Saturday, March 21, 2020

So the Salzberg v. Sciabacucchi Decision is In!

Its the moment weve all been waiting for, and I am sorry to say - I was wrong.

(All right, in my heart, I still believe I was right in my account of existing law, and Salzberg v. Sciabacucchi actually changed the law.  But, if law is just a prediction of what judges will do, then okay, fine, yes, I was wrong.)

As you all know by now, I’ve been blogging about this case, and the issue of litigation-limiting bylaw and charter provisions, for a while, and I’ve written an article, and a book chapter, on the subject.  In this post, I’ll assume the reader’s familiarity with the issue and my prior argument.

 Anyway, the basic logic of the decision is illustrated by this figure from the opinion:



In other words, in the Delaware Supreme Court’s view, there are matters of internal affairs that are governed by the state of incorporation, and then there is a slightly larger category of matters that are still “intra-corporate” but not “internal affairs,” and can be governed by a corporation’s charter, and then there are truly external claims that cannot be the subject of a charter provision.   Federal forum provisions for Section 11 claims, at least facially, count as intra-corporate claims because “FFPs involve a type of securities claim related to the management of litigation arising out of the Board’s disclosures to current and prospective stockholders in connection with an IPO or secondary offering. The drafting, reviewing, and filing of registration statements by a corporation and its directors is an important aspect of a corporation’s management of its business and affairs and of its relationship with its stockholders.” Op. at 11.

I’d love to do a full analysis of the decision but to be terribly honest, I’m just a wee bit distracted right now and also I found the opinion itself kind of … elliptical in its reasoning.  Point being, I’ll give it a more thorough read at a later date but for now I’ve only got a series of quick points:

As I understand it, those matters that are sufficiently intracorporate to be the subject of a charter provisions, but not within the category of internal affairs, are to be determined case by case.  But, per the Court’s earlier decision in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), even provisions related to antitrust lawsuits are at least facially permissible, so it’s going to be really interesting to find out what the court does, and does not, believe can be governed by corporate charters – and even more interesting to see if any other states (hello, California) push back.  I’ll note that simply as a matter of terminology, I find the logic puzzling because the court quotes its own decision in McDermott v. Lewis, 531 A.2d 206 (Del. 1987), where the phrase “intracorporate” is treated as coextensive with “internal affairs.”  Op. at 37.  Moreover, apparently because the court couldn’t find better precedent, in explaining how external matters would be distinguished from intracorporate-but-not-internal-affairs matters, the court cited – well, Mohsen Manesh on the definition of the internal affairs doctrine. Op. at 47-48.  Suffice to say, for those of us trying to figure out what falls into this middle category of “intracorporate” matters, a definition that distinguishes only between internal affairs and external affairs is not helpful.

As Larry Hamermesh says of the decision, “I thought we were in a predictable room, but the door has opened up into very uncertain challenges and positions.”

The case largely focuses on charter provisions, even going so far as to mention charter provisions specifically in its discussion of why forum selection clauses do not violate federal policy.  Op. at 45.  But occasionally, the decision cites to DGCL 109, regarding the bylaw power. I … do not know how to interpret this.  And this is not a minor issue: Part of the reason I have been arguing that corporate constitutive documents cannot govern “external” claims is precisely because there’s no vocabulary outside the corporate law context to discuss whether a waiver, say, of a jury right, or an agreement to pay litigation expenses, should be in bylaws, charters, or both, or subject to supermajority voting provisions, or what happens if someone has dual-class stock or is a controller, etc.  We know how to answer those questions when they concern matters of corporate law; we don’t when we step outside that realm.

The opinion very much hangs the NJAG out to dry.  As I previously blogged here, here, and here, Professor Hal Scott has been pushing for bylaw at J&J which would mandate arbitration of all federal securities claims, including ones brought under Section 10(b)/10b-5.  J&J is chartered in New Jersey.  As part of the dispute over whether the proposal could be included on J&J’s proxy under Rule 14a-8, NJ’s Attorney General argued that such provisions violate NJ law, relying on Chancery’s Sciabacucchi decision.  Now, that decision has been reversed.  Professor Scott’s lawsuit will go forward and New Jersey will … I don’t know.

I think? there’s a basis for distinguishing Section 11 and 10b-5 in the opinion.  The court emphasizes that Section 11 necessarily involves directors (“Section 11 claims are ‘internal’ in the sense that they arise from internal corporate conduct on the part of the Board and, therefore, fall within Section 102(b)(1)”), but 10b-5 does not.  The court also says that tort claims are “external,” and 10b-5 is akin to common law fraud.  But, umm … then there’s the antitrust thing so I really don’t know.

Further to this, the decision opens with a description of how both Section 11 and Section 12 claims operate.  Section 12, like 10(b), also does not necessarily involve directors.  But the opinion doesn’t discuss whether such claims count as intracorporate, even though the forum provisions at issue in the case cover both types of claims.

So, yeah. I got nothing.

