Saturday, October 31, 2020

Not All Heroes Wear Capes

Earlier this week, VC Laster issued his decision in United Food & Commercial Workers Union v. Zuckerberg.  Professor Stephen Bainbridge blogged about the decision here, with a lot more detailed discussion of the law than I’m going to provide, but I’m covering the same territory anyway because this case is an interesting example of the pathologies associated with the common law.

So, before stockholder plaintiffs are permitted to bring a derivative action on behalf of a corporation, they must first make a showing that the corporate board is too conflicted to be able to make the litigation decision themselves.  This may occur because board members are themselves at risk of liability regarding the underlying transaction being challenged, or because they are too close to someone who is.  The test was first articulated by the Delaware Supreme Court in Aronson v. Lewis, 473 A.2d 805 (Del. 1984), but because this was a common law creation and the court was mostly focused on the dispute in front of it, the test it articulated conflated the general inquiry – is the board able to be objective about the litigation – with the specific application of that inquiry to the Aronson Board.  In other words, the Aronson test conflated the issue of objectivity with respect to bringing a lawsuit with liability on the underlying claim, and phrased the former in terms of the latter.

As time wore on, that conflation made the Aronson test difficult and confusing to apply, for two reasons: First, in many cases – unlike the situation in Aronson – board members change between the time of the alleged fiduciary breach and the time of the lawsuit, making liability on the underlying claim irrelevant.  And second, the legal standards for liability changed, making Aronson’s articulation – which was tied to the liability standards for that board at that time – increasingly disconnected from the actual liability risk.

The Delaware Supreme Court started to fix these problems in Rales v. Blasband, 634 A.2d 927 (Del. 1993), where it created a new test – one rooted solely in the objectivity of the board at the time of the lawsuit – but instead of overruling Aronson, it said that the Rales test would only apply when the board entertaining the possibility of a lawsuit had not made a decision being challenged by the plaintiffs.

That, naturally, led to decades of confusing caselaw about whether Rales or Aronson would apply in a particular matter, making the issue the bane of corporate law professors who tried to teach the distinction to their students (ahem, some of us don’t bother and just teach Rales). 

And here’s the part that’s interesting to me: Why would the law persist in this obviously maladaptive way?  Because, I believe, no litigant had any interest in arguing for a change.  At the end of the day, Rales and Aronson are asking the same question, and regardless of which is used, they come out the same way – a point that several Delaware courts have made.  Which means neither plaintiff nor defendant had much of an interest in briefing the distinction or arguing the law should be changed, and they didn’t.  Without any litigants to press for clarification, Delaware courts allowed this state of affairs to continue and torture corporate law professors and junior associates throughout the land.

I_dont_like_it_supernatural

This is the weakness of common law rulemaking, and the adversarial system in general; courts decide what litigants ask them to decide. And litigants don’t always ask the right questions.

Which is likely why earlier this week, VC Laster – sua sponte – seized the initiative and gave Aronson the boot, even though the parties had assumed Aronson would apply and briefed the matter that way.  In so doing, Laster painstakingly detailed the problems with the Aronson test, concluding, “Precedent thus calls for applying Aronson, but its analytical framework is not up to the task….This decision therefore applies Rales as the general demand futility test.”

Now all that remains is to see if Laster’s bid for a change takes hold.  Notably, litigants still don’t have any incentive to make a serious argument on this score, but if they – like the academy – are relieved to see the shift, they may make a perfunctory gesture towards Aronson in future cases, but then cite Zuckerberg for the idea that Aronson may be dead letter, and go from there.  Even if the plaintiffs appeal Laster’s specific ruling in Zuckerberg dismissing their complaint, I’d be surprised if they waste precious briefing space on the Aronson/Rales distinction, which means the Delaware Supreme Court would have to go affirmatively out of its way to question Laster’s reasoning if it wants to preserve Aronson’s vitality.  Let’s hope it doesn’t bother.

That said, when it comes to the underlying substantive dispute in Zuckerberg, I’m not sure I agree with Laster’s analysis.

The lawsuit arose out of Mark Zuckerberg’s ill-fated proposal to amend Facebook’s charter to create a class of no-vote shares, essentially to allow him to transfer much of his financial interest in the company while maintaining his hold on the high-vote B shares that give him control.  As many will recall, the Board recommended the charter amendment and the shareholders – dominated by Zuckerberg’s high vote shares – voted in favor, but in a subsequent lawsuit, stockholder-plaintiffs uncovered multiple irregularities that had occurred in the course of negotiating the proposal.  Zuckerberg dropped the plan, and that was that, until new plaintiffs brought a derivative lawsuit alleging that even though the plan was abandoned, all of the expenditures associated with it damaged the company.  Thus, the question before Laster was whether the Facebook Board was sufficiently disinterested and independent to decide whether to bring a lawsuit over the Board’s earlier approval of the charter amendments, namely, whether to sue many of its own members.  And that question turned, in part, on whether Reed Hastings and Peter Thiel, two of Facebook’s Board members, faced a substantial risk of liability for having voted in favor of the charter amendment in the first place.

