Delaware's Top Five Worst Shareholder Decisions for 2011 (Conclusion)

Shareholders in Delaware have a hard time getting a break, as the list of cases in this series demonstrate.  Having said that, we break with tradition to note a few cases that did not push the law in a management friendly manner. 

These included:

In re Del Monte Foods, 2011 Del. Ch. LEXIS 30 (Del. Ch., Feb. 14, 2011), where the court recognized a possible conflict of interest with one of the company's advisors ("Here, the taint of self-interest came from a conflicted financial advisor rather than from management.");

La Mun. Police Emples. Ret. Syst. v. Morgan Stanley,  2011 Del. Ch. LEXIS 42 (Del. Ch. Feb. 17, 2011), where the court recognized that "[b]asic notions of accountability require that stockholders be able to use Section 220 to evaluate whether the demand-refusal decision was made in good faith" and allowed access to an investigative report used by the board in responding to litigation demand. 

Johnston v. Pedersen, CA No. 6567 (Del. Ch. Sept. 23, 2011), where the court found that the board breached its fiduciary duty by "structuring the stock issuance to prevent an insurgent group from waging a successful proxy contest." 

Encite LLC v. Soni, 2011 Del. Ch. Lexis 177 (Del. Ch. Nov. 28, 2011), where the court recognized that "generalized contentions that [directors] relied on expert counsel during the bidding proceess" were
"insufficient to establish fair dealing."  Thus, reliance on counsel was not "outcome determinative of entire fairness." 

We note that our friends over at the Delaware Corporate and Commercial Litigation Blog have done a very thorough recap on the decisions issued by the Delaware courts in 2011.  

Nonetheless, shareholders, as usual, had a bad year in the Delaware courts in 2011.  The trend explains why efforts at reform have been shifted to the federal level and have encouraged federal preemption.  Unable to obtain sufficient ability to participate in the governance process under state law, shareholders seek reform at the federal level.  Thus, say on pay, shareholder access, clawbacks, and jurisidiction of audit and compensation committees have all become matters of federal law. 

The shift to federal law is not without consequences.  Federal law is probably more political.  See Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.  Moreover, federal intervention provides greater room for participation by constituencies other than shareholders and managers.  Thus, for example, Britain is considering reforms of the compensation process in part because of the importance not to owners and managers but to society. 

The trend toward federalization, however, can only be arrested if and when shareholders are given a greater voice under state law.  Until then, preemption is likely to continue. 


Delaware's Top Five Worst Shareholder Decisions for 2011 (#1: The Continuing Concern over the Lack of Diversity on the Delaware Courts)

The Delaware courts, as anyone involved in the corporate area knows, has disproportionate influence, particularly in the area of governance.  In many ways, the courts set fiduciary standards that are, in effect, national in scope. 

Yet the two principle courts -- the Delaware Court of Chancery and the Delaware Supreme Court -- that determine these standards are remarkably undiverse.  The two courts have ten jurists.  The Supreme Court has five justices, four men and one woman.  There are no people of color.  The Court of Chancery has five Chancellors or Vice Chancellors.  There are no women or people of color.  So the two courts collectively have 10% women and 0% persons of color. 

Needless to say, these numbers are hardly reflective of the make-up of the United States.  The country has slightly more than 50% women and 35% people of color (including four states with a majority of minorities).  Even boards of directors of public companies, bodies that are routinely criticized for a lack of diversity, do better than this. 

What about an apples to apples comparison?  How does this lack of diversity compare to the federal courts?  Of the 162 active judges in the US Court of appeals, 49 are women (30%).  The percentage of trial judges?  30%.  See also Lehrer Thesis, at 81 ("the number of female federal judges has increased from 1.2% to 29.5% between 1977 and early 2010.").  Moreover, the trend has accelerated under President Obama. As one AP Story reported:  "Of the 98 Obama nominees confirmed to date, the administration says 21 percent are African-American, 11 percent are Hispanic, 7 percent are Asian-American and almost half — 47 percent — are women."

Does diversity matter?  Some certainly think it does.  When President Obama nominated Elena Kagan to the Supreme Court, he had this to say

  • It is, as Justice Ginsburg recently put it, “one of the most exhilarating developments” -- a sign of progress that I relish not just as a father who wants limitless possibilities for my daughters, but as an American proud that our Supreme Court will be a little more inclusive, a little more representative, more reflective of us as a people than ever before.

Diversity in the Delaware court system is lacking in other ways.  We have noted that most have experience in law firms with a management orientation. 

