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What Corporate Law Can Teach Us About Government Ethics

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On March 13, 2015, Donna M. Nagy, Executive Associate Dean and Professor of Law at Indiana University Maurer School of Law, delivered the annual Ruby R. Vale Distinguished Scholar Lecture as part of the 2015 Ruby R. Vale Interscholatic Corporate Moot Court Competition.

Nagy’s lecture began by observing that acts of governing, whether in Congress or in the boardroom, implicate a host of agency issues. Conflicts of interest and other issues of ensuring that agents are acting in the best interest of the principals can exist in both contexts. But while corporate law has safeguards regarding conflicted directors, the discipline of the electoral process is often cited as the reason why there is no need for robust laws against self-dealing in the political context. Yet, directors also stand for election. In practice, Nagy asserted, elections often fail to provide a check: in the corporate context, challenges rarely succeed even where there is high shareholder dissatisfaction, and in politics, incumbency has large structural benefits.

Nagy identified two specific instances that raise questions regarding the ethics of lawmakers: congressional insider trading and the broader use of material non-public information for personal gain, and financial conflicts of interest.

Regarding congressional insider trading, Nagy suggested that the courts and federal prosecutors look to corporate law for an analogy because federal officials serve the public in a fiduciary capacity. According to Nagy, the Stock Act, a 2012 law that bans insider trading by Congress, was not necessary. The Stock Act amended the Securities Exchange Act so that all federal officials owe duties (e.g., of trust and confidence). Though conceding that the Stock Act improved on the status quo by creating a more effective system of transparency, Nagy nevertheless maintained that it was not necessary to amend the SEA to reflect what most ordinary people believe—that federal officials serve the public in a fiduciary capacity.

As to the broader issue of the use of material non-public information by elected officials, Nagy asserted that the Stock Act did not resolve the access that state officials have to inside information, or the ability, even on a federal level, to purchase real estate, or any other property not constituting a security, using material non-public information. Because an elected official’s self-serving use of material non-public information to profit from real estate has already been prosecuted, federal prosecutors should be able to draw upon an analogy from corporate law.

Regarding financial conflicts of interests and the widespread practice of holding personal investments in companies that are the subject of legislation, Nagy noted that members of Congress continue to own interests in companies directly affected by legislation, and disproportionately own interests in industries under their purview. Despite well-established fiduciary principles, Congress’ internal rules insulate financial conflict of interest practices.

In the corporate context, statutory provisions allow for three ways to justify an interested director transaction: (1) full disclosure and approval by disinterested directors; (2) approval by a majority of disinterested directors; (3) entire fairness to stockholders.

For government fiduciaries in the executive branch, there are strict regulations that mostly exceed the prophylactic rules of fiduciary law. 18 U.S.C. 208 is a criminal statute that includes broad anti-conflict regulation. It criminalizes conflicted actions even if it is unlikely that the conflict will influence the executive’s actions. Rather, the mere presence of conflict is sufficient for criminal liability.

In the judiciary, federal judges are prohibited by statute from hearing matters in which their impartiality could be affected. The statute mandates recusal where a judge’s financial interests are implicated, and broadly defines “financial interests” so much so that the ownership of one share of stock is enough to mandate recusal.

Congressional officials, however, are allowed to work and vote on legislation so long as they are not the sole beneficiary. This “sole beneficiary” provision in the rules of Congressional ethics places a gloss on their fiduciary obligations. The commentary to the Congressional rule explains that the rule is intended to be construed narrowly. There is a strong presumption that the lawmaker is working in the public interest and that any personal gain is incidental. Interested directors, however, are not granted any presumption that they are working in the best interests of the stockholders, and the business judgment rule applies only with disinterested transactions. Therefore, Nagy concluded, when personal financial interests are involved, political judgments—at least Congressional judgments—are more insulated than business judgments.

Nagy concluded the lecture by submitting that unlike in other branches of government, however, recusal is not an optimal solution for Congress. Nevertheless, Congress can, and should, prohibit members from holding interests in industries on which committees they serve. Notably, added Nagy, this rule is already applied to committee staffers, who are prohibited from holding interests in industries substantially affected by committee work. A stricter rule would prohibit members of Congress from holding securities interests except for general (mutual) funds.

Upon the conclusion of Nagy’s lecture, Professor Luke Scheuer commented that an outright ban on securities activities for Congressional members sounds attractive because, unlike the corporate context where stockholders can sue as a remedy for director ethical breaches, private suits alleging ethical violations would be problematic in the political sphere. Nagy responded that she has not yet advocated for derivative litigation in politics, but House and Senate rules would empower congressional ethics committee to take action.

