Remarks to the Federal Regulation of Securities Committee of the Business Law Section of the American Bar Association
March 24, 2012, Las Vegas, Nevada
Lawrence A. Hamermesh
Ruby R. Vale Professor of Corporate and Business Law
Widener University School of Law, Wilmington, Delaware
Two questions have been bothering me – and I hope to bother you with them today. First, what do investors really agree to when they buy securities, either in public offerings or in secondary market trading? Second, when should the law (whoever that is) regulate and limit the substantive terms of securities? These questions surface repeatedly, like eruptions along the border of tectonic plates. They surface in a lot of current controversies: exclusive forum selection bylaws; mandatory arbitration provisions in public company charters and public limited partnership agreements; and “other constituency” charter provisions that require boards to look beyond stockholder interests in making decisions, including decisions involving the sale of the company.
I approach these questions in three steps. First, my remarks today on this subject are framed by two chronologically remote bookmarks that I’ll identify shortly; the second step describes two polar opposite schools of thought on the question of regulating substantive investment terms; and the third step poses questions designed to suggest that perhaps nobody really adopts either of these polar opposite views.
First, the two chronologically remote bookmarks. The older one goes back almost 80 years, and yet is familiar to everyone in this room: it’s the Securities Act of 1933. I chose that bookmark because of what we all know, or have been told, about the central policy decision reflected in that Act: namely, that if adequate disclosure is made when securities are offered to the public, the government ought not to regulate the merits or substance of the investment opportunities being offered. Any merits regulation is to come from the States that define the substance of securities through the laws of contract or business organizations. And from what we know about those state laws, the range of investment securities is enormously malleable, because contract and business organizations law have for a long time encouraged and enabled a broad range for private ordering, with default rules only as a backstop.
Fast forward now to my second and very recent bookmark: the March 6, 2012 opinion from the Delaware Court of Chancery in the Delphi Financial Group Shareholder Litigation. Many of you probably are familiar with that bookmark too, but because it’s a fairly new opinion I thought I’d describe it briefly.
Delphi went public in 1990, with a dual class capital structure in which the founder, Robert Rosenkranz, retained 49.9% voting power through ownership of high-vote Class B common stock. Unusually, though, the company’s charter at the time of the IPO contained a provision requiring that merger consideration be allocated ratably on a per share basis among the Class A (public) and Class B (Rosenkranz/control) stock. Vice Chancellor Glasscock surmised that this provision enabled Delphi to achieve a higher issue price in the IPO than would have been the case absent the provision, presumably because the value of a sale of control would be shared ratably by Class A and Class B stock, and Rosenkranz wouldn’t receive a premium, relative to the Class A, on account of his controlling stock position.
Well, guess what? Last year, when Delphi began to explore a sale of the company, Rosenkranz decided that a premium would have to be paid to him in order to secure his indispensable approval as a 49.9% stockholder, and that as a result, the charter would have to be amended to eliminate the equal-treatment provision that had been in place since before the IPO.
The Vice Chancellor didn’t like this. He did acknowledge that a controlling stockholder is ordinarily entitled to receive a premium for control and doesn’t have to share it with the public stockholders. But what he also asserted – and found a likelihood of success at trial on – was that when Delphi went public with the equal-treatment provision in its charter, Rosenkranz gave up any such entitlement to a premium, and gave it up for good, or at least until a vote by stockholders on a free-standing charter amendment that would eliminate the equal-treatment charter provision – a vote that Rosenkranz would presumably have had to pay something for in order to regain the value of the control premium he gave up through the IPO and the original charter provision. As the Vice Chancellor saw it, the IPO charter represented a contract among Delphi and its stockholders, and Rosenkranz was essentially breaching it, or his fiduciary duty, or both, by insisting on getting back a bargained-away premium as a condition to supporting an attractive merger.
Clearly, the Vice Chancellor had a distinct view about what “deal” was struck when Delphi went public, and when thousands or millions of Delphi shares traded hands in the two decades since the IPO. Let me just say, however, that while Vice Chancellor Glasscock may have been right in all this, there’s surely another way of looking at the case. The Vice Chancellor stressed that the equal-treatment provision had affected – upwardly – the IPO offer price. Certainly a plausible conclusion: the charter was fully disclosed, and if you believe in anything resembling market efficiency, the value of the charter provision was built into the IPO price. The charter provision mattered, and the price properly reflected the way in which it mattered. But two questions about this: first, how certain are we about that? How do we know what increment, if any, was paid by investors in the IPO and in the ensuing secondary markets on account of the equal-treatment provision?
