Business Law Prof Blog

Revising How to Handle Derivative Claims (or Not)

Yesterday, Professor Bainbridge posted "Is there a case for abolishing derivative litigation? He makes the case as follows: 

A radical solution would be elimination of derivative litigation. For lawyers, the idea of a wrong without a legal remedy is so counter-intuitive that it scarcely can be contemplated. Yet, derivative litigation appears to have little if any beneficial accountability effects. On the other side of the equation, derivative litigation is a high cost constraint and infringement upon the board’s authority. If making corporate law consists mainly of balancing the competing claims of accountability and authority, the balance arguably tips against derivative litigation. Note, moreover, that eliminating derivative litigation does not eliminate director accountability. Directors would remain subject to various forms of market discipline, including the important markets for corporate control and employment, proxy contests, and shareholder litigation where the challenged misconduct gives rise to a direct cause of action.

If eliminating derivative litigation seems too extreme, why not allow firms to opt out of the derivative suit process by charter amendment? Virtually all states now allow corporations to adopt charter provisions limiting director and officer liability. If corporate law consists of a set of default rules the parties generally should be free to amend, as we claim, there seems little reason not to expand the liability limitation statutes to allow corporations to opt out of derivative litigation.

I think he makes a good point.  And included in the market discipline and other measures that Bainbridge notes would remain in place to maintain director accountability, there would be the shareholder response to the market.  That is, if shareholders value derivative litigation as an option ex ante, the entity can choose to include derivative litigation at the outset or to add it later if the directors determine the lack of a derivative suit option is impacting the entity's value.  

Professor Bainbridge's post also reminded me of another option: arbitrating derivative suits.  A friend of mine made just such a proposal several years ago while we were in law school: 

There are a number of factors that make the arbitration of derivative suits desirable. First, the costs of an arbitration proceeding are usually lower than that of a judicial proceeding, due to the reduced discovery costs. By alleviating some of the concern that any D & O insurance coverage will be eaten-up by litigation costs, a corporation should have incentive to defend “frivolous” or “marginal” derivative claims more aggressively. Second, and directly related to litigation costs, attorneys' fees should be cut significantly via the use of arbitration, thus preserving a larger part of any pecuniary award that the corporation is awarded. Third, the reduced incentive of corporations to settle should discourage the initiation of “frivolous” or “marginal” derivative suits.

Andrew J. Sockol, A Natural Evolution: Compulsory Arbitration of Shareholder Derivative Suits in Publicly Traded Corporations, 77 Tul. L. Rev. 1095, 1114 (2003) (footnote omitted). 

Given the usually modest benefit of derivative suits, early settlement of meritorious suits, and the ever-present risk of strike suits, these alternatives are well worth considering.  

More on Corporations, Accountability, and the Proper Locus of Power

My colleague, Joan Heminway, yesterday posted Democratic Norms and the Corporation: The Core Notion of Accountability. She raises some interesting points (as usual), and she argues: "In my view, more work can be done in corporate legal scholarship to push on the importance of accountability as a corporate norm and explore further analogies between political accountability and corporate accountability."

I have not done a lot of reading in this area, but I am inclined to agree that it seems like an area that warrants more discussion and research.  The post opens with some thought-provoking writing by Daniel Greenwood, including this:  

Most fundamentally, corporate law and our major business corporations treat the people most analogous to the governed, those most concerned with corporate decisions, as mere helots. Employees in the American corporate law system have no political rights at all—not only no vote, but not even virtual representation in the boardroom legislature.

Joan correctly observes, "Whether you agree with Daniel or not on the substance, his views are transparent and his belief and energy are palpable." Although I admit I have not spent a lot of time with his writing, but my initial take is that I do not agree with his premise. That is, employees do have political rights, and they have them where they belong: in local, state, and federal elections.  Employees, in most instances, do not have political rights within their employment at all.  Whether you work for the government, a nonprofit, or a small sole proprietorship, you don't generally have political rights as to your employment.  You may have some say in an employee-owned entity, and you may have some votes via union membership, but even there, those votes aren't really as to your employment specifically. 

 

The idea of seeking democratic norms via the corporate entity itself strikes me as flawed.  If people don't like how corporations (or other entities) operate, then it would seem to me the political process can solve that via appropriate legislation or regulation. That is, make laws that allow entities to do more social good if they are so inclined. Or even require entities to do so, if that's the will of the people (this is not a recommendation, merely an observation).  Scholars like Greenwood and others continue to make assertions that entities cannot make socially responsible choices. He states, " The law bars [corporations], in the absence of unanimous consent, from making fundamental value choices, for example, from balancing the pursuit of profit against other potential corporate goals, such as quality products, interests of non-shareholder participants or even the actual financial interests of the real human beings who own the shares."  And judges and scholars, like Chancellor Chandler and Chief Justice Strine, have reinforced this view, which, I maintain, is wrong (or should be).  

 

Professor Bainbridge has explained, "The fact that corporate law does not intend to promote corporate social responsibility, but rather merely allows it to exist behind the shield of the business judgment rule becomes significant in -- and is confirmed by -- cases where the business judgment rule does not apply." Todd Henderson similarly argued, and I agree, 

Those on the right, like Milton Friedman, argue that the shareholder-wealth-maximization requirement prohibits firms from acting in ways that benefit, say, local communities or the environment, at the expense of the bottom line. Those on the left, like Franken, argue that the duty to shareholders makes corporations untrustworthy and dangerous. They are both wrong.

I don't disagree with Joan (or with Greenwood, for that matter), that accountability matters, but I do think we should frame accountability properly, and put accountability where it belongs.  That is political accountability and corporate accountability are different. As I see it, corporations are not directly accountable to citizens (employees or not) in this sense (they are in contract and tort, of course). Corporations are accountable to their shareholders, and to some degree to legislators and regulators who can modify the rules based on how corporations act.  Politicians, on the other hand, are accountable to the citizens.  If citizens are not happy with how entities behave, they can take that to their politicians, who can then choose to act (or not) on their behalf.  

 

I think entities should consider the needs of employees, and I believe entities would be well served to listen to their employees. I happen to think that is good business. But I think the idea that employees have a right to a formal voice at the highest levels within the entity is flawed, until such time as the business itself or legislators or regulators decide to make that the rule. (I do not, to be clear, think that would be a good rule for legislators or regulators to make for private entities.) The proper balance of laws and regulations is a separate question from this discussion, though. Here, the key is that accountability -- or, as Prof. Bainbridge says, "the power to decide" -- remains in the right place.  I am inclined to think the power structure is correct right now, and whether that power is being used correctly is an entirely different, and separate, issue.  

Long Live Director Primacy: Social Benefit Entities and the Downfall of Social Responsibility

The more I read about social enterprise entities, the less I like about them.  In 2014, my colleague Elaine Wilson and I wrote March of the Benefit Corporation: So Why Bother? Isn’t the Business Judgment Rule Alive and Well?  We observed:

Regardless of jurisdiction, there may be value in having an entity that plainly states the entity’s benefit purpose, but in most instances, it does not seem necessary (and is perhaps even redundant). Furthermore, the existence of the benefit corporation opens the door to further scrutiny of the decisions of corporate directors who take into account public benefit as part of their business planning, which erodes director primacy, which limits director options, which can, ultimately, harm businesses by stifling innovation and creativity.  In other words, this raises the question: does the existence of the benefit corporation as an alternative entity mean that traditional business corporations will be held to an even stricter, profit-maximization standard?