In response to a question from Professor James May regarding analogies beyond the corporate context, Nagy noted that the United States is unique in that insider trading regulation is derived from interpretation of anti-fraud statutes, whereas other countries have direct statutory bans. In those jurisdictions that more specifically and explicitly ban uses of material non-public information, public officials can simply be added to the list.

Finally, Professor Lawrence Hamermesh noted that a ban on stock ownership may not face the same challenges as campaign finance laws because there is no First Amendment protections to own stock, whereas campaign contributions are now a form of protected political speech.

Stock-Based Compensation as a Cash Expense in Appraisal Rights Litigation

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The treatment of stock-based compensation as a cash expense when determining fair value has become a point of debate in appraisal litigation. Most investment firms recognize the expense when determining fair value of a company’s shares. The Delaware Court of Chancery, however, excluded stock compensation as an expense when determining fair value in Merion Capital, L.P. v. 3M Cogent, Inc., No. 6247-VCP, 2013 WL 3793896 (Del. Ch. July 8, 2013). In a blog essay written for the Delaware Journal of Corporate Law, DJCL articles editor John Gentile examines the diverging viewpoints of the financial industry and the Court of Chancery, and concludes that to achieve the most appropriate estimate of fair value, the Court of Chancery should count for stock based compensation as a cash expense.

Read more at www.djcl.org.blog.

Ex Post Facto Fee-Shifting Law?

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In a recent blog post about legislative proposals relating to charter and bylaw fee-shifting provisions, Francis Pileggi writes:

Unlike routine amendments to the DGCL, this proposed legislation confronts powerful lobbyists on both sides of the issue. Thus, this proposal may be more akin to typical legislation in which the final version of the bill that is passed is not always similar to the first version of the bill that was introduced. The only certainty about this proposed bill, is that it will generate an enormous amount of commentary and discussion. I would not expect a final outcome until the last day of the session on June 30.

If some legislation is passed that ultimately limits the ability of a corporation to adopt fee-shifting bylaws, an interesting issue will be the impact, if any, that the legislation will have on those companies that already adopted fee-shifting provisions. Generally, there is a prohibition against ex post facto laws. Stay tuned.

Francis is right that statutes generally are not interpreted to apply retroactively. But in this case, there are two circumstances that suggest that charter or bylaw fee-shifting provisions that have been adopted by Delaware stock corporations would not survive enactment of the proposed legislation.

The first circumstance is Section 394 of the Delaware General Corporation Law , which provides that “all amendments [of the DGCL] shall be a part of the charter or certificate of incorporation of every corporation except so far as the same are inapplicable and inappropriate to the objects of the corporation.” As interpreted by the Delaware courts, this statute establishes that amendments to the DGCL apply to existing corporations. There may be a legitimate argument about whether a fee-shifting provision currently in place would be enforced in litigation initiated before the proposed statutory prohibition becomes effective (if it does), but given Section 394 there’s nothing ex post facto about prohibiting the operation and application of a fee-shifting provision with respect to litigation initiated after that effective date.

Nor is there anything unfair about the operation of Section 394 in the situation at hand. Last June, the Delaware General Assembly made it clear in Senate Joint Resolution 12 that “a proliferation of broad fee-shifting bylaws for stock corporations will upset the careful balance that the State has strived to maintain between the interests of directors, officers, and controlling stockholders, and the interests of other stockholders.” In the same resolution, the General Assembly called upon the Delaware State Bar Association to consider formulating legislative proposals on this and other litigation-related subjects. Many law firm publications on the subject warned corporations to proceed with caution given the possibility of legislation. No one can fairly claim surprise that a proposal has now emerged that would prohibit fee-shifting in stock corporations by charter or bylaw provision.

In short, Delaware stock corporations that adopted fee-shifting provisions after the ATP decision came down last spring would be well advised to consider removing them if and when it appears that the proposed legislation will be enacted.

Debating Appraisal Arbitrage Legislation

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Recent appraisal litigation in the Delaware Court of Chancery has defendants calling for relief from the Delaware legislature. But is that a good idea? In two blog essays written for the Delaware Journal of Corporate Law, DJCL Internal Managing Editor William Burton and senior staff editor Tom Kramer discuss opposing viewpoints on appraisal arbritrage legislation. Burton examines the arguments raised in two recent cases before the Court of Chancery and ultimately concludes that the Delaware legislature must act to address major concerns with practices in appraisal litigation. Kramer, on the other hand, takes a critical look at the term “appraisal arbitrage” and a forthcoming paper on appraisal litigation in Delaware, and concludes that a legislative fix would be premature. Read both essays in full at http://www.djcl.org/blog.

