Friday, March 1, 2024

*spins roulette wheel* Moelis and OpenAI!

I had so many choices for what to blog about this week.  The dispute about Donald Trump’s Truth Social SPAC?   Chancellor McCormick’s conclusion that the Activision/Microsoft merger might have violated Delaware law?  VC Laster’s Moelis decision?  Musk’s lawsuit against OpenAI

I ultimately decided to go with Moelis and OpenAI because they actually are fundamentally kind of the same thing, and this way I kill two birds with one stone.

So, earlier this week, it seemed like the big business law news was VC Laster’s holding in West Palm Beach Firefighters’ Pension Fund v. Moelis, issued last Friday, invalidating the shareholder agreement that Ken Moelis reached with Moelis & Co. when he took it public, and that allowed him to functionally remain in control of the business even when his voting stake dropped below a majority.  VC Laster held that the contract violated DGCL 141(a), which requires that corporations be managed by their boards of directors.

VC Laster recognized that every time a corporation enters into any kind of contract at all, the board’s choice set becomes more limited, but – using a word that I personally had never heard before and don’t know how to pronounce – concluded that there is a spectrum, starting with ordinary commercial contracts and ending with arrangements that ultimately intrude so far into corporate governance that they leave the realm of the commercial and raise a Section 141(a) issue.  Relying on Abercrombie v. Davies, 123 A.2d 893 (Del. Ch. 1956), he explained that the validity of a contract therefore depends on two inquiries: first, is it a governance arrangement at all?  If not, we’re done.  A number of factors go into determining whether the contract implicates corporate governance, including whether the contract involves some kind of commercial exchange, and whether it restricts the actions of internal corporate actors, namely, boards and shareholders.  

If the contract does implicate corporate governance, it will be invalid if it substantially restricts the board’s ability to manage the company.   In this case, the Moelis contract fit both bills: there was no commercial exchange, and the contract limited the board’s choices at every turn.  (My personal fave: The board was not permitted to discard the “Moelis” name without Moelis’s approval, even though name changes aren’t usually subject to a shareholder vote at all).

Among other interesting questions raised by the opinion are – what are the nondelegable functions of a corporate board?  DGCL 141(a) requires that corporations be “managed by or under the direction of a board of directors,” but in practice boards take advantage of the “under the direction of” piece and delegate most of those responsibilities to others.  What are the definitional board responsibilities that must remain with the board itself?  Certainly, merger negotiations fall into this category.  And in the Caremark context, Marchand v. Barnhill’s concept of “mission critical” risks is, functionally, a delineation of compliance responsibilities that are definitionally part of the board’s job and cannot be delegated to others.  The Moelis case also circles around the idea of core board functions that cannot be outsourced without violating Section 141(a).

Laster explains, however, that – though there are still outer limits imposed by the DGCL – many restrictions that would be prohibited in a stockholder agreement may still be permissible if they are contained in the corporate charter, or even in a new preferred stock issuance whose terms become part of the charter by operation of law.  And that’s the thing that grabs me.

Why does it matter whether something is in a shareholder agreement, versus a preferred share issuance?

Well, we can talk about transparency, and procedures for amendment – topics covered by Jill Fisch in her paper, Stealth Governance: Shareholder Agreements and Private Ordering.  I can also point out that now, after Moelis is already listed on the New York Stock Exchange, issuing new preferred stock that undermines the governance rights of existing shareholders may not be possible (does it count as a disparate reduction or restriction on shareholder rights if a shareholder agreement that existed at the IPO stage was invalidated and reconstituted in the form of a preferred share issuance?  I dunno).  But also, as I explain in my paper, Inside Out, preferred share terms are treated as internal affairs matters, subject to the law of the state of incorporation.  But shareholder agreements are ordinary contracts, and subject to ordinary choice of law.  Indeed, it’s not uncommon for shareholder agreements to contain a choice of law provision that is different from the state of incorporation.  (Yeah, that’s right, I answer to “Cassandra” now).

So the difference between putting it in a shareholder agreement and a preferred share issuance may be choice of law.


VC Laster, when explaining how to test for whether a shareholder agreement addresses governance matters (again, remember the mere fact that it addresses such matters does not invalidate it; you need to go to the second step of degree of constraint), he repeatedly referred to “internal affairs” and “internal governance.”  He didn’t mention choice of law, but the implication? was kind of? that a contract containing such restrictions might not, in fact, be subject to ordinary choice of law after all?  And might be deemed to be subject to the law of the state of organization? 

Which brings us, hilariously, to Elon Musk’s suit against OpenAI.  The gravamen of which, as I understand it, is that Sam Altman had an idea for developing AI for the benefit of “humanity,” pitched this to Musk, and Musk donated a bunch of resources while Altman organized multiple (Delaware) entities to effectuate the vision.  Generally speaking, those entities consist of a Delaware nonprofit corporation, OpenAI, Inc., which has a number of Delaware for-profit LLC subsidiaries.  Musk now advances various California breach of contract and analogous claims because, in his view, OpenAI, Inc. and its subsidiaries have failed to operate in accordance with the original humanity-focused set of promises. “This case is filed to compel OpenAI to adhere to the Founding Agreement and return to its mission to develop AGI for the benefit of humanity,” is an actual allegation at ¶33.

I will leave it to the nonprofit folks to talk about the standing of a donor to sue when a nonprofit fails to operate in accordance with expectations, though the fact that the complaint cites the relevant statute as “E.g. Cal. Bus. & Prof. Code § 17510.8” does not inspire confidence (the “eg” means “for example,” which I interpret as, there is no direct statute on point).  I will leave it to the contract folks to talk about whether promises of benefitting humanity are enforceable, or whether you can even cobble together a contract from the multiple conversations, emails, and organizational documents Musk cites.

Instead, I’ll talk about the fact that, in addition to disgorgement and damages, Musk seeks specific performance in the form of:

  1. An order requiring that Defendants continue to follow OpenAI’s longstanding practice of making AI research and technology developed at OpenAI available to the public, and
  2. An order prohibiting Defendants from utilizing OpenAI, Inc. or its assets for the financial benefit of the individual Defendants, Microsoft, or any other particular person or entity;

In other words, Musk claims that he has a contract, formed under California law, that allows Musk to dictate the governance choices of a Delaware organized (nonstock) corporation, and further, that a California court should order that this Delaware corporation conduct itself in accordance with his contract. 

Now, as a nonprofit, OpenAI is subject to jurisdiction not only of the Attorney General of its state of organization, but also the Attorney General of the states where it operates.  And I have no idea whether it has violated the legal rules governing nonprofits in those states – that’s up to the AGs.

But Musk is not invoking AG authority; he’s claiming a contractual right to dictate the governance of a Delaware-organized (nonstock) corporation.  So, especially in light of Moelis, if OpenAI wanted to take this as a serious threat, it could file a declaratory judgment action in Delaware to the effect that these “contracts” – if they even exist – are in fact contracts concerning internal affairs matters governed by Delaware law.  And, under Delaware law, at least at the corporate (OpenAI, Inc.) level, they are illegal intrusions into the board’s authority. (Though, I suppose, it might have difficulty getting personal jurisdiction over Musk in Delaware these days)

March 1, 2024 in Ann Lipton | Permalink | Comments (0)

Friday, February 23, 2024

The Materiality of Audit Opinions

A while back, I posted about an eyebrow-raising opinion out of the Second Circuit holding that clean audit opinions may not be material to investors because they use generic language.  Happily, the Second Circuit has agreed to take a second look at the issue, and invited the SEC to file an amicus brief, which it did.  (Alison Frankel has a column on the case here; the brief is linked here)

The brief is simple and makes the obvious point that the language of a clean audit opinion may be standardized, but its use reflects an industry understanding regarding the procedures used in the audit and the auditor’s conclusions.

One thing worth highlighting: As I explained in my original post, the way we seem to have gotten here is that the defendant auditor conducted a shoddy audit, but then argued that there was no link between its own audit deficiencies and the actual flaws in the underlying financial statements – i.e., even a proper audit would not have caught the problems.

The SEC argues that, even if true, that would not make the audit opinion immaterial; it might, however, affect the analysis of loss causation.  The distinction matters a lot to the SEC, because loss causation is only an element for private litigants; materiality, however, is an element that the SEC must prove in its own enforcement actions.

I agree with the SEC: a claim that the auditor would have issued a clean opinion – and missed the problems in the underlying financials – even if it had used proper procedures, is more properly characterized as a claim about loss causation, i.e, whether the false statement resulted in losses to the shareholders.

I like to use a little rule of thumb on the distinction between transaction causation (materiality) and loss causation.  Transaction causation asks, what would have happened if investors knew the truth?  Loss causation asks, what would have happened if the lie had been true? 

If investors would have done nothing differently, even had the truth been disclosed, the lie is immaterial. (This is, by the way, precisely what the Second Circuit has previously said about materiality). 

If the same losses would have occurred even if the allegedly false statements had been truthful – i.e., if there was some intervening cause that tanked the stock price – there is no loss causation.

In this case, it is impossible to believe that investors would have had no reaction had they been told the company was incapable of presenting a clean audit opinion.  Therefore, the Second Circuit should hold that the opinion was material.

And okay fine since I can’t resist…

As Ben Edwards blogged on Thursday, VC Laster came down with his long-awaited opinion in TripAdvisor.  The case was fascinating enough as it was – could it be a violation of fiduciary duty for a Delaware corporation to leave Delaware? – but in light of Elon Musk’s latest threats, it took on a heightened significance.

Most interestingly, VC Laster found, first, yes, a controller’s choice to relocate to a state that scrutinizes conflict transactions less closely than Delaware may itself be a conflict transaction.  And, second, damages rather than an injunction would almost certainly be the correct remedy.  Damages, he claimed, could be assessed by watching stock price movements; and not even necessarily at the moment of a shareholder vote, but even upon announcement of an intention to hold one.  (Which works for a public company, I guess; I assume we won’t see these disputes in private companies but that context would make a damages remedy much harder to fashion).

But here’s the thing.  To get there, he had to distinguish some prior cases that concluded that the elimination of litigation rights did not state a claim for breach of fiduciary duty.  This issue had come up, for example, in the context of charter amendments adding an exculpation clause under Section 102(b)(7), and in a reincorporation to California.  VC Laster was pretty clear that he simply thought some of them were wrongly decided, but his main point was that in those cases, the amendments were immaterial – i.e., it was not clear that the change conferred a non-ratable benefit on existing directors.  By contrast, he held, in this case, the differences between Nevada law and Delaware law are sufficiently plain – and the controller’s reasons for wanting the move sufficiently blatant – that the stockholder plaintiffs had at least, for pleading purposes, established they were losing a valuable right.

So … Texas?  As I previously wondered, Texas’s law might be different than Delaware’s but it is not obvious that it is so different – especially with respect to conflict transactions – that plaintiffs would be able to plead the same case.  And Musk may believe the Texas judges will less receptive to stockholder claims than Delaware judges, but, in TripAdvisor, VC Laster held that stockholders’ loss of access to any particular forum does not confer a material benefit on fiduciaries.

But!  If plaintiffs were able to plead that the move to Texas conferred a material benefit on Elon Musk, and then they had to prove damages via stock price movements – well, Musk gave them quite a boon by tweeting on January 30, in the middle of a dramatic slide in Tesla’s stock price due to the Tornetta verdict, that he hoped to reincorporate out of state.  That will sufficiently muddy the waters about price impact so as to give plaintiffs plenty of runway. 

Once again, foiled by bad tweets.

But finally, I think it will take quite a while to get that far, because if Tesla ever files a proxy statement for a shareholder vote, we will see some truly popcorn-worthy litigation over the completeness of the disclosures.  Will the proxy admit – or deny – the move was based on a Twitter poll?  How will the purposes of the move be characterized?  What was the board’s process for recommending the move, and how independent were the directors?  According to the WSJ, the directors intentionally keep concerns about Musk’s drug use out of the board minutes – can shareholder plaintiffs use §220 to get emails, then?  Etc, etc.

February 23, 2024 in Ann Lipton | Permalink | Comments (0)

Friday, February 16, 2024

More thoughts about advance notice bylaws

Fights over advance notice bylaws are becoming more common; I previously posted about Paragon Technologies v. Cryan, and right after that, VC Will decided Kellner v. AIM Immunotech.  In both situations, boards were found to have been overly aggressive in drafting and enforcing their bylaws, and VC Will went case by case to determine which actions were permissible and which were not.  And since the dissidents had not fully complied with even the permissible bylaws, VC Will would not order that their nominees be permitted to stand for election.

This strikes me as such a difficult problem.  On the one hand, there are good reasons for these bylaws, as both the Paragon and AIM disputes make clear.  In Paragon, the dissident really was playing games about providing information regarding its plans; in AIM, the contest was a continuation of one spearheaded a year earlier by a convicted felon who tried to conceal his involvement.  So yeah, boards have really legitimate interests in ensuring that shareholders have full information.