I am more firmly convinced this is the path we are on.  The emergence of social enterprise enabling statutes and the demise of director primacy threaten to greatly, and gravely, limit the scope of business decisions directors can make for traditional for-profit entities, threatening both social responsibility and economic growth. Recent Delaware cases, as well as other writings from Delaware judges, suggest that shareholder wealth maximization has become a more singular and narrow obligation of for-profit entities, and that other types of entities (such as non profits or benefit corporations) are the only proper entity forms for companies seeking to pursue paths beyond pure, and blatant, profit seeking. Now that many states have alternative social enterprise entity structures, there is an increased risk that traditional entities will be viewed (by both courts and directors) as pure profit vehicles, eliminating directors’ ability to make choices with the public benefit in mind, even where the public benefit is also good for business (at least in the long term). Narrowing directors’ decision making in this way limits the options for innovation, building goodwill, and maintaining an engaged workforce, to the detriment of employees, society, and, yes, shareholders. 

I know there are some who believe that I see the sky falling when it's just a little rain. Perhaps. I would certainly concede that the problems I see can be addressed through law, if necessary.  I am just not a big fan of passing some more laws and regulations, so we can pass more laws to fix the things we added.  My view of entity purpose remains committed to the principle of director primacy.  Directors are obligated to run the entity for the benefit of the shareholders, but, absent fraud, illegality, or self-dealing, the directors decide what actions are for the benefit of shareholders. Period, full stop.  

Why Do So Many People Assume States Can Disregard Series LLCs?

The Uniform Law Commission is in the process of considering the Limited Liability Company Protected Series Act (f/k/a Series of Unincorporated Business Entities Act), and the final reading is schedule to take place in July 2017.  (Draft is here.) I have been discussing the challenges of Series LLCs with a variety of folks, and it strikes me that a consistent theme about the Series LLC is a concern about asset protection between each LLC in there Series. That is, there is concern that some courts may disregard the separateness of each LLC in the Series and treat the entire Series as a single entity.  I share this concern, but it strikes me that it is a rather outlandish concern that a court would do so without some significant level of fraud or other injustice to warrant whatever the state version of veil piercing would mandate. 

One source goes so far as to state: 

Case law has not been developed on Series LLCs yet, and there is much fear in the professional world that the assets may not be as protected as when the entity is formed. What is clear is that the “corporate formalities” must be carefully followed, such that:

1. Separate books and records should be maintained for each series;

2. Creditors need to be made specifically aware of the separate existence of each series; and

3. The assets of each must be unambiguously identified as belonging to that series.

I don't consider these corporate formalities as at all, given that we're talking about an LLC, but it's true that any Series LLC would be well served to follow the entity formalities we'd expect of any entity seeking to protect limited liability.  Perhaps because the Series LLC as an entity is new, there is a need for heightened vigilance, but I am of the mind these kinds of measures are proper for all entities, if one wants to reduce the likelihood of veil piercing, enterprise liability, or other agency/guarantor concerns.  

Another source warns of the risks of the Series LLC:

The biggest problem with series LLCs is that many states (including California) don’t have series legislation and may choose to ignore the laws of the state where the series was created. That’s because you’re subject to their rules when doing business in their state. The example of the attitude of the California Franchise Tax Board applies to fees, but liability protection is also an issue. Since series LLCs are so new they’ve never been tested by courts, even in the states that permit them. That means there’s no guarantee that limited liability protection will be extended to each series until every state rules on the subject. It’s hard to see how a court would choose to grant this kind of protection inside one entity, and only time will tell if courts will do this. But do you want this type of uncertainty when you are trying to protect your assets?

Again, perhaps valid, but the idea that a state would simply ignore a properly created entity formed in another state is an outrageous proposition, in my mind.  If a state sees fit to define an entity, and such an entity is properly formed, that should be sufficient to follow the entity rules.  That might be different if a state were to write a law that specifically disallows certain kinds of entity structures. (I'd likely have a problem with that, too, but on the merits of such a law.)  And some laws clearly change the analysis, like bankruptcy. But to simply disregard another state's entity structure if the business is properly operating? That's not right.  

Anyway, I agree with those who are cautious about the relative limited liability protections of the Series LLC, especially outside of the eight(?) states that have such laws (Delaware, Nevada, Illinois, Iowa, Oklahoma, Tennessee, Texas and Utah). But I do find it disturbing that so many people are comfortable with the idea that courts would (and perhaps should) be so inherently skeptical of a structure chosen by a state legislature that the court would disregard the concept completely.  I am all for requiring entities to be clear which entity is to bound (and I think those doing business with those entities should seek guarantees, co-signers, or other assurances where they want them).  Courts allowing plaintiffs to expand limited liability beyond a Series entity to include other entities, based only on the use of the Series structure, is different. Like haphazard veil piercing, such decisions run the risk of incentivizing careless or ambiguous drafting and give creditors a chance to pursue a windfall in the form of an un-negotiated guarantee. 

As I often remind my students, to argue against the concept of limited liability is a very different thing than arguing that the current law allows one to disregard an entity in a particular circumstance. One asks, "What should be?,"  while the other asks, "What is?"  And to dislike the idea of a Series LLC is very different than suggesting a Series LLC law is invalid.  There, the former says what the law should be,"  while the latter says that what is, is not.  

 

First Standalone Publicly Traded Benefit Corporation - Laureate Education

Laureate Education recently became the first standalone publicly traded benefit corporation. They are organized under Delaware's public benefit corporation (PBC) law, are also a certified B corporation, and will be trading as LAUR on NASDAQ.  

Plum Organics, also a Delaware PBC, is a wholly owned subsidiary of publicly-traded Campbell Soup Company. And Etsy is a publicly traded certified-B corporation, but is organized under traditional Delaware corporation law.

Whether the for-profit educator Laureate will hurt or help the popularity of benefit corporations remains to be seen, but some for-profit educators have not been getting good press lately.

Inside Higher Ed reports on Laureate Education's IPO as a benefit corporation below:

The largest U.S.-based for-profit college chain became the first benefit corporation to go public Wednesday morning.

Laureate Education, which has more than a million students at 71 institutions across 25 countries, had been privately traded since 2007. Several major for-profit higher education companies have over the last decade bounced back and forth between publicly and privately held status; also yesterday, by coincidence, the Apollo Group, owner of the University of Phoenix, formally went back into private hands….In its public debut, the company raised $490 million….

Becker said the move to become the first benefit corporation that is public is one way to show that Laureate is putting quality first.“There is certainly plenty of skepticism about whether for-profit companies can add value to society, and I feel strongly we can,” Becker said, adding that Laureate received certification from the nonprofit group B Lab after years of “rigorous” evaluations….

But the certification and the move to becoming a benefit corporation doesn’t prove a for-profit will not make bad decisions or commit risky actions that hurt students, said Bob Shireman, a senior fellow at the Century Foundation and for-profit critic.

"The one thing that being a benefit corporation does is reduce the likelihood that shareholders would sue the corporation for failing to operate in the shareholders' financial interest," Shireman said. "So it makes a marginal difference, and there's no evidence that benefit corporations, in the 10 or so years they've existed in the economy, cause better behavior."

Companies and investors could make better choices and decisions for their students without needing a benefit corporation model to do that, Shireman said, adding that the legal protection it provides is small.

