Friday, March 29, 2024

What is the value of the corporate form?

The Tulane Corporate Law Institute this year was unusually contentious, and that’s because a lot of corporate practitioners – defense side – were unhappy with a number of recent Delaware decisions

Tornetta v. Musk made headlines because of the colorful personalities involved, but it actually rested on fairly commonplace, well-established Delaware standards of review.  More unsettling, I think, from the corporate bar’s perspective, were decisions like  Sjunde AP-Fonden v. Activision Blizzard (which I blogged about here), Crispo v. Musk (which I blogged about here), and West Palm Beach Firefighters’ Pension Fund v. Moelis & Co. (which I blogged about here), because those cases upset settled expectations of practitioners.  (VC Laster obliquely referred to some of the complaints in his decision denying interlocutory review in TripAdvisor: “Rule 42 does not invite a trial court to consider the level of media attention that a decision has received. That does not mean that the Delaware Supreme Court could not consider it. The justices might conclude that given the media attention and practitioner-driven stormlets over Delaware’s place in the corporate universe, Delaware’s highest court should weigh in. But that is not a consideration that Rule 42 instructs a trial court to take into account.”)

So it was in some sense unsurprising to see the Council of the Corporation Law Section of the Delaware State Bar Association immediately propose some legislative fixes.

Now, with the caveat that these proposals were just released, and I read them quickly, so I reserve the right to be totally wrong in my interpretation/analysis -

For Crispo, the proposal would make it possible for merger partners to specify that lost premium damages are available in the event of a broken deal, and further allow the target to create a shareholder’s representative who can seek lost premium damages on shareholders’ behalf (which, as I blogged, is something companies have sought to arrange through private ordering).

For Activision, the proposal allows boards to approve “substantially final” versions of merger agreements, especially if key terms are not included in the agreement but otherwise available to the board, and that disclosure schedules are not considered to be part of the merger agreement subject to board approval. 

I don’t find either of these particularly controversial (though I can imagine classroom hypos that have fun with how far a disclosure schedule can go; it doesn’t strike me as a particularly precise term).  As I previously blogged, in Activision, the violation seemed rather technical in nature, and Crispo just seemed like there was a divergence between the formal requirements of common law contract doctrine and the purposes a merger contract is meant to serve.

It’s the Moelis amendment that’s a bit more striking.  Proposed DGCL §122(18) would allow corporations to:

Make contracts with one or more current or prospective stockholders (or one or more beneficial owners of stock), in its or their capacity as such, in exchange for such minimum consideration as determined by the board of directors (which may include inducing stockholders or beneficial owners of stock to take, or refrain from taking, one or more actions). Without limiting the provisions that may be included in such contracts, the corporation may agree to: (a) restrict or prohibit itself from taking actions specified in the contract, whether or not the taking of such action would require approval of the board of directors under this title, (b) require the approval or consent of one or more persons or bodies before the corporation may take actions specified in the contract (which persons or bodies may include the board of directors or one or more current or future directors, stockholders or beneficial owners of stock of the corporation), and (c) covenant that the corporation or one or more persons or bodies will take, or refrain from taking, actions specified in the contract (which persons or bodies may include the board of directors or one or more current or future directors, stockholders or beneficial owners of stock of the corporation). With respect to all contracts made under this subsection, the corporation shall be subject to the remedies available under the law governing the contract, including for any failure to perform or comply with its agreements under such contract.

In conjunction with this amendment, there’s a new change to DGCL §122(5), as underlined:

Appoint such officers and agents as the business of the corporation requires and to pay or otherwise provide for them suitable compensation; provided that any contract or other appointment or delegation of authority that empowers an officer or agent to act on behalf of the corporation shall be subject to § 141(a) of this title, to the extent it is applicable.

According to the Richards, Layton & Finger memo on the proposed changesMoelionly held that contractual restrictions on the board’s authority must be contained in preferred shares rather than a separate contract; therefore, these amendments to the DGCL would not substantively affect the extent to which the board can contract out its authority.  Rather, they only have the effect of allowing boards to use ordinary contracts, rather than preferred shares, to make those arrangements.