What about the law schools attended?  Almost all are private and on the East Coast.  Those on the Chancery Court and Supreme Court graduated from Duke (Glasscock), Penn (Holland, Strine and Noble), Boston University (Berger), Harvard (Jacobs), Catholic (Ridgely), and Georgetown (Parsons).  Only two members of the court graduated from a state school, the University of Virginia (Steele & Laster). 

How does this compare to the federal courts?  See Lehrer Thesis, at 41 ("Thus, while these percentages are occasionally a bit more or a bit less, it generally holds true that a slight majority of district court judges attend private or Ivy League institutions for undergraduate and law school.").  In other words, the Delaware bench is more heavily weighed toward private schools than the federal bench. 

We rank this issue #1 this year because the opportunity arose to increase the court's diversity.  The Chancery Court had a vacancy.  The person selected to fill the vacancy, VC Glasscock, looks from his background and initial round of opinions, to be a smart and able jurist.  Nonetheless, he continues the pattern of appointments that lack diversity.  Whatever benefits that arise from a diverse bench, therefore, they are benefits that are not available to the Delaware Chancery Court and Delaware Supreme Court.    


Delaware's Top Five Worst Shareholder Decisions for 2011 (#2: In re Goldman)

More than any case this year, the decision in In re Goldman explains the inexorable shift of compensation decisions from state to federal law. 

Goldman involved a challenge to the compensation practices used by the investment bank and approved by the board.  Shareholders essentially argued that the board approved a compensation scheme that was not designed to benefit shareholders.  By assigning a percentage of net earnings to compensation, the board, according the shareholders, provided employees with an incentive to take risks that maximized short term earnings.  If the risks succeeded, their compensation went up.  If the risks failed, it was shareholders who suffered the consequences.  In other words, the compensation created a "divergence of interest between Goldman’s management and its stockholders."  Shareholders also argued that the amount of compensation was waste since it was significantly higher than that paid by other investment banks.

The case provided the Delaware courts with an opportunity to set some standards with respect to the approval of compensation.  In effect, the court could have required the board to engage in a more exacting review of compensation.  Instead, however, the court dismissed the suit at the pleading stage. 

In doing so, the court first found that the Goldman board was independent.  In an analysis reminiscent of Disney, the court found that numerous connection between the directors and Goldman (or Goldman's foundation) were not sufficient to create reasonable doubt (at the pleading stage) about director independence.  Thus, for example, one director, Rajat Gupta, had connections to three nonprofits, a business school in India, a school of economics and management in China, and a commission for the UN.  Moreover, plaintiff asserted that "a member of these boards and commission, it is part of Gupta’s job to raise money.”  In fact, the Goldman Foundation had given the three organizations a total of $6.7 million since 2002. 

In considering whether these payments raised "reasonable doubt" about Gupta's independence, the court concluded that they did not.

  • The Plaintiffs do not mention the materiality of the donations to the charities or any solicitation on the part of Gupta. The Plaintiffs do not state how Gupta’s decision-making was altered by the donations. Without such particularized allegations, the Plaintiffs fail to raise a reasonable doubt that Gupta was independent.

In other words, the court discounted entirely the possibility that a director could lose his or her objectivity through significant payments by the company (or its foundation) to nonprofits and charities supported by the director.  Instead, shareholders had to show that the payments were subjectively important to the particular director, the type of information not likely to be in the public domain. 

In considering whether directors are "independent," Delaware law already does not adequately account for friendship, former positions with the company, or material income streams in the form of fees.  Moreover, these categories of "independent" directors are well represented on Boards.  See Essay: Neutralizing the Board of Directors and the Impact on DiversityGoldman effectively adds another category, those affiliated with nonprofits, even where the company (or its foundation) makes substantial contributions.  

Given the independence of the board, plaintiffs were stuck with a claim for waste.  In asserting the claim, they alleged that Goldman, when compared to other large investment banks, "consistently allocated and distributed anywhere from two to six times the amounts that its peers distributed to each employee".  In other words, the amount of compensation was excessive.  Rather than at least shift the burden back to Goldman to justify the discrepency, the court dismissed the claim out of hand.

  • A broad assertion that Goldman’s board devoted more resources to compensation than did other firms, standing alone, is not a particularized factual allegation creating a reasonable doubt that Goldman’s compensation levels were the product of a valid business judgment.

Yet in this case, "more resources" included allegations that Goldman paid a multiple of two to six times what was paid by other investment banks.  A showing of disproportionate payments, therefore, is not enough to get a shareholder past a motion to dismiss.