"What's more important are what commitments are being made under the rubric of being a benefit corporation," he said. "How is that going to be measured and enforced … and how can they be changed or overruled by stockholders."

Head of Legal Policy at B Lab Rick Alexander, also authored a post on Laureate Education. For those who do not know, B Lab is the nonprofit responsible for the B Corp Certification and an important force behind the benefit corporation legislation that has passed in 30 states.

 

Appraisal Standard Intellectual "Cage Match": DFC Global Corp Amici Briefs

Prominent corporate governance, corporate finance and economics professors face off in opposing amici briefs filed in DFC Global Corp. v.  Muirfield Value Partners LP, appeal pending before the Delaware Supreme Court.   The Chancery Daily newsletter, described it, in perhaps my favorite phrasing of legal language ever:  "By WWE standards it may be a cage match of flyweight proportions, but by Delaware corporate law standards, a can of cerebral whoopass is now deemed open."   

Point #1: Master Class in Persuasive Legal Writing: Framing the Issue

Reversal Framing: "This appeal raises the question whether, in appraisal litigation challenging the acquisition price of a company, the Court of Chancery should defer to the transaction price when it was reached as a result of an arm’s-length auction process."

vs.

Affirmance Framing: "This appeal raises the question whether, in a judicial appraisal determining the fair value of dissenting stock, the Court of Chancery must automatically award the merger price where the transaction appeared to involve an arm’s length buyer in a public sale."

Point #2:  Summary of Brief Supporting Fair Market Valuation:  Why the Court of Chancery should defer to the deal price in an arm's length auction

• It would reduce litigation and simply the process.
• The Chancery Court Judges are ill-equipped for the sophisticated cash-flow analysis (ouch, that's a rough point to make).
• Appraisal does not properly incentivize the use of arm's length auctions if they are not sufficiently protected/respected.
• Appraisal seeks the false promise of THE right price, when price in this kind of market (low competition, unique goods) can best be thought of as a range.  The inquiry should be whether the transaction price is within the range of a fair price.  A subset of this argument (and the point of the whole brief) is that the auction process is the best evidence of fair price.
• Appraisal process is flawed because the court discounted the market price in its final valuation.  The argument is that if the transaction price is not THE right price, then it should not be a factor in coming up with THE right price.
• Appraisal process is flawed because the final valuation relies upon expert opinions that are created in a litigation vacuum, sealed-off from market pressure of "real" valuations.
• The volatility in the appraisal market—the outcome of the litigation and the final price—distorts the auction process.  Evidence of this is the creation of appraisal closing conditions.

Point #3: Summary of Brief Supporting Appraisal Actions:  Why the Court of Chancery should reject a rule that the transaction price—in an arm's length auction—is conclusive evidence of fair price in appraisal proceedings.

• Statutory interpretation requires the result.  Delaware Section 262 states that judges will "take into account all factors" in determining appraisal action prices.  To require the deal price to be the "fair" price, eviscerates the statutory language and renders it null.  
  • The Delaware Legislature had an opportunity to revise Section 262—and did so in 2015, narrowing the scope of eligible appraisal transactions and remedies—but left intact the "all factors" language.
• The statutory appraisal remedy is separate from the common law/fiduciary obligations of directors in transactions so a transaction without a conflict of interest and even cured by shareholder vote could still contain fact-specific conditions that would make an appraisal remedy appropriate.
• There are appropriate judicial resources to handle the appraisal actions because of the expertise of the Court of Chancery, which is buttressed by the ability to appoint a neutral economic expert to assist with valuations and to adopt procedures and standards for expert valuations in appraisal cases.
• The threat of the appraisal action creates a powerful ex ante benefit to transaction price because it helps bolster and ensure that the transaction price is fair and without challenge.
• Appraisal actions serve as a proxy for setting a credible reserve in the auction price, which buyers and sellers may be prohibited from doing as a result of their fiduciary duties.
• Any distortion of the THE market by appraisal actions is a feature, not a bug.  All legal institutions operate along side markets and exert influences, situations that are acceptable with fraud and torts.  Any affect that appraisal actions create have social benefits and are an intended benefit.
• Let corporations organized/formed in Delaware enjoy the benefits of being a Delaware corporation by giving them full access to the process and expertise of the Delaware judiciary.

Conclusions:

My thinking in the area more closely aligns with the "keep appraisal action full review" camp on the theory--both policy and economic.  Also the language in the supporting/affirmance brief is excellent (they describe the transaction price argument as a judicial straight jacket!).  I must admit, however, that I am sympathetic to the resources and procedural criticisms raised by the reversal brief. That there is no way for some corporate transactions, ex ante, to prevent a full scale appraisal action litigation—a process that is costly and time consuming—is a hard pill to swallow.  I can imagine the frustration of the lawyers explaining to a BOD that there may be no way to foreclose this outcome.  Although I hesitate to put it in these terms, my ultimate conclusion would require more thinking about whether the benefits of appraisal actions outlined in the affirmance brief outweigh the costs to the judiciary and to the parties as outlined in the reversal brief.  These are all points that I invite readers to weigh in on the comments--especially those with experience litigating these cases.

I also want to note the rather nuanced observation in the affirmance brief about the distinction between statutory standards and common law/fiduciary duty.  This important intellectual distinction about the source of the power and its intent is helpful in appraisal actions, but also in conflict of interest/safe harbor under Delaware law evaluations.

For the professors out there, if anyone covers appraisal actions in an upper-level course or has students writing on the topic-- these two briefs distill the relevant case law and competing theories with considerable force.  

-Anne Tucker

Delaware Pre-suit Demand Refusal & Bad Faith Standards

Spoiler alert:  wrongful refusal of demand and bad faith standards are the same in recent Delaware Court of Chancery case: Andersen v. Mattel, Inc., C.A. No. 11816-VCMR (Del. Ch. Jan. 19, 2017, Op by VC Montgomery-Reeves).  

But sometimes a reminder that the law is the same and can be clearly stated is worth a blog post in its own right.  Professors can use this as a hypo or case note and those in the trenches can update case citations to a 2017 (and 2016) case.

In Andersen v. Mattel, Inc., VC Montgomery-Reeves dismissed a derivative suit, holding that plaintiff did not prove wrongful refusal of pre-suit demand.  The derivative action claimed that the Mattel board of directors refused to bring suit to recover up to $11.5 million paid in severance/consulting fees to the former chairman and chief executive officer who left in the wake of a falling stock price. Plaintiff challenged disclosure discrepancies over whether Stockton resigned or was terminated and the resulting entitlement to severance payments.  Mattel's board of directors unanimously rejected the demand after consultation with outside counsel, 24 witness interviews and a review of approximately 12,400 documents.

The relied upon case law is unchanged, but the clear recitation of the law is worth noting:

Where, as here, a plaintiff makes demand on the board of directors, the plaintiff concedes that the board is disinterested and independent for purposes of responding to the demand. The effect of such concession is that the decision to refuse demand is treated as any other disinterested and independent decision of the board—it is subject to the business judgment rule. Accordingly, the only issues the Court must examine in analyzing whether the board’s demand refusal was proper are “the good faith and reasonableness of its investigation. (internal citations omitted)

To successfully challenge the good faith and reasonableness of the board's investigation, Plaintiff's complaint was required to state particularized facts raising a reasonable doubt that: 

(1) the board’s decision to deny the demand was consistent with its duty of care to act on an informed basis, that is, was not grossly negligent; or (2) the board acted in good faith, consistent with its duty of loyalty. Otherwise, the decision of the board is entitled to deference as a valid exercise of its business judgment.