I am not sure that is an accurate interpretation of Moelis.  VC Laster seemed to leave open the question how far a preferred share issuance could restrict board authority; in footnote 19, he wrote:

Moelis may not be able to get everything he wanted. Even a charter provision cannot override a mandatory feature of the DGCL....This court has indicated that some restrictions on board action could be invalid even if they appear in the charter....Some transactions, like mergers, require a specific sequence of events in which the board initiates action, then the stockholders vote.  It is unclear whether a charter provision could require a stockholder’s pre-approval, before the board could act....Regardless, those issues are for another day....

So as I read it, Moelis actually touched upon a couple of different issues.  The first was, how much can corporate governance be privately ordered in a personal contract/stockholder agreement, rather than in a corporate charter (including preferred share classes)?  The second was, what are the fundamentally nondelegable functions of a corporate board, that cannot be restricted at all?

These are both unsettled questions because, usually, if you want that much tailoring, you either form a close corporation or – more likely these days – an LLC. 

But proposed Section 122(18) blows past all that – not only does it allow for stockholder agreements to contain the kinds of governance rights previously associated with preferred shares, but it also does not seem to place any limits on the kinds of rights that can be given to stockholders directly in the first place.

We could ask why it matters whether a restriction appears in a stockholder agreement rather than a preferred share issuance.  The most obvious is, if it’s a private company, the stockholder agreement may not be known to the public or even other investors.  And even in a public company, stockholder agreements may be more easily amended than preferred share terms (though I imagine at least some of that difference could be mitigated with careful drafting regarding procedures for amendment of the preferreds).

But I think the broader question is the more interesting one: how much authority must a Delaware corporate board retain?  Or, where is the actual line between a corporation and an LLC?  Or, more generally, whether Delaware is going to be so firmly committed to private ordering in the corporate context that it functionally eliminates the distinction between the two.

And that just begs the question whether we really do need the two forms, or whether instead we should just have “the firm” which is a set of defaults that can be altered by the parties. 

(Yes, yes, I know LLCs are taxed differently than corporations, but that’s an IRS choice. It can decide separately which governance arrangements stray so far into the LLC territory that the firm should be taxed like an LLC.  Certainly, I don’t see any reason the label – and not the actual governance arrangements – should drive the taxation determination.)

One major argument in favor of keeping the corporate form “pure” is network benefits.  It’s easier for investors when there’s a basic governance arrangement that’s stable across firms, and that way they can focus on analyzing the substantive nature of the business when making investment decisions.  Writing in 2013, Michael Klausner pointed out that IPO charters demonstrate very little customization, which he took as evidence of the value of these network effects.

I genuinely wonder if that same result would be found today.  Increasingly, companies are going public with shareholder agreements, byzantine multiple-class share structures, forum selection clauses, corporate opportunity waivers – and that doesn’t even count all the private companies with impenetrably complex governance and cash flow rights

Does that suggest the network effects of the corporate form are overstated?  That’s the challenge that the proposed Section 122(18) poses.

And of course it goes further.  I have written about (and written about) the unsettled definition of what it means to be a controlling stockholder; allowing shareholders complete freedom to take on these kinds of governance powers demands a determination of when the powers are so overweening that the shareholder becomes a fiduciary.  Unless we want to make fiduciary obligations in this context waivable as well – which again brings the corporate form closer to the LLC.

One of the odder things about the proposed legislation is that the amendments to DGCL §122(5) recognize there must be some inherent powers in the board, that cannot be delegated to someone acting on the company’s behalf – like an officer.  This, presumably, is how you reconcile proposed §122(5) with proposed §122(18) – a stockholder, exercising rights under an agreement, is not acting on the corporation’s behalf, and therefore the §141(a) limits do not apply.

But think about the situation in Moelis itself.  There, the stockholder was Ken Moelis, who was also CEO, and also Chair of the Board.  He certainly, by virtue of the stockholder agreement, was a controlling shareholder.  If he exercised his rights under the agreement, would he be acting in his private capacity, or on behalf of the company?  And if on behalf of the company, does that mean §122(5) would kick in, preventing the board from delegating away its §141(a) power?  I’m very confused.

