All posts by Lawrence Hamermesh

Section 124 Unchained

In a short letter opinion dated August 31, the Court of Chancery in SEPTA v. Volgenau dismissed a claim that a completed merger should be invalidated because it provided for different treatment of shares of the same class of stock, in violation of a charter provision that “holders of each class of Common Stock will be entitled to receive equal per share payments or distributions.” According to the complaint, the allegedly controlling stockholder rolled a portion of his shares into equity ownership of the ongoing company, an option not provided to holders of other shares of the same class.

The opinion declined to dismiss a claim that the directors breached their fiduciary duties by approving a transaction that violated the company’s charter. But the court concluded that the merger itself was beyond legal challenge by a stockholder, because of Delaware General Corporation Law Section 124, which precludes stockholder challenges to corporate acts based on “the fact that the corporation was without capacity or power to do such act,” except in proceedings to enjoin the acts. And because the plaintiff did not seek to enjoin the merger, Section 124 barred its claim to invalidate that transaction.

I admit that this application of Section 124 took me by surprise. Two main considerations drove that reaction. First, I always understood that this statute only addresses claims of ultra vires – i.e., claims that the corporation had purported to act beyond its powers as conferred by the State. I suppose, though, that one could conceive of a transaction that is invalid because if fails to comport with limitations in the charter (or the statute itself, for that matter) as ultra vires. I never thought of it that way myself, however, because I tend to think of the question of ultra vires in terms of corporate purpose, and I would have thought that the now ubiquitous and all-encompassing purpose provisions in charters, based on statutes like Section 102(a)(3), eliminate any question whether the corporation’s purposes include a merger like the one at issue in SEPTA. In short, I wouldn’t have thought that either Section 124 or the concept of ultra vires has anything to do with the disparate treatment claim advanced in SEPTA.

Second, and in any event, if the opinion is correct, a whole lot of case law seems to be placed in doubt. Take the landmark case of Moran v. Household, for instance, in which the Delaware Supreme Court first upheld the poison pill. In that case, the defendant company famously issued rights to acquire stock. That act drew a host of challenges, all aimed at setting aside the issuance. Among those challenges was the assertion that the issuance was not authorized by statute. The Supreme Court rejected those challenges on the merits; but if Section 124 really precludes a stockholder challenge to a completed corporate act, the Supreme Court could have made its life a lot easier by simply invoking Section 124 and dismissing the case, or at least any claim to set aside the pill.

Lots of other cases would similarly become off limits to stockholders. Suppose a charter required a supermajority vote for a merger, and it was discovered after purported consummation of the merger that the requisite vote was lacking. Would Section 124 bar a stockholder challenge? Or suppose that a stock issuance violated a covenant in a charter provision precluding issuance of senior stock without consent of a particular class of outstanding shares? Would Section 124 bar a holder of such shares from challenging the issuance?

I appreciate the value of predictability in commercial affairs, and doctrines of repose, like laches, usefully limit the scope of judicial relief that could impair desirable certainty in business affairs. I can’t resist thinking, however, that the SEPTA opinion goes too far, because it risks unmooring Section 124 from achieving its limited purpose of reining in the ultra vires doctrine, and letting it become an impossible hurdle to legitimate stockholder challenges to corporate actions that violate the provisions of governing documents or statutes. Or conversely, a stockholder’s irreparable harm argument on a motion for a preliminary injunction could become a lot stronger: while mergers or other transactions may often be viewed as “scrambled eggs” once consummated and thus beyond rescission, a robust application of Section 124 would arguably go even further and place all or most all transactions beyond the reach of rescissory relief, at least in stockholder actions.

Delaware Supreme Court Upholds Historic $2 Billion Judgment in Southern Peru Case

Prof. Paul L. Regan

 On Monday, August 27, 2012 the Delaware Supreme Court issued a 110 page opinion in which the Court upheld the decision of Chancellor Leo E. Strine Jr. awarding a judgment of more than $2 billion in damages in a shareholder derivative action on behalf of Southern Copper Corporation (formerly Southern Peru Copper Corporation (“Southern Peru”)) against its controlling shareholder Grupo Mexico (“Grupo”) and the directors on the board of Southern Peru who were affiliated with Grupo.  The $2 billion judgment, premised on a finding of a breach of the fiduciary of loyalty by Grupo and the Grupo affiliated directors on the board of Southern Pacific, is the largest award ever issued by a Delaware court.

 The case arose out of a controlling shareholder conflict transaction completed in 2005, originally proposed by Grupo, in which Southern Peru paid Grupo $3.7 billion in newly issued Southern Peru shares to acquire Grupo’s 99% stake in Minera Mexico (“Minera”).   Chancellor Strine found after trial that Grupo’s ownership stake in Minera was worth only $2.4 billion and that Southern Peru thus had overpaid Grupo by $1.3 billion.  With pre-judgment and post-judgment interest added to the $1.3 billion in transaction damages, the final judgment against the defendants was $2.031 billion.  The Supreme Court also affirmed the Chancellor’s decision to award 15% of this amount, or $304 million in attorneys’ fees, to counsel for the shareholder plaintiff, emphasizing under established Delaware precedent that the most important factor to consider on fee petitions in common fund cases is the size of the benefit obtained for the corporation or its shareholders.