On the other hand, the blue pencil approach – where the noncompliant bylaws are severed and the legitimate ones remain standing – strikes me as having the same problem that’s been identified in the context of noncompetition agreements.  In the employment context, Chancery does not blue pencil, because:

To blue-pencil the provision creates a no-lose situation for employers, because the business can draft the covenant as broadly as possible, confident that the scope of the restriction will chill some individuals from departing. If someone does challenge the provision, then the worst case is that the court will blue-pencil its scope so that it is acceptable. It also enables employers to extract benefits at the expense of employees by including unenforceable restrictions in their agreements. The logical result of such a system is sprawling restrictive covenants.  Accordingly, “[w]hile, in some circumstances, a court may use its discretion to blue pencil an overly broad non[1]compete to make its restrictions more reasonable, this court has also exercised its discretion in equity not to allow an employer to back away from an overly broad covenant by proposing to enforce it to a lesser extent than written.”

Obviously, the employment context is not the same as an advance notice bylaw – dissidents are not nearly as vulnerable as employees – but there is, I think, a similar set of concerns.  If Delaware courts blue pencil the bylaws back to what – ex post – is determined to be reasonable, then boards have no incentive not to draft the most lengthy and unreasonable bylaws they can.  The dissident then has to guess at which ones are and are not permissible, and comply with the right set of bylaws – reveal too much and make themselves vulnerable, too little and disqualify themselves – while mounting an expensive court challenge that won’t necessarily create useful precedent for the next set of creative bylaws.

One aspect of the AIM case highlights the problem.  In 2016, the board had adopted a bylaw requiring disclosure of “all arrangements or understandings between such stockholder and each proposed nominee and any other person or persons (including their names) pursuant to which the nomination(s) are to be made.”  In 2023, after having dealt with the convicted felon’s earlier contest, the board amended the bylaw to broaden that provision and capture associates and family members in a manner that VC Will found was unreasonable.  When the dissidents challenged the amended bylaw, rather than strike it entirely, Will decided to restore it to the narrower, 2016 version, and measured the dissidents’ compliance against that bylaw – the one that did not exist anymore.  The dissidents had not complied with the bylaw that did not exist, and that was one of the reasons why VC Will affirmed the board’s decision not to permit them to advance their nominees. 

Now, given the peculiar facts of this case, I’m not troubled by that result, but notice the bind this would have placed on a good-faith dissident slate.  They would have found it nearly impossible to guess what information was actually required of them.

I wonder, then, if the solution is to set some kind of blanket rule that certain types of bylaws are almost always going to be permissible.  If the board adopts bylaws that go beyond that floor, it does so at its own risk – if any additions are deemed unreasonable, all are struck, but the floor (to the extent adopted by the board) remains intact.  That way, dissidents know what the floor is for compliance, and there is no risk that, say, a felon gets through without any disclosure just because the board was overzealous.  Meanwhile, if the board has genuine need for information beyond the floor, it has an incentive to be judicious in crafting its additional requirements.

February 16, 2024 in Ann Lipton | Permalink | Comments (2)

Friday, February 9, 2024

This Post is Not (Just) About Elon Musk

Look, it’s not like I want to post about Elon Musk every week, it’s just that he keeps doing things that result in interesting corporate governance conundrums.  So this week’s post covers several things, only one of which is a Musk thing.

The Musk Thing

After Chancellor McCormick struck down his Musk’s 2018 pay package, one bit of speculation that floated about was whether Musk could sue Tesla to recover the package, on some kind of restitution/quantum meruit theory.  My suspicion is that such a claim would be unlikely to succeed because Musk’s own fiduciary breaches are what led to the original forfeiture, and he who comes into equity must do so with clean hands.  Or, as the famous jurist Leo Rosten put it, it would be like “a man who, having killed his mother and father, throws himself on the mercy of the court because he is an orphan.”

But despite the dubious merit such a claim would have, given the close ties McCormick identified between Tesla’s board and Elon Musk, there would be a risk that the board would take a dive and settle unnecessarily.

(More under the cut)

Continue reading

February 9, 2024 in Ann Lipton | Permalink | Comments (0)

Saturday, February 3, 2024

On Texas

Given all the news about Governor Abbott's pitch to create a business law infrastructure that will compete with Delaware, and Musk's threat to decamp there, it's worth pointing out that this is an amendment that was recently proposed to the Texas Business Organizations Code:

BURDEN OF PROOF IN CERTAIN DERIVATIVE PROCEEDINGS. Notwithstanding any other law, in a derivative proceeding by a shareholder that alleges an act or omission related to the improper consideration of environmental, social, and governance criteria in the performance of the act or omission, the burden of proof is on the corporation to prove the act or omission was in the best interest of the corporation.

In 2022, Texas legislators proposed amending its law to permit shareholders to bring a fiduciary duty claim against the managers of any public company that provided women employees with travel benefits for abortion care (though, to be fair, in that case, the proposal would have applied even to non-Texas organized companies).

Texas Attorney General Ken Paxton has been very vocal about his objections to ESG - he is among those suing to block a Department of Labor rule, among other things - and as Attorney General, he would, as I understand it, have the power to seek involuntary dissolution of Texas entities.

We can also throw in Texas’s refusal to do business with financial institutions it perceives as “boycotting” oil companies, with “boycott” defined both capaciously and idiosyncratically.

I think it would be very difficult for Governor Abbott to assure companies that if they organize in Texas, their business decisions will not be second-guessed on political grounds.

February 3, 2024 in Ann Lipton | Permalink | Comments (5)

Thursday, February 1, 2024

The Bill Comes Due

So, anything interesting happening in corporate law this week?

I kid, I kid. On Tuesday, Chancellor Kathaleen McCormick of the Delaware Court of Chancery issued her long-awaited opinion in Tornetta v. Musk, where she took the extraordinary step of holding that Elon Musk’s Tesla pay package from 2018 was not “entirely fair” to Tesla investors, and ordered that it be rescinded.  In practical effect, she ordered the cancelation of stock options worth about $51 billion, or, according to news reports, about a quarter of his current wealth.  Put that together with the Twitter purchase, the State of Delaware and Chancellor McCormick have cost Musk about $90 billion, give or take (though a contrary take would involve the words “actions” and “consequences”).

The legal standards

Normally, the decision of what to pay a corporate CEO – like any other business decision – is controlled by the board of directors, and not subject to second-guessing by a court.  But, like any other business decision, that changes if the executive pay package can be seen as self-dealing, namely, the decisionmakers have a financial interest in the arrangement.

In a normal company, that isn’t a problem; the corporate directors act at arm’s length from the CEO for the purposes of negotiating the pay package. 

In companies with controlling shareholders – like Meta and Mark Zuckerberg, for example, which McCormick namechecks in her opinion – any compensation package would necessarily be tainted with the specter of self-dealing (how seriously can the Meta board bargain against Zuckerberg?), and so controllers tend to forego compensation entirely, which, of course, seems reasonable because they already have so much equity in the company that they are plenty incentivized to come to work every day.

That said, if a company chooses to engage in a conflicted transaction, it is not automatically illegal; it simply is assessed under a complex set of legal standards if it is later challenged in court by a stockholder.

The basic rule is, if an independent decisionmaker interposes themselves in the process, the court will defer to that decisionmaker.  If not, the court will closely examine the transaction to ensure its fairness.

Typically, the independent decisionmaker will be independent board members.  In the process of negotiating an executive pay package, for example, some board members may have close ties to the executive, but others will not, and so the ones who can be objective will make the call.

Alternatively, the independent decisionmaker can be the disinterested shareholders, who can vote to approve the transaction.

In Delaware, however, those rules only hold for conflicted transactions that do not involve a “controlling shareholder,” or controller.  Typically, controllers are those who control more than 50% of the company’s voting power, but control may in fact exist through other means.  More on that in a minute.

Delaware courts have come to coalesce around the rule that if a controlling shareholder is on the other side of a conflicted transaction, both board members and disinterested stockholders may be so intimidated or captured by the controller that they will be hesitant to buck his will.  Hence, those transactions can only be cleansed if both the independent directors, and the disinterested stockholders, approve it.

If only one mechanism is used – just independent directors, or just disinterested stockholders – controlling shareholder conflict transactions will still be assessed for their fairness, but the stockholder plaintiff will have the burden of proving by a preponderance of evidence a lack of fairness, rather than the defendant controller proving fairness.

What McCormick found

Formally, in Tornetta, the court concluded that Elon Musk was a controlling shareholder of Tesla, at least for the purposes of setting his compensation package.  The court considered both his 21% percent stake, and his “ability to exercise outsized influence in the board room” due to his close personal ties to the directors and his “superstar CEO” status.  She recounted the process by which the pay package was set, noting in particular that Musk proposed it, Musk controlled the timelines of the board’s deliberation, and he received almost no pushback – board members and Tesla’s general counsel seemed to view themselves as participating in a cooperative process to set Musk’s pay, rather than an adversarial one.

What about the stockholder vote?  That, too, was tainted, because – McCormick concluded – the proxy statement delivered to shareholders contained material misrepresentations and omissions.  It described Tesla’s compensation committee as independent when in fact the members had close personal ties to Musk, and it did not accurately describe the manner in which his pay package was set – again, with Musk himself proposing it and the board largely acquiescing.  With those findings in hand, McCormick did not rule on the plaintiff’s additional arguments that the proxy statement was misleading for other reasons (namely, it falsely described the payment milestones as “stretches” when in fact the early ones were already expected within Tesla internally.)

Therefore, McCormick turned to the fairness analysis, with defendants bearing the burden of proof.  McCormick recognized that Musk had delivered extraordinary value for Tesla, but that was only one side of the equation.  The other side was whether his shockingly large pay package was necessary to get that result; given that Musk already held a 21% stake and had no intention of leaving the company, she concluded it was not.  Or, at the very least, the package was flawed because the Board had not even asked whether such sums were necessary.  Moreover, in its deliberations, the Board had identified precisely one particular concern about Musk: Whether he was too distracted by his outside interests to focus on Tesla.  But there was no further discussion of that issue, and no proposal to condition his pay on limiting his distractions. 

McCormick did not specifically so hold, but she must have been aware that, far from incentivizing Musk’s undivided attention, the Tesla pay package enabled Musk’s purchase of another massive distraction that almost certainly is damaging Tesla’s brand.  

And, well. Here we are.

Currently, however, Delaware is in the process of reevaluating its standards for reviewing controlling shareholder transactions.  The argument under consideration is whether certain kinds of transactions – executive pay packages, for example – can be cleansed, and thus insulated from judicial review, through one protective mechanism rather than two (independent board or independent shareholder approval), the same way conflict transactions that do not involve a controlling shareholder usually are.  Even if the Delaware Supreme Court so holds, though, that fact alone would not necessarily save Musk’s pay package, because McCormick concluded Musk’s pay package was not cleansed either way.  She might have to rejigger her findings a little to clarify, but that’s all.

Similarly, if the Delaware Supreme Court were to conclude that Musk did not, in fact, deserve the formal label of controlling shareholder – say it suddenly set a bright line rule that controlling shareholders must have 50% of the vote – that still would not save Musk’s pay package (though, again, McCormick might have to revise her opinion a little), because McCormick made clear that the board’s decisionmaking was tainted by close ties to Musk no matter what label you apply (see fn. 546: “The factual findings that render Musk a controller, however, support a finding that the majority of the Board lacked independence.”), and so was the stockholder vote, so either way, there was no independent decisionmaker.

If, however, the Delaware Supreme Court did two things – say it both concluded that Musk was not a controlling shareholder, and it overturned McCormick’s factual finding that the shareholder vote was tainted – that might save Musk’s $51 billion, though – again, more below – the more likely outcome is McCormick would have to retry certain aspects of the case.

The takeaways

The overriding sense that one gets from this opinion that the bill for Tesla’s open and notoriously poor governance standards just came due.

Tesla shareholders, as well as other commenters, have for years complained about everything from the close personal ties Tesla’s board has to Musk, to the manner in which Musk’s other companies compete for his attention, to Musk’s open defiance of his settlement with the SEC, to the fact that Musk casually conscripts Tesla employees to work at other companies in his empire.  Now, for the first time, all of these aspects of Musk’s reign coalesced into a single, legal conclusion that was fairly obvious to the rest of us but I think has devastating implications for Tesla going forward: Tesla’s board exercises no oversight over Elon Musk.

McCormick even took on the “Technoking” title:

Musk testified that the title was intended as a joke, but that is a problem in itself.  Organizational structures, including titles, promote accountability by clarifying responsibilities. They are not a joke.

McCormick was obviously ruling in the shadow of VC Slights’s previous conclusion that Musk had not exercised control over the board for the purposes of the SolarCity acquisition, and so formally, she limited her own holding to Musk’s control for the purposes of his pay package, but she also drew in the entirety of Musk’s tenure.  And, in a footnote, she pointed out that though Slights had characterized board member Robyn Denholm as a “powerful, positive force,” that particular version of Denholm had not shown up in McCormick’s courtroom: 

this court previously held that Denholm was “an independent, powerful and positive force during the deal process” that led to the SolarCity acquisition. And that was surely true at the time. But it was not a factual finding that carries forward for all time. Moreover, Denholm’s approach to enforcement of the SEC Settlement, including unawareness of one of its key requirements, suggests a new lackadaisical approach to her oversight obligations.

Leaving aside the legal formalities, the obvious question is – was McCormick right?  Whether or not Tesla formally complies with Delaware corporate governance standards, Musk has unquestionably delivered extraordinary value to its shareholders.  The “Technoking” title may very well highlight the casualness with which Tesla directors approach their responsibilities, but also that’s the kind of thing Tesla shareholders value.  It may not improve cash flows, but, at least historically, it improves stock prices by pleasing Musk fans.  Which raises a very interesting doctrinal question – one I think posed in a more academic way in this paper by Charles Korsmo and Minor Myers – is it the duty of a Delaware board to raise stock prices – even by, say, taking Zoom calls with no pants on or buying a gold mine – or is it the duty to improve fundamental value?  

