Professor Bainbridge...on law, politics, religion, culture & food

Minority Shareholders

My essay There is No Affirmative Action for Minorities, Shareholder and Otherwise, in Corporate Law has been posted to SSRN. Abstract:

I review and comment herein on Anupam Chander’s article, Minorities, Shareholder and Otherwise, 113 Yale L.J. 119 (2003). My critique focuses mainly on his underlying premise or, to put it another way, on showing that his analysis of corporate law doctrine is fundamentally flawed. Chander argues that, unlike constitutional law, “corporate law places minorities at the heart of its endeavor.” Central to his project is an empirical claim that corporate law has an “elaborate framework” for “minority interests in the corporation.” I argue that Chander’s theoretical construct rests on a doctrinal foundation of sand. He persistently overstates the extent to which corporate law protects minority shareholders, while understating the freedom that law gives majority shareholders.

Measuring Shareholder Activism

Public Pension Funds as Shareholder Activists: A Comment on Choi and Fisch by Randall S. Thomas critiques On Beyond CalPERS: Survey Evidence on the Developing Role of Public Pension Funds in Corporate Governance by Stephen J. Choi and Jill E. Fisch.

Behavioral Economics and the Financial Crisis of 2008

Economics blogger Megan McArdle runs through a bunch of mostly behavioral finance explanations.

Would Delaware Courts Follow Baron v. Allied Artists Pictures Today?

In Baron v. Allied Artists Pictures Corp., 337 A.2d 653 (Del. Ch. 1975), app. dismissed, 365 A.2d 136 (Del. 1976), Allied’s articles of incorporation provided that if six or more quarterly dividends were missed the preferred shareholders, voting as a class, would have the right to elect a majority of the board of directors. Allied missed the requisite number of preferred dividends, triggering the preferred shares’ contingent voting rights. The idea behind contingent voting rights, of course, is that the preferred shareholders’ board representatives will change corporate policy so that the firm can begin paying dividends on the preferred. Once the missed dividends are caught up, the preferred shareholders’ representatives step down and control returns to the common. (Classically minded readers will note the parallel to the story of Cincinnatus, the Roman general who left his farm to defeat the Aequi and Volscians and, after victory, went back to his farm.) In Allied’s case, however, the board failed to begin paying dividends on the preferred stock. As a result, the preferred retained their right to elect a majority of the board—for a period of ten years.

Plaintiff was a common shareholder who sued, in effect, to compel the board to declare such dividends as would be necessary to return control to directors elected by the common. The Chancery Court rejected plaintiff’s claim, holding that the directors have discretion to declare dividends or to refrain from doing so. The exercise of that discretion is not unbounded, of course. A board elected by the preferred “does have a fiduciary duty to see that the preferred dividends are brought up to date as soon as possible in keeping with prudent business management.” Note, however, that the latter qualification substantially eviscerates the scope of the stated duty. The board need not begin paying dividends on the preferred the moment sufficient funds have become available, so long as there is a good business reason for retaining earnings. Worse yet, the business judgment rule precludes the court from second-guessing the board’s decision absent “fraud or gross abuse of discretion.” In light of the volatile nature of the motion picture business and the resulting need to retain sufficient reserves against major losses, the court refused to grant relief.

Two conceptions of the business judgment rule compete in the cases—some view it as a rule of abstention, while others treat it as a substantive standard of review?  As its invocation of an “abuse of discretion” standard suggests, Allied Artists leans towards the view that the business judgment rule is a substantive standard of review, albeit a quite deferential one. That impression perhaps is confirmed by the relatively extensive analysis in the decisions of the firms’ ability to pay a dividend in the circumstances.

