Some view the case as a tempest in a teapot.  Even the Vice Chancellor who wrote the opinion went to great lengths to minimize the significance of the decision (largely blaming the defendants for the result).  Nonetheless, the case did breath life into the idea that directors could be liable for falling below a modest standard of behavior designed to protect shareholders.  The explanation may be judicial pique but it also may be concern over federal preemption.

This summer, a Delaware court actually struck down bonuses paid to executive officers.  Rather than apply the business judgment rule, the court subjected the payments to the "entire fairness" standard.  Julian v. Eastern States Development, Civil Action No. 1892-VCP (Del. Ch. July 8, 2008), involved a dispute among three brothers conducting business together.  Two sat on the board of Benchmark and, after a meeting of “less than a half an hour” attended by “no legal or financial advisors,” they voted themselves substantial bonuses. In the ensuing litigation, the directors had the burden of showing the fairness of the payments.

The directors argued that bonuses were ordinary and that the amounts were in return for the company’s “good year.” The court conceded a preexisting practice of paying bonuses but viewed the amounts as uncharacteristically large. 

• From 1999 through 2004, [Company's] bonuses as a percentage of adjusted income hovered between 3.30% and 3.36%. In contrast, the challenged 2005 bonuses constituted 22.28% of adjusted income. Additionally, 2005 marked the first time [the non- brother director] received a bonus beyond the performance-based compensation set forth in his Employment Agreement.

These amounts were not sufficiently explained by the company’s “good year.” “Regarding the reward for a good year, Benchmark had a better year in 2004 than 2005, and the bonuses in 2004 were still only 3.36% of adjusted income." The court held that the board had not met its burden of showing fairness.

In other words, the Delaware court merely made the board justify the payments.  Had the court applied the more standard approach (the business judgment rule), it would merely have asked whether the board was informed.  Based on the absurdly low standards set out in Disney, these same payments likely would have been upheld.  In other words, the Delaware courts use the business judgment rule to shield unfair payments made to fiduciaries.  But at least in Julian, the court had the temerity to apply modest but meaningful standards to the board of directors in connection with executive compensation.  Perhaps this portends a shift in the law in Delaware, one that will entail a return of an examination of fairness to the determination of executive compensation.  Or, perhaps, the decision is nothing more than an attempt to head off federal preemption in the area.

Delaware courts have used this language to go well beyond voidability.  A number of suits have found that conformity with Section 144 results in the application of the business judgment rule.  Thus, approval by disinterested and independent directors under Section 144(a) results in the application of the business judgment rule.   See  Oberly v. Kirby, 592 A.2d 445, 466 (Del. 1991)("First, section 144 allows a committee of disinterested directors to approve a transaction and bring it within the scope of the business judgment rule.").   Subsequent cases repeated the dictum.  See Cinerama, 663 A.2d 1156, 1170 ("In Oberly, even though Section 144(a) did not apply to the action being contested, this Court relied upon the provisions in that statute to illustrate the general principle that, as to the duty of loyalty, approval of a transaction by a board of which a majority of directors is disinterested and independent 'brings it within the scope of the business judgment rule.'").  The same has been found true of shareholder approval under Section 144(a).  See Ryan v. Lyondell Chem. Co., 2008 Del. Ch. LEXIS 105 (Del. Ch. July 29, 2008)("Ratification in those instances is governed by statute, 8 Del. C. 144, and the effect of a fully-informed vote of the shareholders is to sustain the protections of the business judgment rule."). 

There are several problems with this.  First, Section 144 says nothing about the standard of review.  It merely renders a transaction not voidable.  Second, the Section says nothing about approval by disinterested and independent directors.  By its terms, the transaction is limited to disinterested director approval (because it was dealing with voidability not the standard of review).  The courts have nonetheless used the provision to justify the application of the business judgment rule to conflict of interest transactions that are approved by a majority of independent and disinterested directors.  By relying on Section 144, they have not taken any steps to require elimination or sterilization of the conflict of interest from the approval process. 

Thus, for example, in the area of executive compensation, the CEO can participate in the debate and even vote on his/her compensation.  So long as the compensation is approved by a majority of independent and disinterested transactions, it is subject to the business judgment rule.  This is more than speculation.  CEOs appear to be very involved in compensation decisions.  It is this example of judicial legerdemain that at least in part explains the explosion in executive compensation (discussed more fully in Returning Fairness to Executive Compensation).

