerdemain. This forces them to find a method of permitting judicial review, often in an analytically suspect manner.

An example concerns the current trend of recasting of derivative actions involving claims of dilution as direct actions. Direct actions do not require demand, avoiding the unreasonable standards set by the Delaware courts for demand futility. Gatz v. Ponsoldt, 2007 Del. LEXIS 167 (Del. April 16, 2007) is a case in point. The facts essentially involved allegations that a recapitalization transferred economic value and voting power from the minority to the majority/controlling shareholder. Essentially, therefore, it was a claim for dilution, something typically brought as a derivative action. See Kramer v. W. Pac. Indus., 546 A.2d 349 (Del. 1998)(”Delaware courts have long recognized that actions charging ‘mismanagement which depress[] the value of stock [allege] a wrong to the corporation; i.e., the stockholders collectively, to be enforced by a derivative action.’ Thus, where a plaintiff shareholder claims that the value of his stock will deteriorate and that the value of his proportionate share of the stock will be decreased as a result of alleged director mismanagement, his cause of action is derivative in nature.”)(citation omitted & emphasis added).

It was true that in Gatz all of the diluted value went to a controlling shareholder (and a business associate), causing harm only to the minority. Nonetheless, a derivative suit would conceptually have provided an avenue for redress.  The company could recover the amount of the overpayment from the controlling shareholder, restoring the value to the interests of the minority shareholders.

In Gatz, however, the plaintiffs could not overcome the standard for demand futility. The board contained a majority of independent directors. This was true even though a majority of the board was appointed by the controlling shareholder who benefited from the transaction. In Delaware, this factor is largely irrelevant in the analysis of director independence.  See Beam v. Stewart , 845 A.2d 1040, 1054 (Del. 2004)(“Beam attempts to bolster her allegations regarding the relationships between Stewart and Seligman and Moore by emphasizing Stewart's overwhelming voting control of MSO. That attempt also fails to create a reasonable doubt of independence.”).  See also Kantor v. Barella, No. 05-5398 (3^rd Cir. May 25, 2007)  (relying on Delaware law and upholding district court determination that directors nominated by shareholder owning 71% of company’s commons stock were still independent).

Similarly, the court also ignored the outside business connections of some of the directors, another area largely ignored by Delaware courts.  See Gatz v. Ponsoldt, 2004 Del. Ch. LEXIS 203 (Del. Ch. Nov. 8, 2004)(“ Although the complaint alleges that one of the members of the independent committee, Glasser, has had "significant prior business dealings with Levy," such a conclusory allegation does not demonstrate that Glasser has an inability to consider impartially issues related to potential transgressions involving Levy, let alone Ponsoldt.”)(footnotes omitted).  The pleadings, therefore, raised at least some doubt about the board's independence.  Had the Chancery Court agreed, demand would have been excused and the suit could have proceeded as a traditional derivative action.  

Instead, the board was deemed independent and the case dismissed.  On appeal, the Delaware Supreme Court confronted both allegations that a controlling shareholder engaged in an unfair transaction and a finding that the board could not be sued in part because of its independent status.  Rather than address the real problem -- an unrealistic application of the definition of independent -- the Supreme Court opted to conclude that the action could be brought a a direct rather than derivative action, rendering the presence of an "independent" board irrelevant (at least at the pleading stage).

The exception made little logical sense. As a matter of substance, the Court never explained why a derivative action would not have provided an adequate remedy. Moreover, the case apparently limited the exception to transactions involving a controlling shareholders. In other words, what made the case unique in Gatz was the presence of a controlling shareholder. Rather than use alchemy to transform derivative into direct, the Court should have relied on this fact to conclude that the board was not independent and demand was excused. This would have allowed the action to go forward as a traditional derivative action.

Gatz is beneficial to minority shareholders by, at least in some instances, allowing a category of dilution claims to sidestep the pleading standards for demand futility. Minority shareholders would have benefited more, however, had the courts used the case to fix some of the problems that they have created in meeting these standards in the first instance.