Societally we may prefer the latter but Tesla shareholders individually presumably prefer the former.  On the other hand, even the share-price approach is a bit like catching the tiger by the tail; it only lasts as long as Musk’s star power lasts, and that may not be forever.

I was struck by Antonio Gracias’s testimony that the package was designed to give Musk “dopamine hits,” because I think that is not a bad way to look at it.  Yes, he presumably was internally motivated to boost Tesla’s stock price because of his own 21% stake, but we all know – or we think we know – Musk’s psychology.  What motivates him psychologically isn’t (just) the money, but things he views as outrageous challenges.  Maybe by gameifying his compensation package – presenting him with impossible goals and then, when he met them, ringing bells and showering confetti and gold coins – the board really did extract maximum performance.

On the other hand, as McCormick repeatedly emphasized, there was some evidence that at least the early goals were not particularly challenging.  But that’s just like any game; the first levels are always the easiest.

We could also ask whether McCormick reached the right conclusion about the shareholder vote.  Yes, the proxy statement may not have explained the full extent of Musk’s board ties, but did anyone really not understand the Tesla board’s (lack of) independence?  (An internal document from ISS made pretty clear that ISS, at least, believed the board to be weak, but for whatever reason was hesitant to say so openly).  And once you know all that, did it really matter that the full embarrassing process by which the compensation package was formulated was not laid out in the proxy?  Surely no one thought this was an arm’s length negotiation?

The problem, from my perspective, is that those gut level reactions do not map to the legal standards in a coherent way (you can use concepts like “materiality” or whatnot but there is no way to apply those in the kind of “one ticket only” way that Musk and Tesla require).  And of course, the legal standards have a societal function of professionalizing large, powerful companies, in a way that is important even to nonstockholders, regardless of their specific impact at Tesla, though that’s not something Delaware can formally acknowledge.

What happens now?

Now, I assume, Tesla appeals.  I am not going to hazard a guess on outcome, though I will make a couple of quick observations.

First, as I have previously writtentwice – Delaware’s standards for determining who gets the label of “controlling shareholder” are very malleable.  However, as I blogged previously, I think in its SolarCity opinion, the Delaware Supreme Court did provide some guidance on that score, suggesting, in a roundabout way, that only the power to elect directors and approve transactions, or possibly block them, should factor in to the analysis.  McCormick did not take that hint, though; she did a more holistic review, which may turn out to be legally vulnerable.  But, as I said above, that’s not enough, standing alone, to knock out her core conclusions.

Another area that might be the focus of an appeal would be the shareholder vote.  Musk could argue that the omissions were, in fact, immaterial to shareholders.  I will not say that is a losing argument, but I will say it would be aggressive if the Delaware Supreme Court were to reverse on that score.  If it did so, however, that – standing alone – would not save Musk’s pay package.  So long as Musk retains the “controlling shareholder” label – and Delaware maintains its double-protection rule for controlling shareholder transactions – a reversal on that score would mean, at most, a remand to shift the burden of proof from defendants to the plaintiff, and I think it’s … unlikely … the outcome would change.  Plus, McCormick did not even rule on arguments that the proxy statement was misleading for other reasons, so a remand would give her another crack at that issue.

And if Delaware both changes its standards for cleansing controlling shareholder transactions (or holds Musk was not one), and holds the shareholder vote was not tainted, that still should result in a remand for McCormick to determine whether the plaintiff’s additional arguments that the proxy statement was false – the ones she did not engage – succeed.  For Musk to get a complete win, in other words, the Delaware Supreme Court would likely have to conclude either that he is not a controller (or that controller-conflicted transactions do not need two levels of protection), and that the shareholder vote was not tainted, and that the claims McCormick did not rule upon have no merit and do not need to be tried.

That is … a tough lift for Musk.

Notice I have not even considered the possibility the Delaware Supreme Court would reverse McCormick’s findings that the board was beholden to Musk because … no.  I mean, Musk could argue that there is nothing bad about a board “cooperating” with a CEO to develop a pay package; he could try to make a parody of McCormick’s findings by claiming that she unfairly seemed to want the CEO and the board to be at loggerheads, but … no.

Which means on the law, I like the plaintiff’s chances.  On the political economy, though – well, Musk is obviously beating some very loud drums about reincorporating out of Delaware, and I have previously asked whether that kind of thing could influence Delaware’s decisionmaking.  On the other hand, the Delaware Supreme Court cannot be seen as capitulating to Musk, which means if it reverses McCormick, it must have a fairly solid basis to do so.

Edit: I suppose the Delaware Supreme Court could reweigh the evidence and conclude the pay package was fair, but that would be extremely aggressive. So aggressive that it literally did not occur to me, which is why I had to edit this post.

Edited again (Feb. 3): The “fairness” inquiry that Delaware courts conduct consists of two aspects: the fairness of the process, and the fairness of the ultimate price.  I went back to the Delaware Supreme Court’s SolarCity opinion, and there, the court was very clear that ultimate question of whether a price was fair (one half of the overall fairness inquiry) is a legal question that rests upon factual conclusions.  As the Delaware Supreme Court put it reviewing the Chancery court’s findings, “We conclude that the record supports the Court of Chancery’s legal conclusion that the price paid was a fair one and that the trial court did not misapply the entire fairness standard.”  That matters because the Delaware Supreme Court will defer to Chancellor McCormick’s factual findings, but does not defer to her legal ones.  So that’s probably one of Musk’s best lines of argument: even if you accept all of Chancellor McCormick’s factual findings about the flaws in the process by which his compensation package was set, the Delaware Supreme Court has the authority to consider anew whether, in light of the huge value Musk was required to deliver to shareholders, the grant was unfair. 

As for the board’s failure to curb Musk’s outside ventures, the response is obvious: it chose to directly compensate him for performance, rather than the methods he used to achieve that performance.  I.e., promise him the moon if he substantively delivers, and let him decide what efforts will be required.

That said, the first tripwire I see for him is McCormick’s conclusion that the early milestones were easy ones.

No, but what happens now to Tesla?

Let’s assume the opinion stands.  That company does not have a lot of great choices.

Assuming Musk does not want to go the Zuckerberg-no-compensation route, any new compensation award will have to be negotiated by the board in the shadow of McCormick’s findings (not to mention Musk’s threat to breach his fiduciary duties by diverting AI opportunities from Tesla to his other companies, which, this post is long enough, I am not going there). 

But the problem extends beyond compensation to a host of other issues. There are already pending cases, that have been stayed, about board oversight of Musk – the failure to monitor his tweets, for example, or to enforce the SEC settlement – at this point, I’ve lost track of them all.  Tesla was just accused of dumping hazardous waste; that’s the stirring of a Caremark claim.  Musk has been using Tesla engineers at Twitter – there’s a claim for self-dealing.  Each new Musk antic will prompt another lawsuit, and every single time, the plaintiff will begin by citing the Tornetta decision as evidence that the board is not independent of Musk and cannot consider a demand.  It’s like a dam has broken, a wall of protection around Musk – the polite fiction, which no one believed to begin with, that he operates under board oversight.

One way out would be to visibly and strongly restructure the board – possibly by appointing new members.  But can anyone imagine Musk tolerating a genuinely empowered board that tried to, among other things, curb his outside ventures?

Another way out would be for Tesla to follow through on Musk’s latest suggestion: Reincorporation to Texas.  That would require a shareholder vote, but Tesla’s stock is, like, 40-50% retail, with another chunk held by Musk and Musk allies, it’s not literally impossible that the vote would succeed.

But can you even imagine what the lawsuit would look like if Musk’s board proposed reincorporation to Texas on the basis of Musk’s Twitter poll, after a shocking indictment of its stewardship? 

Musk texas

There is currently pending a lawsuit challenging a Delaware reincorporation to Nevada.  It’s a novel claim that the controlling shareholder is seeking to avoid Delaware’s strict standards for reviewing conflicted transactions.  I have no idea how that will come out; it’s a dilemma for the Delaware courts.

But in Tesla’s case – and someone correct me if I’m wrong – it’s not quite as obvious that the formal legal standards in Texas are so different from Delaware’s.  They seem pretty MBCA-like: universal demand, there may be some limits on what counts as interested/dependence/independence but nothing a clever plaintiff couldn’t plead around.  That’s not the reason Musk wants to go there; he wants to go there because he expects the judges will be biased in his favor. 

Suing shareholders would argue that the reincorporation was intended to protect Musk’s ego and his power, not shareholder value.  Which brings us back to the question posed by Tornetta: Is shareholder value measured by stock prices alone?

As for me, here’s to another round of edits to my Twitter v. Musk paper, now forthcoming in the Virginia Law & Business Review.

February 1, 2024 in Ann Lipton | Permalink | Comments (15)

Friday, January 26, 2024

The Specter of Twitter v. Musk Keeps Reappearing

So, there was a lot going on in Twitter v. Musk, some of it in the actual case, but much of it in the speculation of we legal types as we gamed out various potential scenarios.

One scenario that kept recurring was whether Delaware would in fact have the ability to actually enforce a judgment against Elon Musk, should he choose to simply defy court orders.  That was never a likely scenario; Musk is a repeat player in Delaware and it was never feasible for him to remain the CEO of a public company organized in Delaware while running from the Delaware courts.

But if that happened, it seemed one solution would be for Delaware to seize his Tesla shares, and his SpaceX shares, and then either sell them or more likely simply hold them until he complied with the judgment.  The logic was that, according to DGCL §169, shares of a Delaware corporation exist, in the abstract, within the state of Delaware, and Court of Chancery Rule 70 says:

If a judgment directs a party to execute a conveyance of land or to deliver deeds or other documents or to perform any other specific act and the party fails to comply within the time specified… On application of the party entitled to performance, the Register shall issue a writ of attachment or sequestration against the property of the disobedient party to compel obedience to the judgment. The Court may also in proper cases adjudge the party in contempt. If real or personal property is within the jurisdiction of the Court, the Court in lieu of directing a conveyance thereof may enter a judgment divesting the title of any party and vesting it in others and such judgment has the effect of a conveyance executed in due form of law. When any order or judgment is for the delivery of possession, the party in whose favor it is entered is entitled to a writ of execution or assistance upon application to the Register in Chancery. The provisions of this paragraph shall not be construed to replace any statutory authority granted this Court to compel performance by a substitute.

…For failure to obey a restraining or injunctive order, or to obey or to perform any order, an attachment may be ordered by the Court upon the filing in the cause of an affidavit showing service on the defendant, or that the defendant has knowledge of the order and setting forth the facts constituting the disobedience. …

Which, as I read it, grants Chancery pretty wide latitude to force compliance with court orders by seizing property within its jurisdiction.

And, in fact, on October 3, 2022 – right before Twitter v. Musk settled – VC Laster issued an opinion in In re Stream TV Networks Omnibus Agreement Litigation doing just that.

Now a big difference between that case and Twitter was, in that case, the shares themselves were the subject of the dispute.  SeeCubic had been ordered to transfer its assets to Stream, and instead of doing so, it arranged matters to ensure that certain shares of a Delaware company were seized by another company, Hawk.  Stream filed an emergency motion to get the shares back, and VC Laster relied on Section 169 and Chancery Court Rule 70 to order that Hawk be divested of the shares, and that they be vested in Stream.  So yes, it seemed a Delaware Chancery court could in fact simply order that shares of a Delaware company be transferred to someone else or sequestered to ensure compliance with a court order, and there did not seem to be a reason why the same principle wouldn’t apply to assets unrelated to a particular dispute.

But then!  In May 2023, then-Superior Court Judge LeGrow (now on the Delaware Supreme Court) decided Deng v. HK XU Ding.  There, Plaintiff Deng sold shares of iFresh, a Delaware corporation, to Defendant HK.  HK never paid the full purchase price, however, and Deng sued in New York for the remainder of the purchase price.  He won a default judgment of around $2.5 million, and then went to Delaware to execute.  The assets available to satisfy the monetary judgment were, of course, the iFresh shares, so Deng sought to attach them.

The problem was that these shares actually had been certificated, and the physical certificates had been seized by Chinese authorities.  Deng argued that didn’t matter; Judge LeGrow held that it did.

Relying on DGCL §324(a) and 6 Del. C. §8-112, Judge LeGrow held that when certificates of the stock exist, they may be attached to satisfy a debt only if the physical shares are seized.  The Delaware Supreme Court heard oral argument on that question earlier this month.

So, I’ll openly admit I don’t know how far the two situations interact; maybe not at all.  Sections 324 and 8-112 are about creditors satisfying debts, not about seizing for the purpose of forcing compliance with a court order/as a sanction for contempt, and possibly those are different scenarios.  (If you are a Delaware law maven who has a definitive answer, please drop a comment.)  But if LeGrow’s interpretation holds up across all scenarios, that would mean future Musks could, if they wanted to, evade sanction in Delaware by I guess going to DTC and getting physical certificates of their shares, and then sticking them in a vault in another state.  Or Bermuda or the Cayman Islands.  Of course, that would make them hard for anyone to seize, and I have no idea whether that would interfere with attempts to use them as security for personal loans, as Musk and many other executives do.

