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Lebovitch on DGCL § 122(18)

As you may recall, Ann and I got a bit wound up last summer about the Delaware General Assembly's consideration of Delaware S.B. 313 (and, within it, the proposed addition of § 122(18) of the General Corporation Law of the State of Delaware ("DGCL")). We each offered brief oral testimony and even wrote letters to the Delaware House Judiciary Committee, which you can find here and here.

A comrade in that effort, Mark Lebovitch, has taken time to reflect a bit on the crazy summer that brought a new and troubling corporate purpose to Delaware's venerable corporate law and to prognosticate about the future impact of DGCL § 122(18).  The result?  Soap Opera Summer: Five Predictions About DGCL 122(18)’s Effect on Delaware Law and Practice.  The abstract follows.

Predictability and stability are often cited as leading reasons for why Delaware’s corporate law system is world renowned and widely emulated, giving the First State dominance in the competition for domiciling business entities. The first half of 2024 was anything but predictable and stable in Delaware’s legal community. Rarely has an amendment to the Delaware General Corporation Law (“DGCL”) triggered as much public debate as SB 313, which became effective as of August 1, 2024. The crux of the dispute turned on identifying the greater risk to Delaware’s standing as the global leader in corporate law – a few recent judicial opinions that would have forced certain market practices to change, or the legislative fix seeking to nullify those opinions.

This article focuses on the most controversial aspect of SB 313. New DGCL Section 122(18) overrides the Court of Chancery’s February 23, 2024, Opinion in West Palm Beach Firefighters’ Pension Fund v. Moelis & Company ("Moelis"), by broadly allowing corporate boards to contractually delegate to any stockholder or prospective stockholder the power to cause the company to act or refrain from acting in almost any manner, including many decisions normally reserved for the board itself. Now that the debate about recent cases and new legislation is over, this article takes the opportunity to assess how the new law will actually affect Delaware’s corporate law doctrine and litigation practice. Looking beyond the atypical drama of the past six months, this article offers five subtle (but hopefully not boring) predictions and observations about how new Section 122(18) is likely to affect the corporate world going forward.

Time will tell whether Mark gets the predictions "right" or not.  In the meantime, I am prepared for the eventual advent of legal challenges.  Like Mark, I see them coming . . . .

Fiduciary Duties Trump Contracts?!

Many in the business law world have been following the saga involving the adoption of  S.B. 313 by Delaware's General Assembly last week.  S.B. 313 adds a new § 122(18) to the General Corporation Law of the State of Delaware (DGCL) that broadly authorizes corporations to enter into free-standing stockholder agreements (not embodied in the corporation's charter) that restrict or eliminate the management authority of the corporation's board of directors.  See my blog posts here and here and others cited in them, as well as Ann's post here.

In the floor debate on S.B. 313 last Thursday in the Delaware State House of Representatives, a proponent of the legislation stated that fiduciary duties always trump contracts.  That statement deserves some inspection in a number of respects.  I offer a few simple reflections here from one, limited perspective.

The historical centrality of corporate director fiduciary duties (which were the fiduciary duties referenced on the House floor) is undeniable.  Those who have taken business associations or an advanced business course with me over the years know well that I emphasize in board decision making that the directors’ actions must be both lawful and consistent with their fiduciary duties in order to be legally valid and enforceable.  I doubt my teaching is exceptional in that regard.

But the floor debate involved a different kind of tangle between legal obligations and fiduciary duties than exists in the board decision-making context in which corporate action is written on a tabula rasa.  The comment made in last Thursday’s legislative session responded to the suggestion that a board of directors may later decide to breach a contract that is lawful and was approved by the board in a manner that is consistent with director fiduciary duty compliance.  That scenario involves board action to disregard the terms of an agreement—by authorizing and directing the corporation to breach a legal obligation of the corporation because the directors have, in good faith and with due care, determined that the breach of contract is in the best interest of the corporation.

This type of board action is certainly not unprecedented.  An example from my practice immediately springs to mind: no-shop, non-solicitation, and related clauses in business combination (M&A) agreements.  These provisions may be (or at least appear to be) lawful and compliant with director fiduciary duties when made but may interfere with a target board’s fiduciary duties if the board later determines it has a fiduciary obligation to engage in interactions with a potential transactional partner in violation of that type of deal protection provision. 

The resolution of this issue in the M&A context has largely been contractual.  Fiduciary outs of various kinds have been common in M&A agreements for decades.  (I gave my first CLE talk on them back in the 1980s.)  Through these provisions, directors consider and prepare in advance for the potentiality of a later conflict between the deal protection obligations of the corporation and their fiduciary duties to the corporation.  Properly drafted, fiduciary outs help  protect the legal validity and enforceability of the original contract from future challenge and preserve the board’s legal right to respond to new circumstances without breaching the contract.

As those who work in this space well know, a watershed case involving deal protection provisions is Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003). In its Omnicare opinion, the Delaware Supreme Court assesses the validity of a merger agreement that effectively locked up a majority of the votes needed to approve the merger.  The merger agreement did not include a fiduciary out provision. The directors had no ability to terminate the merger agreement or nullify its terms to comply with their fiduciary duties without breaching the contract.  The court found the deal protections invalid and unenforceable.

Proponents of S.B. 313 clearly state that a corporation's exercise of its authority to enter into stockholder agreements under § 122(18) will be subject to challenge if the directors breach their fiduciary duties to the corporation in approving a stockholder agreement or in later authorizing the corporation's performance under that agreement.  If the corporation's directors are found to be in breach, the stockholder agreement then may be found invalid or unenforceable.  The prospect of that occurring in the stockholder agreement context is as real as it is in the M&A deal protection context.

Perhaps, then, fiduciary outs are a best practice that should grow out of the new DGCL § 122(18).  If the parties truly intend for fiduciary duties to trump the contract (as the bill proponents have claimed) and we can anticipate challenges in that regard based on the nature of the agreement, stockholder agreements should provide in advance for the eventuality of a conflict.  Otherwise, a stockholder agreement authorized under DGCL § 122(18) may be found either invalid ex post because the board’s original approval of the agreement may later be determined to have been a breach of the directors’ fiduciary duties (for failure to include a fiduciary out, as in Omnicare) or unenforceable in litigation over a board decision to breach or refrain from breaching the agreement in the face of a perceived fiduciary duty conundrum related to the corporation’s performance under the terms of the agreement.  A well-crafted fiduciary out (which would undoubtedly be somewhat bespoke, as it should be in the M&A context, based on the nature of the corporation’s obligations in the contract) should help avoid litigation, or at least enable its early dismissal, in the event of either type of legal claim.

Your reactions to these musings are, as always, welcomed.  We will be operating in new territory here assuming the Governor of Delaware signs S.B. 313 into law (as he has signaled).  If I am missing an element of statutory or decisional law or strategic litigation practice that impacts my arguments, I would appreciate hearing about it.  Regardless, it is now time that we all think about how to address anticipated issues arising from the Pandora’s box that the Delaware General Assembly has opened.  That may include practice-oriented solutions to perceived legal questions or tensions as well as potential further adjustments to the DGCL.  As to the latter, I note that I raised in one of my earlier posts the desirability of looking at DGCL subchapter XIV in light of the provisions of DGCL § 122(18).  Perhaps that issue merits a subsequent post . . . .

I Also Write Letters!

Further to Ann's post on Sunday sharing the text of her comment letter on Delaware's S.B. 313 (and more particularly the proposal to add a new § 122(18) to the General Corporation Law) and my post on § 122(18) last week, I share below the text of my comment letter to the Delaware State House of Representatives Judiciary Committee.  Although Ann and I each got one minute to deliver oral remarks at the hearing held by the Judiciary Committee on Tuesday, 60 seconds was insufficient to convey my overarching concerns--which represent a synthesis and characterization of selected points from my post last week.  The comment letter shared below includes the prepared remarks I would have conveyed had I been afforded additional time.

Madame Chair and Committee Members:

I appreciated the opportunity to speak briefly at today’s hearing. As I explained earlier today, although I am a professor in the business law program at The University of Tennessee College of Law, my appearance before the committee relates more to my nearly 39 years as a corporate finance practitioner, which has included bar work (most recently and extensively in the State of Tennessee) proposing and evaluating corporate and other business entity legislation. This letter expands on the virtual oral comments I offered at the hearing on the proposed addition of § 122(18) to the General Corporation Law of the State of Delaware (DGCL). My goal is simply to best ensure that the committee and the General Assembly are well informed about the significance of this proposed new section of the DGCL.

Both proponents and critics of proposed § 122(18) concur that the stockholder agreements that would be authorized by that provision can currently be accomplished in a corporation’s certificate of incorporation—the corporate charter. Indeed, as was alluded to in the testimony earlier today, current Delaware law expressly authorizes transferring governance authority from a corporation’s board of directors to its stockholders through charter amendments and through certificates of designation (instruments providing for new classes or series of stock) as well as for statutory close corporations, a status designated in the certificate of incorporation. As a result, questions raised at today’s hearing about why the new authority embodied in proposed DGCL § 122(18) is needed—or why it would be objectionable—are well taken. As I indicated in my oral testimony earlier today, the answer to those questions lies in public policy.

Current Delaware law on stockholder agreements promotes notice, transparency, and assent. Provisions in a Delaware corporation’s certificate of incorporation are matters of public record in the State of Delaware on which stockholders and prospective stockholders rely. They must be filed with the Delaware Secretary of State. Thus, Delaware’s corporate law currently requires that stockholders and potential future stockholders have public notice of any fundamental alteration in the statutory power of the board of directors to manage the corporation. Stockholder agreements like those authorized under proposed DGCL § 122(18) are not required to be filed with the state (although they would have to be filed with the U.S. Securities and Exchange Commission under the federal securities laws at some point after they are signed, for public companies). Moreover, under current Delaware law, if an amendment to the certificate of incorporation is required to achieve a shift in governance authority from the board of directors, then a stockholder vote is required. These requirements, which evidence Delaware’s public policies of notice, transparency, and assent, are what ultimately divide the supporters and detractors of proposed DGCL § 122(18). Your ultimate views on these policies—your determination as to whether they are important to the integrity of Delaware corporate law—should be strong factors in your determination of how to vote on proposed DGCL § 122(18). I submit that these policies should not be abandoned or reduced without careful consideration.

