This playlist is a virtual casebook for the Corporations course. I designed it as a substitute for the traditional hardbound casebook.
[Note: I use additional transactional materials in my class (see here for an example). If you are a student in my class, you will receive them as indicated in the syllabus. If you are an instructor who is considering adopting this casebook, please contact me for the additional materials.]
Compared to standard casebooks, I use fewer cases, but I edit them sparingly and sometimes not at all. One reason for this is that the number of seminal cases in corporate law is small. I believe you are better served by knowing the important cases well, rather than by skimming a lot of less important cases. Additionally, much of corporate law consists of broad standards that take on real meaning only in their application. That is why understanding the law often requires reading the full facts of the opinion. The judges clearly considered these factual details important, even on appeal, and so should you! The other reason for focusing on fewer cases is that I want to give you the time necessary to understand the underlying business scenarios, and to reflect on the interactions of the rules discussed in the cases. In corporate law, this is not easy. The structures and transactions are often complex. Please try to understand them as best you can.
I have organized the materials largely around the doctrine and particular corporate events. But any one case involves multiple issues, including the underlying business issues. You will learn better if you try to understand the full case, rather than zooming in narrowly on the headline doctrine.
With one exception, all of the cases in these materials are either Delaware or federal cases. Delaware law is the dominant corporate law of the United States. In the U.S., each state has its own corporate law, and the applicable law is the law of the state of incorporation. Corporations are free to incorporate where they want, in return for paying incorporation tax (“franchise tax”) in that jurisdiction. Delaware has attracted more than half of all public corporations and many private corporations in the U.S. (Delaware derives a third of its state revenue from the franchise tax!) Furthermore, Delaware is also the model followed by many other states. As a result, I see no point in teaching you other states’ law. I occasionally use other countries’ laws to expose you to alternative arrangements; the variance between countries is much larger than between US states.
For similar reasons, I teach only corporations proper. I do not cover partnerships, limited liability companies (LLCs), or the many other entity forms now available. These other forms are undoubtedly important in practice. But an introductory course cannot teach the nuanced differences between these forms, many of which lie in tax law. So I only give you a brief warning about involuntary partnership in the first class. However, the commonalities between the various entity forms are great. So if you understand corporate law and the underlying business problems, I trust you will easily learn the other forms when the need arises.
Bylaws = a corporation’s secondary governing document (cf. DGCL 109). Unlike the charter, the bylaws can be amended by the board without shareholder consent.
Certificate of Incorporation = a corporation’s founding and primary governing document (cf. DGCL 102).
Charter = certificate of incorporation.
Common stock / share: see share.
Debt holders = creditors.
Equity; equity capital = the excess of assets over liabilities, if any (or equivalently, non-debt financing).
Equity holders = shareholders. The term derives from the fact that roughly speaking, equity is available for distribution to shareholders.
Limited liability = no liability (of shareholders). The expression “limited” comes from the observation that shareholders stand to lose whatever they put into the corporation, as this is available to satisfy the corporations' creditors' claims. However, shareholders have no liability beyond that, absent pathological circumstances.
Merger = the fusion of two corporations into one (cf. DGCL 251).
Preferred stock / share = stock with special rights (“preferences”), generally with respect to dividends. A standard term is that preferred shares are entitled to a certain dividend per year, payable if and when a dividend will be paid to common stockholders. In return, preferred shares often do not carry voting rights.
Public corporation = a corporation whose stock is publicly traded, usually on a regulated stock exchange such as the New York Stock Exchange.
Share = an interest in the corporation with rights that are defined by the corporation’s charter. Unlike debt, shares do not provide a right to fixed payouts. Rather, the board decides if and when shareholders will receive so-called dividends. The default rule is that each share provides one vote (cf. DGCL 212) and equal dividend rights; such shares are called “common shares” or “common stock.”
Stock = a synonym or collective term for shares (as in “twenty shares of the corporation’s stock”).EDIT PLAYLIST INFORMATION DELETE PLAYLIST
Edit playlist item notes below to have a mix of public & private notes, or:MAKE ALL NOTES PUBLIC (6/6 playlist item notes are public) MAKE ALL NOTES PRIVATE (0/6 playlist item notes are private)
|1.2.1||Show/Hide More||Litigator's perspective|
|1.2.2||Show/Hide More||Transactional View|
|2||Show/Hide More||The Basics|
This section of the course will acquaint you with the basics of U.S. corporate law. It will also give you an idea of what boards actually do, and introduce you to a variety of shareholder types and relationships.
The basic corporate governance problem is how to control those who have been entrusted with the assets assembled in the corporation: managers and directors.
This economic problem is called an “agency problem”: how to ensure that the “agents” (managers/directors) act in furtherance of the “principals’” (shareholders’) interests rather than the agents’ own interest? If this agency problem cannot be addressed satisfactorily, investors will not be willing to put their money into corporations, and the wealth generating machine matching savers and businesses to finance investment won't work (see The Really Big Picture above). Not employing agents at all is not a solution because centralized management is essential in large organizations. Instead, the trick is to devise appropriate controls.
(NB: the economic terminology of “agent” and “principal” employed in this section is related to, but much broader than, the legal terminology in the law of agency. Legally, managers are agents for the corporation, not for shareholders, and directors aren’t legal agents for anybody – in particular, they are not subject to shareholder directives. From an economic perspective, however, the corporation is a fiction — a convenient way of describing relationships between human beings. In this perspective, directors and managers ultimately work for shareholders and hence are shareholders’ agents in an economic, though not legal, sense.)
U.S. corporate law offers two basic solutions to the corporate agency problem: shareholder voting, and fiduciary duties enforced by shareholder lawsuits.
First, shareholders vote on certain important corporate decisions. In particular, shareholders elect, and can remove, directors, who in turn appoint management. This is often referred to as “corporate democracy” but, as we will see shortly, shareholder voting differs considerably from political elections.
Second, directors and managers hold their corporate powers as fiduciaries, i.e., for the sole benefit of “the corporation and its shareholders.” As fiduciaries, directors and managers owe a duty of care and a duty of loyalty to “the corporation and its shareholders.” Crucially, U.S. courts liberally grant shareholders standing to enforce these duties in court through derivative suits:
“The derivative action developed in equity to enable shareholders to sue in the corporation's name where those in control of the company refused to assert a claim belonging to it. The nature of the action is two-fold. First, it is the equivalent of a suit by the shareholders to compel the corporation to sue. Second, it is a suit by the corporation, asserted by the shareholders on its behalf, against those liable to it.”
Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984).
In addition to voting rights and standing to sue, shareholders also have the right to access certain corporate information. This is an important ancillary right because both shareholder voting and derivative suits require information to work well. DGCL 220 allows shareholders “to inspect for any proper purpose . . . [t]he corporation’s . . . books and records.” Furthermore, publicly traded corporations must make extensive affirmative disclosures under the securities laws.
Finally, shareholders can sell their stock. This is important for individual shareholders’ liquidity, i.e., shareholders’ ability to convert the value of their corporate investment into cash when necessary. However, this so-called Wall Street Walk is useless, at least by itself, as a protection against bad management. If the corporation has bad management, its value to shareholders will be less than it could be, and its stock price will be discounted to reflect this. So a shareholder can sell, but that just locks in the loss from bad management; it does not fix it. (By analogy, an arson victim’s right to sell the land with the burnt ruins hardly compensates the victim for, nor prevents, the arson.) Selling is useful only in as much as it enables a buyer to amass a large enough position from which to challenge the sitting board using the first two tools (voting and suing).
Importantly, U.S. corporate law generally sets only default rules. Charter provisions and other contractual or quasi-contractual arrangements can supplement or alter all or most of these rules. Indeed, “contractual” arrangements pervade corporate law, from the definition of shareholder rights and allocation of management power in the corporate charter, to bylaws on voting, to executive compensation contracts. Read: DGCL 102(b)(1), 151(a), 141(a), and 109(b).
So far, I have framed the basic problem of corporate governance as how to control managers and the board. An important tool of corporate governance, however, is control of managers by the board. Arguably, the primary role of a board composed mostly of outside members (i.e., non-management) is to select, monitor, and thus control managers. It is now standard or even legally required for public corporations’ boards to consist mostly of independent directors, i.e., directors who do not have other relationships with the corporation, especially not a role in management. That being said, in U.S. corporations, it is still customary for CEOs and other top managers to sit on the board and even to chair it.
Some countries go even further and fully separate outside directors and management. Under the so-called two-tier system, a “supervisory board” composed exclusively of outside directors is superimposed on the “management board” composed of top managers. Shareholders elect the supervisory board, which in turn appoints and monitors the management board. (In some jurisdictions the supervisory board is self-nominating or partially elected by the corporation's employees.)
But while directors may indeed monitor management, this only shifts the basic problem one level up: how can we control those who have been entrusted with this monitoring role? Quis custodiet ipsos custodes?
Monitoring the monitor is a particularly acute problem with respect to large, dominant shareholders. Most public corporations around the world have a dominant shareholder. In the U.S. and in the U.K., dispersed ownership is the norm but far from universal. On the positive side, dominant shareholders help overcome shareholders' collective action problem in monitoring managers and the board. On the flip side, however, dominant shareholders may attempt to extract a disproportionate share for themselves. Delaware limits such minority abuse by imposing fiduciary duties on “controlling shareholders.” Other jurisdictions impose super-majority requirements, or outright prohibit certain transactions, etc.
In general, a shareholder needs to own close to 50% of the outstanding stock to control the corporation. (“close to” because some other shareholders tend not to vote, such that the controlling stockholder can command a majority of the stock voted at the meeting even though owning less than a majority of the stock outstanding.) However, if the corporation issues multiple classes of stock with differentiated voting rights (“dual class stock”), a shareholder can control (by owning the high-voting stock) even while owning only a small fraction of the cash flow rights (cf. Google Exercise above, and “Shareholder Democracy” below). This exacerbates the conflict of interest with the other shareholders: the lower the controlling shareholder's proportional economic stake in the corporation, the higher the controlling shareholder's gain from diverting value from the corporation into the controlling shareholder's own pockets (cf. Some (Not So) Fictitious Examples in the Duty of Loyalty section below).
Many non-U.S. jurisdictions prohibit dual class stock, but dominant shareholders employ a pyramid structure to achieve a very similar result. To wit, the dominant shareholder will be the majority shareholder of corporation A, which is in turn the majority shareholder of corporation B, which may be a majority shareholder of corporation C, and so on. In such a structure, the dominant shareholder controls each of the layers even though economically the dominant shareholder only receives much less than 50% of the cash flows from the lower layers. For example, if the dominant shareholder owns 50.01% of the stock of A, which owns 50.01% of B, which owns 50.01% of C, then the dominant shareholder indirectly controls C even though the dominant shareholder will receive only 50.01% × 50.01% × 50.01% = 12.51% of any dividend paid by C and passed through B and A to their respective shareholders. In the U.S., pyramids are tax-disadvantaged, and for this and perhaps other reasons virtually inexistent. (For the avoidance of doubt: U.S. corporations do employ holding structures where the top-level corporation owns several subsidiaries, which may own sub-subsidiaries and so on, but all the subsidiaries are wholly-owned by their respective parent(s).)
I defer until the end of the course the question of whether corporate law does or should protect constituencies other than shareholders (often called “stakeholders”), such as creditors, workers, or customers. For the time being, I just note that the question is not whether stakeholders should be protected at all, but whether they should be protected by the tools of corporate law beyond the level of protection afforded by contract (loan agreements, employment contracts, collective bargaining, etc.) and other branches of law (employment law, labor law, consumer law, etc.).
Enforcement and its problems are of paramount importance for corporate law. At the extreme, if general law enforcement were too weak, managers could, for example, simply abscond with the corporation’s money. No fiduciary duties, shareholder litigation, or shareholder voting could protect against this. Fortunately, criminal law enforcement in the U.S. is strong enough that outright fraud and theft are not the most pressing concerns and can be mostly ignored in this course.
In the more subtle form of inadministrability, however, enforcement problems are key to understanding the rationale behind much of corporate law — and indeed behind much of law generally. Administrability refers to courts’ ability to administer the laws as written. The problem is that courts often lack the requisite information. For this reason, many superficially appealing rules do not work as intended. For example, it is certainly desirable that managers always do only what is best for shareholders, or at least what they think is best for shareholders, and that they do so flawlessly or at least to the best of their abilities. Formally speaking, that is indeed more or less what fiduciary duties require of managers. That does not mean, however, that it is realistic to think that courts could actually enforce such a standard. Courts may not know what action was best for shareholders, much less what the managers truly thought was best for shareholders. Nor can courts easily know whether managers gave their best. Courts will inevitably misjudge many careful, loyal actions as disloyal or careless, and vice versa — in spite of costly and lengthy investigations.
Faced with such difficulties, it may be best to forego costly judicial review altogether unless a transaction raises a red flag. The reddest of red flags is when the decision would financially benefit the decision-makers or their affiliates more than (other) shareholders. That, in a nutshell, is the approach taken in Delaware and other U.S. states and epitomized by the business judgment rule. We will dive deep into the details later. For now, here is the scoop in the words of the seminal case, Aronson v. Lewis:
“The business judgment rule is an acknowledgment of the managerial prerogatives of Delaware directors under Section 141(a). It is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Absent an abuse of discretion, that judgment will be respected by the courts. . . .
[However, the rule’s] protections can only be claimed by disinterested directors . . . .. From the standpoint of interest, this means that directors can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from it in the sense of self-dealing . . . . See 8 Del.C. § 144(a)(1).
[Moreover], to invoke the rule's protection directors have a duty to inform themselves, prior to making a business decision, of all material information reasonably available to them. Having become so informed, they must then act with requisite care in the discharge of their duties. While the Delaware cases use a variety of terms to describe the applicable standard of care, our analysis satisfies us that under the business judgment rule director liability is predicated upon concepts of gross negligence."
473 A.2d 805, 812 (Del. 1984) (footnotes and internal references omitted).
More generally, many rules of corporate law are decidedly second-best. That is, they are optimal only in recognition of the difficulties of enforcing any alternative rule. Agency problems can be reduced. They can never be eliminated.
|2.1||Show/Hide More||Shareholder Voting|
Shareholders vote to elect the board and to approve fundamental changes, such as charter amendments (cf. DGCL 242(b)) or mergers (cf. DGCL 252©). Other matters may be submitted to a shareholder vote.
Shareholder voting is often labeled “shareholder democracy.” It differs considerably, however, from political elections in contemporary democracies such as the U.S.
First, the default rule in corporations is one vote per share (“one share one vote”), rather than one vote per shareholder (cf. DGCL 212(a)). Moreover, the corporate charter can authorize the issue of shares with different voting rights (DGCL 151(a)), which corporations such as Google, Facebook, or Snap have done: their founders hold high-voting stock, whereas outside investors hold low- or non-voting stock, such that the founders can maintain control even after selling a majority of the equity (measured by cash flow rights) to outside investors.
Second, voting rights are determined on the “record date,” 10-60 days before the actual vote (DGCL 213). At least in practice, one keeps one’s voting rights even if one sells the shares in between. (Any problem with this?)
Third, incumbents enjoy a large advantage. They control the voting process, and the corporation pays for their campaign.
Fourth, rational apathy is more pronounced in shareholder voting than in (national) political elections. In large corporations with dispersed ownership, an individual small shareholder has practically no influence on the outcome. It is thus rational for the shareholder not to spend time and resources learning about the issues at stake (“rational apathy”). So-called institutional investors such as pension funds or mutual funds might have more influence but their decision-makers lack the incentive to use it: The decision-makers are the funds’ managers, but the benefits of higher share value accrue primarily to the funds’ beneficiaries. (You might think that a fund manager benefits indirectly by attracting more new customers if the fund generates a higher return for existing customers. This is true for some idiosyncratic funds. But many funds, particularly index fund, invest in the same assets as their competitors and are evaluated relative to one another. The only way such funds can distinguish themselves from their competitors is through lower cost. For these funds, spending resources on voting hurts their competitive position relative to passive competitors even if the voting does lead to higher asset values.)
Unless otherwise provided in the charter or the statute, a majority of the shares entitled to vote constitutes a quorum (DGCL 216.1), and the affirmative vote of a majority of the shares present is required to pass a resolution (DGCL 216.2). The default for director elections is different (plurality voting, DGCL 216.3), but most large corporations have instituted some form of majority voting rule for director elections as well. This matters mostly when shareholders express their dissatisfaction through a “withhold campaign” against a particular director. Under the default rule, the director could be elected with a single vote (if running unopposed, as is the norm).
