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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The sale process began on July 16, 2010, when to Citi Venture Capital International (“CVCI”) made an unsolicited bid to acquire Ness Technologies, Inc. (“Ness”).   A special board committee that excluded the one director “appointed” by CVCI was created to deal with the offer.  The four disinterested directors also relied on legal and financial advisors, specifically Ropes & Gray LLP as legal advisor and Jefferies & Co. as the financial advisor.  . 

The special committee attempted to negotiate a higher price with CVCI but negotiations ended in September 2010.  After the negotiations ended, the special committee contacted a total of 27 strategic and financial buyers and obtained confidentiality agreements from  three additional potential buyers. 

The three buyers offered between $6.40 and $6.70 per share to acquire Ness. In January 2011, a fourth bidder (“Bidder D”) entered the scene offering between $6.50 and $7.00 per share.  On March 16, 2011, following Bidder D’s increased bid of $7.40 per share, Ness and Bidder D entered into an exclusivity agreement.  On March 31, 2011, CVCI returned with an unsolicited expression of interest in acquiring Ness at $7.75 per share.  When Bidder D’s exclusivity agreement expired on May 20, 2011, Bidder D lowered its bid to $7.00 per share.  CVCI confirmed the offer of $7.75 per share and the parties entered into a confidentiality agreement on May 25, 2011.  Ness and CVCI announced their merger agreement on June 10, 2011. 

Plaintiff sought expedited discovery.  The court first addressed the plaintiff’s “concerns” over the sale process but concluded that the allegations had not sufficiently shown a colorable claim that the price or the process were unfair to the shareholders.  As the court noted:

This sale process lasted eleven months, involved approximately thirty potential bidders, and resulted in a sale price that is $2.00 per share higher than the price at which CVCI originally expressed its interest in acquiring Ness, higher by at least $0.65 per share than any other bidder was willing to pay, and 68% higher than Ness's stock price on day before potential acquirors' interest in Ness became public. There is little in the Plaintiffs' allegations to suggest that either the price of, or the process leading up to, the Proposed Transaction were unfair to Ness's shareholders.

Plaintiff also alleged a possible conflict of interest between the financial advisor used by the special committee and CVCI.  Specifically, Jefferies and its affiliates allegedly provided “financial advisory and financing services” for CVCI and related companies.  The court conceded  that “if the amount of business involved would be material to either of the advisors, the Plaintiffs might have a colorable claim” and therefore granted the right to expedited discovery to determine whether the past, present, or future dealings between the advisors and CVCI created a conflict of interest. To the extent the relationships were material, a disclosure issue could exist.

The plaintiff’s requests for additional detail regarding Ness’ continued performance, additional detail regarding the financial advisors selection of comparable companies, and a detailed description of the sale process were dismissed by the court.  The court determined that the “shareholders are not entitled to a ‘play-by-play’ description of the merger negotiations.”  Based on the foregoing reasons, the court granted the Plaintiff’s Motion for Expedited Proceedings limited to whether the advisors to the board and special committee were conflicted because of their relations with CVCI.       

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

• It appears that counsel for the Board was so influenced by the fact that a majority of the Board were defendants in the Derivative Claims that counsel essentially told the Board not to give any weight to the pendency of those Claims in determining whether to do a deal with Alpha. Although the record is not clear, the plaintiffs themselves embrace the notion that the Board was told that the Claims would survive the Merger but that control over the Claims would pass to Alpha. The defendants also admit that the Board did not value the Derivative Claims and that the Advisory Committee set up to investigate whether Massey should pursue those Claims stopped its work when the Merger negotiations got serious.  As a result, one cannot conclude that the Massey Board was presented with a reasoned analysis of the “value” of the Derivative Claims.

The court went on to list "the better practice" that the board could have used in considering the derivative claims. 