Coming back to Oss v. Ross, Vice Chancellor Parsons largely igored those decisions and had this to say about Section 144.

• Section 144(a) protects against the invalidation of a transaction solely because it is an interested one. Satisfying its requirements alone, however, does not automatically trigger application of the protections of the business judgment rule.  "Nothing in the statute sanctions unfairness to [the Company] or removes the transaction from judicial scrutiny."  As this Court explained in Benihana of Tokyo, Inc. v. Benihana, Inc., 144 is best seen as establishing a floor for board conduct, but not a ceiling. Because the parties have not shown that they are likely to succeed in proving they have satisfied the requirements of 144(a), it follows that they also have failed to demonstrate that the TRCLP Transaction and the Rights Offering are likely to qualify for business judgment rule protection in light of the interestedness or nonindependence of a majority of the Board. (citations omitted). 

In other words, the court appeared to be backing off the proposition that conformity with Section 144 automatically resulted in application of the business judgment rule.  Perhaps this quote portends a more reasonable approach by the Delaware courts, one that determines the standard of review based on the underlying rational of the business judgment rule (a presumption of fairness applied to transactions devoid of a conflict of interest) rather than a misreading of the statute.  Alternatively, it reflects a temporary shift designed to minimize federal intrusion into fiduciary obligations.

There were some who were suspicious that the shift was designed to prevent further encroachment by Congress into the Delaware reserved area of corporate governance.  (Take a look at footnote 382 in The Irrelevance of State Corporate Law in the Governance of Public Companies).  To the extent true, the cases represented an expediency rather than a genuine shift in approach.  And, in fact, the trend (if it really was one) didn't last.  When congressional interest in governance reform receded, the Delaware decisions returned to their more traditional, pro-management approach.

The question is whether we are about to see (or are seeing) a repeat performance.  Considerable criticism has been heaped on CEO compensation.  Congress included substantive limits on executive compensation in TARP and had them in the proposed auto bailout bill.  These are a direct result of the amounts paid to CEOs, particularly in connection with bonuses and golden parachutes.  While the efforts have (unfortunately) not taken the standards used by the Delaware courts to task by name, the reality is that the "excessive" payments to CEOs were invariably approved by the standards developed by the Delaware courts. 

Pressure is, therefore, building for reform of the method of determining executive compensation.  This would generally require preemption of Delaware law.  The question is whether there will be a noticeable shift in the Delaware decisions that are designed to tighten the fiduciary obligations of management (particularly in the area of executive compensation) in an effort to head off any effort at federal preemption.  We suggest that this may in fact be taking place.  The next few posts will give some possible examples.

In other words, so long as a system is in place (with the Delaware courts essentially putting in place no standards designed to ensure that the system is thorough and meaningful), boards have few if any affirmative duties with respect to corporate oversight.  In other words, they merely must react to what is given to them.  They have no affirmative obligations to ask for information or require additional reports.  Moreover, much of the information flow is controlled by the chairman of the board (who traditionally sets the agenda for board meetings).  In the United States, the CEO and Chairman are typically one and the same, giving management a substantial amount of control over the information flow to the board.

Perhaps its time for a system of monitoring that has affirmative obligations attached.

Delaware has moved in a direction of allowing entities to waive all rights, including those that favor investors, if the waiver is in the formation documents. Thus, operating agreements for LLCs can include a waiver of all fiduciary duties by the managers. The statute does provide, however, that an LLC cannot waive the contractual obligation of good faith and fair dealings.

In the corporate world, the statute does not go so far. Fiduciary duties cannot be waived in toto, although companies can and usually do waive liability for breaches of the duty of care.

Amirsaleh shows how this can work in practice.The case involved a merger between two entities. The target, the NY Board of Trade, required that to have trading privileges, each member had to be an owner. When the merger took place, existing owners could either cash out or receive an interest in the merged entity, thereby retaining their trading privileges.

The merger agreement provided owners with the choice but did not require that each owner be notified of the election. It merely required that the election form "be mailed on the same date as the Proxy Statement . . . or on such date as ICE and NYBOT shall mutually agree."