Also, by the way, there’s the bit about remedies.  The Richards, Layton & Finger memo on the proposed changes has this curious comment:

While the plain language of the new subsection would appear to give the board the power to bind the corporation to take fundamental action, such as approving a merger, at the direction of a stockholder, the real-world operation of any provision included in a stockholders’ agreement will be much more limited.  Although an agreement adopted pursuant to new Section 122(18) may require a corporation to cause fundamental action to be taken, nothing in the statute expressly provides that individual directors may be parties to the agreement and expressly bound thereto in their directorial capacities.  For example, fashioning a remedy for a corporation’s failure to cause a merger to occur as required by a stockholders’ agreement due to the failure of stockholders to adopt the merger agreement likely would involve consideration of the principles of preclusion and coercion applicable to termination fees.  While new Section 122(18) recognizes that a stockholder may receive damages if the corporation fails to cause a contractually specified event to occur, the amount of any such damages will be constrained, in most cases involving fundamental corporate actions, by equitable principles.  For example, fashioning a remedy for a corporation’s failure to cause a merger to occur as required by a stockholders’ agreement due to the failure of stockholders to adopt the merger agreement likely would involve consideration of the principles of preclusion and coercion applicable to termination fees.   

Actually, the amendment says that any remedies may be available under the law governing the contract.  Nothing in that language would prohibit equitable remedies where available, like specific performance, and courts enforce specific performance obligations against corporations all the time, including where board action (like completing a merger) is required.  I agree that matters requiring a stockholder vote will still require one, but the drafting of 122(18) does not on its face prohibit an order requiring the board perform its own obligations under the agreement.

Instead, the synopsis to proposed 122(18) says:

New § 122(18) does not authorize a corporation to enter into contracts with stockholders or beneficial owners of stock that impose remedies or other consequences against directors if they take, or fail to take, specified actions as required by the contract or that purport to bind the board of directors or individual directors as parties to the contract. Contracts that would impose such remedies or consequences on directors or that would bind directors as parties are subject to existing law. Abercrombie v. Davies, 123 A.2d 893 (Del. Ch. 1956); Chapin v. Benwood Foundation, Inc., 402 A.2d 1205 (Del. Ch. 1979). Instead, new §122(18) authorizes contracts that impose remedies only against the corporation, including as a result of any failure by the corporation, its board of directors, or its current or future directors, stockholders or beneficial owners of stock, to take, or refrain from taking, actions specified in the contract. If an action addressed in a covenant by the corporation requires director or stockholder approval under title 8, that approval must still be obtained in order to effect the action pursuant to title 8. For example, the lack of stockholder approval of an action under title 8 requiring such approval would render specific performance of the covenant unavailable. Moreover, as noted below, even the enforceability of a claim for money damages for breach of the covenant may be subject to equitable review if the making or performance of the contract constitutes a breach of fiduciary duty.

Notice how this says specific performance is not available if stockholder approval is required but lacking?  It conspicuously does not say specific performance is unavailable if only board action is required.  So I am not at all certain how the remedies section of the proposed law squares with the claim that it would not change existing cases like Abercrombie, which holds that stockholder agreements may not significantly limit the ability of directors to exercise their judgment on matters of corporate policy.

I’ll go further – I keep beating this drum about choice of law (wrote a whole paper about it).  Stockholder agreements are subject to ordinary choice of law principles, and proposed §122(18)’s reference to “the law governing the contract” apparently plans to keep it that way.  Which means, we get the possibility of a California law, or Texas law, or whatever other state law, determination of whether specific performance is required.  That sounds … very coherent.

Anyway, the Delaware Supreme Court has increasingly insisted that corporations are just contracts so now we’re really reaching put up or shut up time.  Is there anything left for the corporate form to do?  Or should we all just be teaching the law of the firm?

Ann Lipton | Permalink


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