First, Plaintiff challenged the board's demand refusal on the grounds that they did not disclose the investigation report or the supporting documents in conjunction with the demand refusal.  The Court was unpersuaded given that Plaintiff had the right to seek the report and records through a Section 220 demand, but chose not to do so.

Second, Plaintiff challenged the board's demand refusal on the grounds that it failed to form a special committee. Absent any facts that the Mattel board considering the demand was not independent, there was no requirement for the board to form a special committee.

Third, and final, Plaintiff challenged the board's good faith in rejecting the demand on the grounds that Stockton's employment was not voluntarily terminated. The court cautioned that:

[T]he question is not whether the [b]oard’s conclusion was wrong; the question is whether the [b]oard intentionally acted in disregard of [Mattel’s] best interests in deciding not to pursue the litigation the Plaintiff demanded. [T]he fact that the [b]oard’s justifications for  refusing [the] demand fall within ‘the bounds of reasonable judgment’ is fatal to [the] claim that the refusal was made in bad faith. (citing to Friedman v. Maffei, (Del. Ch. Apr. 13, 2016))

Francis Pileggi at the excellent Delaware Corporate and Commercial Litigation Blog first brought this case to my attention.  Practitioners and Professors alike should be certain to include his blog on your weekly round up.  He is a sure source of concise and insightful summaries of the latest Delaware court developments.  

-Anne Tucker

The Importance of the Business Judgment Rule

Bernard Sharfman, a prolific author on corporate governance, has written his fourth article on the business judgment rule. The piece provides a thought-provoking look at a subject that all business law professors teach. He also received feedback from Myron Steele, former Chief Justice of the Delaware Supreme Court, and William Chandler III, former Chancellor of the Delaware Court of Chancery during the drafting process. I don’t think I will assign the article to my students, but I may take some of the insight when I get to this critical topic this semester. Sharfman has stated that he aims to change the way professors teach the BJR.

The abstract is below:

Anyone who has had the opportunity to teach corporate law understands how difficult it is to provide a compelling explanation of why the business judgment rule (Rule) is so important. To provide a better explanation of why this is so, this Article takes the approach that the Aronson formulation of the Rule is not the proper starting place. Instead, this Article begins by starting with a close read of two cases that initiated the application of the Rule under Delaware law, the Chancery and Supreme Court opinions in Bodell v. General Gas & Elec. By taking this approach, the following insights into the Rule were discovered that may not have been so readily apparent if the starting point was Aronson.

First, without the Rule, the raw power of equity could conceivably require all challenged Board decisions to undergo an entire fairness review. The Rule is the tool used by a court to restrain itself from implementing such a review. This is the most important function of the Rule. Second, as a result of equity needing to be restrained, there is no room in the Rule formulation for fairness; fairness and fiduciary duties must be mutually exclusive. Third, there are three policy drivers that underlie the use of the Rule. Protecting the Board’s statutory authority to run the company without the fear of its members being held liable for honest mistakes of judgment; respect for the private ordering of corporate governance arrangements which almost always grants extensive authority to the Board to make decisions on behalf of the corporation; and the recognition by the courts that they are not business experts, making deference to Board authority a necessity. Fourth, the Rule is an abstention doctrine not just in terms of precluding duty of care claims, but also by requiring the courts to abstain from an entire fairness review if there is no evidence of a breach in fiduciary duties or taint surrounding a Board decision. Fifth, stockholder wealth maximization (SWM) is the legal obligation of the Board and the Rule serves to support that purpose. The requirement of SWM enters into corporate law through a Board’s fiduciary duties as applied under the Rule, not statutory law. In essence, SWM is an equitable concept.

 

 

Delaware Supreme Court to Rehear Appraisal Action

In July, Delaware Chancellor Andre Bouchard found that payday lender DFC Global Corp was sold too cheaply to private equity firm Lone Star Funds in 2014.  Chancellor Bouchard held that four DFC shareholders were entitled to $10.21 a share at the time of the deal, or about 7 percent above the $9.50 per share deal price that was approved by a majority of DFC shareholders.

A Gibson Dunn filing related to the DFC case on appeal before the Delaware Supreme Court sheds light on the appraisal process in Delaware.  The claim is the Chancellor Bouchard manipulated the calculations to reach the $10.21 prices.  The full brief is available here, but this summary might provide easier reading.  Reuters reports:

Bouchard made a single clerical error that led him to peg DFC’s fair value at $10.21 per share.

DFC’s lawyers at Gibson Dunn & Crutcher spotted the mistake and asked Chancellor Bouchard to fix the erroneous input. If he did, the firm said, he’d come up with a fair value for the company that was actually lower than the price Lone Star paid. The chancellor agreed to recalculate – but in addition to fixing the mistaken input, Bouchard adjusted DFC’s projected long-term growth rate way up, to a number even higher than the top of the range proposed by the plaintiffs’ expert. The offsetting changes brought the recalculated valuation back in line with Chancellor Bouchard’s original, mistaken analysis.

Gibson Dunn is now arguing at the Delaware Supreme Court that the chancellor’s tinkering shows just why appraisal litigation – in which shareholders dissatisfied with buyout prices ask Chancery Court to come up with a fair price for their stock – has become a big problem for companies trying to sell themselves.

Last week The Chancery Daily reported on a December 16th appraisal case, Merion Capital, where Chancellor Laster held that a fair price was paid. The questions remains what is the significance of deal price and what is the significance of expert opinion shifting these technical cases in or outside of fair value?

-Anne Tucker

 

Trump as a Teaching Tool for Business Associations

A friend of mine is considering teaching his constitutional law seminar based almost entirely on current and future decisions by the President-elect. I would love to take that class. I thought of that when I saw this article about Mr. Trump’s creative use of Delaware LLCs for real estate and aircraft. Here in South Florida, we have a number of very wealthy residents, and my Business Associations students could value from learning about this real-life entity selection/jurisdictional exercise. Alas, I probably can’t squeeze a whole course out of his business interests. However, I am sure that using some examples from the headlines related to Trump and many of his appointees for key regulatory agencies will help bring some of the material to life.

Happy Grading!

Director Primacy and the BJR: Reconciling Strine v. Signatories

Prof. Bainbridge the other day commented on the following, which is item 10 from the Modern Corporation Statement on Company Law (available here):  

Contrary to widespread belief, corporate directors generally are not under a legal obligation to maximise profits for their shareholders. This is reflected in the acceptance in nearly all jurisdictions of some version of the business judgment rule, under which disinterested and informed directors have the discretion to act in what they believe to be in the best long term interests of the company as a separate entity, even if this does not entail seeking to maximise short-term shareholder value. Where directors pursue the latter goal, it is usually a product not of legal obligation, but of the pressures imposed on them by financial markets, activist shareholders, the threat of a hostile takeover and/or stock-based compensation schemes.

Bainbridge take a contrary position, citing Delaware Supreme Court Chief Justice Strine, who says, "a clear-eyed look at the law of corporations in Delaware reveals that, within the limits of their discretion, directors must make stockholder welfare their sole end, and that other interests may be taken into consideration only as a means of promoting stockholder welfare." Strine further notes that "advocates for corporate social responsibility pretend that directors do not have to make stockholder welfare the sole end of corporate governance, within the limits of their legal discretion."

