Friday, February 21, 2020

A study in evolution

Sean Griffith recently wrote a book chapter explaining how plaintiffs’ merger-related challenges developed over time.  Plaintiffs began by seeking disclosure-only settlements, but after Trulia stamped out the practice in Delaware, plaintiffs began bringing claims in federal court challenging corporate proxies under Rule 14a-9.  And once they got there, they realized they did not have to limit themselves to merger litigation, and began bringing other kinds of proxy-related claims, and eventually these morphed into individual, rather than class, actions.

That’s what I thought of when I read the new books and records complaint filed against Facebook in Employees’ Ret. Sys. Of Rhode Island v. Facebook, No. 2020-0085-JRS.

In it, Rhode Island’s pension fund is seeking privileged documents related to Facebook’s $5 billion settlement with the FTC over allegations that it violated a previous FTC settlement regarding its data practices.  Much of the complaint is redacted – the plaintiff received some documents already, just not the privileged ones it is seeking now – but the basic allegation is that, according to news reports, the FTC wanted to charge Mark Zuckerberg personally, but the company refused, and accepted a larger fine to protect him.  The plaintiff now claims that this was the equivalent of giving a “non-ratable” benefit to a controlling shareholder.  I.e., the company could, theoretically, rationally conclude that keeping its CEO out of legal crosshairs was the best course of action for the company as a whole, but when that CEO is also a controlling shareholder, those decisions must either be made using the procedural protections of Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”) (negotiation by independent directors and conditioned on independent stockholder approval), or reviewed for entire fairness by a court ex post.  Therefore, argues the Rhode Island fund, it is entitled to books and records to evaluate potential claims, and under Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970), even attorney-client privileged documents should be made available.

This case is just getting started – all that’s happened is that the complaint was filed – but it reminded me of the 14a-9 situation because we’re seeing a similar kind of evolution with respect to controlling shareholder arguments.

(I am not – let’s be clear! – suggesting that the Facebook complaint is frivolous in the way that a lot of 14a-9 litigation has been accused of being.  This is just about how claims shift over time.)

It began, as I’ve frequently argued (in this essay, plus numerous blog posts, most recently last week), when Delaware tightened the screws on merger-related challenges with Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015), MFW, and also C&J Energy Services v. City of Miami General Employees’ and Sanitation Employees’ Retirement Trust, 107 A.3d 1049 (Del. 2014).  Those cases made it very difficult for plaintiffs to challenge a merger unless they were able to demonstrate that the merger involved a controlling stockholder.  Suddenly, everything turned on demonstrating that even minority blockholders had effective control of the company, which put enormous pressure on courts to find the presence of a controller when transactions appeared to be conflicted or suspicious in some way.

But there was more.  This sharp divide between transactions that could be cleansed with a shareholder vote, and those that could not, led courts to question whether the MFW/Corwin divide should be extended to nonmerger transactions – which they decided to do, in cases like IRA Trust FBO Bobbie Ahmed v. Crane, 2017 WL 7053964 (Del. Ch. Dec. 11, 2017), In re Ezcorp Inc. Consulting Agreement Derivative Litig., 2016 WL 301245 (Del. Ch. Jan. 25, 2016), and Tornetta v. Musk, 2019 WL 4566943 (Del. Ch. Sept. 20, 2019) (the latter of which I blogged about here).

Now, suddenly, new rule: Any transaction with a controller gets entire fairness review absent MFW protection.

And that rule was even extended into the books-and-records space, where the failure to use MFW protections in a given transaction was deemed suspicious enough to weigh in favor of granting plaintiffs access to internal documents.  We saw that happen in CBS, which I blogged about here.  At the time, I said:

Slights determined that the mere fact that CBS made no attempt to adhere to MFW cleansing was itself evidence of wrongdoing for Section 220 purposes.  That interests me [because] it extends MFW into a novel space: previously, its purpose was to trigger business judgment review for controlling shareholder transactions, but now it will also be used to “cleanse” for the purpose of avoiding a 220 demand. 

Leading us to where we are now: An argument that even a legal settlement is subject to the MFW/Corwin divide, and therefore can be bootstrapped to justify plaintiffs’ access to internal (privileged) documents.

I wouldn’t begin to guess how this case will play out – to be honest, I am sympathetic to the argument but I worry about implications (i.e., starting with Tesla’s and Musk’s settlement with the SEC, which may have become worse for the company because of Musk’s initial recalcitrance) – but it strikes me that this is a rulification problem.

In the earliest days, Delaware didn’t sharply distinguish between controlling shareholder transactions and other kinds of interested transactions.  And the development of the law was messy, in its common-law way.  Sometimes Delaware suggested independent-director cleansing was enough, sometimes not, the types of transactions that received extra scrutiny were sometimes limited to “transformative” transactions, sometimes not; it was as much an issue of how the court felt about a given scenario than anything else.  It was only recently that courts began to set down a bright-line rule that all controlling shareholder transactions would receive entire fairness scrutiny absent MFW protections, and to some extent, that rule was hastened by MFW itself, as courts struggled to identify the cases to which it applied.  And we’re now seeing the implications of that, because it turns out, when a controlling shareholder is involved in corporate governance, lots of otherwise-mundane business decisions could implicate their interests.   Throw back in the issue of whether someone’s a controlling shareholder in the first place, and you’ve just invited bedlam.  One rule (MFW) begets another (all controlling shareholder transactions, except the demand requirement) which presumably will beget another (except for some set of cases) and possibly more (except these factors do/do not contribute to the inquiry whether someone is a controller in the first place).

Not sure I have any great conclusions to draw here, but if Delaware doesn’t watch out, it’s going to become the MBCA.

Ann Lipton | Permalink


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