In Delaware, Plaintiffs Lose Even When They Win: In re Del Monte (Part 2)

We are discussing In re Del Monte, where shareholders succeeded in obtaining an injunction that delayed the acquistion of Del Monte for 20 days, providing an opportunity for a "topping" bid.

In granting the injunction, the court found that shareholders confronted the risk of irreparable harm.

• Absent an injunction, the Del Monte stockholders will be deprived forever of the opportunity to receive a pre-vote topping bid in a process free of taint from Barclays’ improper activities. The threatened foreclosure of this unique opportunity constitutes irreparable injury.

Without the pre-acquisition cure, shareholders would be left only with a suit for monetary damages.  But, as the court noted, "[e]xculpation under Section 102(b)(7) can render empty the promise of post-closing damages." 

While plaintiffs sought an injunction for 30 - 45 days, the court awarded only 20.  The court took into account the fact that Del Monte had already been thoroughly shopped.

• The reality is that although a conflicted banker conducted the go-shop process, the Del Monte transaction was shopped actively for 45 days. Since the go-shop process ended on January 10, 2011, the Company has been subject to an additional passive market check.  A further delay of 30 to 45 days ignores the fact that many potential bidders have already evaluated this opportunity. I will therefore enjoin the merger vote for a period of only 20 days, which should provide ample time for a serious and motivated bidder to emerge.

The court did, however, enjoin the "deal protection measures" including the termination fee payable to KKR but left in place the reverse termination fee applicable to KKR.

Despite having granted the injunction, the court viewed the likelihood of a higher bid as slight. 

• The likelihood of a topping bid, however, is low.  With KKR as the buyer and a market check (albeit a tainted one) already completed, a topping bid seems all the less likely.  I will not be surprised if no one emerges.

With plaintiffs having won the case (albeit over the skepticism of the Vice Chancellor) and obtained the injunction, the court went on to take an extraordinary step. 

Relying on Chancery Court Rule 65(c), the court required plaintiffs to post a bond of $1.2 million.  The rule, which had a federal counterpart, permits a court to require a bond in the case of an injunction in an amount as the court "deems proper."  In Delaware, parties wrongfully enjoined may recover an amount not more than the amount of the posted bond.  See Guzzetta v. Serv. Corp. of Westover Hills, 7 A.3d 467, 469 (Del. Ch. 2010).

In requiring the bond, the court acknowledged that the parties "have not presented evidence on this issue."  Moreover, the court concluded that "this Court has required at most a nominal bond."  See Levco Alternative Fund, Ltd. v. Reader’s Digest Ass’n, 2002 WL 31835461, at *1 (Del. Ch. Aug. 14, 2002) (conditioning injunction against 54 recapitalization on bond of $5,000); Solar Cells, Inc. v. True N. P’rs, LLC, 2002 WL 749163, at *8 (Del. Ch. Apr. 25, 2002) (conditioning injunction against merger on bond of $2,500).

Not all of the cases involved bonds with amounts that low.  The court in Emerald Partner's set the bond at $500,000.  See Emerald P’rs v. Berlin, 726 A.2d 1215, 1218 & n.1 (Del. 1999).  But see Gimbel v. Signal Co., 316 A.2d 599 (Del. Ch. 1974), aff’d, 316 A.2d 619 (Del. 1974).  VC Laster ultimately imposed an obligation that was far from nominal.  Shareholders were required to post a bond of $1.2 million.

The method of calculating the amount was convoluted.  The court reasoned that the "harm" that could arise out of the injunction was the loss to KKR of its $120 million termination fee.  The court, however, took into account "low probability of harm" (arising from the low likelihood of a topping bid) and the desire not to chill "the socially-beneficial and wealth-enhancing efforts of responsible plaintiffs’ counsel to remedy and deter breaches of fiduciary duty" while at the same time taking into account "the problem of over-incentivizing deal litigation by giving entrepreneurial law firms a free option to enjoin transactions."  In the absence of "guidance from the paties," VC Laster set the bond at 1% of the enjoined termination fee.

If ever there was a case that justified no bond or at most a highly nominal one, it was this one.  Shareholders made a strong case and the court adopted an appropriate remedy that largely eliminated the harm of any potential malfeasance.  Moreover, there is little likelihood that the injunction will be reversed on appeal (it would likely expire before any appeal could even be completed) or reversed by the trial judge.  In other words, the bond is not needed (although it does represent a form of continued exposures for shareholders). 

What it does do, however, is add to plaintiffs' costs and make these kind of actions more expensive to bring.  For law firms without deep pockets, it could cause them to avoid bringing actions, even meritorious ones like the injunction in this case. 

The only thing that can be said is that it could have been worse.  At least the Vice Chancellor saw fit not to require the bond sought by defendants.  How much did they suggest?  $1,076,612,698.80. 

The primary materials are, as usual, posted on the DU Corporate Governance web site.

In Delaware, Plaintiffs Lose Even When They Win: In re Del Monte (Part 1)

We have noted this phenomena in Delaware before.  Plaintiffs demonstrate untoward behavior by management -- no small accomplishment in the Chancery Court -- yet end up with a remedy that effectively penalizes them rather than the established malefactors.  Cryo-Cell is a good example of this phenomena.  So is In re Del Monte. 

Shareholders sought to enjoin the buyout of Del Monte.  The buyout group was led by Kohlberg, Kravis, Roberts & Co. (“KKR”).   As a result of discovery, shareholders obtained a more complete picture of the role played by Barclays Capital, the financial advisor for Del Monte.  The picture was not a pretty one.  As the court described:

• Barclays secretly and selfishly manipulated the sale process to engineer a transaction that would permit Barclays to obtain lucrative buy-side financing fees. On multiple occasions, Barclays protected its own interests by withholding information from the Board that could have led Del Monte to retain a different bank, pursue a different alternative, or deny Barclays a buy-side role. Barclays did not disclose the behind-the-scenes efforts of its Del Monte coverage officer to put Del Monte into play. Barclays did not disclose its explicit goal, harbored from the outset, of providing buy-side financing to the acquirer. Barclays did not disclose that in September 2010, without Del Monte’s authorization or approval, Barclays steered Vestar into a club bid with KKR, the potential bidder with whom Barclays had the strongest relationship, in violation of confidentiality agreements that prohibited Vestar and KKR from discussing a joint bid without written permission from Del Monte.

Barclays ultimate involvement in the buy-side financing, according to VC Laster, resulted in additional costs incurred by Del Monte. 