I read these positions as consistent, though I think the scope of what is permissible is certainly implicitly different. I agree that Strine is right to say that "directors must make stockholder welfare their sole end."  But I also agree that "disinterested and informed directors have the discretion to act in what they believe to be in the best long term interests of the company as a separate entity." My read of the business judgment rule (BJR) is that, absent fraud, illegality, or self-dealing, courts should abstain from reviewing director decisions, meaning that the directors decide what"stockholder welfare" means and what ends to use in pursuit of that end.  That is, I think it's wrong to say "directors generally are not under a legal obligation to maximise profits for their shareholders," but I do think directors usually get to decide what it means to "maximise profits." 

I am a firm believer in director primacy, and I believe directors should have a lot of latitude in their choices, subject to the BJR requirements.  Thus, if a plaintiff can show self dealing (like maybe via giving to a "pet charity" described in A.P. Smith v. Barlow), then the BJR might be rebutted (if the gift is inconsistent with state law and/or constituency statutes).   But otherwise, it's the board's call. Furthermore, where a company builds its brand and acts consistently with its prior actions, that might expand the scope of permissible behavior for a company (i.e., not be evidence of self-dealing).  Thus, companies like Tom's Shoes and Ben and Jerry's should be able to continue to operate as they always have when they bring in new directors, because what might look like self-dealing in another context, is consistent with the business model.  

eBay v. Newmark (pdf here) is often used to rebut that notion, but I still maintain that case is really about self-dealing  -- the actions taken by Jim and Craig were impermissible not because they were working toward "purely philanthropic ends," but because they took actions that benefited themselves to the detriment of their minority shareholder, such as use of poison pills).  

Anyway, I am still a believer in the BJR as abstention doctrine.  Show me some fraud, illegality, or self-dealing or I'm leaving the board's decision alone. 

Guest Post: Controlling Shareholders and the Geography of MFW-Land*

 

*The guest post is contributed by Itai Fiegenbaum who teaches corporate law at Tel Aviv University and Ramat Gan College of Law and Business.  

Today's post continues the discussion started by Anne’s informative post regarding the law of controlling stockholders. Anne astutely notes that the MFW “enhanced ratification” framework was rendered in connection with a going private merger. Although I recognize the intuitive appeal, I wish to call into question the impact of MFW’s holding on other manners of controlling shareholder transactions.

Going private transactions differ from going concern transactions in that their successful completion wipes out the minority float. This distinction accelerates stockholders' divergent incentives and raises the possibility for minority stockholder abuse. An unscrupulous controller might structure the transaction in a manner that captures all unlocked value for later private consumption. Going private transactions allow controlling stockholders to shed the restrictions of the public market, thereby evading future retribution by minority stockholders. Policy considerations accordingly call for superior protection of minority stockholders participating in a going private transaction.

Since MFW establishes a procedure for achieving less intrusive judicial review for going private transactions, it stands to reason that this procedure should apply to all transactions involving a controlling stockholder. Indeed, without addressing the distinction between going private and going concern transactions in this context, a fairly recent Chancery Court decision has explicitly opined that the MFW framework applies to all controlling stockholder transactions (In re Ezcorp Inc. Consulting Agreement Derivative Litig., 2016 WL 301245, at *28 (Del. Ch. Jan. 25, 2016)).

In a forthcoming article at the Delaware Journal of Corporate Law, I argue that the borders of "MFW-Land" are not as clear-cut as they appear. The Delaware Supreme Court decision does not create a universally-applicable safe harbor procedure for all manner of controlling stockholder transactions. Two main arguments form the basis of this contention. 

The dual tenets of doctrinal clarity and cohesion underpin the first argument. A careful reading of the MFW decision fails to detect any mention of competing precedent or a general proclamation regarding its applicability to other types of controlling stockholder transactions. MFW is clearly situated on a path of doctrinal evolution of judicial inspection of going private transactions with controlling stockholders. Canons of judicial interpretation counsel against an indirect reversal or modification of established precedent.

Additionally, the theoretical justifications for the MFW decision hold significantly less weight in the going concern context. MFW's doctrinal shift is grounded on the twin pillars representing the competency of independent directors and non-affiliated stockholders. Whatever the validity of these mechanisms in the freeze out context, the legal and financial scholarship does not validate an extension to going concern transactions. Serious flaws hamper the ability of independent directors and non-affiliated stockholders to pass meaningful judgment on going concern transactions. In the final tally, MFW does not produce an all-encompassing framework for all controlling stockholder transactions.

 

Stockholder Approval and the BJR in the Absence of a Controlling Shareholder

I am preparing to teach the doctrine on controlling shareholders in my corporations class tomorrow, and found the recent Delaware opinions on non-controlling shareholder cleansing votes and the BJR to be helpful illustrations of the law in this area.

In summer 2016, the Delaware Court of Chancery dismissed two post-closing actions alleging a breach of fiduciary duty where there was no controlling shareholder in the public companies, where the stockholder cleaning vote was fully informed, and applied the 2015 Corwin business judgment rule standard.  The cases are City of Miami General Employees’ & Sanitation Employees’ Retirement Trust v. Comstock, C.A. No. 9980-CB,  (Del. Ch. Aug. 24, 2016) (Bouchard, C.) and Larkin v. Shah, C.A. No. 10918-VCS, (Del. Ch. Aug. 25, 2016) (Slights, V.C.), both of which relied upon  Corwin v. KKR Financial Holdings, LLC, 125 A.3d 304 (Del. 2015).  (Fellow BLPB blogger Ann Lipton has written about Corwin here).

The Larkin case clarified that Corwin applies to duty of loyalty claims and will be subject to the deferential business judgment rule in post-closing actions challenging non-controller transactions where informed stockholders have approved the transaction.   The Larkin opinion states that:

(1) when disinterested, fully informed, uncoerced stockholders approve a transaction absent a looming conflicted controller, the irrebuttable business judgment rule applies; (2) there was no looming conflicted controller in this case; and (3) the challenged merger was properly approved by disinterested, uncoerced Auspex stockholders. Under the circumstances, the business judgment rule, irrebuttable in this context, applies. ....The standard of review that guides the court’s determination of whether those duties have been violated defaults to a deferential standard, the business judgment rule, which directs the court to presume the board of directors “acted on an informed basis, in good faith and in the honest belief that the action was taken in the best interests of the company.” In circumstances where the business judgment rule applies, Delaware courts will not overturn a board’s decision unless that decision 'cannot be attributed to any rational business purpose.' This broadly permissive standard reflects Delaware’s traditional reluctance to second-guess the business judgment of disinterested fiduciaries absent some independent cause for doubt.  Larkin at 21-22 (internal citations omitted).

Two-sided controller transactions (a freeze out merger where a controlling shareholder stands on both sides of the transaction) is covered by the 2014 Kahn v. M & F Worldwide Corp., 88 A.3d 635(Del. 2014) case, which I summarized in an earlier BLPB post here.

To refresh our readers, the controlling shareholder test is a stockholder who owns a majority of stock. Additionally, a stockholder may qualify as a controller if:

Under Delaware law, a stockholder owning less than half of a company’s outstanding shares may nonetheless be deemed a controller where 'the stockholder can exercise actual control over the corporation’s board.'This “actual control” test requires the court to undertake an analysis of whether, despite owning a minority of shares, the alleged controller wields “such formidable voting and managerial power that, as a practical matter, [it is] no differently situated than if [it] had majority voting control.'A controlling stockholder can exist as a sole actor or a control block of “shareholders, each of whom individually cannot exert control over the corporation . . . [but who] are connected in some legally significant way—e.g., by contract, common ownership agreement, or other arrangement—to work together toward a shared goal.' Larkin at 33-34 (internal citations omitted).