And more importantly: if investors, individually or collectively in an invisible-hand sense, took into account and priced the value of that charter provision, why can’t we surmise that they also took into account and priced (or deducted from the price) the legal possibility that Rosenkranz would someday insist on restoring his right to a premium in exchange for his necessary support for any merger? In short, what exactly was the bargain struck, so to speak, when the IPO Class B shares were issued? Did Rosenkranz’ approach to the merger and his demand for a premium and a related charter amendment really defeat investor expectations? Would a premium be a windfall to him? If so, then Vice Chancellor Glasscock may have been right in suggesting that legal intervention, in the form of post hoc fiduciary review, was appropriate.
I don’t actually have an opinion about this – and as you’ll see, I don’t have much of an opinion about anything. I’m just asking questions. But as I see it, these two chronologically remote bookmarks expose the two pervasive questions of corporate and securities law I mentioned earlier: namely, how do we know what investors agree to when they buy securities, either in an initial public offering or in trading markets? And what if anything should the law – state or federal – do to limit the substance of that agreement, in the name of investor protection or efficient capital markets?
Now for my second step: identifying two different ways of approaching these questions. One school of thought – I’ll call it the “disclosure/free market” school – holds that for any substantive term of a publicly offered or traded security, the effect of that term will be built into the price being paid by all investors, either in the public offering or in the market. And if that’s true, then we can console ourselves with the idea that investors are at least getting what they pay for, and aren’t overpaying for an investment whose warts and drawbacks aren’t taken into account in the price of the security.
This school of thought, as you might expect, favors maximum – even unlimited – opportunity for private ordering of investment terms, and looks with disfavor at any attempt to limit or regulate those terms, whether that limitation comes from the federal government or even state law.
The polar opposite school of thought, which I’ll call the “regulatory” school, distrusts the premises of the “disclosure/free market” school. The regulatory school is skeptical that securities markets, especially the IPO market, fully and fairly price arcane substantive terms of securities, so that the potential consequences of those terms can’t really be predicted, and therefore can’t be, and aren’t, priced effectively. According to this school, therefore, state and federal law need to limit the menu of securities terms offered to investors, so that what might be viewed as fundamental rights and expectations of investors aren’t defeated.
As I said earlier, I’m firmly in neither camp, neither school of thought. And that brings me to my third step: some questions for adherents of both schools, questions that I hope suggest some ambivalence and indeterminacy about whether there’s a “right” answer.
For adherents to the “regulatory” school of thought, I ask the following:
• How do you feel about a provision of state law that gives the board of directors the power, with the approval of as little as a bare majority of a quorum of stockholder votes, to force investors to convert their stock into cash or some other stock, against their will? Sounds pretty draconian, right? Yet as everyone here knows, we all now accept that as perfectly normal, as a function of state merger laws. We accept that investors consent to this sort of never specifically agreed-to conversion of their property, albeit with some modest assurances about enforcement of the fiduciary duty of loyalty and the availability of appraisal rights in limited circumstances.
• Next question: how do you, as a member of the “regulatory” school, feel about a charter provision that eliminates the monetary liability of the directors for breach of fiduciary duty, with limited exceptions for self-dealing or intentional misconduct? Again, sounds pretty draconian, no? I can tell you that a lot of people thought so in 1986. Yet again, as everyone here knows, we all now accept such a provision as perfectly normal, as part of the “deal” that investors accept.
• Finally, how do you, as a member of the “regulatory school,” feel about a charter provision that requires that all claims by stockholders of breach of fiduciary duty be brought in the courts of the state of incorporation, and nowhere else? Funny how we aren’t yet all quite as solidly on the same page on this one, but it’s not clear to me why the case for prohibiting such a provision in an initial, pre-IPO charter is any stronger than the case for prohibiting cash-out mergers or fiduciary duty exculpatory provisions adopted after the IPO by board and stockholder vote.