Last week, I wrote about my policy concerns relating to proposed DGCL § 122(18) in a blog post published on the Business Law Prof Blog. That post can be found here. Although my blog post was written for a different and broader legal audience (and therefore includes some technical legal references), it may be useful to you as additional statutory and judicial support for the positions I have taken in this letter and in my oral testimony. The post also includes several drafting observations relevant to the productive introduction of statutory authority for stockholder agreements that you may appreciate having.

I am grateful to have had the opportunity to share these insights with you today in writing and orally during the hearing this afternoon. I wish you well in your deliberations.

Very truly yours,

Joan M Heminway
Rick Rose Distinguished Professor of Law, The University of Tennessee College of Law
Member and Former Chair, Tennessee Bar Association Business Law Section
Former Chair and Member, Boston Bar Association Corporate Law Committee

The Delaware State House of Representatives may vote on the bill tomorrow (Thursday) afternoon.  It is the last item listed in the Main House Agenda for tomorrow's session.  I can only hope that the members of the House feel better informed after the House Judiciary Committee hearing on Tuesday.  I know many of us tried to ensure that they are well informed.

Moelis, § 122(18), and DGCL Subchapter XIV - Knowing Legislative Policy Shift?!

Like so many others, I have wanted to say a word about West Palm Beach Firefighters’ Pension Fund v. Moelis & Company, 311 A.3d 809 (Del. Ch. 2024).  My angle is a bit different from that of many others.  It derives from my 15-year practice background, my 24-year law teaching background, and my 39-year bar service background.  It focuses on a doctrinal analysis undertaken through a policy lens.  But I want to note here the value of Ann Lipton’s existing posts on Moelis and the related proposed addition of a new § 122(18) to the General Corporation Law of the State of Delaware (DGCL).  Her posts can be found here, here, here, and here.  (Sorry if I missed one, Ann!)  Ben Edwards also published a related post here.  They (and others offering commentary that I have read) raise and touch on some of the matters I address here, but not with the same legislative policy focus.

I apologize at the outset for the length of this post.  As habitual readers know, long posts are “not my style” as a blogger.  This matter is one of relatively urgent legislative importance, however, and I am eager to get my thoughts out to folks here.

I begin by referencing the DGCL provision in the eye of the storm.  DGCL § 141(a) provides for management of the business and affairs of a Delaware corporation by or under the direction of the corporation’s board of directors, except as otherwise provided in the corporation’s certificate of incorporation or the DGCL.  In Moelis, Vice Chancellor Travis Laster found various provisions in a stockholder agreement unlawful under DGCL § 141(a).  Specifically, a series of governance-oriented contractual arrangements at issue in Moelis were not authorized under the corporation’s certificate of incorporation or another provision of the DGCL.

The tension in this space involving DGCL § 141(a) is not new.  For many years, the legal validity of so-called stockholder agreements—technically, agreements (as opposed to charter provisions) that shift governance power from the directors of a corporation to one or more of its stockholders—has been questionable for most Delaware corporations, including public companies.  (I say “many years” because the legal validity of these agreements was an issue I routinely wrestled with before I left the full-time private practice of law in 2000.) 

The DGCL is different from the Model Business Corporation Act (MBCA) in this regard.  The MBCA has long had a broad-based statutory provision, MBCA § 7.32, authorizing shareholder agreements under specified conditions.  States adopting the MBCA have made a (presumably) conscious choice to embrace shareholder governance under the circumstances provided in the MBCA, including through § 7.32.  The MBCA’s provision expressing the management authority of the corporation’s board of directors, MBCA § 8.01(b), expressly references MBCA § 7.32, providing that:

[e]xcept as may be provided in an agreement authorized under section 7.32, and subject to any limitation in the articles of incorporation permitted by section 2.02(b), all corporate powers shall be exercised by or under the authority of the board of directors, and the business and affairs of the corporation shall be managed by or under the direction, and subject to the oversight, of the board of directors.

There is no analogous provision in the DGCL.  The only way to be sure that one could accomplish a shift in governance power from directors to stockholders under the DGCL has been for a corporation either to include the governance provisions in its certificate of incorporation or to organize as a close corporation under Subchapter XIV.  Close corporation status requires charter-based notification and conformity to a number of statutory requirements set forth in DGCL §§ 341 & 342, including that the certificate of incorporation provide that the stock be represented by certificated shares “held of record by not more than a specified number of persons, not exceeding 30,” that the stock be subject to transfer restrictions, and that there not be a “public offering” of the stock. DGCL § 342(a)(1)-(3).  Thus, by legislative design, statutory close corporation status is not available to publicly held corporations organized under Delaware law (which makes total sense for those who understand what a closely held corporation is, in a general sense).

Members of the Delaware State Bar Association (DSBA) Corporation Law Section know all of this well.  As leaders in reviewing and proposing changes to the DGCL over the years, this group of folks has thoughtfully weighed policy considerations relating to the DGCL’s application to the myriad situations that Delaware corporations may face.  Without having researched or inquired about the matter, I find it hard to believe that the section has not previously discussed the desirability of an express statutory provision allowing for the approval and execution of stockholder agreements outside a corporation’s certificate of incorporation.  The matter has been addressed by the Executive Council of the Tennessee Bar Association’s Business Law Section, which engages in similar legislative initiatives in Tennessee, more than once during the time I have been serving on it.  I therefore assume that the choice to refrain from proposing a specific statute authorizing stockholder agreements outside a corporation’s certificate of incorporation over the years has been both informed and intentional.

Yet, earlier today, Senate Bill 313 passed in the Senate Chamber of the Delaware General Assembly.  In that bill, vetted and approved by the DSBA Corporation Law Section and blessed by the DSBA Executive Committee, the longstanding policy decision to refrain from allowing stockholder agreements outside of the certificate of incorporation or Subchapter XIV is being summarily reversed through the proposal to adopt a new DGCL § 122(18)—an alteration of the corporate powers provision of the DGCL.  That new proposed DGCL section provides a corporation with the power to enter into stockholder agreements within certain bounds, but those bounds are relatively broad.

As others have noted (at least in part), the drafting of the proposed DGCL § 122(18) (and the related additional changes to DGCL § 122) reflects a belt-and-suspenders approach and is otherwise awkward.  Multiple sentences are crammed into this one new subpart of DGCL §122 to effectuate the drafters’ aims.  The DGCL has been criticized for its complex drafting in the past (resulting in, among other things, a project creating a simplified DGCL), and the approach taken by the drafters of the proposed DGCL § 122 changes adds to the complexity of the statute in unnecessary ways.  A provision this significant should be addressed in a separate statutory section, the approach taken in MBCA §7.32.  That new section then can be cross-referenced in DGCL § 141(b)—and, if deemed necessary, DGCL § 122.  Breaking out the provision in its own section also should allow legislators to more easily and coherently identify strengths and weaknesses in the drafting and build in or remove any constraints on stockholder governance that they may deem necessary as the proposed provision gets continued attention in the Delaware State House of Representatives.  I offer that as a drafting suggestion.

Apart from the inelegance of the drafting, however, I have one large and important question as Senate Bill 313 continues to move through the Delaware legislative process: do members of the Delaware General Assembly voting on this bill fully understand the large shift in public policy represented by the introduction of DGCL § 122(18)?  If so, then they act on an informed basis and live with the consequences, as they do with any legislation they pass that is signed into law.  If not, we all must work harder to enable that understanding. 

It is all fine and good for us to point out how hasty the drafting process has been, how traditional debate and procedures may have been short-changed or subverted, how waiting for the Delaware Supreme Court to act on the appeal of the Chancery Court decision before proceeding is prudent, etc.  But the fact of the matter has been that potential and actual stockholders of Delaware corporations have been able to rely exclusively on charter-based exceptions to the management authority of the board of directors—whether those exception are authorized in Subchapter XIV of the DGCL or otherwise.  This has meant that prospective equity investors in a Delaware corporation knew to carefully consider a corporation’s certificate of incorporation to identify any pre-existing constraints on the management authority of the board of directors before investing.  This also has meant that any new constraints on the board of directors’ authority to manage the corporation’s business and affairs required a charter amendment of some kind—either a board-approved and stockholder-approved amendment of the certificate of incorporation or the board’s approval of a certificate of designations under charter-based authority of which existing stockholders should be aware.

Ann noted this issue in a previous post.  The enactment of proposed DGCL § 122(18) will make it more challenging for potential equity investors to identify the locus/loci of management power in the corporation.  Although both the certificate of incorporation and any stockholder agreement would be required to be filed with the U.S. Securities and Exchange Commission for reporting companies (the latter as an instrument defining the right of security holders under paragraph (b)(4) or as a material contract (b)(10) of Regulation S-K Item 601), the current draft of proposed DGCL § 122(18) does not provide that a copy of any contract authorized under its provisions be filed with the Delaware Secretary of State or that its existence be noted on stock certificates (a requirement included in MBCA §7.32(c)).  In addition, stockholders will lose their franchise if the stockholder agreement would otherwise have required a stockholder vote.

Finally, it seems important to note that the judicial doctrine or independent legal significance—or equal dignity—has been strong in Delaware over the years as a factor in the interpretation of Delaware corporate law.  This has helped practitioners and the judiciary to navigate difficult issues in advising clients about the outcomes of Delaware corporate law debates.  The rule typically has been that, if one takes a path afforded by the statute, they get what the statute provides.  And if one does not take a provided statutory path, they cannot later be heard to argue for what the statute provides for users of that untaken statutory path. 

