Shareholders of the Dow Chemical Company (“Dow”), brought an action against current directors and officers of Dow, alleging that the defendants breached their fiduciary duties to the company.  See In re Dow Chemical, 2010 Del. Ch. Lexis 2 (Del. Ch. Jan. 11, 2010). 

Specifically, plaintiffs’ complaint alleged breaches of fiduciary duty by the defendants by 1) approving a strategic merger with Rohm & Haas Company (“R & H”), 2) misrepresenting the relationship between the R & H transaction and another transaction with Kuwait’s Petrochemicals Industries Company ("Kuwait"), 3) failing to notice and avoid alleged bribery in connection with Dow’s merger with Kuwait, 4) failing to notice and avoid certain alleged misrepresentations, 5) failing to notice and avoid insider trading, and 6) failing to prevent allegedly excessive and wasteful compensation. 

In addition, plaintiffs alleged a Caremark claim asserting a failure to supervise, with the failure exposing Dow to bribery allegations and misrepresentations about the K-Dow and R&H transactions.   

In December 2007, Dow’s board of directors caused the company to enter into a Memorandum of Understanding with Kuwait.  The Memorandum provided for $9 billion in cash payments to Dow upon the transfer of a 50% interest in five Dow commodities chemical businesses into a joint venture with Kuwait.  The joint venture, known as “K-Dow,” provided that each company was to take a 50% equity interest in the new company.  The transaction was expected to close in late 2008.

In July 2008, the Dow board of directors approved and caused Dow to enter into a merger agreement with R & H.  This agreement provided that Dow was to acquire all of R & H’s stock for $78 a share, which comes out to approximately $18.8 billion.  The merger was expected to close two days after Dow acquired all the regulatory approvals.  The R & H merger agreement provided no traditional “outs” from completing the transaction.  There were, however, specific penalties listed for any delay or failure to close.  Additionally, the Dow board informed stockholders that the financing for the R & H merger did not depend on completing the aforementioned contract with Kuwait. 

Over the next six months, Dow felt the effects of the global economic recession.  Its cash reserves fell dramatically, and in the span of five days between December 29, 2008 and January 2, 2009, all three credit rating agencies (S & P, Moody’s and Fitch), lowered Dow’s credit ratings to just above “junk."

Nevertheless, Dow’s board of directors did everything in their power to keep the R & H merger on schedule.  Despite their efforts, on December 28, 2008, Kuwait informed Dow that the Kuwait Supreme Petroleum Council had rescinded their approval of the merger.  Although the notice given to Dow at the time did not mention a reason for the rescission, an article released in the Kuwait Times a month later alluded to the existence of bribery allegations.

Shortly thereafter, on January 25, 2009, Dow refused to close the R & H merger, citing economic concerns and viability of the combined entities.  R & H filed suit on January 26, 2009, seeking specific performance of the merger.

Resolution of the fiduciary duty claims turned upon demand excusal.  Under Aronson, the plaintiffs had to plead with particularized facts that raised a reasonable doubt that either 1) a majority of the directors who approved the transaction were disinterested and independent, or 2) the transaction was the product of the board’s good faith and informed business judgment.

First, in analyzing the first prong of the Aronson test, the Court found that plaintiffs failed to show with particularity that any members of the board of directors were not independent and disinterested.  Second, in analyzing the second prong, the Court found that the plaintiffs failed to prove with similar particularity that the board of directors had acted in bad faith.  Instead, it appeared that plaintiffs took issue with the substantive decisions of the R & H merger, and not with the process the board followed in executing the merger.  In in re Citigroup Inc. Derivative Litigation,  the Court held that the business judgment rule prohibits against this kind of second-guessing of the merits of a business decision.  In re Citigroup Inc. Derivative Litigation, 964 A.2d 106 (Del. Ch. 2009).  Because plaintiffs were not able to show the presence of either prong, the claim for breach of fiduciary duties was dismissed without prejudice pursuant to Rule 15(aaa). 

With respect to the Caremark claim, the Court found that plaintiffs failed to establish “oversight liability” by the directors.  To establish such, the plaintiffs “must show that the directors knew that they were not discharging their fiduciary obligations, or that the directors demonstrated a conscious disregard for their responsibilities by failing to act in the face of a known duty to act.”  Citigroup, 964 A.2d at 123.  While plaintiffs did present particularized facts that bribery may have occurred (although it is equally likely that in the wake of the global economic crisis, Kuwait merely used the allegations of bribery to back out of the deal), they failed to show that the board had any reason to know about or be aware of the behavior.  

Therefore, the Court found that because the plaintiffs failed to allege facts that established a substantial likelihood of direct liability due to oversight liability, their claims as to bribery in Count III are dismissed with prejudice pursuant to Rule 15(aaa).  

Primary materials are located at the DU Corporate Governance web site.

In Proctor v. Vishay Intertechnology Inc., 581 F.3d 305 (6^th Cir. 2009) and Segal v. Fifth Third Bank, N.A., No. 07-16527, 2009 WL 3260535 (9^th Cir. Oct. 9, 2009), two Federal Court of Appeals addressed the scope of the Securities Litigation Uniform Standards Act (the  “SLUSA”), each holding that the statute precludes class action law suits brought in state court.

The SLUSA sought to close the “federal flight” loophole created by the previous Private Securities Litigation Reform Act (the “PSLRA”).  The loophole refers to the use of state class action suits to avoid the stricter pleading requirements of the PSLRA.  To close that loophole, the SLUSA bars class actions based upon the statutory or common law of any state when a party alleges a misrepresentation or use of manipulative tactics in connection with the purchase or sale of a nationally listed security. 

In Segal, the beneficiary of certain trust accounts administered by Fifth Third Bank, N.A., filed a class action suit alleging breach of contractual and fiduciary duties.  The district court granted Fifth Third’s motion to dismiss for failure to state a claim under the SLUSA, concluding that the claims alleged prohibited misrepresentation or manipulation theories and could not, therefore, be filed in state court.  On appeal, the issue was whether the complaint alleged an “untrue statement” or a “material omission of fact” in connection with the sale of the nationally traded mutual funds. 

