Corporations, Fiduciary Duties, and Profit Maximization: The Case of the Beverage Industry

When teaching corporations (or securities for that matter), I try to integrate ongoing developments in the market into my lectures.  Last semester, the public offering of Twitter (which had a board of directors that lacked any diversity) provided plenty of examples to illustrate key points.

With respect to fiduciary duties, I still teach that profit maximization is the obligation of boards.  I stress that the statute and case law refers to the "best interests of shareholders" and says nothing explicit about profit maximization.  I further stress that profit maximization does not mean short term profit maximization but is a matter to be determined by the board and invariably results in a balance of long and short term goals.  I also note that the law of fiduciary obligations, particularly when applying the duty of care, is extremely deferential to the board's determination of what constitutes profit maximization.  In that way, fiduciary duties align with, rather than go against, business practices.  

With that in mind, I thought it interesting to point out an ongoing example of the diverse approaches to profit maximization within the same industry.  Coca Cola does one thing:  Drinks.  The Company's 10-K describes the business as beverage concentrates (i.e. syrups) and "finished sparkling and still beverages." Pepsi in contrast not only sells bevereges but also owns Frito-Lay and is active in the "snack business."  At one time Pepsi owned several chains of fast food restaurants (pizza hut, taco bell, and kfc) but has gotten out of that business.

So is a business selling beverages better run (that is maximizing profits) by emphasizing only one area (beverages) or by expanding into others?  Anecdotally my impression is that the singular focus of Coca Cola on beverages means that it may access markets, particularly overseas, that become available, more quickly than Pepsi.  When I was in Kazakhstan in 1997 (Fulbright), there was a Coke bottling plant and the product was readily available.  I do not remember seeing Pepsi (although perhaps it was sold in outlets I didn't frequent).  Moreover, Coca Cola is the dominant player in the beverage market.  Coke has 42% of the carbonated soft drink market while Pepsi has 28.1%.

At the same time, however, operating in a single industry means that your fortunes can go up and down with that industry, potentially making profits more vulnerable to developments that are beyond the control of the company. Presumably there is no one right answer and even after selecting a particular approach, boards, consistent with their fiduciary obligations, keep alternatives in mind. Thus, McDonalds at one time owned a number of other restaurant chains (recall that it owned Chipotle) but ultimately decided to sell them and go back to its core business.   

In the soda/beverage industry, boards are likely weighing that very issue at both Coca Cola and Pepsi.  News reports indicate that Coke is not doing well. According to the WSJ:   

  • Earnings per share are seen at $2, up slightly from $1.97 a year earlier with a slight drop in revenue, according to FactSet. Coca-Cola's stock performance has trailed the S&P 500 by 16 percentage points over the past year as stagnating developed markets and slowing growth in developing ones take their toll. 

Coke is apparently looking for other profit making opportunities and has purchased an interest in Green Mountain Coffee Roasters.  Perhaps snacks will be the next area of interest.  

So that must mean that the Pepsi approach is the right one.  Not exactly.  At least one significant shareholder is pushing Pepsi to profit maximize by splitting beverages from snacks. Snacks, apparently, is the faster growing business.  So far Pepsi has rejected this idea.

So which is it?  Separate or combined?  It is for the board of directors to determine and a matter of the board's fiduciary obligation to profit maximize.  


A Management Friendly Philosophy Applied to Management Disputes: Klaassen v. Allegro Development (Part 3)

We are discussing Klaassen v. Allegro Development.

In Klaassen, the Vice Chancellor declined to overturn the decision by the non-management directors to terminate the CEO.  In doing so, the Vice Chancellor declined to find that the non-management directors erred by failing to provide notice of the plan to terminate the CEO.  The case is on appeal.

The management friendly nature of Delaware dictates that its Supreme Court will either reaffirm (or at least not overturn) the obligation of boards to notify the CEO in advance of an impending termination.  The Court will affirm (or at least not overturn) the obligation to provide this notice irrespective of the percentage of shares owned by the CEO.  In other words, the aftermath of the opinion will be that CEOs are entitled to advanced notice of their termination. 

This approach will effectively prevent boards from removing the CEO as a fait accompli.  As a result, the instances of CEO removal will decline.  In some cases, the obligation to inform the CEO in advance and the unwillingness to confront the CEO’s disapprobation, will cause the board to reconsider.  In other cases, the CEO will have the ability to call a shareholders meetings and/or lobby the weak links in any group of directors favoring removal.

Characterizing the right to notice as mandatory (that renders the meeting and act of removal void) is the most management friendly.  At the same time, however, this would essentially amount to a categorical rule.  This categorical rule requiring notice favors management but there may rare cases where it does not. 

By treating the failure to give notice as a voidable act, the courts retain some discretion.  Moreover, the discretion can be exercised in a management friendly manner.  At the same time, the discretion needs to be narrow so that CEOs know that in Delaware they can usually count on a right to advance notice of any termination.  CEOs will know that in Delaware, there can be no secret coups.    

So how will the case come out?  Based upon the race to the bottom, the Court will likely affirm the equitable nature of the notice requirement, specify that it is subject to equitable defenses, and make clear that the defenses are to be narrowly applied.  As to the actual decision in Klaassen, any prediction is a bit more problematic.  The Supreme Court in Delaware may change the reasoning of a lower court opinion but they are often hesitant to actually reverse.  Take a look at the way the Supreme Court in Axcelis completely rewrote the reasoning of the lower court but found a way not to reverse.  The facts in Klaassen provide room for this.  The CEO in that case waited a relatively lengthy period before challenging his dismissal.  This may be sufficient for the Court to be unwilling to disturb the Chancery Court’s findings in connection with the application of equity.

But, to go out on a limb, we predict that the Court will not just tamper with the reasoning but will actually reverse the Chancery Court opinion.  The case was written by a Vice Chancellor that has shown significant independence.  Indeed, the decision in Klaassen was to uphold the dismissal of a CEO by a non-management board.   

Moreover, under the race to the bottom, management has incentive to find jurisdictions with favorable law.  Favorable law generally means reduced liability for management, greater discretion with respect to their decision making, and limited ability of removal.  Reversing a decision that permitted removal of the CEO without advance notice will be an outcome that management will see has highly favorable.  


A Management Friendly Philosophy Applied to Management Disputes: Klaassen v. Allegro Development (Part 2) 

We are examining the decision in Klaassen v. Allegro Development.

In Klaassen, the Chancery Court conducted a tutorial on the developpment of notice requirements for directors.  The early cases set out the black letter law in the area.  Directors were required to receive advance notice of special meetings in order to have "the right to be heard upon all questions considered. . . ."  Without notice, the actions at the meeting were void.  At the same time, however, notice could not be willfully avoided.  Thus, a director could not assert the lack of notice when refusing to permit the delivery of notice in the form of a registered letter.

The courts also recognized that a "quorum obtained by trickery" was invalid.  This could occur where a director notified of the meeting failed to attend when told that it had been postponed.  In effect, the approach eviscerated the requirement of notice by denying the director of an opportunity to attend and be heard.  Trickery was not present, however, where a meeting was called on an impromptu basis (the directors were all present to attend the annual meeting of shareholders) and in a manner consistent with the bylaws.  

These cases largely provided common sense rules of the road.  Directors were required to have notice of special meetings.  Notice was ineffective if they were tricked into not attending.  Trickery, however, had to involve some type of misbehavior.  These cases largely reflected the state of the law through the 1990s.  

Beginning in the 1990s, however, the courts, as VC Laster put it, "took a very different approach to advance notice for special board meetings."  Unlike the 1980s, when shareholders could occasionally win a major governance case (recall Van Gorkom or Unocal), the 1990s began a period of decision making where this was less likely to occur.