• Late in the process, at a time when Barclays was ostensibly negotiating the deal price with KKR, Barclays asked KKR for a third of the buy-side financing. Once KKR agreed, Barclays sought and obtained Del Monte’s permission. Having Barclays as a co lead bank was not necessary to secure sufficient financing for the Merger, nor did it generate a higher price for the Company. It simply gave Barclays the additional fees it wanted from the outset. In fact, Barclays can expect to earn slightly more from providing buy-side financing to KKR than it will from serving as Del Monte’s sell-side advisor.  Barclays’ gain cost Del Monte an additional $3 million because Barclays told Del Monte that it now had to obtain a last-minute fairness opinion from a second bank.

Based upon the evidence presented by plaintiffs, the court agreed that shareholders deserved a preliminary injunction for breach of fiduciary duty by the board.  Shareholders had demonstrated a reasonable probability of showing that the board failed to provide the "serious oversight that would have checked Barclays misconduct." 

With the alleged wrongful behavior mostly committed by Barclays, the court viewed the likelihood of monetary damages against the directors of Del Monte as "vanishingly small."  Nonetheless, "while the directors may face little threat of liability, they cannot escape the ramifications of Barclays’ misconduct. For purposes of equitable relief, the Board is responsible."  The court reasoned that shareholders should be granted an injunction preventing the closing of the merger for 20 days.  The extra time period would provide an opportunity for a "topping" bid, something that would largely cure any potential misbehavior by Barclays.

Thus, in this case, a victory for shareholders.  Moreover, the remedy preceded the merger, essentially cured any misbehavior, and eliminated the likely possibility of protracted litigation over damages.  It was, in short, the type of action that shareholders should bring.

But, in Delaware, things are never quite as clear as they seem and shareholder victories are rarely as complete as they should be, as we will see in the next post.

The primary materials are, as usual, posted on the DU Corporate Governance web site.

Reis v. Hazelett Strip-Casting: Mistaken Analysis or Freudian Slip?

Reis is a recent decision issued by the Delaware Chancery Court and involved a reverse stock split.  VC Laster rightfully applies the entire fairness analysis.  The opinion contains a nicely written discussion of the different standards applied by Delaware courts when reviewing the actions of management. 

The Vice Chancellor notes that "Delaware has three tiers of review for evaluating director decision-making: the business judgment rule, enhanced scrutiny, and entire fairness."  He describes "enhanced scrutiny" as "Delaware’s intermediate standard of review."  In this category, he places, among others, the modified business judgment rule and the Revlon auction standard.  Entire fairness, in turn, is "Delaware’s most onerous standard." 

Fair enough, except for one thing.  He puts the Blasius analysis in the "intermediate standard" category and, perforce, views the standard as less onerous than entire fairness.  He describes it this way:

• Enhanced scrutiny also applies in other situations where the law provides stockholders with a right to vote and the directors take action that intrudes on the space allotted for stockholder decision-making. See Mercier, 929 A.2d at 804-10 (discussing application of enhanced scrutiny to board action affecting stockholder voting); State of Wis. Inv. Bd. v. Peerless Sys. Corp., 2000 WL 1805376, at *10-11 (Del. Ch. Dec. 4, 2000) (applying enhanced scrutiny to meeting adjournment that kept polls open for vote on increasing shares allocated to stock option plan).

The Blasius standard applies when management has engaged in behavior designed to disenfranchise shareholders.  The general test in those circumstances is that management has to show a "compelling justification" for its actions.  The standard is hardly less onerous than entire fairness and, in actual application, is likely far more onerous.  See Blasius Indus. v. Atlas Corp., 564 A.2d 651, 661 (Del. Ch. 1988)(describing stanard as one imposing a "heavy burden" on the board).

As a result, VC Laster may have erred in including Blasius and its progeny in the intermediate category.  Or did he?

His analysis may reflect the fact that he has thrown his lot in with others on the Chancery Court who want to weaken the Blasius standard.  Although the Delaware Supreme Court has affirmed the compelling justification standard (see MM Cos. v. Liquid Audio, Inc., 813 A.2d 1118 (Del. 2003)), at least one Vice Chancellor has sought to abandon the compelling justification standard in favor of a far less protective "reasonableness" standard borrowed from Unocal.  See Mercier v. Inter-Tel (Del.), Inc., 929 A.2d 786, 810 (Del. Ch. 2007).  

As Airgas has shown, application of the Unocal standard provides shareholders with little protection.  Opting for the standard in the Blasius context would effectively remove all meaningful restraints from managerial behavior designed to disenfranchise.  Mercier and the effort to weaken Blasius is discussed here. 

Reasonableness as defined by Unocal would certainly qualify as intermediate (or lower), using VC Laster's categorization, while compelling justification would not.  That in fact would leave entire fairness as the most onerous standard.  So, perhaps by including Blasius in the intermediate category, VC Laster is signaling his agreement with the Vice Chancellor in Mercier and the elimination of meaningful protections for shareholders when management engages in disenfranchising behavior.

Delaware's Top Five Worst Shareholder Decisions for 2010 (Conclusion)

Shareholders in Delaware have a hard time getting a break.  It is highly likely that the law will continue to evolve in a management friendly fashion.  Moreover, as federal law increasingly intervenes into areas heretofore left to the states, the courts seem ready to respond.  Thus, it may be coincidental, but the poison pill cases from 2010 seem likely to interfere with the exercise of shareholder access. 

The long and the short of it is that tension between federal and state law will increase, with Delaware seen less and less as a neutral arbiter and more and more another interest group in the debate over the appropriate standards for corporate governance.  The views of the Delaware courts deserve to be heard; they  represent a serious repository of understanding of the governance process.  They also reflect the views of important constituencies in the debate.   But they are only one view and sometimes the wrong view. 

It will increasingly fall to the federal government not Delaware to resolve important governance issues.  It is the forum that will take into account all potential views rather than the views of one particular side. 

Delaware's Top Five Worst Shareholder Decisions for 2010 (#1: Airgas v. Air Products)

Airgas v. Air Products, 2010 Del. LEXIS 585 (Del. Nov. 17, 2010), represents the worst shareholder decision in 2010.  We did a series on this case back in November.

The case itself is not particularly profound from a legal perspective.  Airgas had a staggered board.  Insurgent shareholders at an annual meeting held in September elected one third of the board and succeeded in having a bylaw adopted that would advance the next annual meeting to January.  The effect was to hasten the meeting at which the next class of directors would be up for election, shortening the time it would take the insurgents to gain control by approximately eight months.  

