Saturday, December 24, 2016
I previously posted in praise of Sandys v. Pincus for its excellence as a teaching tool – which meant that its reversal was inevitable, as occurred days after classes concluded. (Same with the Salman v. United States decision, though that changed little; naturally; we won’t even what get into what changes midstream when I’m teaching Securities Regulation). The reversal itself is quite interesting, though, as the latest entry in the Delaware Supreme Court’s developing jurisprudence on friendship/social ties as a basis for director disqualification. And, strikingly for Delaware, it generated a dissent.
In Sandys, the basic dispute involves a secondary offering by the social-media game company Zynga. The plaintiffs filed a derivative lawsuit alleging that the secondary offering was designed to allow major insiders – including the controlling shareholder, himself a member of the Zynga board – to cash out before a disappointing earnings announcement. As a result, the secondary offering materials were alleged to have omitted critical facts about the company, ultimately exposing Zynga to a securities fraud lawsuit.
The Chancery decision held that demand was not excused, resting in large part on the court’s conclusion that the directors who were not directly implicated in the scheme were sufficiently independent of those who were to be able to consider the plaintiffs’ demand. The court found that numerous business and social ties among the directors were not sufficient to call these directors’ impartiality into question.
When I taught the case, I told my students that Delaware is largely persuaded by two things: blood and money.
Well, I’m going to have to revise that lesson.
On appeal, the Delaware Supreme Court – per Chief Justice Strine – held that the fuzzy half-business/half-social ties alleged by the plaintiffs were, in fact, sufficient to suggest that the directors were conflicted. (After first excoriating the plaintiffs for failing to pursue a Section 220 request – I don’t know what kind of competitive pressures the plaintiffs may have been under in this particular case, but let’s just say Delaware’s gonna have to do some retooling if it wants that advice to stick. See also Lawrence Hamermesh & Jacob Fedechko, Forum Shopping in the Bargain Aisle: Wal-Mart and the Role of Adequacy of Representation in Shareholder Litigation.)
First, one director co-owned an airplane with her husband, and with the controlling shareholder. The court held that an airplane is such an unusual asset, requiring such “close cooperation in use,” that joint ownership suggests an “intimate personal friendship” sufficient to call the director’s impartiality into question.
Second, two other directors were partners at Kleiner Perkins, a firm with a 9.2% stake in Zynga. Kleiner Perkins had also invested in a company started by the controlling shareholder’s wife, and had invested in a third company that also counted one of the other Zynga secondary-offering sellers (himself also a Zynga director) as one of its investors.
These interrelationships did not make the directors beholden to the controlling stockholder and other sellers in the financial sense, but, the court concluded, were evidence of a “network” of “repeat players” who had created a “mutually beneficial ongoing business relationship.” This created “human motivations” that called the directors’ impartiality into question. Additionally, the court noted that Zynga had not classified these directors as independent for NASDAQ purposes, a determination that itself deserved deference, and had particular relevance in a case, like this one, involving potential wrongdoing by the controlling stockholder.
Justice Valihura dissented. She believed that without more details of the size and scope of the Kleiner Perkins investments, or the financial or personal significance of the co-owned airplane, these relationships could not be used to challenge the directors’ impartiality.
Sandys is thus the latest in a line of Strine decisions pushing Delaware law toward greater legal recognition of the fact that structural coziness may make directors reluctant to accuse each other of wrongdoing. This has always been a delicate area; it’s fair to say that any human being who has lived some time among other humans understands the kind of bias that these relationships may generate, but courts have always feared that formal recognition of them would open the floodgates to frivolous/damaging litigation, and force judges to engage in impossible determinations as to the exact point at which friendship becomes compromising. Strine, plainly, believes that the law has overcorrected – i.e., the complete failure to recognize these informal relationships creates an intolerable artificiality in how questions of conflict are examined, and he’s pushing the law in a new direction.
(If I had to guess, I'd also say that Strine recognizes that as Delaware becomes a mini-SEC for transactions on which shareholders vote - i.e., disclosure becomes the only requirement - Delaware's relevance may hinge on its ability to stake out territory for vigorous court oversight that can't be cured by disclosure.)
What’s particularly striking here is that – as Justice Valihura’s dissent makes clear – Sandys goes much further than its predecessor, Del. County Emples. Ret. Fund v. Sanchez. In Sanchez, the allegedly conflicted director had a 50-year friendship with the interested party as well as a strong financial dependency; the Sandys relationships are nowhere near that scale. So Delaware – presumably at Strine’s urging – seems to be in the process of some rather aggressive redrawing of the lines. Where those lines will end up remains to be seen.
I may still teach the Chancery decision in my business class, though – it’s just so useful, with charts, and you can make alternative hypothetical charts and ask how the case might have come out differently. But then I’ll have to either talk the students through the reversal, or assign them the relevant excerpts.
That's all! Wishing everyone a happy erev Chanukah and erev Christmas!