A more radical but rare deviation from the default rule is cumulative voting. See DGCL 214 for the technical details. Roughly, cumulative voting ensures proportional representation. Cf. eBay v. Newmark later in the course.
The corporation must hold a stockholder meeting at least once a year, DGCL 211(b). Under the default rules, only the board can call additional meetings (DGCL 211(a)(1)); shareholders may act instead by written consent (DGCL 228), but even that possibility is usually excluded in the charters of public corporations.
By default, all board seats are up for election every year. Under DGCL 141(d), however, the charter or a qualified bylaw can provide that as few as one third of the seats are contestable each year, i.e., that directors hold staggered terms of up to three years. This so-called “staggered board” probably seems like technical minutiae to you now. But it turns out to be an extremely important provision because it may critically delay anybody’s attempt to take control of the board. We will first see this in Blasius. An important complementing rule is that unlike standard boards, staggered boards are subject to removal only for cause (DGCL 141(k)(1); cf. DGCL 141(k)(2) for the case of cumulative voting).
In principle, shareholders still vote at a physical “meeting” (but see the possibility of action by written consent, DGCL 228). But in large corporations, few shareholders attend such meetings in person, and those who do may not be the most important ones. Instead, shareholders vote by mail — sort of. U.S. corporations do not mail shareholders a proper ballot. Instead, the board solicits “proxies” on behalf of, and paid by, the corporation. Shareholders “vote” by granting or withholding proxies, and by choosing between any options that the proxy card may provide.
A proxy is a power of attorney to vote a shareholder’s shares (cf. DGCL 212(b) — see sample card here (2nd last page)). The board solicits proxies on behalf of the corporation to ensure a quorum, to prevent a “coup” by a minority stockholder, and because the stock-exchange rules require it (see, e.g., NYSE Listed Company Manual 402.04). The board decides which proposals and nominees to include on the corporation’s proxy card, with the exception of SEC proxy rule 14a-8, which allows shareholders to submit certain proposals for the corporation’s proxy card (see below). The corporation pays.
Occasionally, “insurgents” solicit their own proxies in opposition to the incumbent board, usually in order to elect their own candidates to the board. This is called a proxy fight. Outside the takeover context, however, proxy fights are very rare. Shareholders face a considerable collective action problem. The soliciting shareholder bears the entire cost of the solicitation, while receiving only a fraction of any benefit created.
This explains why it is so important who or what gets onto the corporation’s proxy card. If it’s not on the corporation’s card, it won’t receive any votes at the meeting, even if properly moved during the meeting. As far as the board is concerned, that’s not a problem. They’ll put onto the corporation’s card whatever resolution and candidate they support. By contrast, challengers must rely on the law to get their proposals onto the corporation’s card, otherwise boards happily reject the challengers’ proposals. The “Proxy Access” section below deals with this question directly.
Proxy solicitations are heavily regulated by the SEC’s proxy rules (Regulation 14A promulgated under section 14 of the Securities Exchange Act). As a result, the rules of corporate voting in the U.S. are a complicated interaction of federal proxy rules, state law, and a corporation’s bylaws and charter.
The federal proxy rules are tedious. I provide a guide at simplifiedcodes.com. For a first course on corporations, you only need to know the following:
1. Before any proxy solicitation commences, a proxy statement must be filed with the SEC (rule 14a-6(b)). In contested matters, a preliminary proxy statement must be filed 10 days before any solicitation commences (rule 14a-6(a)).
2. The content and form of the proxy materials are heavily regulated (rules 14a-3, – 4, and – 5, and Schedule 14A). Virtually everything you see in an actual proxy statement is prescribed by the rules.
3. “Proxy” and “solicitation” are defined extremely broadly (rule 14a-1(f) and (l)(1)). Accordingly, the sweep of the proxy rules is very wide. In fact, in the past, the proxy rules impeded even conversations among shareholders about their votes. Certain exceptions to the definitions (particularly rule 14a-1(l)(2)(iv)) or requirements (particularly rules 14a-2(a)(6) and 14a-2(b)(1)-(3)) are therefore extremely important — you should read them.
4. Rule 14a-8 is the only federal rule requiring corporations to include shareholder proposals in the corporation’s proxy materials. Under the rule, corporations must include in their proxy certain precatory resolutions and bylaw amendments sponsored by shareholders. By contrast, the rule does not cover director nominations or anything else that would affect “the upcoming election of directors” (see official note 8 to paragraph (i) of the rule). You should read the rule — unlike the rest of the proxy rules, it’s written in plain English.
5. There is a special anti-fraud provision (rule 14a-9).
HLS Inc. has a single class of stock and three shareholders owning one third each: John M., John G., and Kristen S. Each shareholder is also a member of the current board. John M. currently serves as CEO. HLS Inc. generates about $10 million in annual profits; it has traditionally paid out all profits to the three shareholders every year.
Consider the following questions – what is the answer under the Delaware statute, not considering fiduciary duties (which will [fortunately] change many of the answers)?
|2.1.1||Show/Hide More||Schnell v. Chris-Craft Industries, Inc. (Del. 1971)|
|2.1.2||Show/Hide More||Blasius Industries, Inc. v. Atlas Corp. (Del. Ch. 1988)|
Blasius is the classic Chancery Court decision applying, and expanding on, Schnell. What exactly does Chancellor Allen have to say about corporate voting— what is it about voting that is important? Does Allen’s discussion of voting, its importance, and its judicial treatment matter for the ultimate outcome of the case here? If not, why would he have bothered?
As always, also pay attention to what is going on in the underlying business dispute: Is this a normal vote taken at a meeting? What did the board do to frustrate the vote, and why would that work?
I edit this case more than usual because it involves M&A issues and terminology that we will only learn later in the course. For present purposes, it is enough to understand that Blasius attempted to get its people elected to the Atlas board, and that Atlas's management did not like this at all.
|2.2||Show/Hide More||Fiduciary Duties|
As previously mentioned, fiduciary duties originate in equity and comprise the duty of care and the duty of loyalty. Both duties apply equally to directors and officers (Gantler v. Stephens, Del. 2009). Controlling stockholders are subject to fiduciary duties as well and generate some of the most important duty-of-loyalty cases (cf. Sinclair in this section and Weinberger, MFW, and Delphi in the M&A part of the course).
As a first approximation, the duties of care and loyalty target what their names imply: the duty of care demands that the fiduciary act with appropriate care, while the duty of loyalty demands that the fiduciary act loyally, i.e., guided by the interests of the principal. In other words, the former addresses simple mistakes, while the latter addresses conflicts of interest, i.e., self-dealing. Delaware courts vigilantly police self-dealing but are unreceptive to claims of honest mistakes.
|2.2.1||Show/Hide More||Conflicted behavior (self-dealing): The Duty of Loyalty|
(Minority) Shareholders' interests are most at risk in transactions between the corporation and its controllers, be it management or large shareholders. The risk is obvious: the controllers may attempt to extract a disproportionate share of the corporation’s value for themselves, at the expense of (minority) shareholders.*
Here are three typical ways controlling shareholders do it. I will illustrate using a fictitious oil company, OilCo, with a controlling stockholder, Mikhail. Mikhail owns 50% of OilCo, and 100% of another fictitious company, Honeypot.
1. The first thing Mikhail can do is to have OilCo sell its oil to Honeypot at below-market prices. For example, if the market price of oil is $16 per barrel, Mikhail might arrange for OilCo to sell its oil to Honeypot for $10. For every barrel of oil, this redistributes $3 from minority shareholders to Mikhail. Why? Because if OilCo had sold its oil on the market instead, it would have received $16 per barrel. These $16 would have been shared equally between Mikhail and the minority shareholders. Each would have received $8. But when OilCo instead sells to Honeypot for $10 per barrel, minority shareholders get only $5 (half of $10). The difference of $3 is captured by Mikhail: per barrel of oil, he gets $5 as a shareholder of OilCo and $6 as the sole shareholder of Honeypot (because Honeypot buys for $10 and sells for $16, generating a $6 profit), or a total of $11. The use of artificially inflated or deflated prices to shift value from one company to another is called a transfer pricing scheme. It is also used for tax avoidance purposes.
2. Mikhail can also have OilCo issue new shares to himself or to Honeypot at low prices. For example, imagine that OilCo owns oil fields worth $100 m(illion), and that OilCo has one million shares outstanding. That means each share is worth $100 (assuming no transfer pricing scheme), and Mikhail’s 50% stake and the 50% minority shares as a group each comprise 500,000 shares worth $50 million in total. Mikhail now has OilCo issue 100 million shares to himself at $0.01 per share for an overall price of $1 million. This means three things. First, OilCo is now worth $101 million: In addition to the $100 million oil field, it now has the $1 million cash that Mikhail put in for the new shares. Second, Mikhail now owns almost the entire company, owning 100.5 million out of 101 million shares (99.5%). Third, the transaction earned him $49.5 million: Before the transaction, Mikhail owned OilCo shares worth $50m (50% × $100m). After buying the new shares, Mikhail now owns shares worth $100.5m (99.5% × $101m). Thus, Mikhail spent $1m to increase his OilCo holding by $50.5m ($100.5m – $50m), generating a pure profit of $49.5m ($50.5m – $1m). Mikhail’s gain is the minority shareholders’ loss: they lost $49.5 million in this dilution of their share.
3. Finally, Mikhail can also dispense with the minority altogether by selling OilCo’s assets to Honeypot for a low price. To wit, he could have OilCo sell its oil fields to Honeypot for less than their $100 million value. This is another transfer pricing scheme, but executed on OilCo’s productive assets rather than its products, and hence also known as asset stripping. As with other transfer pricing schemes, it can also be done in reverse: Mikhail could have OilCo buy an asset from Honeypot at an inflated price.
None of these schemes is fictitious at all. For example, they are stylized versions of what Mikhail Khodorkovsky and all the other Russian oligarchs are said to have done to the oil companies they came to control in Russia in the 1990s. Russian corporate law erected barriers to such self-dealing. But corrupt, scared, or just plain incompetent courts breached those barriers. It is a vivid illustration of the importance of the general “legal infrastructure” for the enforcement of corporate law. See generally Bernard Black, Reinier Kraakman, and Anna Tarassova, Russian Privatization and Corporate Governance: What Went Wrong?, 52 STAN. L. REV. 1731 (2000).
Now back to the U.S., where we nowadays take a functioning “legal infrastructure” for granted. What protections does it offer against minority expropriation?
First, public corporations must disclose all self-dealing transactions in an amount above $120,000 in their annual report (item 404 of the SEC’s Regulation S-K). Managers or a controlling shareholder may choose to not comply with this rule, but only at the risk of becoming the target of an SEC enforcement action.
The only provision of the DGCL that explicitly addresses self-dealing is DGCL 144. On its face, DGCL 144 merely declares that transactions between the corporation and its officers and directors are not void or voidable solely because of the conflict of interest, provided the transaction fulfills one of the three conditions in subparagraphs (a)(1)-(3). This statutory text implies that transactions not fulfilling either of these conditions are automatically void or voidable. But the text leaves open the possibility that some conflicted transactions might be void or voidable even though they do fulfill one of the three conditions of DGCL 144(a)(1)-(3).
Notwithstanding, Delaware courts do treat the three conditions as individually sufficient and jointly necessary for the permissibility of self-dealing by directors and officers. That is, self-dealing by officers and directors is beyond judicial reproach if and only if it has been approved in good faith by a majority of fully informed, disinterested directors or shareholders, or it is otherwise shown to be “entirely fair.” The courts do not derive this formulation from DGCL 144, however, but from “equitable principles.” Moreover, controlling shareholders are subject to more stringent review: their self-dealing is always reviewed for “entire fairness;” approval by a “well-functioning committee of independent directors” or by fully informed disinterested shareholders merely shifts the burden of proof (subject to the recent doctrinal-transactional innovation of Kahn v. MFW, covered in the M&A part of the course).
What is “entire fairness”? It is not clear anybody knows. The Delaware Supreme Court essentially refuses to define it. In the authoritative words of Weinberger (covered in the M&A part below):
“The concept of fairness has two basic aspects: fair dealing and fair price. The former embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained. The latter aspect of fairness relates to the economic and financial considerations of the [transaction], including all … elements that affect the intrinsic or inherent value of [the object of the transaction]. … However, the test for fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness.”
Presumably the message to fiduciaries is: if you are self-interested, then you better pay top dollar and generally go out of your way to show you treated the corporation fairly (or, if you are a mere director or officer, you get absolution from the independent directors or shareholders).
Before diving into the details of this self-dealing jurisprudence, consider a preliminary question: why permit any self-dealing? Delaware law can be characterized as an attempt to differentiate self-dealing that expropriates shareholders, from self-dealing that does not. It is likely that courts will make mistakes, however, and that some expropriation will slip through the judicial cracks.** Why not seal those cracks by prohibiting all self-dealing? The potential harm from self-dealing is great. What is the redeeming benefit, if any?
* There is nothing intrinsically wrong with “disproportionate” value sharing if “disproportionate” is measured against some extra-contractual standard such as equal dollar per person. Rather, what I mean by “disproportionate” here is disproportionate relative to the contractually agreed split.
** The transactions at issue in Sinclair (the oil sales), Weinberger, and Americas Mining below resemble the three Mikhail examples above. While they were ultimately caught, the controlling shareholders in these Delaware corporations must have thought they might get away with the expropriation. And sometimes, they arguably do, as in Aronson (which, viewed in a skeptical light, resembles the first Mikhail example above).
|188.8.131.52||Show/Hide More||Guth v. Loft (Del. 1939) [Pepsi]|
Guth is the mother of all Delaware duty of loyalty cases. The decision introduces the basic idea that it is incumbent on the fiduciary to prove that the fiduciary acted “in the utmost good faith” (or, in modern parlance, with “entire fairness”) to the corporation in spite of the fiduciary’s conflict of interest. As mentioned above, approval by a majority of fully informed, disinterested directors or shareholders can absolve the fiduciary or at least shift the burden of proof. In Guth, however, the Court of Chancery had found that Guth had not obtained such approval from his board.
The decision deals with two separate aspects of Guth’s behavior. The corporate resources that Guth used for his business, such as Loft’s funds and personnel, clearly belonged to Loft, and there was little question that Guth had to compensate Loft for their use. The contentious part of the decision, however, deals with a difficult line-drawing problem: which transactions come within the purview of the duty of loyalty in the first place? Surely fiduciaries must retain the right to self-interested behavior in some corner of their life. Where is the line? In particular, which business opportunities are “corporate opportunities” belonging to the corporation, and which are open to the fiduciaries to pursue for their own benefit? Cf. DGCL 122(17). And why does it matter here, seeing that some of Guth's actions clearly were actionable self-dealing? Hint: Which remedy is available for which action?
|184.108.40.206||Show/Hide More||Sinclair Oil Corp. v. Levien (Del. 1971)|
|2.2.2||Show/Hide More||Unconflicted behavior (mistakes): The Duty of Care|
Is there room for liability — and thus judicial involvement — in corporate decision-making, outside of self-dealing? Applying the business judgment rule, Delaware courts hardly ever sanction managers and boards absent self-dealing. Nor do other states’ courts. In a well-known case, the New York Supreme Court absolved American Express's board of liability even though they had forgone an $80 million tax benefit (in today's money) without any convincing countervailing benefit. Some have called this area of the law the “law of director non-liability.”
This raises two questions: Why no liability? And if there truly is no liability, why not say so outright and save the expense and distraction of litigation?
Importantly, the cases in this area still involve conflicts of interest, albeit of a subtler kind than the outright financial or similarly strong conflicts giving rise to claims of self-dealing. Boards' and managers' interests diverge from shareholders' interests at least inasmuch as the former have to do all the work but surrender most of the benefits to the latter, incentive compensation notwithstanding. As you read the cases, you should be on the lookout for more specific conflicts.
|220.127.116.11||Show/Hide More||Smith v. Van Gorkom (Del. 1985)|
This is the one case where Delaware courts imposed monetary liability on disinterested directors for breach of the duty of care. It caused a storm. Liability insurance rates for directors skyrocketed. The Delaware legislature intervened by enacting DGCL 102(b)(7), which allows exculpatory charter provisions to eliminate damages for breaches of the duty of care (see next section). Such charter provisions are now standard. Even without them, however, it is unlikely that a Delaware court would impose liability on these facts today. The courts seem to have retrenched — not in their doctrine but in how they apply it. Cf. Disney below.