Classically, in dicta in Nixon v. Blackwell, 626 A.2d 1366 (1993), Chief Justice Veasey wrote (on pp. 1380-81) about the importance of DGCL Subchapter XIV in construing corporate governance arrangements in light of the doctrine of independent legal significance:

 . . . the provisions of Subchapter XIV relating to close corporations and other statutory schemes preempt the field in their respective areas. It would run counter to the spirit of the doctrine of independent legal significance and would be inappropriate judicial legislation for this Court to fashion a special judicially-created rule for minority investors when the entity does not fall within those statutes, or when there are no negotiated special provisions in the certificate of incorporation, by-laws, or stockholder agreements.

With the passage of proposed DGCL § 122(18), parts of Subchapter XIV of the DGCL will seemingly be rendered vestigial (i.e., they will no longer have independent legal significance).  Consideration of this and any other potential collateral damage to the interpretation of Delaware corporate law that may be created by the enactment of proposed DGCL § 122(18) should be carefully undertaken and, as desired, additional changes to the DGCL should be debated before voting on Senate Bill 313 is undertaken in the Delaware State House of Representatives.

I do not argue for a specific result in this post.  Rather, I mean to illuminate further the significance of the decision facing the Delaware General Assembly (and, potentially, the decision of the Governor of the State of Delaware) in the review of proposed DGCL § 122(18).  In doing so, I admit to some sympathy for those who may have clients with stockholder agreements they now know or suspect to be unlawful under the Moelis opinion.  In all candor, any legislation on this topic should more directly address those existing agreements given that the provisions of proposed DGCL § 122(18) are not a mere clarification of existing law.  Agreements not re-adopted under any new legislative authority may be found unlawful in the absence of clarity on this point.  As a reference point, I note that, in amending MBCA § 7.32 to remove a previous 10-year duration limit, the drafters specified the effect on pre-existing agreements in MBCA § 7.32(h).  Take that as another drafting suggestion . . . .

I welcome comments on any or all of what I offer here.  If I have anything incorrect, please correct me.  Regardless, I hope this post provides some additional information to those in the Delaware General Assembly and elsewhere who have an interest in proposed DGCL § 122(18).

What is Equity, Anyway?

I just came back on Sunday from the 2024 Law and Society Association Annual Meeting in Denver.  It was, as always, a stimulating few days.  A number of us business law profs were in attendance.  The corporate and securities law collaborative research network (CRN46) habitually organizes several programs.  This year was no exception.  I was privileged to be featured in two.  But I will say more on my participation in the conference later.

Today, I want to highlight an interesting piece that was presented at the conference during one of the CRN46 paper panels: "The Original Meaning of Equity " by Asaf Raz (forthcoming in the Washington University Law Review).  The SSRN abstract follows:

Equity is seeing a new wave of attention in scholarship and practice. Yet, as this Article argues, our current understanding of equity is divided between two distinct meanings: on one side, the federal courts, guided by the Supreme Court, tend to discuss equity as the precise set of remedies known at a fixed point in the past (static equity). On the other, state courts—most prominently, in Delaware—administer equity to preserve the correct operation of law in unforeseeable situations (substantive equity). Only the latter interpretation complies with the historical and functional idea of equity.

This Article makes the first detailed argument for resolving the problem of static equity, and reinvigorating substantive equity in the federal judiciary and the broader legal community. To do so, this Article takes a highly innovative step, by connecting the federal discussion with an in-depth analysis of the legal scene where equity is employed most systematically (and most faithfully to its historical roots): Delaware law, including its corporate law. As this Article demonstrates, substantive equity is fully compatible with originalism and textualism; the "equity" mentioned in the Constitution and later federal texts is substantive, not static, equity. Federal law has always operated within the sphere of the common law, and this Article offers a new bridge between the two, exposing the members of each community to insights from the other, in a manner that promotes both the original understanding of the legal text, justice, and the rule of law.

Asaf's presentation of the piece at the conference generated several questions and an interesting extended discussion.  The term "equity" has many meanings in law that we must be conversant with in our work.  We also need to help students define "equity" in context and sort out its varied meanings as they learn about law in its multifarious manifestations.  These factors alone make the article a valuable read.  However, more centrally, I applaud Asaf for taking on the task of adding some clarity to the term and on connecting his research to both federal (including constitutional) and Delaware law in novel ways.  I look forward to spending more time with this piece.  And I know Asaf welcomes your comments!

Guest Post: Politics as a New Differentiator Between American Business Courts: A View on the Debate Between Former Attorney General Barr and Vice Chancellor Laster

Today's guest post comes to us from Anthony Rickey of Margrave Law:

The Thanksgiving weekend witnessed a debate between former Attorney General William Barr and attorney Jonathan Berry and Vice Chancellor Travis Laster over whether Delaware risks “driving away” corporations through “flirtation with environmental, social and governance [“ESG”] investment principles.”  Reuters reports that Chancellor McCormick further criticized Barr’s article at a Practicing Law Institute event, and Vice Chancellor Will  commented in a Bloomberg Law interview.  Professor Stephen Bainbridge has published two posts on the controversy.

When giants wrestle, wise men stay out from underfoot.  Nonetheless, I think the debate merits a close look because, however much I agree with Vice Chancellor Laster on matters of doctrine, I suspect that similar articles will become more common in the future.  Three factors influence my prediction:  a) Delaware has weakened its reputational bulwark against accusations of partisanship, b) the influence of politics in corporate law has increased (largely via ESG) and c) other states are now seeking to differentiate themselves from, rather than imitate, the Delaware Court of Chancery.

Delaware Dissolves One of Its Fundamental Corporate Law Pillars

The heart of Barr’s argument is that Delaware risks following “many blue states [that] are using ESG to inject the progressive political agenda on climate, race, and other issues into corporate governance,” and that “red states are developing potentially attractive alternatives.”  I think Vice Chancellor Laster has by far the best of the doctrinal debate on this point.  Formally, nothing in Delaware law preferences “progressive” governance over “conservative” governance, however one defines those terms.

 But Delaware recently eliminated one of its longstanding bulwarks against this accusation:  the requirement that the Court of Chancery and the Delaware Supreme Court be split between Republicans and Democrats.  On January 30, a federal court approved a consent judgment between (Democrat) Governor John Carney and a former Democrat (now independent) plaintiff declaring that the “major political party” requirement of the Delaware Constitution violates the First Amendment.  In theory, each political party is still limited to a bare majority of the seats on both courts.  But these protections are porous:  for instance, the Washington, D.C. City Council has similar restrictions, and its seats tend to be occupied by Democrats and “Independents” who are former Democrats.

So far, Delaware’s courts remain politically balanced.  But tradition is a weak restraint on politicians once they set their sights on other goals.  For instance, traditionally at least one vice chancellor and justice resided in each of Delaware’s three counties.  Today, Kent County has no resident justice and no resident judicial officer listed on the Court of Chancery’s website.  Tradition seems no more likely to sustain political diversity than geographic diversity.

Delaware’s Blue State Disadvantage

Questions of political balance will, I suspect, become a larger topic as politics intrudes more deeply into corporate law—and especially as conservatives begin to use litigation in a way once dominated by the political left.   (For instance, Professor Ann Lipton recently described a derivative lawsuit filed by several communities of Catholic nuns against Smith & Wesson in Nevada, mentioning another derivative suit against Starbucks filed by a conservative plaintiff challenging Starbuck’s DEI policies.)  Corporate law is a matter of doctrine, but politics is as much a matter of appearance as precedent.  And here, respectfully, I think Delaware is vulnerable:  however neutral the doctrine, its critics will not need to look far for examples if they seek to portray Delaware to outsiders as “blue”-leaning.

Take the recent decision involving a books-and-records action by a Disney stockholder, discussed both by AG Barr and Vice Chancellor Laster.  As the Vice Chancellor stated, the Disney decision found that “the demand was pretextual because the plaintiff was rather acting as a front for a politically motivated group.”  But looking closer at Disney, one criticism of the (conservative) plaintiff stands out:  he “reviewed but made no edits to the Complaint.”   The decision cites no precedent holding a previous litigant to that standard.  I went back and looked at Disney’s briefs:  they offered no examples either.  Indeed, I can’t find any case criticizing a books-and-records plaintiff for not editing (as opposed to simply reviewing) a draft complaint.  Disney appears to find fault in the plaintiff’s law firm going out and finding a plaintiff—an accusation that can be leveled at every plaintiff’s shop that makes “fraud monitoring agreements” with multiple pension funds.

Compare Disney to New York State Common Retirement Fund v. Oracle Corp., C.A. No. 11642-VCL, where a pension fund sought books-and-records relating to Oracle’s political donations following the United States Supreme Court’s decision in Citizens United v. F.E.C., 558 U.S. 310 (2010).  One would think that, as in Disney, decisions on political spending are quintessential matters of business judgment.  Yet the plaintiff relied upon an article by then-Chief Justice Strine to contend otherwise.  The trustee of the pension fund seeking records concerning political donations was the New York State Comptroller—himself a politician with interests in political giving.  Rather than take things to trial, Oracle settled quickly.  I can’t find anything in the record suggesting that the Court of Chancery ever considered whether the pension fund’s interests were a “pretext” for the politician’s. 

Doctrinally, it is easy to reconcile Oracle and Disney:  the former settled, creating no law.  But even if the doctrine is clear, it is easy for Delaware’s critics to ask:  would Oracle have settled without a supportive law review article from a sitting justice critiquing Citizens United?  Would Disney have gone to trial if the plaintiff could have cited a similar law review article by a sitting judge supporting Florida’s legislation?