Despite the complaint expressly disclaiming that the state law allegations were based on misrepresentation or manipulation, the court held that such disclaimers were mere artful pleading.  The court concluded that in applying the SLUSA, courts should look to the overall substance of the complaint, and not resort to a formalistic search for the “magic” words (i.e. “untrue,” “deceptive,” “manipulation”, etc.).  Reasoning that to do otherwise would “frustrate the objectives” of PSLRA and SLUSA, the court further explained that the question under SLUSA was not whether the complaint used the “magic” words, but whether the complaint used the prohibited theories.  The court affirmed the district court’s decision but noted that Segal could have avoided the “unforgiving” operation of the SLUSA if he and other class members had filed the identical complaint individually. 

In Proctor, on the other hand, minority shareholders brought a derivative action against the corporation alleging corporate waste and breach of fiduciary duty in addition to a class action claim for breach of fiduciary duty in connection with a tender offer made by Vishay to its shareholders.  The defendants removed the action to federal court under the SLUSA.  The district court dismissed the class action claim on grounds that the claim was barred by the SLUSA.  The court sustained the remaining claims against the corporation and remanded the case back to state court. 

On appeal, the issue was whether the SLUSA required dismissal of all the claims under the SLUSA appearing in the same complaint as an entire precluded action.  In a matter of first impression for the Ninth Circuit, the court acknowledged a current circuit split on this issue.  This court joined the Second and Third Circuits, concluding that SLUSA precluded the class action, the statute did not bar the other claims, which could proceed in state court.  The court reasoned that the intent of the PRLSA, achieved through the SLUSA, was to reduce abusive litigation and that precluding otherwise valid claims would not serve this goal.  Indeed, the court noted, that to do otherwise may in fact reopen the “federal flight” loophole by forcing litigants to file two separate actions in state and federal court.

In Segal, where the complaint contained several claims incorporating prohibited theories under the SLUSA, as well as other non-prohibited theories that could be brought in state court, the court had no choice but to dismiss the entire action.  In Proctor, however, where the complaint carefully separated potentially SLUSA precluded federal claims from other non-precluded state claims, at least in the Second, Third and Ninth Circuits, those non-precluded state claims may proceed in state court. 

The practical import of theses recent appellate decisions is that a class action suit filed in state court arising out of a nationally listed security must be carefully pled so as to distinguish and separate theories of recovery that may be precluded under the SLUSA.  

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

The brief filed by shareholders also noted the risk of preemption should the Supreme Court affirm the Chancery decision. 

• Shareholders will be forced either to compel companies to eliminate the policies, or to look elsewhere for authority to get corporate directors to justify their decisions.8

Footnote 8?

• 8 See J. Robert Brown, City of Westland v. Axcelis Technologies: Majority Voting and Delaware Law (The Beginning of the Evisceration), http://theracetothebottom.org (Jul. 22, 2009, 6:00 a.m.): 

The problem in the end is that there shouldn't be a need to invoke a higher standard of review. For matters that directly contradict the voting position of shareholders, shareholders ought to have an inherent right to know the reasons and explore any supporting documentation. Only with the information can shareholders be certain that the board acted in a manner consistent with its fiduciary obligations. In other words, there should be no need for "credible" evidence beyond the actions taken by the board to overturn the shareholder vote. ... If the Chancery Court does not allow inspection to occur in this case, it will be another area where the SEC will need to preempt and substantially increase the disclosure obligations on the company. It will be the only way for the owners of the company to obtain the information they need to assess the quality of the managers.

This is not an idle possibility.  The Commission, we understand, is quite aware of this case and likely quite aware of the lacuna in shareholder disclosure that it creates.  With the most recent disclosure reforms delving into board diversity and the separation of chairman/CEO, it would be eminently consistent that the SEC would undo this case. 

After all, the SEC has tried to use disclosure to affect the substantive behavior of the board (see Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure), a stretch of its regulatory mandate.  In this instance, there is no stretch.  It is about providing material information to shareholders.  Look for a proposal if the Supreme Court affirms the denial of access to the documents connected to the decision to not accept the resignation of the directors who did not receive the requisite majority.

TheRacetotheBottom was mentioned in the appeal.  As the brief states:

• This Court has described the “credible basis” standard as “the lowest possible burden of proof.” Seinfeld, 909 A.2d at 123. Nevertheless, the standard has been harshly criticized as eliminating Section 220 as a viable option for shareholders seeking to investigate corporate mismanagement.3  Although such criticism has been dismissed as “sensationalized” by the Court of Chancery,4 the threat that the “credible basis” standard can be misapplied so as to create an unnecessary and insurmountable hurdle for shareholders seeking to investigate legitimate claims is very real.

And the authority in footnote 3? 

• 3 See, e.g., J. Robert Brown, Inspection Rights Under Delaware Law, http://www.theracetothebottom.org (Nov. 20, 2007, 6:16 a.m.)(arguing that the “credible basis” standard imposes an “evidentiary burden that is often difficult or impossible to meet at the pleading stage”; see also J. Robert Brown, City of Westland v. Axcelis Technologies: The Myth of Majority Vote Provisions and the Further Need for Preemption of Delaware Law (Credible Evidence As An Excessive Pleading Standard), http://theracetothebottom.org (Oct. 21, 2009, 6:00 a.m.).

The reference to “sensationalized” came from a Delaware Chancery Court opinion and was used to describe this Blog.  The basis for the charge of sensational was that the Delaware courts used excessive pleading standards to deny shareholders their right to inspect.  Axcelis illustrates this point with great clarity. 

The brief and the other primary documents can be found at the DU Corporate Governance web site.

Plaintiffs in their brief have made a very straightforward argument.  First, plaintiffs challenged the standard used by the Chancery Court in dismissing the inspections request.