The decision turned upon the meaning of language in both the company's articles/bylaws and in the statute.  The trial court found that the reference to "annual meeting" in the relevant bylaw/article provision was ambiguous, that it could refer either to calendar years or to durational years (365 days).  Noting that uncertainties were to be interpreted in a manner that promoted the shareholder franchise, the trial court concluded that calendar year was an appropriate interpretation and upheld the provision calling for the January meeting. 

The Supreme Court reversed.  The Court conceded that the term "annual meeting" was ambiguous but rather than relying on the adage about protecting the shareholder franchise found a source of "intent" that allowed for elimination of the ambiguity in a manner that worked against shareholders.  The source was not the parties themselves but essentially the view of anyone writing a staggered board bylaw or charter provision. 

In some respects, the case was nothing more than a predictably management friendly decision of the type often issued by the courts in Delaware, hardly worthy of a number one ranking for 2010.  The outcome was made more predictable by the managerial headache potentially caused by the lower court's decision.  By finding the term "annual meeting" ambiguous and susceptible to a "calendar" year interpretation, the lower court essentially put companies with similar ambiguous language in a position of having to rewrite the provision.  To the extent the language appeared in the articles, companies would need to submit any revision to shareholders, providing a renewed opportunity for opposition to, and criticism of, staggered board provisions.  

The real importance of the decision was the message sent to the Chancery Court.  The Chancery Court decision was written by Chancellor Chandler, a well respected and rarely reversed member of the Chancery Court.  His decision was thoughtful and well reasoned.  When he concluded that the relevant provision was ambiguous, he implemented a shareholder friendly approach by favoring the interpretation that promoted the shareholder franchise.

By reversing, the Delaware Supreme Court reminded the Chancery Court that deviations from the management friendly approach to decision making confronted a meaningful risk of reversal.  That the decision had been by a widely respected jurist made no difference.  In other words, as the battle over corporate governance continues, the Delaware courts will speak with in a single management friendly voice.  To the extent the lower courts forget this, the Supreme Court stands ready to reverse. 

Delaware's Top Five Worst Shareholder Decisions for 2010 (#2: Versata Enterprises v. Selectica)

Our second most anti-shareholder case for the year is Versata Enterprises v. Selectica, 5 A.3d 586 (Del. 2010).  We did a series of posts on this case, both at the Chancery Court and the Supreme Court. 

The case has historical significance.  It represents the first time a poison pill was triggered in a manner that resulted in dilution of the acquirer's interest (one was also triggered back in the 1980s in connection with the acquisition of Crown Zellerbach but resulted in no dilution).  For that, it will be cited often ("No poison pill has ever been triggered except . . . ").   

The case, however, has far greater practical significance and amounts to an important salvo in the relationship between the Delaware courts and the Securities and Exchange Commission.  The case demonstrates that the courts have no intention of sitting by idly as federal preempts state law in the area of corporate governance. 

Selectica upheld a poison pill with a 5% trigger.  Plaintiffs argued, among other things, that the low threshold violated Unocal (really Unitrin) because it rendered a proxy contest preclusive.  By setting the triggering percentage at 5%, insurgents could not buy a block sufficient to make a proxy contest viable.  Nor could they negotiate any meaningful alliance with other shareholders in connection with a proxy contest since agreements also triggered the pill.  The low threshold applied even though the Company had a staggered board, making it impossible for the insurgents to acquire control in one election.

The Chancery Court and the Supreme Court found that a 5% pill did not render a proxy contest preclusive.  The Supreme Court held that to be preclusive, a pill had to "render a successful proxy contest realistically unattainable given the specific factual context" and summarily concluded that the pill did not meet that standard.  The Chancery Court was a bit more overt, holding that a pill was not preclusive unless it "render[ed] a successful proxy contest a near impossibility or else utterly moot, given the specific facts at hand." 

Effectively, therefore, the courts have reduced the concept of preclusion with respect to the application of poison pills to proxy contests to one of impossibility.  The effect is to read the preclusion element out of the test.  As a result, poison pills with very low triggering thresholds will be unchallengeable based upon the preclusion element.  The fact that the Company also had a staggered board, something that doubly discouraged a putative insurgent, was deemed irrelevant to the analysis.

The decision will have two additional and significant effects.  First, the decision validated the use of poison pills with very low thresholds, encouraging companies to adopt pills with similar triggers.  Until now, pills have typically had triggers of 15 or 20%.  That will change.  The result will significantly tilt the playing field in management's favor.  More importantly, however, it will discourage insurgents from engaging in proxy contests in the first instance. 

Second and more interesting will be the effect of the decision on efforts by shareholders to elect a short slate of directors.  The SEC's shareholder access rule (Rule 14a-11) allows shareholders owning more than 3% of the voting shares (individually or in a group) for at least three years to submit a short slate of nominees for inclusion in the company's proxy statement.  In many companies, this will require shareholders to organize to put together a 3% block of shares.  Yet to the extent the size of the shareholder block exceeds 5%, it may trigger a poison pill, with the members of the group seeing their shares suffering immediate dilution. 

It is more than a mere possibility.  While the threshold is only 3%, it would be logical for larger groups of shareholders to form.  The poison pill will make this impossible.  Moreover, to the extent competing groups of shareholders emerge, each seeking to submit nominees, a low threshold pill will prevent them from reaching agreement on a common slate or the sharing of expenses. 

Finally, the requirement of a three year holding period means that not all shares will be eligible to be counted toward the access ownership threshold.  Thus, a group of shareholders may barely meet the 3%/3 year requirement yet when the shares owned for less than three years are included have, collectively, more than 5%, triggering the poison pill.

No institution will agree to even discuss a short slate if there is any risk that in doing so the poison pill will be triggered.  Individual institutions will not always know of the insurgent has reached agreement with other shareholders, potentially triggering the poison pill.  Moreover, even if there is room for challenging the legality of the pill, Selectica demonstrates the risks.  The plaintiff in that case triggered the pill, challenged it, and lost, seeing its ownership diluted in percentage and value.  Institutions will not incur this risk even if they have a significant chance of invalidating the pill in post-hoc litigation. 

Nor is there anything in Selectica that bars the possibility of a poison pill with a lower threshold, say 2%, essentially eliminating any possibility of the formation of a group formed in order to avail itself to the rights provided in Rule 14a-11. 

Selectica shows that the Delaware courts will not sit back and accept federal intervention into the governance process, at least where the intervention is disadvantageous to management.  The real issue is whether the federal government, in this case the SEC, will allow this to occur.

Delaware's Top Five Worst Shareholder Decisions for 2010 (#3: Yucaipa American Alliance Fund v. Riggio)

Yucaipa American Alliance Fund v. Riggio, 1 A.3d 310 (Del. Ch. 2010) is the second worst decision for shareholders in Delaware in 2010.  We did a series of posts on the case back in September. 