When it comes to politics and optics, the Court of Chancery faces another disadvantage in comparison to other states’ business courts:  it is a court of equity and hears non-business cases.  Take, for instance, this passage from State of Delaware v. City of Seaford, C.A. No. 2022-0030-JTL, involving not corporate governance, but the invalidation of a “fetal remains” ordinance:

In a society divided over the issue of abortion, any decision that touches on that topic carries heightened significance, and particularly so after Dobbs v. Jackson Women’s Health Organization, 597 U.S. — (2022). The Dobbs decision overruled Roe v. Wade, 410 U.S. 113 (1973), and Planned Parenthood of Southeastern Pennsylvania v. Casey, 505 U.S. 833 (1992), which recognized that women have rights to bodily integrity, personal liberty, and self-determination under the United States Constitution, that respecting those rights is necessary to achieve the equality of women and men under the law, and that a woman’s right to make decisions about bodily integrity, parenthood, and family therefore must be balanced against any interests that a government might seek to address when regulating abortion. Particularly after Casey, challenges to laws regulating abortion frequently turned on whether the challenged regulation imposed an undue burden on or a substantial obstacle to the ability of women to exercise their federal constitutional rights.

The passage is dicta.  The very next sentence is: “This case does not involve federal constitutional rights.”  Nevertheless, it is hard not to divine an opinion concerning the propriety of the Dobbs decision from City of Seaford.

As Professor Bainbridge points out, the intersection of politics and corporate law raises a concern because of the “chicken heart” problem created by the recent Marchand decision.  Much of Delaware corporate litigation involves exercises of discretion by a court of equity, and those decisions may be fact-intensive.  This is an advantage when addressing non-political matters, such as whether a particular subspecies of deal protection is or isn’t acceptable.  Political issues raise thornier issues of perception.

Consider a hypothetical:  the board of a chain of general goods stores, mostly concentrated in red states, wants to differentiate itself from companies like Target or Bud Light by supporting a Florida bill like the one Disney criticized.  That board has a good faith belief that the policy will increase sales (and thus stockholder value) in the medium- to long-term.  In the short term, however, it causes a large staff walkout.  A public sector pension fund like New York’s, led by a politician, files a Delaware books-and-records action, and the politician publicly proclaims his antagonism to the Florida law.  Just as the Oracle complaint cited a Delaware Chief Justice’s law review article, the new complaint highlights the Delaware court’s recent report commending (among many other things) the establishment of gender-neutral bathrooms to benefit transgender and nonbinary people.  Doctrinally, the facts still seem to fall within Vice Chancellor Laster’s scope of a good faith business judgment.  Reading Disney and City of Seaford, how confident could one be in advising about the likelihood dismissal of a well-crafted Section 220 action brought by a blue-state politician concerning a matter where Delaware’s political culture is far closer to the plaintiff than the defendants?  About a Caremark claim?  What are the odds that the board settles, as in Oracle, rather than roll the dice that some fact distinguishes a “pretextual” individual from a pension fund led by a respected (but blue state) politician?

As Caremark claims become easier (if still not easy) to win, directors may legitimately wonder whether future lawsuits will extend to their consideration of ESG issues.  And directors may look differently at the risks than judges do.  After all, even if a Caremark claim is unlikely to succeed, or even survive a motion to dismiss, it is unpleasant to be named in complaint and have one’s personal assets placed in jeopardy.  Litigation paradigms that offer routes to avoid lawsuits in the first place, rather than simply winning on a motion to dismiss, may become more attractive.

In considering the decisions above, however, two points are critical.  First, I agree entirely with Vice Chancellor Laster as to the relevant doctrine and make no suggestion that Disney or City of Seaford are wrongly decided.  Second, I’m hardly suggesting that Delaware is a poor forum for conservatives.  I’m a conservative myself (albeit of the pro-choice varietal) and have litigated here for most of my career.  But I doubt that City of Seaford’s description of Casey raised many eyebrows, even among most conservative members of the Delaware bar.  Delaware is a deep blue state.  The implications of Disney and City of Seaford may be perceived differently by directors in a purple, let alone red, state.

The Trend for Differentiation Among Non-Delaware Business Courts

Given that difference in perspectives, I’m somewhat surprised that it took so long for an article like Barr’s to appear.  As he mentions, several “red” states have recently set up their own business courts.  This isn’t new:  a majority of states now have specialized fora for corporate disputes.  But when I started writing about Delaware’s competition over a decade ago, most states were trying to imitate Chancery.  Now, they’re seeking to differentiate themselves.

Take Nevada, which recently changed its corporate code to preclude the application of an “inherent fairness” standard, similar to Delaware’s “entire fairness” standard of review.  Certainly the Delaware plaintiff’s bar considers this a challenge:  a plaintiff is currently suing to prevent TripAdvisor from leaving Delaware for Nevada.  Keith Bishop thinks the plaintiff’s concerns about Nevada being a “no liability” regime are overstated.  Still, the fallout suggests that Nevada is consciously seeking to compete by creating a different litigation environment.

Texas provides another example.  The new business court imitates the Court of Chancery in certain respects.  For instance, the new court’s judges, unlike their counterparts in the Texas judiciary, will be appointed rather than elected.   But Texas did not adopt a political balance requirement.  And the Texas political and litigation environment is markedly different.  Tort reform groups like Texans for Lawsuit Reform advocated for the new court; several Texan legal associations (plaintiff- and defense-side) unsuccessfully opposed it.  Earlier tort reforms will influence the new court’s decisions, including rules that limit fees in class actions to four times lodestar.  (Notably, Texas’ accompanying rules on non-monetary fees eliminated “merger tax” lawsuits in the Lone Star State before Delaware did.)  Corporations may well perceive that the Texas legislature and the Delaware General Assembly view the cost/benefit balance of representative shareholder litigation differently.

Here, I part ways with Professor Bainbridge, who thinks it unlikely that Caremark, or most anything else, can pose a competitive challenge to Delaware because the First State can simply adopt any successful reform.  That has long been the conventional wisdom, but competition is dynamic.  To the extent that states like Utah and Georgia intend to challenge Delaware, I expect that they will follow Texas and Nevada in adopting reforms that Delaware will find hard to replicate due to its own entrenched constituencies.  (Professor Bainbridge has himself commented on this.)  Statutorily eliminating entire fairness review or adopting fixed limits on attorneys’ fees would be revolutionary in Delaware and inspire spirited opposition from the bar.

Does this mean an end to Delaware’ dominance of corporate law?  Given Delaware’s successful century, it would take a brave person to bet against the First State.  But I agree with Professor Jay Verret:  Barr’s article was a “wake up call.”  Barr’s doctrinal analysis deserves skepticism for the reasons expressed by Vice Chancellor Laster.  But I doubt Barr will be the last to highlight Delaware’s blue-state political status.  As other jurisdictions seek to entice corporations away from the First State, politics is an obvious and easily understandable point of differentiation.

Quotables: Lipton & Edwards on TripAdvisor

Friend-of-the-BLPB Tom Rutledge alerted me earlier today to a Thomson Reuters piece on the TripAdvisor reincorporation litigation that quotes not one but two of our blogger colleagues: Ann Lipton and Ben Edwards (in that order).  Ann is quoted (after a mention and quotation of one of her recent, more entertaining tweets) on the Delaware judicial aspects of the case.  Ben is quoted on the Nevada corporate law piece.  So great to see these two offering their legal wisdom on this interesting claim.

Ann's tweet (perhaps predictably) offers a different "take" on Nevada law than Ben's press statements.

Ann: “I tell my students, Nevada is where you incorporate if you want to do frauds . . . .” 

Ben: “The folks here are people acting in good faith, trying to do what’s right – not cynically racing to the bottom . . . .”

And then Ben gets the last word: “Nevada . . . has become a home for billionaires leaving Delaware in a huff.”

Beautiful.

Ten Ethical Traps for Business Lawyers

I'm so excited to present later this morning at the University of Tennessee College of Law Connecting the Threads Conference today at 10:45 EST. Here's the abstract from my presentation. In future posts, I will dive more deeply into some of these issues. These aren't the only ethical traps, of course, but there's only so many things you can talk about in a 45-minute slot. 

All lawyers strive to be ethical, but they don’t always know what they don’t know, and this ignorance can lead to ethical lapses or violations. This presentation will discuss ethical pitfalls related to conflicts of interest with individual and organizational clients; investing with clients; dealing with unsophisticated clients and opposing counsel; competence and new technologies; the ever-changing social media landscape; confidentiality; privilege issues for in-house counsel; and cross-border issues. Although any of the topics listed above could constitute an entire CLE session, this program will provide a high-level overview and review of the ethical issues that business lawyers face.

Specifically, this interactive session will discuss issues related to ABA Model Rules 1.5 (fees), 1.6 (confidentiality), 1.7 (conflicts of interest), 1.8 (prohibited transactions with a client), 1.10 (imputed conflicts of interest), 1.13 (organizational clients), 4.3 (dealing with an unrepresented person), 7.1 (communications about a lawyer’s services), 8.3 (reporting professional misconduct); and 8.4 (dishonesty, fraud, deceit).  

Discussion topics will include:

1. Do lawyers have an ethical duty to take care of their wellbeing? Can a person with a substance use disorder or major mental health issue ethically represent their client? When can and should an impaired lawyer withdraw? When should a lawyer report a colleague?
2. What ethical obligations arise when serving on a nonprofit board of directors? Can a board member draft organizational documents or advise the organization? What potential conflicts of interest can occur?
3. What level of technology competence does an attorney need? What level of competence do attorneys need to advise on technology or emerging legal issues such as SPACs and cryptocurrencies? Is attending a CLE or law school course enough?
4. What duties do lawyers have to educate themselves and advise clients on controversial issues such as business and human rights or ESG? Is every business lawyer now an ESG lawyer?
5. What ethical rules apply when an in-house lawyer plays both a legal role and a business role in the same matter or organization? When can a lawyer representing a company provide legal advice to an employee?
6. With remote investigations, due diligence, hearings, and mediations here to stay, how have professional duties changed in the virtual world? What guidance can we get from ABA Formal Opinion 498 issued in March 2021? How do you protect confidential information and also supervise others remotely?
7. What social media practices run afoul of ethical rules and why? How have things changed with the explosion of lawyers on Instagram and TikTok?
8. What can and should a lawyer do when dealing with a businessperson on the other side of the deal who is not represented by counsel or who is represented by unsophisticated counsel?
9. When should lawyers barter with or take an equity stake in a client? How does a lawyer properly disclose potential conflicts?
10. What are potential gaps in attorney-client privilege protection when dealing with cross-border issues? 

