H2O

The Basics

Original Creator: Holger Spamann Current Version: Holger Spamann Show/Hide

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 problem

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? 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, directors and managers are agents for the corporation, not for shareholders. 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.)

The basic partial solutions

Shareholder voting and fiduciary duties

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).

Other shareholder rights

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).

Default rules vs. contractual arrangements

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).

Variations on the basic problem

The board as a monitor

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?

Dominant shareholders

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.

Protecting other constituencies

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

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.

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  1. 1 Show/Hide More Shareholder Voting
    Original Creator: Holger Spamann Current Version: Holger Spamann

    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 democracy”

    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)).

    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.)

    Voting rules and frequency

    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). 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).

    Proxies

    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.

    The federal proxy rules

    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).
    1. 1.1 Show/Hide More Schnell v. Chris-Craft Industries, Inc. (Del. 1971)
      Original Creator: Holger Spamann Current Version: Holger Spamann
      Schnell is the classic Supreme Court authority emphasizing the importance of corporate voting, and announcing special judicial vigilance towards anything that interferes with this voting. Pay close attention to the legal reasoning. Is it compelling? We will come back to this often.
    2. 1.2 Show/Hide More Blasius Industries, Inc. v. Atlas Corp. (Del. Ch. 1988)
      Original Creator: Holger Spamann Current Version: Holger Spamann

      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
    Original Creator: Holger Spamann Current Version: Holger Spamann

    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. Weinberger and Sinclair, infra).

    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.

    1. 2.1 Show/Hide More Conflicted behavior (self-dealing): The Duty of Loyalty
      Original Creator: Holger Spamann Current Version: Holger Spamann

      (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.*

      Some (not so) fictitious examples

      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 million, 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 oil field, it now has the $1m 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% × $101 million). 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. 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).

      The U.S. approach

      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).

      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?

      Notes

      * 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).

      1. 2.1.1 Show/Hide More Guth v. Loft (Del. 1939) [Pepsi]
        Original Creator: Holger Spamann Current Version: Holger Spamann

        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?

      2. 2.1.2 Show/Hide More Sinclair Oil Corp. v. Levien (Del. 1971)
        Original Creator: Holger Spamann Current Version: Holger Spamann
        As we learned in Guth and will see in more detail in Weinberger, the standard of review for self-dealing — “utmost good faith” or “intrinsic fairness” or, nowadays, “entire fairness” — is demanding. It is, thus, extremely important to determine which transactions count as self-dealing. What is Sinclair‘s answer? Do you agree with it? May Sinclair's answer condone abuse of minority stockholders? What would happen if Sinclair had accepted the plaintiff’s broader view, not just in the short run but also in the long run (when a corporate group has time to restructure)?
      3. 2.1.3 Show/Hide More Weinberger v. UOP, Inc. (Del. 1983)
        Original Creator: Holger Spamann Current Version: Holger Spamann

        This decision introduces the modern standard of review for conflicted transactions involving a controlling shareholder.

        1. What is that standard of review, generally speaking?
        2. Can the controlling shareholder do anything to obtain a more favorable standard, or at least a more sympathetic application of the standard (cf. footnote 7)?
        3. How does the judicial treatment of self-dealing by a controlling shareholder compare to that of self-dealing by simple officers and directors (as described in the introduction to this section 2.2.1)?
        4. Does the harsher treatment of controlling shareholders make sense?

        Some terminology (for details, see the M&A section of the course):

        • Cash-out merger: A transaction in which some group of shareholders, generally minority shareholders, are “squeezed out” of the corporation. That is, they cease to be shareholders of the corporation in return for a cash payment, whether they like it or not. The name comes from the fact that the transaction is technically a merger between the corporation and some other corporation. The other corporation is usually a mere shell corporation, meaning it has been set up only for the merger and does not have any assets. While DGCL 251© requires shareholder approval for a merger, a simple majority vote is sufficient and hence minority approval is unnecessary. DGCL 251(b)(5) expressly allows conversion of existing shares into cash. Minority shareholders' only statutory remedy is an appraisal of the “fair value” of their shares under DGCL 262.
        • Tender offer: An offer to purchase shares addressed to all shareholders.

      4. 2.1.4 Show/Hide More Hypo: board service?
        Therein of Meinhard v. Salmon (NY 1928).
    2. 2.2 Show/Hide More Unconflicted behavior (mistakes): The Duty of Care
      Original Creator: Holger Spamann Current Version: Holger Spamann

      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.

      1. 2.2.1 Show/Hide More Smith v. Van Gorkom (Del. 1985)
        Original Creator: Holger Spamann Current Version: Holger Spamann

        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. 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?

        Background: the Acquisition Process (more in M&A, infra)

        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.

        Questions

        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?
      2. 2.2.2 Show/Hide More In re Walt Disney Co. Derivative Litigation (Del. 2006)
        Original Creator: Holger Spamann Current Version: Holger Spamann

        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.


        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?

      3. 2.2.3 Show/Hide More Stone v. Ritter (Del. 2006)
        Original Creator: Holger Spamann Current Version: Holger Spamann

        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?
    3. 2.3 Show/Hide More Shareholder Litigation etc.
      Original Creator: Holger Spamann Current Version: Holger Spamann

      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?

      1. 2.3.1 Show/Hide More Aronson v. Lewis (Del. 1984)
        Original Creator: Holger Spamann Current Version: Holger Spamann

        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: 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 [i.e., the plaintiff’s demand to the board to direct the corporation to sue] 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 the board rightfully rejected the plaintiff’s demand, or, if no demand was made, 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, Weinberger and Van Gorkom were direct (class) actions, while Sinclair, Disney, and Stone were derivative actions.

        1. Does it make sense to treat direct and derivative actions differently, erecting special procedural hurdles only for the latter?
        2. The Aronson court ultimately rules that “demand was not futile” in this case, i.e., the shareholder-plaintiff was not entitled to prosecute this suit. What should the shareholder have done to achieve a different outcome, and was this feasible? In light of this, do you think Aronson's hurdle for derivative suits is appropriate, too high, or too low?
      2. 2.3.2 Show/Hide More Indemnification and Insurance
        Indemnification and Insurance
      3. 2.3.3 Show/Hide More Americas Mining Corp. v. Theriault (Del. 2012) (Attorney's fees)
        Original Creator: Holger Spamann Current Version: Holger Spamann

        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).

      4. 2.3.4 Show/Hide More In re Trulia Inc. Stockholder Litigation (Del. Ch. 2016)
        Original Creator: Holger Spamann Current Version: Holger Spamann

        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?

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December 07, 2017

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