VC Strine and an Admission Against Self Interest

Earlier this month, the SEC conducted a roundtable over the relationship between state law and the proxy rules.  One of the participants was Leo Strine, Vice Chancellor of the Delaware Court of Chancery.  Among the many interesting comments made at the Roundtable, Vice Chancellor Strine had this to say about the behavior of independent directors:

• "We are seeing compromise right and left.  The rise of the independent director affects this in a big way.  A lot of the independent directors now make their living as independent directors.  They don't want to oppose anything at a particular company which will get them in trouble with the advisory institutions.  They are more than willing to compromise.  They look like elected officials, but not the most courageous ones.  They look like the ones who want to stay in office."  (emphasis added)

Judge Strine is admitting that there are a class of "independent" directors who will change their decisions out of desire to remain in office.  In other words, the risk of losing a comfortable, well paid sinecure will influence decision making.  This has been something noted repeatedly on this Blog (go here and here) and in my article on the topic, Disloyalty without Limits:  "Independent" Directors and the Elimination of the Duty of Loyalty.  We are hoping to see this awareness reflected in court decisions in Delaware, which currently employ something approaching a categorical rule that the payment of fees (no matter how exorbitant) will not result in a loss of independence.  

One observation about the comment.  Judge Strine seems peeved by directors influenced by "advisory institutions."  He is presumably referring to ISS, Glass Lewis and similar organizations that take positions on shareholder proposals and candidates for the board.  These organizations represent shareholders.  So he is peeved at directors who take positions viewed as favorable to shareholders. 

He appears not to be bothered by directors who seek to keep their position on the board through excessive deference to executive officers.  It is still the case that while the advisory organizations can turn up the heat, they can engineer the removal of a director only rarely.  Unhappy CEO's, in contrast, have much greater ability to achieve this result.  A director wanting to stay in office and retain the fees has much greater incentive to avoid getting into trouble with the CEO than with advisory organizations.  Delaware courts should keep this in mind when considering the impact of "independent" approval of conflict of interest transactions such as executive compensation. 

Bring it On: The Delaware Courts Speak on Precatory Proposals under Rule 14a-8

We were commenting yesterday on the Commission's role in forcing shareholders to use recommendations in order to avoid having their proposal excluded under Rule 14a-8.  The discussion came up in the context of the shareholder proposal recently adopted by the Verizon shareholders to recommend that management allow for advisory votes on executive compensation.  The post is here.

In the Roundtable held earlier this month at the SEC on the relationship between the proxy rules and state law, Marty Dunn from the Division of Corporation-Finance made the following observation:  

• "Every time we get a binding [shareholder proposal], we get competing state law opinions, one of which says form the company that 141 doesn't allow this, and then we get one that says 109 does allow this.  We sit there and go we don't know.  We are going to say you haven't met your burden of proof because we have competing opinions."

In other words, staff at the Division get competing opinions on whether bylaws submitted by shareholders are proper subjects for shareholder action.  Because of the set up of Rule 14a-8, the staff must spend time trying to resolve disputes where there is no controlling case law.  As we noted in the Verizon post, one consequence of this approach is to push shareholders to make preceptor proposals, ones that only recommend certain action that can then be disregarded by management. 

At the same roundtable, Leo Strine, Vice Chancellor of the Delaware Court of Chancery, had a very interesting retort.  Bring it on, he more or less advised the Commission.  

• "I think those of us from Delaware would say one of the things the Commission could do to facilitate this is to make clear that if it's uncertain under state law and it's a by-law proposal, then it shouldn't be excluded and they should be able to put it on absent some showing, and then leave it to us, hold us accountable, and if we make the wrong decisions, you can bet we are going to hear about it from the institutional investor community and from the management community." 

In other words, when in doubt, allow the proposal to remain in the proxy statement.  It will be up to the parties and the Delaware courts to resolve the legality of the bylaw.  It is exactly what the Commission staff should do.  Precatory proposals should be used by shareholders when they view them as tactically necessary (to win support, for example), not because they are afraid the proposal might otherwise be excluded under Rule 14a-8. 