But I don’t want to pick only on those who espouse a regulatory approach to investment terms. For those of you in the “disclosure/free market” school, I have questions for you too:
• How do you, as a member of that school, feel about permitting a board of directors, with approval by a bare majority of stockholders, to adopt a charter provision establishing that stockholders have no right to nominate candidates for election to the board? And don’t avoid the question by telling me that state corporate statutes prohibit such a provision: for one thing, I defy you to show me anything in the Delaware General Corporation Law that contains such a prohibition, or explicitly defines any stockholder right to nominate directors (as opposed to voting for directors). Also, you can’t tell me that such a prohibition offends some supervening general policy of state law: after all, public limited partnership agreements routinely do not afford public investors any right to nominate the general partner. And anyway, if you nonetheless tell me that state law prohibits such a charter provision, don’t you have to tell me too that you think that such state law should be abolished, so that market choices and private ordering can be given full rein? Not prepared to tell me that? Why not? What ur¬-bargain are you postulating that would be offended by a provision that denies stockholders the right to nominate directors?
• Here’s another case for you. As a member of the “disclosure/free market” school, how do you feel about a post-IPO charter amendment, adopted by board vote and a bare majority of a quorum at a stockholder meeting, adding a provision requiring that all stockholder claims of breach of fiduciary duty be submitted to arbitration, and that no such claims be brought as a class action? If you’re true to your school, you should be OK with this, right? After all, stockholders who invested in the company consented in advance to charter amendments adopted in accordance with statutory requirements; the possibility of such an amendment was baked into the initial contract, as it were, right? And if a charter – and the potential for amendments to it – are part of a contract among the corporation and its stockholders, why is that contract in the example at hand any less effective than any other contract for arbitration?
• And one last question: how do you (the “disclosure/free market” person) feel about even a pre-IPO charter provision that requires directors to consider the interests of all relevant corporate constituencies, and the interests of society as a whole, even when the directors are voting on the sale of the company for cash? (In order words, a charter provision that purports to overrule the Revlon doctrine, so that a board could decide that the company should be sold to the Sierra Club for a nominal price, for the greater good of society). Or let’s just cut to the chase: how about a charter provision that eliminates all fiduciary duties of directors? If state law permitted that, it should be OK, right? Just another instance in which investors to whom the charter provision is adequately disclosed can and will effectively account for the impact of the provision such that the IPO price will fairly reflect the value (positive or negative) of that provision.
OK, so maybe this last example is sort of extreme. But the more I think about all of these examples, the more convinced I am that what seems acceptable and what seems extreme is simply a matter of conventional wisdom. And what I’d like to know – and don’t – is whether there’s any unconventional wisdom, any more reasoned analysis, that should go into determining when, if ever, a regulatory limitation on substantive investment terms serves the interests of investors and the public.
For one thing, we could distinguish between pre-IPO provisions and mid-stream amendments: in the latter case, maybe the law should intervene to prevent defeat of reasonable expectations. Maybe the law of fiduciary duty exists in part to perform that intervention, as was perhaps the case in Delphi.
For pre-IPO charter provisions, the case for regulation is harder. Are there aspects of corporate law – like the right to nominate directors – that are so ingrained in corporation law that a charter provision purporting to eliminate them would defeat reasonable investor expectations no matter how thoroughly the prospectus points them out as risk factors? And if so, how do we know one of those inalienable rights when we see one?
I admit that when I saw the arbitration requirement, subsequently withdrawn, in the Carlyle Group’s limited partnership IPO, it certainly made me wonder whether we were seeing something so inconsistent with settled expectations of public investors that it couldn’t ultimately be viewed as fairly agreed to by those investors, no matter how carefully disclosed. That provision certainly seemed to go against the grain of the Delaware system, in which the courts play such a large role in shaping the law and protecting the interests of both investors and management, and in which access to those courts seems almost an indispensable aspect of business entity law.
Given the SEC staff position against declaring effective an IPO containing such an arbitration requirement, maybe the issue is unlikely to be one that state legislatures will have to decide. But if an arbitration requirement were introduced in mid-stream, via a proposed charter amendment, where the issuer doesn’t depend upon an SEC effectiveness declaration, would Vice Chancellor Glasscock or his colleagues step in and refuse to enforce the provision against a stockholder who didn’t vote for it? We know that you can take away a non-consenting stockholder’s stock by means of a merger, but can you take away a non-consenting stockholder’s right to sue in the Court of Chancery, by means of a charter amendment?
Look, I’m a professor: I ask the questions, I don’t answer them. Anyway, as professors sometimes say at the end of their exams, “Discuss.” I hope you’re enjoyed the meetings, and safe travels back home.