Business Law Prof Blog

WarGames, DefCon 5, and Another Round on Chancellor Chandler

I have been thinking again about Chancellor Chandler's eBay v. Newmark decision, so I decided to take another look.  I had been thinking about that quite a bit, because I have been having a hard time reconciling the Airgas and eBay decisions.  (A quick summary of Airgas commentary is available here.) I think I figured out why. The overall feel I get from the Airgas decision is an embracing of director primacy.  The feel of eBay  feels more like shareholder primacy wrapped in director primacy language. Here's an example, from eBay, which I provide both to help make my point and to further illustrate the greatness of Chancellor Chandler's decisions: 

n.23 For example, during negotiations, Price sent an email to eBay executives explaining that Jim and Craig understood that if they insisted eBay sign a non-compete agreement it would be “a defcon 5/deal breaker issue” for eBay. PTX-30 (email from Garret Price to eBay executives (June 24, 2004)). I include this email in the story (1) to illustrate how strongly eBay felt about maintaining the right to compete and (2) because we all appreciate a good reference now and then to the Defense Readiness Condition (“DefCon”) of the armed forces. A good DefCon reference, however, is even better when it makes use of the appropriate DefCon level. Accordingly, Price’s DefCon reference would have been more adept if he had used DefCon 1, which signals “maximum force readiness.” See Description of DefCon Defense Condition, Federation of American Scientists, http://www.fas.org/nuke/guide/usa/c3i/defcon.htm (last visited August 12, 2010); see also WARGAMES (Metro-Goldwyn-Mayer 1983) (Dr. McKittrick: “See that sign up here—up here. ‘DefCon.’ That indicates our current ‘def’ense ‘con’dition. It should read ‘DefCon 5,’ which means peace. It’s still 4 because of that little stunt you pulled. Actually, if we hadn’t caught it in time, it might have gone to DefCon 1. You know what that means, David?” David: “No. What does that mean?” Dr. McKittrick: “World War Three.”). Price, however, referenced DefCon 5, which merely signals “normal peacetime readiness.” I assume, therefore, that Price’s reference to DefCon 5 is not an accurate characterization of what eBay’s negotiation stance would have been had Jim and Craig fired a mandatory non-compete across eBay’s bow.

Chancellor Chandler seems to care quite a bit what eBay wanted here, but later in the opinion he gives very little deference to what the craigslist Board wanted. Chancellor Chandler determined that craigslist was wrong for not appropriately maximizing profits.  He says:

The corporate form in which craigslist operates, however, is not an appropriate vehicle for purely philanthropic ends, at least not when there are other stockholders interested in realizing a return on their investment. Jim and Craig opted to form craigslist, Inc. as a for-profit Delaware corporation and voluntarily accepted millions of dollars from eBay as part of a transaction whereby eBay became a stockholder. Having chosen a for-profit corporate form, the craigslist directors are bound by the fiduciary duties and standards that accompany that form. Those standards include acting to promote the value of the corporation for the benefit of its stockholders.

As I have argued before, this is what eBay signed up for when they became craigslst stockholders. eBay wanted adamantly to be able to compete; craigslist wanted adamantly to keep their culture and business model. That's the contract, and both should be bound by it. Instead, though, this reads as though shareholders, at least big ones, should have the power to influence how a company conducts business. Note the allegation is not that the craiglist gives away too much money instead of issuing dividends. Instead, as I read it, it is that the company doesn't appropriately charge for its product.  Is the Wal-Mart board violating their fiduciary obligations because it could charge more for potato chips? Of course not, but that's the same kind of question raised here.  Recall -- craigslist is a market-leading, profitable company in its sector.  Yet the Chancellor questions the board's decisionmaking here because a big shareholder squawked.  (Admittedly, the were other actions of the craigslist board that merited review.)

Contrast this with the Airgas decision, as Gordon Smith et al. explain: "The Airgas case is the latest in a long line of Delaware cases in which a board of directors defied its own shareholders. Under modern corporation statutes, like Delaware’s, shareholders have few options in circumstances like these." In Airgas, a board rejected a "non-discriminatory, all cash, all-shares, fully financed offer" that shareholders wanted to accept.  Chancellor Chandler said fine, under Delaware law, the board wins. In eBay, though, the board maintained their long-held business model, a shareholder complained, and Chancellor Chandler said nope, board loses.  

The common sense part of this that bothers me is that, ultimately, these can be viewed a contract cases (at least, if buy Professor Bainbridge's nexus of contract theory).  Airgas shareholders almost certainly thought that their agreement with the board meant that the board would try to maximize value and provide shareholders a chance to reap the return of their investment. eBay certainly knew that craiglist had no intention of shifting to a profits-first business model.  And yet, in both cases, what I view as the terms of the contract aren't followed.  If Delaware law trumps the shareholder-board agreement, then okay, but it seems to me that if that's the rule, either the shareholders or the board should have won both of these cases.  

Nonetheless, Chancellor Chandler's opinions will be missed.  I was hoping he'd follow up his WarGames citation with a reference to something like Ferris Bueller's Day Off.  With Chancellor Chandler moving into the private sector, I'll bid him farewell from the court with this one: "Life moves pretty fast. If you don't stop and look around once in a while, you could miss it."   

--JPF

"[C]onstrained by Delaware Supreme Court precedent"?