The "very different approach" with respect to board meetings and notice occurred in the context of efforts by non-management directors to remove the CEO.  In one case, Koch v. Stearn, 1992 WL 181717 (Del. Ch. July 28, 1992),vacated as moot, 628 A.2d 44 (Del. 1993), the removed CEO, who was also a controlling shareholder,  alleged that he had been "tricked" into attending the meeting.  The "trick" was providing a notice that suggested a purpose of the special meeting that did not encompass his removal.  

In Adlerstein v. Werthemer, 2002 WL 205684 (Del Ch. Jan. 25, 2002), two outside directors sought to raise additional capital and remove the CEO.  Again, the CEO, a controlling shareholder, had no notice and again, the court invalidated the meeting (and his removal).  As the court reasoned, in the case of a controlling shareholder, equity would not permit the withholding of advance notice when done “for the purpose of preventing the controlling stockholder/director from exercising his or her contractual right to put a halt to the other directors' schemes.” 

In a third case, Fogel v. US Energy Sys., Inc., 2007 WL 4438978 (Del. Ch. Dec. 13, 2007), the doctrine was extended to directors who were not also controlling shareholders.  The CEO (who also served as chairman) scheduled a special meeting of the board.  In advance of the meeting, the three independent directors decided to fire the CEO.  Before the meeting, the three directors told the CEO that “they had lost faith in him and wanted him to resign.”  When he refused to resign, he was terminated. 

The termination was ultimately invalidated.  The Chancery Court found that “the directors deceived Fogel by not specifically warning him in advance about his potential termination.”  Although not a controlling shareholder, the court reasoned that the CEO was disadvantaged because  "had he known beforehand, he could have exercised his right under the bylaws to call for a special meeting before the board met." 

In Klaassen, the Vice Chancellor described the decision as “dramatically expanding” the existing line of authority. The case essentially required advance notice to a CEO before termination.  “If Fogel is correct, then a board with a Chairman/CEO cannot fire its CEO without first giving the CEO explicit advance notice and an opportunity to call a special meeting of stockholders at which the composition of the board might change, regardless of how few shares the Chairman/CEO owns.”

The Vice Chancellor tried to summarize the state of the law.  He reasoned that:

  • Delaware law distinguishes between (i) a failure to give notice of a board meeting in the specific manner required by the bylaws and (ii) a contention that the lack of notice was inequitable. In the former scenario, board action taken at the meeting is void. In the latter scenario, board action is voidable in equity, so equitable defenses apply. . . . this distinction fits with the general rule that the stockholders, through bylaws, may dictate the process that directors use to manage the corporation, so long as the restrictions are not so onerous as to interfere with the board's power to manage the corporation under Section 141(a). The distinction also recognizes that, traditionally, when a board took action in contravention of a mandatory bylaw, the board action was treated as void.

The Vice Chancellor found that the termination of the CEO in Klaassen was a voidable act subject to equitable defenses.  He found equitable defenses applicable and declined to overturn the termination of the CEO.  Recognizing the “unsettled questions” raised by the case, the court agreed to issue a stay pending appeal.

So what will happen on appeal? We will address that possibility in the next post.


A Management Friendly Philosophy Applied to Management Disputes: Klaassen v. Allegro Development (Part 1)

Delaware courts issue management friendly decisions.  For the most part, this means decisions that favor management over the interests of shareholders.  Or, as VC Laster recently noted, Delaware has a "director-centric system of corporate governance."  Klaassen v. Allegro Development Corp., CA No. 8626-VCL (Del. Ch. Nov. 7, 2013).  

Increasingly, however, governance cases involve disputes among directors.  What does a management friendly approach mean in that context?  Most likely, it means an approach that favors management  directors (i.e., the CEO) over non-management directors, particularly independent directors.  Whatever the failings of independent directors, they are designed to reduce the influence of management in the governance process.  A judicial approach designed to limit their influence would be very management friendly.    

This hypothesis provides an interesting template for a review of Klaassen v. Allegro Development.  The case essentially involved a dispute between a CEO and the non-management directors.  At the time of the removal, the board consisted of two directors appointed by the holders of the Series A Preferred shares, the CEO (who also owned 70% of the common shares), and two outside directors designated by the CEO but approved by the holders of the Series A Preferred shares.  As a result, the board consisted of one management director and four non-management directors.

At a meeting held on Nov. 1, 2012, the board voted to remove the CEO.  Klaassen eventually filed suit challenging the dismissal.  Among other things, he asserted that he was entitled under equity to notice in advance of the meeting of the plans of the non-management directors to remove him.  As the court characterized: The CEO "contends that a board cannot take action adverse to the interests of such an individual unless the board provides him with advance notice and an opportunity to pre-empt the board by changing its composition. An individual with this combination of capacities and rights becomes a super director whose authority trumps Section 141(a) of the DGCL." 

The CEO asserted that the failure to provide notice rendered the actions of the board void.  The board in turn asserted that the actions were at most voidable and subject to equitable defenses.  They argued for, and the Chancery Court found applicable, the equitable doctrines of laches and acquiescence.  

The case is now on appeal.  In the next post, we will examine the case through the prisim of a management friendly outcome and use it to predict the decision of the Delaware Supreme Court.   


More Political and Social Disclosure Likely? 

While the views of past SEC members cannot be used to predict with certainty what will befall the agency in the future, they may provide useful insight.  With that in mind it is worth noting a speech given by Meredith Cross, the former director of the agency's Division of Corporation Finance in which she predicted that Congress is likely to continue requiring the SEC to craft disclosure rules to effect social and political goals.  Earlier posts have discussed this use of the SEC in connection with conflict minerals disclosures and disclosures required of certain resource extractive industry participants.  Ms. Cross predicts that other areas of potential rule-making include corporate political spending, the steps taken by companies to prevent cybersecurity risks, and business dealings with Syria.

“Requiring companies to post potentially embarrassing information…even if the information is not qualitatively or quantitatively material to investors, can be a very powerful motivator to change corporate behavior,…”“Congress has figured this out, and the dam” has broken, Cross said. “And I think there is a significant risk that people will keep pushing for it.”  This of course will require the SEC to both craft disclosure regulations governing areas outside its ordinary purview and to assess the impact such regulations will have on competition, capital formation, and efficiency, as required by the Administrative Procedure Act.   “I'm not sure what the SEC will do with that in the future but it is certainly a very difficult” challenge, according to Cross.

The conflict minerals and resource extractive industry provisions were the first time that Congress has required the SEC to create disclosure regulation for purely social and political goals.  The result of SEC rulemaking in this arena is mixed.  Both rules were challenged shortly after being adopted.   The U.S. District Court for the District of Columbia vacated the resource extraction rule (45 SRLR 1245, 7/8/13), but upheld the conflict minerals rule (45 SRLR 1378, 7/29/13). The SEC did not appeal the decision invalidating the resource rule but said it will undertake further rulemaking pursuant to the court's directions. The decision affirming the conflict minerals rule is on appeal before the U.S. Court of Appeals for the District of Columbia Circuit (45 SRLR 1522, 8/19/13).  

Congress can compel political and social disclosure without requiring the SEC to craft disclosure regulation.  For example, the Iran sanctions law, signed by President Barack Obama signed in August 2012 (44 SRLR 1567, 8/20/12)—includes a provision that requires public companies to report Iran-related dealings to the SEC.  Regardless of the route chosen, it is becoming increasingly common for Congress to turn to disclosure as a method to deter “bad’ behavior rather than attempting to regulate it substantively, particularly “where it would be too expensive, or complex or controversial to regulate the behavior directly.”