You should, therefore, read the case not as an exemplary application of the duty of care, but as a policy experiment: why is the corporate world so opposed to monetary damages on these facts?
The case involves the acquisition of the Trans Union Corporation by Marmon Group, Inc. As is typical, the acquisition is structured as a merger. The acquired corporation (the “target”) merges with the acquiror (the “buyer”) or one of the buyer's subsidiaries. In the merger, shares in the target are extinguished. In exchange, target shareholders receive cash or other consideration (usually shares in the buyer).
Under most U.S. statutes such as DGCL 251, the merger generally requires a merger agreement between the buyer and the target to be approved by the boards and a majority of the shareholders of each corporation. This entails two important consequences.
First, the board controls the process because only the board can have the corporation enter into the merger agreement. This is one example of why it is at least misleading to call shareholders the “owners of the corporation.”
Two, in public corporations, the requirement of shareholder approval means that several months will pass between signing the merger agreement and completion of the merger. This is the time it takes to convene the shareholder meeting and solicit proxies in accordance with the applicable corporate law and SEC proxy rules. Of course, many things can happen during this time. In particular, other potential buyers may appear on the scene.
1. According to the majority opinion, what did the directors do wrong? In other words, what should the directors have done differently? Why did the business judgment rule not apply?
2. What are the dissenters’ counter-arguments?
3. How do you think directors in other companies reacted to this decision — what, if anything, did they most likely do differently after Van Gorkom?
|18.104.22.168||Show/Hide More||In re Walt Disney Co. Derivative Litigation (Del. 2006)|
After Smith v. Van Gorkom, Disney is the closest Delaware courts have come to imposing monetary liability on disinterested directors. The litigation was heavily colored by Disney's 102(b)(7) waiver, which Disney and most other large corporations had adopted after Van Gorkom. The Delaware Supreme Court, however, chose first to make an affirmative finding that the defendants met even the default standard of due care. As you read that part of the opinion (chiefly IV.A.1), ask yourself why the court reached the opposite result from Van Gorkom:
1. Did the court apply different law, i.e., did it overrule Van Gorkom, explicitly or implicitly?
2. Did the case present materially different facts? The Disney court certainly paints a more favorable picture of the board process than the Van Gorkom court. But were the processes substantively different? Imagine you are the plaintiffs' lawyer (or a judge in the Van Gorkom majority) and try to recast the Disney facts in a light less favorable to the defendants.
In answering the last question, consider the following questions about executive compensation, which is at issue in Disney:
The Disney court next addresses “good faith,” which is a necessary condition for liability protection under DGCL 102(b)(7) (as well as for indemnification under DGCL 145(a) and (b)).
1. How does the court interpret “good faith”?
2. How does “good faith” relate to the duty of care and the duty of loyalty?
3. Was addressing both “good faith” and the default standard of due care necessary for the court’s decision of the case? If not, why did it?
|22.214.171.124||Show/Hide More||Stone v. Ritter (Del. 2006)|
The business judgment rule, as authoritatively stated in Aronson and applied in Disney, should provide comfort to directors and officers even in the absence of a 102(b)(7) waiver (which does not cover officers). For a long time, however, directors and officers might have been worried by the following passage from Aronson:
“However, it should be noted that the business judgment rule operates only in the context of director action. Technically speaking, it has no role where directors have either abdicated their functions, or absent a conscious decision, failed to act.”
Aronson v. Lewis, 473 A.2d 805, at 813 (Del. 1984).
To be sure, Aronson continued that “a conscious decision to refrain from acting may nonetheless be a valid exercise of business judgment and enjoy the protections of the rule” and acknowledged in a footnote to the quoted paragraph that “questions of director liability in such cases have [nevertheless] been adjudicated upon concepts of business judgment” (emphasis added). Doubts remained, however, and were only amplified by Chancellor Allen’s famous 1996 Caremark decision, which mused that the absence of a reporting system could give rise to liability. Stone addressed this question.
1. What is the rule of Stone: what is the liability standard for oversight failures?
2. How does the rule compare to the business judgment rule – is it more or less lenient for defendants, doctrinally speaking?
3. Do you think the doctrinal difference matters in practice?
4. What is the role of DGCL 102(b)(7) in this case?
|2.2.3||Show/Hide More||Shareholder Litigation etc.|
It is often said that corporate fiduciary duties are a U.S. specialty. It would be more accurate to say that shareholder litigation is the U.S. specialty. Fiduciary duties or something resembling them exist in all corporate laws that I know of. Most jurisdictions, however, severely limit shareholder litigation that could enforce these duties, relying instead on prohibitions, shareholder approval requirements, or perhaps even criminal law enforcement. Not so the U.S., particularly Delaware.
Like most litigation, shareholder litigation presents an obvious dilemma. On the one hand, fiduciary duties are toothless without shareholder litigation to enforce them. That is why courts encourage it with generous fee awards (see Americas Mining below). On the other hand, litigation is extremely expensive, especially the corporate sort. In particular, defendants can incur substantial costs in discovery even if the case never goes to trial, let alone results in a verdict for the plaintiff. In fiduciary duty suits, the main cost is the disruption caused by depositions of directors and managers and, more generally, their distraction from ordinary business. Opportunistic plaintiffs may threaten such litigation costs to extract a meritless settlement.
In other words, Delaware’s reliance on fiduciary duties creates a conundrum: how to encourage meritorious suits while discouraging deleterious nuisance suits. Meritorious suits are necessary to enforce fiduciary duties and allow the courts to flesh out their content, whereas nuisance suits can be a costly drag on the system. Do the procedural peculiarities introduced in this section succeed in sorting the good shareholder litigation from the bad?
|126.96.36.199||Show/Hide More||Aronson v. Lewis (Del. 1984)|
Having learned the substantive law of fiduciary duties, you are prepared to finally read Aronson itself. As you know by now, the case contains Delaware’s canonical statement of the business judgment rule. What Aronson is really about, however, is a procedural overlay to the business judgment rule (and other substantive fiduciary law): the so-called demand futility test.
The demand requirement is Delaware’s main procedural filter to address the danger of nuisance suits described above. The complaint must provide some initial reason for why a shareholder should be allowed to prosecute the suit instead of the board. In essence, courts will allow the case to proceed to discovery only if the derivative complaint alleges particularized facts that, if true, would create a reasonable doubt that a majority of the directors can impartially assess the expeditiousness of the suit. Directors can be partial either because they themselves are interested in the underlying transaction (not: in the lawsuit!) or violated their fiduciary duties in dealing with it, or because they are beholden to others who are or did. In the case of a suit against the entire board for violation of their duties, this is simply a heightened pleading standard: In particular, it is not sufficient simply to name all directors as defendants; the complaint must allege particularized facts that suggest they may actually be liable. Courts address this question on a motion to dismiss. Even if they do not grant that motion, courts may dismiss the suit at any later time during discovery if a “special litigation committee” so recommends (see Zapata as reported by Aronson).
Reading Aronson is complicated by arcane and even misleading terminology. Some signposts may be helpful. Formally, the case arises under Delaware Chancery Rule 23.1(a), which states:
“The [derivative] complaint shall also allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors [namely, to initiate the suit in the name of the corporation] … and the reasons for the plaintiff's failure to obtain the action or for not making the effort.” [emphasis added]
For this rule to make any sense, it must be read to require dismissal if (a) the board rightfully rejected the plaintiff’s demand, or (b) the plaintiff’s reasons for failing to make a demand were not legally compelling (why else insist that the reasons be stated?). In practice, serious derivative plaintiffs never make a formal demand — the directors will hardly agree to sue themselves, and the Delaware Supreme Court has ruled that making a demand waives the right to contest the independence of the board (such that challenging the demand refusal as “wrongful” is virtually impossible if the board does its homework and considers the demand with reasonable information – business judgment rule!). Hence the relevant question in Aronson and other cases is: when is demand “futile”? To answer that question, the Delaware courts have developed the test summarized in the preceding paragraph, and further explained in Aronson.
Both the demand requirement and the powers of the special litigation committee only apply to derivative suits; they do not apply to direct suits (which are usually filed as class actions). The test for distinguishing direct from derivative actions is “(1) who suffered the alleged harm (the corporation or the suing stock-holders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stock-holders, individually)?” Tooley v. Donaldson, Lufkin & Jenrette, 845 A. 2d 1031, at 1033 (Del. 2004). In practice, this means that shareholders can sue directly over mergers and other transactions that affect their status as shareholders, but not over transactions such as executive compensation that affect shareholders merely financially. For example, of the shareholder suit cases you have read so far, Van Gorkom was a direct (class) action, while Sinclair, Disney, and Stone were derivative actions.
|188.8.131.52||Indemnification and Insurance|
|184.108.40.206||Show/Hide More||Americas Mining Corp. v. Theriault (Del. 2012) (Attorney's fees)|
To generate a substantial amount of shareholder litigation, merely allowing shareholders suits, direct or derivative, is not sufficient. Somebody needs to have an incentive to bring the suit. If shareholder-plaintiffs only recovered their pro rata share of the recovery (indirectly in the case of a derivative suit), incentives to bring suit would be very low and, in light of substantial litigation costs, usually insufficient. Litigation would be hamstrung by the same collective action problem as proxy fights. Under the common fund doctrine, however, U.S. courts award a substantial part of the recovery to the plaintiff or, in the standard case, to the plaintiff lawyer. As Americas Mining shows, that award can be very substantial indeed.
The litigation incentives generated by such awards strike some as excessive. For a while, virtually every M&A deal attracted shareholder litigation, albeit mostly with much lower or no recovery. Corporations tried various tactics to limit the amount of litigation they face, prompting recent amendments of the DGCL (sections 102(f) and 115 – read!).
1. How does the court determine the right amount of the fee award? What criteria does it use, and what purposes does it aim to achieve? Are the criteria well calibrated to the purposes?
2. Who is opposing the fee award, and why?
3. Are the damage and fee awards sufficient to deter fiduciary duty violations similar to those at issue in this case?
Note: I excerpt here only the passages relevant to the attorney fee award. The case below was In re Southern Peru (Del. Ch. 2011).
|220.127.116.11||Show/Hide More||In re Trulia Inc. Stockholder Litigation (Del. Ch. 2016)|
Settlements of class and derivative actions require court approval under Del. Ch. Rules 23(e) and 23.1©, respectively. In Riverbed, Vice-Chancellor Glasscock explained the rationale for this requirement in the context of a class action:
“Settlements in class actions present a well-known agency problem: A plaintiff's attorney may favor a quick settlement where the additional effort required to fully develop valuable claims on behalf of the class may not generate an additional fee as lucrative to the plaintiff's attorney as accepting a quick and moderate fee, then pursuing other interests. The interest of the principal—the individual plaintiff/stockholder—is often so small that it serves as scant check on the perverse incentive described above, notwithstanding that the aggregate interest of the class in pursuing litigation may be great—the very problem that makes class litigation appropriate in the first instance.”
In re Riverbed Tech., Inc. S'holders Litig., 2015 WL 5458041, at *7 (Del. Ch. Sept. 17, 2015).
In particular, as class representatives, plaintiff attorneys have the power to forfeit claims on behalf of the entire class in a settlement. Plaintiff attorneys are thus in a position to “sell” shareholder claims—possibly below value but keeping the “price” (fees) for themselves:
“In combination, the incentives of the litigants may be inimical to the class: the individual plaintiff may have little actual stake in the outcome, her counsel may rationally believe a quick settlement and modest fee is in his best financial interest, and the defendants may be happy to “purchase,” at the bargain price of disclosures of marginal benefit to the class and payment of the plaintiffs' attorney fees, a broad release from liability."
Id., at *9.
In spite of these concerns, Delaware courts had developed a practice of approving settlements containing broad releases of shareholder claims in return for moderate corporate disclosures and six-figure attorney fees. Starting with Riverbed and culminating with Chancellor Bouchard’s authoritative opinion in Trulia, the Chancery Court announced a change in its practice.
Please consider the following questions when reading Chancellor Bouchard’s opinion:
1. Chancellor Bouchard’s “opinion further explains that … the Court will be increasingly vigilant in scrutinizing … settlements” (at 888). What precedential value does this language have, formally speaking? What precedential value do you think it has in practice?
2. Both Chancellor Bouchard and Vice-Chancellor Glasscock disapprove of settlements for disclosures “of marginal value.” Why are settlements for “plainly material” disclosures less suspicious? Do “plainly material” disclosures guarantee that the settlement is in the class’s best interest?
3. Both judges also disapprove of “broad releases from liability.” Can a broad release—including, e.g., antitrust claims—ever be justified?
4. Chancellor Bouchard is also concerned that (892) “defendants are incentivized to settle quickly in order to mitigate the considerable expense of litigation and the distraction it entails [and] to achieve closing certainty.” Is this problem specific to class and derivative actions? Is it a problem for the class members? Is it a problem for stockholders? Does blocking settlements solve this problem?
5. What settlements should be approved? What litigation should be encouraged, and, once encouraged, under which conditions should it be allowed to terminate?
|3.1||Show/Hide More||Introduction to M&A|
Acquisitions are the single most important event in most corporations’ existences. On a formal level, the corporation may cease to exist after the acquisition (see transactional technique below).
More importantly, however, most acquisitions profoundly affect the substantive organization of the business. This is especially so for the acquired firm (the “target”). The target’s management will usually leave (or be made to leave) following the acquisition. Often, business units are sold or shut down. But acquisitions tend to be major events for the acquirer as well, because the acquirer’s business may grow and change dramatically through the transaction.
Acquisitions are routine events only if the acquirer is much bigger than the target. (For example, big pharmaceutical companies frequently buy small biotechs or other startups to add to their technology portfolio.)
In a broader social perspective, acquisitions reallocate large pools of assets to different management and possibly different economic tasks (e.g., Google’s acquisition of Motorola; Facebook’s acquisition of Instagram).
Oftentimes, the capital structure of the corporation changes dramatically as well. This is particularly so in acquisitions or divestitures by so called “financial acquirers” — mainly private equity funds (acquirers who do not have a stand-alone line of business but specialize in acquiring and then improving existing companies).
From the perspective of corporate governance, the most important aspect of acquisitions may be their role as a governance device.
Takeovers have a direct effect on governance when a better-governed firm takes over a worse-governed firm. After the takeover, both firms’ assets will be managed under the former’s better governance structure.
But takeovers also have an indirect effect on governance. The threat of a takeover may incentivize boards to do a better job. If they don’t, the corporation’s stock price may fall below potential. This may create an opportunity for a potential acquirer to take over the firm at a profit. While this indirect effect is hard to measure, it may well be more important than the direct effect.
To be sure, the threat of a takeover would be empty if takeovers only occurred with the approval of the current management (so-called “friendly takeovers”). This is why “hostile takeovers”— takeovers without the approval of current management — deserve special attention as a potentially potent governance device.
By definition, target management opposes hostile takeovers. Over time, target managers and their advisers have devised various “takeover defenses” to fend off such “attacks.” The defenses may be justified because hostile takeovers and the threat thereof can be abused to disrupt the target’s business. The defenses can also be an important bargaining tool to get a better price for target shareholders. At the same time, target management may use defenses merely to perpetuate itself in office and to blunt the governance mechanism of hostile takeovers. We will study an important string of cases struggling with the double-edged nature of takeover defenses— “entrenchment” on the one hand and legitimate protection of corporate interests on the other.
Most acquisitions are structured to involve a “merger” in a technical legal sense. In this sense, it would be more accurate to speak of “acquisitions by way of merger” instead of “mergers and acquisitions.”
A merger in this legal sense is the fusion of two corporations into one (cf. DGCL subchapter 9, especially sections 251, 259-261). The target merges with the acquirer or, more frequently, a wholly-owned subsidiary of the acquirer. The acquirer thus obtains control over the target’s assets directly (if the target merges with the acquirer) or indirectly (if the target merges into the acquirer’s subsidiary). The target shareholders obtain the merger consideration for their shares, if they have not already sold them earlier.