Following up on both Elizabeth's post announcing that Chief Justice Myron T. Steele of the Delaware Supreme Court would be speaking at Stanford, and Josh's post on the Glom's Masters Forum on Chancellor William B. Chandler III's contributions to the Delaware Chancery Court, I note the following:

Over at the Glom, Afra Afsharipour discusses Chancellor Chandler's Airgas decision and notes that "like other commentators … I expected that Chancellor Chandler would uphold the pill. What I didn’t quite expect was Chancellor Chandler’s frank articulation of how decades of Delaware case law on the poison pill essentially gave him no choice but to reach the result that he did."

Meanwhile, a report from a recent panel discussion on cross-border issues in mergers and acquisitions notes that Chief Justice Steele interprets the case law differently:

Steele took issue with the view that the Chancery is constrained in its ability to remove a pill in the appropriate circumstances. He suggested that if the chancellor had found facts that were inconsistent with it being reasonable to keep the pill in place, an injunction against maintaining the pill could be issued under Delaware law. Where there is a battle of valuations, rather than the defence of a long-term strategy, a case can be made for removing the pill and letting the shareholders decide.

SJP

Musings on Chancellor Chandler at The Glom

Over at the Conglomerate, is hosting a "Masters Forum on William B. Chandler III's contributions to the Delaware Chancery Court. There are a series of posts discussing Chancellor Chandler's Disney decisions, M&A (and Airgas), his views on the practice of corporate law and more.  I highly recommend taking a look.

I'd still like to hear more about his eBay v. Newmark decision, which I have posted about here and here. I, like the Masters who have written about Chancellor Chandler, think highly of his work and his decisions. That doesn't mean, though, as my views on his eBay and Airgas decisions indicate, that I necessarily agree with him in every case.  

--JPF

NFL Pundits Show Why We Need the Business Judgment Rule

The Atlanta Falcons lost to the New Orleans Saints in overtime in Sunday.  The Falcons failed in a fourth-down attempt in their own territory, leading to a lot of second guessing on the NFL post-game shows. Here's the breakdown from Slate & Deadspin's NFL roundtable:

So arbitrary formulas aren't always the thing. But pure probabilities? Everyone's an expert today, thanks to the Falcons' decision to go for it in overtime on fourth and inches from their own 29-yard line. They were stuffed by the Saints, who slotted home a gimme field goal for a big division win. Here is a comprehensive list of every reason why Mike Smith's decision is being criticized: because it didn't happen to work.

. . . . A fourth-and-a-yard succeeds 74 percent of the time, and Michael Turner was not a yard away. . . . .

Brian Burke at Advanced NFL Stats has picked the perfect day to unveil the Fourthdownulator, a handy little application that allows you to plug in the situation and decide whether going for it makes statistical sense. Before running the fourth-down play, the Falcons' win probability stood at 47 percent (it would've risen to 57 percent if they had picked up the first down). Had they chosen to punt, that figure would've dropped to 42 percent. The difference is slight but undeniable, and becomes starker when you take into account both the Falcons' success at running the ball all day and the threat presented by the Saints' offense with decent field position.

. . .  Maybe this is why coaches are so hesitant to go for it on fourth down: not because they might be unsuccessful, but because everyone's going to break down why.

Clearly, NFL pundits are paid to second-guess coaches and say what should have happened.  That's their job.  But notice that (in my highly unscientific and unreliable review of NFL commentators) no one seems to have thought it was the right call.  [Update: Via the comment below (thanks), I know there's at least one who thinks the choice, if not the play call, was right.] If the numbers indicate it was a good call -- or even a reasonable call -- it would seem that 50% of the commentators would agree with the coach. But when we know how the decision turned out, that's highly unlikely to happen.  

This is one key reason we have the business judgment rule (BJR) for corporate directors.  That rule states that absent fraud, self-dealing or illegality, directors decisions cannot be judged. "Courts do not measure, weigh or quantify directors’ judgments. We do not even decide if they are reasonable in this context. Due care in the decisionmaking context is process due care only. Irrationality is the outer limit of the business judgment rule. " Brehm v Eisner, 746 A.2d 244 (Del. 2000)(emphasis added)(footnote omitted).  As Smith v. Van Gorkom further explained, "The business judgment rule exists to protect and promote the full and free exercise of the managerial power granted to Delaware directors." 488 A.2d 858 (Del. 1985) Although there are times when the BJR seems to protect stupidity (and it does), the BJR or some similar rule is necessary to allow directors to take chances.  

I realize that the comparison to NFL pundits and judicial review is a stretch given that both the charge and the authority of the judges is very different than that of NFL commentators. Still, I think that the inability to make rational post hoc assessments of decisions that turn out wrong is illustrative. As such, I am becoming more firmly convinced that Professor Bainbridge has it right when he says that the BJR is an abstenstion doctrine, and not a standard of review. As the good professor argues: "[C]orporate decisionmaking efficiency can be ensured only by preventing the board’s decisionmaking authority from being trumped by courts under the guise of judicial review."  

The New York Times says Falcons' Coach Mike Smith's decision "backfired horribly and handed the New Orleans Saints a 26-23 overtime victory over the Falcons at the Georgia Dome."  That's not what the numbers say. The numbers say he made a reasonable call, and it didn't turn out well. There was no "handing" the game to anyone.  If I'm a Falcons fan (and I'm not), I'd hope my coach is making his decisions based on his own judgment and assessment of the situation, and not external noise.  That's what he's been hired to do.  Just like the members of a board of directors.