In other words, the rights of the owners of NYBOT were determined by contract. The contract required mailing but did not require receipt. The undisputed facts of the case was that NYBOT mailed the election form (through the use of a third party service) but plaintiff never received it. Plaintiff, therefore, only learned of the election after the deadline passed. As a result, he received cash rather than stock and lost his trading privileges.

The court concluded that the failure to notify plaintiff did not violate the agreement. The agreement didn't require that he receive the election form, only that the form be mailed.

• Amirsaleh argues that the defendants breached the Merger Agreement because they failed to deliver to him the requisite forms to make his election and pledge his shares going forward. Implicit in this argument is the assumption that the contract granted him guaranteed delivery. The record is clear enough that Amirsalehdid not receive an Election Booklet prior to the January 5, 2007 deadline. This fact alone, however, certainly does not amount to a breach of the contract because the contract does not require delivery of the Election Forms. The terms of the Merger Agreement provide only that the Election Form "shall be mailed" to NYBOT members "on the same date as the Proxy Statement/Prospectus is mailed to the Members or on such other date as ICE and NYBOT shall mutually agree." The evidence in the record supports that such a mailing took place on December 19, 2006. Plaintiff is unable to point to any evidence that shows the existence of a genuine issue of material fact with respect to whether or not the forms were mailed.

In other words, the court was prepared to enforce a contract that did not require the entity to provide notice that an owner's interest would be liquidated and his/her trading privileges extinguished.The court did ultimately remand to determine whether the NYBOT's failure to accept the election form after the initial deadline somehow violated the duty of good faith and fair dealing.

In the LLC area, this kind of thing can happen under Delaware law. There are essentially no default rules that cannot be waived, including fiduciary duties. Under corporate law, this probably could not happen. Fiduciary duties would likely ensure that investors received proper notice.

The not-for-profit Board of Trade of the City of New York, Inc. ("NYBOT") and CFC Acquisition Co., a wholly owned subsidiary of Intercontinental Exchange, Inc. ("ICE"), agreed to merge. Under the merger agreement, those owners wishing to retain trading privileges were required to complete and return both an Election Form and a Pledge Agreement.

The NYBOT distributed proxy materials and held a special meeting on December 11.  The Election Form, however, had not been distributed.  Instead, the Proxy Statement disclosed that the Form would follow in a subsequent mailing and the deadline for returning the Form would be disclosed in the supplemental mailing.  In early December, Plaintiff inquired about the Form and was told that it "would be mailed shortly."  The Forms were distributed later that month, with the NYBOT relying on a third party for execution.

• On December 19, 2006, the Election Forms and Pledge Agreements were sent by first class mail, postage prepaid, to all NYBOT members using the addresses the NYBOT had on file.  To accomplish the printing and distribution of the forms, NYBOT and ICE contracted with a third party, RR Donnelly & Sons Company.  NYBOT provided RR Donnelly with its list of members and addresses -- a list that included Amirsaleh and his proper mailing address.  RR Donnelly contracted with Apple Direct Mail Services, Ltd., and Apple Mailed the Election Forms, which specified that the deadline for making an election was January 5, 2007.

Plaintiff never received the Election Form and apparently remained unaware of the January 5 deadline.  On January 12, an official at NYBOT contacted Plaintiff to inquire about the Pledge Agreement but said nothing about the Election Form.  The Pledge was faxed the same day but not returned until January 18.  The same day, Plaintiff learned of the need to return the Election Form, obtained a faxed copy and returned it the same day.  The NYBOT, however, treated the election as late.  Plaintiff received cash rather than stock, effectively eliminating his trading privileges on the new entity.

Plaintiff alleged that he had not received the Election Form and that this violated the merger agreement.  The court conceded that the Plaintiff has not received the material.  The merger agreement, however, only required that the material be mailed, not received.

• The record is clear enough that Amirsaleh did not receive an Election Booklet prior to the January 5, 2007 deadline. This fact alone, however, certainly does not amount to a breach of the contract because the contract does not require delivery of the Election Forms. The terms of the Merger Agreement provide only that the Election Form “shall be mailed” to NYBOT members “on the same date as the Proxy Statement/Prospectus is mailed to the Members or on such other date as ICE and NYBOT shall mutually agree.” The evidence in the record supports that such a mailing took place on December 19, 2006. Plaintiff is unable to point to any evidence that shows the existence of a genuine issue of material fact with respect to whether or not the forms were mailed.
  