Bankruptcy: A Look Back and a Look Ahead

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Bankruptcy Event     On Wednesday, October 22, 2014, the Institute of Delaware Corporate and Business Law presented Bankruptcy: A Look Back and a Look Ahead.  The program was initially intended to feature Judge Helen S. Balick on the subject of the Bankruptcy Act, and bankruptcy as it developed under the Bankruptcy Reform Act of 1978 (the “Bankruptcy Code”).  But due to Judge Balick’s recent accident, Chief Judge Brendan L. Shannon and Judge Peter J. Walsh, of the U.S. Bankruptcy Court, participated in her stead.  The program, conducted in conversation-style format, was moderated by Bruce Grohsgal, the Helen S. Balick Visiting Professor in Business Bankruptcy Law at Widener University School of Law, Delaware.

Early in the program, Chief Justice Shannon recounted Judge Balick’s background and professional history as set forth in an oral history he had conducted in April 2014.  The account of Judge Balick’s remarkable personal and professional career set a tone of tribute that permeated the entire program.

Judge Walsh, when asked what was it like to practice in the 1960s and 1970s compared to now, explained that bankruptcy in Delaware was a local practice until In re Cont’l Airlines, Inc., 125 B.R. 399 (D. Del.) aff’d and remanded, 932 F.2d 282 (3d Cir. 1991) (“Continental”).  There were no New York or Chicago firms and the cases were all relatively small cases.  There were not really a lot of other bankruptcy professionals, and he used to appear before Judge Balick at least once a week.  When he assumed judgeship in 1993, his staff consisted of only three people.  There was only one bankruptcy courtroom, so he and Judge Balick would have to coordinate their schedules to avoid double booking.

Chief Judge Shannon, when asked what is was like to practice before Judge Balick as a young lawyer, explained that Judge Balick was remarkably kind, especially to young lawyers.  Chief Judge Shannon had been admitted to practice in 1992, right after Continental, which was a “staggeringly busy time” for bankruptcy attorneys.  Because of the fast pace, his early practice was challenging, and he had to appear before Judge Balick almost every day.  He described how Judge Balick always gave guidance to young attorneys without embarrassing them.

Chief Judge Shannon then highlighted Judge Balick’s “no nonsense” tone, and noted that her approach has been adopted to varying extents by other judges.  He explained that Judge Balick set the tone that the court would get to the merits and would not let procedural issues hang up the case.  This tone created a really valuable dynamic that enabled the parties to proceed to the merits.  He further noted that the importance of proceeding to the merits is part of Judge Balick’s legacy, and has been instilled to a certain extent in the courts today.

Judge Walsh and Chief Judge Shannon remarked that Continental, followed by In re Columbia Gas Sys., Inc., 136 B.R. 930 (Bankr. D. Del. 1992), changed the practice of bankruptcy in Delaware.  Perhaps not coincidentally, Judge Balick presided over both cases.  Chief Judge Shannon expressed that the two cases were dealt with promptly and that Judge Balick’s “no-nonsense” approach minimized uncertainty and delay, which was important to counsel on both sides.

As Chief Judge Shannon and Judge Walsh recounted cases that had been argued and heard before Judge Balick, the program developed a nostalgic atmosphere.  Reminiscing about past cases from their days in practice, the judges described a much smaller and tight knit bar, prior to the advent of the larger cases that began in the 1990s.  Judge Shannon and Judge Walsh’s high regard for Judge Balick, as formers and as colleagues, reflected the enduring impact of Judge Balick’s career and legacy.

 

 

 

Delaware and the Development of Corporate Governance

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At the 30th annual Francis G. Pileggi Distinguished Lecture in Law, Brian R. Cheffins, the S.J. Berwin Professor of Corporate Law at the University of Cambridge, evaluated Delaware’s contribution to the development of corporate governance over the past forty years.  Professor Cheffins posited that although Delaware is often identified as having a substantial impact in the field of corporate governance, it has not been the sole player and has not always been the dominant player in the development of corporate law.  Yet, any analysis of the historical development of corporate governance would be seriously incomplete without a consideration of Delaware and Delaware courts.

In the lecture, Professor Cheffins first asserted that due to the nature of the legislature and the judiciary, Delaware’s key corporate players, expectations concerning Delaware’s potential impact should be kept in check.  He then explained his position that Delaware has not been as impactful in the areas of shareholder activism and executive pay, but has made substantial contributions in the development of boards of directors and takeovers.