Opinions may differ on whether disclosure regulation is the most effective means of achieving Congressional goals with respect to any particular political or social issue.  On one hand, it seems that if Congress is truly concerned with a problem they should take more definitive action to confront it. Disclosure may indirectly influence behaviors but its impact is attenuated at best.  Further, it is worth considering whether disclosure regulation will have its desired result. There is fairly strong evidence that the impact of conflict minerals provision is diametrically opposite to Congressional intent—causing great hardship to the populations it was intended to help.

Even if one accepts that disclosure regulation can be effective and achieve its desired goals, it remains to consider whether the SEC should bear the brunt of furthering political and social goals.  These goals, while often admirable, fall far outside the stated mission of the SEC and far outside its area of expertise.  More thought to the allocation of regulatory authority over disclosure regimes may lead to better results.  Of course, some may argue that the SEC “knows” disclosure and is best situated to take on this role if in fact Congress does continue to expand regulation through disclosure.  While I concede that the SEC has long experience in the area that does not mean that other agencies are not capable of the task, particularly when they have richer institutional knowledge of the subject matter of the disclosures.  If the responsibility for disclosure regulation is allocated to agencies other than the SEC, thought will need to be given as to how best structure a coordinated system.  While that task may be difficult, it should not be used as an excuse to simply continue to put all disclosure demands on the SEC.


Corporations, Power, and Obedience

From today’s Wall Street Journal (here -- subscription required):

This year marks the 50th anniversary of Stanley Milgram's experiments on "obedience to authority." In 1963, two years after the Nazi Adolf Eichmann had claimed at his trial that he was "only following orders" in the murder of Jews during the Holocaust, Milgram wanted to know how many everyday, good Americans would obey an authority figure when directly ordered to harm another human being…. To almost everyone's surprise at the time, upward of two-thirds of the participant-teachers administered what they thought were the highest levels of shock, even though many were sweating and suffering over the pain they believed they were inflicting on a stranger in the name of science. 

I have always thought this experiment had implications for corporate governance and regulation.  In particular, I think it calls into question the characterization of corporations as standing squarely on the private side of the private-public divide, defending individual liberty against encroachment from government.  As I have written elsewhere:

[E]ven if one understands the Citizens United opinion to be fundamentally about listeners’ rights, there remains the question whether there is something about corporations that would justify including them in the line of cases carving out exceptions for particular identity-based restrictions on speech…. Daniel Greenwood's argument that corporations could pursue goals that no individual living human being desired (and that might in fact be harmful to human beings) because the relevant decision-makers were legally required to follow the dictates of a fictional shareholder, could implicate the question of whether corporations should fall within that narrow class of speech restrictions justified on the basis of identity due to “an interest in allowing governmental entities to perform their functions.” (citing Daniel J.H. Greenwood, Fictional Shareholders: For Whom are Corporate Managers Trustees, Revisited, 69 S. Cal. L. Rev. 1021, 1093-94 (1996)).

Defenders of corporations as checks on government, and thus defenders of individual liberty, often cite the fact that only government can employ the police power.  However, this is likely not as decisive an argument as it once was, given the seemingly never-ending creep of privatization and the increasing potential for regulatory capture.  Of course, shifting corporations closer to the public side of the line in this debate raises some uncomfortable questions.  If government and large corporations both wield sufficient power to threaten individual liberty, and can leverage similar claims to authority over individuals as the experimenters in the Milgram study, where is the defender of individual liberty to be found?

I’m obviously painting with a very broad brush here, and I am not suggesting corporations have overtaken, or even caught up to, government in terms of the potential to threaten individual liberty, but I am also not convinced that corporations stand as havens against government overreach that should be as unregulated as possible to maintain that status.


Christians on How Starbucks Lost its Social License

Allison Christians has posted, “How Starbucks Lost its Social License — And Paid £20 Million to Get it Back,” on SSRN.  Here is the abstract:

It is well accepted that corporations require various legal licenses to do business in a state. But Starbucks’ recent promise to pay more tax to the UK regardless of its legal obligation to do so confirms that businesses also need what corporate social responsibility experts call a "social license to operate". Companies may now in effect be required to pay some indeterminable amount of tax in order to safeguard public approval of their ongoing operations. This suggests that even as the OECD moves forward on a project to salvage the international tax system from its tattered, century-old remains, the tax standards articulated by governments will no longer be enough to guarantee safe passage for multinationals. Instead, companies may have to deal with a much more volatile, and fickle, tax policy regime: one developed on the fly by public opinion.


Harris on Corporate Elections and Tactical Settlements

Lee Harris posted a revised version of “Corporate Elections and Tactical Settlements” on SSRN a couple of weeks ago.  It hit my inbox this week.  Here is the abstract:

Once yearly, shareholders get an opportunity to vote on who shall serve on the board of directors. From time to time, these elections for board seats are contested. In a contested election the incumbent board is exposed to the risk that a challenger might succeed in winning a seat on the board and oust the incumbent. Once a contested corporate election begins, the board of directors has limited options. Their fate is sealed and in the hands of shareholder voters. Yet, before the voting begins, savvy boards are relatively adept at avoiding the challenge through tactical settlements. For instance, in 2008, Carl Icahn agreed to give up his challenge for control of Yahoo’s board of directors in exchange for three board seats on the company’s 11-member board. In the same year, Motorola’s board settled a potential fight over control with Icahn by giving up two board seats. Two years later, Genzyme, a large pharmaceutical concern, also agreed to give Mr. Icahn a couple of board seats if he would abandon his contest for control of the board. Shortly, when there is a challenge, the incumbent board is often clever enough to entice potential challengers to drop their bid in exchange for board seats, along with a negotiated payment to the challenger to purportedly reimburse the challengers’ expenses. Through these settlements, even when there is a potential corporate election that might give shareholders a meaningful choice about who will serve on the board of directors and, as important, the strategic direction of the firm, directors are able to sidestep a shareholder vote. Although not previously theorized or examined empirically, settlements allow boards of directors to effectively manage and avoid corporate elections and meaningful shareholder votes. This Article is the first to examine the theory and empirical evidence behind board decisions to settle with challengers in order to avoid a shareholder vote.


Rich v. Kwai: Good Faith and Inroads into the Ostrich Approach to Information (Part 4)

A final word on Rich v. Kwai.

Footnote 138 had an interesting insight.  The Vice Chancellor commented on the signficance of the fact that the directors, when unable to perform their fiduciary duties, resigned.  This, according to the court, did not obviate them from liability.  As the court observed:

  • fact that the directors attempted to fulfill their fiduciary duties   It may be that some of the former independent directors, including Hollander and Brody, attempted to fulfill their duties in good faith. For example, based on the pleadings and Fuqi’s disclosures, the Audit Committee was attempting to investigate the demand before its efforts were thwarted by management. Nonetheless, even though Hollander and Brody purported to resign in protest against mismanagement, those directors could still conceivably be liable to the stockholders for breach of fiduciary duty. As Chancellor Strine recently noted, it is troubling that independent directors would abandon a troubled company to the sole control of those who  have harmed the company. See In re Puda Coal, Inc. S’holders Litig. , C.A. No. 6476-CS 15-17, Feb. 6, 2013 (TRANSCRIPT). I do not prejudge the independent directors before evidence has been presented, but neither are those directors automatically exonerated because of their resignations.

Rich v. Kwai: Good Faith and Inroads into the Ostrich Approach to Information (Part 3)

We are discussing Rich v. Kwai.