--JPF 

 

Immaterial Lies

A couple of weeks ago the Wall Street Journal ran an article entitled "Trust Me."  The article asserted that:

Infamous frauds and financial crises have wrecked the public's faith in business in recent years, leading many companies to try to repair the damage by emphasizing codes of ethics. But we do not have a crisis of ethics in business today. We have a crisis of trust.

Later on, the author suggested that:

Spirals of distrust often begin with miscommunication, leading to perceived betrayal, causing further impoverishment of communication, and ending in a state of chronic distrust. Clear and transparent communication encourages the same from others and leads to confidence in a relationship.

I have argued elsewhere that courts have in recent years excaberated this problem of distrust by routinely labeling misstatements "immaterial."  In other words, the judges in 10b-5 cases tell investors that even if we assume the CEO intentionally lied about the company's prospects in order to defraud investors there is no recourse because no "reasonable" investor would consider the statement important.  The article is entitled, "Immaterial Lies: Condoning Deceit in the Name of Securities Regulation."  Here is the abstract:

The financial crisis of 2008-2009 is once again raising the issue of investor trust and confidence in the market.... The pending flood of lawsuits following in the wake of this financial crisis provides an opportunity, however, for courts to restore some of this lost trust. This Article argues that one of the ways courts can do this is by curtailing their over-dependence on materiality determinations as the basis for dismissing what they deem to be frivolous lawsuits under Rule 10b-5. There are at least four good reasons for doing so. First, condoning managerial misstatements on the basis of immateriality arguably has a negative impact on investor confidence because whenever courts find a misstatement to be immaterial as a matter of law they are effectively concluding that there will be no relief for shareholders even if the statement was made with full knowledge of its falsity and with the requisite intent to defraud. Second, the materiality “safety valve” doctrines that have evolved to assist courts in dismissing frivolous suits are often in direct conflict with Supreme Court guidance as to both the proper definition and analysis of materiality in the context of Rule 10b-5. Third, the routine categorization of managerial misstatements as immaterial in order to dismiss frivolous suits creates a tension with the disclosure rules, which are premised on ideals of full and fair disclosure and often turn on materiality determinations. Finally, the dependence on materiality is unnecessary because other elements of Rule 10b-5, such as scienter, have been strengthened to the point where they allow courts to deal with the problem of frivolous suits without having to rule on the issue of materiality.

SJP

Reporting Back From the Ohio Securities Conference

Yesterday, I had the privilege of participating in a panel discussion at the 2011 Ohio Securities Conference entitled, "Dodd-Frank: One Year Later."  A complete list of the panelists, along with a link to related material follows:

Barbara Black: How to Improve Retail Investor Protection After the Dodd-Frank Wall Street Reform and Consumer Protection Act

Eric Chaffee: The Dodd-Frank Wall Street Reform and Consumer Protection Act: A Failed Vision for Increasing Consumer Protection and Heightening Corporate Responsibility in International Financial Transactions

Stefan Padfield: The Dodd-Frank Corporation: More than a Nexus of Contracts

Geoffrey Rapp (moderator): Legislative Proposals to Address the Negative Consequences of the Dodd-Frank Whistleblower Provisions: Written Testimony Submitted to the U.S. House Committee on Financial Services

SJP

The Zapata of Acquisitions?: Special Committees Must Act Like Third Parties

As noted in an earlier post, a Delaware court (pdf here) determined that Southern Peru Copper Corp.'s directors were improper (to the tune of $1.2 billion in damages) in following its special committee's recommendation to purchase Minera for $3.1 billion in Southern Peru stock.  The court explained that the special committee violated its fiduciary obligations by not leveraging its position in the same way a third party would in that situation.  The court explains:

In other words, the Special Committee did not respond to its intuition that Southern Peru was overvalued in a way consistent with its fiduciary duties or the way that a third-party buyer would have.  As noted, it did not seek to have Grupo Mexico be the buyer.  Nor did it say no to Grupo Mexico’s proposed deal.  What it did was to turn the gold that it held (market-tested Southern Peru stock worth in cash its trading price) into silver (equating itself on a relative basis to a financially-strapped, non-market tested selling company), and thereby devalue its own acquisition currency.  Put bluntly, a reasonable third-party buyer would only go behind the market if it thought the fundamental values were on its side, not retreat from a focus on market if such a move disadvantaged it.  If the fundamentals were on Southern Peru’s side in this case, the DCF value of Minera would have equaled or exceeded Southern Peru’s give.  But Goldman and the Special Committee could not generate any responsible estimate of the value of Minera that approached the value of what Southern Peru was being asked to hand over.

Note that the court here was evaluating this case for entire fairness, and not considering the applicablity of the business judgment rule.  Here, "the defendants with a conflicting self-interest [had to] demonstrate that the deal was entirely fair to the other stockholders."  They failed.

The court specifically states, "[T]here is no need to consider whether room is open under our law for use of the business judgment rule standard in a circumstance like this, if the transaction were conditioned upon the use of a combination of sufficiently protective procedural devices."  In essence, the court (appropriately) declines to answer here whether there might be a similar circumstance where the court might treat a special acquisition committee like a special litigation committee.  If so, in this instance, I'm thinking a Zapata-like test might be the right call. 