B&N put in place a poison pill with a 20% trigger.  Given Moran and its progeny, the invalidation of a poison pill that prevents acquisitions above a 20% threshold is all but impossible.  The great debate back in the 1990s about whether the Delaware courts would allow management to "just say no" to a hostile tender offer is over.  The answer is "yes, they can."

This pill, however, was challenged because of its impact on a proxy contest.  Poison pills apply not only to acquisitions but also to agreements among shareholders.  A pill will be triggered by agreements on such matters as a common slate of directors and the sharing of proxy expenses.  No Delaware court has or would strike down a pill simply because it directly interferes with the ability of shareholders to organize an election campaign for the board. 

Yucaipa did not, however, involve conventional circumstances.  First, B&N had a staggered board.  Yucaipa's efforts to elect directors by definition could not result in a change of control.  Yucaipa stood at best to elect only one third of the board. In other words, even had Yucaipa succeeded in the proxy contest, Burkle could have made life unpleasant for the remaining directors but he had no ability to impose his will on the board.

The other inconvenient truth was the controlling block of stock owned by the Riggios and their supporters.  The block, when combined with the shares owned by the brothers, management and employees, consisted of about 40% of the voting shares.  The poison pill prevented Yucaipa, which owned around 20% of the shares, from negotiating with other shareholders and putting together a comparable block. 

Moreover, while the pill also prevented the Riggio brothers from entering into agreements with other shareholders, it did not prevent management from doing the same.  Management could have, for example, agreed to include a shareholder's candidate in management's slate of directors in return for support while Yucaipa could not have done the same thing.  The pill, in other words, decidedly tipped the balance of the proxy contest in favor of incumbent management. What could management do?  Add a dissident to its own slate in return for voting support.  A road map for this approach can be found in Cryo Cell. 

A staggered board and a controlling block of shares seemed to tilt the contest in management's favor, even without a poison pill.  To uphold the pill, the Chancery Court had to "find" a threat and to ignore the decided advantage given to management.  The Vice Chancellor did both.  The threat?  The possibility that the board could not be "intransigent" towards shareholders.  See Id. at 346-47 ("Once an insurgent has won one election, the incumbent board majority's ability to be intransigent in the face of stockholder sentiment is greatly limited.").  Intransigent means "uncompromising" and "inflexible." 

Equating a threat with a reduction in flexibility effectively read the threat requirement out of the Unocal standard.  This is the equivalent of "just say no" in the proxy contest.  Boards can adopt poison pills that sharply curtail the ability of insurgents even absent any real threat to the company. 

As for tilting the field in management's favor, that prospect played no role in the analysis.  Management was allowed to adopt a pill that left the controlling shareholder in an enviable position and left with management the ability to cut deals with other shareholders should the need arise. 

The message is clear.  Proxy contests in Delaware are not favored and to the maximum extent possible poison pills will be allowed to prevent and discourage them.

Apple and a Short Sighted Approach to Governance (Part 2)

Despite some complaints about Apple's system of governance, it in fact has in place relatively traditional Corporate Governance Guidelines.  Moreover, Apple instituted an advisory vote on executive pay ("say on pay") last year before it was legally required.

Nonetheless, the resistance to the majority vote provision sends a message of indifference to shareholders.  It is a strategy that in the short term will work.  The Calpers proposal for majority vote will likely fail in February. 

But it is a bad strategy for the long term.  There will come a time when the Company will go through more difficult economic tribulations.  After all, despite the current streak of successes, there have been some noticeable failures in the past.  The Lisa for one, the Newton for another. 

When that moment comes, Apple will benefit from any good will engendered among its long term shareholders.  Adopting a majority vote provision now will make sure that the good will is there when Apple needs it. 

The Accounting Industry and the Specter of Catastrophic Risk (Part 3)

What would happen if the existence of one of the Big Four was again threatened?

The 2008 Report by Treasury's Advisory Committee on the Auditing Profession discussed the concentration and noted that among the largest companies, the Big Four control the market. 

• In 2006, the four largest auditing firms audited 98% of the 1500 largest public companies with annual revenues over $1 billion and 92% of public companies with annual revenues between $500 million and $1 billion.

Id. at VII:1.  A GAO Study of concentration in the auditing industry in 2008 concluded that "[a]lthough current concentration does not appear to be having a significant adverse effect, the loss of another large firm would further reduce large companies’ auditor choice and could affect audit fee competitiveness."

The Treasury Report also noted the concern and made the following recommendation:

• The Committee therefore recommends that the PCAOB, in furtherance of its objective to enhance audit quality and eff ectiveness, exercise its authority to monitor meaningful sources of catastrophic risk that potentially impact audit quality through its programs, including inspections, registration and reporting, or other programs, as appropriate. The objective of PCAOB monitoring would be to alert the PCAOB to situations in which auditing firm conduct is resulting in increased catastrophic risk which is impairing or threatens to impair audit quality.

The Report also recommended that a mechanism be implemented for preserving and rehabilitating a "troubled larger auditing firm."  In other words, to the extent the firm confronts some type of risk of elimination, there should be a pre-existing plan to rehabilitate the firm and prevent its elimination. 

Certainly, the SEC took proactive steps during the demise of Andersen to at least notify clients that there would be greater administrative flexibility if, as a result of remaining with Andersen, they ultimately found themselves without a signed audit opinion.  See Exchange Act Release No. 45590 (March 18, 2002).  More could be done.  It should also be a high priority for the PCAOB.

But in truth the long term fix is to increase the number of firms that can compete for public company auditing business, eliminating the current situation, which is tantamount to too big to fail.  Yet this in turn can only be done through the development of meaningful standards for audit quality.  Currently there are none.  Audit quality is equated with firm size.  This by definition means that the smaller firms (the cluster of mediums sized auditing firms) cannot compete for business based upon audit quality. This is another task for the PCAOB. We will have much more to say about this in the future.

In addition, though, this case also points to the need to reform the audit opinion issued by accounting firms.  The opinion typically does little more than opine that the financial statements conform with GAAP.  Within these broad, unqualified opinions, are many many judgements.  Accounting firms are left with passing or failing the financial statements, with no room in the opinion for nuances.  The content of the opinion needs to expand and provide firms with an opportunity to issue an unqualified report to note issues of uncertainty or judgement.  Had E&Y noted the Repo 105 transactions in the opinion, the New York Attorney General never would have filed its case.