Excellent commentary on theLarkin and Comstock cases and their practical implications can be found on the Harvard Law School Forum on Corporate Governance and Financial Regulation, available here.

-Anne Tucker

 

Private Ordering in the Uncorporation: Modified and Eliminated Fiduciary Duties Are Often the Same Thing

What does it mean to opt out of fiduciary duties?  In follow-up to my co-blogger Joan Heminway's post, Limited Partnership Law: Should Tennessee Follow Delaware's Lead On Fiduciary Duty Private Ordering?, I will go a step further and say all states should follow Delaware's lead on private ordering for non-publicly traded unincorporated business associations. 

Here's why:  At formation, I think all duties between promoters of an unincorporated business association (i.e., not a corporation) are always, to some degree, defined at formation. This is different than the majority of other agency relationships where the expectations of the relationship are more ingrained and less negotiated (think employee-employer relationship).  

As such, I'd make fiduciary duties a fundamental right by statute that can be dropped (expressly) by those forming the entity.  I'd put an additional limit on the ability to drop fiduciary duties: the duties can only be dropped after formation if expressly stated in formation documents (or agreed unanimously later). That is, if you didn't opt out at formation, tell all those who could potentially join the entity how you can change fiduciary duties later. This helps limit some (though not all) freeze-out options, and I think it would encourage investors to check the entity documents closely (as they should).

At formation, the concerns we might have of, for example, an employee without fiduciary duties, are not the same as they are for co-venturers. Those starting an entity have long negotiated what is a breach of the duty of loyalty, for example.  In contrast, I think fiduciary duties in most employer-employee (and similar) relationships reflect the majoritarian default and they facilitate the relationship existing at all. For LLCs and partnership entities, I think that's less clear. Entity formation is relatively rare compared to how often we enter other agency relationships, and they almost always involve significant negotiation (if not planning).  And if they don't, the rules we expect traditionally should be the default. But where the parties talk about it, and they usually do, allowing a more robust sense of freedom of contract has value.  

Even in Delaware, where one can negotiate out of fiduciary duties, there remains the duty of good faith and fair dealing. I think of that as meaning that the parties still have a right to the essence of the contract.  That is, the contract has to mean something.  It has to have had a purpose and potential value at formation, and no party can eliminate that.  But, the parties only have a right to what was bargained for.  As such, what we might traditionally consider a breach of the duty of loyalty could also breach the duty of good faith and fair dealing, but a traditional breach of the duty of loyalty might not be sufficient to find liability where there is expressly no duty of loyalty. Instead, the act must so contradict the purpose of the contract that it rises to the level of a breach the duty of good faith and fair dealing. 

Part of the reason I support this option is that I think case law has already validated it, but in such an inartful manner that it confuses existing doctrine. See, e.g., McConnell v. Hunt Sports Enterprises, 132 Ohio App. 3d 657, 725 N.E.2d 1193 (Ct. App. 1999) (“An LLC, like a partnership, involves a fiduciary relationship. Normally, the presence of such a relationship would preclude direct competition between members of the company. However, here we have an operating agreement that by its very terms allows members to compete with the business of the company.”).

In closing, I will note that I am all for express provisions that require investors to pay attention at the outset. I don't believe in helping cheaters hide the ball. I just think law that encourages investors and others joining new ventures to pay attention is useful and will provide long-term value to entities.  I don't think that eliminated fiduciary duties at formation raise any more of a risk than we already have with limited or modified fiduciary duties at formation. With the more limited protections described above, freedom of contract should reign. 

Guest Post: Tides May Be Slowly Turning in Delaware Appraisal Arbitrage

If it is true that “a good thing cannot last forever,” the recent turn of events concerning appraisal arbitrage in Delaware may be a proof point. A line of cases coming out of the Delaware Court of Chancery, namely In re Appraisal of Transkaryotic Therapies, Inc., No. CIV.A. 1554-CC (Del. Ch. May 2, 2007), In re Ancestry.Com, Inc., No. CV 8173-VCG (Del. Ch. Jan. 5, 2015), and Merion Capital LP v. BMC Software, Inc., No. CV 8900-VCG (Del. Ch. Jan. 5, 2015), have made one point clear: courts impose no affirmative evidence that each specific share of stock was not voted in favor of the merger—a “share-tracing” requirement. Despite this “green light” for hedge funds engaging in appraisal arbitrage, the latest case law and legislation identify some new limitations.

What Is Appraisal Arbitrage?

Under § 262 of the Delaware General Corporation Law (DGCL), a shareholder in a corporation (usually privately-held) that disagrees with a proposed plan of merger can seek appraisal from the Court of Chancery for the fair value of their shares after approval of the merger by a majority of shareholders. The appraisal-seeking shareholder, however, must not have voted in favor of the merger. Section 262, nevertheless, has been used mainly by hedge funds in a popular practice called appraisal arbitrage, the purchasing of shares in a corporation after announcement of a merger for the sole purpose of bringing an appraisal suit against the corporation. Investors do this in hopes that the court determines a fair value of the shares that is a higher price than the merger price for shares.

In Using the Absurdity Principle & Other Strategies Against Appraisal Arbitrage by Hedge Funds, I outline how this practice is problematic for merging corporations. Not only can appraisal demands lead to 200–300% premiums for investors, assets in leveraged buyouts already tied up in financing the merger create an even heavier strain on liquidating assets for cash to fund appraisal demands. Additionally, if such restraints are too burdensome due to an unusually high demand of appraisal by arbitrageurs seeking investment returns, the merger can be completely terminated under “appraisal conditions”—a contractual countermeasure giving potential buyers a way out of the merger if a threshold percentage of shares seeking appraisal rights is exceeded. The article also identifies some creative solutions that can be effected by the judiciary or parties to and affected by a merger in absence of judicial and legislative action, and it evaluates the consequences of unobstructed appraisal arbitrage.

The Issue Is the “Fungible Bulk” of Modern Trading Practices

In the leading case, Transkaryotic, counsel for a defending corporation argued that compliance with § 262 required shareholders seeking appraisal prove that each of its specific shares was not voted in favor of the merger. The court pushed back against this share-tracing requirement and held that a plain language interpretation of § 262 requires no showing that specific shares were not voted in favor of the merger, but only requires that the current holder did not vote the shares in favor of the merger. The court noted that even if it imposed such a requirement, neither party could meet it because of the way modern trading practices occur.

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Fiduciary Duty Waiver in Delaware Alternative Entities

Just in case you haven't gotten the message yet:  Delaware law means fiduciary duty freedom of contract for alternative entities.  In May 2016, the Delaware Chancery Court upheld a waiver of fiduciary duties in a master limited partnership.  In Employees Retirement System of the City of St. Louis v. TC Pipelines GP, Inc., Vice Chancellor Glasscock upheld challenges to an interested transaction (sale of a pipeline asset to an affiliated entity) that was reviewed, according to the partnership agreement, by a special committee and found to be fair and reasonable.  The waiver has been described as "ironclad" to give you a sense of how straight forward this decision was. No close call here.  