In other words, the court countenanced a meger that threatened to eliminate trading privileges for its members without requiring that the members actually receive notice that the privileges would be extinguished. 

Nonetheless, the court found that the merger agreement contained an implied duty of good faith and fair dealing and that the failure of the NYBOT to accept the Election Form late may have violated that clause.   

• As it currently stands, the record is entirely unclear on precisely how, why, or when the defendants determined to stop accepting late election forms. Although defendants have pointed to specific exhibits in support of their contention that a firm decision was made to extend the deadline to January 18, the proffered exhibits offer no such support. Moreover, although defendants argue that it is unfair to permit plaintiff to contend ICE and NYBOT acted in bad faith when plaintiff failed to take the depositions of NYBOT Member Services employees, those employees did not have any control over defendants’ decision to stop accepting late forms. . . . [As a result, there was] a genuine issue of material fact as to whether ICE and NYBOT’s clandestine and unexplained decision to stop accepting late forms frustrated the purpose of the Merger Agreement’s election provision."
  

The primary materials for this post are available on the DU Corporate Governance website.

MHR was a large stockholder of Loral and used its influence to place one of its own advisors, Michael Targoff, as Loral’s CEO.  Targoff sought to invest in Loral in an effort to allow it to pursue acquisitions and grow its existing business lines.  The Loral board formed a Special Committee to raise the equity capital it desired.  Eventually, the Special Committee adopted the terms of the Finance Agreement.  The terms provided class voting rights, which gave MHR control of 63 percent of Loral’s equity and control over almost any major transaction.  Plaintiffs alleged that the Finance Agreement was not the product of arms-length negotiations because the majority of the board was interested and the terms of the Finance Agreement were unfair.   

To determine whether the transaction was fair, the Delaware Court of Chancery applied the entire fairness standard.  The entire fairness standard applies when a majority of the board is interested or lacks independence from the interested party.  If the majority of the board is interested or lacks independence, the court will then consider two factors as a whole to determine whether the transaction is valid: fair price and fair dealing. Using this test, the court held that the entire fairness standard applied to the analysis of the Finance Agreement.  Because MHR and the Loral directors failed to meet their burden of proving the Finance Agreement was the product of a fair price and fair dealing, the court invalidated the Finance Agreement. 

The Entire Fairness Standard

The court held that the entire fairness standard applied to the Finance Agreement because the majority of Loral’s directors were interested and lacked independence from MHR. The court analyzed the relationships Loral’s directors had with MHR.  The two directors most responsible for negotiating the Finance Agreement, the Special Committee chairman and Targoff, were not independent of MHR.  MHR insisted that Targoff, who is also one of MHR’s investment advisors, become Loral’s CEO.  The Special Committee chairman had business and personal relationships with MHR.  Additionally, the Special Committee chairman was one of MHR’s investment advisors, which the court considered “too material” and thus not independent of MHR.  The court also highlighted that the Special Committee chairman and another director were business school classmates and close friends. The fact that MHR was a controlling stockholder also weighed in favor of invoking the entire fairness standard.  Since the entire fairness standard applied, the burden shifted to the defendants to prove the Finance Agreement was the result of fair price and fair dealing.

Fair Dealing

To assess fair dealing, the critical issue is whether the special committee functioned as an effective proxy for an arms-length bargain, such that the outcome was equivalent to a market tested result. An effective special committee must function in a manner that indicates the controlling shareholder did not dictate the terms of the transaction and that the committee exercised real bargaining power at an arms-length.

The court held that the defendants did not meet their burden of proving the Finance Agreement was fairly dealt.  Here, like measuring whether the parties were interested, the court looked at the relationships of the parties.  In addition, the court considered that the Special Committee chairman forwarded Loral’s internal corporate communications concerning the Finance Agreement to MHR.  Also, the Special Committee did not disclose to Loral’s legal advisors any if its relationships with MHR.  Furthermore, the court explained that in the context of a special negotiating committee, “[c]ourts evaluate whether the relationships among the members of the committee and interested parties placed them in a position to objectively consider a proposed transaction, and whether the committee members in fact functioned independently.”