• No doubt the better practice would have been to have had the Advisory Committee, whose members are not defendants in the actions based on the Derivative Claims, consider the extent to which the Derivative Claims were an economic asset (even in the sense of arguing to Alpha that its concerns about ongoing liability were overstated because of the possibility to shift costs to the derivative action defendants), with the advice of the Advisory Committee’s own advisors, who were not in the awkward position of also representing Massey Board members in the Derivative Claims, like Cravath.

But in the end, the consequences of this criticism and failure to engage in the better practices was the court's determination that it should withhold its "applause" from the board.  See Id.  ("In acknowledging what seems to me to be an economic reality, I do not mean to applaud how the Massey Board dealt with the Derivative Claims in considering whether to sell the company.").  It is a price many companies will be willing to incur.

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

This case addresses to some degree the possibility of mismanagement by officers and directors.  The court, however, puts at least some of the blame on shareholders.  As a result to the extent that shareholders are not made whole, this may well be an example of "justice."  Why?  Because in effect they encouraged the alleged misdeeds of the board.

• Remember that to the extent that Massey kept costs lower and exposed miners and the environment to excess dangers, Massey’s stockholders enjoyed the short-term benefits in the form of higher profits.  The very reason for laws protecting other constituencies is that those who own businesses stand to gain more if they can keep the operation’s profits and externalize the costs. Thus, the stockholders of corporations, especially given the short-term nature of holding periods that now predominate in our markets, have poor incentives to monitor corporate compliance with laws protecting society as a whole and may well put strong pressures on corporate management to produce immediate profits. . . . Stockholder pressure to produce profits might increase the already well-known risk that profit-seeking entities have incentives to take the profits of their operations for themselves and externalize the risk of operations to others, be it to their workers or society as a whole in the form of environmental degradation.

In other words, the court is effectively saying that shareholders pressured management into cutting corners because of the need for short term profits.  So, when the cost cutting results in harm, shareholders should harness some of the blame and not be made whole.  Justice is in fact done.

The conclusion is driven by the observation that short term holdings "predominate."  This is an unsupported assertion.  But it is the view of the Chancery Court.  The approach allows the court to blame shareholders for board misbehavior.  Shareholders collectively want short term profits and will pressure management to get them.  Management that then cuts corners to obtain short term profits is really only doing what shareholders have pressured them to do.   

The view is wrong for many many reasons.  It ignores the fact that management benefits from short term profits through increases in compensation.  It ignores the fact that many institutional investors are in for the long term.  The "justice" of not making shareholders whole, therefore, is extended not only to the short term investors who are blamed for the cost cutting but the long term investors who are not. 

It ignores the fact that even the investors motivated by profit maximization in the short term would not favor cost cutting that could lead to substantial liability.  While they may benefit if they happen to invest when the cost cutting is taking place, they will be harmed if they own shares when the liability is uncovered.  In effect, the court is attributing to investors a goal of short term profit maximization that results in a form of Russian roulette.

There is no question that management must keep an eye on profits.  But this does not mean that any action that increases profits in the short term is appropriate or favored by shareholders, even those with a short term horizon.  Yet that is, apparently, the view of the Delaware courts.   

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

But of course this is largely a mythical power.  Shareholders have little actual ability to remove directors from office.  The plurality system of voting dictates that management's slate will invariably be elected, even if shareholders have considerable concern over the board's performance.  Indeed, the fact that shareholders can withhold their vote (the equivalent of a no vote) is only because it is a requirement of federal, not state law. 

And while majority vote provisions have become popular, they do not give shareholders any meaningful say in board membership.  In Delaware, they result in a letter of resignation that give the board, not shareholders, the authority to decide the membership issue.  Efforts to increase shareholder authority in this area through access to the proxy statement has been vigorously opposed by the state of Delaware.

In other words, the authority doesn't exist yet it is trotted out as an appropriate remedy for shareholders.  It ought to be an appropriate remedy but in Delaware it is not. 