Vice Chancellor Glasscock's letter opinion starts:

Delaware alternative entity law is explicitly contractual;1 it allows parties to eschew a corporate-style suite of fiduciary duties and rights, and instead to provide for modified versions of such duties and rights—or none at all—by contract. This custom approach can be value enhancing, but only if the parties are held to their bargain. Where equity holders in such entities have provided for such a custom menu of rights and duties by unambiguous contract language, that language must control judicial review of entity transactions, subject only to the cautious application of the implied covenant of good faith and fair dealing. Such is the case in the instant matter, which involves a master limited partnership (“MLP”) created with interested transactions involving the general partner as part of its business model.....

The Defendants point out that the [transaction] was approved by a special committee (the “Conflicts Committee”), which approval, in accordance with the partnership agreement, creates a conclusive presumption that the transaction is fair and reasonable to the Partnership. I find that the Conflicts Committee’s approval, in these circumstances, precludes judicial scrutiny of the substance of the transaction and grant the Defendants’ Motion.

Importantly, the contractual safe harbor for interested transactions established a process which, if followed, created a fair and reasonable transaction outside of judicial scrutiny and without recourse by the other partners.  The court found that the partnership agreement precluded a good faith analysis of the Conflicts Committee's review and limited the court's review purely to matters of process.

The relevant portions of the Special Approval provision, importantly, are silent as to good faith.....According to the contractual language, the Special Approval of a duly constituted and fully informed Conflicts Committee is conclusive evidence that such transaction is fair and reasonable, and such approval is, therefore, preclusive of further judicial review. The Plaintiff does not allege that the Conflicts Committee was not duly constituted—that is, directors who are neither security holders nor employees or officers of the General Partner or its affiliates. Nor does the Plaintiff allege that the Conflicts Committee was not fully informed. Thus, the approval here is conclusive that the [transaction] is “fair and reasonable” to TCP. According to the explicit language of the LPA, when a conflicted transaction is deemed “fair and reasonable” by the terms of the agreement, such conflicted transaction is incapable of breaching the LPA.

Get the message? LOUD and CLEAR!

The opinion contains more analysis and excerpts of the relevant portions of partnership agreement.  Look for an excerpt on this case in my ChartaCourse (electronic platform) Business Organizations casebook. 

-Anne Tucker

Slow Down on the Reverse Veil Piercing of LLCs (Which Are STILL Not Corporations)

Anyone who reads this blog knows that I have issues with how people mess up the distinction between LLCs (limited liability companies) and corporations. In some instances, it is a subtle, likely careless, mistake.  Other cases seem to be trolling me.  Today, I present you such a case: Sky Cable, LLC v. Coley, 2016 WL 3926492 (W.D.Va., July 18, 2016).  H/T: Jay D. Adkisson. The case describes the proceedings as follows: 

DIRECTV asks the court to reverse-pierce the corporate veil and declare that Randy Coley is the alter ego of his three limited liability companies, such that the assets held by those LLCs are subject to the judgment in this case.

Okay, so claiming to pierce the "corporate veil" of an LLC is wrong (it doesn't have a "corporate" anything), but it's also exceedingly common for lawyers and courts to make such an assertion. This case takes the improper designation to the next level.  

First, the court describes the LLCs in questios as "the Corporate Entities."  It then goes on to discuss "Coley's limited liability companies."  Ugh.  The court further relates, "DIRECTV stated that in a forthcoming motion, it would ask the court to reverse-pierce the corporate veil given Coley's abuse of the corporate form."  No such form, but perhaps we can now blame DIRECTV's counsel, in part, for this hot mess.  

Here's the court's Legal Framework: 

Generally, corporations are recognized as entities that are separate and distinct from their officers and stockholders. [Author's note: THERE ARE NO SHAREHOLDERS IN LLCS!] "But this concept of separate entity is merely a legal theory, 'introduced for purposes of convenience and to subserve the ends of justice,' and the courts 'decline to recognize [it] whenever recognition of the corporate form would extend the principle of incorporation "beyond its legitimate purposes and [would] produce injustices or inequitable consequences.' "" DeWitt Truck Brokers, Inc. v. W. Ray Flemming Fruit Co., 540 F.2d 681, 683 (4th Cir. 1976) (citations omitted). When appropriate, and " 'in furtherance of the ends of justice,' " a court may pierce the corporate veil and treat the corporation and its shareholders as one, id. (quoting 18 Am. Jur. 2d at 559), if it finds a corporation and its shareholders have misused or disregarded the corporate form, United States v. Kolon Indus., Inc., 926 F. Supp. 2d 794, 815 (E.D. Va. 2013). This is often referred to as an "alter ego theory."

The court continues: "Delaware courts take the corporate form and corporate formalities very seriously.... " Case Fin., Inc. v. Alden, No. CIV. A. 1184-VCP, 2009 WL 2581873, at *4 (Del. Ch. Aug. 21, 2009)." The opinion then states that veil piercing concepts"apply equally to limited liability companies which, like corporations, have a legal existence separate and distinct from its members."  The concept may, but LLCs do not have to follow the same formalities as corporations to maintain separate existence.  Even if veil piercing were appropriate here, the entire case continues to misstate the law of veil piercing LLCs. Note: Delaware courts do hold some blame here: Westmeyer v. Flynn, 382 Ill. App. 3d 952, 960, 889 N.E.2d 671, 678 (2008) ("[U]nder Delaware law, just as with a corporation, the corporate veil of an LLC may be pierced, where appropriate.").

Based on the opinion, it does seems as though the defendant here was being shady, at best, and perhaps outright fraudulent.  I don't suggest that, based on the facts presented, the defendant shouldn't be held accountable for his debts. Still, in addition to the misstatements of the law, I am not sure veil piercing was necessary.  As the court notes, "veil piercing is an equitable remedy and an extraordinary one, exercised only in exceptional circumstances "when 'necessary to promote justice.'"  It seems to me, then, the court (and the plaintiff) should discuss other remedies first, relying only on veil piercing where "necessary." 

As such, I'd like to see a discussion of fraudulent or improper transfer before veil piercing -- did the defendant improperly move assets that should have been available to the plaintiff into an entity? Before veil piercing three entities, it seems to me the court should determine what should have been available to the plaintiff -- if the answer is "nothing" then no amount of shady behavior should support veil piercing.  If there should be assets, then the question should still be "which ones?"  If the answer is all of the assets in all of then entities, then okay.  But if the court is veil piercing three entities merely to ensure adequate recovery, that's an overreach, it seems to me.  In addition, how about reviewing if there was actual fraud in how the defendant acted?  That, too, could support recovery without the extraordinary veil piercing remedy.  

Ultimately, it's possible the court got the outcome right here.  But it clearly got the law wrong.  A lot.  

 

Direct v. Derivative under the Tennessee Business Corporation Act

In a recent decision of the Tennessee Supreme Court, Keller v. Estate of Edward Stephen McRedmond, Tennessee adopted Delaware's direct-versus-derivative litigation analysis from Tooley v. Donaldson, Lufkin, & Jenrette, Inc., 845 A.2d 1031 (Del. 2004), displacing a previously applicable test (that from Hadden v. City of Gatlinburg, 746 S.W.2d 687 (Tenn. 1988)).  Although this is certainly significant, I also find the case interesting as an example of the way that a court treats different types of claims that can arise in typical corporate governance controversies (especially in small family and other closely held businesses).  This post covers both matters briefly.