The effectiveness of a special committee lies in the quality of the advice it receives from its legal and financial advisors.   Here, the Special Committee chose an unqualified financial advisor who did not perform a market test. The financial advisor made two calls to gauge interest but never sought to raise market interest.  The court found the financial advisor merely sought to make the deal look fair, rather than provide an objective opinion to the Special Committee.  As a result, the court held that the Finance Agreement was not a product of fair dealing. 

Fair Price

Under the second factor of the entire fairness standard, the court considered whether the Finance Agreement resulted in a fair price.  Here, the court determined that the financial terms of the Finance Agreement were more favorable to MHR.  MHR, along with Loral’s directors, tried to prove fairness by arguing that MHR was the only source of capital, took a high risk, and therefore deserved compensation for that risk.  The court stated that MHR took on risk for its own advantage, and that the terms of the Finance Agreement were excessively generous to MHR due to the unfair price paid for an equity stake, the unusually low conversion premium, and the unusually high dividend rate. The Special Committee did not take advantage of numerous opportunities to obtain equity at terms more favorable to Loral.   Additionally, the Special Committee failed to consider other available financing options, which were less risky.  This undercut the defendant’s claim that it was merely being compensated for taking a high risk.  Because the financial terms of the Finance Agreement favored MHR, the court held that the defendants did not prove the Finance Agreement resulted in a fair price.

In conclusion, the court held that the entire fairness standard applied to the analysis of the Finance Agreement.  Because MHR and the Loral directors failed to meet their burden of proving the Finance Agreement was the product of fair price and fair dealing, the court invalidated the Finance Agreement.

We have previously followed the Loral decision.  Here.  

The primary materials for this are available on the DU Corporate Governance website.

The problem starts at the top.  The conservative Supreme Court has certainly issued some decisions that are antagonistic to shareholders and investors.  Stoneridge comes to mind.  There the Supreme Court basically announced that the controlling principle for future antifraud decisions would be "no expansion."  One of the reasons given by Justice Kennedy?  Bad for business.  "Overseas firms with no other exposure to our securities laws could be deterred from doing business here. . . This, in turn, may raise the cost of being a publicly traded company under our law and shift securities offerings away from the domestic capital markets."

But the problem goes much deeper into the judiciary.  Much of his problem may come from the DC Circuit.  It is the DC Circuit that is considered perhaps the most important federal court other than the Supreme Court.  Moreover, in the realm of government regulation, it hears by far the largest number of cases that challenge administrative policy.  Nominees to the Supreme Court often come from the DC Circuit.  Scalia, Ginsburg and Roberts are the current examples.  Judges on the circuit, therefore, have an incentive to adhere to an ideological approach that is likely to bring them to the attention of the doyens in the Administration deciding on nominees to the Supreme Court.  The website for the Circuit lists 13 judges.  The membership consists largely of Republican appointees, with only four appointed by democrat presidents (Edwards, who is now senior, Rogers, Tatel, and Garland).  For the Obama Administration, it will be an unsympathetic court.

With that in mind, we turn to the court's responsibility for the current conflagration in the financial markets.  For that, we return to hedge funds.

Since mutual funds are likewise pooled investment vehicles, the critical component of the definition is private organization and unavailability to the public.  The non-public nature of the funds occurs because they need not register as investment companies with the SEC.  They avoid registration by keeping the number of investors to below 100 persons Investment Company Act of 1940, Section 3(c)(1)) or offering participation only to purchasers that own $5 million in assets (Section 2 (a)(51)(A)). Without registration, hedge funds operate with little or no regulatory oversight (the antifraud provisions an exception) and provide little or no public information about their activities.

Given the growing role of hedge funds in the financial markets, the absence of transparency is troubling. This is one of those issues where the staff at the SEC was out front. In 2003, the staff published a report on the funds. Implications of the Growth of Hedge Funds, Staff Report the United States Securities and Exchange Commission (September 2003). The report noted many of the problems that arise from the lack of transparency and recommended that the funds be required to register with the Commission. The Commission acted and subjected funds to registration and inspection. See 17 C.F.R. § 275.203. The Rule was opposed by the deregulatory faction on the Commission, Commissioners Atkins and Glassman.  See Investment Advisors Act Release No. 2333 (Dec. 10, 2004).