Delaware law relies on "independent" directors to protect the interests of shareholders.  Goldman, however, raises concern over the definition employed by the Delaware courts.  The approach likely explains why, in Dodd-Frank, Congress gave to the SEC for the first time the authority to tamper with the definition of director independence by defining the factors that need to be considered by the board.  The SEC also received authority to regulate the compensation committee of the board.  These transfers reflect congressional concern over the integrity of the compensation process, a concern that was not allayed by the analysis in Goldman

As for the assertion that Goldman paid compensation equal to a multiple of its rivals, it shows that courts in Delaware are not inclined to let cases go forward where the challenge to compensation is based on some type of argument that the amount is excessive.  This is consistent with the view that state law does not adequately ensure that the amounts paid are not excessive.  Initiatives designed to ensure that executive compensation is not excessive will, therefore, have to come from the federal level.      


Delaware's Top Five Worst Shareholder Decisions for 2011 (#3: Espinoza v. HP)

Shareholders in Delaware have a statutory right to inspect records.  Moreover, describing the rights as "tools at hand," the courts have more or less pushed shareholders to excercise these rights before filing a derivative suit.  The approach adds cost and often provides information of questionable value.  Indeed, the courts have essentially used the existence of these rights to blame shareholders when they are not exercised and their derivative suit is dismissed.  See Beam, 845 A.2d at 1056 (“Beam's failure to plead sufficient facts to support her claim of demand futility may be due in part to her failure to exhaust all reasonably available means of gathering facts. As the Chancellor noted, had Beam first brought a Section 220 action seeking inspection of MSO's books and records, she might have uncovered facts that would have created a reasonable doubt.”).

While encouraging the use of inspection rights, the courts have taken steps limit the documents accessible to shareholders.  One common mechanism for doing so is to establish pleading standards that are difficult to meet.  The courts for example require shareholders at the pleading stage to set out a "credible basis" for any alleged proper purpose.  We have noted that this standard at the pleading stage is often insurmountable since the requisite information is frequently not in the public domain.  Our challenge to this standard earned one post the sobriquet from Chancery Court of "sensationalized criticism." 

Espinoza adds to the pleading burdens imposed on shareholders seeking to exercise their inspection rights.  The case involved an attempt by a shareholder to acquire an investigative report prepared by a law firm that looked into allegations of possible wrongdoing by the CEO.  In refusing to require disclosure, the Court conceded that there was a proper purpose and the shareholder had alleged sufficient evidence to meet the credible basis standard.  Nonetheless, the shareholder had the additional burden of showing that the document was "essential" to its purpose or "central" to the board's decision.  The burden of showing "essential" or "central" was placed on the plaintiff.

The burden was, therefore, imposed on the party who did not know the actual contents of the document and who did not have access to complete information on the process used by the board.  Because the burden was on the shareholder, companies were allowed to withhold documents they knew were "essential" so long as plaintiff had not adequately met this evidentiary standard.  As a result, the pleading standards set out in Espinoza effectively ensured that at least sometimes "essential" documents would not be made available.

The reliance on pleading standards to dismiss potentially meritorious claims is more striking given that there was an equitable solution.  The Court could have required that relevant documents be examined in camera, allowing the trial court to determine their relative importance.  Disclosure would not turn upon the strength of the shareholder's allegations but upon the actual importance of the document.  Yet while the Court in Espinoza indicated that in camera review was acceptable, it did not mandate the practice.  Thus the state of the law in Delaware is that shareholders who have raised a proper purpose and have presented a credible basis, are not guaranteed that they will receive all "essential' documents that they have requested. 


Delaware's Top Five Worst Shareholder Decisions for 2011 (#4: The Poison Pill Cases: Airgas and Yucaipa)

Delaware, as we have noted on this Blog, is a management friendly jurisdiction.  Yet in academia, many favor the approach taken by Delaware because they believe that it promotes efficiency.  By allowing maximum discretion in the management of the company, private ordering can flourish and companies can select the most efficient structure that meets their particular needs.  To the extent they operate in an inefficient manner, the market is there to exact a penalty. 

We have questioned this analysis.  The dynamics of corporate law do not permit meaningful private ordering.  Shareholders, for example, cannot initiate amendments to the articles of incorporation.  As such, management has a negotiating advantage, acting as the drafter for any amendment and is able to determine the timing of the approval process.  The problems with private ordering are discussed in  Opting Only in: Contractarians, Waiver of Liability Provisions, and the Race to the Bottom

The management friendly approach and the goal of efficiency often overlap in outcome, but not always.  One place where they do not is with respect to hostile takeovers.  Delaware cases permit the use of defensive tactics to restrict hostile acquisitions even when inconsistent with efficiency goals.  Not all of the jurists in Delaware agree with this approach but they do not control the law in Delaware.  When it comes to a conflict between efficiency and the management friendly approach, it is the Delaware Supreme Court that resolves the outcome and efficiency that is the loser.    

