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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.