Because a merger tends to be such an important transaction, it generally requires approval by the board and a majority of the shareholders (DGCL 251(b)/©). Furthermore, shareholders can request to receive the “fair value” of their shares as appraised by the Chancery Court rather than the merger consideration (appraisal, cf. DGCL 262). There are, however, numerous exceptions and conditions – see Delaware Merger ABC below.
The shareholder approval requirement has major implications for deal structure and timing even if a clear majority of shareholders approves of the deal when it is signed. Properly calling a shareholder meeting and soliciting proxies takes time – usually several months. (You wouldn’t know this from DGCL 213(a) and 222 alone, but you need to factor in the time it takes to clear the proxy statement with the SEC [again, not a statutory or regulatory requirement but everybody does it] and then to solicit the proxies – at least 50% of the shareholder need to approve, DGCL 251©.) Many things can happen between signing and shareholder vote. Most importantly, a new bidder may arrive on the scene—usually to the (then) delight of the seller and dismay of the buyer
Question: Why do buyers tend to like the appearance of other bidders whereas sellers dread them?
A partial alternative is to structure the deal as a tender offer, i.e., an offer to all shareholders to sell (“tender”) their shares to the bidder at the price announced by the offeror (and, in a friendly deal, agreed by the target corporation’s board). Under SEC rules, a tender offer must be open for at least 20 business days (rule 14e-1, see below), but it can still be quicker than calling a shareholder meeting. The tender offer is only a partial alternative because not all of the shares will be tendered, and so the offeror will have to conduct a follow-up merger to “squeeze out” (see below) the remaining shareholders. (But see now DGCL 251(h), which greatly facilitates the post-tender squeeze-out – more on this below.)
The use of the merger technique is a choice of convenience (and possibly tax and accounting considerations, but those are beyond this course). The alternative to a merger is an asset sale, as in Hariton v. Arco Electronics below.
In an asset sale, the target transfers its assets individually to the acquirer. The sales contract must carefully describe all assets and employ transfer mechanisms compliant with the applicable transfer rules, which differ by asset type (e.g., personal property, real property, contracts, negotiable instruments, etc.). If the sales contract fails to do so, the acquirer will not obtain ownership rights in all the assets. Moreover, some assets cannot be transferred in this way without the affirmative approval of some third party. In particular, by default, contracts cannot be transferred without the approval of the contract counterparty. All of this makes asset sales extremely cumbersome. (Unless, of course, the assets are shares in one or more subsidiaries. That sort of asset sale would be very simple.)
An asset sale does have two potential advantages. First, dissenting shareholders do not get appraisal rights (cf. DGCL 262 and Hariton v. Arco Electronics below). Second, the acquirer does not automatically assume all the liabilities of the target. In practice, however, a variety of rules limit the importance of this second point. Some liabilities automatically transfer with ownership of the asset (such as environmental cleanup obligations). Further, a variety of rules covered later in the class protect creditors against opportunistic asset transfers. Last but not least, major debt contracts usually restrict a debtor’s ability to sell off a substantial part of its assets.
To be sure, a contract might also require approval for a merger, and many important ones do. In general, as always, contractual arrangements, including charter arrangements, can add or efface distinctions between asset sales and mergers. What will usually remain, however, is the hassle of transferring assets individually in an asset sale.
The merger, on the other hand, is easy. It usually requires only an agreement between the two corporations, and approval by both boards and shareholder meetings, usually by simple majority vote. Unanimous approval is not required.
In addition, the merger agreement can freely determine just about anything in the organization of the joint entity: its charter, its ownership, and its management. For example, there is no requirement that the shareholders of both merging corporations remain shareholders in the joint entity.
A warning: Don’t be misled by expressions such as “surviving entity.” They are merely naming conventions. In particular, the shareholders, board, management, and charter of the “surviving entity” could all be eliminated in the merger (in the case of shareholders, for due compensation) and replaced by those of the other entity.
A side note: Because the merger is so easy and flexible, it is a versatile device with many uses outside of M&A. For example, it can be used for internal rearrangements inside a corporate group (cf. DGCL 253, 267), reincorporation from one state to another (by merging the corporation into a shell company incorporated in the destination state; this can also be achieved directly by “conversion” under DGCL 265, 266), and so on.
To be sure, the merger is not the only step in many acquisitions. This is most obvious in a hostile takeover. A merger requires approval by the target board. By definition, the hostile takeover is a situation in which the target board is unwilling to approve a merger. So how can a merger happen in a hostile takeover?
The answer is that the merger will come last in a chain of hostile acquisition steps. In a standard hostile takeover, the acquirer would first acquire a majority of the target stock through a “tender offer” (i.e., an offer addressed to all target shareholders to purchase their stock) and then replace the resisting target board. The new board would then cause the target to enter into a merger agreement with the acquirer.
Friendly acquisitions can also involve more than just the merger step. In these cases, however, the merger agreement may act as a road map containing the earlier steps. The 3G / Burger King agreement below provides an example of such a structure.
M&A involves a complicated mix of statutes, rules, and precedents, from many areas of law, including corporate law, securities law, and antitrust.
The securities laws and rules not only regulate disclosure, but also set important timing requirements. In particular, the Williams Act of 1968 requires an acquirer of 5% or more of a corporation’s voting stock to disclose this fact within ten days of crossing the 5% threshold (SEA §13(d)). This means that an acquirer cannot gain control of the target secretly and slowly.
The Williams Act also regulates tender offers (SEA §14(d)/(e)). Among other things, the SEC rules require that any tender offer remain open for at least 20 business days (rule 14e-1). This prevents quick acquisitions by way of a tender offer. Moreover, while the offer remains open, shareholders who already tendered may reverse their decision and withdraw their shares (rule 14d-7(1)).
Other Williams Act rules of particular importance for deal structure are:
• “All holders, best price:” the tender offer must be open to all shareholders, and all must be paid the same consideration (rule 14d-10);
• Conversely, the tender offeror may not buy stock in side deals between public announcement and expiry of the offer (rule 14e-5: “Prohibiting purchases outside of a tender offer”);
• Pro-rata allocation: if the tender offer is oversubscribed — the tender offer is for less than all of the corporation’s outstanding stock, and more shares are tendered — the offeror must take up tendered shares pro rata (SEA §14(d)(6), rule 14d-8).
The listing rules of the stock exchanges can play an important role as well. For example, rule 312.03 of the New York Stock Exchange’s Listed Company Manual requires stockholder approval for certain stock issuances, including those of a certain size (≥20%) or leading to a change in control. Rule 402.04 requires active proxy solicitation for any stockholder meeting, triggering the SEC’s proxy rules and associated delay.
Within corporate law, the statutory provisions relating to mergers are of obvious importance for M&A (e.g., DGCL 251, 253, 262, 271). But as we have already seen (Blasius), many general and perhaps deceivingly innocuous provisions of the DGCL, such as those governing director removal and appointment (DGCL 141, 223), can also play an important role in M&A.
Fiduciary duties play a major role in M&A as well. In fact, most of the cases that we will read will deal with the shaping of fiduciary duties in the M&A context. Nevertheless, this should not lead you to think that the statute is unimportant. Fiduciary duties only become important to the extent that the statute has not preempted a particular question. In other words, the statute demarcates the field on which the game is played, and fiduciary duties regulate the behavior of the players on the field. Both are important to understand the game.
Depending on the industry, various other areas of law may come into play. For example, banks require approval from the banking regulator for acquisitions.
One area of law that is always important in M&A is antitrust. It is covered in a separate course. Here you just need to know that the Hart-Scott-Rodino Act requires that certain antitrust filings be made fifteen or thirty days before the closing of an acquisition. This may be an additional source of delay — and, in the case of “hostile” acquisitions, an early warning to the corporation's management.
|3.1.1||Delaware Merger ABC|
|3.1.2||Show/Hide More||Hariton v. Arco Electronics, Inc. (Del. 1963)|
1. Why did the defendant structure the deal as an asset sale rather than a merger?
2. What is the Delaware Supreme Court’s position on the de facto merger theory? (NB: This position is still good law in Delaware.)
3. How does that answer relate to the court’s opinion in Schnell (which was decided eight years later but did not purport to break new ground)?
|3.2||Show/Hide More||3G / Burger King merger agreement (2010)|
Most of the action in M&A is in the contracts. The following is an excerpt from the acquisition agreement whereby 3G Capital, a private equity fund, acquired Burger King. The full agreement is available on EDGAR.
Please try to answer the following three questions in reading the excerpts:
1. What is the sequence of events mapped out in this agreement?
2. What are the main economic terms?
3. What will happen to Burger King Holdings, Inc. (its shares, its board, etc.) in the merger?
|3.3||Show/Hide More||Controlling Shareholders in M&A|
Controlling shareholders deserve particular attention in M&A because they may have acute conflicts of interest.
To be sure, notwithstanding the presence of a controlling shareholder, every merger and most other steps in an M&A transaction still need to be reviewed by the full board, whose members may not have the same conflict of interest (in particular, the controlling shareholder may not be a member of the board). Technically, the board may recommend the transaction only if it is good for the corporation as a whole. But even if all directors are technically completely independent, the directors must also be aware that the controlling shareholder could replace them at any moment (under the default rules, DGCL 141(k), 228; but even a staggered board etc. would merely delay the replacement). There is thus always a suspicion that the board may be driven to be partial to the controlling shareholder’s interests.
|3.3.1||Show/Hide More||Squeeze-outs / Going-privates|
In a squeeze-out a/k/a cash-out merger, a controlling shareholder acquires complete ownership of the corporation’s equity, squeezing/cashing out the minority. Technically, the transaction is structured as a merger between the controlled corporation and a corporation wholly-owned by the controlled corporation’s controlling shareholder. The controlling shareholder retains all the equity of the surviving corporation, while the merger consideration for the outside shareholders is cash (or something else that is not stock in the surviving corporation). If the controlled corporation was previously publicly traded on a stock exchange, the transaction is also known as a going private merger because the surviving corporation will no longer be public, i.e., it will be delisted from the stock exchange.
There can be good economic reasons for a squeeze-out. It facilitates subsequent everyday business between the controller and the corporation, among other things because there are no more conflicts of interest to manage (cf. Sinclair). Private corporations do not need to make filings with the SEC and the stock exchange. Finally, the controlling shareholder may be more motivated to develop the corporation's business when owning 100% of it.
At the same time, squeeze-outs pose an enormous conflict of interest. Any dollar less paid to the minority is a dollar more to the controlling shareholder. For this reason, the SEC requires additional disclosure under rule 13e-3, and Delaware courts police squeezeouts under the duty of loyalty. In fact, controlling shareholders' duty of loyalty was developed principally in squeeze-out mergers, in particular the adaptation in Kahn v. MFW below.
Question: Can you think of another, procedural reason why squeeze-outs generate most duty of loyalty cases against controlling shareholders in Delaware courts? Hint: Consider Aronson and its scope of application.
|18.104.22.168||Show/Hide More||Weinberger v. UOP, Inc. (Del. 1983)|
This decision introduced the modern standard of review for conflicted transactions involving a controlling shareholder. We could have read it in the general Duty of Loyalty section above, but I wanted you to read it together with the next two cases.
Review questions (answer now or while reading the opinion):
Check your understanding:
|22.214.171.124||Show/Hide More||Glassman v. Unocal Exploration Corp. (Del. 2001)|
|126.96.36.199||Show/Hide More||Kahn v. MFW (Del 2014)|
1. What standard of review does the court apply? Is it different from the cases we had seen thus far?
2. How does the court want to protect minority shareholders? Does it work? Does it work better than alternatives?
3. Why did this case proceed to summary judgment, whereas the complaint in Aronson was dismissed even before discovery? Hint: under what rule was Aronson decided, and did that rule apply here?
|3.3.2||Show/Hide More||Sales of Control|
When the controlling shareholder is not buying but selling, a different problem arises: The controlling shareholder may sell control to a buyer who makes the minority shareholders worse off.1 Concretely, upon assuming control, the buyer might divert more value from the corporation than the seller did, be it through self-dealing transactions or by failing to develop the corporation’s business (e.g., imagine the buyer is a competitor of the acquired corporation or of one of its major clients). Technically, such diversion would violate the buyer’s duty of loyalty, but enforcement is always imperfect.2 Such diversion might even be the business rationale for the sale: the buyer might be able to pay more than the controlling shareholder’s valuation of the control block precisely because the buyer plans to divert more value. To guard against this possibility, many jurisdictions around the world, such as the UK, require the buyer of a control block to offer to buy out all minority shareholders at the same price. The U.S., however, does not have such a mandatory bid rule – control blocks in U.S. corporations can be bought and sold freely without having to deal with the minority stockholders at all, short of selling to a “known looter.”3
One reason not to have a mandatory bid rule is that it creates problems of its own when the buyer is benign, i.e., when the buyer does not divert value, or at least not more than the seller. If the buyer has to offer the same price to everyone, it has to pay everyone as much as it pays the selling controlling shareholder. But the controlling shareholder owns more than the minority shareholder: it has control, which it may value either because it allows diversion of pecuniary benefits, and/or simply because it (or now I should say: he or she) enjoys being in charge. And the controlling shareholder will refuse to sell unless it/he/she is fully compensated for giving up control. So paying the same to the controlling shareholder and to the minority on a per share basis probably means overpaying the minority – and possibly means overpaying for the firm as a whole. Since buyers cannot be expected to overpay, the deal may simply fall through. As a result, insisting on equal treatment may end up hurting everyone, including the minority shareholders.
To illustrate, consider the following numerical example. Imagine a firm with 100 shares outstanding that is worth $125 in total under the current governance arrangements. It has a controlling shareholder who holds 10 shares (= 10% of the equity) but enough votes for control (e.g., through a dual class arrangement). The controlling shareholder diverts 20% of the firm's value ($25) to herself in private benefits.4 In addition, the controlling shareholder gets 10% of the remaining value by virtue of her equity stake. Her total stake is thus worth $25 + 10% × ($125-$25) = $35 to her. Minority shareholders get the rest: $125 – $35 = $90, or $1 per share (there are 100 shares total, and the controlling shareholder owns 10 of them). Now imagine a sale under a mandatory bid rule. The controlling shareholder will accept an offer only if the per share price P gives her more than what she gets without the deal: 10 × P > $35, or P > $3.50. At P > $3.50, the minority shareholders will obviously accept the offer, since the status quo value of their shares is only $1. Consequently, all shares will be tendered, and the acquirer will have to pay 100 × P > 100 × $3.50 = $350 for the firm. This will only be worthwhile for the acquirer if the firm is worth more than $350 to the acquirer, i.e., more than 2.8 times the status quo value. Such buyers will be rare. By contrast, without the mandatory bid rule, any buyer to whom the firm is worth more than $125 could make an offer that makes everyone better off: for example, a buyer valuing the firm at $125.03 could pay $35.01 to the controller (= $3.501 per controller share), $90.01/90 for each minority share (= $1.0001 per minority share), and still make a $0.01 profit. In short, even the minority shareholders might be better off if the controlling shareholder is allowed to get a control premium.
1 By definition, the controlling shareholder owns and can thus sell enough shares to convey full control to a buyer. Absent special rules, the controlling shareholder can therefore transfer control without the minority’s consent.
2 In particular, the controlling shareholder may find a majority of nominally independent but servile directors to approve self-dealing transactions other than mergers. Review question: Why will this be enough to isolate the transactions from judicial review?
3 See Harris v. Carter, 582 A.2d 222, 235 (Del. Ch. 1990, per Allen Ch.): “while a person who transfers corporate control to another is surely not a surety for his buyer, when the circumstances would alert a reasonably prudent person to a risk that his buyer is dishonest or in some material respect not truthful, a duty devolves upon the seller to make such inquiry as a reasonably prudent person would make, and generally to exercise care so that others who will be affected by his actions should not be injured by wrongful conduct.”
4 This could be $25 in cash through a transfer pricing scheme etc., or simply a psychic benefit of being in control that the controlling shareholder values at $25 – that, too, is value. In the latter case, you should think of the firm as generating $100 in financial value plus $25 in psychic value.
|188.8.131.52||Show/Hide More||In re Delphi Financial Group Shareholder Litigation (Del. Ch. 2012)|
This decision involves a target with a controlling stockholder, Rosenkranz. The decision revolves around Rosenkranz’s attempt to obtain a higher price for his shares than for the minority shares.
As you read the decision, consider the following questions:
1. Ex ante, what did Rosenkranz promise to do in a future sale, according to the court? Why do you think he would have made this promise?