• By rejecting Plaintiff’s 220 demands because it did not feel that the Plaintiff presented sufficient “evidence” of the Axcelis Board’s wrongful intent, the Court of Chancery essentially elevated the “credible basis” standard on par with the standard applicable in the context of a motion for summary judgment. The court’s holding thus renders Section 220 completely irrelevant as part of the “tools at hand” thatthis Court repeatedly has urged shareholders to use to investigate possible wrongdoing before commencing litigation.

The second issue challenged the standard used to judge the board's decision not to accept the resignations.  Plaintiff asserted that the correct standard was not the business judgment rule, but the compelling justification standard in Blasius. 

• The Court of Chancery held that because the policy gave discretion to the Axcelis Board, a decision by the Board on that issue necessarily was subject to the protection of the business judgment rule, and as such could not be investigated under Section 220. . . .  And, in any event, the business judgment rule does not apply simply because Axcelis’s voting policy gives certain discretion to the Board.  The Axcelis Board has discretion with regard to director resignations only because the voting policy gives it to them. But what standard applies in reviewing directors’ conduct in this regard is determined under Delaware law. And on this point, Delaware law is clear: Under Blasius, where director conduct is designed to frustrate the outcome of a shareholder vote or impede the shareholder franchise, the business judgment rule does not apply and directors must provide a “compelling justification” for their actions. . . .  By rejecting these resignations (and by agreeing to continue to serve with regard to the directors who resigned), Axcelis’s Board thwarted the will of the majority of the Company’s shareholders. As such, the Axcelis Board should have been required to provide a compelling justification for their actions, and the Court of Chancery erred in holding that the business judgment rule necessarily applied.

We shall await the response from Axcelis before assessing the merits.

The brief and the other primary documents can be found at the DU Corporate Governance web site.

Axcelis ought to have been a simple case that generated little controversy.  Shareholders defeated three directors under a majority vote provision.  The three directors dutifully submitted their resignation letter which the board declined to accept.  Shareholders asked to see the minutes of agendas for the meetings where the resignations were considered as well as the documents distributed at the meeting.  

The case was hardly a fishing expedition.  Moreover, plaintiffs alleged that the company had been inconsistent in its explanation for not accepting the resignations, allowing them to meet the minimal "credible" basis standard to inspect the requested documents.  The Chancery Court, therefore, had plenty of room to grant the request.  Yet it did not.  The court essentially resolved the alleged inconsistency against the plaintiffs as if deciding the matter on the merits.  The result was to effectively cut off any examination by shareholders of the reasons for not accepting the letters of resignation.

In effect, the Chancery Court gutted majority vote provisions.  The opinion allowed directors to refuse to accept resignation letters without allowing shareholders the right or opportunity to look at the reasoning that went into the decision.  In effect, directors could do so for any reason, even an entrenchment one, without concern that the reasoning would be probed or examined.

At one level, the case once again raised issued about the use of excessive pleading standards to deny owners their obvious inspection rights.  That shareholders would want to know in greater detail why the board refused to accept the letters seems obvious and ought to be inherent in the exercise of inspection rights without having to demonstrate a credible basis of wrongdoing.  Nonetheless, even with the credible basis standard, shareholders made a sufficient showing here, given the admonition that the standard is supposed to be a low one.

As it stands, the case demonstrates the meaninglessness of majority vote provisions.  It also invites federal preemption, with the SEC likely at some point to consider adding a specific disclosure item when directors decline to accept letters of resignation from directors who do not receive majority support under a majority vote policy or bylaw. 

The case is, however, on appeal and plaintiffs have filed the first brief.  There is at least a possibility that the Supreme Court will correct this decision if for no other reason that to cut off the inevitable federal intervention.

The brief and the other primary documents can be found at the DU Corporate Governance web site.

In Re John Q Hammons Hotels Inc. Shareholder Litigation, No. 758-CC 2009 Del. Ch. LEXIS 174 (Del. Ch. October 2, 2009), the Delaware Chancery Court granted plaintiffs’ motion for summary judgment regarding the proper standard of review for trial, holding the entire fairness standard applied. Additionally, the court granted defendants’ motion for summary judgment to dismiss a breach of the fiduciary duty of disclosure claim for mischaracterizing a merger approval process in the proxy statement.  The court denied the following motions for summary judgment: the party responsible for bearing the burden of demonstrating entire fairness, unfair dealing, breaches of the fiduciary duty of disclosure, and aiding and abetting breaches of fiduciary duty.

Plaintiffs, Jolly Rogers Fund and Jolly Rogers Offshore Fund, were minority owners of John Q. Hammons Hotels Inc. (“Company”) Class A shares.  The Company owned and operated hotel franchises. Defendant John Hammons served as Company’s CEO and Chairman of the Board. Hammons and the Company’s Board frequently disagreed about Hammons’ actions as CEO and controlling shareholder.

In 2004, the Company began receiving acquisition offers. Hammons controlled seventy-six percent of the Company’s vote, providing him the power to veto any proposed acquisition offer. He made it clear that to approve any acquisition required significant individual tax advantages and personal benefits, regardless of shareholder benefit. In recognition of Hammons’ veto power over proposed acquisitions, the Board formed a three-person committee (“Special Committee”) to represent minority shareholder interests. The Special Committee hired Lehman Brothers to value the Company and retained the law firm Kat­ten Muchin to advise the Board during the acquisition process.  Lehman valued the Class A stock at $21 per share. In 2005, Hammons and the Special Committee approved an offer from purchaser Jonathan Eilian, which included a $24 per share tender offer for plaintiffs’ Class A stock, as well as several hundred million dollars in personal benefits for Hammons. A majority of minority shareholders also approved the acquisition.

In response to the acquisition, plaintiffs brought numerous claims against Hammons, the Board, and the Acquisition Vehicle (Defendants).  At issue was whether the “business judgment” standard or the “entire fairness” standard governed defendants’ conduct. The court reasoned “robust procedural protections” are necessary to ensure minority shareholders have sufficient bargaining power when a minority shareholder and a majority shareholder “compete” for a purchaser’s consideration. Therefore, the business judgment standard applied only if (1) a “disinterested and independent special committee” recommended the transaction, and (2) shareholders approved the transaction “in a non-waiveable vote of all the minority stockholders.”