What the deregulators could not do at the Commission, the DC Circuit did at the appellate level.  In  Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), a panel consisting of a majority of Republican appointees struck down the modest rule.  The result was that as the financial crisis unfurled during the second half of 2008, regulators had almost no information about hedge funds and their activities.  While it is hard to pinpoint the role of hedge funds in the current crisis, it is beyond peradventure that the crisis started with the collapse of two funds run by Bear Stearns.  Moreover, their often highly levereged nature potentially imposes additional systemic risks to the financial system, although without disclosure, assessing the degree of risk is "virtually impossible."

While there may be a political consensus that favors a more activist government in the context of the current economic turmoil, the same consensus probably does not exist in the courts.  It is this interest group that may take the longest to shift.

The existing crisis has caused any number of proponents of dergulation to recant, whether Henry Paulson or Alan Greenspan.  An article in the New Yorker captured the new found consensus:

• Barack Obama’s decisive defeat of John McCain . . . brings to a close another conservative era, one that rose amid the ashes of the New Deal coalition in the late sixties, consolidated its power with the election of Ronald Reagan, in 1980, and immolated itself during the Presidency of George W. Bush. Obama will enter the White House at a moment of economic crisis worse than anything the nation has seen since the Great Depression; the old assumptions of free-market fundamentalism have, like a charlatan’s incantations, failed to work, and the need for some “new machinery” is painfully obvious.

Perhaps this is true of the politicians, but it remains to be seen whether it is true of the courts.  With "deregulatory" presidents holding the White House for most of the last quarter of a century, the federal bench has been populated by judges with the same philosophy.  As of October 2008, 56% of the 179 judges at the court of appeals were appointed by Republican presidents; only 35% by Democrats (the rest are open positions).  With republican majorities, the courts have been able to implement the deregulatory philosophy in a sometimes more effective manner that the politicians.

Thus, while the political wind has shifted and Barack Obama will enter the White House with large majorities not implacably hostile toward regulation (albeit smart regulation rather than more regulation), he will, as President Roosevelt discovered, have to confront a court system that is full of people who do not share his philosophy.  We will relate this to the financial markets and talk about it a bit more in the next post.

But, based upon past decisions, it has not.  Perhaps VC Strine is changing the law and adopting a more reasonable standard for showing a lack of independence.   Perhaps "structural bias" and preexisting friendships will play a larger role in the analysis of independence in the future.  The next case or two on the independence issue will demonstrate whether or not this is the case. 

Our prediction?  The standard in this case will be limited to activist shareholders.  Conclusory allegations, reliance on structural bias, and overlapping board positions will not be enough to challenge the independence of directors tied to the company and the CEO but will be enough to show a lack of independence for directors tied to an activist shareholder.

One thing is for certain.  The conclusion that the standard in the case arose in part because of the type of shareholder involved would have been much tougher to reach but for the external writings and musings of the Vice Chancellor writing the opinion.  The opinion and a number of pleadings are filed on the DU Corporate Governace web site.

The court found a fifth director, John Harkey, to be too connected to MHR to be independent.  Harkey served on the Special Committee considering the financing proposal from MHR.  He lost his independence mostly because of a host of personal connections, perhaps the toughest ground in Delaware for doing so.

The personal relationship?  He was a business school classmate of Rachesky, the founder of MHR.  But of course, that is an example of structural bias, the very type of evidence rejected in Beam.

The court also, however, noted that Harkey had a “long-time friendship” with Rachesky, the founder of MHR.  The long time friendship conclusion was supported by no evidence in the opinion except an isolated citation to someone named Simon, apparently the other director on the Special Committee.  It was not supported by statements from Rachesky or Harkey, the two involved in the relationship. Moreover, there was no surrounding evidence to sustain the conclusion, no examples of interaction between the two directors.  This was the very sort of evidence emphatically rejected in Beam.  As the Court noted in Beam:  "Mere allegations that they move in the same business and social circles, or a characterization that they are close friends, is not  enough to negate independence for demand excusal purposes."  845 A.2d 1040, 1052-53. 