 Grupo owed fiduciary duties to Southern Peru and its minority stockholders as the company’s controlling stockholder.  Grupo held 54% of Southern Peru stock, controlled 63% of its voting power and also had the right to nominate a majority of the Southern Peru board.  At the time of the Minera transaction, 7 of the 13 members of the Grupo board were affiliated with Grupo.  In a thorough and highly fact-intensive opinion, the Delaware Supreme Court sweepingly affirmed Chancellor Strine’s conclusion that Defendant Grupo and its affiliate directors failed to demonstrate the entire fairness of the Minera transaction to Southern Peru and its minority shareholders.  Indeed, the valuation evidence showed that the transaction was demonstrably unfair in this regard and thus could not withstand the strict judicial scrutiny that is the standard of review for such conflicted fiduciary transactions.

 The unprecedented size of the judgment in the case will certainly bring much attention to the decision, but there is really no new doctrinal ground plowed in this one.  Of most interest to this writer, and likely to transaction planners and litigants alike, is the Supreme Court’s discussion of the burden shifting analysis that applies to conflict transactions involving controlling shareholders.

 Long ago the Supreme Court in Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983) ruled that strict judicial scrutiny, comprised of the now familiar entire fairness analysis which places the burden on the defendant to show fair dealing and fair price, was the proper standard of review for parent-subsidiary merger transactions.  In a transparent signal to transaction planners, the Weinberger Court suggested in a footnote that such conflict transactions could receive a more favorable welcome by the Delaware courts if a committee of the subsidiary’s independent directors were established to negotiate exclusively on behalf of the minority stockholders and thereby approximate an arm’s length transaction.   Id. at 709 n.7.  A decade later, in Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994) the Delaware Supreme Court clarified that the effective use of a special committee in a parent-subsidiary conflict transaction, though welcome, would not avoid the strict scrutiny standard of review applicable to such problematic transactions but would however earn the defendants a favorable shift in the ultimate burden of proof.  That is, assuming that a truly independent committee was appointed and then functioned effectively by approximating an arm’s length transaction (the Kahn committee, though independent, failed to function effectively by caving to the controller’s demands at the end of the process), the ultimate burden of proof on the merits – within the strict scrutiny standard of review – would shift thereby requiring the shareholder plaintiff to prove unfairness.  Kahn also clarified that such a shift in the burden of proof would apply if the controlling shareholder empowered the minority shareholders with a “veto” by conditioning the transaction on an informed and approving vote of a majority of the minority shareholders.

 The Southern Peru case decided this week directly addresses some important practical concerns that have remained since Lynch was decided nearly 20 years ago.  Why would a controlling shareholder go to the trouble of a special committee process when the litigation pay-off is seemingly a mere modest shift in the burden of proof but an otherwise continuing application of the entire fairness test?   Moreover, when cases go to trial in the Delaware Court of Chancery, don’t litigants need a trial strategy informed by what rules of law apply to their case?  But the burden shifting that Lynch makes possible will not be known in most cases until after all the witnesses have testified and long after the parties have submitted their post-trial briefs in which they will still be arguing about who has the ultimate burden of proof in the case.  Indeed the defendants in Southern Peru argued that such litigation uncertainty would dissuade corporations from forming independent committees in future transactions but the Supreme Court appropriately would have none of this flimsy claim.

 Since Lynch was decided controlling shareholders planning a conflict transaction haven’t formed special committees for a modest shift in the burden of proof.  They engage in such a process to win the day on the merits under the entire fairness analysis, irrespective of whether the burden of proof shifts from the defendants to prove fairness to the plaintiffs to prove unfairness.  Planning for trial in an entire fairness case means first planning a transaction process that accords with the expectations that Weinberger, Lynch and their progeny have established.  That means establishing a committee of genuinely independent directors to evaluate and/or negotiate a transaction with a controlling shareholder.  Once constituted, the committee must then function effectively to the satisfaction of the reviewing Court, which in the context of a conflict transaction will be appropriately skeptical and untrusting (i.e., will apply strict scrutiny).  Functioning effectively in turn means the committee must take on its responsibility as if it were engaging in an arm’s length negotiation and thus the committee must stand ready to reject any unacceptable proposals by the controlling shareholder and otherwise protect its independence from any influence or retributive threats (express or implied) of the self-interested controlling shareholder.

 At the end of the day, the Supreme Court in Southern Peru unabashedly acknowledged that such genuine practical concerns might be raised by a burden shift that cannot be known before trial, but the Court clarified in such cases going forward that the burden of persuasion would remain “with the defendants throughout the trial to show the entire fairness of the interested transaction.”  In this regard, the Supreme Court’s ruling is likely in keeping with the advice of counsel to controlling stockholders in such cases already, i.e., establish a special committee process that is unassailable but prepare for trial as if the burden of proof remains on the defendants.  For transaction planners and litigation counsel alike, Southern Peru appropriately reinforces the practical reality that defendants in these cases need to protect the transaction with good process irrespective of whether they get the burden shift before, at or after trial.