Ironically, however, everyone seems to have ignored the fact that over half of Allied’s preferred stock was owned by a single shareholder—Kalvex, Inc.—who owned almost none of Allied’s common stock. Because the preferred voted as a class without benefit of cumulative voting, Kalvex controlled the outcome of board elections, despite owning only 7 percent of Allied’s total equity. As a result, there was a substantial interlock between the two companies’ boards and management. Allied’s president, for example, was also the president of Kalvex. Although Kalvex was mainly a preferred shareholder, it could have (and should have) been treated as Allied’s controlling shareholder subject to the attendant fiduciary duties. Under the duty of loyalty applicable to controlling shareholders, the question would be whether Kalvex received a benefit at the expense of and to the exclusion of the other shareholders. If so, Kalvex would have to justify that benefit under the intrinsic fairness standard. Plaintiff would have argued that control of the corporation is itself a benefit, which the preferred shareholders seized to the exclusion of the common, and also pointed to the highly remunerative compensation Kalvex’s officers received by virtue of their positions at Allied. Would plaintiff have won? Maybe not, but certainly plaintiff’s chances would have been far greater than under the theory actually used.

The result in Baron rests uneasily in today’s post-Unocal jurisprudence, in which Delaware courts have been much more sensitive to issues of management entrenchment. In addition, it’s noteworthy that Kalvex’s principals were using a technically lawful set of actions to entrench themselves in office. Jack Jaobs and Leo Strine, among other modern Delaware jurists, have revealed themselves to be quite sensitive to appropriate invocations of the court’s equitable powers under Schnell v. Chris-Craft. See, e.g., Strine’s opinion in Portnoy v. Cryo-Cell Intern., Inc., 940 A.2d 43 (Del.Ch.,2008.), in which he noted “the potency of a good old-fashioned inquiry under precedent such as Schnell, which proscribes conduct that is disloyal in the well-understood sense that it was undertaken not to advance corporate interests, but to entrench managers in office.” Id. at 71. See also Frantz Mfg. Co. v. EAC Industries, 501 A.2d 401, 407 (Del.,1985.) (holding that “Schnell prohibits incumbent management from entrenching itself by taking action which, though legally possible, is inequitable.").

It would not take a particularly aggressive application of those principles to a Baron-like fact pattern to force Kalvex to pay the required dividends.

Strine

Vice Chancellor Leo Strine is one of our favorites here at PB.com. Smart, engaged, active, able to interact seemingly effortlessly with both academics and practitioners. The Deal recently gave him a glowing write up.

Strine has become the court’s leading voice. He writes long opinions in a distinctive voice in which he treats not just the issue before him but related subjects in his state’s law. The references to popular music and culture that he works into his writings suggest a breadth of interests, as does the presence of an old paperback copy of Joe McGinniss’ “The Selling of the President,” an account of Richard Nixon’s 1968 presidential campaign, near a corporate finance textbook on a bookshelf in Strine’s office. The judge has also written 19 law review articles in his time on the bench.

Strine has astutely managed his career, from volunteering as a teenager for Carper’s first congressional campaign to becoming a significant force in American corporate governance as a judge, but it is a career not without its tensions between jurisprudence and politics, business law and a wider world of ideas. His skill along with his relative youth and his political connections has led to talk that he might move to a bigger stage if Barack Obama and his running mate, Delaware Sen. Joe Biden, capture the White House in November. Few of the lawyers who follow Chancery believe he will spend the rest of his career there, but there’s no consensus on what his next move might be. Strine himself offers few clues.

Senator? SCOTUS?

“A Chesapeake v. Shore pours out of you like a clear mountain stream,” Strine says. “I had been thinking a lot as I decided the cases that came up about these various standards of review and seeing some of the frictions and the overlap.” Chesapeake raised precisely those questions, he continues. “The core parts of the standard of review flowed from my brain to my fingertips. When I went running, I would think about it, I would outline it in my head. You don’t have cases like that every year, or every third year.”

And flows and flows and flows! Strine opinions have become famous for their length and complexity.

“To the extent that I’m a Democrat, I would say that I’m a Franklin Roosevelt, Adolph Berle Democrat about the economy,” he says. “I believe that one of the great triumphs of the West was Western Europe’s and Japan’s and our coming up with a form of capitalism that worked for everyone. When I’m not deciding a particular case, I do have concerns about environmental standards, about the future employment of Americans, if the solution is to export jobs to places with no labor concerns.”