2. Ex post, was this promise economically enforceable? In particular, could Rosenkranz be forced to agree to a sale in the first place? How did the court deal with this here?
3. What rule would have governed in the absence of an explicit charter provision?
4. Did Rosenkranz in fact promise what the court says he promised?
5. Bonus question: Could Rosenkranz have amended the charter provision in question without the approval of the minority shareholders? Cf. DGCL 242(b)(2).
|3.4.1||Show/Hide More||Unocal v. Mesa Petroleum (Del. 1985)|
In this famous decision, the Delaware Supreme Court ruled that the board has the power to defend against hostile takeovers, even with discriminatory measures, and laid down the judicial standard of review for scrutinizing such defenses.
The most important things to look for are thus:
1. What is the threat that the board is defending against?
2. Who is being protected?
3. What is the standard of review? How does it relate to our two old friends: the business judgment rule and entire fairness? If it is different, why?
|3.4.2||Show/Hide More||Moran v. Household International (Del. 1985)|
This decision approved the “rights plan” a/k/a “poison pill” invented by Martin Lipton. “Rights plan” may sound innocuous. But it completely transformed US takeover law and practice.
The pill has only one goal: to deter the acquisition of a substantial block of shares by anyone not approved by the board. It does so by diluting, or rather threatening to dilute, the acquired block. If anyone “triggers” the pill by acquiring more than the threshold percentage of shares (usually 15%), the corporation issues additional shares to all other shareholders. The number of additional shares is generally chosen so as to reduce the acquirer’s stake by about half. Needless to say, that would be painful – arguably prohibitively painful – to any would-be acquirer.
Question: How does the pill compare to DGCL 203 – what are their respective trigger conditions, and what are their consequences for the acquirer if triggered? (I recommend that you consult the simplified version of section 203 on simplifiedcodes.com. Note that section 203 was completely overhauled in 1988; the Moran opinion quotes the old version.)
The pill ingeniously obscures this discriminatory mechanism in complicated warrants. The corporation declares a dividend of warrants to purchase additional stock or preferred stock. Initially, these warrants are neither tradeable nor exercisable. If anybody becomes an “acquiring person” by acquiring more than the threshold percentage, however, the warrants grant the right to buy corporate stock for prices below value. Of course, all shareholders will then rationally choose to exercise the warrant. So what is the point? The point is that by their terms, the warrants held by the acquiring person are automatically void.
(The description of the pill in Moran may read slightly differently. The reason is that the industry standard pill has evolved since Moran. You can find a contemporary example here.)
The pill is extraordinarily powerful. In the 30 years since Moran, only one bidder has dared triggering the pill, and that was one with a particularly low trigger of 5% (chosen to preserve a tax advantage). The exercise of the rights did not only dilute the acquirer but caused massive administrative problems (a lot of new stock had to be issued!), leading to a suspension of issuer stock from trading. The issuer, Selectica, also violated the listing rules. See here. What this shows is that the pill really is designed purely as a deterrent – it is intended never to be triggered. It’s MAD (Mutually Assured Destruction) intended to keep out the unwanted acquirer, nothing else.
The upshot is that nowadays no Delaware corporation can be acquired unless the board agrees to sell. The pill has stopped not only hostile two-tier bids, but all hostile bids. To be sure, a would-be acquirer could attempt to replace a reluctant board through a proxy fight. But one proxy fight may not be enough, if and because the corporation has a staggered board in its charter (cf. Airgas below). In any event, the point is that board acquiescence is ultimately indispensable. The acceptance of the pill was thus a fundamental power shift from shareholders to boards in dealing with “hostile” offers (read: offers that the board doesn’t like).
Perhaps understandably, the Moran court did not fully understand these implications. Or perhaps it didn’t want to? The SEC’s amicus brief certainly predicted as much. As it were, the Court gives mainly technical, statutory reasons for approving the pill. But as in Schnell, the Court could have brushed those aside since “[t]he answer to that contention, of course, is that inequitable action does not become permissible simply because it is legally possible.” Why didn’t it? Should it have?
|3.4.3||Show/Hide More||Revlon v. MacAndrews & Forbes (Del. 1986)|
|3.4.4||Beyond the Trilogy|
|3.4.5||Show/Hide More||3G / Burger King merger agreement: Section 6.02 ("go shop")|
1. Do you think buyers like these provisions?
2. What about sellers? (Hint: it may matter at what point in time you ask them.)
|3.4.6||Show/Hide More||Current US Debate (2016)|
So where are we now?
The Airgas excerpt below summarizes the current state of Delaware fiduciary law for takeover defenses. A board can maintain a poison pill for as long as it likes and for the mere reason that it believes the offer price to be inadequate. This means that the only way to overcome determined resistance by an incumbent board is to replace it in a proxy fight.
Until recently, most large corporations’ charters did not permit replacing a majority of the board in a single annual meeting. Their boards were staggered, i.e., only a third of the directors were up for reelection each year (re-read DGCL 141(d), (k)(1)!). Consequently, an acquirer had to win proxy fights at two successive annual meetings to replace the majority of an intransigent board. This takes at a minimum one year and a couple months, and the acquirer would have had to keep the tender offer open (and capital tied up etc.) during that entire time. Hardly any challenger was willing to attempt this. Airgas is about one of the very few exceptions.
In recent years, however, the incidence of staggered boards has declined precipitously among the largest U.S. corporations. By 2012, only a fourth of the corporations in the S&P 500 index had staggered boards. Between 2012 and 2014, most of these hold-outs “destaggered” as well. The impetus came from a law school clinic, the Shareholder Rights Project (SRP) based at Harvard Law School. Acting on behalf of several institutional shareholders, the SRP submitted precatory destaggering proposals (why not binding proposals?) for the corporations' annual meetings. Under rule 14a-8, the targeted corporations had to include these proposals on their proxies. Other shareholders generally supported these proposals, and most recipient corporations soon agreed to destagger. At the same time, staggered boards remain the norm in IPO charters — the charters of corporations selling their stock to the public for the first time.
1. Most observers believe that staggered boards have important consequences for corporate governance and thus ultimately the value of these very large firms. In other words, hundreds of billions are at stake. Other shareholders generally supported destaggering. Why did it take a law school clinic to bring about this change?
2. Why do institutional investors vote against staggered boards in established corporations but continue buying staggered IPO firms? Put differently, why do IPO charters still include staggered boards?
Opinions are sharply divided about the desirability of takeover defenses in general, and of staggered boards in particular. Managers and their advisors argue that defenses allow boards to focus on long-term value creation rather than on catering to short-term pressures from the stock market. Opponents claim that defenses shield slack and prevent efficient reallocations of productive assets.
3. The accountability argument for takeovers is easy to understand. What about the short-termism counterargument? Why would stock markets exert short-termist pressures on boards?
4. Many are concerned that the rules on poison pills, as policed by Delaware courts, allow management and boards to entrench themselves against shareholder interest, but also believe that the pill can be a valuable tool in the hands of a well-motivated management and board. Distinguishing good and bad uses of the pill in a charter or bylaw provision is probably impossible. What other governance device might align use of the poison pill with shareholder interest?
|3.4.7||Show/Hide More||The UK Approach|
In global perspective, Delaware’s heavy reliance on fiduciary duties and judicial case-by-case scrutiny is an outlier. Some countries are more takeover friendly, others less. Almost all, however, are more rule-centric than Delaware.
As a counterpoint to Delaware, the UK is particularly interesting. Like the U.S., the UK is a common law country with very developed financial markets and dispersed ownership of most large corporations. You might, therefore, expect UK takeover law to resemble Delaware’s. You would be quite wrong.
Please read the following excerpts of the Takeover Code, the Companies Act 2006, and the FCA Disclosure Rules and Transparency Rules. Do these rules have analogues in Delaware law or U.S. federal securities law? In particular, consider the following:
1. Would the poison pill be legal in the UK?
2. Would other takeover defenses that we have encountered (think of the board actions in Unocal and Revlon) be legal in the UK?
3. If not, what other rules, if any, protect UK shareholders?
4. Who makes the rules?
5. What is the role of the courts?
|4||Show/Hide More||Securities Trading|
The stock and other securities of large corporations tend to be traded on securities markets. In particular, listed securities such as Apple or IBM stock trade on securities exchanges like the New York Stock Exchange. (These days, exchanges are essentially computer systems matching buy and sell orders received through brokers.) Such trading between investors is also referred to as the secondary market. The primary market denotes sales by the corporation of its own securities to investors—in other words, the primary market is the market where the corporation actually raises capital. By contrast, secondary market trades between investors do not directly impact the finances of the corporation.
Nevertheless, the secondary market is very important for the issuing corporation, and indirectly affects its primary market. Most importantly, the secondary market provides liquidity to its investors, i.e., the ability to turn their investment into cash when desired (by selling to another investor). Investors pay more in the primary market for securities that have a liquid secondary market. In fact, once the secondary market is up and running, the corporation can anonymously sell additional stock directly into the secondary market, or buy it back for that matter (provided it has publicly announced its intention to do this in special SEC filings). Similarly, the liquidity afforded by the secondary market facilitates the acceptance of the corporation’s securities as a means of payment. In particular, public corporations tend to pay their executives mostly in (restricted) stock, and often pay for acquisitions with stock as well (“stock deals”). Illiquid securities without a secondary market are sometimes accepted as payment as well, but less often and only at a discount. Finally, a liquid secondary market supports the accumulation of large minority blocks by activist shareholders without much of a price impact. As a blockholder, the activist will reap a sizeable reward from share price appreciation if the activist’s intervention (engagement with the board, proxy fight, etc.) increases the value of the corporation (see price efficiency below), making the activist’s intervention worthwhile. In this way, liquidity helps overcome the shareholder collective action problem.
Information asymmetry reduces liquidity. The higher the chance that your (anonymous) trading counterparty knows more than you do and trades only because you are getting a bad deal, the less willing you are to trade. To reduce information asymmetry, and to facilitate the exercise of voting and other rights covered in this course, the Exchange Act requires extensive periodic and ad hoc disclosures from issuers of publicly traded securities (see the Securities Law Primer in the introductory part of the course).1
Even with ample disclosure, you might worry that you will lose out against a savvy trader who is quicker at collecting or better at processing the information. Fortunately, savvy traders compete with one another for good deals, pushing the security’s price close to the savvy traders’ best estimate of the security’s value. In fact, the efficient capital market hypothesis (ECMH) holds that, in a liquid market, the price will always be exactly equal to the best estimate of the security’s fundamental value given publicly available information. There are two problems with the ECMH, which had its heyday in the 1970s and early 1980s and features prominently in Basic below. First, the ECMH cannot be completely true: if the price were always equal to the best estimate of fundamental value, then nobody could gain from informed trading, and hence nobody would have an incentive to learn and analyze the information required to bring prices in line in the first place. Second, in a world of uncertainty, “fundamental value” is in the eye of the beholder, and savvy traders may just try to predict the misperceptions of others with whom they hope to trade the security tomorrow.2 Much empirical work has shown that the truth is somewhere between that cynical view and the ECMH, and mostly closer to the ECMH: security prices are not completely efficient (i.e., equal to fundamental value), but they are usually a very good approximation. (In either case, most people who think they can outguess everyone else are fools.)
If security prices are a good approximation of fundamental value, it means they summarize information that can be used to evaluate performance. This is the idea behind stock and options as performance pay for executives: the value of their stock and options will track the price of the stock, which is an indicator, albeit a noisy one, of the executives’ performance. By the same logic, price efficiency ensures that an activist shareholder will increase the stock price and hence gain from an intervention only if the activist’s intervention actually improves the corporation. In the case of the executives (but not of the activist!), an important caveat is that even a fully efficient price only reflects public information.3 Top executives can use their discretion under the accounting and disclosure rules to manage the information flow and hence the stock price to increase the value of their performance pay, or simply to avoid being fired. Similarly, corporate insiders (executives, engineers, etc.) can profitably—but not legally, see below—trade their corporation's securities even in fully efficient markets because they frequently possess “material nonpublic information” (mineral discoveries, engineering breakthroughs, regulatory matters, etc.).
Securities trading and securities regulation are thus inextricably intertwined with corporate governance and corporate law. In this course, we cannot cover the details of the disclosure and trading rules under the securities acts. We must, however, spend at least a little time discussing the enforcement of the disclosure rules that we have encountered in this class (e.g., 8-Ks, 10-Ks, 13-Ds, proxy statements, etc.), and more generally of truthfulness of the corporation’s communications to its shareholders. Much of the enforcement burden falls on the SEC, which again belongs in a specialized course. But some of the enforcement is through private securities litigation, often brought by the same law firms that prosecute shareholder actions in Delaware courts. Indeed, these plaintiff law firms used to substitute federal securities lawsuits for Delaware litigation when Delaware courts were less receptive to shareholder lawsuits, and may try to do so again after Trulia. Specifically, we will study private securities fraud litigation under the Securities Exchange Act (SEA) rule 10b-5, which is the most general and hence most important and most controversial basis for such litigation.
The other aspect of securities law we will study is the prohibition and prevention of insider trading. The reason to do so is twofold. First, it is another area that might have fallen under state corporate law if doctrine had developed differently, and to a limited extent still does. Second, insider trading turns out to involve an important corporate governance issue: If insider trading were legal, executives might manage the corporation to maximize trading opportunities rather than corporate value. Besides, insider trading is a crime that most young lawyers will have opportunity and temptation to commit, so it is in your self-interest to learn what not to do. We will study insider trading liability under the SEA rules 10b-5 and 14e-3 and SEA §16(b).
1 Actually, the utility of information by itself does not quite explain why disclosure needs to be mandated by statute, rather than provided voluntarily or, more to the point, under an obligation self-imposed in the corporate charter. We get to these questions in the last part of the course.
2 In the memorable words of John Maynard Keynes’s General Theory of Employment, Interest, and Money (1935):
“professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”
3 Technically, this is known as the semi-strong form of market efficiency. The strong form holds that the price includes all information, even private information. The strong form is quite clearly false, even though some private information does seep into the stock price, in part through legal and illegal insider trading (covered below).
Before delving into the details, let us take a look at rule 10b-5, which is the formal basis of most securities litigation and most insider trading enforcement.
Rule 10b-5 is only one of many anti-fraud rules in securities law (cf., e.g., SEA §14(e) for statements in connection with tender offers). Rule 10b-5 is just the most general, “catch-all” provision—among other things, it applies to any security, not just registered securities. It implements SEA §10(b), which is not self-executing. §10(b) reads in its most relevant substantive part:
“It shall be unlawful for any person . . . [t]o use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe . . .”
Rule 10b-5 was adopted in 1942 without, it appears, much thought or any anticipation of the role it would come to play in the hands of the SEC and the courts later on. SEC staffers wanted to go after an instance of clear common law fraud. To obtain jurisdiction over the case, however, they needed the Commission to adopt a rule under §10(b) first. So the staffers copied §17 of the Securities Act and submitted it to the Commissioners. The Commissioners approved without discussion. See Louis Loss & Joel Seligman, Fundamentals of Securities Regulation 937-8 (4th ed. 2004).
The rule reads:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
a. To employ any device, scheme, or artifice to defraud,
b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
c. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.
The rule mentions neither a private right of action nor insider trading. But the courts soon implied a private right of action, and the SEC, with approval of the courts, brought insider trading cases under the rule. Ironically, these judicial creations are now recognized in the statute itself. For example, a later amendment of SEA §10 explicitly references “insider trading” rules adopted by the SEC and by judicial precedent, extending such rules to “security-based swap agreements” (i.e., derivatives).
Plaintiffs attempted to bring even more corporate disputes under 10b-5, including cases unrelated to disclosure. In fact, in the early 1970s, most corporate law litigation was brought in the federal district courts under rule 10b-5, rather than in Delaware state courts under state law. Delaware was, at that time, unreceptive to shareholder suits involving fiduciary duty claims. By contrast, the 2nd circuit read rule 10b-5 very expansively. The Supreme Court put an end to this in Santa Fe Industries v. Green (U.S. 1977). In that case, the 2nd circuit had ruled that an unfair cash-out merger could be actionable “fraud” under rule 10b-5 even if defendants had fully disclosed all price-relevant information. The Supreme Court insisted, however, that 10b-5 required “deception, misrepresentation, or nondisclosure.” In general, the Supreme Court has become much more hostile to private securities litigation over time. Thus, you should not expect a judicial expansion beyond what you will read below.