The opinion noted that the two men served as “business resources and references for each other.”  Again, the opinion provided no example or instance where the references had actually been used.  The Chancery Court rejected the argument that the use of a director as a reference resulted in a loss of independence in In re Transkaryotic Therapies, 954 A.2d 346 (Del. Ch. 2008).  In that case, the court did so even though one director used another as a reference during the period when the challenged transaction occurred.  As the court in that case described:

• Second, plaintiffs' attempt to show Yetter's dependence on Emmens for employment is unavailing. Plaintiffs allege that Yetter "was relying on Emmens's reference for a job at the time of Emmens's October 2004 approach."  The actual record evidence, however, shows that Yetter merely included Emmens's name on a list of references submitted in connection with an application for a position with Odyssey Pharmaceuticals. There is no evidence that Emmens was actually contacted by Odyssey or any affiliate. In fact, there is no evidence whatsoever that Emmens  even knew he was listed as a reference.  Moreover, the suggestion that Yetter would sell his vote for a positive job reference is belied by the fact that Yetter--unlike Leff and Moorhead--voted affirmatively to reject the initial Shire offer of $ 31 per share. At the time of that vote, February 26, 2005, Yetter had already listed and was, according to plaintiffs, already relying on Emmens's reference. If indeed Yetter had sold his vote, it would have presumably been sold by then.

We criticized that holding.  But in any event it contained much stronger evidence of a potentially disqualifying relationship that the conclusory references in Loral. 

Finally, the opinion notes that “[b]ased on Rachesky’s recommendation, Harkey serves as a director on three boards – Loral, Leap Wireless International, Inc., and Emisphere Technologies, Inc. Unsurprisingly, MHR holds large blocks of stock in each of these companies.”   In other words, it was enough that Harkey served on boards where MHR owned shares.  No case in Delaware has ever found that this type of evidence has been sufficient to deprive a director of indpendence.  Indeed, on a number of occasions, the evidence has been specifically rejected.  See Khanna v. McMinn, 2006 Del. Ch. LEXIS 86 (Del. Ch. Nov. 7, 2005) ("Second, the Amended Complaint repeatedly alleges that McMinn (or another director) 'recruited' certain individuals to be Covad directors, that those individuals took their seats at McMinn's (or others') 'behest,' and that those individuals became directors with the other directors' 'consent and approval.' Again, conclusory allegations of this nature do not advance the Court's inquiry; they will not 'sterilize' a director's judgment with respect to demand."). 

Similarly, VC Strine has, in an earlier case, indicated that similar information was immaterial in the disclosure context. See In re Netsmart Techs., Inc. S'holders Litig., 924 A.2d 171 (Del. Ch. 2007) ("In view of the tightened definitions of independence that now prevail, I am chary about adding a judicially-imposed disclosure requirement that past interlocking board service involving a target's CEO and another independent director must always be disclosed.").

In other words, Harkey was found to lack independence using standards not typically applicable in prior cases.

The opinion and a number of pleadings are filed on the DU Corporate Governace web site.

In Delaware, the standard of review doesn’t depend upon the conduct involved but on the approval mechanism. For plaintiffs to successfully challenge the board’s behavior, they have to show that the board was not independent. See Opinion, at 43 (“Because MHR had effective control of the Loral board, the plaintiffs argue that MHR has the burden of showing that the MHR Financing was fair to Loral.”). This is a notoriously difficult standard to meet in Delaware. The state courts impose excessive pleading standards at the motion to dismiss/demand excusal stage and apply an unrealistic definition of independence.

In this case, the Loral board contained nine directors. Three of the nine directors were appointed by MHR. Plaintiffs, therefore, needed to show that two additional directors were not independent because of their connections to MHR. The court found that plaintiffs met the standard in what can only be viewed as surprising analysis.

One of the directors was Michael B. Targoff, the CEO and vice chairman of the board. The evidence for a lack of independence? In a letter to its investors, MHR described Targoff as an advisor. He received free office space in MHR’s midtown offices rent free in return for providing advice on “potential transactions and business opportunities.”