In addition to finding that the plaintiffs had alleged inadequate internal controls (the controls were not "meaningful"), the court also examined whether the board was aware of any "red flags" that identified "obvious and problematic occurrences" that would support a claim that they were aware of material weaknesses in the system of internal controls and, despite the red flags, failed to correct the weaknesses.

The court found that sufficient red flags had been alleged.  The court pointed to a number of "warnings" that "all was not well with the internal controls".  Fist was the fact that the company was Chinese and had gained access to the US markets through a reverse merger.  As a result, "Fuqi’s directors were aware that there may be challenges in bringing Fuqi’s internal controls into harmony withthe U.S. securities reporting systems" but, according to the complaint, "did nothing to ensure that its reporting mechanisms were accurate."

The board was also put on alert about accounting problems.  These included the announcement of a restatement and the acknowledgment in the same press release of the likelihood of material weaknesses in the system of internal controls. The board received a letter from NASDAQ warning of the risk of delisting.  As the court reasoned:  "It seems reasonable to infer that, because of these 'red flags,' the directors knew that there were deficiencies in Fuqi’s internal controls".

When confronted with red flags, the board was required to act. 

  • When faced with knowledge that the company controls are inadequate, the directors must act, i.e., they must prevent further wrongdoing from occurring. A conscious failure to act, in the face of a known duty, is a breach of the duty of loyalty. At the very least, it is inferable that even if the Defendants were not complicit in these money transfers, they were aware of the pervasive, fundamental weaknesses in Fuqi’s controls and knowingly failed to stop further problems from  occurring.

The case stands for the proposition that a board cannot rely, as a defense to fiduciary duty claims, that a system of internal controls existed.  To the extent that the controls were not meaningful and the board was aware of red flags concerning deficiencies in the system of controls, the board had a duty to act. 

This is only one case.  But to the extent Delaware gradually veers down a path that would require boards to monitor the system of internal controls in an effective manner and ensure that the system provided adequate information to the board (in this case information about large cash transfers), it would likely make boards far more effective in the monitoring of activities within the corporation.  Said another way, acting like an Ostrich may no longer provide the protections from liability that it once did.


Rich v. Kwai: Good Faith and Inroads into the Ostrich Approach to Information (Part 2)

We are discussing Rich v. Kwai. According to the allegations in the derivative suit, Fuqi engaged in a public offering in 2009, raising approximately $120 million.  Less than a year later, however, problems surfaced.  As the opinion stated: 
  • On March 16, 2010, Fuqi announced that its fourth quarter 10-Q and 10-K for 2009 would be delayed because Fuqi had discovered “certain errors related to the accounting of the Company’s inventory and cost of sales.”  The press release stated that the errors identified were expected to have a material impact on Fuqi’s  previously issued quarterly financial statements for 2009 and that “at least one of the identified deficiencies . . . constitutes a material weakness . . . .”  This press release was followed by another dated April 7, 2010, in which Fuqi disclosed that  it had received a notification letter from NASDAQ that Fuqi was no longer in compliance with NASDAQ rules requiring the timely filing of SEC reports. On September 8, 2010, Fuqi announced that the SEC had initiated a formal investigation into Fuqi, related to Fuqi’s failure to file timely periodic reports, among other matters.

The board formed a special committee to investigate the problems although the court noted that "there is no evidence that the Special Committee performed any investigation". 

In 2011, the company disclosed that the audit committee of the board was investigating certain cash transfers uncovered during the preparation of the resated financial statements for 2009.  As the court described:

  • In essence, Fuqi transferred cash out of the company to third parties, outside of the U.S., who have yet to be verified as legitimate businesses. Fuqi has asserted, but not demonstrated, that the cash has been restored. The press release disclosing these events concluded with “[t]he internal investigation is ongoing.” Since this press release in 2011, Fuqi has provided no additional information about the investigation to the stockholders.

As for the investigation by the audit committee, steps were taken.  After the auditors requested an expedited investigation of the cash transfers: 

  • The Audit Committee retained a Chinese law firm to investigate the transactions and determine whether Fuqi had violated Chinese or U.S. law. In February 2011, the Audit Committee engaged special investigative counsel and a forensic accountant after Fuqi’s auditors requested that the Audit Committee conclude its investigation. After the Audit Committee shared its preliminary findings with its auditors, the auditors requested  that the Audit Committee expand the investigation.

The investigation, however, allegedly "stalled."  The company allegedly "failed  to pay the fees of the Audit Committee’s outside legal counsel, forensic specialists, and auditor. As a result, these professionals have either withdrawn from advising or suspended their services to the Audit Committee."

Plaintiffs brought a derivative action and, among other things, alleged a Caremark claim.  In effect, plaintiffs alleged that the board had inadequate internal controls and had not adequately monitored activities of the company. As the complaint alleged:

  • Each of the Individual Defendants knowingly, and in a sustained and systematic manner, failed to institute and maintain adequate internal controls over Fuqi’s accounting and financial reporting, failed to make a good faith effort to correct or prevent the deficiencies and accounting and financial problems caused thereby, and knowingly caused or allowed the Company to disseminate to shareholders false and misleading financial statements.

The court noted that one type of Caremark claim was to allege that facts showing that "a corporation "had no internal controls in place."  The company had some internal controls but, according to the allegations, the controls were not meaningful. 

  • In its press releases, Fuqi has detailed its extensive problems with internal controls. For example, Fuqi disclosed its “incorrect and untimely recordkeeping of inventory movements of retail operation.” Problems with inventory are particularly troubling here, because Fuqi is a jewelry company, specializing in precious metals and gemstones which are valuable and easily stolen. Nonetheless, the Fuqi directors allowed the corporation to operate few to no controls over these vulnerable assets.

Nor did the meetings of the audit committee result in meaningful internal controls.  "The board of directors may have had regular meetings, and an Audit Committee may have existed, but there does not seem to have been any regulation of the company’s operations in China."

To the court, therefore, it was not enough that the company had in place internal controls.  Instead, the controls had to be meaningful. 


Rich v. Kwai: Good Faith and Inroads into the Ostrich Approach to Information (Part 1)

We are for the most part critical of the governance opinions made by the Delaware courts and have often described them as "management friendly."  Not every decision, however, can be so neatly categorized.  Rich v. Kwai, 2013 Del. Ch. Lexis 106 (Del. Ch. April 25, 2013) is an example,  In striking contrast to the decision in Plains, where the court seemed to apply a quantitative approach to fiduciary duties (the board held "numerous" meetings), this case examined the substance of the behavior and provided a holding that had the potential to elevate fiduciary standards. 

In interpreting fiduciary obligations, the Delaware courts have fostered an "ostrich" approach to decision making by directors.  Despite protestations to the contrary (see Pfeiffer v. Toll, 989 A.2d 683, 693 (Del. Ch. 2010) (declining to "afford an ostrich-like immunity to directors")), the standards adopted by the courts do not ensure that boards are truly informed about important matters that take place inside the corporation.  Moreover, because red flags and other types of disclosure to directors may trigger an obligation to act (in order to avoid allegations of conscious disregard), directors are better off not asking and taking the risk that they will learn something that could result in liability. 

The most notable example of judicial encouragement of the Ostrich Approach is the duty to monitor under Caremark.  These claims arise "from a director’s bad-faith failure to exercise oversight over the company." Rich v. Kwai, 2013 Del. Ch. Lexis 106 (Del. Ch. April 25, 2013).  For the most part, these cases involve allegations that the board had some knowledge of behavior harmful to the company but did nothing in response. 