That is, when (like in Southern Peru) "a controlling stockholder stands on both sides of a transaction" (to parallel Zapata): 

First, the Court should inquire into the independence and good faith of the committee and the bases supporting its conclusions. . . . The corporation should have the burden of proving independence, good faith and a reasonable investigation, rather than presuming independence, good faith and reasonableness. . . . .

[Second, t]he Court should determine, applying its own independent business judgment, whether the [acquisition price was reasonable.] . . . The second step is intended to thwart instances where corporate actions meet the criteria of step one, but the result does not appear to satisfy its spirit, or where corporate actions would simply [ratify an improper valuation to the detriment of disinterested shareholders.]

On the one hand, this might be over broad and limit the ability of a company to take advantage of an opportunity uniquely available to it by virtue of the controlling shareholder.  Still, it seems to me that, just as in Southern Peru, the court is capable of making this assessment. If the special committee can justify the transaction, then it should have before supporting the deal.  If not, the court will take a closer look. Note that this would only apply where there was a controlling shareholder on both sides of the transaction, and not in other arm's length deals, where the business judgment rule is the proper test.

Perhaps this is giving the court too much of a role, but I think they got it right in Southern Peru, and that may translate in other contexts, too.

--JPF

$1.236 Billion of Foreshadowing in Delaware

On October 14, 2011, Chancellor Strine issued the opinion, In re Southern Peru Copper Corporation Shareholder Derivative Litigation, C.A. No. 961-CS (Del. Ch. Oct. 14, 2011). As noted by Francis Pileggi, the opinion has more than 100 pages dedicated to explaining the myriad ways the company's directors breached their fiduciary duties.

When I first started reading the case, I couldn't help but think about receiving the opinion if I were an attorney on the case or one of the litigants.  When I was in practice, it was FERC opinions or orders issued by an ALJ or the Commission, and I remember reading anxiously for hints in the first few paragraphs of where it was headed.  This case had more than a billion dollars on the line, so I have to imagine everyone involved started reading it the moment they knew it was available.  

So here's the start of In re Southern Peru Copper Corporation:

This is the post-trial decision in an entire fairness case.  The controlling stockholder of an NYSE-listed mining company came to the corporation’s independent directors with a proposition.  How about you buy my non-publicly traded Mexican mining company for approximately $3.1 billion of your NYSE-listed stock?  A special committee was set up to “evaluate” this proposal and it retained well-respected legal and financial advisors. 

The financial advisor did a great deal of preliminary due diligence, and generated valuations showing that the Mexican mining company, when valued under a discounted cash flow and other measures, was not worth anything close to $3.1 billion.  The $3.1 billion was a real number in the crucial business sense that everyone believed that the NYSE-listed company could in fact get cash equivalent to its stock market price for its shares.  That is, the cash value of the “give” was known. And the financial advisor told the special committee that the value of the “get” was more than $1 billion less.  

Rather than tell the controller to go mine himself, the special committee and its advisors instead did something that is indicative of the mindset that too often afflicts even good faith fiduciaries trying to address a controller.  Having been empowered only to evaluate what the controller put on the table and perceiving that other options were off the menu because of the controller’s own objectives, the special committee put itself in a world where there was only one strategic option to consider, the one proposed by the controller, and thus entered a dynamic where at best it had two options, either figure out a way to do the deal the controller wanted or say no.

As is probably clear, the special committee did not say no.  And as you probably gathered, the court imposed roughly $1.236 billion in damages for their chosen course of action. There are 100 pages of explanation, but it was pretty clear where this one was going after about line four of the opinion.

--JPF 

If you love corporations, you might want to start taking the protesters a bit more seriously.

Yesterday, Stephen Bainbridge explained why he loves corporations.  In the course of his post he referenced "The Company," by John Micklethwait and Adrian Wooldridge.  I, too, am a fan of that book--though not because (as Bainbridge notes) the authors identify the corporation as "the best hope for the future of the rest of the world."  (I am at best agnostic on that point.)  Rather, my recollection of the book (which I admit may well be distorted by the passage of years since I last read it) is that the authors did a decent of job of acknowledging that the history of corporations is marked by evil as well as goodness, including "imperialism and speculation, appalling rip-offs and even massacres" (p. xx).  Of course, the authors do note that corporations "pillage the Third World less than they used to" (p. 188).

What I liked about the book is that the authors recognized that "[t]o keep on doing business, the modern company still needs a franchise from society, and the terms of that franchise still matter enormously" (p. 186).  Furthermore, they acknowledged that "[t]here is a widespread feeling that companies have not fulfilled their part of the social contract: people have been sacked or fear that they are about to be sacked; they work longer hours, see less of their families--all for institutions that Edward Coke castigated four hundred years ago for having no souls" (p. 188).  (Note that these are all pre-financial crisis quotes.)

All of which leads me to conclude that if you love corporations you might want to start taking the "Occupy" protesters a little more seriously.  You may think they are "illiterates," silly and absurd--but they are growing in number and they may well end up having something to say about the nature of the franchise corporations need in order to survive.