If you need some ethics CLE, please join in me and my co-bloggers, who will be discussing their scholarship. In case Joan Heminway's post from yesterday wasn't enough to entice you...

Professor Anderson’s topic is “Insider Trading in Response to Expressive Trading”, based upon his upcoming article for Transactions. He will also address the need for business lawyers to understand the rise in social-media-driven trading (SMD trading) and options available to issuers and their insiders when their stock is targeted by expressive traders.

Professor Baker’s topic is “Paying for Energy Peaks: Learning from Texas' February 2021 Power Crisis.” Professor Baker will provide an overview of the regulation of Texas’ electric power system and the severe outages in February 2021, explaining why Texas is on the forefront of challenges that will grow more prominent as the world transitions to cleaner energy. Next, it explains competing electric power business models and their regulation, including why many had long viewed Texas’ approach as commendable, and why the revealed problems will only grow more pressing. It concludes by suggesting benefits and challenges of these competing approaches and their accompanying regulation.

Professor Heminway’s topic is “Choice of Entity: The Fiscal Sponsorship Alternative to Nonprofit Incorporation.” Professor Heminway will discuss how for many small business projects that qualify for federal income tax treatment under Section 501(a) of the U.S. Internal Revenue Code of 1986, as amended, the time and expense of organizing, qualifying, and maintaining a tax-exempt nonprofit corporation may be daunting (or even prohibitive). Yet there would be advantages to entity formation and federal tax qualification that are not available (or not easily available) to unincorporated business projects. Professor Heminway addresses this conundrum by positing a third option—fiscal sponsorship—and articulating its contextual advantages.

Professor Moll’s topic is “An Empirical Analysis of Shareholder Oppression Disputes.” This panel will discuss how the doctrine of shareholder oppression protects minority shareholders in closely held corporations from the improper exercise of majority control, what factors motivate a court to find oppression liability, and what factors motivate a court to reject an oppression claim. Professor Moll will also examine how “oppression” has evolved from a statutory ground for involuntary dissolution to a statutory ground for a wide variety of relief.

Professor Murray’s topic is “Enforcing Benefit Corporation Reporting.” Professor Murray will begin his discussion by focusing on the increasing number of states that have included express punishments in their benefit corporation statutes for reporting failures. Part I summarizes and compares the statutory provisions adopted by various states regarding benefit reporting enforcement. Part II shares original compliance data for states with enforcement provisions and compares their rates to the states in the previous benefit reporting studies. Finally, Part III discusses the substance of the benefit reports and provides law and governance suggestions for improving social benefit.

All of this and more from the comfort of your own home. Hope to see you on Zoom today and next year in person at the beautiful UT campus.

Wokewashing and the Board

As an academic and consultant on environmental, social, and governance (ESG) matters, I’ve used a lot of loaded terms -- greenwashing, where companies tout an environmentally friendly record but act otherwise; pinkwashing, where companies commoditize breast cancer awareness or LGBTQ issues; and bluewashing, where companies rally around UN corporate social responsibility initiatives such as the UN Global Compact.

In light of recent events, I’ve added a new term to my arsenal—wokewashing. Wokewashing occurs when a company attempts to show solidarity with certain causes in order to gain public favor. Wokewashing isn’t a new term. It’s been around for years, but it gained more mainstream traction last year when Unilever’s CEO warned that companies were eroding public trust and industry credibility, stating:

 Woke-washing is beginning to infect our industry. It’s polluting purpose. It’s putting in peril the very thing which offers us the opportunity to help tackle many of the world’s issues. What’s more, it threatens to further destroy trust in our industry, when it’s already in short supply… There are too many examples of brands undermining purposeful marketing by launching campaigns which aren’t backing up what their brand says with what their brand does. Purpose-led brand communications is not just a matter of ‘make them cry, make them buy’. It’s about action in the world.

The Black Lives Matter and anti-racism movements have brought wokewashing front and center again. My colleague Stefan Padfield has written about the need for heightened scrutiny of politicized decisions and corporate responses to the BLM movement here, here, and here, and Ann Lipton has added to the discussion here. How does a board decide what to do when faced with pressure from stakeholders? How much is too much and how little is too little?

The students in my summer Regulatory Compliance, Corporate Governance, and Sustainability course were torn when they acted as board members deciding whether to make a public statement on Black Lives Matter and the murder of George Floyd. As fiduciaries of a consumer goods company, the “board members” felt that they had to say “something,” but in the days before class they had seen the explosion of current and former employees exposing  companies with strong social justice messaging by pointing to hypocrisy in their treatment of employees and stakeholders. They had witnessed the controversy over changing the name of the Redskins based on pressure from FedEx and other sponsors (and not the Native Americans and others who had asked for the change for years). They had heard about the name change of popular syrup, Aunt Jemima. I intentionally didn’t force my students to draft a statement. They merely had to decide whether to speak at all, and this was difficult when looking at the external realities. Most of the students voted to make some sort of statement even as every day on social media, another “woke” company had to defend itself in the court of public opinion. Others, like Nike, have received praise for taking a strong stand in the face of public pressure long before it was cool and profitable to be “woke.”

Now it’s time for companies to defend themselves in actual court (assuming plaintiffs can get past various procedural hurdles). Notwithstanding Facebook and Oracle’s Delaware forum selection bylaws, the same lawyers who filed the shareholder derivative action against Google after its extraordinary sexual harassment settlement have filed shareholder derivative suits in California against Facebook, Oracle, and Qualcomm. Among other things, these suits generally  allege breach of the Caremark duty, false statements in proxy materials purporting to have a commitment to diversity, breach of fiduciary duty relating to a diverse slate of candidates for board positions, and unjust enrichment. Plaintiffs have labeled these cases civil rights suits, targeting Facebook for allowing hate speech and discriminatory advertising, Qualcomm for underpaying women and minorities by $400 million, and Oracle for having no Black board members or executives. Oracle also faces a separate class action lawsuit based on unequal pay and gender.

Why these companies? According to the complaints, “[i]f Oracle simply disclosed that it does not want any Black individuals on its Board, it would be racist but honest…” and  “[a]t Facebook, apparently Zuckerberg wants Blacks to be seen but not heard.” Counsel Bottini explained, “when you actually go back and look at these proxy statements and what they’ve filed with the SEC, they’re actually lying to shareholders.”

I’m not going to discuss the merits of these cases. Instead, for great analysis, please see here written by attorneys at my old law firm Cleary Gottlieb. I’ll do some actual legal analysis during my CLE presentation at the University of Tennessee Transactions conference on October 16th.

Instead, I’m going to make this a little more personal. I’m used to being the only Black person and definitely the only Black woman in the room. It’s happened in school, at work, on academic panels, and in organizations. When I testified before Congress on a provision of Dodd-Frank, a Black Congressman who grilled me mercilessly during my testimony came up to me afterwards to tell me how rare it was to see a Black woman testify about anything, much less corporate issues. He expressed his pride. For these reasons, as a Black woman in the corporate world, I’m conflicted about these lawsuits. Do corporations need to do more? Absolutely. Is litigation the right mechanism? I don’t know.

What will actually change? Whether or not these cases ever get past motions to dismiss, the defendant companies are likely to take some action. They will add the obligatory Black board members and executives. They will donate to various “woke” causes. They will hire diversity consultants. Indeed, many of my colleagues who have done diversity, equity, and inclusion work for years are busier than they have ever been with speaking gigs and training engagements. But what will actually change in the long term for Black employees, consumers, suppliers, and communities?

When a person is hired or appointed as the “token,” especially after a lawsuit, colleagues often believe that the person is under or unqualified. The new hire or appointee starts under a cloud of suspicion and sometimes resentment. Many eventually resign or get pushed out. Ironically, I personally know several diversity officers who have left their positions with prestigious companies because they were hired as window dressing. Although I don’t know Morgan Stanley’s first Chief Diversity Officer, Marilyn Booker, her story is familiar to me, and she has now filed suit against her own company alleging racial bias.

So I’ll keep an eye on what these defendants and other companies do. Actions speak louder than words. I don’t think that shareholder derivative suits are necessarily the answer, but at least they may prompt more companies to have meaningful conversations that go beyond hashtag activism.

LLCs Are Not Corporations: A New Hero Emerges

The Honorable Aida M. Delgado-Colón made me smile today.  As BLPB readers know, An LLC By Any Other Name, Is Still Not a Corporation. Finally, I received a notice of a court acknowledging this fact and requiring a party to refer to their legal entity correctly. Judge Delgado-Colón writes: 

Pursuant to this Court’s sua sponte obligation to inquire into its own subject matter jurisdiction and noticing the unprecedented increase in foreclosure litigation in this District, the Court ordered plaintiff to clarify whether it is a corporation or a limited liability company (“LLC”).

REVERSE MORTGAGE FUNDING, LLC, Pl., v. THE ESTATE OF ANGEL RAFAEL ANTONINI-NAZARIO, et al, Defendants., CV 16-3092 (ADC), 2020 WL 881019, at *1 (D.P.R. Feb. 20, 2020).  

 

The opinion continues:

Here, the Court cannot ascertain that diversity exists among the parties. Rule 11(b) of the Federal Rules of Civil Procedure holds attorneys responsible for “assur[ing] that all pleadings, motions and papers filed with the court are factually well-grounded, legally tenable and not interposed for any improper purpose.” Mariani v. Doctors Associates, Inc., 983 F.2d 5, 7 (1st Cir. 1993) (citing Cooter & Gell v. Hartmarx Corp., 496 U.S. 384, 393 (1990). Despite Rule 11’s mandate, the Court finds significant inconsistencies among plaintiff’s representations, which to this date remain unclear. As noted at ECF No. 53, plaintiff has repeatedly failed to explain why its alleged principal place of business is in New Jersey instead of Michigan. To make matters worse, plaintiff now claims to be a “limited liability corporation”¹ under Delaware law.

Id. at *2.