What’s that line about if a man is not a liberal when he’s young he has no heart and if he’s not a conservative when grows old he has no mind? Leo’s got both, so perhaps he’ll end up on the right side eventually.

Good Faith and Risk Taking

In Business Associations today, I taught Smith v. Van Gorkom (BTW, have you read my “story” article on the case? If not, why not?) One of the issues I always raise when teaching it is the standard governing the extent to which directors must inform themselves. To quote from my Corporation Law and Economics text:

The central issue in Van Gorkom was the board’s failure to make an informed decision. The legal standard that emerges from the decision is straightforward—directors must inform themselves of all material information reasonably available to them. This standard seemingly requires an in-depth study of the problem. The board must be informed of the company’s value to the bidder, the course of the negotiations, the terms of the offer and their fairness, and the like. ...

In contrast, the MBCA and the ALI PRINCIPLES only require directors to be informed to the extent that they reasonably believe to be appropriate under the circumstances. Unlike the Delaware standard, at least as read literally, the ALI standard permits directors to make decisions on less than all reasonable available information, provided they reasonably believe doing so is appropriate given the situation. The time available to make the decision may require that the directors take risks to secure what appears to be a good outcome, which includes the risk that they do not have all of the relevant facts. A decision to accept that risk in order to secure the benefits of a proposed transaction will be appropriate under some circumstances.

Is the Delaware standard in fact substantively different than the ALI/MBCA one? In Brehm v. Eisner, the Delaware supreme court stated that:

Compare the American Law Institute test, which requires that a director must be “informed ... to the extent the director reasonably believes to be appropriate under the circumstances.” Principles of Corporate Governance, supra note 30, at § 4.01(c)(2). Because this test also is based on the objective test of reasonableness, it could be argued that it is essentially synonymous with the Delaware test. But there is room to argue that the Delaware test is stricter. See Roswell Perkins, ALI Corporate Governance Project in Midstream, 41 Bus.Law. 1195, 1210-11 (1986). In the end, the debate may be mostly semantic

So let’s assume that the difference is not just semantic. Let’s further assume that a board conscious decided to make a decision even though the directors knew that there were factors as to which they were uninformed, and which might make the decision look bad in hindsight, but the opportunities available justified taking that risk and going forward on the basis of incomplete information. Under Stone v. Ritter--and, especially, Ryan v. Lyondell--this scenario raises a new and even more troubling question.

In Stone, the Delaware Supreme Court held that: “In Disney, we identified the following examples of conduct that would establish a failure to act in good faith: ... where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.” Would directors who conscious decided to take action even though they knew there were facts they didn’t know therefore have acted in bad faith? It would seem as though they consciously failed to act in the face of their duty to gather all material information reasonably available to them.

One would hope that the doctrine of good faith will not deter risk taking. After all, a key rationale of the business judgment rule is to encourage risk taking. Good faith shouldn’t be allowed to gut that key function.

There are two ways the Delaware courts could get at this problem and I would advocate both. First, Delaware should explicitly adopt the MBCA/ALI standard that requires directors to inform themselves to the extent the directors reasonably believe required under the circumstances. This would allow the directors to take appropriate risks with respect to information. Second, Delaware should make it clear that the conscious disregard prong of good faith relates only to duties involving self-dealing. This would clarify that good faith cannot be used to end run the prohibition on judicial review of substantive due care.

What’s NY and NC Law on No Shops in Letters of Intent?

Wachovia and Citi had a pretty strong no shop clause in their so-called ”exclusivity agreement,” which calls for NY law to be applied, and includes a specific performance clause. There is no fiduciary out. Assuming NY law applies, is this provision legal?

Update: Presumably despite the NY choice of law provision, state of incorporation fiduciary duty law would be relevant to issues such as the necessity of a fiduciary out. Wachovia is a North Carolina corporation.  is there NC law on point?