Edit:  I should add that another complexifying factor here is that the Chinese government obviously thinks it has possession of the shares. If Delaware holds that you do not need the physical certificates, is it challenging the claim of the Chinese government?  That presumably is a fight Delaware does not want to have; the problem is, there is a difference between the owner refusing to turn over the certificates to avoid a judgment, and another creditor/claimant refusing to turn them over.  The plaintiff in Deng admits there is a bona fide purchaser exception, but not every certificate seizure will involve those.

January 26, 2024 in Ann Lipton | Permalink | Comments (0)

Friday, January 19, 2024

JetBlue and Spirit

This is a really interesting classroom case study.

As I originally blogged about here, it all begins with Spirit and Frontier agreeing to a stock deal – non-Revlon – and JetBlue swooping in with a topping cash bid.

Spirit’s management resisted, arguing that there was far more regulatory/antitrust risk with the JetBlue deal than with the Frontier deal.  But JetBlue kept insisting that regulatory risks could be managed, and offered an extremely generous set of reverse termination provisions if the deal was blocked (more on those in a minute).

Ultimately, Spirit’s management caved to the demands of its shareholders; it was clear they would reject Frontier in favor of JetBlue.  And the deal was, in fact, blocked on antitrust grounds.

The parties had agreed to use best efforts to complete the deal, including to appeal any court orders enjoining the merger.  As the agreement states:

both Parent and Company (and their respective Subsidiaries and Affiliates) shall contest, defend and appeal any Proceedings brought by a Governmental Entity, whether judicial or administrative, challenging or seeking to restrain or prohibit the consummation of the Merger or seeking to compel any divestiture by Parent or the Company or any of their respective Subsidiaries of shares of capital stock or of any business, assets or property, or to impose any limitation on the ability of any of them to conduct their businesses or to own or exercise control of such assets, properties or stock to avoid or eliminate any impediment under the HSR Act or similar applicable Law,

Termination cannot formally occur until all appeals have been exhausted.

JetBlue agreed to the following reverse termination fees to mitigate the risk of deal failure due to antitrust enforcement.  First, it agreed to pay $70 million to Spirit.  Second – and more unusually – it agreed to pay $400 million to Spirit shareholders.  And third, it agreed to a “prepayment” scheme, of sorts.  An initial payment of $2.50 per share was made to Spirit shareholders right after they voted in favor of the merger; after that, Spirit shareholders have been receiving a $0.10 per share “ticking fee” for every month of delay.  If the deal goes through, these payments are deducted from the merger consideration.  If the deal does not go through, shareholders get to keep them, plus whatever else is necessary to reach the $400 million mark.  If the deal is delayed to the point where the prepayments exceed $400 million, as I understand it – and someone please correct me if I’m getting this wrong – JetBlue keeps paying them, as long as the deal has not been formally terminated.  In other words, the longer the appeal process takes, the more likely it is JetBlue will have to pay reverse termination fees to Spirit shareholders in excess of $400 million.

I have no idea where the numbers are right now, but obviously, that makes fruitless appeals a lot less attractive.

Edit:  A reader pointed out that there is an outside date of July 2024, which is likely far too soon for any appeals to conclude, and JetBlue can terminate then.  But the ticking fees, I believe, still tick until then, and JetBlue cannot end this earlier, which means, Spirit does still have that leverage.

Which is why it’s understandable that, according to reports, JetBlue is not sure it wants to appeal.  And why it’s understandable that Spirit is insisting on adherence to the contract.  But there is a twist: Spirit’s financial condition is so poor that there are reports denying an imminent bankruptcy.  According to Reuters:

JetBlue… is also mindful that Spirit's business has deteriorated significantly since the two agreed the tie-up in July 2022, …

Spirit, which like other airlines took a financial hit during the COVID-19 pandemic, has struggled more than its peers to recover, because its low-budget price model has left it little room to raise air fares after fuel prices rose. Its net debt rose from $3.3 billion to $5.5 billion over the past two years as its losses widened.

Which makes me think that JetBlue is considering pulling the MAE card.  Spirit experiencing an MAE is a separate and independent grounds for JetBlue to terminate, and the merger agreement definition of an MAE has a carve-back for disproportionate impact:

“Company Material Adverse Effect” means any change, event, circumstance, development, condition, occurrence or effect that (a) has had, or would reasonably be expected to have, individually or in the aggregate, a material adverse effect on the business, financial condition, assets, liabilities or results of operations of the Company Group, taken as a whole, or (b) prevents, or materially delays, the ability of the Company to consummate the transactions contemplated by this Agreement; provided, however, that none of the following will be deemed in themselves, either alone or in combination, to constitute, and that none of the following will be taken into account in determining whether there has been or will be, a Company Material Adverse Effect: …  (iv) acts of war, outbreak or escalation of hostilities, terrorism or sabotage, or other changes in geopolitical conditions, earthquakes, hurricanes, tsunamis, tornados, floods, mudslides, wild fires or other natural disasters, any epidemic, pandemic, outbreak of illness or other public health event (including, for the avoidance of doubt, COVID-19 and impact of COVID-19 on the Company) and other similar events in the United States or any other country or region in the world in which the Company conducts business; (v) any failure by the Company to meet any internal or published (including analyst) projections, expectations, forecasts or predictions in respect of the Company’s revenue, earnings or other financial performance or results of operations (it being understood that the underlying facts and circumstances giving rise to such event may be deemed to constitute, and may be taken into consideration in determining whether there has been, a Company Material Adverse Effect); … or (vii) any change in the market price or trading volume, or the downgrade in rating, of the Company’s securities (it being understood that the underlying facts and circumstances giving rise to such event may be deemed to constitute, and may be taken into consideration into determining whether there has been, a Company Material Adverse Effect); provided, further, that the effects or changes set forth in the foregoing clauses … (iv) shall be taken into account in determining whether there has occurred a Company Material Adverse Effect only to the extent such developments have, individually or in the aggregate, a disproportionate impact on the Company relative to other companies in the airline industry, in which case only the incremental disproportionate impact may be taken into account.

From my 30,000 foot view analysis, I’d say JetBlue has a stronger MAE argument than, you know, Musk did when trying to avoid the Twitter deal, and it makes me think that the whole situation could resolve – as is typical – in a settlement, say, where JetBlue pays an additional fee to avoid the appeals.

If that happens, I suppose there may remain messy questions like, will Spirit shareholders sue claiming they missed out on those additional ticking fees they were supposed to receive while appeals were pending?  Will they have a chance, given the merger agreement’s (typical) disclaimer of any third-party beneficiaries? 

Anyhoo, Matt Levine said it first (naturally) but it’s worth reiterating: This was a classic case where Spirit shareholders wanted something, its management wanted something else, and management was right.  I mean, the company not only lost the JetBlue and Frontier deals, but it’s obviously in pretty dire circumstances without either.  This is why management ultimately has such power under Delaware law.

On the other hand, I’ll need someone else to do the math, but maybe this was in fact the best outcome for diversified shareholders (who presumably are perfectly happy to simply own a JetBlue and a Frontier with one less competitor), and in some ways, that’s also what the law is designed to do.

Update: Looks like they went with the appeal after all.

January 19, 2024 in Ann Lipton | Permalink | Comments (0)

Friday, January 12, 2024

Vote buying

In two of his columns this week, Matt Levine highlighted this new company that purports to facilitate vote buying.  It invites passive retail holders to sell their votes to interested buyers.  Though the site itself mentions that buyers might be interested in influencing board selection, advancing ESG initiatives, or affecting takeover/merger decisions, in communications with Matt Levine, the company apparently emphasized the potential to use bought votes to obtain a quorum.  (As we all know, retail-heavy companies – especially SPACs – have had trouble with that recently). 

What no one seems to be talking about is whether any of this is actually legal, and the answer is – maybe?  Maybe not?

Delaware does not prohibit vote buying outright.  First, it draws a distinction between (1) where the company uses company resources to buy a vote; (2) where a third party uses its own resources to buy a vote.

The first is more troubling, because it raises the possibility of conflicted transactions.  For example, in Hewlett v. Hewlett-Packard, 2002 WL 549137 (Del. Ch. 2002), the plaintiffs alleged that HP allocated business to Deutsche Bank in order to persuade Deutsche Bank to vote shares held in its asset management arm in favor of a merger.   The court held that “Management… may not use corporate assets to buy votes in a hotly contested proxy contest about an extraordinary transaction that would significantly transform the corporation, unless it can be demonstrated… that management's vote-buying activity does not have a deleterious effect on the corporate franchise.”  Historically, there have been scenarios where management sought to buy votes to entrench their positions.  See Macht v. Merchants Mortgage & Credit Co., 194 A. 19 (Del.Ch. 1937).

But not every scenario is like that.  In Schreiber v. Carney, 447 A.2d 19 (Del. Ch.1982), the company wanted to reorganize, and pretty much everyone agreed the reorganization would be beneficial, but the proposal would have debilitating adverse tax consequences for one large blockholder.  The blockholder agreed to vote in favor, but only if the company loaned it sufficient funds to exercise certain warrants that would eliminate the tax problem.  When the transaction was challenged by a company shareholder, the Delaware Court of Chancery agreed this was vote buying, but not impermissible vote buying – the facts were fully disclosed, the deal was conditioned on approval by the remaining stockholders, and the purpose of the arrangement was not to defraud or disenfranchise the other stockholders but to further their collective interest.

What about third party vote buying?  That doesn’t use corporate resources at all.

Nonetheless, Delaware has expressed concern about it because it decouples the vote from economic interests in the shares.  See Crown EMAK Partners v. Kurz, 992 A.2d 377 (Del. 2010).  What if, for example, someone were to short the shares and then use bought votes to vote for a value-decreasing transaction?  Now, I’m not exactly sure how this would be economical – especially for retail votes – because you’d have to pay the shareholders enough to compensate them for the lost value of their shares, but maybe retail shareholders aren’t savvy enough to make those calculations and will sell their votes cheap.  As a result, the Delaware Supreme Court, affirming the findings of VC Laster, suggested that arrangements which decouple the vote from the economic interest are illegitimate.  Id. at 390 (“We hold that the Court of Chancery correctly concluded that there was no improper vote buying, because the economic interests and the voting interests of the shares remained aligned….”) .

That said, the whole set of rules is kind of muddled because of the obvious fact that there are plenty of ways, short of outright vote buying, to obtain votes without being exposed to the economic risks of the shares.  Whole articles have been written on the subject, with various proposed reforms. 

What this tells me is that if companies buy votes in order to obtain a quorum, that might be permissible under Schreiber, but you’d kind of have to assume the lack of a quorum wasn’t somehow a deliberate choice by shareholders, and that the final vote in fact advanced their collective welfare.

As for third party vote buying, I mean … I’m honestly not sure, but it doesn’t look good, because the economic interest in the shares remains with the seller.  Even if the buyer also has an economic interest through their own share ownership, they’re by definition obtaining votes that exceed their economic interest.  And if the buyer has no economic interest – if it’s just buying votes because it has other reasons for wanting the corporation to behave a certain way – well, big flashing warning signs.

Anyway, I’ll conclude by pointing out that there’s a case for permitting vote buying, if the sellers are uninformed/retail, and the buyers are long term wealth-maximizing institutional holders.


January 12, 2024 in Ann Lipton | Permalink | Comments (0)

Friday, January 5, 2024

Litigation-limiting constitutive documents – off to the California Supreme Court

Looking back, it’s funny how the issue of litigation limits in corporate constitutive documents has really been a throughline throughout my academic career; my first paper on the subject, Manufactured Consent: The Problem of Arbitration Clauses in Corporate Charters and Bylaws, was written when I was still a VAP.  So now it’s like a theme.

Anyhoo, as you all know, the latest set of developments occurred when the Delaware Supreme Court decided Salzberg v. Sciabacucchi, 227 A.3d 102 (Del. 2020), and approved the use of litigation limiting bylaws and charter provisions even for non Delaware claims, specifically, federal securities and antitrust claims.

That was part of what inspired my latest paper on the subject, Inside Out (or, One State to Rule them All): New Challenges to the Internal Affairs Doctrine, arguing, among other things, that other states pay too much deference to Delaware by automatically treating these provisions as contracts governed by Delaware law, rather than asking which law to apply, and whether the elements of contract are met.

Well, a new case has come up, EpicentRx, Inc. v. Superior Court, 95 Cal.App.5th 890.

EpicentRx is private, organized in Delaware but headquartered in California.  Its charter and bylaws require that shareholder claims be filed in Delaware Chancery.  Well, one shareholder is suing, not only for breach of fiduciary duty under Delaware law, but also for fraud under California law.  In EpicentRx, Inc. v. Superior Court, the California appellate court held that the corporate constitutive documents are, in fact, a contract – governed by the internal affairs doctrine, which, by the way, is not what Salzberg held, there was a diagram and everything – but that in this case, a trial in Delaware Chancery would require the shareholder to forfeit its jury rights under California law, and therefore the contract is unenforceable.  (Yes, that’s an issue I mention briefly in my paper, by the way)

The California Supreme Court recently agreed to hear the case, Epicentrx, Inc. v. Superior Court, 2023 Cal. LEXIS 6991 (Cal., Dec. 13, 2023).