 

Because the court was "unable to determine that complete diversity exists between the parties," the Court dismissed "without prejudice the amended complaint for lack of subject matter jurisdiction." Id.  

 

I might quibble with some parts of the opinion (mostly that I think it could make what the plaintiff should have done even more clear), but that's just quibbling.  I am thrilled to see an opinion that held the responsible party accountable for their entity descriptions.  

 

Thank you, Judge Delgado-Colón. 

The Implied Covenant of Good Faith Means The Contract Makes Some Sense (If Only A Little)

Prof. Bainbridge recently posted, Here's the thing I don't understand about the implied covenant of good faith and fair dealing. He explains: 

In Bandera Master Funds LP v. Boardwalk Pipeline Partners, LP, C.A. No. 2018-0372-JTL (Del. Ch. Oct. 7, 2019), the court reviews the Delaware law of the implied covenant:

“In order to plead successfully a breach of an implied covenant of good faith and fair dealing, the plaintiff must allege a specific implied contractual obligation, a breach of that obligation by the defendant, and resulting damage to the plaintiff.” Fitzgerald v. Cantor, 1998 WL 842316, at *1 (Del. Ch. Nov. 10, 1998). In describing the implied contractual obligation, the plaintiffs must allege facts suggesting “from what was expressly agreed upon that the parties who negotiated the express terms of the contract would have agreed to proscribe the act later complained of . . . had they thought to negotiate with respect to that matter.” Katz v. Oak Indus. Inc., 508 A.2d 873, 880 (Del. Ch. 1986). That is because “[t]he implied covenant seeks to enforce the parties’ contractual bargain by implying only those terms that the parties would have agreed to during their original negotiations if they had thought to address them.” El Paso, 113 A.3d at 184. Accordingly, “[t]he implied covenant is well-suited to imply contractual terms that are so obvious . . . that the drafter would not have needed to include the conditions as express terms in the agreement.” Dieckman, 155 A.3d at 361.

My question is simple: How do you know that the provision was left out because it was obvious? After all, if it was obvious, shouldn't the parties have put it in the contract? Put another way, how do you know the parties did think about it and decide to leave it out?

Agreed.  And I think this concept of the implied covenant matters more than ever, now that Delaware allows the elimination of the duty of loyalty in LLCs (my thoughts on that here). Even in allowing parties to eliminate the duty of loyalty in an LLC, such agreements always retain the duty of good faith and fair dealing. The Delaware LLC Act provides (emphasis added): 

§ 18-1101 Construction and application of chapter and limited liability company agreement.

. . .

(c) To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member’s or manager’s or other person’s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.

So what does that mean? I am of the mind that the implied covenant of good faith and fair dealing means that: (1) you get the express terms of the agreement, and (2) the agreement cannot take away all possible reasons for the deal in the first place.  As to the latter point, it means, quite simply, even without a duty of loyalty, there must be some reason for the contract to exist at all.  So, you may not be entitled to a fair share of proceeds from the agreement, or even a significant share.  But there must always be some value (or potential value) to have been gained by entering the agreement. At a minimum, it can't be an agreement to get nothing, no matter what. 

As one example, a Delaware court explained that a plaintiff's claim was lacking when the 

the incentive [gained by the defendant] complained of is obvious on the face of the OA [operating agreement]. The members, despite creating this incentive, eschewed fiduciary duties, and gave the Board sole discretion to approve the manner of the sale, subject to a single protection for the minority, that the sale be to an unaffiliated third party. . . . [T]he parties to the OA [thus considered] the conditions under which a contractually permissible sale could take place. They avoided the possibility of a self-dealing transaction but otherwise left to the [defendant] the ability to structure a deal favorable to their interests. Viewed in this way, there is no gap in the parties’ agreement to which the implied covenant may apply. The implied covenant, like the rest of our contracts jurisprudence, is meant to enforce the intent of the parties, and not to modify that expressed intent where remorse has set in.

Miller v HCP & Co., C.A. No. 2017-0291-SG (Del. Ch. Feb. 1, 2018). (More commentary on this case here.)

Furthermore, the implied covenant

does not apply when the contract addresses the conduct at issue, but only when the contract is truly silent concerning the matter at hand. Even where the contract is silent, an interpreting court cannot use an implied covenant to re-write the agreement between the parties, and should be most chary about implying a contractual protection when the contract could easily have been drafted to expressly provide for it.

Oxbow Carbon & Minerals Holdings, Inc. v. Crestview-Oxbow Acquisition, LLC, 202 A.3d 482, 507 (Del. 2019) (footnotes omitted). For more on this case see the Delaware Corporate &Commercial Litigation Blog. 

 

Parties have a lot of latitude, but I think the covenant of good faith and fair dealing means that there must be a reasonable effort to honor the express terms of the agreement and there must have been some reason to enter the contract. That's it.  It's not a lot, but it still has teeth where someone takes all of the things.  

Delaware's Duty of Care: Mrs. Pritchard Redux

This post is dedicated to the students in my Business Associations class, who took their final exam this morning.

Two weeks ago, reflecting on Francis v. United Jersey Bank, 432 A. 2d 814 (N.J. 1981), I asked for commentary on the following question: "How would the Francis case be pleaded, proven, and decided as a breach of duty action under Delaware law?"  That post generated some commentary--both online and in private messages to me.  In this post, I forward an analysis and a related request for commentary.

A number of commentators (including BLPB co-blogger Doug Moll in the online comments to my post) posited that a Caremark oversight claim may be the appropriate claim, and that the cause of action would be for a breach of the duty of care.  I find the latter part of that answer contestable.  Here is my analysis.

I begin by agreeing that Mrs. Pritchard's abdication of responsibility constitutes a failure to exercise oversight. Under the Delaware Supreme Court's decision in Stone v. Ritter, I understand that claim to be Caremark claim. ("Caremark articulates the necessary conditions for assessing director oversight liability.")  I think many, if not most, are also in agreement on this.

Here is where there may be some divergence.  Also relying on Stone, I understand that Caremark claim as a breach of the duty of loyalty, founded on a failure to act in good faith.  ("[B]ecause a showing of bad faith conduct . . . is essential to establish director oversight liability, the fiduciary duty violated by that conduct is the duty of loyalty.")  This makes sense to me because of the Delaware Supreme Court's opinion in Brehm v. Eisner, in which it circumscribes the duty of care.  ("Due care in the decisionmaking context is process due care only.")

However, Brehm (as evidenced in the immediately preceding parenthetical quote) addressed the duty of care under Delaware law in a decision-making context.  Francis was largely a case about the absence of decision making.  Moreover, the Brehm court's view on a substantive duty of care are rooted in the contradiction of that doctrine with the business judgment rule.  ("As for the plaintiffs' contention that the directors failed to exercise 'substantive due care,' we should note that such a concept is foreign to the business judgment rule. Courts do not measure, weigh or quantify directors' judgments.")  So, Brehm's wisdom on the duty of care under Delaware law may be inapplicable to facts like those in Francis, since the business judgment rule is inapplicable because the board did not engage in decision making.

Nevertheless, Stone seems to erect barriers to a duty of care claim for oversight like that presented in the Francis case.  BLPB co-blogger Anne Tucker voiced this concern in a 2010 article in the Delaware Journal of Corporate Law

Exculpatory provisions that eliminate liability for negligence and gross negligence (i.e., the duty of care), combined with the assumption of the duty of good faith under the liability standard for the duty of loyalty, narrow the standard of liability for director oversight. The result is while directors have three fiduciary duties-the duties of care, good faith, and loyalty-the three standards of conduct are essentially collapsed into one actionable standard: the duty of loyalty.

Anne Tucker Nees, Who's the Boss? Unmasking Oversight Liability Within the Corporate Power Puzzle, 35 Del. J. Corp. L. 199, 224–25 (2010).  Lyman Johnson similarly had commented, seven years earlier (and before the Stone case was decided)  that

care has been rendered a “small” notion in corporate law. It largely refers to the manner in which directors are to act. It is a process-oriented duty to act “with care.” Having confined care to that narrow chamber, the other meanings of care as found in the phrases “take care of” (the corporation) and “care for” (the corporation) remain fully available for infusion into corporate law through an expansive duty of loyalty.

Lyman Johnson, After Enron: Remembering Loyalty Discourse in Corporate Law, 28 Del. J. Corp. L. 27, 72 (2003).  Others also have written about this.

Based on the foregoing, I conclude that a duty of care cause of action is not available in Delaware for an oversight claim like that raised in Francis.  Delaware's duty of care comprises the duty to fully inform oneself of material information reasonably available under Smith v. Van Gorkom.  As a result, an oversight claim based on facts like those in Francis is a claim for a breach of the duty of loyalty as described in Stone.

Agree?  Disagree?  Provide analyses and, if possible, relevant decisional law.

Dissent Duly Noted: LLCs, Private Ordering, and Ample Notice

Over at Kentucky Business Entity Law Blog, Tom Rutledge recently posted Respectfully, I Dissent: Dean Fershee and Elimination of Fiduciary Duties, in response to my recent paper, An Overt Disclosure Requirement for Eliminating the Fiduciary Duty of Loyalty. Tom and I have crossed paths many times over the past few years, and I greatly value his insight, expertise, and opinion. On this one, though, we will have to agree to disagree, but I recommend checking out his writing.  You may well agree with him.  

I actually agree with Tom in most cases when he says, "I do not believe there is justification for protecting people from the consequences of the contracts into which they enter." Similarly, I generally agree with Tom "that entering into an operating agreement that may be amended without the approval of a particular member constitutes that member placing themselves almost entirely at the mercy of those with the capacity to amend the operating agreement . . . . "  Nonetheless, I maintain that there is a subtle but significant difference where, as in Delaware, such changes can be made to completely eliminate (not just reduce or modify) the fiduciary duty of loyalty. 