Such causes of action are based upon intentional harm to the company through conscious disregard.  These cases can be brought where shareholders allege that the "directors utterly failed to implement any reporting or information system or controls".  Stone v. Ritter, 911 A2d at 370.  Alternatively, they are brought when the directors are alleged to have been aware of facts (red flags) that required action.  For the most part, Delaware courts interpret the "red flag" standard in a highly restrictive fashion.  Few cases illustrate this more clearly than In re Citigroup Inc. S'holder Derivative Litig., 964 A.2d 106 (Del. Ch. 2009).  For a post on the case, go here

With respect to the system of reporting or internal controls, the courts have resolutely refused to judge the quality of any such system.  As long as one exists, it is enough to defeat the claim.  The fact that the system did not provide meaningful information on the matter that caused harm to the company is all but irrelevant.  In Amylin, the Delaware court was confronted with an opportunity to at least sometimes impose on directors a duty to ask for specific types of information (in that case, information on how contract provisions could disenfranchise shareholders), but refused to do so. (For a post on the case, go here). 

As a result, directors for the most part can rely on the presence of a reporting system, no matter how porous, to defeat claims based on their lack of knowledge about developments that caused harm to the company. 

Having said all of that, the law in this area may be underoing evolution.  The Chancery Court's recent decision in Rich v. Kwai suggests that the courts may be less willing to allow any reporting system or system of internal controls to be used to exonerate directors from a lack of oversight.  The opinion suggests that in fact the system must be "meaningful" and directors, to the extent aware that it is not, may have a duty to act.  Failing to do so may can be sufficient to demonstrate conscious disregard. 

We will discuss this case over the next several posts. 


Martin on Business and Human Rights

Jena Martin recently published, “Business and Human Rights: What’s the Board Got to Do With It?,” in the University of Illinois Law Review.  Here is the abstract:

Corporate scandals related to human rights issues have illustrated the hefty cost associated with ignoring humanitarian issues while conducting business. For example, the Royal Dutch Petroleum Company (Shell) has spent tens of millions of dollars related to the Nigerian government's execution of the “Ogoni 9,” which was preceded by a tense relationship between the corporation and Ogoni people of Nigeria. In addition, in India, the Vedanta corporation lost substantial market capitalization following a trial related to its mountain mining activities for its effects on the people of the region. Despite the moral duty that may have compelled action in these examples, it is also clear that a corporation's (particularly a transnational corporation's) decision to develop a framework for proactive corporate responsibility is also good business. Assuming the accuracy of this conclusion, this Article questions what role the board of directors should have in formulating this framework in light of the Alien Tort Claims Act and the United Nations' Guiding Principles on corporate responsibility and human rights. This Article admits that the board of directors will face great challenges when incorporating human rights issues into a company's corporate governance. However, given the central role courts are placing on the board of directors, it would be wise to rise to the challenge and make sure that human rights are a key part of their function.


Director Independence and Personal Relationships: The Limits of the NYSE Definition of Director Independence and the Need for Additonal SEC Disclosure

We just completed a lengthy series of posts on In re MFW Shareholders Litigation.  In that decision, the Chancery Court all but created a presumption that directors approved as independent under the NYSE standard would be presumed to be independent under the Delaware standard.   Moreover, the court examined a number of allegations by the plaintiffs that directors were not independent because of business and personal relationships with the owner of the controlling shareholder. 

All of this brings us to the recent election of directors at Revlon.  One of the directors elected by shareholders was Diana Cantor, the wife of the House Majority Leader. According to the proxy statement, she is listed as an independent director.  Id.  ("Ms. Cantor, a new director nominee, qualify as independent directors within the meaning of Section 303A.02 of the NYSE Listed Company Manual and under the Board Guidelines for Assessing Director Independence").  

The description of her background also suggests that she is eminently qualified.  Again, according to the proxy statement:

  • Ms. Cantor (55), who is a new director nominee for the Company, is a Partner of Alternative Investment Management, LLC, an independent privately-held investment management firm (“Alternative Investment Management”), a position she has held since January 2010. In addition, Ms. Cantor is the co-founder and Managing Director of Hudson James Group LLC, a strategic advisory firm providing consulting services in the public and private sectors. Ms. Cantor also serves as the Chairman of the Board of Trustees of the Virginia Retirement System, for which she is a member of its Audit and Compliance Committee. Ms. Cantor served as a Managing Director of the New York Private Bank & Trust (the wealth management division of Emigrant Bank) from January 2008 through December 2009. From 1996 to January 2008, she served as the Founder and Executive Director of the Virginia College Savings Plan, an independent agency of the Commonwealth of Virginia. Ms. Cantor served from 1990 to 1997 as Vice President of Richmond Resources, Ltd. and from 1985 to 1990 as Vice President of Goldman, Sachs & Co. She previously was an associate at Kaye Scholer LLP from 1983 to 1985. Ms. Cantor has served on the boards of directors of the following public reporting companies within the last five (5) years: Media General, Inc. (“Media General”) (2005 — present), for which she also currently serves as chair of its audit committee; Domino’s Pizza, Inc. (“Domino’s Pizza”) (2005 — present), for which she also currently serves as chair of its audit committee; The Edelman Financial Group Inc. (2011 — 2012); and Universal Corporation (2012 — present), for which she also currently serves as a member of its audit committee.

What the proxy statement did not disclose, however, was the relationship between Ms. Cantor, her husband, and Ron Perelman.  Ron Perelman, as the proxy statement notes, is the chairman of the Board of Revlon and owner of most of the shares of Revlon.  See Id. at 3 ("Mr. Ronald O. Perelman, Chairman of the Board of Directors, directly and indirectly through MacAndrews & Forbes Holdings Inc., of which Mr. Perelman is the sole stockholder (together with certain of its affiliates (other than the Company or its subsidiaries), 'MacAndrews & Forbes'), beneficially owned approximately 77% of the combined voting power of the outstanding shares of the Company’s Voting Capital Stock as of the Record Date that are entitled to vote at the 2013 Annual Meeting."). 

According to an article in Politico

  • The Cantors have a longtime friendship with Ronald Perelman, the chairman of Revlon’s board and the head of holding company MacAndrews & Forbes that owns a large chunk of the cosmetic company. Cantor and Perelman dine together in New York, and the majority leader has slept in Perelman’s home, according to sources familiar with the relationship. Perelman is also a major donor to Cantor’s political campaigns – he has donated $47,300 to Cantor’s various political committees. 

The rules of the NYSE require the board to consider, in determining independence, whether the director has a disqualifying personal relationship.  As the Commission has stated:

  • Although personal and business relationships, related party transactions, and other matters suggested by commenters are not specified either as bright-line disqualifications or explicit factors that must be considered in evaluating a director’s independence, the Commission believes that compliance with NYSE’s rules and the provision noted above would demand consideration of such factors with respect to compensation committee members, as well as to all Independent Directors on the board.

The Board of Revlon, therefore, was required to consider personal relationships.   Moreover, boards have disclosure obligations in this area.  See Item 407 of Regulation S-K ("For each director and nominee for director that is identified as independent, describe, by specific category or type, any transactions, relationships or arrangements not disclosed pursuant to Item 404(a), or for investment companies, Item 22(b) of Schedule 14A, that were considered by the board of directors under the applicable independence definitions in determining that the director is independent.").  The language does not, however, expressly reference "personal and business" relationships. 

The Revlon proxy statement is silent on this issue.  To the extent the relatioship between Perelman and Diana Cantor was examined, the Board did not consider it significant enough to impair independence.  Given the analysis in In re MFW, the Delaware courts would probably agree.  Id. ("The allegations of friendliness—for example, that Byorum has been to Perelman's house—are exactly of the immaterial and insubstantial kind our Supreme Court held were not material in Beam v. Stewart."). 