This can be seen from the decision in Airgas The case invovled a poison pill issued by Airgas in an effort to stop an acquisition by Air Products.  Given the law in Delaware, poison pills are difficult to strike down. Under Unocal, the board has an initial obligation to show that the poison pill was adopted in response to a threat.  Threat includes an inadequate price.  As long as an informed board considers the price inadequate, the requisite threat will be present.  

Airgas, however, involved some unique facts.  The poison pill had been in place for a year.  It prevented consumation of a "structurally non-coercive, all-cash, fully financed tender offer directed to the stockholders of the corporation".  Moreover, the extended time period provided Airgas with "more time than any litigated poison pill in Delaware history."  The year long period pesumably provided Airgas with time to find alternative suitors or to convince shareholders it had a better vision for the future than Air Products.  This sentiment was echoed by the Chancellor charged with assessing the validity of the pill.

  • Air Products' advances have been ongoing for over sixteen months, and Airgas's use of its poison pill—particularly in combination with its staggered board—has given the Airgas  board over a full year to inform its stockholders about its view of Airgas's intrinsic value and Airgas's value in a sale transaction. It has also given the Airgas board a full year to express its views to its stockholders on the purported opportunistic timing of Air Products' repeated advances and to educate its stockholders on the inadequacy of Air Products' offer. . . . . In short, there seems to be no threat here—the stockholders know what they need to know (about both the offer and the Airgas board's opinion of the offer) to make an informed decision.

In other words, the poison pill had outlived its usefulness.  The time had arrived to remove the poison pill and allow shareholders to make the final decision.  Or, as the Chancellor indicated, in his "personal view, Airgas's poison pill has served its legitimate purpose."  That, it would seem, was the most efficient outcome. 

But his view and the law of Delaware, as established by the Supreme Court, diverged. As the Chancellor noted, he was hemmed in by a different approach emanating from the state's highest court.  

  • That being said, however, as I understand binding Delaware precedent, I may not substitute my business judgment for that of the Airgas board. The Delaware Supreme Court has recognized inadequate price as a valid threat to corporate policy and effectiveness. The Delaware Supreme Court has also made clear that the "selection of a time frame for achievement of corporate goals . . . may not be delegated to the stockholders." Furthermore, in powerful dictum, the Supreme Court has stated that "[d]irectors are not obliged to abandon a deliberately conceived corporate plan for a short-term shareholder profit unless there is clearly no basis to sustain the corporate strategy."  Although I do not read that dictum as eliminating the applicability of heightened Unocal scrutiny to a board's decision to block a non-coercive bid as underpriced, I do read it, along with the actual holding in Unitrin, as indicating that a board that has a good faith, reasonable basis to believe a bid is inadequate may block that bid using a poison pill, irrespective of stockholders' desire to accept it.

Said another way, the relevant issue was not market efficiency but deference to management.  Because a trial court was "not free to ignore or rewrite appellate court decisions," the Chancellor declined to overturn the poison pill.  

As if to reiterate this approach, the Supreme Court affirmed the decision in Yucaipa.  See Yucaipa Am. Alliance Fund II, L.P. v. Riggio, 15 A.3d 218 (Del. 2011).  Yucaipa involved a poison pill that limited shareholders ability to form groups in a proxy contest.  The Chancery Court found that the proxy contest amounted to a "threat" justifying the pill even though, because of the presence of a staggered board, the insurgent shareholder had no chance of obtaining control.  As the trial court reasoned:  "For starters, the argument ignores the reality that the election of three directors to a classified board is not a trifling event, which gives the prevailing party no influence." 

The case illustrated that poison pills would be upheld even if they significantly impeded the ability of insurgents to elect even a minority of directors through a proxy contest. 

These cases collectively reiterate that when efficiency and the management friendly approach are in conflict, it is efficiency that must give way. 


Delaware's Top Five Worst Shareholder Decisions for 2011 (#5: In re Massey Energy)

In re Massey Energy is a case that, in any other jurisdiction, might be viewed as more positive for shareholders than negative. In Delaware, however, it ranks as the fifth worst shareholder decision for 2011. 

The case arose in a somewhat odd context.  Massey agreed to merge with Alpha Natural Resources.  As part of the merger, derivative claims filed against the board would effectively be eliminated (or more accurately transferred to Alpha).  Plaintiffs, who had filed claims arising from the Upper Big Branch Disaster, a mining disaster in West Virginia where 29 miners were killed, sought to enjoin the merger, arguing that the board of Massey had not adequately taken the value of the derivative action into account in approving the transaction. 

