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.EDIT PLAYLIST INFORMATION DELETE PLAYLIST
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|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 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).
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?
* 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).
|1.1||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?
|1.2||Show/Hide More||Sinclair Oil Corp. v. Levien (Del. 1971)|
|1.3||Show/Hide More||Weinberger v. UOP, Inc. (Del. 1983)|
This decision introduces the modern standard of review for conflicted transactions involving a controlling shareholder.
Some terminology (for details, see the M&A section of the course):
|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.
|2.1||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. 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?
|2.2||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.
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?
|2.3||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?
|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?
|3.1||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: 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?
|3.3||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).
|3.4||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?
December 07, 2017
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