Friday, October 26, 2018

Talk About Fictional Shareholders

Daniel Greenwood coined the term “fictional shareholders” to refer to courts’ tendency to base corporate law decisions on the preferences of a set of hypothetical investors, untethered to the real-world priorities of the actual shareholders who hold a company’s stock.  See Daniel J.H. Greenwood, Fictional Shareholders: “For Whom Are Corporate Managers Trustees,” Revisited, 69 S. Cal. L. Rev. 1021 (1996).  If ever there were an illustration of Greenwood’s point, it comes in VC Laster’s recent post-trial decision in In re PLX Stockholders Litigation.

And hey, this got really long, so more under the jump

The facts are these:

PLX struck a deal to sell itself to IDT at $7/share.  When the deal fell through due to regulatory opposition, its stock price plummeted, and a hedge fund, Potomac Capital Partners, led by Eric Singer, bought in.  Singer’s investment thesis was that a new acquirer could quickly be identified, even if not quite at the same $7/share price offered by IDT, which would earn fast profits for Potomac.

Singer launched a public campaign to pressure PLX’s board to find a new merger partner.  When the board resisted, he ran a proxy contest, offering a short slate of 3 candidates (including himself) to replace 3 of the 8-member PLX board.  He was very clear in his campaign that his goal was to make a fast sale; the board, meanwhile, sought to convince investors that while it was receptive to a merger, it also had a long term plan that would enhance PLX’s standalone value.  Unsurprisingly, as these things go, new activists bought PLX’s stock in response to the controversy and supported Singer, who by now controlled over 9% of PLX’s stock.

Potomac won the proxy contest with about 70% of the vote, and seated its three nominees to PLX’s board.

Once on the board, Singer was assigned to the Special Committee for Strategic Alternatives, where he basically took control of the process of finding a merger partner.

And at this point, it must be conceded, things got kind of hinky.  Singer hid information from the rest of PLX’s board – apparently to manipulate them into accepting his preferred deal – and there was evidence that the board, cowed, lowered its previously-high financial projections to justify a lower-priced buyout.  Laster found that the board later cleaned up (i.e., falsified) the record, and coached witnesses, to defend that deal in court.  Deutsche Bank, as financial advisor, labored under its own conflicts due to its close relationship with the ultimate acquirer. But it all ended up with PLX being acquired by Avago at $6.50 per share in a medium form merger, and a shareholder lawsuit. By the time things came to trial, the only remaining claim was that Potomac – through Singer – had aided and abetted the board’s breaches of fiduciary duty.

The critical question, then, was whether there had been such a breach in the first place for Potomac to aid.  Plaintiffs alleged two: disclosure of inadequate information, and an inadequate sales process that ended up low-balling the company when it would have been better to forego a deal entirely.

First, Laster concluded that the disclosures to shareholders were incomplete.  They didn’t explain Singer’s role in hiding information from the rest of the board, and they didn’t provide sufficient information about the suspiciously low projections of future performance.  The disclosure deficiencies constituted a standalone breach of duty, and they also prevented the shareholders’ acceptance of the deal from cleansing the board’s substantive conduct under Corwin v. KKR Financial Holdings, LLC, 125 A.3d 304 (Del. 2015), meaning that the Plaintiffs’ second claim – for running an inadequate sales process – would be reviewed under enhanced scrutiny.

Under enhanced scrutiny, the court examines whether the Board’s actions fell within a “range of reasonableness.”  That inquiry, according to Laster, is tied to whether there is “evidence of self-interest, undue favoritism or disdain towards a particular bidder, or a similar non-stockholder-motivated influence that calls into question the integrity of the process.  [W]hen there is a reason to conclude that debatable tactical decisions were motivated not by a principled evaluation of the risks and benefits to the company’s stockholders, but by a fiduciary’s consideration of his own financial or other personal self-interests,” there is a breach. (quoting In re Del Monte Foods Co. S’holders Litig., 25 A.3d 813 (Del. Ch. 2011) and In re El Paso Corp. S’holder Litig., 41 A.3d 432 (Del. Ch. 2012)).