SJP

Ribstein on Energy Law and Corporate Structure

Larry Ribstein has posted the abstract for Energy Infrastructure Investment and the Rise of the Uncorporation.  I haven't yet been able to get a copy of the paper (though I should have it this week), but the abstract is particularly intriguing:

While most large U.S. businesses have long been organized as corporations, a significant portion of our economy, including major parts of our energy infrastructure, are organized as other types of legal entities. These “uncorporations” include such business forms as Master Limited Partnerships (MLPs) and Limited Liability Companies (LLCs). Many practitioners have dismissed these alternative entities as merely tax devices and only peripherally important to mainstream business. But this view misses important features of the uncorporation that make it an important alternative in dealing with the “agency” costs that arise in public companies from separating managerial control from equity ownership. Corporate governance relies heavily on agents such as auditors, class action lawyers, judges, and independent directors to protect shareholders from managerial self‐interest. The obvious costs and defects of relying on these governance mechanisms have generally been seen as a reasonable price to pay for the benefits of the corporate form. But this conclusion depends on the availability and effectiveness of the alternative mechanisms for addressing agency costs. Uncorporations provide such an alternative by tying managers’ economic well‐being so closely to that of their firms that corporate monitoring devices become less necessary. Uncorporate governance mechanisms include managerial compensation that is based largely (if not entirely) on the firm’s profits or cash distributions, and restrictions on managers’ control of corporate cash through liquidation rights and requirements for cash distributions. Business people and policy makers should evaluate the potential benefits of uncorporations before concluding that the costs of corporate governance are an inevitable price of separating ownership and control in modern firms.

Most of my research and scholarship is in the energy law area (and related fields), and I'm particularly interested in how business and business structures impact the energy industry. I've been working on a piece arguing that large public energy companies would be more appropriate as private entities because the interests of management and shareholders lead to improper risk analysis and thus risk taking (leading to less efficiency and less profit), with BP's Deepwater Horizon blow out as a prime example  I look forward to reading the piece, but I fear that I have been, as they say, SSRN'd. Maybe I can build off this piece, but if my piece has been mooted, I take a little comfort in that fact that it was by a leader in the field like Larry Ribstein.  

--JPF

Smythe on The Rise of the Corporation

Donald J. Smythe has posted “The Rise of the Corporation, the Birth of Public Relations, and the Foundations of Modern Political Economy” on SSRN.  Here is the abstract:

The rise of the modern corporation was an integral part the Second Industrial Revolution. This important economic and social transformation would not have occurred if business entrepreneurs had been unwilling to make the large investments necessary to implement the new technologies that drove the industrial growth and development, and entrepreneurs would have been reluctant to make the investments without the shield of limited liability and the opportunity to spread their risks across diversified portfolios of corporate stocks. Nonetheless, the rise of the modern corporation created problems. The most successful corporations grew to unprecedented proportions, and the public’s concerns about their growing economic and political power contributed to the Progressive Movement and pressures for social and political reform. There were no federal or state constitutional protections for corporate speech in the early twentieth century. Indeed, corporations were regarded as creatures of state law, whose powers were usually defined by their charters under state incorporation statutes. The federal and state governments could have enacted sweeping regulations on corporations’ speech and related behavior. But they did not. Corporations thus began to make sustained attempts to alter public attitudes and improve their public images through systematic public relations campaigns and corporate welfare programs. The public never came to think of the corporation as a person or anything other than a business entity, but the public relations campaigns succeeded in humanizing the corporation and integrating it into the American public’s sense of community. More importantly, perhaps, they succeeded in rationalizing the role of the corporation in the American economy and legitimizing its role in modern American life. This has had profound implications for the way that American business law and public policy have evolved during the twentieth century.

SJP

Seattle Law Review's Second Annual Symposium of the Adolf A. Berle, Jr. Center on Corporations, Law & Society

What follows is a list of the symposium pieces.  You can find the full articles here.

• “Directors as Trustees of the Nation? India’s Corporate Governance and Corporate Social Responsibility Reform Efforts,” by Afra Afsharipour

• “The Problem of Social Income: The Entity View of the Cathedral,” by Yuri Biondi

• “Does Critical Mass Matter? Views From the Boardroom,” by Lissa Lamkin Broome, John M. Conley, and Kimberly D. Krawiec

• “Fiduciaries, Federalization, and Finance Capitalism: Berle’s Ambiguous Legacy and the Collapse of Countervailing Power,” by John W. Cioffi

• “The Twilight of the Berle and Means Corporation,” by Gerald F. Davis

• “Frank H. Knight on the ‘Entrepreneur Function’ in Modern Enterprise,” by Ross B. Emmett

• “Behind Closed Doors: The Influence of Creditors in Business Reorganizations,” by Michelle M. Harner and Jamie Marincic

• “Hurly-Berle—Corporate Governance, Commercial Profits, and Democratic Deficits,” by Allan C. Hutchinson

• “Financial Institutions in Bankruptcy,” by Stephen J. Lubben

• “Of Mises and Min(sky): Libertarian and Liberal Responses to Financial Crises Past and Present,” by Brett H. McDonnell

• “Berle and Veblen: An Intellectual Connection,” by Charles R. T. O’Kelley

• “Is Social Enterprise the New Corporate Social Responsibility?” by Antony Page and Robert A. Katz

• “The Judicial Control of Business: Walton Hamilton, Antitrust, and Chicago,” by Malcolm Rutherford

• “Toward an Organizationally Diverse American Capitalism? Cooperative, Mutual, and Local, State-Owned Enterprise,” by Marc Schneiberg

• “The Cosmetic Independence of Corporate Boards,” by Nicola Faith Sharpe

• “Berle’s Conception of Shareholder Primacy: A Forgotten Perspective For Reconsideration During the Rise of Finance,” by Fenner Stewart Jr.