This is an area where attention has primarily focused on whether the auditing partner should have to sign the opinion.  While a fair enough issue, it pales next to the question of the substantive content that ought to be considered for the auditor opinion.   We will have more to say about this in the futue.

The Accounting Industry and the Specter of Catastrophic Risk (Part 2)

Could another one of the Big Four disappear?  While the possibility might seem unlikely, so was the situation with Arthur Andersen back in 2002.

Arthur Andersen's reputation was certainly damaged by the accounting concerns raised about Enron.  But until the firm was indicted in March 2002, only 5% of its clients had departed.  The flood-gates opened after the indictment and continued through the conviction (which was ultimately reversed).   Following the June 2002 conviction, the firm threw in the towel and ended operations a few months later.

What is interesting about Andersen's collapse is that it was not mandated by the law.  Despite the fact that some attributed the end of Andersen's operations to the legal consequences of the conviction, this is not true.  There is nothing that requires a public auditor to go out of business following a felony conviction. 

The SEC  can put a public auditor out of business in these circumstances.  Rule 102(e)(2) allows the Commission to bar an accountant from practicing before the Agency in certain circumstances, including conviction "of a felony or a misdemeanor involving moral turpitude."  Nonetheless, this is not automatic; the SEC must initiate the process.  The Commission instituted no such proceeding in the case of Arthur Andersen. 

Arthur Andersen collapsed because, by the time the conviction arrived, its clients had largely departed (although a small percentage, under 10% remained, even after the conviction).  Some clients may have departed because of concerns over audit quality but most likely they did so for other reasons.  Some clients likely departed when their audit partner abandoned ship and moved to a new firm.

Mostly, though, clients were likely concerned that Arthur Andersen would disappear, leaving them without an auditor when the next fiscal year ended.  In short, Arthur Andersen went under because of an old fashioned run on the bank. 

Arthur Andersen demonstrated that in the right set of circumstances, including those initiated by a government action, the 5th largest accounting firm with some 2300 clients could vanish in less than a year. There is nothing that ensures this will not happen again.  It will merely take a loss of confidence in an accounting firm and fears about the firm's viability.

Does this mattter?  And, if so, what can be done about it?

The Accounting Industry and the Specter of Catatrophic Risk (Part 1)

Andrew Cuomo, the Attorney General of NY (and soon to be governor), filed civil fraud charges against E&Y over auditing work done for Lehman Brothers.  The Complaint is here.  The concerns arose over the role played by the accounting firm in the use of "Repo 105" transactions by Lehman.  As the Complaint states:

• E&Y knew every significant aspect of Lehman’s Repo 105 transactions, and knew that the Lehman financial statements violated Generally Accepted Accounting Principles (“GAAP”), which require that such statements (a) not be misleading, (b) fairly disclose the Company’s financial position, and (c) not omit material information necessary to fairly present the financial position. As the public auditor for Lehman, E&Y had the absolute obligation to ensure that Lehman’s financial statements complied with GAAP and did not mislead the public.  Instead of fulfilling this obligation, E&Y gave a clean opinion each year, erroneously stating that Lehman’s financial statements complied with GAAP. E&Y sat by silently while Lehman deceived the public by concealing the Repo 105 transactions and misrepresenting the Company’s leverage. By doing so, E&Y directly facilitated a major accounting fraud, and helped Lehman mislead the public as to its true financial condition. E&Y, which reaped over $150 million in fees from Lehman, must be held accountable for its role in this fraud.

The investigation is reported to have started after the bankruptcy examiner in Lehman issued a report on the failed investment bank.   Volume 3 discussed the use of the accounting treatment and concluded that:

• "There is sufficient evidence to support a determination by a trier of fact that Lehman’s failure to disclose that it relied upon Repo 105 transactions to temporarily reduce the firm’s net balance sheet and net leverage ratio was materially misleading.

As for the role of E&Y, the Report likewise concluded that "sufficient evidence exists to support colorable claims against Ernst & Young LLP (“Ernst & Young”) for professional malpractice arising from Ernst & Young’s failure to follow professional standards of care with respect to communications with Lehman’s Audit Committee, investigation of a whistleblower claim, and audits and reviews of Lehman’s public filings."  Volume 3, at p. 1027. 

The potential claims against E&Y have caused some to criticize the SEC for its "passive" approach to Lehman and the role played by E&Y.  Others have mostly shrugged and noted that bad behavior happens. 

The significance of the action by the NY Attorney General, however, goes well beyond the specifics of a single case.  It again raises serious systemic questions about the auditing industry.  The possible charges against E&Y recall the specter of Arthur Andersen back in 2002.  The charges resulted in the demise of the firm, reducing the number of large auditors from five to four.

Admittedly, Andersen confronted criminal charges, while the possible action against E&Y is civil. Nonetheless, it was a single government action that resulted in a less competitive industry.  Could the same thing happen again?  We address these concerns in the next few posts.

E&Y, Lehman and the Attorney General of New York

We have some thoughts on the case brought by the Attorney General of New York and will post on it tomorrow.  For now, the Complaint filed today can be found here.

The Director Compensation Project: CVS Caremark Corporation

This post is part of an ongoing series that examines the way stock exchange independence rules influence director compensation.  We are including companies from 2010’s Fortune 500 and using information found in their 2010 proxy statements.  In addition to state standards and the requirements of SOX, the stock exchanges each have their own standards for independence.  While substantially the same, there are some minor differences between NYSE and NASDAQ rules that are worth noting.  

Under NYSE Rule 303A.01, all listed companies must have a majority of independent directors sitting on their boards.  Directors are not independent if they received over $120,000 in direct compensation, other than director’s fees, in any one year period over the last three years pursuant to Rule 303A.02(b)(ii).  This is a looser restriction than the equivalent NASDAQ Rule, 5605(a)(2), which includes all compensation.  Rule 303A.06 requires that, in addition to the general independence standards, audit committee members must comport with the requirements of Exchange Act Rule 10A-3 (C.F.R. §240.10A-3), also know as SOX 301.

One can see some of the effects of these rules when looking at the director compensation table from CVS Caremark's (NYSE:CVS) 2010 proxy statement.  According to the proxy statement, the company paid the directors the following amounts:

Name	Total ($)
Edwin M. Banks	271,366
C. David Brown II	261,538
David W. Dorman	270,000
Kristen Gibney Williams	260,747
Marian L. Heard	261,538
William H. Joyce	280,000
Jean-Pierre Millon	260,000
Terrence Murray	280,000
C. A. Lance Piccolo	267,239
Sheli Z. Rosenberg	270,000
Richard J. Swift	260,867

Director Compensation.  During the 2009 fiscal year, the Board of Directors met nine times. Each director attended at least 75% of the aggregate number of meetings of the Board of Directors and meetings of the Board Committees on which he or she served.  Each director is fully retained by the company and receives an annual retainer of $260,000. Each of these retainers is paid semi-annually and at least 75% of each retainer must be paid in company common stock.  All non-employee directors must own a minimum of 10,000 shares of CVS Caremark common stock within five years of being elected to the Board.  Directors must retain this minimum level of ownership for at least six months after leaving the Board.