And what about the Commission's deliberations over whether to allow shareholder proposals that relate to the election of directors?  Vice Chancellor Strine was equally blunt:

• "If it relates to the actual system of elections, let the state courts determine that.  That will allow stockholders to have innovation and actually elegantly gets you out of the middle of this, which is you are facilitating change of the electoral process, responsiveness to stockholders, without a single solution to myriad circumstances.  You are giving life to the state law right.  I actually do not think you need to go to the Delaware Supreme Court every single time.  If it is uncertain, you put it on the ballot.  You let it come out.  If there is a fight about whether it is valid, frankly, a lot of times, the boards go along with it voluntarily once there is a stockholder vote." 

In other words, allow shareholder to include the proposals and let state law sort out their legality.  On these two issues, the Commission should follow the Chancery Court's advise.

Friday Editorial: Delaware, SOX, and the Prospect of Future Federal Intervention

We will, next week, begin a series of posts on the involvement of the Securities and Exchange Commission in the corporate governance process.  In a process that was accelerated by the adoption of SOX, there has been increasing pressure on the Commission to get more involved, essentially to address deficiencies that come from the lack of standards at state law.  For my essay on the topic, go here.

For all of the criticism of SOX, the Act was in part an effort to fill a void at state law.  The ban on loans to directors and executive officers, as a prior post has illustrated, arose because of the lack of standards applied under Delaware law for the review of these conflict of interest transactions.  The audit committee provisions also arose from an absence, at state law, of meaningful obligations imposed on directors.  It took SOX to require a system that allowed employees to anonymously report problems to the board, that required a more meaningful level of director independence, and that more or less required financial expertise on the board.  SOX also, more or less, stripped from Delaware the regulation of reporting systems within public companies, a product of the dismally low stands imposed under the duty to monitor.  We will write more about this in the future.

Had the standards at state law been sufficiently meaningful, it is doubtful that Congress would have needed to include these provisions in SOX and to increase the role of the SEC in the corporate governance process.  Assessing SOX, therefore, is not only a matter of addressing the particular provisions in the Act but also a matter of examining the alternatives.  In fact, it is in many ways a product of the race to the bottom at state law.

Where is all of this going?  SOX fixed some areas but not others.  SOX did not, for example, fix the problem of the standard of review that applies to conflict of interest transactions (most notably executive compensation).  As the passage of HR 1257 (advisory votes on executive compensation) illustrates, Congress remains quite interested in this area and, over time, likely to intervene further.  Intervention may take the form of absolute bans on certain practices (as was done in the case of loans) or greater regulatory discretion for the Commission to regulate the matter. 

Unless the standards at state law become more meaningful, continued preemption and a continued rise in the role of the SEC in the governance process is inevitable.  It is this role that we will begin discussing next week.

The Solution to the Problem of Executive Compensation (Part 2)

As we noted in a prior post, executive compensation has escalated at least in part because Delaware has opted for a set of standards that eliminate judicial review of the fairness of the compensation paid to top officers.  We discussed that subject here.   Eliminating fairness from the standard of judicial review means that the courts do not examine the terms of the compensation.  It largely makes no difference, for example, whether the CEO receives 1 million stock options or 10 million.  What matters is whether the options were approved by a majority of "independent" directors.  Were these transactions reviewed for fairness, directors confronting the greater risk of liability would likely take a more conservative approach in determining these packages.  That would exert downward pressure on executive compensation. 

Fixing this problem would require a sea change in the attitude of the Delaware courts.  What has to happen? 

First, the Delaware need to make the approval process more meaningful.  This fundamentally requires a more meaningful examination of director independence.  In large part, this means dismissing fewer challenges and allowing shareholders to undertake limited discovery on the issue.  After all, director independence is not required under Delaware law. It is simply a status that provides legal benefits. To get those benefits, boards should have to meet meaningful standards.