Here, defendants argued the business judgment standard applied because Eilian’s negotiation with minority shareholders did not include Hammons, the independent “special committee” adequately represented minority shareholders and a majority of minority shareholders approved the merger in a fully informed vote. The court held, however, that because the shareholder vote could have been vetoed by the Special Committee and did not meet the requirement that a majority of all minority stockholders approve the acquisition, the entire fairness standard applied. Thus, the court granted plaintiffs’ motion for summary judgment for the application of the entire fairness standard.  The court, however, denied plaintiffs’ motion for summary judgment to establish defendants had the burden of showing the entire fairness of the acquisition because material issues of fact remained.

Application of the entire fairness standard requires the court to determine fairness by looking at all aspects of the entire transaction based on two components of fairness: fair dealing and fair price. Plaintiffs contended that Hammons veto power rendered the transaction inherently unfair. As a shareholder, however, Hammons had the freedom to retain his shares, and thus, the “mere possibility that the situation would return to the status quo” because he vetoed an agreement is not sufficient to “render the Special Committee ineffective for the purposes of evaluating fair dealing.” While noting that plaintiffs may be able to prevail at trial if they can establish that Hammons’ self-dealing depressed the share price, the court held material factual issues regarding fair dealing and fair price remained; neither plaintiffs nor defendants were entitled to summary judgment on the unfair dealing claim.

Next plaintiffs alleged defendants breached the fiduciary duty of disclosure by mischaracterizing the Special Committee process in the Company’s proxy statement. The court held that the Proxy statement adequately described the Special Committee’s process. Moreover, plaintiffs conceded that the Proxy Statement disclosed the Special Committee’s recognition that it could not broadly market the Company in light of Hammons’s ability to block potential acquisitions and Hammons’ interest in any transaction would be influenced by personal tax implications.  Accordingly, the court granted defendants’ motion for summary judgment and dismissed the claim.

Conversely, the court dismissed all motions for summary judgment regarding three alleged proxy statement omissions. The first two related to possible conflicts of interest of Lehman and Katten Muchin because both firms solicited acquisition-related business from Eilian. Despite each firm’s contention that the groups soliciting new business were isolated from the Special Committee’s advisors, the court held that these potential conflicts of interest are important and generally must be disclosed to stockholders before a vote. The third omission involved a presentation Eilian made to the Special Committee where the valuation of Company’s Class A stock was estimated to be between $35 and $43 per share. The court held that issues of fact remained for trial because the impropriety of the omission depended on whether the valuation was contingent upon a hypothetical scenario that the Board, in good faith, determined was unlikely to occur. 

Finally, plaintiffs asserted a claim against the acquisition vehicle for aiding and abetting Hammons’ and the Board’s breach of fiduciary duties. There remains a material issue of fact as to whether Eilian was aware that Hammons’ alleged improper self-dealing depressed Company’s stock price. Therefore, the court did not grant either party’s motion for summary judgment on this issue.

In sum, the court held that because minority shareholders needed significant procedural protections not provided here, the entire fairness standard applied. Except for dismissal of an alleged proxy statement mischaracterization, all other claims had significant issues of material facts that remained for trial. As such, that the court denied all other motions for summary judgment.

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

The Act also grants to the Commission the authority to provide shareholders with “access” to the proxy statement.  The Commission almost certainly has the authority already but because business organizations have threatened to challenge any access rule in court, Congress has moved ahead to clarify the authority and cut off resort to judicial challenge.  In one of those examples of “be careful what you wish for,” the threats to challenge access will likely result in a substantially strong regulatory hand by the Commission.

Section 972 would amend Section 14(a) of the Exchange Act to allow the Commission to adopt rules that would require any solicitation to include shareholder nominees.  Moreover, within 180 days of enactment, the Commission “shall issue” rules that provide for access “under terms and conditions as the Commission determines are in the interests of shareholders and for the protection of investors.”

The provision warrants several observations.  First, it applies to all public companies, not just those listed on an exchange.  Second, the mechanism for imposing the obligation is a rule of the Commission, not listing standards.  As such, it is likely to be easier to enforce.  There is not, for example, a mandatory opportunity to cure.  Third, unlike the Shareholder Bill of Rights, the provision does not purport to limit the Commission’s authority by establishing minimum ownership or tenure requirements as a precondition for submitting a nominee.  The Commission gets almost unlimited discretion in the provision to do as it deems fit and establish the thresholds wherever appropriate. 

The proposed legislation demonstrates the short sightedness of those who have opposed access in every shape or form.  Recall that the last Commission under Chairman Cox proposed a ludicrously unfavorable form of access.  Shareholders who owned 5% or more of the company’s voting shares would be allowed to propose a bylaw that if it were adopted would allow for access.  This form of indirect access that would likely almost never be approved by shareholders was too much for those opposing access, including Commissioners Atkins and Casey.  Had they agreed to this approach, one has to wonder whether Congress would have under consideration a proposal to mandate direct access and to give the SEC almost unlimited discretion in determining the parameters of any such right. 

In the meantime, the bill and a summary are posted at the DU Corporate Governance web site.

SEC. 972. PROXY ACCESS.

(a) PROXY ACCESS.—Section 14(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78n(a)) is amended—

(1) by inserting ‘‘(1)’’ after ‘‘(a)’’; and

(2) by adding at the end the following: 

(2) The rules and regulations prescribed by the Commission under paragraph (1) may include—

(A) a requirement that a solicitation of proxy, consent, or authorization by (or on behalf of) an issuer include a nominee submitted by a shareholder to serve on the board of directors of the issuer; and

(B) a requirement that an issuer follow a certain procedure in relation to a solicitation described in subparagraph (A).