Now, I gather that a lot of the action will be about whether the particular claims advanced by the plaintiff are, in fact, jury claims under California law.  But I desperately hope the California Supreme Court will spend some time asking whether there’s even a contract here in the first place, including which state’s law applies (since, I say again, Delaware did not hold this question was governed by the internal affairs doctrine).  Now, since EpicentRx is private, these may be more difficult questions than in the context of publicly traded corporations.  The plaintiff presumably bought stock directly from the company, for all I know the investment contract incorporated the bylaw and charter provisions by reference, although – and I think this is key – one factor that makes constitutive documents noncontractual is that, as Boilermakers Local 154 Retirement Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013) recognized, Delaware managers are subject to fiduciary duties when they enforce them, and I don’t even know how you ask whether it’s a violation of fiduciary duty to enforce a bylaw that causes a shareholder to forfeit a jury right.  In any event, all I really want is for the California Supreme Court to take these questions seriously.

January 5, 2024 in Ann Lipton | Permalink | Comments (2)

Friday, December 29, 2023

AmerisourceBergen, and Who Decides?

Delaware’s Caremark cases continue to be catnip for me.

The latest is the Delaware Supreme Court’s Lebanon County Employees’ Retirement Fund v. Collis, reversing VC Laster’s decision from last year.

Plaintiffs alleged that AmerisourceBergen’s board of directors violated opioid drug laws by failing to monitor suspicious prescriptions, to the point where they altered their internal reporting systems so that fewer prescriptions would be flagged.  Ultimately, this conduct caused severe damage to the company, through a $6 billion global settlement, as well as other settlements and litigation costs.

VC Laster explored the allegations in detail, ultimately determining that, standing alone, the complaint stated a claim against the AmerisourceBergen board for a violation of Caremark duties. 

But!  Plot twist.  Because in mid 2022, after the plaintiffs’ complaint was filed, a federal West Virginia court cleared AmerisourceBergen of misconduct.  The case was filed by a city and county in West Virginia – areas that were ground zero for the opioid crisis – and among thousands of similar cases consolidated for pretrial proceedings in a larger multidistrict litigation.  After a bench trial, the judge found that the plaintiffs had failed to prove that AmerisourceBergen did not maintain an effective control system.  According to Laster, that decision was enough to undermine the plaintiffs’ claims that AmerisourceBergen’s directors had caused the company to break the law.  As he held:

In light of the West Virginia Court’s thorough analysis, it is not possible to infer that the Company failed to comply with its anti-diversion obligations, nor is it possible to infer that a majority of the directors who were in office when the complaint was filed face a substantial likelihood of liability on the plaintiffs’ claims.

Case dismissed.

On appeal, the Delaware Supreme Court held that Laster had improperly deferred to the factfinding of another court as to contested matters, namely, whether the AmerisourceBergen Board had complied with the Controlled Substances Act.  As the Court put it:

the question whether the defendants in the West Virginia litigation engaged in wrongful conduct and failed to comply with the CSA was, it seems clear to us, a question of fact… This Court has not addressed whether a court can take adjudicative notice of the factual findings of another court. The weight of authority in the federal courts applying Federal Rule of Evidence 201, which is nearly identical to D.R.E. 201, indicates that a court may not do so when the underlying fact is reasonably disputed.

So, Laster was reversed, and the complaint sustained.

I’ve posted a lot about how common Caremark claims are becoming, and how they’re becoming more successful.  I think this trend is likely to create a lot of headaches for the Delaware courts and among those headaches – as this case demonstrates – is how Delaware’s decisions are going to interact with the findings of other courts.  After all, Caremark is predicated on the existence of illegal conduct.  Other regulators are the ones who are primarily responsible for determining whether any illegal conduct occurred in the first place; Delaware’s role is secondary to those primary findings of legality/illegality.

In other words, it would be kind of odd if a Delaware court held that a board violated its fiduciary duties by causing the company to break the law, if the company’s primary regulator determined that the company had not broken the law.

Laster’s original decision, then, has the air of trying to work out how Delaware courts will operate in tandem with these other legal systems in the context of Caremark.  Laster treated the West Virginia decision as a legal declaration under Delaware Rule of Evidence 202, which thereby absolved AmerisourceBergen – and thus its board – of any wrongdoing. 

The Delaware Supreme Court, however, rejected that attempt.  In its view, the West Virginia decision was not, for evidentiary purposes, a legal declaration of the propriety of the board’s conduct, but a factual determination of what had historically occurred – contested facts that Delaware is free to revisit (“To be sure, the findings of the West Virginia Court are recorded in the ‘case law . . . of the United States[,]’ but they do not establish or recognize a rule or principle of law of the kind that is subject to judicial notice under D.R.E. 202”).  And though the Delaware Supreme Court’s decision, taken in isolation, certainly makes sense, I wonder if it will create more problems for Delaware going forward, if Caremark claims appear to be proceeding even where underlying regulatory actions fail.  Or, as I put it previously, “Delaware really can’t be in the business of functioning as a backup regulator for the entire United States.”

December 29, 2023 in Ann Lipton | Permalink | Comments (0)

Friday, December 22, 2023

Crispo, Third Party Beneficiaries, and the Twitter Fallout

After Twitter v. Musk concluded, there remained a bit of satellite litigation in the form of a claim brought by Twitter shareholder Luigi Crispo, who alleged that his lawsuit against Musk – filed in the midst of the dispute with Twitter – had in fact materially contributed to the Twitter v. Musk settlement, and therefore he should be entitled to attorneys’ fees. 

(Pause for laughter.)

Anyway, the legal merit of that claim turned on whether Crispo’s claims against Musk – as a stockholder, for breaching the merger agreement with Twitter – themselves ever had any merit to begin with.  In October of this year, Chancellor McCormick held that they did not, but the way she got there put merger planners in something of a bind.

One issue that came up during the whole … thing … was what kind of damages Twitter could get if it prevailed in its claim that Musk breached the merger agreement, but if specific performance was for some reason unavailable.  (And yes, sorry, I can’t help but mention, this is an issue I discuss in more detail in my paper, Every Billionaire is a Policy Failure).  The merger agreement had a damages cap of $1 billion, but leaving that aside, the obvious damages would be for the lost premium.  I.e., Twitter was trading around $40 or so when the whole thing started, Musk offered $54.20, he should at least be required to pay that difference.

Conceptually, though, that’s a problem because Twitter, the entity, and the party to the merger contract, never expected to receive that money – the money was going straight to its stockholders.  Contract damages are supposed to give you the benefit of your bargain, and Twitter’s benefit was not to receive the difference between $40 per share and $54.20 per share, but to transfer that value to its stockholders, while itself receiving the inestimable benefit of submitting to Elon Musk’s leadership.

One way around this would be to make stockholders third party beneficiaries of the contract, but to do that might give them enforcement rights – exactly as Crispo was claiming – which would interfere with the directors’ ability to control any subsequent litigation.

Anyway, merger planners have been aware of this problem for a little while and so they generally write in first, that there are no third party beneficiaries, and second, some kind of liquidated damages provision that counts lost premium as among the damages that acquirers are responsible for.  Twitter’s merger contract did the same (although, apparently, still qualified by the cap).

Which brings us to Crispo.  He argued that notwithstanding all of this, he still had the ability to bring his claims for lost premium damages, which meant his claims when filed were meritorious, which meant his lawsuit could be viewed as having contributed to the final settlement.

In October, McCormick rejected the argument, and along the way she held that if stockholders are not third party beneficiaries, target companies cannot seek lost premium damages, even through a liquidated damages clause, because liquidated damages clauses can only encompass benefits that a contracting party actually expected to receive if the deal went through:

Contractual provisions that define the type of damages for which a party might be liable are enforceable only to the extent they are consistent with principles of contract law.  A contracting party cannot receive more than expectation damages.  “[E]xpectation damages [are] measured by the amount of money that would put the promisee in the same position as if the promisor had performed the contract.”  A party cannot recover damages for consideration that it would not expect to receive had the contract been performed…. A target company has no right or expectation to receive merger consideration, including the premium… Where a target company has no entitlement to a premium in the event the deal is consummated, it has no entitlement to lost-premium damages in the event of a busted deal. Accordingly, a provision purporting to define a target company’s damages to include lost-premium damages cannot be enforced by the target company.

She also held that merger targets like Twitter cannot claim to be seeking lost premium damages on shareholders’ behalf, because “there is no legal basis for allowing one contracting party to unilaterally and irrevocably appoint itself as an agent for a non-party for the purpose of controlling that party’s rights.”

Now, I personally find that technically correct as a matter of contract doctrine, and wholly unsatisfying as a practical matter.  After all, as McCormick herself noted in the same opinion:

[M]erger agreements involve the payment of consideration directly to stockholders. In a Delaware corporation, that benefit to stockholders marks the satisfaction of the board’s fiduciary obligations to them and is a material part of the parties’ purpose in entering into the contract. Indeed, delivering this benefit to stockholders is typically the target corporation’s purpose for entering into a merger agreement.

It seems very … artificial … to ignore that obvious fact for the purpose of remaining faithful to, well, common law forms of action.  But she held what she held, and now merger planners who want to allow for lost premium damages, while not giving shareholders the ability to enforce deals directly, are stuck.

One possibility that’s being floated is to amend the DGCL.  After all, Crispo is simply a common law contract holding; no reason the law can’t be changed by statute.

In the meantime, though, a little birdie alerted me to this private ordering solution by PGT Innovations.  PGTI entered a merger agreement, and when shareholders vote on it, well:

At the PGTI Stockholders Meeting, PGTI expects to submit for the approval or adoption by PGTI’s stockholders an amendment to the Amended and Restated Certificate of Incorporation of PGTI (as amended from time to time) designating PGTI as the agent of stockholders of PGTI to pursue damages in the event that specific performance is not sought or granted as a remedy for Masonite’s fraud or material and willful breach of the Merger Agreement (the “PGTI Organizational Document Amendment”). The PGTI Organizational Document Amendment is intended to address recent caselaw from the Delaware Chancery Court that, could be construed to, in effect, limit the remedies available to PGTI under the Merger Agreement absent the PGTI Organizational Document Amendment.

See?  The merger agreement itself – to which shareholders are not a party – can’t unilaterally make PGTI into shareholders’ agents, but, the theory goes, the charter, which increasingly is treated as a contract between shareholders and managers under Delaware law, can. 

It’s a neat solution (though I don’t think the problem should, umm, exist), though I do wonder what happens when shareholders accuse PGTI of violating its duties as an agent by not seeking exactly the right damages (settling too easily, whatever); the same kind of deference we usually give to board members should not apply if PGTI is acting in a different capacity, though I suppose PGTI might address that with careful drafting (the exact language does not (?) seem to be available yet).

December 22, 2023 in Ann Lipton | Permalink | Comments (0)

Friday, December 15, 2023

Call it an Early Twitter Christmas Gift

You may already have seen the news that Judge Charles Breyer refused to dismiss claims against Elon Musk arising out of l’affaire Twitter.  Specifically, a class of shareholders alleged that Musk’s desperate efforts to get out of the deal – including his accusation of spam and his insistence that Twitter violated its contractual obligations by refusing to provide him with information – depressed the price of Twitter stock by creating uncertainty regarding closing.  As a result, some investors were harmed by selling stock too soon.  In Pampena v. Musk, 2023 WL 8588853 (N.D. Cal. Dec. 11, 2023), Judge Breyer dismissed claims based on several of Musk’s statements, but sustained others.  He reasoned:

The May 13 tweet reads as follows: “Twitter deal temporarily on hold pending details supporting calculation that spam/fake accounts do indeed represent less than 5% of users.” … Defendant represented to a reasonable investor that the Twitter deal was on hold—and would not close—until Twitter provided information supporting its bot calculations. Or, put another way, a reasonable investor could have plausibly understood that Twitter was obligated to provide Defendant with the requested information for the deal to close…. The Court finds that Defendant's statement did give an impression materially different from the state of affairs that existed. Plaintiffs have plausibly alleged that Defendant waived due diligence as a condition to the Merger Agreement, and thus that Twitter had no obligation under the Merger Agreement to provide information supporting its bot calculations. Because Twitter did not have an obligation to provide this data to Defendant under the terms of the Merger Agreement, Defendant's representation that Twitter did have this obligation in order for the deal to close was false.

Plaintiffs state the Defendant “baselessly” announced that fake and spam accounts make up at least 20% of Twitter's users during the “All in Summit,” a tech conference in Miami. Plaintiffs argue that each of Defendant's statements misled investors in “represent[ing] that [Defendant] had some right to data or to cancel the Merger agreement thereto, which he did not.”… Even if Defendant's statement was literally true based on his “random sample” calculation or some other means of data analysis, the complaint plausibly alleges that the statement misled the investing public to believe that Defendant received—and was basing his statement on—bot user data from Twitter, which was not the case…. In light of Defendant's May 13, 2022 tweet that the deal was on hold pending details that spam/fake accounts represent less than 5% of users, a reasonable investor would likely find Defendant's access to and findings about Twitter's data to be material to their investment decision-making. Moreover, Defendant's statement suggested that Twitter had significantly more bot users than reported in its most recent SEC filings, a fact which would certainly be material to an investor given the nature of Twitter's business.