So really, part of the underlying legal question here was whether Hastings and Thiel breached their duties of loyalty by recommending the charter amendment.  The plaintiffs argued, in part, that they did so because they were “biased” in favor of founder control – namely, they believed that corporate founders should be able to run their companies free from the meddling influence of public shareholders.

Laster held that even if this was their reasoning, it did not constitute a lack of loyalty:

A director could believe in good faith that it is generally optimal for companies to be controlled by their founders and that this governance structure is value-maximizing for the corporation and its stockholders over the long-term. Others might differ. As long as an otherwise independent and disinterested director has a rational basis for her belief, that director is entitled (indeed obligated) to make decisions in good faith based on what she subjectively believes will maximize the long-term value of the corporation for the ultimate benefit of its residual claimants.  If a director believes that it will be better for the corporation to have the founder remain in control, then the director may make decisions to achieve that goal. As long as a director acts in good faith, exercises due care, and does not otherwise have any compromising interests, a director will not face liability for making a decision that she believes will maximize the long-term value of the corporation for the ultimate benefit of its residual claimants,…

The belief that founder control benefits corporations and their stockholders over the long run is debatable, but it is not irrational.

To which I respond – what about Blasius?

In Blasius Industries v. Atlas, an incumbent board maneuvered to neuter the effects of shareholder consents that would otherwise have replaced it with a dissident slate.  Chancellor Allen held that even if the Board sincerely and in good faith believed the dissident slate would harm the company and its own plans were better for shareholders, the incumbents would violate their fiduciary duties by taking the choice out of the shareholders’ hands.  As Allen put it:

As I find the facts … they present the question whether a board acts consistently with its fiduciary duty when it acts, in good faith and with appropriate care, for the primary purpose of preventing or impeding an unaffiliated majority of shareholders from expanding the board and electing a new majority. ...I conclude that, even though defendants here acted on their view of the corporation's interest and not selfishly, their December 31 action constituted an offense to the relationship between corporate directors and shareholders that has traditionally been protected in courts of equity. As a consequence, I conclude that the board action taken on December 31 was invalid and must be voided….

The real question the case presents, to my mind, is whether, in these circumstances, the board, even if it is acting with subjective good faith..., may validly act for the principal purpose of preventing the shareholders from electing a majority of new directors. The question thus posed is not one of intentional wrong (or even negligence), but one of authority as between the fiduciary and the beneficiary (not simply legal authority, i.e., as between the fiduciary and the world at large)....

I therefore conclude that, even finding the action taken was taken in good faith, it constituted an unintended violation of the duty of loyalty that the board owed to the shareholders.

Without, umm, weighing in on the overall merits of this particular lawsuit, might Blasius’s reasoning be transferred to the Facebook context?  Directors may believe it’s better if Zuckerberg remains in control of the company, but that doesn’t give them the right to unilaterally effectuate a recapitalization handing him that control even after he sells his shares.

This is not to say the proposed amendments were per se disloyal; just, as with any loss of control rights, you’d expect shareholders to get something in return.  A payment, for example, perhaps coupled with MFW-like protections (which Zuckerberg refused), rather than simply the dubious honor of having Zuckerberg control the company in perpetuity.

I suppose one might argue this isn’t a Blasius situation of interfering with the shareholder franchise so much as it as a Unocal/Unitrin situation of defending against a potentially damaging change in control (and yes, I realize some would argue they’re two sides of the same doctrinal coin).  But Blasius is used for entrenchment; Unocal is applied for mergers and hostile takeovers.  So it would be awfully strange to apply the Unocal framework when the whole issue arises because the existing controller (and the existing directors) are trying to entrench their positions by increasing the separation between control rights and financial rights.  And even if we were to apply Unocal, the maneuver would still fail on preclusiveness grounds; due to a lack of a majority-of-the-minority approval condition, it was mathematically impossible for the minority shareholders to maintain the existing capital structure.*

But that further raises the question whether an impermissible Unocal defense is necessarily a disloyal act (a critical issue here, since the question is being asked in the context of a claim for damages), and I am not certain the caselaw is entirely clear.

In any event, this is probably all old hat; I assume a lot of this territory was covered back during the Google case or during the briefing in the initial Facebook lawsuit.  Still, Laster’s opinion reopens those wounds, and we never got an answer the first time!

*One of the odd doctrinal blips here is that because the proposal was a conflicted-controller transaction, it was subject to entire fairness review, which should be a higher standard than Unocal/Unitrin scrutiny.  But if Unocal is the right framework, we know it fails due to preclusiveness; no further analysis required.  Assuming, of course, that we measure preclusiveness by the ability of the minority shareholders alone (rather than all the shareholders, including Zuckerberg) to reject the transaction.  Which I think we should do, since it was only the minority losing control, and that usurpation of control is what Unocal is concerned about.  But the fact that these kinds of contortions arise when the Unocal framework is used may simply demonstrate the impropriety of applying it in the first instance.

https://lawprofessors.typepad.com/business_law/2020/10/not-all-heroes-wear-capes.html

Ann Lipton | Permalink

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