(b) REGULATIONS.—Not later than 180 days after the date of enactment of this Act, the Commission shall issue rules permitting the use by shareholders of proxy solicitation materials supplied by an issuer of securities for the purpose of nominating individuals to membership on the board of directors of the issuer, under such terms and conditions as the Commission determines are in the interests of shareholders and for the protection of investors.

In City of Westland Police & Fire Retirement System v. Axcelis Technologies, Inc., No. 4473-VCN, 2009 Del. Ch. LEXIS 173, at *1 (Del. Ch. Ct. September 28, 2009), the Court of Chancery of Delaware dismissed a books and records action brought by a shareholder against Axcelis Technologies, Inc. (“Axcelis”).  Plaintiffs claimed Axcelis refused to accept the resignations of three directors who received less than a majority of the votes when standing for reelection, while at the same time selling the company’s principal asset to a competitor after failing to accept an acquisition offer from the same competitor. 

Axcelis specialized in manufacturing ion implantation and semiconductor equipment.  SHI, a Japanese company in the same business as Axcelis, participated with Axcelis in a joint venture, SEN.  SEN manufactured ion implantation and semiconductor equipment.  On two occasions, Axcelis’ board rejected offers by SHI to acquire the company, asserting that the price failed to adequately compensate the shareholders for the synergistic value of SEN. 

In the aftermath of SHI's unsuccessful efforts, Axcelis held elections for three directors on its staggered board.  The company had in place a policy providing that directors failing to receive a majority of the shareholder vote had to submit a letter of resignation to the board.  The board had the discretion to accept or reject the resignation.  The three Axcelis directors ran unopposed in the May, 2008 election but received less than a majority of the votes cast.  They resigned, as required by the policy, but the Axcelis board declined to accept the resignations, explaining that the directors were knowledgeable and experienced, that one or more served on key committees, and that losing them would harm the company and interfere with negotiations with SHI.  As the press release stated:

• In making their determination, the Board considered a number of factors relevant to the best interests of Axcelis. The Board noted that the three directors are experienced and knowledgeable about the Company, and that if their resignations were accepted, the Board would be left with only four remaining directors. One or more of the three directors serves on each of the key committees of the Company and Mr. Hardis serves as lead director. The Board believed that losing this experience and knowledge would harm the Company. The Board also noted that retention of these directors is particularly important if Axcelis is able to move forward on discussions with SHI following finalization of an appropriate non-disclosure agreement.

Plaintiffs sought to inspect the company's records and obtain material concerning the board's review of the offers by SHI and materials related to the decision not to accept the resignations by the directors who did not obtain a majority of the votes cast.  Plaintiff demanded to inspect Axcelis’ books and records under Section 220 of the Delaware Code.

Under Section 220, a shareholder has the right to inspect the books and records of the corporation if the shareholder demonstrates a proper purpose.  Proper purpose requires some evidence of mismanagement, waste or other wrongdoing.  A shareholder must produce some evidence of a credible basis that wrongdoing has occurred.  Delaware courts describe this as a low burden of proof that may be shown through documents, logic, testimony, or otherwise. 

The court held the plaintiff did not show a credible basis from which to infer wrongdoing in the board’s rejection of SHI’s offers to purchase Axcelis.  The board claimed that SHI failed to adequately value the company.  Plaintiff offered no reason to infer that the rejection was anything other than a good faith business decision.  Negotiations only occurred after SHI agreed to sign a confidentiality agreement.  According to the court, the plaintiff demonstrated no evidence of bad faith in the conduct of the negotiations.  Failed negotiations do not form a credible basis from which to infer wrongdoing.

The court also found that plaintiff failed to show any credible basis from which to infer wrongdoing from the board’s decision to reject the directors’ resignations.  Plaintiff's claims that the decision was motivated by entrenchment or to impede a change of control were considered by the court to be bare allegations and therefore insufficient.  Under the court’s analysis, the directors were properly reelected under plurality voting provisions.  The lack of a majority vote triggered the requirement to resign and, by rejecting the resignations, the board fulfilled the requirments of the policy.  The court concluded that the desire for a different outcome did not consitute credible evidence of wrongdoing under Section 220.

Likewise, the court held that plaintiff did not have any credible evidence to show that the sale of SEN should be considered wrongdoing.  The drop in stock price was not sufficient to trigger a Section 220 inspection right.  If it were, Delaware corporations would constantly be subject to inspection, which would be extremely burdensome.

The court concluded that the plaintiff failed to demonstrate credible evidence that wrongdoing occurred in respect to the rejection of SHIs proposals to acquire Axcelis, the board’s decision to retain the directors, and the sale of SEN.  Therefore, the court dismissed the Section 220 books and records action and entered judgment in favor of Axcelis.

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

There were a number of issues in the case.  The most critical from a governance perspective was the board's obligation with respect to the approval of the poison puts.  What is clear from the pleadings and the oral argument, is that the board was unaware of the poison put.

• JUSTICE: Am I correct that the officers and directors were given assurances by their legal advisors that there was nothing, there were no unusual provisions buried in this document?

• MR. FRIEDLANDER: The only -- that's correct.  There was evidence that an inquiry was made: Is there anything unusual or not customary in the agreement?

The only real question, then, was whether the board should have known about the provision and approved it consistent with its fiduciary obligations.  Counsel for Plaintiff asserted that it was an anti-takover device and that boards routinely ought to know about these matters.  

• This -- a proxy put was invented in 1986 as an anti-takeover device. The first generation of proxy puts and poison debt, 1986 to 1988, are generally recognized in the literature as to defend against proxy contests and hostile takeovers. This Court's jurisprudence is based on allocating responsibility to the board to make an informed judgment about whether a given defensive measure satisfies Unocal or satisfies Blasius if it reaches that above . . .

Somehow, however, the importance of the provision got lost on the Court.  The next question back made this clear.

• JUSTICE: Okay, but what I'm trying to get to is the argument you're making, in essence, is that directors must read every page of every document that they have to pass upon.