That’s it. The opinion was devoid of any numbers that put a value on the services or the free office space. Only one other Delaware case has found allegations of free office space to be sufficient to result in a loss of independence.  See In re infoUSA, Inc. S'holders Litig., 953 A.2d 963 (Del Ch 2007).  In that case, however, the case was at a motion to dismiss and the court agreed to allow it to go forward only because an internal memorandum suggested that the space may have deprived the directors of independence and, as a result, the need for discovery.  But the opinion noted the kind of evidence it expected to see after discovery.  "Plaintiffs have not had the benefit of discovery, however, and it would be too much to expect for plaintiffs now to provide the Court with a detailed floor-plan of the Everest offices; an estimate of the cost of office space in Omaha, Nebraska; the square footage occupied by each defendant; an estimate of the personal net worth of Haddix and Walker; and any of the various other factors that would need to be presented to establish by a preponderance of the evidence that the two directors lack independence."

VC Strine needed none of that level of specificity.  The opinion contains no information on the amount of space, the net worth of Targoff, the square footage, or anything else that suggests the type of material impairment necessary to deprive a director of independence.

Similarly, with respect to the advisory role played by Targoff, there is nothing in the opinion that suggests Targoff was actually paid any money.  Nor is there any evidence of actual advice provided.  In other words, there is no evidence that a material business relationship of any kind existed.  It is the very kind of lack of information that ordinarily gets a plaintiff’s challenge to director independence dismissed.  But in the case of a relationship with an activist shareholder, the standard of proof is apparently lower.

Add in that the opinion provides data that suggests that in fact Targoff served in an independent role. First, he worked for a predecessor for Loral for 16 years. In other words, he knew the company and was experienced in the industry. Second, even the court couldn’t avoid noting his role in the negotiations with MHR. "Sadly, by the end of the negotiation process, it appears that Loral’s CEO, Targoff, was a more aggressive negotiator than the Special Committee itself or the Committee’s financial advisor, North Point"

The opinion and a number of pleadings are filed on the DU Corporate Governace web site.

We are supported in the conclusion by the public pronouncements of the author of the opinion.  As VC Strine has more or less espoused in a law review article, activist investors are motivated by self interest and short term returns. They "can use the threat of a withhold campaign to bargain for concessions and the seating of some of their favorites by action of the incumbent slate." It is, as VC Strine believes, something that "smacks of green mail and a hidden form of cumulative voting, the benefits of which arguably flow largely to short-term activist investors."  The antagonism towards these types of shareholders has arguably shown instelf in at least one prior case.

In re Loral Space and Communications is consistent with this antipathy.  In that case, MHR owned 35.9% of Loral.  VC Strine described MHR as having a business model that "involved taking control of distressed companies and position itself to reap the benefits of control for itself and its investors."  Lest one have any doubt that the Vice Chancellor viewed the firm as a short term activist shareholder, he noted that MHR was the “eponymous creation of Mark H. Rachesky” and that Rachesky was "Carl Icahn's chief investment adviser."

These descriptions spell trouble for MHR, something that becomes clear from the decision.  In particular, the decision finds that a majority of the nine person board was beholden to MHR.  In doing so, however, it applied a standard for independence that, to say the least, conflicted with prior approaches by the Chancery Court.

We will examine the problems with the opinion in the next posts.  The opinion and a number of pleadings are filed on the DU Corporate Governace web site.

• Mr. GREENSPAN. I made a mistake ín presuming that the self-interest of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.

In other words, allowing top officers and directors to profit from the company (greed in short) was not the best way to protect shareholders.  It is, as we have noted, a frontal assault on the Delaware model of governance.  The Delaware model presumes that directors should have something approaching unlimited discretion and will use that authority to benefit shareholders.  The courts have done so by all but eliminating the duty of care and removing fairness from the analysis of the duty of loyalty.  The problem of excessive compensation demonstrates that the system works in the best interests of officers and directors.  The current financial turmoil demonstrates that the approach does not work in the best intersts of shareholders.  We have discussed this at length in the article, Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty.

We welcome Alan Greenspan to the position, but note that it took the greatest financial crisis since the Depression to bring him along.

At the same hearing, Congressman Mark Souder had this to say:

• But one of the questions here is where are the corporate boards? Those of us who believe in the private sector believe that there was supposed to be some kind of corporate check on the stockholders. Do any of you have any suggestions of what we might be looking at here because clearly they were asleep at the wheel,

It is the great unaddressed issue.  With the bailout proceeding apace, one can wonder why there has not been an attempt at systemic reform that increases the responsibility of the board of directors to oversee the activities of the company, including examination of excessive risk taking.