As applied, Tom may be right. Still, until Delaware's recent change, we had a long history, in every U.S. jurisdiction, prohibiting the elimination of the duty of loyalty. It is simply expected, that at some basic level, those in control of an entity owe the entity some level of a duty of loyalty. Because that is such a long-held rule and expectation, I remain convinced that the option to eliminate the duty requires some type of special notice to those entering an entity. Until now, even conceding that a lack of control could put an LLC member "almost entirely at the mercy of those with the capacity to amend the operating agreement," the amending member's power was still limited by the duty of loyalty.  

Ultimately, I tend to be a big fan of private ordering and freedom of contract, especially for LLCs. But, when we change fundamental rules, I also think we should more overtly acknowledge those changes, for at least some period of time, to let people catch up.  

What if . . . . Delaware and Mrs. Pritchard

Many of us teach Francis v. United Jersey Bank, 432 A. 2d 814 (N.J. 1981), in Business Associations courses as an example of a substantive duty of care case.  The case involves a deceased woman, Lillian Pritchard, who, in her lifetime, did nothing as a corporate director to curb her sons' conversions of corporate funds.  The court finds she has breached her duty of care to the corporation, stating that:

Mrs. Pritchard was charged with the obligation of basic knowledge and supervision of the business of Pritchard & Baird. Under the circumstances, this obligation included reading and understanding financial statements, and making reasonable attempts at detection and prevention of the illegal conduct of other officers and directors. She had a duty to protect the clients of Pritchard & Baird against policies and practices that would result in the misappropriation of money they had entrusted to the corporation. She breached that duty.

Id. at 826.  In sum:

by virtue of her office, Mrs. Pritchard had the power to prevent the losses sustained by the clients of Pritchard & Baird. With power comes responsibility. She had a duty to deter the depredation of the other insiders, her sons. She breached that duty and caused plaintiffs to sustain damages.

Id. at 829.

Francis is followed in our text by a number of additional fiduciary duty law cases, including Delaware's now infamous Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), Stone v. Ritter, 911 A.2d 362 (Del. 2006), and In re Walt Disney Derivative Litigation, 907 A 2d 693 (Del. 2005).  In covering these cases and discussing them with students during office hours, I became focused on the following passage from the Disney case:

The business judgment rule . . . is a presumption that "in making a business decision the directors of a corporation acted on an informed basis, . . . and in the honest belief that the action taken was in the best interests of the company [and its shareholders]." . . . .

This presumption can be rebutted by a showing that the board violated one of its fiduciary duties in connection with the challenged transaction. In that event, the burden shifts to the director defendants to demonstrate that the challenged transaction was "entirely fair" to the corporation and its shareholders.

In re Walt Disney Co. Derivative Litigation, 907 A.2d 693, 746-47 (Del. Ch. 2005).  I have some significant questions about the application of the "entire fairness" standard of review in certain types of cases.  In thinking those through with some of my colleagues (including a few of my co-bloggers), I realized I was curious about the answer to a related question: How would the Francis case be pleaded, proven, and decided as a breach of duty action under Delaware law?  

I have my own ideas.  But before I share them, I want yours.  How would you categorize/label the breach(es) of duty as a matter of Delaware law?  What standard of conduct and liability would you expect a Delaware court to apply as a matter of Delaware law?  And what standard of review would you expect that court to use?  Leave your ideas on any or all of the foregoing in the comments, please!

New Essay: An Overt Disclosure Requirement for Eliminating the Fiduciary Duty of Loyalty

I have a new(ish) essay that focuses on the concept of eliminating the fiduciary duty in an LLC, as permitted by Delaware law, and what that could mean for future parties. The paper can be found here (new link). When parties A and B get together to create an LLC, if they negotiate to eliminate their fiduciary agreements as to one another, I’m completely comfortable with that. They are negotiating for what they want; they are entering into that entity and operating agreement together of their own free will. So there may be differences in bargaining power—one may be wealthier than the other or have different kinds of power dynamics—but they are entering into this agreement fully aware of what the obligations are and what the options are for somebody in creating this entity.

My concern with eliminating fiduciary obligations comes down the road. That is, how do we make sure that if people are going to disclaim the fiduciary duty of loyalty, particularly, what happens if this change is made after formation? In such a case, I like to look at our traditional partnership law, which says there are certain kinds of decisions, at least absent an agreement to the contrary, that have to go to the entire group of entity participants. That is, a majority vote is not sufficient; there is essentially a minority veto.

I like the freedom of contract elimination of fiduciary duties provides, but I also am sensitive to the risks such eliminations can provide.  Thus, I argue that Delaware (and other states allowing reduction or elimination of the duty of loyalty) should require an express statement about the fiduciary duties (when modified from the default) and an express statement of how those duties can be modified, whether expanding, restricting, or eliminating the duties. To protect against the predatory modification of fiduciary duties, I believe that states should include a statutory requirement that changes to fiduciary duties must be express. Here’s my proposal:

Any limited liability company agreement that provides for a modification of the default rules for what constitutes a breach of duties (including fiduciary duties) of a member, manager or other person to a limited liability company, whether to expand, restrict, or eliminate those duties, must expressly state if the modifications are intended to expand, restrict, or eliminate the duties. Any limited liability company agreement that allows the modification of fiduciary duties must state expressly how those modifications can be made and by whom. Absent such any such statement, fiduciary duties may only be modified by agreement of all the members.

Supporting freedom of contract has value, but I also think we need to account for the fact that we did not traditionally allow for the elimination of fiduciary duties. As such, we should make sure that those participating in LLCs should know both what they signed up for initially, and also if the entity has provided the opportunity for a majority to make a fundamental change to traditional duties. This balance, I think, is essential to protecting investor expectations while still allowing for entities to develop the model that best serves the members’ goals.   

LLCs (Still Not Corporations) Win Some, Lose Some in New Opinion

In 2010, an Illinois court reviewed Delaware business law making the following observations:

With respect to a limited liability corporation, Delaware law states that “[u]nless otherwise provided in a limited liability company agreement, the management of a limited liability company shall be vested in its members....” 6 Del.C. § 18–402. Thus, pursuant to Delaware law, directors are generally provided with authority for managing the corporation and members are generally provided with authority for managing the limited liability company. The bankruptcy court therefore properly found that a member of a LLC would be an analogous position to a director of a corporation under Delaware law.

Longview Aluminum, L.L.C. v. Brandt, 431 B.R. 193, 197 (N.D. Ill. 2010), aff'd sub nom. In re Longview Aluminum, L.L.C., 657 F.3d 507 (7th Cir. 2011).

Well, initially, it must be noted that an LLC is not a corporation at all.  As the quoted Delaware law observes, it is a “limited liability company.” Corporations and LLCs are distinct entities. 

I’ll also take issue with adopting the bankruptcy court’s finding “that a member of an LLC would be an analogous position to a director of a corporation under Delaware law.”  I will concede that a member of an LLCmaybe an analogous position to a director of a corporation under Delaware law, but that is not inherently true. 

The Longview Aluminumcourt had determined that, “under Delaware law, a corporation generally must ‘be managed by or under the direction of a board of directors . . . .’” 8 Del. Code § 141. While that’s technically accurate, it understates that general nature of Delaware directors. Note that the statue is mandatory in nature (“shall”), and then provides limited changes:

The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation. If any such provision is made in the certificate of incorporation, the powers and duties conferred or imposed upon the board of directors by this chapter shall be exercised or performed to such extent and by such person or persons as shall be provided in the certificate of incorporation.

8 Del. Code § 141(a).

Remember, the Longview Aluminumcourt stated that, “[w]ith respect to a limited liability corporation, Delaware law states that ‘[u]nless otherwise provided in a limited liability company agreement, the management of a limited liability company shall be vested in its members....’ 6 Del.C. § 18–402.”  Id.

But Delaware LLC law provides:

“Unless otherwise provided in a limited liability company agreement, the management of a limited liability company shall be vested in its members in proportion to the then current percentage or other interest of members in the profits of the limited liability company owned by all of the members, the decision of members owning more than 50 percent of the said percentage or other interest in the profits controlling . . . .” 

6 Del. Code § 18-402.

That’s different in structure than directors. Directors act as a body, usually with one vote per director. This default provision provides for a very different structure, providing that one member with over 50% of the interests is controlling.  That’s not like a board at all.  And furthermore, those members  in charge of the entity may not have any fiduciary duties to the LLC. The Delaware LLC Act states:

“To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member's or manager's or other person's duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement . . . .” 6 Del. C. § 18-1101(c).

Corporate directors have some version of fiduciary duties. Again, a notable difference.  It appears that the Longview Aluminumcourt (affirming the bankruptcy court) may have been right to extend the corporate director concept to the LLC managers in that case because of the structure of the LLC’s operating agreement.  But the court went on to imply that a member of a LLC is“an analogous position to a director of a corporation under Delaware law.” That very much overstates things.

Why discuss this 2010-11 case at length now? Because this section was cited last week:

“[I]n referencing a director, Section 101(31)(B) was intended to refer to the party that “managed” the debtor corporation.” Longview Aluminum, L.L.C. v. Brandt, 431 B.R. 193, 197 (N.D. Ill. 2010) (citing 11 U.S.C. § 101(31)(B)). “With respect to a limited liability corporation, Delaware law states that ‘[u]nless otherwise provided in a limited liability company agreement, the management of a limited liability company shall be vested in its members ....” Id. (quoting 6 Del.C. § 18–402).

In re Licking River Mining, LLC, No. 14-10201, 2019 WL 2295680, at *41 (Bankr. E.D. Ky. July 19, 2019), as amended (July 19, 2019).

Fortunately, other than failing to correct the mistake of calling an LLC a corporation, the Licking River Miningseems to have gotten the outcome right.  The court determined that a 25% member interest lacked control because all LLC “decisions were to be made either by a majority of the LLC interests or by the entity's managing member.”Id.Good call, and hopefully this case will clarify (and correct) any negative implications from the Longview Aluminum case.  But even if it does, it gives longer life to an incorrect reference to LLCs and increases the likelihood it will be cited repeatedly. 

Win some, lose some, I guess.