Delaware’s Key Corporate Players—the Legislature and the Judiciary

Beginning with the Delaware General Corporation Law (“DGCL”), which has been identified as the formal apex of the structure of Delaware Corporate Law, Professor Cheffins noted that the DGCL has not been overhauled since 1967, before corporate governance became prominent.  Therefore, it was not likely to be the “first mover” on corporate governance; put differently, Professor Cheffins asserted that because the DGCL predated the prominence of corporate governance, it cannot be said to have had a transformative effect on the development of governance standards.  He further noted that Chief Justice Strine has stated that the “Delaware Model” for corporation law makes the DGCL an unlikely foundation for the imposition of governance standards.

Next, in analyzing the role of the Delaware judiciary, Professor Cheffins observed that because of Delaware’s approach to corporate law, Delaware courts have a broad scope to define director’s duties.  This discretion has created the potential for the Delaware judiciary to play a significant role in the development of corporate governance.  But while they have had a profound impact on changes in corporate governance law, Delaware Courts tend to reinforce already-existing trends, rather than foster radical change.

In comparing the legislature and the judiciary, Professor Cheffins explained that with the judiciary, cases tend to be skewed because most filings involve one type of case: a class action challenging actions taken by directors in an acquisition.  Nevertheless, Delaware judges are skilled at creating broad rules and exerting influence on matters not specifically raised by litigants and not before the courts.  The legislature, on the other hand, is not constrained by doctrine and precedent, and can create wide regulatory schemes.  Where courts are constrained, the legislative body can open up doctrine and theoretically investigate and formulate new doctrine.

Delaware’s Influence on Areas of Corporate Governance

After summarily concluding that Delaware’s contribution to shareholder activism has been marginal largely because of institutional constraints, and that Delaware played a largely peripheral role in the transformation of executive pay in the late 20th century, Professor Cheffins, examined Delaware’s role in the development of corporate boards and the decline of hostile takeovers.

Regarding the board of directors, Professor Cheffins set forth that Delaware played a substantial role in rise of independent directors and in establishing standards of deliberation.

Citing Delaware cases in which the independence of the board was seen as a factor in the outcome—Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985), Moran v. Household Int’l, Inc., 500 A.2d 1346, 1349 (Del. 1985), and Paramount Comm’ns, Inc. v. Time Inc., 571 A.2d 1140 (Del. 1989)—Professor Cheffins observed that an indication by Delaware courts that decisions by independent directors would be less scrutinized than decisions by interested parties helped lead to a rise in the importance of independent directors. Yet, despite acknowledging that Delaware courts contributed to the rise of the independent director, Professor Cheffins maintained that Delaware courts were merely reinforcing already occurring key trends in changes to the board.  He further explained that Sarbanes-Oxley and other regulatory reforms in the early 2000s were not transformative because they largely conformed to corporate governance norms shaped by Delaware case law.  Delaware courts had helped transform the legal landscape, and the regulatory reforms went a long way towards mandating the numerical dominance of independent directors and independent committees on boards.

As to the standards of deliberation, Professor Cheffins acknowledged the influence of Delaware case law, but maintained that Delaware’s impact could have been more extensive.  Noting that Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), a case where outside directors of a publicly traded company faced out-of-pocket liability, was widely credited with sensitizing the business community to the deliberative responsibilities of boards, Professor Cheffins expressed that the fears of personal liability may not have been well-founded because a statutory amendment, DGCL § 102(b)(7), permitted restrictions on board liability in the corporation’s charter.  Later, the Disney/Ovitz litigation, In re Walt Disney Co. Derivative Litig., 907 A.2d 693 (Del. Ch. 2005) aff’d, 906 A.2d 27 (Del. 2006), further eased the fears of growing liability risks in Delaware courts.  According to Professor Cheffins, Disney, characterized as “the corporate governance case of the century,” provided Delaware courts with a fresh opportunity to adjudicate on directors’ responsibilities to be more attentive; but the court’s ruling of no liability on the directors likely muted its impact.

Regarding takeovers, Professor Cheffins contended that factors outside of Delaware must have helped to prompt the switch in emphasis from the market for corporate control to internal governance mechanisms.

Observing that Delaware courts were “in the center of the action” during the Deal Decade,[1] Professor Cheffins acknowledged that Delaware rulings that upheld defensive steps taken by boards may have helped bring the deal decade to a close.  He nevertheless put forth that while the Paramount decision, Paramount Commc’ns, Inc. v. Time Inc., 571 A.2d 1140, 1142 (Del. 1989), is largely credited for helping to bring the deal decade to an end, Delaware case law was only one component of a legal matrix that worked to the disadvantage of a hostile bidder.  Explaining that changing market conditions at the end of the 1980s made banks reluctant to lend to those seeking to carry out takeovers, Professor Cheffins posited that other factors must have helped to prompt the switch to internal governance mechanisms at the close of the deal decade.