Shareholders, however, might have other ideas.  Yet in this case the disclosure came about only because of the musings of the writers at Politico.  Perhaps it is time for the SEC to make explicit the obligation to disclose personal and business relationships considered by the board in determining director independence, along with the facts about the relationship known to the board.  This would ensure that shareholders were informed, without having to resort to, or depend upon, Politico.


Killingsworth on Communicating Compliance Through Organizational Values and Culture

Scott Killingsworth posted, Modeling the Message: Communicating Compliance Through Organizational Values and Culture, on SSRN back in October.  Since that time it has been downloaded over 1600 times and earned Killingsworth a Burton Award as one of the Best Law Firm Writers for 2013.  Here is the abstract:

Ethical leadership matters. Organizational culture drives compliance and culture is transmitted and reinforced by communications through multiple channels, notably including the observation by employees of management behavior. In particular, employees judge the legitimacy of an organization’s ethical leadership and authority not only by explicit communications received in the workplace but also by messages received via example and practice. This paper surveys behavioral science findings on how cultural attributes and management practices can either promote or undermine voluntary adherence to ethical standards, workplace rules and legal requirements, with special attention to the communicative aspect of management practices. Legalistic, command-and-control messaging is discussed and its inherent limitations and adverse side effects are contrasted with the virtues of ethical or values-based messaging. Particular concepts discussed include decision framing, group identification and commitment, intrinsic versus extrinsic motivation, legitimacy, procedural fairness, and value congruence. Specific markers of an ethical corporate culture are identified and practical suggestions offered for a communications program designed to foster a genuine “culture of compliance.”


Heins on the Priests of Our Democracy

I apologize in advance if this post is a bit too off-topic for some, but I thought the content would be of interest to enough of our readers to justify it.

I used to work in the mental health field, and I frequently heard it said that: “The opposite of insanity is more insanity.”  In other words, it was not really considered an improvement in social functioning if a client who suffered from excessive passivity suddenly over-compensated by becoming overly aggressive.  I think this concept may be relevant to the current debate about tenure.  On the one hand, to the extent tenure has come to be equated with freedom from any sort of meaningful accountability, it seems fair to view it as excessively costly.  On the other hand, the solution far more likely lies in actually holding tenured faculty accountable as intended (by disciplining or firing them when there is cause) than in eliminating tenure.  All of which leads me to Marjorie Heins’ recent book, Priests of Our Democracy: The Supreme Court, Academic Freedom, and the Anti-Communist Purge (2013 Winner of the Hugh M. Hefner First Amendment Award in Book Publishing).  While the book may not be directly on point, since tenure may actually be a tool for limiting academic freedom via its threatened denial or revocation, the more general point that academic freedom is important is obviously relevant to the current debate about tenure.  Here is the summary from the publisher:

In the early 1950s, New York City’s teachers and professors became the targets of massive investigations into their political beliefs and associations. Those who refused to cooperate in the questioning were fired. Some had undoubtedly been communists, and the Communist Party-USA certainly made its share of mistakes, but there was never evidence that the accused teachers had abused their trust. Some were among the most brilliant, popular, and dedicated educators in the city.

Priests of Our Democracy tells of the teachers and professors who resisted the witch hunt, those who collaborated, and those whose battles led to landmark Supreme Court decisions. It traces the political fortunes of academic freedom beginning in the late 19th century, both on campus and in the courts. Combining political and legal history with wrenching personal stories, the book details how the anti-communist excesses of the 1950s inspired the Supreme Court to recognize the vital role of teachers and professors in American democracy. The crushing of dissent in the 1950s impoverished political discourse in ways that are still being felt, and First Amendment academic freedom, a product of that period, is in peril today. In compelling terms, this book shows why the issue should matter to every American.



Public Benefit Corporations in Colorado: What Will A Public Benefit Corporation Accomplish?

Colorado has adopted, effective April 1, 2014, the public benefit corporation act of Colorado (the “PBCA”) that is similar to legislation being considered in Delaware, but completely different from the model benefit corporation act sponsored by B Lab Company ( and adopted in a number of states.  The previous entries have described the background of the Colorado Bar Association’s efforts (led by a group of attorneys supported by the Business Law Section of the CBA, the “Drafting Group”) that led to the adoption of H.B. 13-1138 and discussed the nature of a public benefit corporation (a “PBC”) as well as material provisions of the PBCA.  This post will conclude the discussion of the PBCA.

Properly used, it can be expected that PBCs and benefit corporations will have limited utility.  Proponents of benefit corporations have predicted that “[f]or-profit social entrepreneurship, social investing and the sustainable business movement have reached a critical mass,” and similar sentiments were expressed in the Senate floor debate on H.B. 13-1138.  Whether this is fact or hyperbole remains to be seen.

On the other hand, reaction to the April 24, 2013 collapse of the garment factory building in Bangladesh where more than 900 people were killed shows that people care about social good.  That came on the heels of a fire at another factory in November 2012 that killed 112 low wage workers.  Factories like these in Bangladesh pump out what author Elizabeth Cline (author of Overdressed: The Shockingly High Cost of Cheap Fashion) calls “fast fashion” or clothes made for and sold inexpensively by big chain stores.  Whether these stores suffer any long-term repercussions for these incidents and the working conditions in their Asian garment factories generally remains to be seen.  Will the public care about how and where their clothes are made, or will price continue to be the driving factor?

Clearly retailers, large and small, have focused on “doing good” and making that known publicly for marketing purposes.  As discussed in a previous post, no company needs to be a PBC or a benefit corporation to do so.  Furthermore, the certification organizations, such as B Lab Company, have certified a number of corporations and other entities that are not benefit corporations or PBCs.   So, what corporation may want to be a PBC or a benefit corporation?

B Lab and others believe that simply being known as a benefit corporation or PBC has value.  We will have to see whether this does in fact have any value, or whether the value will be based on the entity’s performance – is it selling or using low cost merchandise made in inhumane conditions not withstanding its purported social mission? 

B Lab and its supporters also believe that the reporting provisions in the statute provide the needed transparency to ensure that the PBC or benefit corporation carries out the shareholders’ will.  But can any self-assessment not audited by an independent third party ever get to the bottom of that question?

There are undoubtedly businessmen and women who truly want to see their organization do better for the world or their community while making a profit.  They may want to see their vision ingrained in the fiber of the corporation so that the vision survives the individual.  It is for this purpose that a benefit corporation or a PBC may have value. 

  • By being a “benefit corporation,” the corporation’s directors are obligated to pursue or create the “general public benefit” “to create a material positive impact on society and the environment” in addition to any specific public benefit identified in the benefit corporation’s articles of incorporation.
  • By being a PBC, the corporation’s directors are obligated to balance the interests of those materially affected by the corporation's conduct with the pecuniary interests of the shareholders and the public benefits identified in the articles of incorporation.
  • Being a PBC is not a permanent occupation, and two-thirds of the shareholders can vote to amend the articles of incorporation to terminate PBC status or to amend the public benefits identified.

While the articles of incorporation of a regular corporation can identify public benefits the shareholders believe to be important and can exonerate the directors for using profit to focus on these benefits, the directors of a regular corporation generally do not have to look beyond the corporation and its defined purposes as does a benefit corporation or PBC.  On the other hand, persons with a view toward maximizing short-term profit have a completely different perspective than persons with a long-term view.   For example, when selling the Nigerian barges to increase 1999 profits, Enron executives clearly were taking a short-term view which proved to be criminal.  On the other hand, modern corporate governance is focused on creating sufficient incentives that encourage corporate management to take a longer term view.  Colorado’s PBCA concurs, directing management to operate the PBC in a “responsible and sustainable manner” – goals applicable not only to PBCs but to all corporations and, in fact, all business entities.