To avoid confusion, it is important to understand that insider trading cases and securities fraud actions involve and emphasize very different aspects of rule 10b-5. Usually, securities fraud cases turn on whether the information was misleading and material, whereas insider trading cases turn on whether the defendant had access to the information and, if so, whether the defendant improperly obtained or traded on it. The main policy question in securities fraud is the availability of the class action (strike suits? Who is deterred if the corporation pays the damages?), whereas the insider trading debate revolves around the definition of inside information and hence the boundaries of legitimate trading. Procedurally, securities fraud is typically litigated in a private class action, while insider trading is typically prosecuted by the S.E.C. or even the U.S. Attorney’s Office. As a result, the legal questions are quite different, even though they formally arise under the same rule 10b-5.
|4.1||Show/Hide More||Securities Litigation|
You know that listed corporations have extensive affirmative disclosure obligations under the securities acts (see the Securities Law Primer in the introductory part of the course). But what happens if the corporation does not disclose truthfully? One possibility is that the SEC will bring an enforcement action. Another possibility that we will look at here is that a specialized plaintiff law firm will file a “securities fraud” class action against the corporation (!). If the corporate disclosure was misleadingly positive, then the suit will attempt to recover damages for shareholders who bought at an inflated price — inflated because it was based on erroneously positive information. Inversely, sellers will sue if the disclosure was misleadingly negative and thus the price deflated. Notice that those on the other side of these trades—sellers who sell at an inflated price, or buyers who buy at a deflated price—benefitted from the erroneous corporate disclosure, but they are not party to the litigation.
Most of the time, any individual trader’s losses from the fraud are too small to make an individual lawsuit worthwhile. The big question in securities litigation is therefore the availability of the class action. That is the main question addressed in Basic, besides defining the standard of materiality for securities fraud. By endorsing the fraud-on-the-market theory, Basic paved the way for an entire industry of specialized class action law firms. Congress and recently the Supreme Court have tried to reign in some of this litigation, which remains controversial. In 1995, Congress passed the Private Securities Litigation Reform Act, which, among other things, introduced very strict pleading requirements via SEA §21D.
Doctrinally, the fraud-on-the-market theory is an interpretation of the reliance element of the private right of action under rule 10b-5. Notwithstanding the convoluted text of the rule, the elements of a 10b-5 claim appear to be exactly the same as those of common law fraud: (1) a false or misleading statement (2) of a material fact (3) made with scienter that (4) the plaintiff reasonably relied on, (5) causing injury to the plaintiff. As the Basic decision shows, however, these similarities are deceptive. These elements have a special meaning in the context of 10b-5.
|4.1.1||Show/Hide More||Basic Inc. v. Levinson (U.S. 1988)|
|4.2||Show/Hide More||Insider Trading|
We now turn to insider trading. As mentioned above, the main rule is again 10b-5, but the questions are rather different than those in standard securities fraud cases. Doctrinally, the main question is how to fit the idea of insider trading (use of inside information) under an anti-fraud rule (answer: by inventing a duty to disclose, such that insiders commit fraud by omission if they don’t disclose). The main policy question is how far insider trading liability should reach. There must be some informed trading if prices are supposed to be “efficient,” i.e., correct. The three cases we will read are about that.
Practically speaking, the biggest issue of insider trading law is enforcement. In the words of Judge Rakoff at the sentencing of Rajat Gupta (the retired chief executive of McKinsey and board member of Goldman Sachs who passed confidential information from Goldman’s board meeting to a hedge fund as soon as he left the meeting):
Insider trading is an easy crime to commit but a difficult crime to catch. Others similarly situated to the defendant must therefore be made to understand that when you get caught, you will go to jail.
These enforcement difficulties are one reason why insider trading is policed primarily through criminal and administrative enforcement, not private litigation. Many insider trading cases come to light only through criminal law enforcement tools such as wire-tapping. The exchanges also have monitoring systems and report unusual trading activity to the SEC.
Another reason why private litigation plays a minor role is the lack of incentives for plaintiff law firms. The courts and SEA §20A(b)(1), adopted in 1988, have capped insider trading damages at the gain derived by the defendant. In any event, the individual defendants are usually judgment proof beyond some comparatively small amount of personal wealth (compared, that is, to the hundreds of millions the plaintiff law firms can win from corporations).
Perhaps in recognition of these enforcement difficulties, §16 of the Exchange Act provides two rules that do not directly target insider trading but may catch or expose most of it.
Subsection (a) provides that corporate directors, officers, and principal stockholders must within two business days disclose each and every transaction in the corporation’s equity securities, including derivatives written on those securities. The Act defines principal stockholders as those who own at least 10% of the corporation’s stock. The SEC provides further definitions of the subsection’s terms in rules 16a-1 and 16a-2. Rule 16a-3(a) stipulates that filings are to be made on the so-called “form 4.”
Naturally, not all trades by corporate insiders disclosed on form 4 are illegal. If the insider does not possess any material non-public information at the time of trade, the trade is permissible. But once disclosed on form 4, the insiders’ trades can be scrutinized by private and public investigators.
Subsection (b) of §16 grants the corporation a right of action to recover any so-called short swing trading profits from its officers, directors, and principal stockholders. (The provision explicitly contemplates a shareholder derivative action if the corporation does not bring suit within 60 days of a request.) The provision is explicitly targeting insider trading in a prophylactic manner. It reads, in its core part:
“For the purpose of preventing the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer, any profit realized by him from any purchase and sale, or any sale and purchase, of any equity security of such issuer . . . within any period of less than six months . . . shall inure to and be recoverable by the issuer.”
Clearly, not all trades occurring within six months of one another use insider information. Nor are all trades that do use insider information unwound within six months. The provision is thus both over- and under-inclusive as a weapon against insider trading. It is, however, very easy to administer, especially given the information provided on forms 4.
The main rule that directly targets the impermissible use of insider information is 10b-5.
As already mentioned, the issues arising under 10b-5 in insider trading cases are quite different from the main issues in standard securities fraud litigation. Many of the issues occupying private securities fraud litigators are simply irrelevant in criminal insider trading cases. Criminal liability requires only a misrepresentation of a material fact committed with scienter. The other, victim-centric elements of private fraud claims, namely reliance, injury, and loss causation, are irrelevant. Moreover, prosecutors tend to shy away from cases where materiality is not self-evident.
The main doctrinal question in insider trading cases is whether there was a misrepresentation. To cast the mere use of inside information in impersonal security markets as a misrepresentation towards an anonymous counterparty required considerable doctrinal work by the courts. Before rule 10b-5, most courts had refused to subsume insider trading under common law fraud. The SEC, the federal courts, and ultimately the Supreme Court brought insider trading under the 10b-5 anti-fraud rule by stipulating a “duty to abstain [from trading] or disclose.” In reading the cases, you might wonder where exactly that duty comes from. In any event, Congress explicitly endorsed this jurisprudence post hoc.
In comparative perspective, the Supreme Court’s wrestling with the notion of a “duty to disclose or abstain” is an anomaly. Other jurisdictions, such as the UK, have insider trading rules distinct from general anti-fraud rules. The doctrinal issue of a “duty to disclose” does not arise there. Of course, all jurisdictions have to grapple with the legal and policy question of what exactly does and should constitute illegal insider trading.
There are other, more specialized insider trading rules. In particular, after losing Chiarella below, the SEC adopted rule 14e-3 against insider trading in the context of tender offers. As discussed in O’Hagan below, this rule is not directly based on the fraud concept and therefore broader.
Many other SEC rules deal with details of insider trading, in particular under rule 10b-5. Again, the irony is that the SEC never passed an explicit rule against insider trading under SEA §10, even though it did pass rules interpreting the court decisions interpreting rule 10b-5 with respect to insider trading.
For example, the SEC adopted a safe harbor provision for “trading plans” under which executives pre-commit to buy or sell their corporation’s securities at certain future points in time (rule 10b5-1). This rule is important because a large part of executive compensation is stock or options. Executives could hardly ever monetize these awards before retirement if they did not have this safe harbor.
Rule 10b5-2 purports to define the “duty of trust” whose breach can give rise to insider trading liability under the misappropriation theory (see O’Hagan below). Of note, paragraph (b)(3) of the rule presumes such a duty between family members.
Insider trading may also raise a claim under state law. The Delaware Supreme Court recently reaffirmed this rule in Kahn v. Kolberg Kravis Roberts (2011). Relying on Guth, the Court held that such a “Brophy” claim (after a 1949 decision) is not limited to damages sustained by the corporation or even to the loss of a corporate opportunity (to trade). Instead, the Court predicated insider-trading liability on “unjust enrichment based on the misuse of confidential corporate information.” Again, however, such private claims are rarely brought, presumably because of the enforcement difficulties outlined above.
While insider trading is criminal today, it used to be considered a normal executive perk in the not too distant past. Moreover, serious policy analysts have argued that insider trading ought to be permissible. Their main argument is that insider trades reveal information to the market. To wit, if insiders buy, the market can infer good news, and the stock price will go up. Inversely, if insiders sell, the market can infer bad news, and the stock price will go down. In either case, the insider trades move the prices closer to the “fundamental value” of the stock. Insider trading thus makes the price more “informationally efficient,” i.e., correct.
The standard objection is that like any trading gain, the inside trader’s gain is another trader’s loss. Insider trading thus systematically shifts value from outside investors and speculators to insiders. As a result, such outside investment and speculation may be deterred.
The standard objection is seriously incomplete because losing against a better informed trader is a normal part of trading. For an uninformed trader, it is irrelevant if he or she loses to an insider or to hedge funds who compiled the information from public sources. A more subtle objection is that hedge funds might not enter the market if they had to compete against better informed insiders. The net effect of insider trading could thus be less information in stock prices. As long as the information content is at least not less, however, having the insiders do the trading is actually preferable: it saves the resources (personnel, computing power, spy satellites, etc.) that the hedge funds would have directed at figuring out information that the insiders already possess.
There is a much bigger problem with the contrarian view favoring insider trading. It assumes that all other insider behavior would be unchanged if insider trading were allowed. Realistically, insiders would probably be much more reluctant to disclose information if keeping it secret increased their trading profits. Thus, allowing insider trading might reduce, rather than increase, the information available to the public and ultimately the informational efficiency of stock prices. Worse, insiders might intentionally increase the riskiness of the corporation’s business if they could use inside information about risk realizations for profitable trading. That is, the ability to trade would divert insiders’ attention and warp their incentives in choosing projects. They could attempt to profit from, and expend resources on, trading (a social zero-sum game), rather than focusing on producing good products, etc. (a social welfare improvement). Prohibiting insider trading thus helps align insiders’ incentives with social welfare.
|4.2.1||Show/Hide More||Chiarella v. United States (U.S. 1980)|
This decision rejects the so-called “equal access theory” of insider trading, according to which anyone trading while in possession of material nonpublic information violates rule 10b-5.
1. According to the majority, why is the equal access theory inconsistent with rule 10b-5? In other words, what else is required for a 10b-5 violation, besides trading while in possession of material nonpublic information?
2. As Burger’s dissent points out, Chiarella did not simply trade while in possession of material nonpublic information: Chiarella misappropriated that information from his employer. Why is such misappropriation not sufficient to subject his trades to 10b-5 liability? Or is it? Cf. part IV of the majority opinion and O’Hagan, infra.
3. Do you think the equal access theory would be good policy? What interests would it protect, if any? What desirable activities might it hamper?
|4.2.2||Show/Hide More||Dirks v. SEC (US 1983)|
Dirks is the leading case on “tippee” liability under rule 10b-5. A “tippee” is a corporate outsider who trades after receiving material nonpublic information from an insider or another tippee.
1. According to the majority, when are tippees liable under rule 10b-5?
2. Why did the majority exonerate Dirks?
|4.2.3||Show/Hide More||U.S. v. O'Hagan (U.S. 1997)|
In O’Hagan, the Supreme Court endorsed the so-called “misappropriation theory” of insider trading liability under rule 10b-5, and upheld rule 14e-3.
1. The misappropriation theory rests 10b-5 liability on deceiving the source of the information. What exactly is the deception, and does it occur “in connection with the purchase or sale of any security” (see SEA §10(b) and rule 10b-5)?
2. Does rule 14e-3 expand liability beyond rule 10b-5? If so, what is the statutory basis for the expansion?
3. Did O’Hagan overrule Chiarella and Dirks?a. Could the defendant in Chiarella have been convicted under O’Hagan’s theory of rule 10b-5? If so, why wasn’t he? Hint: re-read part IV of Chiarella.
b. Could the defendant in Chiarella have been convicted under rule 14e-3? If so, why wasn’t he?
c. Does O’Hagan’s misappropriation theory of 10b-5 insider trading liability replace the “classical theory” as endorsed and applied by Chiarella and Dirks—liability premised on a duty to the shareholders of the corporation whose shares are being traded? Or are the two theories complementary? What behavior would violate rule 10b-5 under the classical theory but not under the misappropriation theory?
|5||Show/Hide More||Creditors and Other Non-Shareholder Constituencies|
So far, we have been discussing the relationships between boards (managers) and shareholders, and between majority (controlling) shareholders and minority shareholders. We now broaden our horizon and consider other constituencies, such as creditors, workers, and consumers.
You might think that non-shareholder constituencies are fundamentally different because they are “outsiders” to the corporation, while shareholders (and boards) are “insiders.” But this is misleading, at least in large publicly held corporations. Most investors in these corporations are “outsiders” no matter how they invest, be it through debt or equity. In fact, from most investors’ and the controller’s (founder’s) point of view, debt and equity are largely interchangeable as investment vehicles, and the choice between them hinges on details of cash flow and control rights, rather than on any notion of inside/outside.
One frequently hears that shareholders are the corporation’s “owners,” while other constituencies are “merely” contracting partners. This may contain some truth for small businesses, but it is clearly not true for large businesses. In the technical legal sense of the term, shareholders only own their shares, not the corporation. In the functional sense, shareholders lack the control rights that one generally associates with ownership. Obviously, individual shareholders cannot deal with corporate property as they please. And at least in Delaware, shareholders cannot even make decisions about corporate property collectively, since business decisions are the prerogative of the board (cf. DGCL 141(a)). As to replacing the board, this is difficult for dispersed shareholders in practice, as we have seen. In fact, shareholders may not even have the legal right to replace the board, or any other meaningful control rights. For example, the dual class share structure in Google and Facebook gives the founders full control of their corporations even though they have sold off most of the equity.
The better, modern view is that the corporation is simply a nexus of contracts (and other obligations). In this view, many different constituents transact with one another through the corporate form. In addition to managers and shareholders, these constituents include creditors, workers, customers, suppliers, and others. Corporate law’s goal is to facilitate their transactions, not to defend ostensible ownership rights. In this view, shareholders are not special — at least in principle.
This is not to say that the law should not, or does not, treat shareholders differently for pragmatic reasons. In fact, as you have probably already guessed and we will now confirm, corporate law is almost exclusively concerned with the relationships between shareholders and boards, and between shareholders themselves.
To be sure, for the most part, this is mere nomenclature. Many legal rules govern relationships between corporations and other constituencies. It’s just that we group these rules under different headings: “labor and employment law,” “consumer law,” “antitrust,” “contract law,” etc. In this perspective, corporate law is merely the name we give to those legal rules that specifically deal with “internal governance” — the misleading term (see above) for relationships between shareholders and boards, and between shareholders themselves. By definition then, this “area of law” does not deal with other constituencies. But this is without substantive content.
The substantive question is the content of corporate fiduciary duties. Corporate directors and officers obviously have to comply with all the laws protecting other constituencies (cf. DGCL 102(b)(7)(ii))). In exercising their remaining discretion, however, can or must they take into account the interests of all affected? Or must they act solely for shareholders’ benefit?
As we have already glimpsed in Revlon and will now see very clearly in Gheewalla and eBay, directors and officers of Delaware corporations owe fiduciary duties only to common stockholders. To be sure, Delaware courts continue to assert that corporate fiduciaries owe their duties “to the corporation and its shareholders.” But when the rubber hits the road, recent Delaware decisions have opted for shareholders. This is often dubbed “shareholder primacy” — the idea that, within the boundaries of contracts and regulations, corporations are to be run for the benefit of shareholders alone.