Director Tenure.  William H. Joyce holds the longest tenure as a director, serving on the Board since April 1994.  Dr. Joyce also serves as Chairman of the Board and Chief Executive Officer of Advanced Fusion Systems, LLC, and Hercules, Incorporated.  Mr. Piccolo, Mr. Millon, Ms. Williams, Mr. Banks and Mr. Brown have served the shortest amount of time on the Board, as they all joined the Board in March 2007.  All of these members served on the board of Caremark Rx, Inc., until the closing of the CVS/Caremark merger.  Ms. Williams helped found Caremark PBM.  Many directors also serve on other boards.  Mr. Dorman has been the Non-Executive Chairman of the Board of Motorola, Inc. since May 2008.  Mr. Dorman also served as the Chief Executive Officer and Chairman of the Board for AT&T from November 2002 to November 2005.  Mr. Swift is a director of Public Service Enterprise Group Incorporated, Ingersoll-Rand PLC, Kaman Corporation, and Hubbell Incorporated.  Ms. Rosenberg currently serves as a director of Equity Lifestyle Properties, Inc., Ventas, Inc, and Nanosphere, Inc., and is a trustee of Equity Residential, a real estate investment trust.

CEO Compensation.  Thomas M. Ryan is CVS’ President and Chief Executive Officer and received a salary of $1,400,000 in 2009. He also serves as the Company’s Chairman of the Board.  Mr. Ryan began his career with CVS as an in-store pharmacist thirty-five years ago before becoming CEO in 1998.  Mr. Ryan is paid at slightly above the median of CVS’ peer group.  David B. Rickard, CVS’ Executive Vice President, Chief Financial Officer and Chief Administrative Officer, received a salary of $775,000 in 2009.  Mr. Rickard retired effective December 31st, 2009.  According to his employment agreement, upon retirement all restrictions were eliminated on all of Mr. Rickard’s restricted stock units. In addition, all of his stock options became non-forfeitable and he will be eligible for pro rata payments of earned incentive payments under CVS’ Long Term Incentive Plan.  According to his Supplemental Executive Retirement Plan with CVS, Mr. Rickard will also receive an annual benefit equal to 1.6% of a three-year average of final compensation for each year of service for up to thirty years.  Final compensation under this plan considers the executive’s three highest years of annual salary and annual cash bonus during the last ten years of service.

The Director Compensation Project: Berkshire Hathaway

This post is part of an ongoing series that examines the way stock exchange independence rules influence director compensation.  We are including companies from 2010’s Fortune 500 and using information found in their 2010 proxy statements.  In addition to state standards and the requirements of SOX, the stock exchanges each have their own standards for independence.  While substantially the same, there are some minor differences between NYSE and NASDAQ rules that are worth noting. 

Under NYSE Rule 303A.01, all listed companies must have a majority of independent directors sitting on their boards.  Directors are not independent if they received over $120,000 in direct compensation, other than director’s fees, in any one year period over the last three years pursuant to Rule 303A.02(b)(ii).  This is a looser restriction than the equivalent NASDAQ Rule, 5605(a)(2), which includes all compensation.  Rule 303A.06 requires that, in addition to the general independence standards, audit committee members must comport with the requirements of Exchange Act Rule 10A-3 (C.F.R. §240.10A-3), also know as SOX 301.

One can see some of the effects of these rules when looking at the director compensation table from Berkshire Hathaway’s (NYSE:BRK.B) 2010 proxy statement.  According to the proxy statement, the company paid the directors the following amounts:

Name	Total ($)
Howard G. Buffett	3,000
Stephen B. Burke	0
Susan L. Decker	3,000
William H. Gates III	2,700
David S. Gottesman	3,000
Charlotte Guyman	7,000
Donald R. Keough	6,700
Thomas S. Murphy	7,000
Ronald L. Olson	3,000
Walter Scott, Jr.	3,000

Director Compensation.  During 2009, Berkshire’s board held three special meetings and one Annual Meeting of Directors following the Annual Meeting of Shareholders.  Each director attended all of the meetings except for William H. Gates III and Donald R. Keough, who each missed one of the special meetings.  The Audit Committee held seven formal meetings in 2009.  The Governance, Compensation, and Nominating Committee held two meetings in 2009.  Directors who are employees or spouses of employees do not receive fees for attendance at directors’ meetings.  All other directors receive a fee of $900 for each meeting attended in person and $300 for participating by telephone.  Audit Committee members receive a fee of $1,000 quarterly.  Directors are reimbursed for out-of-pocket expenses incurred while attending meetings of directors or shareholders.  The Company does not provide directors and officers with liability insurance.

Director Tenure.  Mr. Warren E. Buffett, a director since 1965, has the longest tenure.  Mr. Burke, elected on December 22, 2009, has the shortest tenure.  Most of the directors sit on other boards.  Ms. Decker is a director of Costco Wholesale Corporation and Intel Corporation.  Mr. Keough is a director of InterActive Corp. and The Coca-Cola Company.  Mr. Munger is a director of Wesco Financial Corporation (80%-owned by Berkshire Hathaway), Daily Journal Corporation, and Costco Wholesale Corporation. Mr. Olson is a director of City National Corporation, Edison International, Southern California Edison and The Washington Post Company.

CEO Compensation.  Warren E. Buffett, Berkshire’s Chief Executive Officer, earned a salary of $100,000 during the 2009 fiscal year.  He also received $75,000 in fees for sitting on the board of directors of The Washington Post Company, in which Berkshire has a significant ownership interest.  In addition, Berkshire provided personal and home security services for Mr. Buffett at a cost of $344,490.  Marc D. Hamburg, the Chief Financial Officer, earned a salary of $862,500 during the 2009 fiscal year, and also received $12,250 in contributions to a defined contribution plan.  Berkshire does not grant stock options to its executives.

The Director Compensation Project: ConocoPhillips

This post is part of an ongoing series that examines the way stock exchange independence rules influence director compensation.  We are including companies from 2010’s Fortune 500 and using information found in their 2010 proxy statements.  In addition to state standards and the requirements of SOX, the stock exchanges each have their own standards for independence.  While substantially the same, there are some minor differences between NYSE and NASDAQ rules that are worth noting. 