To further support his contention that factors outside of Delaware must have helped to prompt the switch to internal governance mechanisms, Professor Cheffins examined DGCL § 203, Delaware’s anti-takeover law.  He noted the general thinking that § 203 was of limited practical importance so long as boards had substantial discretion to adopt poison pills.  He then asserted that Delaware case law indicating that boards had substantial discretion to deploy poison pills was not decisive because poison pills are relatively harmless unless coupled with a staggered board, and only a subset of Delaware companies had staggered boards combined with the poison pill.  Therefore, a poison pill did not necessarily render § 203 moot.

Conclusion

Professor Cheffins concluded the lecture by emphasizing that any discussion of the development of corporate governance in the United States would be seriously incomplete without accounting for Delaware’s role.  Nevertheless, other players and factors were at play, and even in the areas where Delaware was most influential, it tended to reinforce trends rather than foster radical change.

In response to a question posed by Professor Lawrence Hamermesh, director of the Institute of Delaware Corporate and Business Law, Professor Cheffins explained that the ability of Delaware to accept certified questions was not crucial to past developments but could be significant moving forward.


[1] A decade in the 1980s exemplified by aggressive bidders seeking to engineer takeover bids by offering generous premiums to shareholders of target companies to secure voting control

Musings on Future Legal and Regulatory Developments Affecting Shareholder Activism

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Eric Talley[1]at Berkeley, and the Berkeley Business Law Journal[2], put together a great conference[3] on April 4, 2014 on shareholder activism, and I scratched out the following thoughts for our panel.  We were supposed to talk about the prospects for further regulatory and legal developments governing or motivating shareholder activism.  First, though, consider what legal rules facilitate activism – and when you do that, you discover that any change is likely to be marginal at best.  Given my working definition of shareholder activism – using share ownership to promote concerted action, by large numbers of shareholders, to exercise the legal rights of shares – the following are key legal rules that enable this to occur:

  • Putting aside the unusual case of dual class capital structures, stockholders will have one vote per share;
  • They will be entitled to vote on the election of directors at annual meetings;
  • They will be entitled to vote on mergers and, at least in Delaware, those transactions will require approval from a majority of the outstanding shares – and maybe even a majority of public or minority shares, in the case of a going private transaction;
  • Putting aside the currently unusual situation of a stock for stock deal, stockholders will have the right to seek a judicial appraisal of their shares.

All of these features of our legal system that do so much to facilitate shareholder activism have virtually no chance of being eliminated or changing in any dramatic way.

So where do I expect to see regulatory and other legal movement in relation to shareholder activism?  Two possible areas of change have been discussed at the federal level:

  1. Disclosure of a 5% ownership position as required by Section 13(d) makes block acquisitions more expensive, so we’re seeing renewed pressure from Wachtell, Lipton[4] and others arrayed against shareholder activists to close the 10-day window in which share buying can continue, past the 5% level, without public disclosure – and perhaps, while fellow activists are tipped off about the activity before the investing public generally.  And we’re seeing their opponents, like Lucian Bebchuk[5], pressing in the other direction, urging that activism by large blockholders is beneficial to investors generally, and the incentives to accumulate such share blocks shouldn’t be impaired.  So will the window ever get closed?  It’s been talked about, again and again, for my entire professional life, and nothing’s ever been done about it, so forgive me for being skeptical that anything will be done now.  Perhaps more plausibly, there will be further development of the law of groups and common beneficial ownership based on concerted activism.  Certainly those who would prefer to discourage activism would prefer to see this body of law develop more aggressively, but again, this idea has been around for a long time and at least so far activists have been well counseled enough to have avoided serious scrapes with 13(d).
  2. Shareholder access to company proxy statements for shareholder proposals, under Rule 14a-8, is a handy activist tool, but we’re now seeing renewed efforts[6] to trim back its availability, by raising minimum ownership requirements and raising the bar for repeat proposals that don’t get a lot of support when first proposed.  These efforts may be less aimed at activists, though, than at the John Cheveddens of the world.  In any case, I’m not optimistic that a consensus will form to do anything on this subject either, or that it in any event would limit the use of 14a-8 by a well-heeled activist.