The competing “stakeholder model” suggests that boards should and do manage corporations for the benefit of all their stakeholders. As a matter of positive law, proponents interpret the words “to the corporation and its shareholders” (emphasis added) as shorthand for their broader view of fiduciary duties. This interpretation sounds sensible, for what else would the words “to the corporation” mean? Then again, the Delaware courts don’t see it that way (see previous paragraph).
In 2013, the Delaware General Assembly dealt a further blow to the stakeholder model by amending the DGCL to add a new “Subchapter XV. Public Benefit Corporations.” The new DGCL 362(a) explicitly provides:
“A ‘public benefit corporation’ is a for-profit corporation organized under and subject to the requirements of this chapter that is intended to produce a public benefit or public benefits and to operate in a responsible and sustainable manner. To that end, a public benefit corporation shall be managed in a manner that balances the stockholders' pecuniary interests, the best interests of those materially affected by the corporation's conduct, and the public benefit or public benefits identified in its certificate of incorporation. In the certificate of incorporation, a public benefit corporation shall … [s]tate within its heading that it is a public benefit corporation.”
Thus, corporations organized for a public benefit are clearly distinct from standard Delaware corporations under the DGCL. This strongly suggests that standard Delaware corporations are not to be managed for the public benefit.
In normal times, these debates are almost entirely irrelevant from a purely legal point of view. The reason is the lenient standard of review for normal board decisions (i.e., the duty of care). As you already know, the business judgment rule gives boards almost unfettered discretion. Consequently, for a very long time, there was only one reported case where “shareholder primacy” mattered, and of course, everyone cited this one case.
The case is Dodge v. Ford Motor Co. (Mich. 1919). Henry Ford took the stand and argued that the Ford Motor Company did not pay dividends because it needed the money to benefit its workers and customers. In truth, Ford probably just wanted to avoid paying out money to his minority stockholders the Dodge brothers, who had by then become his competitors. In any event, the court held against Ford, on the grounds that “A business corporation is organized and carried on primarily for the profit of the stockholders.” But Ford almost certainly would have won if he had argued that the company needed the cash for future investment or some other business purpose.
There are, however, two ways in which the debate does matter. First, the legal rule probably matters directly in the sale of the company. This is because in this “end game” situation, conflicts between constituencies become very visible. The board can no longer hide behind “long-term shareholder interest” to justify some action that directly benefits a non-shareholder constituency. Cf. the passage on non-shareholder constituencies in Revlon, and watch out for the kind of very nasty things corporate managers are allowed to do to creditors in MetLife v. RJR Nabisco.
Second, the legal rule may matter inasmuch as it guides the behavior of honest, faithful fiduciaries — to the extent it influences “board room culture,” if you will. A director may genuinely care about whether she is legally bound to benefit only shareholders or stakeholders as a whole. Thus, she may vote differently depending on what her legal advisors tell her about the content of fiduciary duties. That these fiduciary duties are not enforceable in court may be irrelevant.
To the extent that the content of fiduciary duties does matter and works literally as intended, it is clearly bad. By definition, maximizing the interests of one group only (common shareholders) generates less social welfare than maximizing the interests of all groups combined. Ex ante, this harms even the favored group, because it will have to make concessions on other points to obtain the collaboration of the other constituencies. Since the pie is smaller (because the law doesn’t maximize it), there will be less for everyone to share.
For example, taken at face value, In re Trados Inc. Shareholder Litigation (Del. Ch. 2013) would force boards of insolvent corporations to bet the corporation’s last cash at the casino (or embark on some similarly risky, negative net present value project). For without the gamble, common stockholders get nothing. With the gamble, there is a chance that the board will win and shareholders get something. To be sure, the gamble is bad for all stakeholders combined, i.e., once creditors and preferred stockholders are included: on average, casino gamblers lose. But Trados claims that boards should work only for common stockholders. Ex ante, this rule is bad even for the common stockholders: to obtain investments from creditors etc., they will have to make other promises that compensate creditors for their anticipated losses from gambling.
Shareholder primacy advocates do not deny the conceptual validity of the preceding argument. They merely question its practical relevance on two complementary grounds. Firstly, they point out that various legal rules and in particular contracts restrict the ability of boards to favor shareholders at the expense of other constituencies. Secondly, they question if there could be any legal oversight over boards if boards were charged with maximizing the interests of all stakeholders. What are those “interests,” and what actions maximize them? It’s hard enough to figure out, e.g., what action maximizes the share price (under Revlon’s deceptively simple maxim of getting the highest price). Shareholder primacy advocates fear that stakeholder interests are so diffuse that they will always provide a pretext for managers to favor themselves. In this view, being accountable to everyone in theory means being accountable to no one in practice.
Importantly, no serious commentator argues that shareholders are the only people who matter in the grand scheme of things, workers etc. be damned. Rather, the disagreement is about the method of getting the best collective outcome. The debate between shareholder primacy and stakeholder models is thus closely related to the framing of the main conflict surrounding corporations. Which is the worse problem: (1) unfaithful managers wasting (mostly) shareholders’ money, or (2) shareholders and their faithful managers exploiting other constituencies?
In favor of shareholder primacy, commentators argue that shareholders have no legal means beyond fiduciary duties to get any of their money back. They have no right to dividends, or to withdraw their principal investment. By contrast, creditors (including, e.g., workers as wage claimants) have contractually specified payment rights, and the corporation must file for bankruptcy if it does not fulfill these obligations. Moreover, many other constituencies can withdraw or withhold their contribution if the corporation does not keep to its bargain: workers can move to a different job, customers can buy from different providers, etc. By contrast, shareholders part with their equity investment up front and do not get it back unless the board in its discretion decides to make a distribution. Importantly, this feature is arguably essential to equity as the most flexible form of financing.
Against this, proponents of the stakeholder model argue that shareholders in fact already have strong protection, namely their right to elect the board. No board would completely disregard shareholder wishes, or else it would be fired. There is, therefore, a tendency for boards to favor shareholders at the expense of everybody else, or so the argument goes, and fiduciary duties should at least not exacerbate this tendency. Moreover, the argument that laws other than corporate law sufficiently protect other constituencies is circular and defective to the extent that corporations in fact shape those other laws through lobbying. (To this latter argument, shareholder primacy proponents reply that this is a much broader problem of deficient rules on political spending and lobbying. You should keep this connection in mind when reading Citizens United later in the course.)
In this connection, it is worth pointing out that some countries push the stakeholder model considerably further in large corporations. They mandate that workers elect part of the board (so-called co-determination in Germany and many other Northern and Central European countries), or that the board be self-perpetuating (Netherlands). In this comparative perspective, U.S. corporate law heavily leans towards shareholder primacy, both normatively and factually, because only common shareholders elect the board in U.S. corporations.
To be sure, shareholder governance is merely the U.S. default. The charter may give board seats to other constituencies. (For example, preferred stockholders nominated the majority of the board of Trados Inc. in the aforementioned Trados case.) That so few large corporations adopt such alternative arrangements may provide some clues about their desirability. But this is an even deeper question that we must postpone until we have encountered some more concrete scenarios.
We begin with creditors because (1) creditors are the only constituency that still has some remnants of protections in corporate law, and (2) most other claims ultimately resolve into damages or other financial claims, transforming all constituencies into creditors at the end of the day.
Gheewalla sets forth the principle that creditors cannot invoke the protections of fiduciary duties against corporate directors (although they may occasionally have standing to enforce a derivative claim on behalf of the corporation). MetLife v. RJR Nabisco declines to protect the plaintiff-creditor under a contractual implied duty of good faith and fair dealing. The bottom line is that creditors have to rely on contractual protections. The MetLife decision reviews many customary protective clauses.
Do you find the courts' reasonings convincing?
|5.1.1||Show/Hide More||NACEPF v. Gheewalla (Del. 2007)|
The decision addresses, and you should look out for, two related but separate questions:
1. Who has standing to assert a fiduciary duty claim?
2. Whom is the fiduciary duty owed to, i.e., whose interests does it protect?
How might the answer to the second question have made a difference in this case? Whose interests were conflicting, and how, if at all, could the courts have adjudicated this conflict?
|5.1.2||Show/Hide More||Metropolitan Life Ins. Co. v. RJR Nabisco Inc. (SDNY 1989)|
MetLife, a very sophisticated creditor of RJR, claimed that the leveraged buyout of RJR by KKR was an entirely unanticipated event that violated RJR's implied duty of good faith and fair dealing towards its creditors. The court doesn't buy it. Do you?
Regardless, notice the striking contrast between the treatment of creditors and shareholders in this and other 1980s takeover cases. In MetLife, the court blesses a takeover that clearly reduced creditor value by billions of dollars without the deal-specific approval of creditors. At about the same time, Delaware cases empowered and even required boards to defeat takeovers in the name of “inadequate value” to shareholders even when the latter would have approved the deal. Does this make sense?
NB: The book Barbarians at the Gate tells the tale of the “bidding war” referred to in Judge Walker's introduction — it is a fun read.
|5.2||Show/Hide More||eBay v. Newmark (Del. Ch. 2010)|
This case pits eBay against Craig Newmark and Jim Buckmaster in a battle for control of craigslist. Craig and Jim are craigslist’s founder and CEO, respectively.
craigslist is a close corporation — a corporation with only few shareholders and no public market for its shares. craigslist’s only shareholders at the time were Craig, Jim, and eBay. Close corporations tend to generate two problems not seen in public corporations. First, personal relationships loom much larger. By the time close corporations show up in court, these relationships have generally soured. Second, exit for a shareholder is difficult in the absence of a public market for the shares. This is related to the first point, as it makes it harder to dissolve sour relationships. Moreover, it means that shareholders cannot obtain liquidity (i.e., cash in some, or all, of their stake) by selling, which leads to disputes over payout policy when some shareholders need liquidity and others don’t (or they do but they are in control and pay themselves generous salaries). In fact, controlling shareholders may abuse a minority’s liquidity need to force the minority to sell out at a low price. When no individual shareholder has control, disputes can easily lead to deadlock. Court intervention may be necessary to resolve the deadlock. Cf. DGCL 226 (read!; also skim DGCL 341, 342, and 350-353).
Both of these problems are at play in the present case, but with a twist. The twist is that the shareholders do not just disagree about payouts. They disagree about the more basic question of whether the corporation should be generating profits in the first place. eBay thinks so, but Craig and Jim do not. This is our main focus here. What is the purpose of a Delaware corporation, according to the court? Can shareholders enforce that purpose in court? Hint: Beyond the confines of this particular lawsuit, what did eBay ultimately want, and do you think eBay could have successfully sued for it (eBay never did)?
I assign the full opinion because (1) the context is crucial to understand the outcome, as always, and (2) the opinion is an excellent review of almost everything we have done so far: fiduciary duties, shareholder voting, shareholder litigation, and takeover defenses.
|5.3||Show/Hide More||Enforcement of Regulations against Corporations|
As previously mentioned, corporations are subject to extensive regulations protecting non-shareholder constituencies. Regulatory enforcement is a major practice area, and virtually all corporations now employ dedicated regulatory compliance departments. Examples of such regulations include antitrust, banking regulation, and environmental protection law. While these laws all have their specialized courses, their enforcement presents some common issues that deserve mention even in an introductory corporate law course.
Civil enforcement against corporations is easy, at least conceptually speaking, because it is similar to any other civil litigation. (In practice, corporate civil litigation employs armies of lawyers.) By and large, in civil proceedings, it does not matter whether the defendant is an individual or a corporation. In particular, under the law of agency, acts of individual employees are imputed to the corporation as they would be to an individual employer. Thus, the only question particular to corporate suits is whether the same corporate agent or group of agents — for example, the CEO or the board — had all relevant knowledge or intent where such is required, or whether “collective knowledge” is sufficient. On this question, courts have given divergent answers.
Unlike civil enforcement, criminal enforcement raises a host of issues particular to corporate defendants. This is because first, a corporation does not have a mind and hence cannot have a “guilty mind” —mens rea—, and second, it does not have a body and hence cannot be incarcerated.
At common law, corporations could not be criminally liable. In the 19th century, however, criminal statutes regulating economic behavior through fines proliferated. Some of those statutes explicitly extended criminal liability to corporations. In 1909, the Supreme Court assessed the constitutionality of one such statute in New York Central & Hudson River Railroad Co. v. U.S., holding that
“Applying the principle [of respondeat superior] governing civil liability, we go only a step farther in holding that the act of the agent, while exercising the authority delegated to him …, may be controlled, in the interest of public policy, by imputing his act to his employer and imposing penalties upon the corporation for which he is acting ….
“It is true that there are some crimes, which in their nature cannot be committed by corporations. But there is a large class of offenses … wherein the crime consists in purposely doing the things prohibited by statute. In that class of crimes we see no good reason why corporations may not be held responsible for and charged with the knowledge and purposes of their agents, acting within the authority conferred upon them. … If it were not so, many offenses might go unpunished and acts be committed in violation of law, where, as in the present case, the statute requires all persons, corporate or private, to refrain from certain practices forbidden in the interest of public policy.”
212 U.S. 481, 494–95 (1909).
Nowadays, federal criminal statutes targeting a “person” — almost all statutes — presumptively apply to corporations (cf. 1 U.S.C. §1), as long as the agent acted within the scope of her employment and sought, at least in part, to benefit the corporation.
Is this extension of criminal liability a good idea? Or is civil liability sufficient?
Leaving aside moral blame and retribution, there are two main arguments for why civil liability is insufficient for individuals: deterrence and incapacitation. Do these two arguments also support criminal liability for corporations?
For individuals, the threat of (criminal) imprisonment can improve deterrence beyond (civil) monetary liability, which is limited by an individual’s wealth. Corporations, however, cannot be imprisoned. They can only pay monetary fines. Thus, as far as penalties go, criminal liability does not improve deterrence for corporations beyond what civil liability could do. But criminal law does offer procedural enhancements that matter for corporate deterrence. First, certain aggressive enforcement tools, such as wiretaps, are only available in criminal prosecutions. These tools increase deterrence by increasing the probability that a violation will be discovered. Second, in criminal proceedings the government can act as a central enforcer on behalf of a dispersed class of injured parties, none of whom might have individual incentives to pursue a civil claim (but note that class actions would achieve the same purpose). For example, these two procedural enhancements are crucial for the government's enforcement of insider trading rules (but note that the majority of insider trading enforcement actions are brought by the S.E.C. in civil or administrative proceedings) and of antitrust rules against price fixing.
The second argument for individual criminal liability is incapacitation. Some individuals cannot be deterred, and society may be better off keeping them in prison. Similarly, if an organization is prone to illegal behavior despite the threat of civil liability, society may be better off shutting down that organization or at least excluding it from certain activities or businesses. In particular, some corporations may have more “aggressive” corporate cultures — the ingrained norms of behavior inside the organization — than others.
Some commentators worry that corporations can offend with impunity because their well-financed legal defense teams overwhelm prosecutors' resources and resolve.
However, other commentators have the opposite concern — corporate criminal liability may overdeter. The optimal amount of certain crimes, such as the bribing of foreign officials, may well be zero. But shareholders, or even boards, do not have direct control over such crimes, which may be committed by lower-level employees. Therefore, shareholders and boards can prevent such crimes only through costly compliance programs. In other words, what is an intentional crime at the level of the acting individual (and, in the eyes of the law, for the corporation as a whole) is essentially a negligent tort at the level of the overseeing board and shareholders.
If the criminal penalty equals the societal harm caused by the crime, then corporations will be incentivized to spend only the socially optimal amount on compliance programs. However, if the penalty is higher than the social harm, then compliance spending may be socially excessive. A similar problem arises when it is unclear what constitutes lawful behavior, which is frequent in heavily regulated areas. For example, a bank might violate anti-money-laundering rules by not disclosing some transactions to its regulator, and violate privacy rules by disclosing too much. The net social benefit of disclosure is likely to vary little as the bank discloses a little bit more or less. But the bank itself is affected drastically if there is any small variation which leads to illegal disclosure or non-disclosure, since such violations can carry heavy sanctions. Again, the bank would be incentivized to spend more than the socially optimal amount on ensuring compliance.
|5.3.1||Show/Hide More||Federal Sentencing Guidelines: Introductory Commentary to Chapter 8 - Sentencing of Organizations|
How do the Federal Sentencing Guidelines address the concerns described in my introductory note on enforcement? Do they profess to aim at optimal deterrence or optimal incapacitation? Do they achieve either? If not, what else do they aim to do, and does that make sense?
