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.

“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 12^th 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.

In its opinion last week in Microsoft Corporation v. Amphus, Inc., the Court of Chancery considered whether corporation’s knowledge in a laches inquiry can bar a plaintiff’s derivative suit under the theory that if laches bars the corporation from bringing a claim, then derivative plaintiffs should also be barred as well because they should not be in a better position than the corporation in prosecuting the corporation’s claim.  The Court in Amphus answered the question in the negative, but cracked the door open for reconsideration.

In this case, between 1999 and 2000, the defendant director restructured his corporation, so that the corporation’s assets spun off into four new subsidiaries.  These four subs were sprinkled with directors also on the board of the parent corporation.  The plaintiff alleges that the restructuring was a scheme by which the defendant director obtained a larger financial stake in valuable intellectual property, although the fledgling corporation was in need of capital.

Although the events giving rise to the litigation occurred over a decade ago, the plaintiff argued the three-year limitation on the breach of fiduciary duty claim should be tolled “under the doctrines of fraudulent concealment and equitable tolling.”

A plaintiff asserting fraudulent concealment must allege an “act of artifice by the defendant that either prevented the plaintiff from gaining material facts or lead the plaintiff away from the truth.”  Under the doctrine of equitable tolling, “the statute of limitations is tolled for claims of wrongful self-dealing, even in the absence of actual fraudulent concealment, where a plaintiff reasonably relies on the competence and good faith of a fiduciary.”  Even if the limitation period is tolled under either of these doctrines, the period is tolled only until the plaintiff has inquiry notice of their cause of action.

The defendant, on the other hand, argued that the corporation was on inquiry notice in 2000 and failed to bring an action, thus the derivative plaintiff’s claim is time-barred.  The Court then considered the relevance of the corporation’s knowledge.  The defendant asserted that the derivative plaintiff’s complaint is addressing harms suffered by the corporation, and, if the corporation had actual or inquiry notice of the harm, then it had a responsibility to take action to protect its rights.  A derivative plaintiff’s right to bring an action on behalf of the corporation, as the defendant argued, “should be no greater than the corporation’s right to pursue the claim directly.”

In response to this argument, the Court stated:

Although [the defendant’s] argument is intuitively appealing, [the defendant] has not cited any cases that supported its position that in a derivative suit, the nominal defendant company’s knowledge is relevant in determining whether there was inquiry notice.  For purposes of this case, in determining whether [the plaintiff’s] claims are time-barred, I have focused on whether [the plaintiff], and not [the corporation], had actual or inquiry notice of [the director’s] wrongdoing.

But the Court, in a footnote, signaled that the defendant’s knowledge could be “relevant in a laches inquiry in a derivative suit.”  It noted that the defendants had several “interlocking directors,” so it is possible that knowledge was imputed between the defendant and its subsidiaries.  However, the Court found that the defendants in this case did not point to any facts that indicated the directors had any knowledge about the challenged transactions.  Therefore the Court found that at the motion to dismiss phase it would be inappropriate to presume the defendant’s knowledge, but it did leave open the possibility of different result once a “factual record is created through discovery.”

The Court’s opinion nudges the defendants to raise their laches defense again after the record is more fully developed through discovery.  However, in this case should the Court accept defendants’ argument?  Is it possible that the corporate defendant’s knowledge bars a derivative action?  Perhaps the key question is whether the corporation with such knowledge was meaningfully able to pursue the claim, or whether the corporation was under the control of the alleged wrongdoers and thus effectively unable to bring the claim.  If the former circumstance were found to be the case, there is at least a reasonable argument that application of the equitable tolling doctrine would be inappropriate, and the corporation’s claim – and the ability to pursue it derivatively – should be time-barred.

Vice Chancellor Glasscock’s opinion yesterday in Huff v. CKx is an interesting development in appraisal case law. Like many appraisal opinions, Huff reflects a persistent frustration with the (euphemistically speaking) indeterminacy of the valuation exercise, and a tendency to want to rely on the results of actual market transactions – in this case, the actual merger price.

The appraisal proceeding in Huff arose out of an acquisition resulting from what the court found to be a reasonable, arm’s length auction process. The Vice Chancellor considered but rejected petitioners’ effort to disregard the result of the auction on the theory that it proceeded on a suboptimal basis (i.e., didn’t use a Vickrey auction approach, in which the price offered in the second highest bid in a sealed bid competition is selected). Accepting the auction result as a reasonable indicator of maximum fair value, and finding comparable company and discounted cash flow analyses unreliable in the circumstances,* the Vice Chancellor instructed the parties to submit evidence regarding the extent to which the merger price impounded synergistic value that should be subtracted in order to arrive at the statutorily-mandated determination of “fair value.”

In adopting this approach, the Vice Chancellor candidly acknowledged direction from the Delaware Supreme Court in Golden Telecom (11 A.3d 214 (2010)) that the merger price resulting from even a full and fair auction cannot place a presumptive upper limit on “fair value.” Indeed, in some post-Golden cases, such as 3M Cogent, the Court of Chancery has been reluctant to rely on sale process results in lieu of strong evidence of going concern value. As Vice Chancellor Glasscock reads Golden Telecom, however, the Supreme Court has by no means denied to the Court of Chancery the ability to consider the merger price as evidence of value, where other indicia of value are found to be unreliable – or perhaps even along with such other indicia, even when reliable. To adopt a rule precluding such consideration of the merger price would be just as inconsistent with the flexibility contemplated by the statute as the presumption rejected in Golden Telecom.

*The primary uncertainty in the DCF analyses presented at trial was the inability to predict, within any reasonable tolerance, licensing revenues associated with the once (but perhaps not future) hit show “American Idol.”