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

Yet in confronting plaintiff's argument that Alpha, when it obtained the derivative action, would not continue the suit, the court chose to ignore the "practical realities."  In fact, the practical reality is that acquiring companies rarely if ever sue the management of the acquired company.  Yet relying on "economic" rather than "practical" realities, the court tried to make the case that in fact Alpha might bring such an action. 

Thus, for example, Alpha had an incentive to bring an action in order to pay any additional direct costs imposed on Massey as a result of its safety violations. 

• The situation here is quite different. Alpha has to deal with all of the Disaster Fall-Out and Massey’s unique approach to dealing with regulators. This will almost certainly require Alpha to pay settlements, fines, and remediation costs. To the extent that the direct actions against Massey result in findings that Massey, as a corporation, consciously violated the law, Alpha has a rational incentive to shift as much of that liability to the former Massey directors and officers as can efficiently and realistically be achieved. If Alpha does so, it would not be in the position of seeking any windfall, given that it assumed the risks that came with buying Massey and was simply using one tool belonging to Massey to reduce the harm to it.

The incentive for Alpha to bring an action against the Massey board would arise out of its fiduciary obligations to shareholders.

•  Alpha’s own pre-existing stockholders will also likely be watching the Merger integration process and ask questions if Alpha is exposed to liability and lost profits because of Massey’s past conduct and does not seek some recompense if that can be obtained. Alpha’s board will have a fiduciary duty to all its stockholders, including the former Massey stockholders who as a result of the Merger will become Alpha stockholders, to use all its assets in a good faith pursuit of profit and its actions will be subject to great scrutiny.

The conclusion is theoretically possible but as anyone practicing in this area knows, not practically likely.  First, Alpha likely took into consideration the additional costs and fines when determining the purchase price.  As a result, any additional collection would in fact be a windfall.  Second, Alpha will incur the same problems listed by the court in describing why shareholders will have a tough time in any derivative suit.  This provides a "fiduciary out" for any cause of action against management of the acquired company. 

Third, the court, as if often the case in Delaware, uses fiduciary obligations when convenient.  The idea that fiduciary obligations would compel the board to bring a suit is wrong.  Fiduciary obligations are contentless enough that they can be used to justify any board decision.  In this case, there is nothing in the board's fiduciary obligations that prevents them from concluding that the claim should not be brought. 

But in truth the practical reality is that purchasers are not likely to sue the very persons who sold them the company.  If there was an appreciable risk of that, the directors probably would have been less likely to approve the transaction and give up control over the derivative suit.  Indeed, the evidence from the Massey directors was consistent with this view.  When one of the directors was asked whether he expected Alpha will continue the claims, he responded "no."  The court mostly just ignored the evidence and instead relied on the conclusion that Alpha had an incentive to bring an action "[a]s an economic matter". 

The practical reality suggests otherwise. 

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

In arriving at the conclusion, the court had to address the fact that plaintiffs produced expert testimony claiming that the alleged mismanagement resulted in losses to the company of anywhere from $400 million to $1.4 billion.  These allegations, while unproven, seemed to provide a damage amount that clearly met any definition of materiality. 

The court, however, concluded that the value of the derivative claim could not be equated with the value of the losses to have resulted from the board's alleged mismanagement.  The difference was not in the method of calculating damages.  Instead, the court focused less on the actual damages and more on the practical reality of what was likely to be collected.  

First, the total amount of the damages would have to be discounted by the litigation risk.  Given the waiver of liability provision in place at Massey, plaintiffs, to recover, had to show scienter, a standard dictated by Caremark.  As the court noted:

• The Caremark liability standard is a high one, and requires proof that a director acted inconsistent with his fiduciary duties and, most importantly, that the director knew he was so acting. For obvious reasons, the motive of independent directors to put profits ahead of compliance with the law is weaker than for managers and thus the challenge for a plaintiff to convince a fact-finder of any specific independent director’s culpability has to be regarded as at best difficult.

Second, the practical reality was that the harm caused from any mismanagement was likely to have little bearing on the amount actually recovered, particularly when looking to the personal assets of the individual defendants.     