Much more interesting to me are two state corporate law battlegrounds.  The first one involves various aspects of the right to nominate directors.  Running short slates is, of course, a powerful tool in the shareholder activism kit, and a perennial source of friction as management and activist tectonic plates continually collide.  And there have been a number of recent tremors along that fault line:

  1. Shareholder activist Third Point has a suit pending in the Delaware Court of Chancery[7] seeking relief against Sotheby’s poison pill.  It owns almost 10% of the company, and the directors have adopted a pill that would prevent acquisitions of over 10%, with two notable exceptions:  (i) for acquisitions of over 50% pursuant to an all shares all cash tender offer, and (ii) for persons who buy up to 20%, as long as they confirm that they don’t seek to influence control of the company.  Third Point’s suit claims that the pill is intended not to deter inadequate takeover bids (which is what one usually thinks a poison pill is for), but to impede its effort to elect three dissident directors.  Its challenge is set for a preliminary injunction hearing shortly, before the company’s May 6 annual meeting.  The use (or potential use) of the pill to deter a proxy contest is old news, but this latest chapter is written against the backdrop of the shareholder activist story, as opposed to the more traditional takeover bidder story.
  2. In the last year or so, we’ve seen initiatives by activists seeking to elect candidates to the board to sponsor performance compensation for their nominees.  Corporate managements and their supporters have pushed back[8], in a number of ways.  They criticize these arrangements as improper influences on directors (compromises their independence, it is said, or misaligns their incentives relative to those of stockholders generally).  And for a while last year many corporations were adopting bylaws[9] that purported to disqualify director nominees who were parties to such shareholder-sponsored compensation packages.  In the face of negative recommendations from ISS,[10] though, some of these companies have repealed those bylaws, but the battle is still being fought.  Maybe some day the validity of one of these bylaws will come before the Delaware courts – but I sort of doubt it, honestly; it’s pretty rare to see validity issues actually go all the way to the litigation mat.
  3. In the longer run, I predict other battles along the electoral fault line.  The extent to which boards can adopt bylaws that more generally limit an activist’s right to nominate director candidates is a very undeveloped topic (despite a limited effort on my part[11] in a recent article to explore the subject).  Over time I expect we’ll see disputes about the validity and enforceability of other director qualification bylaws and maybe even minimum share ownership requirements for the right to nominate.

So much for battles over electing directors.  M&A is the other major battleground for shareholder activists, and there have been at least two notable areas in which this conflict has played out:

  1. The first area also involves voting.  There have been some notable successes in shareholder activist efforts to resist going private transactions.  The most famous one, of course, was the Dell acquisition, which saw fierce resistance led by Carl Icahn.  The deal ultimately went forward of course, but with at least modest price bump.  And according to one recent source[12], 71% of activist initiatives in 2013 succeeded in either raising the deal price or terminating a deal, compared to just 25% in 2012 and 19% in 2011.
  2. The other area for shareholder activism in relation to M&A has hit practically epidemic proportions, and is best illustrated in the Dole going private transaction.  I’m referring to the increasing shareholder activist use of statutory appraisal rights.  So I’ll talk briefly about why the increase has occurred, and then suggest some possible pushback that we might see or already be seeing.
    1. The key to it is the rule established in Delaware (back in the Salomon Brothers v. Interstate Bakeries case in 1989[13]) that one can buy shares after a deal is announced and still demand appraisal for the newly acquired shares, as long as you’re the holder on the date of the demand (which can be as late as just before the merger vote).  This practice has been described, plausibly, as “arbing appraisal rights.”  Other attractions include the fact that prejudgment interest is presumptively set by statute[14] at 5% over the federal funds rate – maybe not such a great long-run return on equity, but a darn sight better than market interest rates.  Finally, the risk of getting an appraisal award that’s less than the merger price is not mythological, but it’s not all that salient either, especially in deals like going private transactions, that don’t involve an acquisition by an independent strategic bidder.
    2. So what’s the push back likely to be?  Some have suggested that Delaware needs to fix its rule that shares acquired after deal announcement are entitled to appraisal, and to reduce the assertedly overcompensatory prejudgment interest rate in appraisal cases.  More immediately and practically, I think you’re likely to see even more use of appraisal outs in merger agreements, where the acquirer gets to walk if appraisal demands exceed a specified percentage of the shares.  Andrew Noreuil at Mayer Brown in Chicago put together a nice chart[15] showing that use of such outs actually declined, from 23% of all deals in 2006 to 4.4% in 2012; but it’s on the upswing again (8.2% last year), and I expect that acquirers are going to be even more aggressive about demanding these outs, at least at some level (an out at 10% seems to be the most common so far).
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26th Annual Ruby R. Vale Interschool Corporate Moot Court Competition

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From March 13 to March 16, Widener University School of Law hosted its annual Ruby R. Vale Interschool Moot Court Competition.  Students from twenty-one law schools from the across the country came to Widener to argue Mercer Christian Publishing Co. v. Praise Video, Inc. on appeal to the Delaware Supreme Court.