Is Delaware Becoming a Tort Haven?

If you believe the WSJ, Delaware is turning into the next Madison County, becoming a wholly-owned subsidiary of Trial Lawyer’s Inc.:

A remarkable political fact of Mr. Biden career is that his top campaign contributor is SimmonsCooper, a law firm in Madison County, Illinois, of all places. Aficionados of tort law will understand. SimmonsCooper is a big asbestos player, and Madison County was until recently one of America’s meccas for jackpot justice. But the story gets better: Mr. Biden has been helping the tort bar turn his home state of Delaware into a statewide Madison County....

The trial bar’s strategy has been to overwhelm Delaware’s once-sensible legal system, taking advantage of rules that pressure companies to settle. In the 22 months following SimmonsCooper’s first asbestos filing in Delaware, the state was hit with 412 suits, primarily from SimmonsCooper and fellow asbestos giant Baron & Budd.

According to the Madison County Record—a legal journal that has doggedly followed this story—clerks in Wilmington were “working nights and weekends to keep up” with the filings. The trial lawyers drew sympathetic judges that have already overseen big verdicts against defendants, primarily Detroit auto makers. Plaintiffs have obtained certain procedures that raise the costs of defense, and restrict defendants’ ability to take discovery.

To keep the jackpots coming, the tort bar has focused on reshaping Delaware’s political and judicial landscape. SimmonsCooper knows all about this, having spent a fortune on judicial and county board elections in Madison County. The trial bar poured money into the 2004 re-election campaign of Democratic Governor Ruth Ann Minner, who happens to control judicial appointments in Delaware. Some 24 national asbestos and plaintiffs attorneys—including Dickie Scruggs, since convicted of bribery—contributed the legal maximum in the run-up to Ms. Minner’s victory. SimmonsCooper has also contributed nearly $35,000 to Jack Markell, the Democrat running to replace Ms. Minner this fall.

Also up for special attention was Beau Biden, son of Senator Biden. SimmonsCooper needed a local firm to file its Delaware suits, and it settled on Bifferato, Gentilotti and Biden, where Beau was a partner. This gave young Beau a share of the firm’s asbestos winnings. Beau Biden was also widely known to have political ambitions, and SimmonsCooper donated $35,000 to help Beau get elected state attorney general in 2006. Meanwhile, SimmonsCooper employees have funneled $200,000 in campaign donations to the senior Biden.

“Delaware is fast becoming asbestos lawsuit central,” says Steve Hantler, president of the American Justice Partnership Foundation, and a former Chrysler assistant general counsel. “A tsunami of lawsuits being filed by the SimmonsCooper firm, along with the flow of campaign dollars to Delaware politicians is quite the troubling coincidence.”

I don’t follow Delaware politics or Delaware’s non-corporate law, so I have no first hand knowledge. If true, however, it’ll be interesting to see if Delaware lets the effects bleed over into their corporate law. Given how much Delaware benefits from being the leading corporate jurisidiction, it’s hard to imagine that the Delaware bar would trade their birth right for a mess of abestos pottage, but the plaintiff’s counsel wing of any Bar makes tons of money from shaking down business that can be funneled into precisely this sort of political campaign.

So let’s watch closely: Will the Delaware courts continue eviscerating 102(b)(7) (not that there’s very much left after the repeated judicial guttings its suffered)? Will the expansion of cases covered by “Revlon duties” continue? Will the new good faith jurisprudence continue to be applied as expansively as it was in Ryan v. Lyondell? Will care cases continue to be transformed into good faith or loyalty cases, continuing the shrinking of the business judgment rule? Will more and more cases go to trial, as has seemed to be the case of late?

I haven’t counted heads. (I leave that sort of thing to the bean counters empiricists), but my gut feeling is that Delaware corporate law is less protective of directors and managers than it used to be. The balance seems to be shifting a bit from deference to authority and towards accountability. Delaware needs to remember the lessons of director primacy, which made it strong.