In opposing the injunction, defendants asserted that the fiduciary claims arising out of the Upper Big Branch Disaster were merit less.  In effect, the defendants were arguing that the directors should be given a clean bill of health with respect to the mining disaster.  The Chancery Court, however, had no intention of complying.   There would be no replay of Disney, where the Chancery Court viewed the magnitude of the event as irrelevant to the analysis.  See In re Disney, 731 A.2d 342, 350 (Del. Ch. 1998), rev'd, Beam v. Eisner, 746 A.2d 244 (Del. 2000) ("When the Delaware General Corporation Law is followed, a large severance package is just as valid as an authorization to borrow. Nature does not sink a ship merely because of its size, and neither do courts overrule a board's decision to approve and later honor a severance package, merely because of its size."). 

Plaintiff's claim centered on the failure of the board to ensure compliance with "applicable laws designed to protect the safety of miners,"  thereby contributing to the disaster.  The board defended against the allegations by pointing to considerable "motion" by directors designed to ensure legal compliance.  Moreover, directors had some metrics indicating that "Massey had improved its safety record so that it was in the great middling of American coal operators in terms of committing violations of mining safety laws."

Ordinarily under Delaware law, sufficient motion would be enough to avoid liability.  Under the duty of good faith, directors cannot ignore significant red flags.  Most cases in this area, therefore, involve allegations of red flags and conscious disregard of those red flags.  Where, as in Massey, the board knew about the red flags and responded, plaintiffs are subject to an almost impossible burden of showing that the response was so insufficient that it constituted bad faith. 

Nonetheless, the Chancery Court found that plaintiff had made a sufficient showing to elevate the claim above the standard of frivolous.  The court focused on the failure of the board to alter the management culture at the company.  Whatever "motion" was undertaken by the board, plaintiffs had sufficiently alleged that they were not really intended to "ensure that Massey cleaned up its act."  As the court explained: "when a company has a 'record' as a recidivist, its directors and officers cannot take comfort in the appearance of compliance".  

Having agreed that plaintiffs sufficiently put the behavior of directors at issue, the court then turned around and transformed the entire discussion into dictum.  The court held that the derivative claim, while not frivolous, was immaterial as a matter of law.  In minimizing the amount, the Chancery Court essentially determined that the reality of what shareholders might collect was substantially lower and that this lower amount was not material.  Actual damages collected would be reduced by litigation risk, particularly the need to show scienter on the part of the directors, the difficulty of actually collecting a judgment ("Even if a defendant like [the CEO] has a high personal net wealth, is it high enough to provide a material level of recoupment, particularly if the company has to go after him for the judgment and also to recoup the legal fees it will have to advance for his defense?"), and the limits of D&O coverage.  Id.  ("And if the hope is to settle for the full amount of the D & O insurance, it appears that the total amount of applicable coverage for all of the derivative action defendants is $95 million, which is not a trifle but is also not material in the context of an $8.5 billion Merger."). 

The dynamics identified by the Court are present in all derivative suits.  There is always litigation risk.  There is always the practical difficulty in collecting from individuals.  There is always the likelihood that the settlement will be an amount within the D&O coverage.  The practical import of the decision, therefore, is to hold that derivative suits against large companies are always immaterial as a matter of law.  After all, this Court found that something approaching $100 million in a transaction set at $8.5 billion, or 1.1% of the value, was immaterial as a matter of law. 

This analysis renders as irrelevant the actual claims for damages resulting from alleged mismanagement.  The court essentially limited materiality analysis to the amount of the D&O insurance (but made clear that the collection of even this amount was unlikely).  The approach, therefore, rewards companies that maintain low levels of D&O insurance.  Moreover, for large companies, the amount of coverage is almost never likely to be material.  Apple, for example, at a market capitalization of $363.69 billion, a number it hit this summer, could have D&O coverage of $4 billion and would be right around the 1.1% coverage level that the Court held in Massy was immaterial as a matter of law. 

Moreover, the overbroad analysis was entirely unnecessary.  Shareholders were seeking an injunction.  The Chancery Court held that plaintiffs were not irreparably harmed because they could still pursue damage claims after the merger.  In other words, the Court could have conceded materiality for purposes of the law suit but then found an absence of irreparable harm.  In failing to do so, the opinion provides authority in the future for any company that wants to argue that a derivative suit is immaterial as a matter of law despite claims for substantial damages. 