Plaintiffs argue that Defendant's May 17, 2022 tweet that the number of fake accounts on Twitter could be “much higher” than 20% and that the deal “cannot move forward” was false because it created the impression that Defendant was entitled to due diligence and that he had the right to terminate the merger. The tweet is composed of two parts: (1) Twitter is made up of 20% fake/spam accounts, which Defendant thinks could be higher than 20%, and (2) the deal cannot move forward until the Twitter CEO shows proof that the spam accounts are less than 5%... it is reasonable that investors would infer that Defendant, the next day, tweeted about user data because he actually received evidence from Twitter “demonstrating that Twitter's SEC filings were false and that the number of fake accounts exceeded 5%.” For the same reason, Plaintiffs have adequately alleged that this tweet would alter the “total mix” of information available to investors, and is therefore material.

The second statement is materially false or misleading for the same reasons that the May 13, 2022 tweet is materially false or misleading. Plaintiffs plausibly allege that Defendant waived due diligence as a condition to the Merger Agreement, and thus that Twitter did not have an obligation to provide him with “proof” that spam accounts make up less than 5% of users.  In contrast, the statement that the deal “cannot move forward” until he receives “proof of <5%” fake/spam account implies that Twitter did have an obligation to provide this data to Defendant and that Defendant was able to terminate the deal absent Twitter doing so. Accordingly, the Court concludes that Plaintiffs have adequately pleaded a material misrepresentation with respect to this tweet.

Among other things, Musk alleged that the plaintiffs could not demonstrate loss causation, because the “truth” was never revealed.  Now, I mean, that doesn’t make … sense … in a depressed stock case.  The truth doesn’t have to be revealed for a depressed price case in order to show losses; the losses occur when you sell your stock too cheaply even if the truth is never revealed to the market and remains a secret.  This is not like an inflated price case, where you buy at the inflated price but so long as the price remains high, you can sell and recoup the overpayment.  But, nonetheless, Judge Breyer held that the plaintiffs sufficiently alleged a connection between the statements and their losses because:

With respect to the statements that the deal was “temporarily on hold” (the May 13, 2022 tweet) as well as the statement that the deal “cannot move forward” until Twitter showed proof of its bot-user claims (within the May 17, 2022 tweet), Plaintiffs adequately plead loss causation through corrective disclosure…. Plaintiffs have plausibly alleged that when Defendant announced that he would move forward with the deal—after a public battle with Twitter about the Merger Agreement and absent any apparent resolution around his due diligence requests—the market reasonably reacted to the “truth” that Twitter never had the obligation to provide the bot-account information to Defendant.

Now, the interesting thing here is that the claims sustained were based on Musk’s statements on May 13, 2022, May 16, 2022, and early May 17, 2022.  But the merger agreement was filed on an 8-K on April 26.  And at that point, everyone on the planet was aware of what Twitter’s obligations were and were not.  There was, you may recall, something of a public conversation about that very issue.  So it was a bit … surprising … to see Judge Breyer conclude that the truth about Twitter’s obligations was only revealed when Musk caved in Delaware. 

That said, I’ve read Musk’s briefing and he seems more devoted to claiming that Twitter did, in fact, owe additional information under the merger agreement than to claiming that any mischaracterizations were immaterial because the public could evaluate Twitter’s obligations themselves.  So.  There you go.

But here’s the fun part.

There is another putative securities class action currently pending in the Central District of California, Baker v. Twitter, that also arises out of Musk’s efforts to get out of the Twitter deal.  This case, however, alleges that Twitter committed fraud with respect to its spam counts, and that Musk’s accusations revealed the truth.  The entire predicate of the action is that Musk himself admitted Twitter’s statements were false, and Musk’s accusations were sufficiently credible to sustain a complaint, given his access to internal information.  And the court agreed!  In August, the court held that one of Musk’s accusations – that Twitter lied about removing identified spam from the mDAU – had a sufficient basis to allege fraud on the part of Twitter.  See Baker v. Twitter, 2023 WL 6932568 (C.D. Cal. Aug. 25, 2023).  The court dismissed the complaint for failure to allege loss causation, but plaintiffs are repleading.  And, of course, since Musk now owns Twitter, he’s going to be the one who has to defend against the fraud accusations if the case goes much further.

Which means, we could have parallel securities class actions, both based on Musk’s accusations that Twitter committed fraud, one claiming the accusations were false, the other claiming they were true – and Musk is (directly or indirectly) liable for damages in both.

Anyhoo, I’ll just conclude by (once again) plugging my paper on Twitter v. MuskEvery Billionaire is a Policy Failure, now forthcoming in the Virginia Law & Business Review.

December 15, 2023 in Ann Lipton | Permalink | Comments (0)

Saturday, December 9, 2023

It's another internal affairs doctrine post

Two interesting matters related to the internal affairs doctrine came up recently, and since I just wrote a whole paper on this subject, I can’t resist mentioning them here.

First, VC Laster issued an opinion in Sunder Energy v. Jackson et al,.  The question was whether certain LLC members and employees violated noncompetes included in the LLC agreement, but Laster began by railing against the trend of companies attempting to avoid the employment law of states where they do business by writing employment-related terms into entity organizational documents, and then issuing equity compensation to employees.  The companies do so apparently in hopes that the employment-related terms will then be treated as entity internal affairs matters governed by the state of organization (Delaware), rather than employment terms governed by the employee’s home state.  Sunder Energy was not the first time Laster objected to the practice; earlier, he gave a long speech on the matter in his transcript ruling in Strategic Funding Source Holdings LLC v. Kirincic, which I quoted extensively in my paper

Anyway, that’s not the only thing of interest in the case; it also presents an interesting cautionary tale that will work well in the classroom.  Several people formed an LLC.  They did not, however, draft an LLC agreement.  At the moment of founding, they referred to themselves as “partners,” though they agreed that two members in particular would manage the business and receive a majority of the equity, with the remainder split among the other founders, who would be employees. 

Later, the two managing members sought legal counsel for themselves and drafted a formal LLC agreement that dramatically changed the arrangement in a manner that favored themselves and limited the rights of the other members.  The other members signed the new agreement as presented to them, but the changed terms were never explained, and the managing members implied this was just a formality recommended by entity lawyers.

Laster held that when the original LLC was formed – before the agreement was drafted – the default rules for LLC organization kicked in, which meant the managing members had fiduciary duties to the minority.  By rewriting the agreement in such a self-interested fashion – and presenting it to the minority members without disclosing what it meant – they violated those duties, rendering the new agreement unenforceable.  As Laster put it:

At the very least, Nielsen and Britton had an obligation to state plainly to the Minority Members that it was time to switch out of a mindset of fiduciary reliance and into a mindset of arm’s-length bargaining. They were obligated to put the Minority Members on notice that this was a really big deal. They needed to say, in substance, that the 2019 LLC Agreement materially and adversely altered the Minority Members’ rights, that Snell & Wilmer represented Sunder and its controlling members (viz., Nielsen and Britton) and not the Minority Members, and that the Minority Members should retain their own counsel and obtain independent advice because there were major changes in the draft agreement.

Anyway, the whole situation reminded me a little of Christine Hurt’s Startup Partnerships, about the inadvertent partnerships that form before companies formally organize.  Also, for contract and restrictive covenant mavens, there’s some great stuff on how choice of law affects the restrictive covenant analysis, and very amusing language about the overbreadth of the restrictions.

Which brings us to our next internal affairs issue, regarding the complaint filed in Adrian Dominican Sisters et al. v. Mark P. Smith, in the District of Nevada.  There, several communities of Catholic nuns filed a derivative lawsuit against Smith & Wesson, arguing that the company acted in bad faith by failing to oversee Smith & Wesson’s compliance with laws regarding the marketing of its AR-15 – functionally, a Caremark/Massey claim.  And yes, I realize this is particularly well-timed given the recent shooting at UNLV, which Ben posted about earlier this week.

The lawsuit in and of itself is interesting, but what struck me is that Smith & Wesson is organized in Nevada, but, until recently, its headquarters were in Massachusetts (they just moved to Tennessee).  The plaintiffs aver that they obtained books and records before filing their lawsuit, but as I understand Nevada law, inspection rights are only available for investors with at least a 15% stake.  So, the plaintiffs sought books and records under Massachusetts law.  And the reason that’s striking is, nothing in the complaint suggests Smith & Wesson objected – in fact, it provided records – but not long ago, in Juul Labs, Inc. v. Grove, 238 A.3d 904 (Del. Ch. 2020), VC Laster held that inspection rights are an internal affairs matter.  (Which is something I also discuss in my paper).  The choice of law for inspection rights has always been a bit fuzzy; I don’t know if Smith & Wesson acceded in in this case because of prior unfavorable precedent, or for some other reason.

As for the lawsuit itself, traditionally, religious orders have focused on shareholder proposals rather than derivative lawsuits, but it’s not surprising to me that they’re branching out because – as I previously posted – Delaware is in the process of establishing some mighty broad rules about derivative lawsuits on the grounds of intentional lawbreaking by corporate boards.  Unsurprisingly, plaintiffs are alleging even unadjudicated lawbreaking as a violation of fiduciary duty, and so, a conservative plaintiff recently latched on to that precedent to challenge Starbucks’s diversity policies, and now we’re seeing liberal-side plaintiffs claim that Smith & Wesson’s marketing of the AR-15 was illegal and rendered the company vulnerable to future liability.  (I mean, these are not Delaware companies or cases, but I think the litigants are inspired by Delaware precedent).  Also, the complaint alleges that this conduct violated the Board’s ESG Committee charter, so it turns out that Smith & Wesson has an ESG Committee.

December 9, 2023 in Ann Lipton | Permalink | Comments (0)

Friday, December 1, 2023

A Tale of Two Anti-Activist Bylaws

This week, we had two interesting, and very different, decisions on the validity of anti-activist bylaws.

The first decision, out of Delaware, upheld certain advance notice bylaws in the context of a motion for a preliminary injunction, while the second, from the Second Circuit, rejected control share acquisition bylaws adopted by a closed-end mutual fund.

The first decision, Paragon Technologies v. Cryan, concerned Paragon’s activist attack on penny stock Ocean Powers Technology (OPT).  After Paragon expressed interest, OPT adopted an advance notice bylaw requiring director nominees offer a wealth of information, including any plans that would be required to be disclosed on a 13D, any business or personal interests that could create conflicts between the nominees and OPT, and any circumstances that could delay a nominee receiving security clearance, while simultaneously adopting a NOL pill (for more on those, read Christine Hurt).

Paragon submitted some documents in connection with the bylaw, but the “plans” only said it would “fix OPT.”  OPT identified numerous deficiencies in Paragon’s submission, Paragon submitted more information including that its plans were to reduce expenses and focus on industry growth.  Long story short: OPT kept finding deficiencies to complain about, and ultimately Paragon’s nominees were rejected.  Paragon had also requested an exemption from the pill, which was denied.

On Paragon’s motion for a preliminary injunction ordering that its nominees be permitted to stand for election, and for relief from the pill, VC Will concluded that neither side had covered itself in glory.  She agreed that OPT very possibly had nitpicked Paragon’s application, and some of its demands – like the security clearance thing – were vague and potentially unnecessary.  But she also found that Paragon had deleted certain text messages, which contributed to her finding that the record was inconclusive as to whether Paragon had complied with even reasonable bylaws.  Like, it might have had plans that were not disclosed; there were discussions among Paragon personnel about a stock-for-stock upside down merger with Paragon.  Like, there was the possibility that such a merger would also have had to have been disclosed as a potential conflict.  Like, even if the security clearance demand was vague, on this record, Will could not be sure that Paragon had been genuinely confused.  And though the timing of the NOL pill was certainly suspicious, the OPT Board’s tax advisor had pointed out that there was a real financial risk to OPT if it granted Paragon’s exemption request.

Given these factual disputes, she concluded that Paragon had not met its burden of proof that it was entitled to an injunction suspending operation of the bylaw and the pill.

I admit, I’m a bit uncomfortable with this holding, because it seems to me that with these kinds of bylaws, it will be very easy for boards to create factual “disputes” about whether all of an activist’s plans were disclosed, or whether there was some undisclosed conflict lurking somewhere, or whether a bylaw really was vague in application, and with those factual disputes in hand, stave off a proxy challenge for at least another year, which may render it uneconomical for an activist to even litigate the bylaw issues in the first place.  Perhaps the board’s actual conduct – evasiveness and foot-dragging when addressing requests for clarification – should carry more weight.  But I don’t want to overstate; deleted text messages were a real issue, Paragon’s first 13D disclosures were laughable, and Will suggested that she might have looked more favorably on a different request for relief, such as, delay of the annual meeting until trial on Paragon’s claims that OPT breached its duties with respect to the bylaw and the pill.  Still, I do think there needs to be more work on how advance bylaws function to undermine activists’ strategies and to what extent that’s good – or at least acceptable – or bad, and unacceptable.  (If that paper’s been written, point me to it!)

But then we come to the Second Circuit’s decision in Saba Cap. CEF Opportunities 1, Ltd., Saba Cap. Mgmt., L.P. v. Nuveen.  Saba launched an activist attack on a Nuveen closed-end fund, and Nuveen passed a control share acquisition bylaw – any shares Saba acquired in excess of 10% would lose their voting rights, unless the remaining shareholders voted to restore them.