• if the Disaster Fall-Out is really above $1 billion as the plaintiffs’ expert suggests, how likely it is that one can actually collect a judgment in that amount against the derivative action defendants? The plaintiffs’ expert does not take this consideration or other related ones into account in valuing the Derivative Claims, and instead simply assumes that the value of the Derivative Claims equates with the Disaster Fall-Out. . . . Even if a defendant like [the CEO] has a high personal net wealth, is it high enough to provide a material level of recoupment, particularly if the company has to go after him for the judgment and also to recoup the legal fees it will have to advance for his defense?

Third, the case, to the extent it settled, would likely involve an amount within the D&O coverage for the eligible directors. 

• And if the hope is to settle for the full amount of the D & O insurance, it appears that the total amount of applicable coverage for all of the derivative action defendants is $95 million, which is not a trifle but is also not material in the context of an $8.5 billion Merger. Anyone who has dealt with coverage questions and insurance carriers would also tell you that a scenario in which the D & O insurers in the “tower” would easily pay out anywhere near the full amount of the policy in a quick and low-cost way to Alpha is more the stuff of dreams than of real life. Given that Alpha would be looking to insurers for future coverage, it would likely also consider the extent to which current recompense would affect its future rates.

The court in part concluded that something approaching $100 million was immaterial as a matter of law but also hinted that in fact it was unlikely, given the practical realities, that this amount would actually be collected.

This analysis renders as irrelevant the actual claims for damages resulting from alleged mismanagement.  Instead, the court chose to look at practical realities.  Given the unlikely possibility that there would be a judgment paid directly by the directors, the court essentially limited materiality analysis to the amount of the D&O insurance.  The approach, therefore, rewards companies that maintain low levels of D&O insurance.  Moreover, for large companies, the amount of coverage is not likely to be material.  In short, the court in this case used its views of the practical realities to generally find that derivative actions in the context of a merger are always immaterial as a matter of law.  

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

Plaintiffs claim was that the directors failed to adequately ensure compliance with legal requirements, particularly those related to miner safety.  This occurred after the board received "red flags" suggesting issues with safety compliance.  As the court described:

• The plaintiffs allege that the independent directors of the Massey Board did not make a good faith effort to ensure that Massey complied with its legal obligations. Rather than respond to numerous red and yellow flags by aggressively correcting the management culture at Massey that allegedly put profits ahead of safety, the Board allowed itself to continue to be dominated by [the CEO]. 

What makes the court's analysis so interesting is that this is not the traditional case where the board allegedly knew of red flags but did nothing in response.  As the court noted, there was, apparently, a great deal of "motion" by the board.  Despite the "motion," the court agreed that plaintiffs had made a plausible case did not engage in a good faith effort to ensure legal compliance. 

• Although the defendants point to a lot of motion by the independent directors, some of which resulted from a 2008 court-ordered settlement, the plaintiffs in turn point to evidence creating a plausible inference that the independent directors of Massey did just that — go through the motions — rather than make good faith efforts to ensure that Massey cleaned up its act. Notably, the plaintiffs point to evidence that in the wake of pleading guilty to criminal charges and suffering liability for numerous violations of federal and state safety regulations, Massey mines continued to experience a troubling pattern of major safety violations. But, instead of using their supervisory authority over management to make sure that Massey genuinely changed its culture and made mine safety a genuine priority, the independent directors are alleged to have done nothing of actual substance to change the direction of the company’s real policy. 

To make the case, plaintiffs pointed to evidence:

• that Massey was experiencing an increase in 2008 and 2009 in the number of violations of safety regulations; that Massey was continuing to engage in adversarial tactics toward the MSHA; that important safety rules were regularly flouted; that increases in violations assessed to the company were attributed to improper political motives on the part of regulators rather than genuine concerns about mine safety; and, perhaps most damning of all, to the McAteer Report’s conclusion that the Disaster at Upper Big Branch was caused not by a freak and unavoidable accident, but instead by a corporate culture premised on the view that the company’s management knew better than the law about what was necessary to run safe mines.