• “Berle and Social Businesses: A Consideration,” by Celia R. Taylor

• “Chicago’s Shifting Attitude Toward Concentrations of Business Power (1934–1962),” by Robert Van Horn

SJP

CML V, LLC v. Bax: In Defense of (My Read of) DGCL Section 327

A little while back I wrote that section 327 of the Delaware General Corporate Law, as written, excluded the right to a derivative action for anyone but a shareholder. (In CML V v. Bax, the court determined that the Delaware Limited Liability Company Act, 6 Del. C. § 18-1002, does not permit creditor-based derivative actions for LLCs, despite the argument that the LLC Act was meant to track the court's interpretation of the DGCL.)  Obviously, the Delaware Supreme Court does not agree with me about section 327, as the Court granted creditors the rights to proceed in a derivative suit where the company is insolvent.  N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007).

A comment to my prior post also takes issue with my read of section 327. Ht4 says:

You're putting the rabbit in the hat.

This is where your analysis breaks down: "My reading of section 327 is that derivative claims are unambiguously reserved to shareholders." I disagree. 327 applies it restrictions to "derivative suit[s] instituted by a stockholder of a corporation." It does not purport to apply its restrictions to all derivative actions and, therefore, leaves open the possibility of other derivative suits. 18-1002, on the other hand, is written in exclusive language; it applies to ALL derivative actions. It does not leave open the possibility of other proper plaintiffs. That is the crutial difference.

I appreciate the comment, and I guess we'll have to agree to disagree.  I concede that ht4's interpretation is plausible, especially in light of current Delaware law. (And, after all, there is a maxim or canon of construction that can help lead to most any conclusion on this.)  Still, I think that inherent in section 327 was the assumption that only a shareholder could bring a derivative action. Section 327 explains which shareholders have such a right of action. The failure to mention in the statute any other type of derivative action tells me that no other type was contemplated.  Section 327 simply limits the scope of shareholder derivative actions that are permitted.  

It is certainly plausible that the drafters intended to allow creditors or even other stakeholders to have a right to a derivative action, but then why not have some mention, or some prerequisite, as provided for shareholder actions in section 327, to allow the suit to proceed?  It is hard for me to imagine a legislature contemplating an easier road to a derivative action for someone other than shareholders, and yet that's what is implied (or at least permitted) if section 327 is not exclusive to shareholder actions.

Further, in affirming the right of derivative actions for creditors, the Delaware Supreme Court provided a prerequisite for creditor standing: insolvency (or, arguably, a company close to insolvency).  N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007).  The Court determined that "equitable considerations," and not the DGCL, "give creditors standing to pursue derivative claims against the directors of an insolvent corporation."  Id. Thus, the DGCL provides the scope of shareholders who can bring such suits, and equity (via the Court) does the same for creditors. Although this outcome is one reasonable interpretation, it is hardly required.

I'm of a mixed mind about whether creditors should have a right bring a derivative suit against an insolvent corporation or LLC.  I am, however, reasonably certain that if there is to be such a right, it should be created via statute.  In Delaware, I maintain that, as drafted, neither the DGCL or the LLC Act permit such rights to creditors. Obviously, the Court has spoken, and there is now a body of law that makes the law clear in both instances. But section 327 still looks exclusive to me.

--JPF

Forward-Looking Statements and the Business Judgment Rule

Berkshire Hathaway today announced that the Board of Directors has authorized the company "to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares."   (The press release PDF is here; H/T: Bloomburg Businessweek.)  The company explains:

In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest.

The release, as it should, has its forward-looking statement safe harbor language about the uncertainty of any future performance. I have often wondered if releases such as these should also include a statement of the business judgment rule.  That is, the release explains: "If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest."  Perhaps added to that should be the statement:  "And if we're wrong, the shareholders retaining their interests will have no recourse, because (1) they will have had the opportunity to participate in the repurchase or otherwise sell their shares  in the market and (2) the business judgment rule protects such decisions."  

Obviosuly, that's the state of the law generally, anyway, but perhaps pointing it out would have some effect on how shareholders view derivative suits down the road. By specifically reminding them of their options at the time of annoucement, it might just reduce later lawsuits predicated on disappointing results when the board of directors is not "correct."  Perhaps, but I admit, not likely.  

--JPF

Davidoff on Britain’s new takeover rules

Over at DealBook, Steven Davidoff provides some excellent analysis of Britain’s new takeover rules, which went into effect this past Monday.  The title of his post sums up his predictions:  “British Takeover Rules May Mean Quicker Pace but Fewer Bids.”

If this sort of thing interests you, you’ll definitely want to read the entire post—but I’ll note some of the highlights here.  First, Davidoff reports that a wide array of rules were originally considered by the Takeover Panel of Britain, but the most controversial of these (requiring a two-thirds vote, requiring disclosure upon acquisition of 0.5 percent, and disenfranchising shareholders who acquired shares after the offer was announced) were rejected.  Second, the rules that were adopted, “set up a nice dichotomy with the American takeover scheme”:

In the United States, targets can agree to large termination fees and provide extensive deal protections to an initial bid. Targets can also adopt a shareholder rights plan, or poison pill, which can prevent a company from acquiring the target. But in Britain none of these devices are allowed.