In other words, the Court converted a discussion over whether the board should know about an anti-takover device in a loan document into whether a board had to review every page of every document.  It was not an argument that plaintiffs were suggesting and not an argument that anyone has likely ever made to the Delaware Supreme Court.  Yet it is how at least one Justice potentially heard things.  

Indeed, reframing the question in these terms is misguided.  Even if directors read every page of every agreement, they would not understand them.  The issue is whether directors understand the contents of the material presented to the board.  This is usually done by having experts attend, make presentations and answer questions.  Actually reading the documents is probably the least efficient way to be "informed," particularly for non-lawyers.

So this wasn't what this case was about.  It is whether the decision makers (the directors) have an obligation to be informed about certain types of provisions in agreements.  Presumably when the presentation was made about the debt agreement, the directors were told the amount of the loan and the interest rate, as well as other terms.  It would not have been unreasonable to expect them to be informed about anti-takeover provisions as well. 

The question nonetheless provided insight into the Court's perspective.  They likely saw this case as the potential beginning of the obligation to read every page of every agreement.  If directors needed to know about anti-takeover devices, what would be next?  Before it was over, they would need to know about choice of law provisions and severability clauses.  The Court was determined not to go down this path.

In fact, it was a false path.  To adopt reasonable standards about what directors need to know when they approve important agreements would provide some certainty, protect shareholders and, frankly, help directors ask the questions that require answers.  The standards would never extend to every provision of every agreement.  It would also incidentally put the directors on alert about provisions that in fact they might want excluded.

But that is not what the Court did in this case.  Better to not be told at all than to walk down the path of having to read every page of every agreement. 

Primary materials can be found at the DU Corporate Governance web site.  The oral argument in this case is posted at the Delaware Supreme Court's web site.

The PSLRA imposes a number of procedural hurdles in bringing a class action fraud suit under Rule 10b-5.  The need for a "strong inference" of scienter is perhaps the best known, but there are others, including the need to plead fraud with particularly, as the plaintiff in this case discovered. 

Novastar Financial, Inc. (“Novastar”) was the subject of a class action suit alleging that the lending company violated various SEC rules, allegedly making misleading statements in press-releases and filings concerning their 2007-2011 fiscal years.  The Eighth Circuit affirmed the trial court’s decision to dismiss the complaint, finding that the lead plaintiff failed to satisfy the heightened pleading requirement of the Private Securities Litigation Reform Act of 1995 (“PSLRA”), 15 U.S.C. § 78u-4(b).  The Eighth Circuit also denied plaintiff the opportunity to amend his complaint.

Novastar is a publicly traded company that offers loans to borrowers who cannot satisfy the underwriting standards of conventional mortgage lenders.  They also raise additional capital by selling the rights to the income generated by groups of loans that are consolidated into mortgage-backed securities. 

On February 20, 2007, Novastar announced its financial results from fiscal year 2006.  These results were well below expectation.  Furthermore, Novastar stated that they expect an even greater financial loss in fiscal years 2007-20011.  Within days of this announcement, Novastar’s stock dropped significantly, trading at less than 30 percent of its high in May 2006.  Novastar investors who acquired Novastar securities between May 4, 2006 and February 20, 2007, filed a class action lawsuit.  The suit alleged that the defendants violated SEC Rule 10b-5, 17 C.F.R. § 240.10b-5, and section 10(b) and 20(a) of the SEC Act of 1934, 15 U.S.C. §§ 78j(b), 78t(a) by making false and misleading statements concerning the company’s financial status during the time they acquired Novastar securities. 

The complaint reproduced 19 press releases, SEC filings, and conference call transcripts in their entirety or in large part.  The complaint alleges that Novastar made false or misleading statements and that the company acted with the required state of mind to render their actions in violation of the stated rules. The trial court granted Novastar’s motion to dismiss, holding that the plaintiff did not state with any sort of particularity which statements in the 180-page complaint were false or misleading.

In its decision, this court agreed with the trial court’s determination that, despite the length of the complaint, plaintiff failed to meet the requirements of the PSLRA that they plead fraud with sufficient particularly by specifying the particular statements alleged to be misleading.  The plaintiff merely reproduced various public communications made by the company during the time they invested in Novastar securities.  The plaintiff therefore did not meet the burden of proof required by the PLSRA’s heightened pleading standards, requiring the plaintiff to prove with particularity the “who, what, where, when, and why.”  Cornelia I. Crowell GST Trust v. Possis Med., Inc., 519 F.3d 778, 782 (8th Cir. 2008) (quoting In re K-tel Int’l, Inc. Sec. Litig., 300 F.3d 881, 890 (8th Cir. 2002)). 

The dismissal was, therefore, based upon flaws in the pleading process.  Plaintiff unsurprisingly sought leave to amend his complaint.  The district court refused and the Eigth Circuit affirmed.  The court noted that plaintiff had "never submitted a proposed amended complaint to the district court, nor did he proffer the substance of such an amended complaint until he filed his appellate brief."  Moreover, after denial of leave to amend, plaintiff did not file a motion under FRCP 15(a)(2), 59(e), or 60(b) to seek leave to file an amended complaint.

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

In arguing against shareholder access, commentators and pundits often point to majority vote provisions.  These are given as an example that private ordering really works.  It is used to suggest that access should be left to private ordering rather than a mandatory rule issued by the Commission.

Put aside that the possibility of access has always existed and, small anamolous exceptions aside, there has been no private ordering on the part of public companies.  But somehow the use of majority voting provisions suggests otherwise.

As we have noted on this Blog and in a letter to the SEC, that is simply not true.  There is serious doubt as to whether there is ever meaningful private ordering in the corporate context given the inherent advantages held by management.  See Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom.  More specifically, in the context of majority vote provisions, they are common only among the largest companies.  Moreover, the common models merely require directors to submit letters of resignation that can be and have been rejected. 

Yet still the argument is made.  Well, the death knell should be the data put out by Riskmetrics.  It seems that the instances of a director failing to obtain a majority are up, 93 board members in 50 companies so far in 2009.  The number of these directors removed from the board?  "0".  That right, zero.  All of the companies have plurality vote requirements (in other words, they've rejected majority voting bylaws completely).  In two of the companies, the directors offered to resign but the letters weren't accepted.  The data shows that only one director who did not receive a majority lost his seat last year because of the requirements of California law.