The Second Circuit held that the bylaw violated the Investment Company Act’s requirement that all shares have equal votes.  Per the court:

Read together, these two provisions of the ICA control. The first provision requires that all shares of stock must be “voting stock” and have “equal voting rights.” Id. § 80a-18(i). The second defines an umbrella term, “voting security,” as one “presently entitling” the owner to vote. Id. § 80a-2(a)(42).  The language is plain and unambiguous. In addition to requiring that all investment company stock be voting stock, the statute defines it with reference to its function—that it “presently entitles” the owner to vote it. Id. § 80a-2(a)(42).

Nuveen’s Amendment violates this provision because under it, if an owner of Nuveen stock cannot “presently” vote their stock, the stock loses its function and is not “voting” stock. The Amendment also violates Section 80a-18(i) because it deprives some shares of voting power but not others—contrary to the provision’sguarantee of “equal voting rights.” Id. § 80a-18(i).

The court distinguished Delaware decisions as being about, you know, Delaware, and noted that poison pills – if permissible at all, which the court would not say definitively – at least are different in that they distinguish shareholders’ economic interests, not the voting rights of the shares.  The court repeatedly made somewhat derisive references to Nuveen’s claim that the bylaws were intended to “limit[] the risk that the [f]und will become subject to undue influence by opportunistic traders pursuing short-term agendas adverse to the best interests of the [f]und and its long term shareholders,” obviously believing such arguments to be irrelevant to the statutory provisions at issue.

What do I find interesting in all this?

First, it is more evidence for one of my recurring themes, namely, that corporate governance is not an exercise in private ordering, but that the hand of the state is now less visible in operating companies than it is in regulation of investors.  Corporate organization may carry the patina of private ordering, but the levers of governance are held by institutional investors who are subject to far more intrusive regulations than Delaware ever dreamed of imposing on companies themselves. 

Second, Delaware would almost certainly have accepted Nuveen’s claim to be protecting itself against Saba’s desire to “alter[] investment strategies away from long-term investments, all to turn a ‘quick profit,’” while the Second Circuit nearly laughed the argument out of court.  And that’s interesting because Delaware’s invocation of “long termism” has often been interpreted as a sub rosa grant of permission for corporate managers to consider stakeholder interests instead of shareholder ones.  I.e., Delaware would never say so explicitly, but every time it permitted directors to fend off a hostile takeover to protect company “long term” interests, it functionally was permitting directors to adopt a stakeholder model of governance. 

The Investment Company Act, according to the Second Circuit, grants no such permission.  Shareholder primacy reigns supreme.  Which means our tightly federally regulated investors are engineered for pure profit seeking without regard for other concerns.  Federal law doesn’t contain the “give” of Delaware law, and that’s an aspect of governmental choice, as well.

December 1, 2023 in Ann Lipton | Permalink | Comments (0)

Friday, November 24, 2023

Call it Anti-Anti-ESG

The big corpgov news this week is obviously L’Affaire du OpenAI, but I have no idea what I think about that so instead I’m quickly going to highlight an interesting new lawsuit filed by a retired Oklahoma pensioner, alleging that the state’s anti-ESG law violates the First Amendment, as well as both state and federal requirements.

You can find all the relevant documents at this link, but the backstory is that Oklahoma passed a law prohibiting state agencies from contracting with financial institutions that “boycott” oil and gas interests.  OPERS – the state retirement system – took advantage of an exception that allowed continued investment if necessary to fulfill fiduciary responsibilities, which then prompted some nastygrams back and forth between the State Pension Commission (headed by the Treasurer, who is on the OPERS board, but was outvoted) with OPERS itself, regarding whether OPERS qualified for the exception.

And now, a former officer of the Oklahoma Public Employees Association has sued, claiming that the state is using his retirement assets to make an (illegitimate) political statement instead of protecting retiree savings.  The lawsuit is backed by the Oklahoma Public Employees Association.

Anyway, I’m not going to express an opinion on the merits of the suit but I am fascinated by the political economy here, given that OPERS’s board appears to be mainly political appointees.  Despite that fact, the Treasurer stood alone in his insistence on severing ties with “boycotting” institutions.  And I’m constantly trying to wrap my mind around how the First Amendment issues should play out, given the Supreme Court’s insistence that corporate speech may be controlled by shareholders through “the procedures of corporate democracy” – which of course should include shareholders like, say, state pension funds.

November 24, 2023 in Ann Lipton | Permalink | Comments (0)

Saturday, November 18, 2023

I’m having flashbacks to the IPO Cases

Back when I was in practice, so many years ago, I spent a bit of time on the IPO Cases, namely, a series of around 300 class actions involving dot-com startup IPOs that, we alleged, had been manipulated by underwriters.  Details differed from case to case, but the typical claim was that the underwriters used manipulative techniques, such as laddering, to cause dot com startups to “pop” in price upon their initial offering, thereby violating Section 10(b).

But we stumbled at class certification.  For false statements, there’s a well established paradigm for creating a classwide presumption of reliance that satisfies Rule 23.  For manipulative conduct there isn’t a paradigm, and our cases faltered.  The Second Circuit reversed one grant of class certification and remanded, In re IPO Securities Litigation, 471 F.3d 24 (2d Cir. 2006) and 483 F.3d 70 (2d Cir. 2006).  We moved for class certification a second time, and eventually matters settled.

Anyway, the recent decision denying class certification in In re January 2021 Short Squeeze Litigation, 21-2989-MDL-ALTONAGA (S.D. Fla. Nov. 13, 2023), takes me back.  It is not on Westlaw or Lexis yet, so all I can do is link the Law360 article, which attaches the opinion.  Anyway - 

This a Robinhood case, where plaintiffs alleged that Robinhood manipulated the prices of various meme stocks when it halted trading and closed out positions.  This was done, plaintiffs alleged, because Robinhood was experiencing liquidity issues at National Securities Clearing Corporation, but Robinhood misled the market as to the full extent of its actions and the reasons behind them.

The plaintiffs survived a motion to dismiss, but the court held that they could not prove reliance on a classwide basis.  The plaintiffs explicitly alleged that the market was not efficient – Robinhood was manipulating it, by halting trades!  Therefore, the plaintiffs could not claim the fraud on the market presumption of Basic v. Levinson, 485 U.S. 224 (1988), based on Robinhood’s lies.  And because Robinhood affirmatively lied, there could be no omissions liability under Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128 (1972). 

What about reliance on the manipulative conduct, specifically, that allegedly distorted market pricing?  The court said, it would not accept some kind of lightened fraud on the market presumption for manipulation cases, that did not depend on market efficiency as articulated in Basic, because such a presumption “would prove too much while doing too little. Prove too much, because it would obviate the need for plaintiffs in manipulative conduct cases to prove reliance; do too little because it does not complete the causal connection between a plaintiff’s transaction in securities and a defendant’s manipulation.” (Op. at 60, quoting Desai v. Deutsche Bank Sec. Ltd., 573 F.3d 931 (9th Cir. 2009) (O’Scannlain, J., concurring)).  Therefore, no class certification.

Well, I’m not in the weeds of the facts enough to be able to say whether the class should have been certified, but the court misunderstood – just as the Desai court misunderstood – the argument for a reliance presumption in manipulation cases.  Properly interpreted, plaintiffs in manipulation cases should get a presumption of reliance, but they have a higher burden than for statement cases, and not a lower one, and plaintiffs do not need to ask for anything beyond what Basic already established.

We begin by observing that the fraud on the market presumption is actually two distinct propositions.  As the Supreme Court explained in Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258 (2014):

The [Basic] Court based that presumption on what is known as the “fraud-on-the-market” theory, which holds that the market price of shares traded on well-developed markets reflects all publicly available information, and, hence, any material misrepresentations.” Id., at 246, 108 S.Ct. 978. The Court also noted that, rather than scrutinize every piece of public information about a company for himself, the typical “investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price”—the belief that it reflects all public, material information. 

See the two ideas?  When I teach it, I call them the “objective” presumption – which is about how markets absorb information – and the “subjective” presumption – which is about how investors think about markets.  The Halliburton Court was clear in distinguishing these when it discussed the defendant’s attacks on Basic:

Halliburton’s primary argument for overruling Basic is that the decision rested on two premises that can no longer withstand scrutiny. The first premise concerns what is known as the “efficient capital markets hypothesis.”…. Halliburton also contests a second premise underlying the Basic presumption: the notion that investors “invest ‘in reliance on the integrity of [the market] price.’”

See the two premises, objective, and subjective?  Of course, as we know, the Supreme Court beat back Halliburton’s challenges, and the two presumptions – the objective and the subjective – remain intact.  (That said, the subjective presumption is in fact somewhat controversial – many argue it shouldn’t be necessary to prove a case at all, see eg Donald C. Langevoort, Basic at Twenty: Rethinking Fraud on the Market, 2009 Wis. L. Rev. 151 – but it’s there, so I accept it.)

Together these two presumptions establish: first, that the false statements impacted market prices, and second, that investors relied on market prices when trading.  Together, they create a syllogism: by relying on a price that was in fact manipulated, investors are deemed to have relied on the original false statement.  That is ultimately what reliance means in this context: Investors relied upon a market price that defendants fraudulently manipulated.

In the typical fraud on the market class action, plaintiffs bring in experts to attest as to market efficiency.  They demonstrate the market was liquid, followed by analysts, they show correlations between price movements and new information, they analyze bid-ask spreads, all in service of demonstrating that this is the kind of market to which the fraud on the market presumption should apply.

That evidence is important, but only for the objective presumption – namely, that false statements impact market prices.  If the market is not liquid and widely followed and has not historically reacted to new information etc etc, then it may very well be inappropriate to simply presume, without more, that a false statement influenced price.

But is this evidence important for the subjective presumption, namely, what investors think about markets?

I submit not.  No one conducts an event study to identify historic correlations between price and new information before they place a trade; they just trade.  Investors, when deciding whether they “rely” on market prices, use a much looser set of criteria – is it widely traded, a famous stock, heavily analyzed, on a major exchange?  That’s probably enough to get at whatever it is investors are in fact relying on in their heads when they “rely” on market prices, and it’s reasonable for them to do so.

If that’s right, then those loose indicia of market efficiency should be enough to presume that investors subjectively believed prices to reflect true value or a market price validly set or whatever work it is we think the subjective presumption is doing.

The detailed analysis, the event studies, the Cammer factors – that stuff is only necessary for the objective presumption, namely, that false statements did in fact impact the market.

Now, let’s think about manipulation claims – where the argument is “investors are misled to believe that prices at which they purchase and sell securities are determined by the natural interplay of supply and demand, not rigged by manipulators.”  ATSI Commc’ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87 (2d Cir. 2007).

There is no reason why the criteria should change for when we adopt the subjective presumption.  That is, if we can presume investors rely on market prices from basic indicia of efficiency in the context of false statements – widely traded stock on a major exchange – we should be able to presume investors rely on market prices in manipulation cases from the same criteria.  So, if the case concerns a widely traded and followed stock on a major exchange, the subjective presumption should be satisfied.

What about the second presumption, that false statements affect prices? 

In a manipulation case, there are no false statements.  Therefore, there is no presumption of price impact.  Instead, the plaintiffs are expected to prove price impact.  They are expected to come into court with evidence that the defendants’ manipulative conduct in fact affected the market price of the stock.  They do not ask for or receive a presumption at all.

If they do that, if they satisfy their burden, they will have satisfied both halves of the Basic syllogism.  The subjective presumption allowed them to show that investors relied on market prices, and the objective presumption was absent – it was replaced by actual facts proof.

In other words, manipulation plaintiffs are asking for less, not more.  They want only half of the Basic presumptions; they will prove the other half.  And they should be entitled that first half presumption.

So the Robinhood court was wrong when it followed Desai in holding that a presumption of reliance in the manipulation context would “Prove too much, because it would obviate the need for plaintiffs in manipulative conduct cases to prove reliance; do too little because it does not complete the causal connection.”   The presumption that plaintiffs need is one that Basic readily provides; beyond that, plaintiffs don’t need a presumption at all. 

November 18, 2023 in Ann Lipton | Permalink | Comments (0)

Friday, November 10, 2023

Follow the Money

Today, I am at the ILEP conference that Joan blogged about, honoring the career of Jill Fisch.  In keeping with the ESG theme of the conference, this week, I’ll make a brief observation.

For the past couple of years, there has been a rising anti-ESG backlash on the right, accusing Disney and Target and Bud Light of engaging in “woke” marketing, and seeking to bar the likes of BlackRock and other large asset managers from taking ESG factors into account.  The latest salvos are taking place in Congress, where subpoenas are being issued to groups like As You Sow, accusing them of antitrust violations, and another hearing was just held to criticize ESG investing – this time, focusing on the Department of Labor’s new rules.

Now, the thing about the anti-ESG push on the right is, it’s not making headway with voters.  Which isn’t surprising; most people don’t think much about corporate law or investing guidelines, so I’d honestly be more surprised if the anti-ESG push was getting political traction.

So when politicians continue to ostentatiously push this line, the obvious question is – why?  And my instinct has always been, despite the attention paid to DEI initiatives and trans rights and so forth, this is all originating with oil money.  The oil companies are, it seems, putting real resources behind a push to stop fossil fuel divestment initiatives and considerations of climate change in investing.

The reason that is intriguing is that the usual line is that taste – like, divestment as a means of boycott and so forth – can’t affect public stock prices.  Which means, you would think, if climate change-aware investing is not financial, it should be having no affect on oil company stock, and the oil companies would not waste all this money campaigning against it.  And if it is financial, then all the campaigning in the world won’t actually change anything – and oil companies are still wasting their campaign donations.