Under this standard, Laster concluded that even with the flaws, the Board’s sales process would have fallen within a “range of reasonableness,” slip op. at 108, but for the fact that Singer took an outsized role in the process (including manipulating the Board’s decisionmaking), and Singer harbored personal interests that diverged from those of the other stockholders.

How did his interests diverge?

Well, according to Laster, they diverged because of Singer’s – and Potomac’s – “interest in achieving a near-term sale.”  As Laster put it:

[P]articular types of investors may espouse short-term investment strategies and structure their affairs to benefit economically from those strategies, thereby creating a divergent interest in pursuing short-term performance at the expense of long-term wealth.  In particular, “[a]ctivist hedge funds . .. are impatient shareholders, who look for value and want it realized in the near or intermediate term. They tell managers how to realize the value and challenge publicly those who resist the advice, using the proxy contest as a threat.”…

The record in this case convinces me that Singer and Potomac had a divergent interest in achieving quick profits by orchestrating a near-term sale at PLX.

In so holding, Laster likened the interests of Singer and Potomac to those of controlling shareholders whose immediate need for liquidity results in a firesale that harms minority stockholders.

Thus, the fact that Potomac’s interest in a sale diverged from that of the other stockholders was the deciding factor in Laster’s conclusion that the board had breached its duties when conducting the sales process.

Okay, so much going on here.

First, seventy percent of PLX’s stockholders voted for Singer’s slate knowing his plans.  Even if we discount Potomac’s votes, that’s still something like sixty percent of the stock.  Much of that stock – as Laster himself found – was owned by activists who presumably shared Singer’s investment horizon.  It seems fairly obvious that Singer’s interest, far from diverging from those of other stockholders, was aligned with them.  The majority wanted a short term profit.  Yet Laster, untroubled by the discrepancy, instead based his decision on a hypothetical, fictional investor with whom Singer’s interests conflicted.

Laster’s decision is particularly striking when compared to the controlling shareholder cases on which he relied.  In those cases, the controller had a fairly idiosyncratic need for cash – like, for example, a controller who was personally subject to multimillion dollar judgments. See N.J. Carpenters Pension Fund v. infoGROUP, Inc., 2011 WL 4825888 (Del. Ch. Sept. 30, 2011, revised Oct. 6, 2011).  If simply having an investment horizon measured in months rather than years is enough to render a shareholder’s interests “divergent” from the others, there’s really no limit to the concept; in today’s markets, lots of shareholders’ interests diverge.

And that’s important, because these days, a lot of Delaware law relies on the cleansing vote of “disinterested” shareholders.  Corwin itself, for example, holds that a cash-out merger is subject to business judgment review only if approved by a “disinterested” majority.  But of course, all shareholders have their own time horizons and other priorities.  If that’s enough to render their votes “interested” for Corwin purposes, well, then there’s no Corwin at all.  (An issue, by the way, I discuss in my paper Shareholder Divorce Court, obligatory plug can’t resist etc)

Critically, in reaching this decision, Laster cited William W. Bratton & Michael L. Wachter, The Case Against Shareholder Empowerment, 158 U. Pa. L. Rev. 653 (2010).  That’s important because Bratton & Wachter’s paper is explicitly critical of new movements to give shareholder more involvement in corporate decisionmaking, on the grounds that shareholders are relatively uninformed as compared to management.  The paper, then, is a critique of existing law, not an affirmation of it.  Which, it should be said, is well in keeping with Laster’s previously-expressed skepticism of shareholder wisdom.  Maybe he’s right, maybe he’s wrong, but it’s hard to say Laster is following the law here so much as challenging it.

By the way, I note that Laster previewed some of these arguments in his transcript ruling on the motion to dismiss – which Greg Shill explored in his paper, The Golden Leash and the Fiduciary Duty of Loyalty, 64 UCLA L. Rev. 1246 (2017).