In this light, is there a place for PBCs?  The answer is a cautious “yes.”  Successful businessmen and women may want to see their vision survive their tenure.  Where the balancing requirements of the PBCA (or the “general public benefit requirement of the B Lab model act and its progeny) fit the entrepreneur’s vision, the relevant act may form a reasonable basis for incorporation or adoption.   It must be done carefully and after a consideration of relevant factors and directors’ duties and in light of the shareholders’ needs and desires.  Finally, and perhaps most importantly, becoming a PBC or a benefit corporation is not an “out-of-the-box” activity.  It requires careful drafting of articles of incorporation and consideration of other factors, including designating priorities for the directors to consider and weight to the various factors to be balanced.

The PBCA enabling PBCs is the product of compromise and therefore is imperfect in the eyes of the Drafting Group as well as the proponents of the B Lab model act.  It is also the product of several years of work by the Drafting Group seeking to create a statute for Colorado that protected directors when following public benefit direction from the shareholders but which did not put the corporation and its shareholders in the inflexible handcuffs of the B Lab model act as adopted in a number of states.  It is unlikely that the PBC legislation or any benefit corporation legislation will provide a panacea for the socially responsible business movement. It will, however, put another arrow in its quiver.

Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C.


Public Benefit Corporations in Colorado: Unanswered Questions

Colorado has adopted, effective April 1, 2014, the public benefit corporation act of Colorado (the “PBCA”) that is similar to legislation being considered in Delaware, but completely different from the model benefit corporation act sponsored by B Lab Company ( and adopted in a number of states.  The previous entries have described the background of the Colorado Bar Association’s efforts (led by a group of attorneys supported by the Business Law Section of the CBA, the “Drafting Group”) that led to the adoption of H.B. 13-1138 and discussed the nature of a public benefit corporation (a “PBC”) as well as material provisions of the PBCA.  This post will discuss a number of other unresolved issues facing corporations that elect to become PBCs under Colorado law or benefit corporations under the laws of other states.

The PBCA does not address issues under the Colorado Securities Act (§ 11-51-101 et seq.) which regulates offers and sales of securities in Colorado.  Generally compliance will require disclosure to prospective investors of the public benefit purpose so that investors are not misled into believing that the PBC is a Colorado Business Corporation Act entity with a profit motive and the directors’ duty of care obligations under C.R.S. § 7-108-401(1) “for the best interests of the corporation.”  Other normal compliance with the exemption/registration requirements of the Colorado Securities Act and the licensing of broker-dealers is also required.  If a PBC (or a benefit corporation organized under the laws of another state) solicits funds from investors, it will need to consider the applicability of federal and state laws regulating the offer and sale of securities.

The PBCA also does not address issues that may arise for PBCs under the Colorado Charitable Solicitations Act (§ 6-16-101 et seq.).  The Colorado Charitable Solicitations Act was enacted “to protect the public’s interest in making informed choices as to which charitable causes should be supported” and “to help the secretary of state investigate allegations of wrongdoing in charities, without having a chilling effect on donors who wish to give anonymously or requiring public disclosure of confidential information about charities.”  The Charitable Solicitations Act requires that “charitable organizations” that solicit donations for “charitable purposes” file certain reports with the Colorado Secretary of State.  A PBC’s public benefit purpose may fit within the broad definition of a “charitable purpose” and, as a result, the PBC may be considered to be a “charitable organization.”  If soliciting funds for its public benefit purpose, each PBC should consider whether compliance with the Colorado Charitable Solicitations Act is required and how to accomplish such compliance.

Note that the potential application of the Charitable Solicitations Act is not a problem that was caused by the PBCA.  Limited liability companies can be formed in Colorado to conduct (as set forth in § 7-80-103) “any lawful business” whether or not for a profit.  It can have a hybrid (public benefit or charitable) purpose even if it also is engaged in a business for a profit.  As a result, there is a risk that the PBC (like a limited liability company formed for a public benefit purpose or a non-profit corporation) might solicit funds for “charitable purposes” and thereby be subject to the Charitable Solicitations Act.

The Colorado legislation, and legislation for benefit corporations generally, does not and cannot address the many issues that may arise under the Internal Revenue Code for a PBC pursuing its public benefit purpose. For example, § 162(a) of the Internal Revenue Code authorizes taxpayers to deduct from income their “ordinary and necessary business expenses.” Marketing expenses generally fall within this section, such as the expenses incurred in advertising “organically grown ingredients," "sustainably grown coffee," or "contributions to local schools or charities.” Will expenditures for a public benefit purpose that do not fit within the marketing rubric or which may be excessive when compared to normal marketing budgets be deductible?  That is a question to be answered.

The PBC may be a wholly unsuitable investment for an employee stock ownership plan (an “ESOP”) or other plan governed by the Employee Retirement Income Security Act of 1974 (“ERISA”).  As set forth in ERISA § 404 and the regulations thereunder, the primary responsibility of fiduciaries of an ERISA plan is to run the plan solely in the interests of the participants and beneficiaries, and for the exclusive purpose of providing benefits and paying plan expenses.  What fiduciary will be able to conclude that a PBC or benefit corporation which is not being operated solely for profit or the pecuniary benefit of its shareholders meets the mandated ERISA fiduciary standard of care?  Any decision by an ERISA fiduciary to invest in or hold securities of a PBC or a benefit corporation (or any corporation claiming a purpose other than profit) is likely to be a personally risky decision to the fiduciary under current law.

Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C.


Public Benefit Corporations in Colorado: Why A Public Benefit Corporation Rather Than A Non-PBC?

Colorado has adopted, effective April 1, 2014, the public benefit corporation act of Colorado (the “PBCA”) that is similar to legislation being considered in Delaware, but completely different from the model benefit corporation act sponsored by B Lab Company ( and adopted in a number of states.  The previous entries have described the background of the Colorado Bar Association’s efforts (led by a group of attorneys supported by the Business Law Section of the CBA, the “Drafting Group”) that led to the adoption of H.B. 13-1138 and discussed the nature of a public benefit corporation (a “PBC”) as well as material provisions of the PBCA.  This post will discuss some reasons a corporation may choose to become a PBC.

As noted above, there is a school of thought that a public benefit corporation is necessary because a regular corporation cannot protect its directors when making decisions that may intentionally reduce profit or positive cash flow, or otherwise have no direct correlation to the success of the corporation’s business.

Of course, the business judgment rule serves to protect directors when they make a bad business judgment provided the directors did so in good faith and after a reasonable investigation.  That is not the type of decision in question.  The decision for which the public benefit corporation is useful to protect directors is the intentional decision by the directors to divert some of the corporation’s profit or cash flow to purposes that may have a socially-beneficial purpose (at least in the opinion of the shareholders) which is not intended to have any demonstrable positive impact to the corporation itself.  In effect, the directors are intentionally diverting cash resources which could be used for the benefit of the business or as a distribution to the shareholders to a non-business purpose.  Such an action would likely not be protected by the customary interpretations of the business judgment rule.