This case implicated the question of the extent to which Delaware’s recently enacted Public Benefit Corporation Statute affects the contours of Revlon and its progeny.  The parties in the case were Praise Video, a closely-held public benefit corporation with a stated purpose to promote Christian values, and Mercer Christian Publishing Company, a wholly-owned subsidiary of a media conglomerate.

After Praise Video solicited bids, two potential merger partners emerged with offers.  Mercer offered a superior per share price, but the competing bidder was more compatible with Praise Video’s public benefit purpose.  Despite Mercer’s higher offer, Praise Video’s board opted for the competing bid to ensure that Praise Video would continue with its Christian purpose after the change of control.  The board relied on the public benefit statute’s balancing test that allows a board to balance between shareholders’ pecuniary interests, constituents affected by the corporation, and the public benefit purpose when making decisions.  Ordinarily, under Delaware’s well-settled jurisprudence in this context, the board’s decision would have unquestionably been a violation of the directors’ duty to the shareholders to maximize value.  However, because of the new public benefit corporation statute, the question at issue was whether shareholder monetary value could be sacrificed to some extent in the interest of promoting the corporation’s public benefit purpose.

The Honorable Jack B. Jacobs and the Honorable Henry DuPont Ridgeley of the Delaware Supreme Court, Vice Chancellor John W. Noble and Vice Chancellor J. Travis Laster of the Delaware Court of Chancery, and Mr. Simon M. Lorne, Esquire, Vice Chairman and Chief Legal Officer of Millennium Management LLC, served as the distinguished Judges on the bench for the Final Argument.  The advocates consisted of, for the Appellants, Jenna Grassbaugh, Ryan Harmanis, and Hunter West from Ohio State University’s Moritz School of Law, and Zachary Hutchinson and Daniel Woodard, for the Appellees, from Georgetown University Law Center.  After well-argued presentations by both parties, the competitors from Ohio State University’s Moritz School of Law were crowned as this year’s winner.  Competitors Mark Snyder and Alex Yarborough from Seton Hall School of Law were awarded the Donald E. Pease Award for the best brief.  In addition, Mark Snyder received the award for Best Oral Advocate.

On the second day of the competition, Simon M. Lorne delivered to the audience in the Vale Moot Court Room the Vale Distinguished Scholar Lecture titled “Constituency Directors and the Objects of their Attention.”  The lecture focused on the issues related to representative directors and their competing considerations for the shareholders who elected them and their fiduciary duties to the entire company.  Mr. Lorne questioned whether the doctrinal emphasis on serving the interests of the corporation and its stockholder generally adequately acknowledges the reality that representative directors are expected to, and do, serve the interests of the stockholder who chooses them.

Playing a Prevent Defense in a Game Without a Clock – The Need to Amend Section 203

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Guhan Subramanian, the Joseph Flom Professor of Law & Business at Harvard Law School, faced a skeptical bench and bar at the 29th annual Francis G. Pileggi Distinguished Lecture in Law to assert that Section 203 of Delaware’s General Corporation Law needs to be amended before a hostile bidder successfully challenges its constitutionality.  Professor Subramanian was critical of Delaware’s wait and see approach to amending Section 203. He reasoned that because of the drastic decline in the use of poison pills resulting from shareholder activism, removal of the poison pill would leave corporations dependent on Section 203 for a takeover defense, and that corporations may therefore choose to flee Delaware if a constitutional challenge to Section 203 succeeds.

When Section 203 was upheld, back in the late 1980s, federal courts relied on a finding, based on statistical analysis, that the statute afforded a bidder a “meaningful opportunity for success.” However, Professor Subramanian argues this finding was factually incorrect even when made, and that since 1990, no hostile bidder has been able to surmount Section 203’s 85% hurdle, which calls into question whether the decisions upholding it were correct.

Instead of waiting for the shoe to drop and be left with the dilemma to start from scratch, Professor Subramanian proposes that Section 203’s 85% threshold requirement be reduced to 70%.  To support his proposal he points to the shift from effective staggered boards to unitary boards.  According to Professor Subramanian, Delaware missed its opportunity then to amend its corporate code before activists, such as institutional shareholder services, forced corporations to adopt a unitary board system.  He opined that Delaware should not fall into the same trap again and stop the train before it leaves the station, otherwise activists may infect the corporate code with another undesirable change as seen with the unitary board.

Before Professor Subramanian opened the floor to questions from the audience, he asked three questions.  (1) Is the constitutionality of Section 203 settled law?  (2) If not, should a bidder be advised to challenge its constitutionality the next time it becomes a binding restraint?  (3) And if yes, what should Delaware do to avoid this challenge?  According to Professor Subramanian, Section 203’s constitutionality is in question and no plausible reason has been given as to why a bidder would not seek to bring it under judicial scrutiny.