Second, before according legal benefits to an "independent" approval process (in the form of an elevated standard of review), the interested influence should be excluded.  In other words, those with the interested influence (and those under their control) should not be part of the decision making process.  This is already done in the context of special litigation committees asked to determine whether to dismiss derivative actions where the board had the burden of showing independence.   

Third, and most importantly, the standard of review for conflict of interest transactions should not be the business judgment rule, even where an independent approval process is used. The business judgment rule is a strong presumption designed to insulate directors from liability in cases where there is no conflict of interest.  It ought not to be applied where the conflict is still part of the decision making process.  Moreover, even if excluded (by something like a special litigation committee), directors are still being asked to pass judgment on their brethren who are not in the room. In other words, it is impossible to create a decision making process that truly excludes the conflict.  In those circumstances, it is appropriate to encourage independent review but not wholly insulate the decision from review.  Rather than apply the business judgment rule to the resulting decision, therefore, independent approval should only shift the burden to shareholders to show that the transaction was unfair.  This is the very standard that the Delaware courts use with respect to transactions between the company and controlling shareholders.

Leaving fairness (or unfairness) as part of the standard of review would signal to boards that the terms of executive compensation matter and would be reviewed. By effectively forcing boards to justify fairness, it is likely that this standard would have a sedating influence on the escalation of executive compensation (assuming, of course, Delaware courts don’t render the fairness analysis meaningless).

What will happen if Delaware does not change its approach and the terms of the transaction continue to have little relevance? Congress will intervene and ultimately preempt Delaware law. We have seen signs of this with the adoption by the House of Representatives of the bill requiring advisory approval by shareholders of executive compensation.

The Solution to the Problem of Executive Compensation (Part 1)

We have been discussing the approach used by the Delaware courts to eliminate fairness from the review of transactions implicating the duty of loyalty. Go here, here and here.  The courts do so largely by applying the business judgment rule to transactions approved by a majority of independent directors. This is true even though there is no guarantee the directors are in fact independent and even though the interested director may participate in the decision making process. These points are discussed in my article here.  In particular, directors are often paid enormous fees while still meeting the defintion of independent.  See the post on Countrywide  (where, in addition to restricted stock grants of over $200,000, "independent" directors received the right to designate $1 million in charitable contributions over a five year period). 

The application of the duty of care and the business judgment rule means that the terms of the compensation paid to the CEO largely becomes irrelevant (unless they cross into the realm of waste, a standards almost never met). Thus, when CEOs receive tens of millions of options or tens of millions in bonuses or use of the company jet for personal use, the question of whether the terms of the transaction are fair to the corporation is neither asked nor answered (at least when reviewed by the courts). This was the case, for example, with the lucrative contract received by Michael Ovitz. The contract ought to have been examined under the duty of loyalty with the board obligated to establish why the terms were fair to the corporation. This never happened.

By employing a defective process that eliminates any review of the terms of the transaction, the consequences are predictable and obvious. There are no meaningful legal limitations on the amount of compensation paid.  When a particular board approves a compensation package that pushes the envelope, they do not have to worry that the terms will ever be reviewed for fairness to the company.  As one might expect, compensation in those circumstances has escalated upward.

The solution is straightforward but will not be easy to implement.  It would require a sea change in the attitude of the Delaware courts.  What has to happen?  We will share that tomorrow. 

Advance Notice Bylaws

One governance issue that has received scant attention has been the use of advance notice bylaws to prevent shareholders from nominating directors.  For a post on these provisions, go here.  They typically require that all nominations to be submitted to the board some period of time (often a lengthy one) before the meeting.  Failure to meet the terms of these bylaws may result in the omission of the nominee from the ballot.  

In Openwave, discussed elsewhere on this page, a shareholder nominee received the most number of votes.  The company, however, argued that the director was not nominated properly under two advance notice bylaws.  Despite noting that "there is little question that the bylaws at issue are poorly drafted and could easily lead to some confusion," the Chancery Court determined that the matter could not be resolved on summary judgment. 