It is, of course, possible that the articles of incorporation of a CBCA corporation can include, among its stated purposes, a non-business purpose.  The articles can also include an instruction to the directors that, in pursuing the purposes of the corporation they are to include in their decision-making this other non-business purpose even at the expense of business profit and business opportunities.  This is consistent with the view of Professor Celia Taylor, University of Denver Sturm College of Law who, has said in The Race to the Bottom here:

I continue to believe that special legal designation of benefit status is not necessary.  In time, empirical analysis may be able to establish whether the new legislation in Delaware and elsewhere makes any meaningful difference in corporate behavior or whether it simply provides another avenue for corporations to tout their ‘good’ behavior.

On the other hand, the law supporting that approach is uncertain.  Furthermore, it is important to note that the public benefit corporation and the benefit corporation are designed to do more than simply support a corporation’s view of social responsibility and beneficial causes.  Under the B Lab model act, every benefit corporation must create the general benefit purpose which is defined as follows:

A material positive impact on society and the environment, taken as a whole, assessed against a third-party standard, from the business and operations of a benefit corporation.

This requires that the directors of the benefit corporation look beyond any specific benefit purposes identified in the benefit corporation’s articles of incorporation.

This is similarly the case with the PBCA.  Unlike the B Lab model act, the PBCA does not require that the PBC create the general public benefit.  Also unlike the B Lab model act, the PBCA requires that the PBC pursue or create one or more specific public benefits which are to be described in its articles of incorporation.  However, the PBCA makes it clear that pursuing the identified specific public benefits at the expense of profit is not sufficient.  The PBCA provides that (in their decision-making) the directors must balance:

  1. The pecuniary interests of the shareholders (usually defined as “profit”);
  2. The specific public benefit identified by the PBC in its articles of incorporation; and
  3. The best interests of those materially affected by the corporation's conduct.

The third factor requires the directors to look beyond the PBC itself in their decision-making and is the most significant distinction between a CBCA corporation that has added provisions to its articles of incorporation and a PBC. 

This third factor will require significant future interpretation and at present leads to significant potential uncertainty.  For example, competitors of the PBC are potentially “materially affected by the corporation’s conduct.”

  • Must, then, the directors of a PBC consider the best interests of the PBC’s competitors?  As a part of the balancing process, the answer would be ‘yes.’ 
  • How must the directors, in their decision making process, document their balancing?  May the Board minutes or consent simply state that the directors “approved the following resolutions after balancing the factors set forth in C.R.S. § 7-101-506(1).”  This is to be determined.

It should be noted that the PBCA does not require any specific decision as a result of the directors’ balancing or that the directors give greater weight to one factor over other factors.  Of course, the shareholders could draft the PBC’s articles of incorporation to be more specific or to give more weight to certain factors as compared to others.

Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C.


Public Benefit Corporations in Colorado: PBCs As Compared to Benefit Corporations

Colorado has adopted, effective April 1, 2014, the public benefit corporation act of Colorado (the “PBCA”) that is similar to legislation being considered in Delaware, but completely different from the model benefit corporation act sponsored by B Lab Company ( and adopted in a number of states.  The previous entries have described the background of the Colorado Bar Association’s efforts (led by a group of attorneys supported by the Business Law Section of the CBA, the “Drafting Group”) that led to the adoption of H.B. 13-1138 and discussed the nature of a public benefit corporation (a “PBC”) as well as material provisions of the PBCA.  This post will point out some differences between the B Lab model act and the PBCA.

Provisions In The B Lab Model Act Not Included In The PBCA.

Under Section 102 of the B Lab model act and the legislation previously introduced in Colorado, every benefit corporation had the obligation to create "the general public benefit," defined to be "a material positive impact on society and the environment, taken as a whole, assessed against" a third party standard.  The Drafting Group noted that, among other issues, things good for society (such as increased employment, availability of petroleum products and nuclear energy providing energy for houses, transportation, and factories) may not be good for the environment.  Matters that may be good for the environment (creating large roadless areas, closing down factories, and reducing the availability of energy from petroleum and nuclear sources) may not be good for society.

Under Section 301 of the B Lab model act and the legislation previously introduced in Colorado defined the standard of conduct for directors by requiring the directors, in making any decision for the benefit corporation, to consider the interests of the shareholders, the employees and workforce of the benefit corporation and its suppliers, the interests of the benefit corporation's customers, the community in which the benefit corporation operated and societal factors, the short- and long-term interests of the benefit corporation, and other relevant factors.   This raised a significant concern to the Drafting Group because these considerations were required for each decision made by the board, not merely decisions related to the benefit corporation's general or specific benefit purpose.  Furthermore, unless the directors carefully documented their consideration of each of the factors mandated by the B Lab model act in connection with each decision, the decisions could be questioned.

Section 102 of the B Lab model act as it existed at the time and the legislation previously introduced in Colorado mandated a third party assessment performed on an annual basis against a standard that was defined in the 2011 and 2012 bills introduced in Colorado with almost two full pages of text.  The definitions were in such strict terms that the Drafting Group was convinced that the standard did not yet exist and perhaps could not exist.  (Perhaps in recognition of this, the current version of the B Lab model act has a simpler definition of “third party standard.”)

The B Lab model act and the legislation as initially introduced in Colorado in 2011 did not provide a right for shareholders objecting to the conversion to a benefit corporation to dissent from the transaction.

Section 302 of the B Lab model act requires that benefit corporations that are publicly traded must, and other benefit corporations may, appoint a benefit director who has certain obligations that differ from the other directors.  In addition to being a member of the board, the benefit director must prepare an “annual compliance statement” that offers the benefit director’s opinion whether the benefit corporation “acted in accordance with its general public benefit purpose and any specific public benefit purpose in all material respects during the period covered by the report.”  The B Lab model act exonerates the benefit director from any personal liability unless the liability derives from self-dealing, willful misconduct, or a knowing violation of law.  The Drafting Group believed that including a director with a special constituency different from the other directors was inadvisable under and inconsistent with Colorado law.

Sections 303 and 304 of the B Lab model act contemplates the possibility that benefit corporations may appoint a “benefit officer” and establishes standards of conduct for officers generally.  The Drafting Group believed that the standards of conduct for officers with discretionary authority found in C.R.S. § 7-108-401(1) was sufficient and there did not need to be a special provision for officers of a PBC.

Section 305 of the B Lab model act provides that a “benefit enforcement action” may be brought against the board by the benefit corporation itself.  The Drafting Group did not see the value in this provision because it is the board of directors who would make the determination for the benefit corporation to bring the action.

Section 305 of the B Lab model act also contemplated that persons other than the shareholders of the benefit corporation could bring a derivative action, notwithstanding clear guidance in both the federal and Colorado Rules of Civil Procedure, Rule 23.1 to the contrary.  It is clear in s 7-107-402 of the CBCA and in Rule 23.1 that only equity owners can bring a derivative action, and the right to do so does not extend to directors, owners of an affiliated entity, and “other persons.”

Under § 301 of the B Lab model act and under the original H.B. 13-1138 as introduced in the House there was a clear exoneration of the corporation and its officers and directors of liability for monetary damages if they met the applicable standard of care.  There is no similar provision under the PBCA.  There is merely the provision discussed above that the PBC’s articles of incorporation may provide that a failure by any disinterested director to satisfy the requirements of C.R.S. § 7-101-506 “does not, for the purposes of section 7-108-401 or article 109 [of the Colorado Business Corporation Act] constitute an act or omission not in good faith or a breach [of the director's] duty of loyalty.”  The term “disinterested” is not defined and this leaves room for interpretation.  This, again, is a provision that may be looked at for further amendment.

One provision in the PBCA that is not included in either the Delaware legislation from which the PBCA was adapted or the B Lab model act is that the PBCA includes the right for certain cooperatives organized under Articles 55 or 56 of Title 7, C.R.S., to elect PBC status.

Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C.