Under NYSE Rule 303A.01, all listed companies must have a majority of independent directors sitting on their boards.  Directors are not independent if they received over $120,000 in direct compensation, other than director’s fees, in any one year period over the last three years pursuant to Rule 303A.02(b)(ii).  This is a looser restriction than the equivalent NASDAQ Rule, 5605(a)(2), which includes all compensation.  Rule 303A.06 requires that, in addition to the general independence standards, audit committee members must comport with the requirements of Exchange Act Rule 10A-3 (C.F.R. §240.10A-3), also know as SOX 301.

One can see some of the effects of these rules when looking at the director compensation table from ConocoPhillips (NYSE:COP) 2010 proxy statement.  According to the proxy statement, the company paid the directors the following amounts:

Name	Total ($)
R.L. Armitage	220,015
R.H. Auchinleck	255,237
J.E. Copeland, Jr.	251,008
K.M. Duberstein	250,015
R.R. Harkin	242,015
H.W. McGraw III	220,644
H.J. Norvik	227,820
W.K. Reilly	246,515
B.S. Shackouls	236,595
V.J. Tschinkel	240,076
K.C. Turner	230,015
W.E. Wade, Jr	258,776

Director Compensation.  During fiscal year 2009, ConocoPhillips held nine Board of Directors meetings.  Each director attended at least 75% of the total number of meetings of the Board of Directors and meetings of the Board Committees on which he or she served.  Directors participate in an equity compensation program and a cash compensation program.  Under the equity compensation program, non-employee directors receive an annual grant of restricted stock units with an aggregate value of $120,000 on the date of grants.  Under the cash compensation program, all non-employee directors receive $100,000 annual cash compensation and receive additional cash compensation if they serve in specified committee positions.  Due to the difference in tax laws in other countries, in July 2003 the Board approved a modification of compensation for directors living in other countries. This compensation plan applies to Mr. Auchinleck, who lives in Canada, and Mr. Norvik, who lives in Norway.

Director Tenure.  Mr. Reilly, Ms. Tschinkel, Ms. Turner, Ms. Harkin, and Mr. Mulva have served the longest on the board.  All of these directors joined the board in August 2002, when Phillips Petroleum Company merged with Conoco, Inc.  Robert A. Niblock joined the board in February 2010 and has the shortest tenure as a director.  Several directors also sit on other boards.  Mr. Niblock is also the Chief Executive Officer and Chairman of the Board for Lowe’s Companies, Inc., a position he has held since January 2005.  Harold J. McGraw is the Chairman, President, and Chief Executive Officer of The McGraw-Hill Companies.  Kenneth Duberstein serves on the boards of The Boeing Company, Mack-Cali Realty Corporation, and The Travelers Companies, Inc.  Mr. Mulva is also a director of General Electric Company.

CEO Compensation.  J.J. Mulva, who serves as ConocoPhillips’ Chief Executive Office & Chairman, earned $14,388,661 in 2009.  Mr. Mulva began his career with Phillips Petroleum Company over 35 years ago, and was the Chief Executive Officer and Chairman of the Board for Phillips Petroleum beginning in 1999 until its merger with Conoco, Inc. in 2002.  He has personal use of the company aircraft, a company car and also a home security system.  All of these perks are required under the company’s Comprehensive Security Program.  Rather than award bonuses to employees, the Human Resources and Compensation Committee annually awards employees, including executives, under the Variable Cash Incentive Program.  J.A. Carrig, President and Chief Operating Officer of ConocoPhillips earned $12,297,171 in 2009.  This total compensation reflects a 15% increase in salary to $1,145,000 in 2009 and a 50% increase in option awards. 

The Director Compensation Project- Valero Energy

This post is part of an ongoing series that examines the way stock exchange independence rules influence director compensation. We are including companies from 2010’s Fortune 500 and using information found in their 2010 proxy statements. In addition to state standards and the requirements of SOX, the stock exchanges each have their own standards for independence. While substantially the same, there are some minor differences between NYSE and NASDAQ rules that are worth noting.

Under NYSE Rule 303A.01, all listed companies must have a majority of independent directors sitting on their boards. Directors are not independent if they received over $120,000 in direct compensation, other than director’s fees, in any one year period over the last three years pursuant to Rule 303A.02(b)(ii). This is a looser restriction than the equivalent NASDAQ Rule, 5605(a)(2), which includes all compensation. Rule 303A.06 requires that, in addition to the general independence standards, audit committee members must comport with the requirements of Exchange Act Rule 10A-3 (C.F.R. §240.10A-3), also known as SOX 301.

One can see some of the effects of these rules when looking at the director compensation table from Valero Energy’s (NYSE:VLO) 2010 proxy statement. According to the proxy statement, the company paid the directors the following amounts:

Name	Total ($)
W.E. "Bill" Bradford	290,010
Ronald K. Calgaard	273,010
Jerry D. Choate	280,010
Irl F. Engelhardt	275,010
Ruben M. Escobedo	291,010
William R. Klesse	0*
Bob Marbut	288,010
Donald L. Nickles	265,010
Robert A. Profusek	270,010
Susan Kaufman Purcell	281,935
Stephen M. Waters	265,010

*See below for Mr. Klesses compensation for service as Valero’s Chief Executive Officer.

Director Compensation. During fiscal year 2009, Valero Energy held 7 Board of Directors meetings and 24 Board Committee meetings. No member of the Board attended less than 75% of the meetings of the Board and committees of which he or she was a member. All non-employee directors received a retainer fee of $91,000 per year, plus $2,000 for each committee meeting attended in person.

Board Tenure. Mrs. Purcell and Mr. Escobedo, who have held their positions as members of the Board of Directors since 1994, held the longest tenure. Several directors also sit on other boards. Senator Nickles sits on the boards of Chesapeake Energy Corporation, Washington Mutual Investors Fund, JP Morgan Value Opportunities Fund, and American Funds Tax Exempt Series I. Mr. Choate also serves as a director of Amgen, Inc. and Van Kampen Mutual Funds.

CEO Compensation. William Klesse, who has served as Valero’s Chief Executive Officer since the end of 2005 and was elected President in January, 2008, earned $11,698,231 in 2009. This represented a 49% increase from his 2008 earnings. Richard J. Marcogliese, Executive Vice President and Chief Operating Officer, earned $5,940,686 during the fiscal year.