The analysis has a potential to suggest a fundamental change in the approach traditionally used under the good faith doctrine (and Caremark) in Delaware.  The court is suggesting that despite considerable response from the board, it may be a violation of fiduciary duties to leave in place a harmful managerial culture.  At a minimum, the failure to correct the culture may cut against the representations made by the board when its conduct is challenged.

• it must be noted that the same directors who gave that testimony continued the same management in office for years, despite all the legal and safety troubles and despite viewing that management as unable to deliver on their promised numbers. This inconsistency gives color to the plaintiffs’ view that the Massey Board was under [the CEO's] thumb for many years.

The case suggests that at least sometimes, boards have an obligation not only to address the specific compliance matter at issue but also to change the culture of the board.  Certainly a culture change will be more necessary where the company is run by an imperial CEO.  To the extent that boards allow this approach to management to go unaddressed, they may find themselves sued for breach of fiduciary obligations. 

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

The case arose in an odd context.  Shareholders sought to enjoin a shareholder vote on a merger between Alpha Natural Resources and Massey Energy, the company involved in the April 2010 mining disaster where 29 miners were killed. The merger would deprive Shareholders of standing to bring the derivative actions and transfer the cause of action to Alpha.  Shareholders alleged that the board of Massey failed to take into account the value of the derivative claims relating to the mining disaster when it agreed to the transaction.

The case could have been decided in two pages.  As the opinion noted on page 70, Shareholders had not made the case for irreparable harm.  Monetary damages were still available after the merger.  Moreover, a suit could still be maintained to the extent that Shareholders could show that the merger was motivated by a desire to deprive shareholders of standing to bring a derivative action.

But the opinion was not two pages but took up 79 pages.  Within those pages were all manner of observations, factual findings, and advice to future parties.  Most interestingly perhaps were the comments on Caremark and the discussion of the board's duties when serving with an imperial CEO.   We will examine some of these observations in the next few posts. 

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

There are any number of reasons.  But one of them is influence.  Any single public company incorporated in Delaware has only limited ability to influence the state legislature.  After all, one company, no matter how large, is a small presence in the state.  Moreover, most of these companies (Du Pont excepted) do not have their headquarters in the state, further reducing their influence.

Large public companies incorporated in smaller states, however, will often have greater influence with their own legislature.  Most other states have only a modest number of incorporated public companies, enhancing the voices of those that remain in the state.  Moreover, as a practical matter, public companies not incorporated in Delaware are, for the most part, incorporated where they have their headquarters.  This provides a powerful economic voice in the state.  In those circumstances, public companies may well have accentuated influence with their local legislature. 

With that in mind, we turn to Oklahoma and the potential influence of Chesapeake Energy.  As we have noted, Oklahoma adopted a law that requires public companies to put in place staggered boards (following a brief opt out opportunity).  The law no doubt has a number of justifications.  But one practical result is that it reduces shareholder pressure to eliminate the staggered board through the mechanism of Rule 14a-8.  The rule allows shareholders to submit proposals for inclusion in the company's proxy statement.  Proposals can, however, be omitted if they would result in the violation of state law.  A proposal calling for the elimination of a staggered board in a state where staggered boards were mandatory would arguably fall within this exclusion. 

As the WSJ reports, the law in Oklahoma was written with the participation of Chesapeake Energy, a public company incorporated in the state.  At Chesapeake disclosed: 

• The purpose of the Plan is to help protect AIG’s ability to recognize certain tax benefits in future periods from net unrealized built-in losses and other tax attributes (the “Tax Benefits”). AIG’s use of the Tax Benefits in the future may be significantly limited if it experiences an “ownership change” for U.S. federal income tax purposes. In general, an ownership change will occur when the percentage of AIG’s ownership (by value) of one or more “5-percent shareholders” (as defined in the Internal Revenue Code of 1986, as amended) has increased by more than 50 percent over the lowest percentage owned by such shareholders at any time during the prior three years (calculated on a rolling basis).