I tend to think that companies spend money rationally, which means, one way or another, they think campaigning can affect asset pricing.

Which is why I found this article, Voice Through Divestment, rather interesting.  Authors Marco Becht, Anete Pajuste, and Anna Toniolo conclude that divestment initiatives do affect stock prices, but it’s not just the fact of divestment.  The campaign itself raises awareness, puts pressure on companies to reduce their emissions, and thereby increases regulatory risk for oil companies – which causes even purely financial investors to adjust their risk-benefit calculations and devalue the stock.

In other words, there is a neat story here of how “financial” ESG and “profit-sacrificing” ESG interact with each other.

November 10, 2023 in Ann Lipton | Permalink | Comments (0)

Friday, November 3, 2023

Sell the News

The Financial Times recently reported that

A group of veteran US financial journalists is teaming up with investors to launch a trading firm that is designed to trade on market-moving news unearthed by its own investigative reporting.

The business, founded by investor Nathaniel Brooks Horwitz and writer Sam Koppelman, would comprise two entities: a trading fund and a group of analysts and journalists producing stories based on publicly available material…

The fund would place trades before articles were published, and then publish its research and trading thesis….

I saw a lot of online commentary asking why this isn’t just a model for insider trading, and even though Matt Levine went through some of the issues here and here, I am moved to do something I rarely do and delve into insider trading law to explain the matter further.  For a lot of readers, this is probably nothing new, but hopefully this will be helpful for some of you.

So, the first thing to make clear is that the rules for what counts as insider trading in the U.S. are bizarre and arcane.  And the reason for that is, with a few exceptions like the “Eddie Murphy” provisions of Dodd-Frank, there are no statutory prohibitions on insider trading.  What the statutes prohibit is fraud, mainly through Section 10(b) of the Securities Exchange Act.  And, beginning in the 1960s, courts and the SEC began to interpret Section 10(b) fraud to include insider trading.  Except that meant they had to define the contours of what kind of trading is and is not permitted, and those definitions came about through meandering and contradictory common law rulemaking.  The caselaw is meandering and contradictory because people have very different instincts about what should be illegal and what should not be illegal.  As one article amusingly summed it up:

Manifesting the extent to which even authorities on the subject are unable to articulate a compelling legal theory of what insider trading is and why the conduct it encompasses should be declared unlawful, a large body of case law and commentary, for instance, variously portrays insider trading doctrine as based on principles drawn from or analogous to the law of fraud, breach of fiduciary duty, agency, theft, conversion, embezzlement, trusts, property, contracts, corporations, confidential relationships, unjust enrichment, lying, trade secrets, and corruption.

Andrew W. Marrero, Insider Trading: Inside the Quagmire, 17 Berkeley Bus. L.J. 234 (2020).

In general, there are those who believe insider trading should try to level the playing field, by giving all traders equal access to information, or at least equal opportunity to attain access, and there are those who believe that equal access is impossible – ordinary retail traders will never match the resources of professional firms – and what actually protects ordinary traders is market efficiency, which only comes about from informed trading that sets the price appropriately for everybody.  So the caselaw tends to contain rhetoric that switches back and forth between extolling the virtues of a level playing field versus extolling the virtues of informed market prices.  I also think some of the instincts here are driven by specific distributional concerns – i.e., the print shop employees of the world usually have less access to information than the white-shoe M&A lawyers of the world – and so when prohibitions on insider trading are very narrow, the poor stay poor and the rich get rich.

Anyway, you end up drawing a lot of distinctions that do not, from the outside, appear to make a lot of moral sense.

So, back to this new fund model.  The company is called Hunterbrook, and financial journalists will be tasked with writing articles about publicly traded companies.  The plan, quite explicitly, is for the journalists to rely solely on public information.  I.e., carefully read SEC filings and news reports and use big data calculations and perhaps access obscure but not secret information (Matt Levine suggested FOIA requests).  Before publication, the fund will decide whether to place a trade – long, or short, securities, but also commodities and currencies.  And then, the article will run, and the hope of course is that the article’s insights will move markets, which will then permit the traders to profit from their position. 

That model is similar, but not identical, to those of activist short sellers – they too ferret out information and publish reports, but less formalized as journalism, and only for shorting purposes; this model wants to have some kind of regular news arm attached, and will go long as well as short.  It is, under current law, legal.  The entity is generating its own in-house information – including information about which stories it will run – and trading on the information that it generates.

This is very different than, say, the R. Foster Winans case, where a columnist for the Wall Street Journal tipped a broker about the companies he planned to feature in Heard on the Street. Because in that case, the information – which columns would run – did not belong to Winans, but to the Wall Street Journal, and Winans misappropriated it.  (No, David Carpenter was not Winans’s “roommate,” but this was 1986, so.)

But the Hunterbrook model envisions that the trader is the same entity that owns the information.

That raises the question whether, in the Winans case, the Wall Street Journal could have traded on its own knowledge of upcoming columns – or sold that information to a third party.  And the answer to that is, it depends.  Remember, the Hunterbrook model is that all the information used in the articles is public.  If that were true of the Heard on the Street columns, then yes, the Wall Street Journal could have traded on advance knowledge of its own publication plans.  But Wall Street Journal articles are typically based on inside sources.  Trading on that information, whether by the WSJ or anyone else, depends on an analysis of those sources and their relationship to the WSJ.

Let’s say the sources were revealing inside information about someone else – like, say, information about their employers, or clients, or people they do business with.  There might be all kinds of laws that those sources broke by revealing information to a newspaper (trade secret laws, employment contracts and NDAs, etc), but for the law of insider trading, the only issue is whether that source revealed information to the journal wrongfully, and wrongfully is defined in a particularly convoluted manner

First, the source must be bound by some kind of duty to keep the information confidential – that duty can come from law, or contract, or just a personal relationship where there is an expectation of privacy.  And second, the source must be revealing the information to the WSJ for an improper reason.  For a long time, improper reasons meant the source/tipper expected to “personally benefit” from the tip.  And that usually meant, the tipper was paid – like, someone paid them off for their information.  Or the tipper expected to receive confidential tips in return, that he could trade on, and there was a regular practice of people going back and forth tipping each other.  Sometimes, it meant that the tipper expected to “gift” the information to a close friend, in lieu of monetary compensation.  “Happy birthday, Mom, I didn’t have a chance to buy flowers, but Amazon is acquiring Whole Foods.  Buy yourself something nice!”  It might even mean the source expected a job offer – “Look how valuable I am to you, I can tell you that Amazon is buying Whole Foods!”  What it did not mean was, say, whistleblowing.

So, on first order analysis, if the WSJ’s sources were whistleblowing – and not expecting any personal benefit by talking to the paper, they were not being paid for their information – then the information would not have been wrongfully revealed, and the WSJ would be free to trade on it.

But we are not done.

The “personal benefit” test is difficult to apply; it sent government prosecutors searching for any quid pro quo, including steak dinners or theater tickets or plumbing services or other kinds of trivial rewards.  Eventually, then, in United States v. Martoma, the Second Circuit declared that it would be sufficient if the government could show the source tipped someone in the expectation that the recipient of the information would trade – i.e., instead of hunting for a personal benefit to the source, we’d look to see if the source was trying to benefit someone else – like the Mom’s birthday hypothetical above, but now extended to all relationships, not just especially close ones.

Additionally, in United States v. Blaszczak I, the Second Circuit looked at a brand new securities fraud statute – not Section 10(b) of the Exchange Act, but Section 1348 of Sarbanes Oxley – and held that the fraud prohibitions in Section 1348 do not require a showing that the tipper personally benefitted.  I, personally, never understood that logic – the “personal benefit” requirement was, in a roundabout way, intended to identify when tipping inside information constituted deceptive conduct, and since Section 1348 prohibits fraud, just like Section 10(b), you’d think they’d be read the same.  But no matter, because in Blaszczak I, the Second Circuit held that instead of showing a personal benefit, it would be sufficient to show that the information was “misappropriated” for one’s own use – including to give to another to trade on.  In the end I don’t see a whole lot of daylight between that standard and Martoma, so, fine, they are roughly the same. (Then, the Second Circuit decided United States v. Blaszczak II and two judges on a 3-judge panel suggested they might want to go back to a personal benefit test even for Section 1348 fraud, so who knows what that even means now).

Under this analysis, the question would be, did the WSJ’s source provide information intending that the newspaper would trade on it?

Again, the answer would probably be no, and so – on first blush – the information was not provided wrongfully, and the WSJ would be free to trade.

But we still are not done.

Because if the source gave this information to the WSJ as, say, a whistleblower – not for the purpose of having the WSJ trade – it’s possible a court would say that if the WSJ traded, then the WSJ violated its own duty of confidentiality to the source, in a manner of speaking, and misused the information for its own benefit. 

That would be sort of a weird argument, because the source never intended confidentiality – the source intended publication! – but courts tend to punish based on gut instincts of fairness and it’s not at all difficult to imagine a court holding that the WSJ misappropriated information that was given to it for a specific purpose, and, hence, fraud.

But now let’s translate all of this to the Hunterbrook context.  If the journalism arm is attached to a trading arm, then for sure any source who gives the journalist information knows it will be used for trading.  And we’re back to that first analysis: It’s wrongful to give someone confidential information, derived from an employer or a client or whatever, so that they can trade.  And maybe our source could thread the needle – “I knew they would trade but that’s not why I told them; I told them to expose the bad stuff!!” – but I wouldn’t want to be that source’s lawyer, is what I’m saying.

Anyway, all of this means that Hunterbrook will not be talking to confidential sources, but instead believes it has a viable business model by synthesizing and digesting public information, which it can use to earn a trading advantage and move markets.  Note, for whatever reason, Hunterbrook does not thinking trading alone will do it – it does not trust that the market will eventually catch up to Hunterbrook’s own wisdom, or, will do so on a fast enough time frame for Hunterbrook to profit.  No, Hunterbrook has to trade, and then move things along by publishing what it discovers. 

And I don’t know if they can pull it off or they can’t, but if they do manage to regularly publish breaking news stories culled entirely from public information, which have the effect of moving markets and allowing Hunterbrook to earn outsized returns – what do you imagine will happen when securities fraud plaintiffs bring follow-on complaints against the companies targeted with Hunterbrook’s negative information?  Do you think the obvious evidence that this “public” information was nonetheless not incorporated into market prices will make courts any more likely to accept that transaction causation and loss causation have been properly alleged?  (Reader, it will not.)

November 3, 2023 in Ann Lipton | Permalink | Comments (0)

Saturday, October 28, 2023

Dalia Tsuk Mitchell on Delaware's Legacy

I've mentioned before in this space that Delaware's increasingly baroque rules for cleansing transactions - and thus winning business judgment rule protection - are starting to resemble the MBCA in their rigidity, and are drifting from the more equity-focused caselaw of the past, where cleansing procedures were less clear and cases often seemed to turn on the court's gut instinct about a transaction's fairness.

So I was delighted to see Dalia Tsuk Mitchell's new article, Proceduralism: Delaware's Legacy.  Her thesis is that when managerialism reigned as a corporate philosophy - viewing corporate elites as a kind of enlightened guardian of the public - Delaware justified deference to their decisionmaking on the grounds of their expertise.  Later, as managerialism fell out of favor, Delaware courts developed a new narrative to justify deference, namely, procedural fairness, that was not rooted in managers' expertise or elite status at all.  She contends that the new proceduralism, which focuses solely on firms' internal decisionmaking process, parallels a shareholder primacist view of the world, which abandons any notion that corporate managers have responsibilities to the communities in which they operate.  

Here is the abstract:

This article examines the Delaware courts’ 1980s shift from managerialism to a theory I label proceduralism. I argue that managerialism, which justified corporate law’s deference to directors in the preceding fifty years, was corporate law’s response to social, political, and cultural concerns outside corporations. At the turn of the twentieth century, corporations and their managers were empowered to fight socialism by protecting the interests of workers, while in the midcentury, corporations became the first line of defense against the threats of totalitarianism and later the Cold War. Corporate directors were viewed as heroes and their power justified as necessary for the survival of American democracy. By the 1980s, however, in response to numerous hostile acquisitions, decisions of the Delaware Supreme Court appeared to discard managerialism as the Court used the fairness standard to review, and even invalidate, directors’ actions. Yet, as this Article demonstrates, the Court did not abandon its deference to corporate directors. Rather, the Court substituted proceduralism for managerialism as a theory justifying managerial power. Grounded in the concept of fairness, specifically fair dealing, proceduralism is the idea that certain procedures—for example, authorization by disinterested directors or ratification by shareholders— ensure maximization of value, and that corporate law should focus on incentivizing corporate directors to follow these procedures by assuring them that, when they so do, their actions will not be subject to judicial review. Proceduralism was cemented into law in the decades following the hostile takeover boom, as the Delaware Chancery Court enmeshed fair dealing, or fair procedure, with the presumption of the business judgment rule, assuring directors that if they followed the procedural frameworks suggested by the Court, their actions will receive the protection of the business judgment rule whether such actions offered their shareholders a fair price or a price at all. By the twentieth century’s end, Delaware corporate law became fixated on internal processes rather than discretion and expertise; proceduralism became Delaware’s legacy.

October 28, 2023 in Ann Lipton | Permalink | Comments (0)