The Director Compensation Project, Part II

As part of The Race to the Bottom's focus on student collaboration, we are continuing with our publication of the third annual "Director Compensation Project."  This student-developed project examines compensation for the Board of Directors of many of the top 2010 Fortune 500 companies.  We began this project in July and continue it now to look at director compensation for the most recent fiscal year.  These posts will appear over the next few days. 

Some of the companies reviewed in this project are:

Berkshire Hathaway

ConocoPhillips

Wal-Mart

Exxon Mobil

Verizon

Hewlett-Packard

Wells Fargo

Airgas and the Management Friendly Nature of Delaware Law (Part 3)

We noted in the last post a series of cases that can be described as management friendly.

Occasionally, however, a few cases slip through that cannot be characterized in that fashion.  Two come to mind.  Kurz, a decision by VC Laster, among other things, found for insurgent shareholders and did away with management's control over the omnibus proxy.  Airgas found that a staggered board provision was ambiguously written and, compelled by state law principles, interpreted the provision in a manner most consistent with the shareholder franchise. 

Why are such decisions so rare?  There are no doubt a variety of explanations but one of them has to be the risk of reversal.  It seems that while an individual Chancellor or Vice Chancellor might occasionally deviate from the management friendly approach, the Supreme Court is less likely to do so.  Part of the explanation may arise from the collective decision making process.  On courts with multiple judges, a single Justice who seeks to make decisions that goes against the grain will likely have a difficult time and often fail. 

But there is something else going on here.  The Delaware Supreme Court has five justices.  Three of them (CJ Steele, and Justices Berger and Jacobs) all first served on the Chancery Court.  In other words, they had a very clear record on corporate governance matters, something that would be known, for example, to any bar committee vetting their nominations or any governor making the ultimate selection.  The vetting process presumably helps ensure a consistency in view and reduces the likelihood of the appointment of a "maverick" to the bench.  Such a Court would likely be counted on to view "maverick" decisions by the Chancery Court less favorably.  Indeed, both Kurz and Airgas were reversed.  

In short, even if trial courts want to make decisions that deviate from the common approach in Delaware, they know that there is a high risk of reversal.  Like shareholders who know that there is a high risk of defeat in a proxy contest because of a poison pill with an exceedingly low threshold (say 5%) and, as a result, forgo the opportunity in the first instance, those on the Chancery Court know that there is a high risk of reversal for certain types of governance decisions and, therefore, may opt to forgo the effort.   

Airgas and the Management Friendly Nature of Delaware Law (Part 2)

The Delaware General Corporation Law provides considerable discretion to management.  There is nothing inherently wrong with discretion and, in fact, an enabling approach to corporate law may be the most appropriate.  But discretion can be abused.  Abuse is supposed to be prevented by rigorous fiduciary standards, particularly those governing self interested transactions (the duty of loyalty).  In fact, however, the Delaware courts have resolutely weakened fiduciary standards.

While this topic is much too broad to address in a short series of posts, a number of cases decided over the last year of so illustrate the approach.  Examples?

Amylin:  Where the Chancery Court held that boards did not have to be aware of contractual provisions that disnefranchised shareholders, essentially rendering such provisions unreviewable.  The decision was affirmed by the Delaware Supreme Court.

Citigroup:  Where the Chancery Court essentially said that fiduciary responsibilities of directors did not extend to risk taking by management, even where the risk taking could bankrupt the entire company.  This particular holding was largely erased by Congress in Dodd-Frank, at least for financial firms with more than $10 billion in assets. 

Selectica:  Where the Chancery Court upheld a poison pill with a 5% threshold that prevented shareholders that collectively owned more than that percentage from coming to agreement on a common slate of directors and a sharing of proxy expenses.  The decision (also affirmed by the Supreme Court) did not make proxy contests mathematically impossible but it clearly discouraged them and tilted the playing field in management's favor. 

Axcelis:  Where the Chancery Court and the Supreme Court declined to allow shareholders to use inspection rights to obtain documents used by the board in deciding to not accept letters of resignation from three directors who did not receive majority support from shareholders and, as a result, were required to resign. 

But, occasionally, a decision slips through that cannot be viewed as management friendly.  The instances are so rare that they are noticeable.  We will discuss this phenomena in the next post and provide at least one reason why it is so rare. 

Airgas and the Management Friendly Nature of Delaware Law (Part 1)

Delaware is a small state based upon population and area.  Yet the state is very big in the area of corporate governance.  Some 60% of the Fortune 500 are incorporated there.  Most IPOs of companies to be listed on an exchange are for Delaware companies.

Delaware benefits from this stature financially.  As we have noted, a large portion of the state's tax revenues come from these out of state corporations.  The state has no sales tax and low income tax rates.  Moreover, there are other the indirect benefits that help support the state's economy.  The small state, therefore, has every incentive to attract in more out of state companies.  Adopting a management friendly approach to corporate law is the best way to do it. 

This much is widely known and generally accepted (see the discussion in The Irrelevance of State Corporate Law in the Governance of Public Companies).  The primary defense used to be that this approach (reducing management liability and increasing management discretion, often at the expense of shareholders) was justified based upon the notion of private ordering.  Management of each company received maximum flexibility to operate the company in a manner most likely to profit maximize.  In other words, directors would use the flexibility to benefit shareholders.

The approach always contained a central analytical flaw.  Management had an incentive to use the discretion in a self interested way (say through the payment of large amounts of compensation) rather than in the best interests of shareholders.  This possibility was rationalized away in the 1980s through reference to the market for corporate control.  If management used the authority in an inefficient manner, share prices would fall and the company would be acquired, resulting in the displacement of the inefficient managers. 

The approach provided some degree of intellectual cover for the Delaware approach.  Yet the state was not adopting laws and making decisions with the goal of promoting efficiency.  Indeed, while the market for corporate control was used to justify the Delaware approach, the Delaware courts largely eliminated the market (at least with respect to hostile tender offers) through management friendly decisions such as Unocal, Moran, and Unitrin.  As a result, there is no serious credible market mechanism that will routinely penalize management if discretion is not used to promote the best interests of shareholders.  

With the intellectual venire stripped away, the management friendly nature of Delaware law has become clearer.  Moreover, the justification (beyond the pecuniary benefits earned by the state) for doing so has become increasingly more difficult to sustain.  It is because of this that Congress has, in SOX and in Dodd-Frank, increasingly intruded into areas of governance traditionally left to the states.  Delaware is treated in a less sacrosanct fashion and instead viewed as one more interest group seeking to promote a particular definition of governance.

In all of this, what is the role of the courts in Delaware?  We will pick that matter up in the next post.