The Plan would, therefore, discourage "any person or group from becoming a 4.99 percent shareholder" and discourage "any existing 4.99 percent shareholder from acquiring additional shares of AIG stock." 

AIG has submitted the matter to shareholders, but merely for an advisory opinion.  As the proxy statement notes:

• The Board of Directors is asking AIG’s shareholders to ratify the Board’s adoption of the Plan. AIG’s By-laws and other governing documents and applicable law do not require shareholder ratification of the Plan. However, AIG considers this proposal for shareholders to ratify the adoption of the Plan to be an important opportunity for AIG’s shareholders to provide direct feedback on an important issue of corporate governance. If AIG’s shareholders do not ratify the Plan, the Board will consider whether or not to terminate the Plan. But, because the Board owes fiduciary duties to all shareholders, it must make an independent decision in the exercise of its fiduciary duties whether it is in the best interests of AIG and all of its shareholders to terminate the Plan, and may not rely solely on the shareholder vote in making this decision. Accordingly, the Board may decide that its fiduciary duties require it to leave the Plan in place notwithstanding the failure of shareholders to ratify the Plan. Likewise, even if the Plan is ratified by shareholders, the Board may at any time during the term of the Plan determine, in the exercise of its fiduciary duties, that the Plan should be terminated.

AIG has put this pill into place even though the US Government owns 1,655,037,962 shares or 92.2% of the outstanding total.

While the need for the pill was the preservation of tax benefits, the effect will also impede any ability to acquire control of the company once the US winds down its position.  In Selectica, the Delaware Supreme Court specifically validated a poison pill with a 5% triggering threshold.  Moreover, the courts in Delaware have indicated that these pills are valid in proxy contests where they prevent insurgents from reaching an agreement with other shareholders on a common slate of directors or the sharing of expenses.  This is true even when proxy contests involve only a short slate of directors where, for example, the company has in place a staggered board provision.

Allowing pills with low thresholds in the context of proxy contests where the company has a staggered board does nothing to protect shareholders.  It instead insulates boards from proxy contests.  The provision demonstrates the management friendly approach of Delaware decisions and the reason why, for better or worse, more governance matters shift to the federal government and the federal courts. 

Back in late January, I had this to say about the poison pill in Airgas:  "Either Chandler will uphold the pill or it will get reversed on appeal," said J. Robert Brown, a professor at the University of Denver's Sturm College of Law."

A poison pill is simply too important to Delaware's preeminance in the corporate governance realm.  If the courts suggested any meaningful limitations on the pill, companies would consider going elsewhere.  Its not that the judges are thinking specifically about how they can keep companies incorporated in Delaware but the philosophical approach used by these jurists is so management friendly that they path they have chosen compels a certain result.  In this case, upholding the poison pill was one of them.

Chancellor Chandler upheld the poison pill adopted by Airgas.  Airgas viewed the offer by Air Products at $70 as unfair.  Oridinarly, this is a winning argument for the poison pill.  But Airgas had the pill in place for a year and no other company made a competing bid.  See Opinion, at 4 ("Now, over a year since Air Products first announced its all-shares, all cash tender offer, the terms of that offer (other than price) remain essentially unchanged.").  The one year period provided strong evidence that the Air Products price was fair and that the board was "just saying never."

The court upheld the poison pill.  The court emphatically concluded that it was not validating the "just say no" approach to tender offers.  But in fact it was.  Moreover, the pill emphasized what had become clear in Selectica and Yucaipa that pills can remain in place as long as the insurgents had a chance to win a proxy fight.  Moreover, the chance to win a proxy fight really meant the chance to win a contest over two years.  The court in Airgas was locked into the reasoning by the Supreme Court in Selectica that held that poison pills were not to be given a more searching review even when the company had in place a staggered board. 

We will discuss the implications of this opinion in the next few posts.

We will have the opinion posted later today on the DU Corporate Governance web site.