 

 

Can A Board's Knowing Violation of the Law Also Be Entirely Fair? How About Moral?

Prof. Justin Pace, Haworth College of Business,  Western Michigan University recently sent me his paper, Rogue Corporations: Unlawful Corporate Conduct and Fiduciary Duty. In it, he discusses Delaware's "per se doctrine where the board directs the corporation to violate the law. A knowing violation of positive law is bad faith, which falls under the duty of loyalty. The business judgment rule will not apply and exculpation will not be available under Section 102(b)(7). The shareholders may not even need to show harm." 

In the paper, he considers this concept from a moral and ethical perspective, which are interesting in their own right, though I remain more interested in the doctrine itself.  The paper is worth a look.  A few comments of my own, after the abstract:

Abstract

On February 28, 2018, Dick’s Sporting Goods announced that it would no longer sell long guns to 18- to 20-year-olds. On March 8, 2018, Dick’s was sued for violating the Michigan Elliott-Larsen Civil Rights Act, which prohibits discrimination on the basis of age in public accommodations. Dick’s and Walmart were also sued for violating Oregon’s ban on age discrimination. In addition to corporate liability under various state civil rights acts, directors of Dick’s and Walmart face the threat of suit for breaching their fiduciary duties—suits that may be much harder to defend than the more usual breach of fiduciary duty suit.

Delaware corporation law appears to have an underappreciated per se doctrine where the board directs the corporation to violate the law. A knowing violation of positive law is bad faith, which falls under the duty of loyalty. The business judgment rule will not apply and exculpation will not be available under Section 102(b)(7). The shareholders may not even need to show harm.

This paper examines the relevant legal doctrine but also takes a step back to consider what the rule should be from an ethical and a moral standpoint. To do so, rather than apply traditional corporate governance arguments, this paper considers broader moral theories. In addition to the utilitarian calculus that is so ubiquitous in corporate governance scholarship via the law and economics movement, this paper considers the liberalism of both John Rawls and Robert Nozick. But liberalism may seem less persuasive given the rise of illiberalism politically on both the American right and left. Given that, this paper also considers two non-liberal models: one a populist modification of Charles Taylor’s democratic communitarianism and the other Catholic Social Thought.

Unsurprisingly, the proper rule depends on which moral theory is applied. If that theory is liberalism (of either form covered), then a per se approach is troubling. Harm to the corporation must be shown, and either the Delaware legislature or the corporate players, depending on the form of liberalism, must acquiesce to a per se rule. Counterintuitively, it is the per se rule that runs counter to basic democratic norms. It gives the power to litigate in response to harm not to the party harmed but to a third party. Given the divergent results from applying different moral theories, and given the democratic difficulty, the Delaware legislature should clarify the standard. It will likely find that a harsh, per se standard is unjustified.

First, I have always thought that some people read DGCL § 102(b)(7) too literally (or at least broadly).  The statute reads:

(b) In addition to the matters required to be set forth in the certificate of incorporation by subsection (a) of this section, the certificate of incorporation may also contain any or all of the following matters: 

. . . .

(7) A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director:  (i) For any breach of the director's duty of loyalty to the corporation or its stockholders;  (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law;  (iii) under § 174 of this title;  or (iv) for any transaction from which the director derived an improper personal benefit.  No such provision shall eliminate or limit the liability of a director for any act or omission occurring prior to the date when such provision becomes effective.  All references in this paragraph to a director shall also be deemed to refer to such other person or persons, if any, who, pursuant to a provision of the certificate of incorporation in accordance with § 141(a)of this title, exercise or perform any of the powers or duties otherwise conferred or imposed upon the board of directors by this title.

I have never been one to believe that directors face potential liability for any type of "knowing violation of law."  Anyone who has seen a UPS or FedEx truck in New York City knows that the drivers knowingly park illegally and risk tickets (which they often get) for doing the job. It is a cost of doing business, and I find it hard to believe any court would hold directors liable for such a thing, though directors certainly know (or should) of the practice. That would make for one of the most absurd Caremark-like cases ever, in my view.

Prof. Pace argues in his paper:

A per se standard might prove lucrative. It opens up liability for losses normally insulated by business judgment rule. If Nike loses market share because it made Colin Kaepernick the face of a large marketing campaign, shareholders cannot successfully sue because that decision is protected by the business judgment rule. But if Dick’s Sporting Goods loses market share because it stops selling long guns to 18- to 20-year-olds, shareholders presumably can sue and recover based on that market share, even though civil liability for violating state bars on age discrimination may be negligible.

Perhaps, but I would still think that most courts would likely work around this. First, I think a court could easily calculate damages as the modest civil liability incurred, not the lost market share.  Second, in Dick's Sporting Goods situation, as I observed elsewhere, "it is worth noting that Dick's sales dropped, but profits rose after the decision because the company cut costs by replacing some guns with higher-margin items." If there is no harm, is there a foul? Or maybe better said, it is possible that there is no director liability unless one can show actual harm. 

I will concede that DGCL § 102(b)(7) likely eliminates business judgment rule protection for directors where one can show a knowing violation of the law. However, getting past the business judgment rule does not automatically lead to liability.  It simply allows the court to review the board's decision, but the plaintiff still must show harm. And I am not at all sure one can show harm in the Dick's gun sales circumstance. It is, in my view, entirely fair. I also gather that I am may be in the minority on this one.  But a good conversation, either way.  

Delaware Supreme Court Affirms Triggering of MAE Clause

In Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715, 730 (Del. Ch. 2008) – a case I worked on as a judicial clerk – the court wrote, “[m]any commentators have noted that Delaware courts have never found a material adverse effect to have occurred in the context of a merger agreement.”

That statement is no longer true.

Today--in a 3 page opinion--the Delaware Supreme Court affirmed the 240+ page opinion by Vice Chancellor Travis Laster in Akorn, Inc. v. Fresenius Kabi, AG, et al., which held that Akorn triggered the Material Adverse Effect ("MAE") clause of the merger agreement at issue.

As the Chancery Daily reports, and as is clear looking at the recent opinions, the Delaware Supreme Court opinion does not provide much reasoning for its decision to affirm, but the Court of Chancery opinion does provide plenty of guidance. In the first few pages, the Court of Chancery notes that Akorn experienced a "dramatic, unexpected, and company-specific downturn in...business that began in the quarter after signing." The Court of Chancery also notes the importance of whistleblower letters and issues with Akron and the FDA. 

Also of interest, the court notes that this was an expedited case -- a real benefit of the Delaware Court of Chancery. The parties only had 11 weeks leading up to the trial. At the five day trial, there were 54 depositions transcripts lodged, 1,892 exhibits introduced into evidence, and 16 live witnesses (including 7 experts). Those poor lawyers -- and judicial clerks! 

Not the Default Rule, But LLC Members Definitely Can Be Employees

Last week I posted Can LLC Members Be Employees? It Depends (Because of Course It Does), where I concluded that "as far as I am concerned, LLC members can also be LLCs employees, even though the general answer is that they are not. " I thought I would follow up today with an example of an LLC member who is also an employee.  

I am not teaching Business Associations until next semester, but it galls me a little that I did not note this case last week, as it is a case that I teach as part of the section on fiduciary duties in Delaware.  

The case is Fisk Ventures, LLC v. Segal and the relevant facts excerpted from the case are as follows: 

Genitrix, LLC, is a Delaware limited liability company formed to develop and market biomedical technology. Dr. Segal founded the Company in 1996 following his postdoctoral fellowship at the Whitehead Institute for Biomedical Research. Originally formed as a Maryland limited liability company, Genitrix was moved in 1997 to Delaware at the behest of Dr. H. Fisk Johnson, who invested heavily. 

Equity in Genitrix is divided into three classes of membership. In exchange for the patent rights he obtained from the Whitehead Institute, Segal's capital account was credited with $500,000. This allowed him to retain approximately 55% of the Class A membership interest. . . . 

 

Under the [LLC] Agreement, the Board of Member Representatives (the “Board”) manages the business and affairs of the Company. As originally contemplated by the Agreement, the Board consisted of four members: two of whom were appointed by Johnson and two of whom were appointed by Segal. In early 2007, however, the balance of power seemingly shifted. . . . 

 

Dr. Andrew Segal, fresh out of residency training, worked for the Whitehead Institute for Biomedical Research . . . [and when he] left the Whitehead Institute and obtained a license to certain patent rights related to his research.

With these patent rights in hand, Dr. Segal formed Genitrix. Intellectual property rights alone, however, could not fund the research, testing, and trials necessary to bring Dr. Segal's ideas to some sort of profitable fruition. Consequently, Segal sought and obtained capital for the Company. Originally, Segal served as both President and Chief Executive Officer, and the terms of his employment were governed by contract (the “Segal Employment Agreement”). Under the Segal Employment Agreement, any intellectual property rights developed by Dr. Segal during his tenure with Genitrix would be assigned to the Company.

Fisk Ventures, LLC v. Segal, No. CIV.A. 3017-CC, 2008 WL 1961156, at *2 (Del. Ch. May 7, 2008) (emphasis added) (footnotes omitted).  

So, for my purposes, that's a solid example of an LLC member who is also an employee, and it is from a case featured in more than one casebook, I might add.  

Co-blogger Joan Heminway noted in a comment to last week's post that what it means to be an employee can vary, based on statutory and other conditions, which is certainly true. I stand by my prior conclusion that it depends on the case whether a particular member of an LLC is an employee, and even that can vary based on context.  Thus, LLC members are not inherently employees, and perhaps most of the time they are not, but it's also true that LLC members can be employees. 

Finally, as to the Fisk Ventures case, in case you're curious, the short of it is that Fisk decided not to provide additional financing to Genitirx, and Segal sued claimed that not doing so breached certain fiduciary duties under the LLC agreement and further various acts "tortiously interfered with the Segal Employment Agreement."  Ultimately, Chancellor Chandler determined that there was no duty breached, the obligation of good faith and fair dealing did not block certain members from exercising express contractual rights, and the agreement's clause disclaming any fiduciary duties was valid.