As mentioned above, Davidoff sees the net result of these new rules being less initial bids (because bidders will be entering the fray subject to more risks), but more competition for targets once bids are launched.

SJP

Will BP Derivative Suit Become the U.K. version of Caremark?

A U.S. District Court has dismissed a BP shareholder derivative suit claiming that BP's directors and officers breached their fiduciary duties to the corporation when they "engaged in a pattern of disregard for the safety of BP's energy exploration operations."  The PDF of the opinion is available here. The opinion explains that the basis for the suit is the United Kingdom Companies Act of 2006, "which governs the fiduciary duties that officers and directors owe English companies." Law.com reports that the Act is "a relatively new statute with little case law interpreting it."

So, we'll see how this proceeds in the United Kingdom. If the case were in the United States, it would be an awfully tough one to prove, anyway.  As Professor Bainbridge has explained,

Shareholder losses attributable to absent or poorly implemented risk management programs are enormous [and e]fforts to hold corporate boards of directors accountable for these failures likely will focus on so-called Caremark claims. The Caremark decision asserted that a board of directors has a duty to ensure that appropriate "information and reporting systems" are in place to provide the board and top management with "timely and accurate information." 

Furthermore, in the Caremark decision, Chancellor Allen explained that such claims are “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” In re Caremark Intern. Inc. Derivative Litigation, 698 A.2d 959, 967 (Del. Ch. 1996). With the law still evolving in the United Kingdom, it should be interesting to see what the U.K. version of Caremark looks like.

--JPF

Coates and Lincoln on Fulfilling the Promise of Citizens United

John Coates and Taylor Lincoln have posted “SEC Action Needed to Fulfill the Promise of Citizens United” over at the Harvard Forum.  Here’s a brief excerpt:

[T]he Supreme Court’s Citizens United decision to let corporations spend unlimited sums in federal elections was premised on a pair of promises: Corporations would disclose expenditures, and shareholders would police such spending. Those promises remain unfulfilled …. The best chance to fulfill those promises may now rest with the SEC, which was recently petitioned to begin a rule-making process to require disclosure of political activity by corporations.

SJP

Unauthorized Trading at UBS

UBS, the big Swiss banking firm, announced today that it had lost $2 billion as a result of unauthorized trading by one of its traders. (Yes, that’s $2 billion.) UBS did not name the alleged wrongdoer, but news reports indicate that British police have arrested Kweku Adoboli, a UBS trader in London. Follow the links for stories from CNN, the Wall Street Journal, and the New York Times.You might also enjoy the BBC's Q & A on how unauthorized trading occurs and what can be done about it.

This is the fourth billion-dollar unauthorized trading loss that I’m aware of. Barings Bank lost over a billion dollars in 1995; Sumitomo Corporation lost $2.6 billion in 1996; and Societe Generale lost over $6 billion in 2008.

No compliance system, no matter how well designed, is perfect. Some fraud and unauthorized trading is going to leak through the controls. And, if derivatives are involved, it’s easy to lose a lot of money quickly. But $2 billion? It is going to be interesting to see exactly what sort of reporting and oversight measures UBS had in place and how those controls were skirted. I’m sure UBS’s directors and officers are anxiously consulting their attorneys this morning to see if they have any potential liability for allowing this to happen.

UBS is a Swiss company, so U.S. corporate law doesn’t apply. If UBS were a Delaware corporation, its directors would have an obligation to assure themselves that “information and reporting systems exist . . . that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and the board . . . to reach informed judgments concerning both the corporation’s compliance with law and its business performance.” In Re Caremark Int’l, Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). However, the board is not liable just because the company’s compliance system fails to catch wrongdoing. As long as the directors decide in good faith that the company’s compliance system is adequate, they are protected by the business judgment rule. Caremark says that “only a sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists” is grounds for liability.

-Steve Bradford

CML V, LLC v. Bax Strikes An Ambiguously Unambiguous Tone

As I reported last week, the Supreme Court of Delaware decided CML V, LLC v. Bax on September 2, 2011. I promised a follow up with my take, so here it is:  The Court got the outcome right, but it relies too much on the wrong rationale for the outcome. 

On appeal, CML argued that the Delaware Limited Liability Company Act does not eliminate standing for creditors seeking to bring derivative actions on behalf of insolvent LLCs (in 6 Del. C. §§ 18-1001 and 18-1002). The defendants, in turn, asserted that the LLC Act exclusively limited standing to LLC  “member[s]” or “assignee[s]” as stated in 6 Del. C. § 18-1002.  The Delaware Supreme Court agreed with the defendants, finding that language of the LLC Act was clear and unambiguous, and thus deprived the creditors standing.  

I'm okay with that result, but I'm troubled by what I view is an overstatement of part of the rationale. The Court explains that CML claimed the legislature intended 6 Del. C. §§ 18-1001 and 18-1002 to rephrase the language of the Delaware General Corporate Law, which the Delaware Supreme Court has concluded does allow creditors standing to sue insolvent corporations derivatively.  CML was thus arguing that the Delaware legislature "merely intended to take the corporate rule of derivative standing for creditors of insolvent corporations and apply it in the LLC context."  The Court disagrees, and states: "When statutory text is unambiguous, we must apply the plain language without any extraneous contemplation of, or intellectually stimulating musings about, the General Assembly’s intent."