Openwave Sys. v. Harbinger and Advance Notice Bylaws

In Openwave Sys. v. Harbinger Capital Ptnrs. Master Fund I, Ltd., 2007 Del. Ch. LEXIS 34 (Del. Ch. 2007), Harbinger, a hedge fund, attempted to nominate two candidates for election to the Openwave board. Openwave asserted that the nominees did not meet either of two advance notification bylaws for director nominations but nonetheless allowed the names to appear on the ballot, expressly reserving the right to subsequently challenge the nominations. When one of the Harbingner nominees received the most number of votes, an action was instituted under Section 225, a provision that allows accelerated review of challenges to board elections.

The Court of Chancery first reaffirmed its deep concern over the franchise rights of stockholders and noted that Delaware courts were "'vigilant in policing fiduciary misconduct that has the effect of impeding or interfering with the effectiveness of a stockholder vote.'" The court noted that "there is little question that the bylaws at issue are poorly drafted and could easily lead to some confusion where, as is true in this case, the date of the annual meeting is delayed due to circumstances beyond the control of the board of directors." Nonetheless, the Chancery Court concluded that the matter could not be resolved on motion but instead required a trial, particularly "because the outcome may well turn on an assessment of the overall equities of the parties' conduct."

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

Duty of Loyalty and the Rote Counting of Heads: The Viacom Case

In 2004, while Viacom was apparently on its way to recording a multi-billion dollar loss, compensation packages totaling about $160 million were approved for several of the company's top executives. A group of shareholders brought a derivative suit action against Viacom, members of Viacom’s Board of Directors, and several executives citing breach of fiduciary duty and unjust enrichment. Defendants sought to dismiss Plaintiff’s motion under Civ. Pro. Rule 12(b)(6).

The Supreme Court of New York decision to allow Plaintiff’s case to go forward turned on the number of independent and disinterested directors on the board. See 2006 N.Y. Misc. LEXIS 2891 (S Ct NY June 23, 2006). The court concluded that a majority did not meet this standard, with the analysis turning the the independence of a single director (Alan Greenberg, who, the court concluded: "The fact that Greenberg advised Redstone in his personal affairs in two large acquisitions, provided services and continues to provide services to Viacom is sufficient to create a reasonable doubt as to his ability to evaluate plaintiffs' demand without a taint of interest, "extraneous considerations" or influences."

In light of the board being interested, the court stated that the compensation packages could be analyzed under the two-pronged entire fairness test: fair dealing and fair price. Had the court decided differently on that one director, the case likely would have been dismissed. Additional primary material for this case may be found on the DU Corporate Governance website.

Delaware and the Responsibility for SOX: The Case of Loans to Management

As discussed in a prior post, SOX included a prohibition on loans to executive officers and directors. See Section 402 of SOX.  The provision engendered considerable criticism and not without good reason.  It prevents the board from engaging in transactions that will sometimes benefit the company. 

But the provision did not arise in a vacuum.  Under state law, the standard of review for transactions between the company and executive officers became meaningless as long at the transaction was approved by a majority of independent directors.  In those circumstances, courts presume the transaction valid and make no resort to fairness.  Thus, loans approved by independent directors could be in extraordinary amounts or on terms that no bank would make.    

Let's look at the poster child example.  Bernie Ebbers, as CEO of Worldcom, found himself incurring margin calls as the price of WorldCom dropped.  Rather than sell his shares, he borrowed from his own company. The loan and guarantees ultimately climbed to over $400 million. How much was that to Worldcom? See Restoring Trust, Report Prepared by Former SEC Chairman Richard Breeden,  August 2003, at 28 (Breeden Report)  (“ Ultimately the program of loans and guarantees grew to more than $400 million, representing a substantial portion of WorldCom’s cash reserves and its net worth, had its balance sheet been accurately reported.”).