Things will heat up with the end of brokers voting uninstructed shares in board elections.  More directors will likely not receive a majority.  But in the world of shareholder rights, it does not mean that more directors will lose their seat on the board.

Only competition for the board seats will do that.  Shareholder access is a step in that direction.

Institutional investors (including union pension plans) achieve fewer dismissals and greater settlement amounts.  What else?  According to Institutional Monitoring Through Shareholder Litigation, they also generate improvements in governance.  As the study notes: 

• The changes in audit committee independence exhibit similar patterns. Firms with institutional lead plaintiffs experience a significantly higher increase in audit committee independence than firms with individual lead plaintiffs. We also find that, after lawsuit filings, defendant firms with institutional lead plaintiffs are more likely to establish a lead director position than defendant firms with individual lead plaintiffs.

In short, companies that confront pension plans as lead plaintiffs are going to have to pay more and institute better governance.   The data suggests the need for more not less institutional involvement in the shareholder litigation process. 

Remember in the prior administration the complaints that surfaced because of shareholder activism by pension plans, particularly ones sponsored by unions?  We recall, in particular, the editorial written by  Justice Scalia's son (Eugene) criticizing union shareholder activism and calling on the Department of Labor to do something about it, a position that engendered a reply from this Blog. 

With that in mind, we note the study Institutional Monitoring Through Shareholder Litigation, by professors Cheng, Huang, Li and Lobo.  The study concludes that institutional lead plaintiffs produce better outcomes for shareholders, with fewer of their cases dismissed and the settlement amount higher.  In addition, however, they had this to say:  "we find our results are not driven solely by public pension fund lead plaintiffs; the impact on immediate litigation outcomes is also significant for union pension fund, mutual fund and other institutional lead plaintiffs." 

In short, when union pension plans become active in litigation and serve as lead plaintiffs, the outcome is better for shareholders.  This study doesn't validate shareholder activism in all spheres (that is mostly left to common sense) but does validate it in one of them.  As we noted back in the day, if there was any investigation that ought to be conducted it would be why more pension plans do not take an active role in the governance process. 

We've noted before the often short sighted approach taken by opponents to shareholder access.  The Cox Commission proposed a wholly ineffective form of access (requiring an access bylaw to pass first) yet it was opposed with enormous vehemence.  The consequence has been a change in administration and an even more invasive form of access (one that is much better and promises to be more effective).  Anti-access groups are grousing about possible litigation. 

The likely effect of litigation?  Either a judicial decision that clarifies the broad nature of SEC authority (leading to the prospect of even more intrusive corporate governance regulation) or congressional intervention, largely to the same effect.

With that in mind, we note the study Institutional Monitoring Through Shareholder Litigation, by professors Cheng, Huang, Li and Lobo.  The study examines the impact of institutional investors as lead plaintiffs.  Before we give some of the conclusions, recall that the lead plaintiff provisions in place today were included in the PSLRA.  The PSLRA was an attempt to cut back and restrict securities litigation.  Specifically, the lead plaintiff provisions were designed to stop the race to the courthouse and end or at least limit lawyer driven litigation.  In other words, the provisions were inspired by those who opposed the plaintiffs' bar and the existing method of determining lead plaintiffs. 

What has been the consequence of this requirement?  First, the number of insitutional lead plaintiffs is increasing.  "The percentage of lawsuits with institutional lead plaintiffs has more than doubled from less than 15% in 1996 to more than 30% in 2004."  And the consequence?  As the study concludes:

• After controlling for these determinants of having an institutional lead plaintiff in our multivariate regression analysis, we find that relative to lawsuits with an individual lead plaintiff, lawsuits with an institutional lead plaintiff are less likely to be dismissed and have significantly larger settlements. Further analysis indicates that all types of institutions show significantly better litigation outcomes with public pension funds generating the largest settlement amount. We also find that within three years of filing the lawsuit, defendant firms with institutional lead plaintiffs experience greater improvement in board independence than those with individual lead plaintiffs.

In other words, the reform in fact encouraged greater participation by institutions.  And their participation has resulted in a lower likelihood of dismissals and greater payouts. 

Opposition to access will also likely generate these types of unintended consequences.  Comparing the last access proposal to the current one shows that this has already occurred. 

Access is inevitable.  As we have written (The SEC, Corporate Governance, and Shareholder Access to the Board Room), the denial of access only occurred because, in the early days of the proxy rules, issuers opposed it and, frankly, so did shareholders.  With no constituency of consequence supporting the right (to the extent there was a consistent support of access, it was the staff of the Commission), access languished.

But it remained an anomaly.  For an agency that ostensibly was on a mission to protect shareholders and investors, it was a provision that largely allowed federal law to eviscerate the right of shareholders under state law to nominate directors.  As shareholders began to lobby for access, the incongruity of the restriction became harder and harder to justify.  

Putting aside the merits of the proposal, the blunt truth is that the proxy rules are being used to mask what ought to be done under state law.  To the extent that restrictions on shareholder nominations exist, they should be imposed under state law.  Yet state law (read Delaware) has not really had to address this since the restrictions in the proxy rules did it for them.  

When access is adopted, the remarkably responsible Delaware legislature (not to mention the courts) has an out.  They can effectively give to corporations the right to prohibit nominations by shareholders, perhaps based on the size of the holdings or the tenure of ownership.  Access does not allow the submission of nominees from those shareholders who cannot nominate.  

The effect of this, however, would be to force Delaware to affirmatively restrict the right of shareholders to nominate directors.  As a result of their pro-management bias, the legislature and the courts would, almost certainly have no problem with the approach.  Nonetheless, it would be an overt example of anti-shareholder bias that would make the role of this state and its courts much clearer (and facilitate the arguments by those who seek federal preemption in the area). 