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


Delaware's Top Five Worst Shareholder Decisions for 2011 (Introduction)

For the fifth year in a row (for prior listings, see 2010, 2009, 2008, and 2007), we ring in the new year with a retrospective on the decisions from the prior year that were the least favorable to shareholders.  There are, as usual, a bounty of choices.  Nonetheless, as in prior years, we narrow the list to five.  Anyway, on with the countdown of the five worst shareholder decisions by the Delaware courts for 2011.


Delaware's Top Five Worst Shareholder Decisions for 2010 (#4: City of Westland Police v. Axcelis Technologies)

Majority vote provisions have been trumpeted as a source of shareholder rights.  They give shareholders the right, in the absence of a proxy contest, to defeat directors nominated by management.  As we have noted, however, these rights are a myth.  Under Delaware law, the most that can happen if a director does not get the percentage dictated by a bylaw or governance policy is that the director must submit a letter of resignation to the board. 

As we have noted, this merely increases the discretion of incumbent directors.  Directors in general cannot remove those elected by shareholders, a relatively ancient but recently reaffirmed principle.  Majority vote provisions amount to an exception to this general rule.  By not providing majority support, shareholders merely transfer to the board the authority to remove the otherwise properly elected nominees.  Moreover, the pattern emerging already (and that was entirely predictable) is that the boards will routinely decline to accept the resignations of the defeated directors. 

The Delaware Supreme Court in City of Westland Police v. Axcelis Technologies, 1 A.3d 281 (Del. 2010) confirmed the mythical nature of majority vote provisions.  We posted on this case back in August.  Posts on the Chancery Court opinion date back to 2009.

In Axcelis, three directors on a staggered board did not get a majority of the votes cast.  They dutifully submitted their letters of resignation.  The Board declined to accept the resignations, mostly noting that it needed the experience and expertise of the defeated directors.  Thereafter, shareholders sought to inspect the records used by the board in rendering that determination.  The request was narrowly drawn.  Shareholders mostly sought agendas of meetings where the resignations were considered and documents distributed to the Board on the matter. 

The Chancery Court denied access to the documents.  Under prevailing law, plaintiffs were obligated to allege some type of mismanagement or improper behavior and produce credible evidence to support the allegations.  In other words, they had no automatic right to information about  board decisions that overturned the will of shareholders. 

The case effectively laid bare the use of pleading standards by the Delaware courts to deny shareholders access to information pursuant to their inspection rights.  The Chancery Court's decision, while philosophically inconsistent with the notion that shareholders have rights to information relative to their status as owners of the country, was faithful to the law created by the Supreme Court (see Seinfeld).   This use of pleading standards to deny shareholders access to information is discussed to some degree in Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty

Nonetheless, the lower court opinion was too much even for the Delaware Supreme Court.  Although affirming the decision to deny access, the Court did what it was asked to do in Seinfeld and did away with the credible basis standard, at least with respect to majority vote provisions.  In effect, the Court held that shareholders could get the underlying documents whenever directors refused to accept letters of resignation pursuant to a majority vote provision.

What the Court gave with one hand, however, it took away with the other.  The opinion made absolutely clear that the standard of review for board decisions to decline to accept resignations was the process driven, impossible to overturn, business judgment rule.  In doing so, the Court rejected application of the Blasius standard, somehow reaching the mystifying conclusion that refusing to accept the decision of shareholders was not a disenfranching act that required application of the compelling justification standard. 

The case makes clear that boards seeking to overturn the will of shareholders under a majority vote provision may do so for any rational reason (their experience is needed on the board).  Future inspection requests will produce evidence of a single meeting and documents that attest to the experience of the resigning directors. 

Axcelis made clear what many have suspected.  While shareholders can vote against an incumbent director under a majority vote provision, the board may (and will) ignore the message.  In other words, the decision confirms that any notion that a majority vote provision gives meaningful authority to shareholders is a myth. 


Delaware's Top Five Worst Shareholder Decisions for 2010 (#5: In re Revlon)

VC Laster is the newest member of the Chancery Court.  He has made a number of bold decisions and will be an interesting figure to watch.  It remains to be seen whether his decision making flair will gradually dim as he incurs reversals by the less colorful approach of the Delaware Supreme Court.

But one of his opinions makes the list this year, In re Revlon, 990 A.2d 940 (Del. Ch. 2010).  We blogged on this case back in April

In many ways, Revlonreflects the bold nature of VC Laster's decision making.   He dealt with what he saw as lawyers not adequately representing the interests of shareholders.  Rather than ignore the situation, he weighed in and took action.  

  • I find that Old Counsel has not provided adequate representation in this case. After the initial skirmish over consolidation and lead counsel status, Old Counsel fell blithely into Cox Communications mode. They literally did nothing.  To put the best spin on it, Old Counsel seemingly recognized that they filed their complaints prematurely and that the consolidated case was subject to a motion to dismiss. I infer that the defendants did not challenge the premature litigation because they wanted the case to stay alive to support a settlement. Everyone knew their parts.