And the terms?  Apparently the loans weren't properly collateralized.  See Report of Investigation by the Special Investigative Committee of the Board of Directors of Worldcom, Inc., Dennis R. Beresford, Nicholas deB. Katzenbach, C.B. Rogers, Jr., March 31, 2003 (“The Company did not have a perfected security interest in any collateral for the loans for most of the time period during which they were outstanding.”); or subject to standard repayment terms; see Id. (“Ebbers was not required to make regular payments; rather, payments were required only on the Company's demand, and no payments were demanded."); or market interest rates.  See Id. ("The promissory notes provided that the interest charged to Ebbers would be equal to the fluctuating rate of interest charged under a WorldCom credit facility, almost always the lowest rate available to WorldCom at the time, and a rate of interest lower than that of Ebbers' other outside loans. Moreover, this rate was lower than the average rate WorldCom paid on its other debt.”).   As the Study concluded:  The loans were involved an assumption of risk “that no financial institution was willing to assume.”

The Ebbers loans are widely known.  But given the terms and amount, how could they have happened, consistent with state law fiduciary obligations?   As long as the loans were subject to some type of independent approval process, the terms didn't matter.  The loans were approved by the compensation committee, a committee that "seemed to spend most of its efforts finding ways to enrich Ebbers, and it certainly did not act as a serious outside watchdog against excessive payments or dangerous incentives.”  See Breeden Report.  The three directors on the compensation committee were apparently independent, at least under the reigning, inadequate definitions. As the Breeden Report noted:

• "Both [Stiles] Kellett and [Max] Bobbitt appeared to satisfy the “independence” standards for directors of the time, and might well satisfy current definitions used by the New York Stock Exchange (“NYSE”) and NASDAQ. However, both men had received millions of dollars worth of WorldCom stock when Ebbers acquired predecessor companies. Both men had been involved in business with Ebbers for years, and both owed a substantial portion of their net worth to his actions. This made them uniquely poor choices to represent the interests of WorldCom’s shareholders in exercising oversight responsibilities over Ebbers. As demonstrated by their actions in extending stockholder loans to bail out Ebbers’ personal debts, both men seemed to be more solicitous of Ebbers’ wishes than shareholder interests."

Moreover, it turns out that Kellett had leased a plane from Worldcom, with the terms later determined by Breeden to be “below fair market value.”

Nonetheless, so long as the loans were approved by directors who met the requisite definition of independent under state law and were otherwise informed, a decidedly low standard, the loans were beyond challenge, irrespective of the amount or terms. As one report concluded: “We do not understand how the Compensation Committee or the Board could have concluded that these loans were in the best interests of the Company or an acceptable use of more than $400 million of the shareholders’ money.” Report of Special Investigative Committee.  

Had the board retained the obligation to show fairness, the loans probably never would have occurred.  At a minimum, fairness would have required commercially reasonable terms. With the decision subject to the business judgment rule, the terms and fairness of the transaction hardly mattered.  It was this void that Congress entered in banning executive loans by public companies.

Thus, the issue is not whether the prohibition in SOX results in inefficiencies or additional costs but whether these consequences are more costly and inefficient than the approach employed under Delaware common law.  We will explore this aspect of Delaware law in later posts.  

Delaware Law and the Responsibility for SOX

Today we will begin a series of posts that examine the responsibility of Delaware for the adoption of much of what is in SOX.  Those who criticize the Act the most vociferously are often those who also view state regulation of governance as a race to the top, an evolutionary process that results in a more efficient corporate law.  What ever the merits of the argument, it is clear that SOX was a fundamental rejection of the approach.  I have discussed these views and the congressional reaction here.  SOX effectively treated state law and it's regulation of corporate governance as a race to the bottom and overturned it in a number of respects.  Had state law fiduciary standards been more rigorous, some of the provisions in SOX would not have been adopted.