Access is about overturning federal restrictions on shareholder rights.  It does not displace the role of states but forces states to more clearly define their restrictions. 

We are the first to note that access upsets the current state of the law.  Delaware allows any shareholders to nominate directors, the proxy rules effectively take that right away.  Many of the letters, therefore, contained pleas to leave things as they were, as if this supported the state law role in the governance process.

At least one commentator, however, noted that any access rule should "[p]reserve the nominating committee's vital role in maintaining the quality and diversity of the board as a whole."  See  O'Melveny letter.   We appreciate that this is a comment calling for the preservation of the committee's authority to preserve board quality.  But the reference to preserving the board's role in maintaining diversity?  Come on.  That's a role that, given the dismal performance to date, ought not to be maintained but changed outright, with access likely to play a role in that process.

For a history of access, go here.

One of the much repeated arguments against access has been that corporate governance has so improved over the last few years (since SOX), that this additional right is not needed.  The letters usually refer to the same developments:  The adoption of majority vote provisions (which we address in a separate post), the increase in the number of independent directors on the board, and the use of independent chairmen/lead directors.

We will address this issue in much greater terms when we put up some posts on an ABA Report on Governance.  Suffice it to say that there is not much credit to be given for these reforms.  The existence of more independent directors (again, something likely limited to the largest companies) while at the same time allowing the CEO to remain chair of the board (collapsing lead director and independent chair stats masks the fact that almost no large companies rely on the latter model) simply facilitates CEO control and capture of the board (the chair largely controls the information flow to these directors and is far less likely to circulate materials critical of his/her performance).  We have likewise noted over and over that "independent" directors are not, in many cases, actually independent. 

Maybe a much stricter definition of independence coupled with an independent chair of the board would make access far less urgent.  In those circumstances, the board might well be in a position to look out for shareholder interests.  But that is not the system that is currently in place and until it is, access is an imperative. 

For the complete letter filed by this Blog with the SEC on the access proposal, go here.  For a history of access, go here.

One of the main arguments made in opposition to access has been the widespread adoption of majority vote provisions.  Somehow, the evidence implies, access will undergo something similar and, in the corporate governance realm, a thousand access flowers will bloom.  In fact, this is almost certainly wrong and misstates the reasons why majority vote provisions have become "widespread" in their adoption.

The use of majority voting as evidence is misguided for a number of reasons.  Almost everyone using the evidence overstate their popularity.  They typically refer to the percentage of companies in the S&P 500 or Fortune 500 that have adopted these provisions.  While it may be true that they have been broadly implemented among the largest companies, they are far less common among smaller public companies. According to Directorship, for example, around 75% of the companies in the Russell 3000 still use straight plurality voting.

Second, and more importantly, the popularity of these bylaws is no doubt due in large part to the lack of any meaningful authority extended to shareholders. The most common models of majority voting merely require that nominees not receiving a majority of votes submit a letter of resignation. Boards may reject the letter and, in fact, have done so on a number of occasions, effectively overturning the decision of shareholders.  Our posts on the Axcelis litigation illustrate the point and the difficulty incurred by shareholders in trying to learn all of the facts surrounding the decision.

Even if a bylaw were to require resignation, with no residual discretion given to the board, shareholders still have no real authority. Any vacancy that results from the defeat of a director will be filled by the board. The board can, if it wants, fill the position with the very director who did not receive a majority of the votes cast.  See Commentary to Section 10.22 of the Model Business Corporation Act ("In the exercise of its power under Section 10.22(a)(2), a board can select as a director any qualified person, which could include a director who received more against than for votes.").

Because of this lack of real authority for shareholders, majority vote provisions have been labeled on this Blog as a “myth.”[15] Other commentators have described them as “smoke and mirrors.” William K. Sjostrom, Jr. & Young Sang Kim, Majority Voting for the Election of Directors, 40 Conn. L. Rev. 459, 487 (2007).

Access proposals, in contrast, are not illusory. They provide shareholders with meaningful and substantive rights. They allow shareholders to insert nominees in the company’s proxy statement, increasing the likelihood that the candidates will be elected. Management has no discretion to ignore the results or otherwise fill the board position. Boards can, therefore, be expected to vigorously oppose these bylaws, as has been the case so far.

For the complete letter filed by this Blog with the SEC on the access proposal, go here. For a history of access, go here.

Many have taken the position that the SEC is taking a "one size fits all" approach that should be eschewed in favor of private ordering.  Private ordering is a concept that suggests companies ought to put in place provisions that uniquely fit their own needs and circumstances and, that, presumably, includes the views of management and owners.

In fact, the whole concept of private ordering in the corporate law environment is flawed.  It presupposes that directors and shareholders will somehow negotiate and adopt the most efficient set of provisions. The theory does not coincide with the practice. Evidence suggests that management’s control over the drafting process and its ability to rely on the corporate treasury eliminate any real prospect of private ordering. Instead, when matters are made discretionary, they result in a categorical rule that favors management. This has been the case with respect to waiver of liability provisions and likely to be the case with respect to access proposals.  This has been chronicled in Brown & Gopalan, Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom, 42 Indiana L. Rev. (2009).

The evidence points to a categorical rule against access.  Until the SEC's proposal, there has been no history of boards adopting access bylaw.  Since the new milenium, only three companies have done so (Comverse, Aprial Healthcare, and Riskmetrics).  In three other instances, proposals were submitted to shareholders and vigorously resisted.  Two failed (HP and United Health), one passed (Cryo Cell).  The empirical evidence to date (supported by the comment letters filed in connection with the access proposal) shows almost implacable opposition by issuers.

There is no evidence that in the absence of an SEC rule in this area, that shareholders will obtain meaningful access in an appreciable number of cases.  Indeed, the evidence is entirely to the contrary.  Those calling for private ordering are really proposing a system that will result in a categorical rule denying shareholders access.  It is, in fact, the system that is currently in place.

For the complete letter filed by this Blog with the SEC on the access proposal, go here.  For a history of access, go here.