More than criticize, he took action, replacing Old Counsel with New. 

Had that been the extent of the opinion, VC Laster would have sent a firm message to counsel that in his court this type of representation would not be tolerated. 

But the message was obscured by two actions that betrayed hostility towards counsel for plaintiffs in general.  The first was his decision to describe counsel for shareholders in pejorative terms.  As he described:  "Firms who are early filers are frequently early settlers, leading some wags in the defense bar to label them 'Pilgrims.'"  Later in the opinion, he would note that he had "no desire to replace Pilgrims with Puritans."

The term had, until its exposure in the opinion, represented an example of inside baseball.  VC Laster was apparently repeating an adage commonly spoken among the defense bar.  The term (as a pejorative label) appears in no other Delaware case nor in any federal case.  One can find a mention of the term in an article by Professor Coffee.  He provides no citation for the origin of the term but notes that it is derisive.  See ACCOUNTABILITY AND COMPETITION IN SECURITIES CLASS ACTIONS: WHY "EXIT" WORKS BETTER THAN "VOICE", 30 Cardozo L. Rev. 407, 413 n. 15 (2008). 

Future articles and opinions need not use the term in an unattributed manner.  Revlon provides the requisite citation.  The derisive term should have remained a part of the sotto voce conversations of defense lawyers, without bleeding into the judicial lexicon. 

Moreover, the unfortunate terminology could be juxtaposed against his characterization of independent directors.  They were described as "courageous."  This was the case even though, as we noted, their behavior seemed anything but. 

The second unfortunate step was, that in replacing Old Counsel, he faced three firms seeking to intervene, two from New York and one from Delaware.  The three firms had already cobbled together an arrangement.  The two New York firms would act as lead counsel, the Delaware firm was liaison counsel.  Although these firms had no role in the concerns expressed about Old Counsel, VC Laster largely treated them with equal disdain.  As he reasoned:  

  • I therefore find that New Counsel can take over as lead counsel in the case. I will not, however, adopt the leadership structure that New Counsel proposed, in which the Harwood Feffer firm and the Trinko firm would serve as co-lead counsel with Smith Katzenstein as Delaware liaison counsel. The qualifications and modus operandiof the Harwood Feffer and Trinko firms closely resemble those of Old Counsel. As relatively small firms managing a portfolio of representative litigation, the Harwood Feffer and Trinko firms have similar economic incentives to settle early to maximize the net benefit to themselves, rather than expending resources to press litigation further for the benefit of the class. I have no desire to replace Pilgrims with Puritans.

Instead, he appointed liaison counsel as lead counsel.  The basis for the decision?  The reputational capital that liaison counsel had built up with the new Vice Chancellor.

  • The Smith Katzenstein firm, by contrast, is a Delaware law firm that is well-known to the Court. The firm frequently represents paying clients and does not appear to litigate plaintiffs' cases using a portfolio strategy. The members of that firm, including the lead lawyer in this case, have built up reputational capital with the Court and have proven willing to engage in the hard work of actual litigation.

Given the local nature of liaison counsel, VC Laster was in effect announcing that Delaware firms would have greater credibility in his courtroom.  Moreover, his attitudes about Old Counsel was allowed to bleed over into New Counsel, despite any significant evidence of similar concerns.  Whatever reasons VC Laster had in replacing Old Counsel, he lacked similar evidence to disrupt the arrangement worked out by New Counsel. 

We hope that this case does not reflect VC Laster's general views on counsel for shareholders.  We also hope that VC Laster will continue to decide cases in a bold fashion but will avoid the type of actions and language in Revlon that otherwise obscure important and necessary analysis. 


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

We like to bring in the new year with our own countdown. 

For the fourth year in a row (for prior listings, see 2009, 2008, and 2007), we conduct a retrospective on the decisions that emerged from the Delaware courts over the last year and rank the five most anti-shareholder in analysis and result.  There are plenty to choose from.  The courts in Delaware make what can only be described as consistently "management friendly" decisions, often at the expense of shareholders. 

The last four years have seen some evolution.  Overt anti-shareholder rehtoric has decreased, although we will set out a noticeable exception in our countdown.  The Supreme Court hasn't described plaintiffs (aka shareholders) as "prolix" since Wood v. Baum, 953 A.2d 136 (Del. 2008); the Chancery Court since In re Citigroup, 964 A.2d 106 (Del. Chan. 2009).  Prolix is, as we have noted, a term reserved exclusively to describe pleadings submitted by plaintiff/shareholders; never by management. 