I note that since the decision permits charters to govern securities claims, there is now apparently no barrier to inserting a loser-pays provision in corporate constitutive documents for federal securities claims.  After all, the DGCL only bars loser-pays for internal claims.  So, Professor Bainbridge’s preferred policy may yet (mostly) prevail.  Which again highlights why I think this is a problem.  If a corporation adopts such a provision, Delaware will have to decide if it’s permissible, if it violates public policy, whether the provision must be in the charter or the bylaws, what to do if there are nonvoting shares, etc, and that’s just way outside of its area of expertise.  What happens when a director invokes a loser-pays provision and a shareholder argues that, under the circumstances, doing so was a breach of the director’s fiduciary duty?  How will Delaware make the call?  The Supreme Court has not, umm, demonstrated much savvy with respect to the difference between Section 11 and Section 12 claims (or, if you read some decisions, even the difference between a Schedule 14D-9 filing and a Schedule 14A), so I’m not confident of its ability make these judgments.

The Delaware Supreme Court should maybe start boning up on PSLRA pleading standards now, is what I’m saying.

Which brings us to arbitration.  At the very end of the opinion, in Footnote 169, the court mentions that even though this case only involved forum selection provisions, many commenters – and I’d fall into this category, naturally – are concerned about using charters and bylaws to force individualized arbitration of shareholder claims.  The court dismisses this concern on the grounds that DGCL 115 would prohibit mandatory arbitration for internal affairs claims.  The problem here is twofold: First, the court opens the door to corporations adopting arbitration provisions for federal securities claims – precisely as Prof. Scott is currently arguing – but secondly, there looms the possibility that DGCL 115 is invalid under the Federal Arbitration Act. 

Now, I wrote a whole long paper explaining why I believe the Federal Arbitration Act does not apply to corporate constitutive documents, but the basis for that article is that corporations are not ordinary contracts within the meaning of the FAA.  Every decision – like this one – that expands the boundaries of the corporate “contract” and applies ordinary contract law principles to define its scope not only, ahem, renders my article less relevant, but also undermines the basis for excluding corporations from FAA’s purview.  This is not an abstract issue; Professor Scott’s lawsuit, for example, argues that the FAA renders arbitration bylaws valid, regardless of any New Jersey law to the contrary.  Again, his lawsuit only deals with a bylaw mandating arbitration of federal claims, but there is no reason the logic would not extend to bylaws purporting to mandate arbitration of internal affairs claims.

In other words, this decision hands corporations the keys to challenging the viability of DGCL 115, and in that respect, I have a sinking fear that it signs Delaware’s death warrant.

But people have made that prediction before, so who knows.

My final observation is this: I think the contrast between the Supreme Court and Chancery decisions as a matter of corporate theory are quite striking.  The Chancery decision is a fairly stark example of the concession theory of the corporation: Laster makes very clear that Delaware, as sovereign, is intimately involved in establishing corporations, designing their operations, and articulating their limits.  The Supreme Court, by contrast, is a model of contracts theory; it treats the corporation as simply a private arrangement among its constituents, with few prohibitions on what that arrangement may entail.  I have been thinking about designing a corporate theory seminar; if it comes to fruition, I’ll likely include excerpts of both opinions.

Ann Lipton | Permalink


The concession / contract distinction makes sense, although the Vice Chancellor's decision in this case (and others, such as In re Carlisle Etcetera) might be characterized not as concession, but natural entity theory. Since the corporation is a separate person, with interests of its own that deserve equitable protection, the Chancery correctly noted that a "certificate of incorporation differs from an ordinary contract, in which private parties execute a private agreement in their personal capacities to allocate their rights and obligations". The Delaware Supreme Court ignored the distinction - this time in the securities, rather than internal affairs, context. Unfortunately, as I describe below, Salzberg is extremely likely to spill over to internal affairs, as well.

A few facts should be clearly and immediately stated on the record, so no one could say they didn't see this coming.

1. On the last page of the decision, in a footnote, the Delaware Supreme Court pays lip service to the real issue: arbitration. The link between federal forum provisions and forced arbitration is nowhere mentioned above the line in the 53-page decision.

2. Yet, the link is very real, due to the New Jersey federal district court's Feb. 24, 2020 decision in the Johnson & Johnson arbitration clause case. That decision made the arbitration issue contingent upon the Delaware decision in Salzberg. Again, the phrase "Johnson & Johnson" is not mentioned in the Delaware decision. Did the court choose to ignore it, or just forgot to discuss the most immediate implication of its decision?

3. To be sure, the federal district court did not have to make this connection. Mandatory arbitration is far more troubling than mandatory forum selection. In the latter case, at least some court hears the complaint. In the former, no complaint can or will be filed. Professor Grundfest himself makes this distinction, in the same article cited in Salzberg. Still, the New Jersey court did link the two.