 The problem I have with that is that section 327 of the DGCL provides as follows:

In any derivative suit instituted by a stockholder of a corporation, it shall be averred in the complaint that the plaintiff was a stockholder of the corporation at the time of the transaction of which such stockholder complains or that such stockholder’s stock thereafter devolved upon such stockholder by operation of law.

To my knowledge, there is no "operation of law" that transfers shareholders' stock to creditors of an insolvent corporation. In fact, in determining that creditors of an insolvent corporation can bring a derivative suit, the Delaware Supreme Court explained: 

The corporation's insolvency “makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm's value.”  Therefore, equitable considerations give creditors standing to pursue derivative claims against the directors of an insolvent corporation.

N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 Del. 2007) (footnote omitted).  So the corporate creditors' right of standing is equitable, not statutory, under the DGCL.  My reading of section 327 is that derivative claims are unambiguously reserved to shareholders. Thus, in my view, the Court is either saying that Gheewalla is wrongly decided or the Court vastly overstates the case when it says that "section 18-1002 is unambiguous, is susceptible of only one reasonable interpretation, and does not yield an absurd or unreasonable result." Give the contours of the law, and Delaware law specifically, CML's interpretation is entirely reasonable.  CML's view is not right, in my view, but it is reasonable, because laws are should be considered in context.  

The Court should have stuck with its earlier analysis, and stopped there:

Ultimately, LLCs and corporations are different; investors can choose to invest in an LLC, which offers one bundle of rights, or in a corporation, which offers an entirely separate bundle of rights.

Moreover, in the LLC context specifically, the General Assembly has espoused its clear intent to allow interested parties to define the contours of their relationships with each other to the maximum extent possible. It is, therefore,logical for the General Assembly to limit LLC derivative standing and exclude creditors because the structure of LLCs affords creditors significant contractual flexibility to protect their unique, distinct interests.

I know it could be argued that I'm picking nits here, but I think the Court should have rested on the proposition that the language of the LLC Act clearly excludes creditors from derivative standing, while acknowledging the same is true of the DGCL. In the analogous situation in corporate law, the Court determined that creditors of insolvent corporations have standing to sue derivatively. Because LLCs are different, and intended to be distinct entities from corporations, the Court declined to do so here.  

It's not just that the statute is unambiguous; it's that LLCs are inherently different. And while a reasonable person may think LLCs should be analogous to corporations, the reality is that LLCs can be, but need not be, analogous to corporations. The nature of the LLC is such that those who form the LLC and do business with the LLC must contractually make the LLC analogous if that is what they desire. Default rules and gap fillers will not save the day in the LLC setting as they might in the corporate world.

I concede that my rationale leads to the same result, but the Delaware Supreme Court missed an opportunity to, once and for all, make clear that LLCs and corporations are wholly different entities. While it is of little consequence in this case, in future situations, courts may still miss that point, and again inappropriately apply corporate concepts where the statute is not so clear.  As such, while much of the language from Vice Chancellor Laster's opinion below remains intact, the Supreme Court's focus on the unambiguous nature of the statute diminishes the tone.  I would have stuck with the tone Vice Chancellor Laster captured in the last sentences explaining the rationale behind his opinion:

In light of the expansive contractual and statutory remedies that creditors of an LLC possess, it does not create an absurd or unreasonable result to deny derivative standing to creditors of an insolvent LLC. The outcome does not frustrate any legislative purpose of the LLC Act; it rather fulfills the statute’s contractarian spirit. 

--JPF

Awrey on Complexity, Innovation and the Regulation of Modern Financial Markets

Dan Awrey has posted his paper, “Complexity, Innovation and the Regulation of Modern Financial Markets,” on SSRN.  Here is the abstract:

The intellectual origins of the global financial crisis (GFC) can be traced back to blind spots emanating from within conventional financial theory. These blind spots are distorted reflections of the perfect market assumptions underpinning the canonical theories of financial economics: modern portfolio theory; the Modigliani and Miller capital structure irrelevancy principle; the capital asset pricing model and, perhaps most importantly, the efficient market hypothesis. In the decades leading up to the GFC, these assumptions were transformed from empirically (con)testable propositions into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society’s resources. This ideology, in turn, exerted a profound influence on how we regulate financial markets and institutions.

The GFC has exposed the folly of this market fundamentalism as a driver of public policy. It has also exposed conventional financial theory as fundamentally incomplete. Perhaps most glaringly, conventional financial theory failed to adequately account for the complexity of modern financial markets and the nature and pace of financial innovation. Utilizing three case studies drawn from the world of over-the-counter (OTC) derivatives – securitization, synthetic exchange-traded funds and collateral swaps – the objective of this paper is thus to start us down the path toward a more robust understanding of complexity, financial innovation and the regulatory challenges flowing from the interaction of these powerful market dynamics. This paper argues that while the embryonic post-crisis regulatory regimes governing OTC derivatives markets in the U.S. and Europe go some distance toward addressing the regulatory challenges stemming from complexity, they effectively disregard those generated by financial innovation.

SJP