What are some examples? Section 301 of SOX requires that audit committees of listed companies have a procedure for receiving, retaining and treating complaints about accounting or auditing matters and for confidential submissions concerning questionable accounting or auditing matters. Did it really require a federally mandated listing standard to cause companies to put this type of system in place? Had the fiduciary obligation to monitor been stronger, companies likely would have had such a system, obviating the need for federal intervention.

Section 407 requires companies to disclose (in accordance with Commission rules), whether the audit committee has a financial expert. The provision stopped short of requiring financial expertise but clearly pushed companies in that direction by requiring an explanation if they did not. The provision arose because state law was not sufficiently rigorous that public companies routinely included directors on the audit committee with this type of experience.

There are plenty of other examples.  But the first that will be examined in detail are the problems that arose out of the treatment under state law of the duty of loyalty. The duty of loyalty applies to any transactions between the company and a fiduciary.  The category includes executive compensation. 

When the duty applies, the courts ordinarily apply the entire fairness analysis, a fairly rigorous standard. Delaware courts, however, exempt from this standard conflict of interest transactions that are subject to certain process.  In particular, the courts apply the business judgment rule to conflict of interest transactions approved by a majority of “independent” directors.  One problem with the standard is that in fact directors deemed independent under Delaware law are, in fact, not independent.  This topic is addressed more fully in my article here and in a prior post here. 

The other problem is that the courts allow for the interested influence to be in the decision making process.  The courts are quite clear that approval need only be by a majority of independent directors.  The interested minority can remain in the decision making process, debate the matter, and even vote, with the courts still apply the business judgment rule to the transaction.  Moreover, in apply the business judgment rule, fairness and the terms of the transaction all but become irrelevant. 

Thus, Section 402 of SOX prohibited most loans to directors and executive officers, a provision aptly titled “Enhanced Conflict of Interest Provisions.” Congress singled out loans and dealt with the lack of standards imposed under state law through a categorical prohibition. The approach did not address other types of conflicts or the fundamental problem at state law of exempting conflict of interest transactions from any kind of fairness review.  In that sense, SOX was too narrowly drawn, addressing a symptom and not the root cause.   

Tomorrow we will begin an examination of the root cause, Delaware’s approach to the duty of loyalty, starting with the poster child example of what happens when fairness becomes irrelevant to the duty of loyalty analysis.

Standards for Executive Compensation

I had intended the second post on this blog to begin a discussion of the benefits of Sarbanes-Oxley but George Bush's speech on the State of the Economy gave me a different idea. He criticized executive compensation and called on "America's corporate boardrooms" to  " step up to their responsibilities" in approving these packages. 

A fundamental legal problem with executive compensation is the standard of review adopted by the Delaware courts.  Delaware courts provide (as a matter of common law) that conflict of interest transactions approved by a majority of "independent" directors are entitled to the protection of the business judgment rule. Requiring only a majority means that the interested influence can remain a part of the decision making process. Moreover, the definition of independent (coupled with the onerous pleading standards) used by Delaware courts is inadequate to ensure that the directors are in fact independent. As a result, the courts in that jurisdiction give business judgment protection to interested party transactions approved and/or influenced by interested, non-independent directors.  Fairness no longer matters and compensaton has no substantive limits (unless one thinks the waste standard is really a limit).  The results of such a standard are predictable and obvious.  Read more on this here.

In all of the litigation around the Michael Ovitz transaction at Disney, for example, the courts never actually analyzed whether the execution of a contract that provided for the payment of $140 million after a little over one year of work was fair to the company.  

Those who see Delaware as exclusively a race to the top ignore these problems.  Congress does not. Sarbanes-Oxley amounts to a congressional rejection of the race to the top, preempting state (read Delaware) law in a number of places. More on that here. If the courts in Delaware continue to apply a standard of review for executive compensation that ignores the fairness of the transaction and allows for interested influence in the approval process, it will likely find itself again ousted from the regulatory process, with Congress continuing the process of shifting corporate governance principals away from the states.  This blog ranks executive compensation as the #1 area of state corporate governance most likely to be preempted.  We will keep a list.  If you have other examples, send them to the blog.