Second, along the way, Laster took a few potshots at ISS – notably, just ahead of the SEC’s planned roundtable on the proxy process, at which ISS and other proxy advisors will come under scrutiny.  Specifically, here’s what Laster said:

As in many proxy contests, the outcome turned on the recommendation of Institutional Shareholder Services Inc. (“ISS”), and both sides worked on presentations that would convince ISS to support their nominees. Potomac’s internal communications show that Singer had no meaningful ideas other than selling the Company. Potomac struggled to come up with “specific ideas on what we will do differently” because “the company is taking all the right steps.”  Singer personally could not come up with anything, so his proxy advisor offered some generic ideas that “[h]istorically . . . have worked” at other companies.  Potomac’s presentation ultimately focused on the Company’s historical losses, its failed acquisitions in 2009 and 2010, and its failure to meet revenue forecasts in 2012, 2013, and 2014.  As its “plan,” Potomac incorporated nearly verbatim its proxy advisor’s generic list of ideas.

PLX’s presentation was detailed and substantive.  It emphasized the incumbent directors’ willingness to sell the Company if warranted … It also emphasized the Company’s improving product pipeline and rapidly growing market share.  PLX described Potomac as “a self-interested activist investor that is focused on short-term gains at the expense of other PLX Technology stockholders.”  On December 6, 2013, ISS endorsed Potomac’s slate….

After ISS issued its endorsement, PLX management began preparing for a Potomac victory and the arrival of three new directors. 

The implication here is that PLX’s management had a much more considered, researched, thorough plan, which included both long range strategy and the potential for an acquisition, but ISS foolishly endorsed the short-term raider, and its clients blindly followed its lead.  (Perhaps this is why Laster discounted the actual votes of actual shareholders when concluding that they did not share Singer’s interests). 

Third, despite the flaws in the sales process, Laster refused to award any damages to the plaintiffs.  Why?  Because they were unable to show that PLX’s standalone long term value was, in fact, higher than the deal price of $6.50 per share.  Plaintiffs argued that PLX’s internal projections of future performance indicated that the company had a higher value (before those projections were revised downward to facilitate a deal), but Laster found these projections were unreliable, and observed that management had a history of being overly optimistic about PLX’s potential to meet its targets (which, by the way, is exactly what Potomac argued to ISS).

So, as I understand it, Laster’s view is that Singer and Potomac exploitatively manipulated the company into a short-term firesale at the expense of long-term value, and ISS blindly followed them, but at the same time, they were totally right, because management did not in fact have a viable plan for increasing value in the long term and had deluded itself into thinking otherwise.

The contradiction, again, goes unremarked.

That said, I will make this point in Laster’s defense: It seems to me that at least some of where Laster is coming from is that the sales process really was screwed up.  Singer did play games with his duty of candor, and the board really did end up manipulating internal projections to match Avago’s bid, Deutsche Bank really was playing both sides of the fence, and the attorneys really did mess with the record to justify the board’s position.  But even under enhanced scrutiny, this might not rise to the level of a breach of duty without evidence that it was motivated by an actual conflict.  So Laster found one: Singer’s short-term interest.  The real issue, then, is that all of these irregularities do not, by themselves, constitute actionable wrongdoing on their own.  And that may be the ultimate, troubling lesson.

Ann Lipton | Permalink


Great analysis, thanks. I'm not sure how troubling this is, though. Unless the process is so tainted and screwed up that it deterred a higher bid from someone else, I don't see how shareholders could be harmed.

Posted by: Frank Snyder | Oct 26, 2018 8:52:00 AM

Hi, Frank! I guess I'd like to distinguish between the breach and the damages. I'd rather identify this behavior as a kind of bad faith breach, and then possibly award no damages if it turns out (as Laster found) there was no thwarted higher bid and the standalone value was the same as the sale price.

But Laster - who also drew the distinction between the breach and the damages - felt he needed to first find a conflict before there could even be a breach.

Posted by: Ann Lipton | Oct 26, 2018 8:56:50 AM