The Keller case involves a family business eventually organized as a for-profit corporation under Tennessee law ("MBI").  As is so often the case, after the children take over the business, a schism develops in the family that results in a deadlock under a pre-existing shareholders' agreement.  A court-ordered dissolution follows, and after a bidding process in which each warring side of the family bids, the trustee contracts to sell the assets of MBI to members of one of the two family factions as the higher bidder.  These acquiring family members organize their own corporation to hold the transferred MBI assets ("New MBI") and assign their rights under the MBI asset purchase agreement to New MBI

Prior to the closing, the losing bidder family member, Louie, then an officer and director of MBI who ran part of its business (its grease business), solicited customers and employees, starved the MBI grease business, diverted business opportunities from MBI's grease business to a corporation he already had established (on the MBI property) to compete with MBI in that business sector, and engaged in other behavior disloyal to MBI.  Louie's actions were alleged to have contravened a court order enforcing covenants in the MBI asset purchase agreement. They also were allegedly disloyal and constituted a breach of his fiduciary duty of loyalty to MBI.  Finally, they constituted an alleged interference with New MBI's business relations.  

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Drinker Biddle's Analysis of the First 50 Crowdfunding Offerings

Robert Esposito (Drinker Biddle) passed along his firm's interesting report on early crowdfunding offerings. The report is available here. Be sure to download the firm level detail spreadsheet available via the data download on the top right of the page.  

The report shows that social enterprise and breweries/distilleries account for outsized portions of the early offerings. A group of us (including co-blogger Joan Heminway) predicted, at the University of Colorado's business school in July 2013, that social entrepreneurs would gravitate to equity crowdfunding. Separately, in my social enterprise law seminar, I was surprised by how many students presented on breweries that were social enterprises, and looking at this list it appears that there is at least one company (Hawaiian Ola Brewing Corporation - a Certified B Corporation) that falls into both the social enterprise and brewery categories highlighted below. It may be that both areas appeal to younger entrepreneurs who may also be eager to try this new form of capital raising. 

Go read the entire report, but I provide a teaser quote below the dotted line with some emphasis added.

--------------------

In general. As of June 30, 2016, 50 companies have filed a Form C with the SEC to offer securities under the Regulation Crowdfunding exemption. Minimum target offering amounts range from $20,000 to $500,000 per offering, with a median of $55,000. All but one of these issuers, however, have disclosed that they will accept offers in excess of the target amount, including 27 issuers that say they will accept investments at or near the maximum permitted offering amount of $1,000,000.  In contrast, 18 of the first 50 issuers elected to cap their offering at just $100,000, with the remainder setting an offering cap of between $200,000 and $500,000.  In the aggregate, if this first wave of retail crowdfundings is successful, 50 small companies will raise an aggregate of $6 to $30 million in new capital to fund their businesses. 

While announced offering durations range from 21 days to one year, the median period that issuers say they will keep their offerings open is just under six months, with about half electing an offering duration between 166 and 182 days.

Eighteen different jurisdictions of incorporation are represented among the first 50 issuers; however, nearly half of the initial filers (24) are Delaware entities. Early data shows that issuers tend to be early-stage startups, with a median issuer age of just 354 days. Nevertheless, nine of the issuers were more than five years old, and the oldest was incorporated in 2003. . . . 

While a total of 12 funding portals have registered with FINRA to date, the early mover Wefunder portal hosts more than half (26) of the first 50 offerings. The StartEngine portal has secured eight offerings, with the remainder split among other portals, including SeedInvest, Next Seed, Flashfunders, and Venture.co. 

Early Adopters.

• Social Enterprises. According to the Global Entrepreneurship Monitor’s Special Topic Report on Social Entrepreneurship, social enterprises account for only 5.7 percent of entrepreneurial activity in the United States. However, early crowdfunding data shows that social enterprises are strongly represented among crowdfunding issuers. Seven issuers, representing 14 percent of the first 50 offerings, are either registered as benefit corporations or benefit LLCs, or are certified by B Lab as B Corps, and at least an additional nine issuers operate within traditional corporate forms with strong social and/or environmental missions. Combined, these issuers represent 32 percent of the first 50 offerings.
   
• Raise a Glass. Craft breweries, distilleries, and licensed establishments are also disproportionately represented among the first 50 issuers. Eight issuers, representing 16 percent of the first 50 offerings, fall into this category, including 2 distilleries, 2 craft breweries, 2 bars, as well as a frozen alcohol producer and a producer of ginger liqueur. 

Thoughts on the Berle Symposium: Doing Well by Doing Good?

Like Anne and Joan, I enjoyed the Berle Symposium and found it incredibly valuable. As they have mentioned, former Chancellor Chandler's presentation was definitely a highlight, and it was affirming to hear Delaware law described as I understand it, if much more eloquently expressed than I have managed. Former Chancellor Chandler appeared to make clear that directors of Delaware firms could be at risk if they admit to taking an action that is not aimed at (eventually) meeting the short or long-term financial interests of shareholders.  

Former Chancellor Chandler's description of Delaware law, both in the symposium and in his eBay case, coupled with the law review writings of Delaware Supreme Court Chief Justice Leo Strine, confirm, in my mind, that benefit corporations could be useful, at least in Delaware, for entrepreneurs who want to admit pursing strategies that are not aimed at benefiting shareholders in the short or long run. For example, I think some companies, like Patagonia, make decisions that benefit the environment, even though the directors may honestly believe that financial costs will far exceed financial benefits, even in the long-term. 

Interestingly, however, much of what I heard from the B Lab representatives at the symposium was about how benefit corporations can do just as well, if not better, than traditional corporations from a financial perspective. This obviously poses an empirical question that we may get better answers to in the coming years. But if you can "do well by doing good" then then entrepreneurs, even under Delaware law, seem likely to avoid legal problems given the protection of the business judgment rule and the argument that financial benefits will eventually follow from their society-focused actions.

The benefitcorp.net website has a list of reasons to become a benefit corporation, which are:

• Reduced Director Liability

• Expanded Stockholder Rights

• A Reputation For Leadership

• An Advantage in Attracting Talent

• Increased Access to Private Investment Capital

• Increased Attractiveness to Retail Investors and Mission Protection as a Publicly Traded Company

• Demonstration Effect

I am a bit surprised that more of these reasons are not focused on societal and environmental benefit (and am not sure why mission protection is limited to publicly traded companies, especially when there are no stand-alone publicly traded benefit corporations today -- though there will likely soon be some soon.) I question whether all of these benefits are true. For example, I have heard mixed things about benefit corporations from investors, and the liability issue is completely untested. But if all of these things are true, and social entrepreneurs do get better access to capital and an advantage attracting employees, etc., then I think the benefit corporation form is less necessary as a legal matter. Maybe the thought is that benefit corporations have expressive value or that they provide an extra layer of protection. But, as a legal matter, if you can justify your social actions by pointing to potential long-term financial benefits, you do not really need a new form, even in Delaware (and, of course, many other states are even more permissive with social actions). Maybe benefit corporation proponents see the real value in the M&A context when facing Unocal/Revlon, but Page & Katz showed ways around those issues, especially if focused on long-term value. Entrepreneurs could also incorporate outside of Delaware, in a state that has expressly rejected Revlon.

Personally, while it is possible for some firms to do well by doing good, I think social entrepreneurs will often be openly sacrificing financial returns---they will be doing good through purposeful financial sacrifice. As such, an benefit corporation option, at least in states like Delaware.

There was quite a lot of good discussion at the Berle Symposium, and I may have more to write about it in later posts.