In rebuttal, A. Gilchrist Sparks of Morris, Nichols, Arsht & Tunnell LLP, argued that Section 203 would not be declared unconstitutional based on the Supremacy Clause’s clear and convincing evidence standard.  Mr. Sparks took issue with the interpretation of data used by Professor Subramanian.  Of 1101 bids between 1988 and 2008, 145 were hostile.  In approximately 40% of those bids a transaction was ultimately completed, while another 15% resulted in a white knight deal.  Mr. Sparks asserted that these statistics are evidence of Section 203’s effectiveness to force the board to get the best deal it can get.  Specifically, the hostile-turned-friendly or white knight deals, excluded from Professor Subramanian’s statistics, are likely to be cases where the contestants perceived that the bidder was likely to achieve 85% or more in its tender offer, and where the board accordingly chose to go forward with a sale of the company.  Mr. Sparks concluded from this data that Section 203 does not deny a bidder a “meaningful opportunity of success.”  Moreover, Mr. Sparks discussed his concern about unpredictability that follows in the legislature when initiating an amendment to the code, such as Professor Subramanian proposes.  Lastly, Mr. Sparks argued that the lower 70% threshold would dilute the Section 203’s original intention and, as a matter of public policy, would encourage good corporate form to take on 70% majority ownership.  Chancellor Strine added to the debate by suggesting that Professor Subramanian examine EU regimes identical to Section 203 that have been shown to facilitate change of control transactions.

Professor Subramanian took his chance to respond, and closed by saying that he does not argue that Section 203 would be held unconstitutional.  Instead, he reasons, in light of the incorrect factual analysis from the previous holdings, the statute’s constitutionality remains an unsettled question of law, and therefore Delaware should act preemptively to avoid any potential repercussions.

Visiting Scholar Discusses Stockholder Appraisal in Delaware

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“Delaware occupies such an important place in my teaching and my work that it is an absolute privilege to be here,” said Brooklyn Law School Associate Professor Minor Myers to an audience of faculty, students, and staff on Tuesday, November 12th before launching into the substance of his talk, “Do the Merits Matter in Stockholder Appraisal?”

Myers, the 2013 visiting scholar in residence in business and corporate law, also spoke on Monday, Nov. 11 at 4 p.m. at The Wilmington Club to members of the Delaware bench and bar. The annual visiting scholar program was developed to provide a venue for rising young corporate law scholars to share their research with the Delaware legal community and receive valuable feedback. Widener Law is grateful to The Delaware Counsel Group LLP and the Ruby R. Vale Foundation for co-sponsoring Myers’ visit.

Presenting a paper that he authored with Professor Charles R. Korsmo of Case Western Reserve University School of Law, Myers discussed empirical research into stockholder appraisal litigation in Delaware Chancery Court as compared to fiduciary class action suits. “Does the absence of a class action remedy mean more meritorious claims?” Myers asked of the central question that he hoped to address with the research.

Myers pointed out that the typical academic treatment of the appraisal remedy is to dismiss it as ineffective and therefore rarely used.  He countered that perception with statistics indicating substantial and increasing use of the remedy, especially among sophisticated institutional investors.  He then offered a detailed analysis and comparison between stockholder appraisal claims and traditional fiduciary class action claims brought in the Delaware Court of Chancery between 2004 and 2012. He noted that deal size seemed to be the most important variable in explaining when fiduciary class actions are initiated, with such class actions tending to target larger deals (and a commensurately greater prospect of settlement leverage), whereas the incidence of stockholder appraisal petitions correlated most strongly with deals that involved lower than expected premiums, and appeared to be uncorrelated to deal size. The implication of this research, as Professor Myers explained it, is that appraisal litigation appears to be driven by the merits from the standpoint of stockholders, while fiduciary duty class actions appear to be driven more by the fee motivations of plaintiffs’ counsel rather than the underlying merits of the claims.

These statistical observations, according to Professor Myers, are consistent with the differences in structure between appraisal actions and fiduciary duty class actions.  First, an appraisal plaintiff typically has a substantial stake in action as compared to the representative plaintiff in a fiduciary duty class action.  Second, the class of plaintiffs in a fiduciary action includes all stockholders, while an appraisal action consists only of stockholders who affirmatively elect to pursue the remedy.  Finally, fiduciary actions offer a variety of equitable remedies, and permit settlements for non-financial consideration (like supplemental disclosure), while an appraisal claim is limited to monetary compensation.  As a result of these features, appraisal litigation may tend to be relied upon only when there is a significant prospect of financial recovery, and lawyer-driven suits and settlements are less likely to occur than may be the case with fiduciary duty class actions.