In terms of outcomes, however, this has been a very bad year for shareholders.  If there is a trend, it is that this type of outcome is far more common than in the past.  In the 1980s, the Delaware courts occasionally sided with shareholders (Van Gorkom comes to mind; in some ways, Unocal was at least a partial victory for shareholders).   In the new millennium, these sorts of victories are largely nonexistent. 

Anyway, on to the countdown of the five worst shareholder decisions by the Delaware courts for 2010.


Top Top 10 Reasons Why “Independent” Directors Are Not Independent Under Delaware Law

Delaware law provides substantial benefits to companies with boards consisting of a majority of independent directors.  In the case of transactions not involving a controlling shareholder, courts analyze conflict of interest transactions under the duty of care and the business judgment rule.  In demand excusal cases, demand will not be excused where the board has a majority of independent directors.  Yet despite providing these advantages, an analysis of Delaware decisions indicates that, in practice, the test (and the application of the test) for independence does not ensure that directors are in fact independent.  This issue is discussed at length here.   

The topic is a large one and will be addressed throughout the life of this Blog.  Still, we start today with a list of the top reasons why directors treated as independent under Delaware Law are in fact often not independent. 

  1. Delaware courts use a subjective test for defining director independence then disregard it when convenient (such as the categorical exclusion of fees);
  1. Delaware courts effectively exclude from the analysis of independence personal relationships (other than those arising from family bonds);
  1. Delaware courts largely treat as independent directors employed by non-profit organizations where the non-profit receives substantial contributions from the company (or its employees);
  1. Delaware courts impose unreasonable pleading standards, frequently terminating the analysis of independence at the motion to dismiss stage, precluding the use of discovery as a means of uncovering a director’s actual relationship with the company or CEO;
  1. Delaware courts typically examine each allegation of non-independence in isolation, without weighing all of the factors together;
  1. Delaware courts make factual determinations in connection with the analysis of independent directors on motions to dismiss;
  1. Delaware courts discourage challenges to independence by all but requiring plaintiffs to first invoke their inspection rights, a step that adds costs and delay without yielding appreciable benefits;
  1. Delaware courts rely on the standards employed by the stock exchanges to justify findings of independence, without discussing the differences in the standards;
  1. Delaware courts routinely disregard information suggesting a lack of independence at the motion to dismiss stage; and
  1. Delaware courts routinely require, on a motion to dismiss, that plaintiffs produce information about independence that cannot be obtained in the public domain.

Top 10 Benefits Resulting from the Adoption of SOX

1. SOX has improved investor confidence in the financial disclosure of public companies (perhaps there's a relationship between investor confidence and the record high set by the Dow Jones Average last Wednesday, Jan. 24);  see also the student post below this one;  

2. SOX has resulted in the uncovering of a considerable amount of dodgy accounting. A record number of companies have restated their financial statements, with the GAO estimating that the market capitalization of companies announcing restatements between July 2002 and Sept. 2005 "decreased by $63 billion when adjusted for market movement."  GAO Report 6-678 (July 2006).

3. SOX (and the fear of liability) has contributed to the transformation of accounting firms into true gatekeepers against fraud and sloppy financial statements;

4. SOX has resulted in the Audit Committee of the Board of Directors becoming a real watchdog over the accuracy of the financial statements;

5. SOX and the certification requirement has largely eliminated the Bernie Ebbers defense (aka the Ostrich defense) that the financial statements were not the responsibility of the CEO; 

6. SOX, by requiring the attestation of internal controls by independent auditors, has significantly improved the ability of the board to monitor the company’s activities, correcting one of the most serious weaknesses in fiduciary obligations under Delaware law;

7. SOX, by requiring changes of beneficial ownership within two days, has made the practice of backdating more obvious and more difficult;

8. SOX has provided in house counsel with greater leverage to ensure legal and ethical business practices;

9. SOX has provided a greater role for the SEC in the corporate governance process, undoing some of the harm caused by Business Roundtable v. SEC, 905 F.2d 406 (DC Cir. 1990) (see for example the use of the case by Roberta Karmel at Brooklyn Law School citing the case in a letter to the Commission questioning the agency's rule making authority to give shareholders access to management's proxy statement for their director nominees); 

10. SOX has resulted in the widespread use of disclosure committees inside corporate america, broadening the voices involved in the disclosure process; and (I know I said only 10, but its hard to be so limiting when it comes to the benefits of SOX);

11. SOX has encouraged employees to come forward with concerns about financial reporting, through both whistle blowing protections and mechanism that provide mandatory access to the board of directors.