4. Next, the federal district court is about to authorize mass arbitration of securities law claims. Aside from perhaps a few corporations with very strong activist investors, every American corporation (or roughly the same fraction that has 102(b)(7) provisions in their charters) is going to get such clauses in their organic documents. This means no more securities class actions, or anything but SEC enforcement (which, as numerous court decisions have confirmed, is complementary to private enforcement). Securities law is going to look like most other areas of U.S. private law, as documented in Margaret Jane Radin's 2013 Boilerplate: The Fine Print, Vanishing Rights, and the Rule of Law, and as every U.S. consumer is unwittingly familiar with from the Concepcion / American Express saga. Needless to say, neither the Third Circuit nor the U.S. Supreme Court will reverse that decision.

5. Furthermore, when the U.S. Supreme Court (which has little grasp of corporate law's unique aspects - after all, corporate law is state law) affirms Johnson & Johnson, it is also likely to announce that corporate charters and bylaws are "contracts", full stop.

6. At around that time, several Delaware corporations will place internal affairs arbitration clauses in their organic documents, in defiance of DGCL Section 115. A shareholder complaint will be filed. If the Delaware Supreme Court takes its own language - in a footnote, on the last page of Salzberg - seriously, the complaint will be successful.

7. A certiorari will then be sought from the U.S. Supreme Court, which might well grant it. The decision in the internal affairs arbitration case will echo the "contract" language from the Johnson & Johnson case. This will be in line with Concepcion, etc., striking down state laws "preempted" by the Federal Arbitration Act.

8. Thus, not only will Salzberg's chain reaction put an end to securities law private enforcement, it will do so for corporate law enforcement as well. Moreover, for internal affairs matters, there is nothing equivalent to the SEC; in many cases, private enforcement is the only thing separating fiduciaries from standing above the law.

9. The fact that shareholder litigation, although imperfect, is an inherent part of law enforcement - as evidenced by countless successful cases (take Americas Mining, 51 A.3d 1213 (Del. 2012), for one prominent example) - will be cast aside. Disloyal fiduciaries, such as those in Americas Mining, will be able to take $2 billion of other people's money into their own pockets, with no sanction or remedy whatsoever. Essentially, as this sequence of events unfolds, the majority of what we teach and study as corporate law scholars - and the tens of millions of human hours that went into creating and improving that law - will become a dead letter.

10. Forced arbitration touches upon even broader themes. For one, contract absolutism has nothing to do with capitalism or free markets - quite the opposite. When one party writes the contract on a take-it-or-leave-it basis (and especially when that party is a fiduciary), giving unchecked power to the strong party, with no judicial oversight of wrongdoing, simply results in unmerited wealth transfer to that party. Contract law is one, important part of private law. Corporate and fiduciary law are other, equally important parts, meant to deal with specific problems, arising in the corporate framework. Further, contrary to what the Chamber of Commerce and similar groups try to depict, corporate entities and shareholders are no less "free market" than directors and officers. Both equally represent "business". See, for example, Brian Fitzpatrick's 2019 The Conservative Case for Class Actions. Yet, this one-sided view is reinforced by Wednesday's decision.

11. How can we stop this cascade? Activist shareholders are largely disempowered in this context, because they cannot amend certificates of incorporation, just bylaws, and even that from a disadvantage compared to directors (see CA, Inc. (Del. 2008)). As Jill Fisch's research shows, despite all that activism, traditional insiders still call most of the shots. So, one possible path is legislation. The Delaware General Assembly can reverse Salzberg. Congress can amend the FAA to be more nuanced in regard to asymmetric relationships, including securities and corporate law. In fact, a proposal in that direction (the FAIR Act) has already been introduced in 2019. Can this pass? Definitely - once legislators stop inexplicably perceiving the enforcement of private law as a partisan, right-vs.-left issue.

12. As scholars, we can help. There are many works by leading professors, including you (104 Geo. L.J. 583), Jill Fisch (106 Cal. L. Rev. 373) and James Cox (93 Wash. U. L. Rev. 257), that analyze corporate law's distinct, not-purely-contractual nature in great detail. These are part of a growing movement, and it should act quickly and attentively (through amicus briefs or otherwise) in what will now become an extremely rapid series of developments. In any case, this is a make-or-break moment for corporate law.

Posted by: AR | Mar 21, 2020 9:06:20 AM

I agree with all of what AR says above, but with one caveat: It's not clear to me that public corporations will rush to adopt mandatory arbitration provisions. Perhaps they will. But mandatory arbitration, as AR says, is far more troubling, than forum selection. So it's unclear to me what the market response will be to mandatory arbitration provisions.

Posted by: Mohsen Manesh | Mar 21, 2020 10:17:29 AM

This made me crack up:

"The Delaware Supreme Court should maybe start boning up on PSLRA pleading standards now, is what I’m saying."

Posted by: Mohsen Manesh | Mar 21, 2020 10:18:25 AM

"This made me crack up"

I do try to entertain :-)

Posted by: Ann Lipton | Mar 21, 2020 10:24:18 AM

Post a comment