The complete Guidelines for organizations are available here.
|5.3.3||Show/Hide More||U.S. Attorney S.D.N.Y.: Deferred Prosecution Agreement with General Motors (2015)|
The complaint below memorializes the outcome of the federal government's investigation into General Motor's ignition switch scandal. Judge Nathan of the S.D.N.Y. entered the forfeiture order sought in December 2015.
What exactly did the government prosecute General Motors for? Was GM's prosecution necessary for deterrence? For incapacitation?
We have seen that U.S. corporate law focuses on protecting only shareholders, rather than all stakeholders — with some very limited protections for creditors. In fact, U.S. corporate law, at least the Delaware variety, contains few rules, period. Further, even those few rules can mostly be abrogated or circumvented in a corporation’s charter. This lack of strict rules is why this course mainly focuses on fiduciary duties and the occasional shareholder approval requirement.
In sum, Delaware corporate law does little more than enable charter contracting by supplying default terms, gap-filling (?) fiduciary duties, and, importantly, an able judiciary to enforce these terms and duties. By contrast, corporate law outside the U.S. tends to be much more rule based. We have seen one example in UK takeover law. This raises questions: Why is U.S. corporate law as liberal as it is? Is this liberality a good thing?
U.S. corporate law’s liberality and lack of concern for non-shareholder constituencies are intimately related to the rise of Delaware as the foremost state of incorporation. Delaware attracts so many corporate charters mainly because “foreign corporations” — corporations with few or even no operations in Delaware — can opt to be governed by Delaware law as long as they incorporate in Delaware. That is, Delaware’s prominence is predicated on a choice of law rule. Under the “internal affairs doctrine” the applicable corporate law is the law of the state of incorporation. This doctrine undergirds Delaware’s business of “competing for corporate charters.” Such competition would not be possible if the applicable corporate law were, for example, the law of the state of the corporation’s headquarters, as it is in many non-U.S. jurisdictions.
Charter competition treats corporate law as a product. That is, corporate law appears not as regulation, but as a service to contracting parties organizing a business. The “contract” consists of the charter terms and the applicable corporate law. The contracting parties, in a narrow sense, are those involved in drafting the charter. In a broader sense, the contracting parties include all those who voluntarily interact with the corporation, such as shareholders. To be sure, their agreement to the charter terms is not literally required. But they have the option not to interact, to charge higher prices, to invest less money, and so on, if the charter terms displease them. In anticipation of these options, the drafters of the charter have strong incentives to take these other parties’ concerns into account. Or so the argument goes.
Such reliance on private contracting has indeed been the hallmark of U.S. state corporate law (but not federal securities law) for many decades. It complements the internal affairs doctrine in two ways. First, confidence in private contracting provides a normative underpinning for free choice of corporate law. Second, any restrictions on private contracting imposed by an individual state could be easily circumvented by (re-)incorporating in another state. Do you think this deference to private contracting is appropriate?
|6.1||Show/Hide More||Choice of Law: The Internal Affairs Doctrine|
The “internal affairs doctrine” is a choice of law rule that applies the law of the state of incorporation to the corporation’s “internal affairs.”
While many in the U.S. treat the internal affairs doctrine as self-evident, other countries frequently insist on applying their corporate law to all corporations that have their headquarters in that country, or some other substantial connection to that country. Such insistence on a substantial connection is no stranger to U.S. choice of law. In fact, for most contracts, U.S. courts generally refuse to apply “[t]he law of the state chosen by the parties to govern their contractual rights and duties” if “the chosen state has no substantial relationship to the parties or the transaction and there is no other reasonable basis for the parties choice,” see Restatement of the Law (2nd) Conflict of Laws § 187(2)(a). U.S. courts will, however, enforce any chosen state's corporate law under the internal affairs doctrine.
The internal affairs doctrine allowed corporations to migrate away from states that imposed restrictions. Again, “migration” is a mere figure of speech — no people or assets need to move out of state to avoid that state's corporate law. Mere reincorporation in another state is sufficient.
Nowadays this issue is mostly discussed in connection with shareholder rights. In recent decades, commentators have been intensely debating whether Delaware’s enabling approach to shareholder rights is the result of a “race to the top” or a “race to the bottom” from the perspective of the shareholder/manager relationship. But Delaware actually became a major corporate domicile only because other states tried to protect non-shareholder constituencies through corporate law. In particular, in an attempt to combat “trusts,” a/k/a cartels, New York in the later 19th and early 20th century prohibited holding companies — it prohibited its corporations from owning stock in other corporations. In response, corporations migrated to New Jersey. When New Jersey’s governor Woodrow Wilson ran for the presidency in 1912, he advocated amendments that limited holding companies in New Jersey as well. Thus, the corporations moved on to Delaware and they have stayed there ever since. The issue of “trusts” was left to federal antitrust law.
In general, regulatory competition may work for the contracting parties writ large. As previously indicated, this group includes all those who voluntarily interact with the corporation. But regulatory competition clearly does not address the concerns of third parties, such as tort creditors or the general public. To the extent that these groups are affected by corporate law, regulatory competition is apt to generate negative externalities. Such externalities would then require federal intervention, such as the federal antitrust and securities laws.
Are negative externalities a real problem in corporate law, or a negligible quibble? The answer depends on two related issues: First, the scope of the internal affairs doctrine. The fewer rules the doctrine covers, the less potential for externalities. As its name implies, the internal affairs doctrine covers internal organizational rules, but the details can be tricky, as Lidow illustrates.
Second, do third parties really need the protection of rules covered by the internal affairs doctrine? After all, tort victims are already protected by tort law, the environment is protected by environmental statutes and so on. Nevertheless, additional protection through organizational law may be required. The reason is that this other law is imperfect, owing to the limits of both the political process and of law’s capacity to regulate human affairs. Hence societies must rely on non-legal norms to regulate most human interaction. However, the corporate context may interfere with the operation of non-legal norms, be it by diffusing responsibility, by suppressing internalized norms, or by some other mechanism. Do we need to insist on some mandatory internal corporate structure to avoid “sociopathic” corporate behavior? Or to take a more positive view, does organizational law provide opportunities for “mandatory betterment” that would be infeasible or unethical for individuals? For example, should we impose co-determination or affirmative action for boards? The U.S. has neither, but many European countries do.
If one concludes that externalities from corporate law are a real problem, then one should wonder why states accept the internal affairs doctrine. It is often said, especially in Delaware, that the U.S. Constitution enshrines the internal affairs doctrine; CTS is usually cited as support. See, e.g., VantagePoint below. Read CTS and judge for yourself.
|6.1.1||Show/Hide More||CTS v. Dynamics (U.S. 1987)|
This decision upheld Indiana’s version of DGCL 203 against constitutional challenge. In the 1980s, most states passed some form of an anti-takeover statute. They were hotly politically contested, as you might infer from the heated debate between the Justices and the various amici.
In Edgar v. MITE (1982), a plurality of the Supreme Court struck down an Illinois law that purported to apply to any tender offer for shares of “corporation or other issuer of securities of which shareholders located in Illinois own 10% of the class of equity securities subject to the offer, or for which any two of the following three conditions are met: the corporation (1) has its principal executive office in Illinois, (2) is organized under the laws of Illinois, or (3) has at least 10% of its stated capital and paid-in surplus represented within the State,” 457 U.S. 624, 627 (1982).
The Indiana statute at issue here in CTS is different as it applies only to corporations chartered in Indiana. Does this fact or anything else in the decision imply that the internal affairs doctrine is enshrined in the U.S. Constitution?
|6.1.2||Show/Hide More||VantagePoint v. Examen Inc. (Del. 2005)|
This Delaware case deals with the only sustained challenge to the internal affairs doctrine in the U.S.: section 2115 of the California Corporations Code.
1. By its own terms, does section 2115 apply in this case?
2. Why does the Delaware Supreme Court not apply section 2115?
3. Does the Delaware Supreme Court hold that the internal affairs doctrine is embodied in the U.S. constitution?
4. What is better for Delaware’s business – section 2115 or strict adherence to the internal affairs doctrine?
5. As a policy matter, did the party arguing for application of section 2115, VantagePoint, deserve its protection in this case?
|6.1.3||Show/Hide More||Lidow v. Superior Court (Cal. 2012)|
This California decision accepts the internal affairs doctrine in principle. Nevertheless, in this case it applies California law to a dispute between a Delaware corporation and its officer.
1. How does the Court of Appeals of California determine the scope of the internal affairs doctrine?
2. Looking beyond this particular case, what scope of the internal affairs doctrine increases the application of California law – a narrow scope or a broad scope?
3. What can corporations—or rather those who control them—do to escape application of California law under section 2115 or under Lidow, and are they likely to do that? What can corporations do to escape application of Delaware law under the internal affairs doctrine, and are they likely to do that?
|6.2||Show/Hide More||What is the right normative lens for corporate law?|
We are now ready to tackle the ultimate question: What is the point of corporate law? Is it merely to facilitate contracting? If so, what is the best way to do it? If not, what other goals should corporate law aim to advance?
In this context, commentators like to contrast the so-called contractarian and entity views of the corporation. As its name suggests, the contractarian view emphasizes the contractual aspects of the corporation, from drafting the initial charter to executive compensation contracts to customer relationships. By contrast, the entity view emphasizes the importance of the (large) corporation on the life of its constituents and beyond. Commentators tend to associate the contractarian view with an argument for contractual freedom, and the entity view with an argument for more mandatory rules.
In truth, this is a false dichotomy. The views are two sides of the same coin. A corporation is both one or more contracts (the charter above all) and an entity. Contracts can be regulated, and often are — for example, in the criminalization of cartels. And the mere fact that the corporate entity is important for people does not necessarily mean that we think the state should regulate how people organize it.
What the two views do, however, is illustrate the different rationales for corporate law-making. One rationale is to remedy contracting imperfections even between the contracting parties. Another rationale is to prevent externalities on non-contracting parties. U.S. corporate law tends to downplay the latter, perhaps because its perspective has been narrowed by the internal affairs doctrine and the doctrine’s limiting effects on regulation through corporate law. Implicitly, however, U.S. law also seems to fear externalities arising specifically from incorporation. If not, why would a law firm not be allowed to organize as a corporation? Or perhaps it should be allowed? We will approach such questions through Citizens United.
As we have seen, U.S. corporate law grants very extensive contractual freedom. Choose your state. Choose your corporate charter (cf. DGCL 102(b)(1) – read!). Even choose your entity type. For example, anyone not satisfied with DGCL 102(b)(7)’s restrictions on eliminating corporate fiduciary duties can choose a Delaware Limited Liability Company instead, where “[fiduciary] duties may be . . . eliminated by provisions in the LLC agreement; provided, that the LLC agreement may not eliminate the implied contractual covenant of good faith and fair dealing.” Del. LLC Act § 1101©. If that is still not enough, the Delaware statutory trust may help. Cf. Del. Code title 12, ch. 38.
Indeed, why limit permissible charter provisions at all? Once we rely on contracting to get the right result, why stop at particular provisions? In fact, if law is a “product” why not allow private providers to supply it? That is, why require election of any state law for incorporation? Private providers might be better at generating and maintaining private contract forms, registries, and arbitration — instead of, for example, the Delaware General Corporation Law, Secretary of State, and Chancery Court respectively. If the contractual model holds, people’s self-interest will ensure that they choose the most suitable package. The more options, the better.
Perhaps having so many options would make contracting too complex and confusing? That can hardly be a good argument because the existing options allow for plenty of confusion — for example the offer of non-voting shares and complicated voting structures. Many financial contracts are extremely complex, much more complex than we could reasonably expect charters to be — at present, public corporation charters are generally short, overwhelmingly boilerplate, and show very little variation. And the difficulty of evaluating a charter term pales in comparison to that of valuing a business.
Of course, human fallibility can undermine the contractual model (careful, though — it undermines faith in regulation as well). For example, if gullible investors do not price charter provisions correctly, savvy founders will produce bad charters. This might warrant prohibiting certain charter terms. But why stop there? Why not stop investors from investing in bad businesses? In other words, should some agency review the “investment worthiness” of securities before they can be issued to the public? Such review did exist in many states for a long time.
Perhaps the best argument for why charter freedom may not produce optimal results even if people generally contract well is charters’ long life. Drafters cannot foresee everything, and corporations can be around for a very long time. Then again, drafters know this, so they could build whatever flexibility they desire into their charter.
Of course, the contractarian view of the corporation is not the only possible view. In fact, for most of the 20th century, a different view prevailed in the U.S. and elsewhere. This was the view of the corporation as a social entity. This view saw a much larger role for mandatory law in structuring the entity and in regulating the entity’s interaction with the world. For example, the most famous account of large U.S. corporations in the 20th century, Adolf Berle & Gardiner Means’ “The Modern Corporation & Private Property” (1932; 1968) reviewed the dispersion of (family) ownership and the rise of professional management to conclude (pp. 310-313):
“Observable throughout the world . . . is this insistence that power in economic organization shall be subjected to the same tests of public benefit which have been applied in their turn to power otherwise located. . . .
“By tradition, a corporation ‘belongs’ to its shareholders . . . and theirs is the only interest to be recognized as the object of corporate activity. Following this tradition, and without regard for the changed character of ownership, it would be possible to apply in the interests of the passive property owner [i.e., shareholders] the doctrine of strict property rights . . . . Were this course followed, the bulk of American industry might soon be operated by trustees for the sole benefit of inactive and irresponsible security owners. . . .
“[Another] possibility exists, however. On the one hand, the owners of passive property, by surrendering control and responsibility over the active property, have surrendered the right that the corporation should be operated in their sole interest . . . At the same time, the controlling groups [i.e., managers], by means of the extension of corporate powers, have in their own interest broken the bars of tradition which require that the corporation be operated solely for the benefit of the owners of passive property. . . . The control groups have . . . cleared the way for the claims of a group far wider than either the owners or the control. They have placed the community in a position to demand that the modern corporation serve not alone the owners or the control but all society. . . .
“In still larger view, the modern corporation may be regarded not simply as one form of social organization but potentially (if not yet actually) as the dominant institution of the modern world. . . .
“The rise of the modern corporation has brought a concentration of economic power which can compete on equal terms with the modern state — economic power versus political power, each strong in its own field. The state seeks in some aspects to regulate the corporation, while the corporation, steadily becoming more powerful, makes every effort to avoid such regulation. . . . The future may see the economic organism, now typified by the corporation, not only on an equal plane with the state, but possibly even superseding it as the dominant form of social organization. The law of corporations, accordingly, might well be considered as a potential constitutional law for the new economic state. . . . "
|6.2.1||KKR & Co. L.P.|
|6.2.2||Show/Hide More||Citizens United v. Federal Election Com'n (US 2010)|
In this very controversial decision, the Supreme Court’s conservative majority held that a prohibition of corporate expenditures on certain types of speech violates the First Amendment. The decision implicates important legal issues of free speech, stare decisis, and judicial restraint. For our purposes, however, I have edited the case down to the passages dealing directly with the constitutionality of, and rationale for, distinguishing corporate from non-corporate speech. Please focus on this distinction.
The First Amendment reads, in relevant part:
“Congress shall make no law … abridging the freedom of speech, or of the press.”
As a preliminary matter, consider the following questions:
1. Does a literal reading of the First Amendment protect corporate expenditures?
2. Does an originalist reading of the First Amendment, adopted in 1791, protect corporate expenditures? You may recall that incorporation required a special act of the legislature well into the 19th century. Cf. Justice Scalia’s concurrence and Justice Stevens’ dissent.
In answering the latter question, you may want to distinguish between different types of corporations. In particular, many of the arguments and precedents that the Justices discuss relate to news, media, and political organizations, and the petitioner in the case is a non-profit advocacy organization funded mostly by donations from individuals. In this class, we are primarily interested in business corporations.
The main questions to consider are:
3. Do the Justices treat the corporation as an abstraction—a convenient way of summarizing legal relationships between individual human beings? Or as a “concentration of economic power which can compete on equal terms with the modern state” (Berle and Means)? Or as something different altogether?
4. Do the “the procedures of shareholder democracy” protect dissenting shareholders when they disagree with speech approved by (a) boards and managers or (b) majority shareholders? Should they? What would be the contractarian answer?
5. What other arguments for distinguishing corporate and individual speech do the Justices consider?
December 12, 2017
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