Synthes-is: Strine on Pro Rata Treatment in a Sale of a Company with a Controlling Stockholder

Should courts permit deal litigation to go forward when there’s no evidence that the sale process was rushed, or was tainted by an interest on the part of those influencing the process in favoring themselves at the expense of public shareholders generally?

In his typically colorful opinion in In re Synthes, Inc. Litigation (Aug. 17, 2012), Chancellor Strine says no, because facts matter. The overwhelmingly significant fact in the case, according to the Chancellor, was that the allegedly controlling stockholder (Wyss) would receive exactly what all other stockholders would receive, no more, no less. And speaking of no less, the Chancellor was adamant – and supported by long-standing case law – that the controller wasn’t obligated to pursue a partial bid for the company that might have given public stockholders a marginally better deal, perhaps, but would have required the controller to retain a significant equity interest in the continuing enterprise, and thus sacrifice the ability, available to public stockholders, to sell his entire holdings.

Two aspects of the opinion seem particularly notable. The first is probably dictum, because the opinion rejects the application of Revlon to the transaction at issue, in which the stock component represented 65% of the total consideration. But the Chancellor notes that “even if Revlon applied, … there are no pled facts from which I could infer that Wyss and the Board did not choose a reasonable course of action to ensure that Synthes stockholders received the highest value reasonably attainable.” This is a powerful statement, and a welcome one. In particular, it is a useful reminder that the application of Revlon does not dispense with the requirement that a complaint adequately allege a breach of the fiduciary duties implicated in that case. Nor does Revlon’s application preclude dismissal simply because the transaction includes what are widely recognized as standard deal protection measures (3% breakup fee, no-solicitation provision with fiduciary out, and matching rights).

The second notable aspect of the opinion also bears on the question of dismissing deal litigation at the pleading stage. The plaintiffs’ main theory for applying the entire fairness standard was the notion that the controller’s interest in liquidity created a conflict in relation to the public stockholders, for whom a potentially higher bid would be preferable even though it would deny the controller the full liquidity he desired and that the public stockholders would have. According to the opinion, and most remarkably, plaintiffs did not rely “in any way” on McMullin v. Beran, 765 A.2d 910 (Del. 2000). Perhaps because of that, the Chancellor addresses that opinion only in a footnote, albeit an extended one. That footnote (fn. 91) bears close reading, because I would have thought that plaintiffs would have relied extensively on McMullin. As the Chancellor explained, that opinion might have assisted the plaintiffs in Synthes because “the Supreme Court accepted the contention that a duty of loyalty claim could be filed against the parent for negotiating an ‘immediate all-cash [t]ransaction’ to satisfy a liquidity need by accepting as true the plaintiff’s allegation that the full value of the subsidiary “might have been realized in a differently timed or structured agreement.” Id. at 921.

The Chancellor’s footnote, however, closely questions the financial reasoning implicit in McMullin:

McMullin seems to contemplate that that it was disloyal for the controlling stockholder to accept an all-cash deal in part because a ‘differently … structured’ deal (e.g., a stock-for-stock deal) ‘might have’ delivered more shareholder value, but the controller accepted a lower-valued all-cash deal because of its need to use that cash to fund an acquisition of a separate company. McMullin, 765 A.2d at 921. But, this reasoning glosses over the reality that the present value of stock depends on the currency value into which it can be converted, plain and simple.

Appropriately enough, the Chancellor recognizes in Synthes that a controller’s interests could in some case inappropriately conflict with the interests of public stockholders, even where the deal consideration is shared pro rata:

It may be that there are very narrow circumstances in which a controlling stockholder’s immediate need for liquidity could constitute a disabling conflict of interest irrespective of pro rata treatment. Those circumstances would have to involve a crisis, fire sale where the controller, in order to satisfy an exigent need (such as a margin call or default in a larger investment) agreed to a sale of the corporation without any effort to make logical buyers aware of the chance to sell, give them a chance to do due diligence, and to raise the financing necessary to make a bid that would reflect the genuine fair market value of the corporation. In those circumstances, I suppose it could be said that the controller forced a sale of the entity at below fair market value in order to meet its own idiosyncratic need for immediate cash, and therefore deprived the minority stockholders of the share of value they should have received had the corporation been properly marketed in order to generate a bona fide full value bid, which reflected its actual market value.

But the lesson of Synthes, as I see it, is that a complaint should do more than speculate about possible inconsistency of interests between controller and public: to survive a motion to dismiss, it should lay out facts indicating in some reasonably specific way why it is conceivable that such an inconsistency actually exists.

Insurer Standing in the Ninth Circuit—Focusing Solely on the Express Terms of the Debtor’s Reorganization Plan

This post is authored by Peter Tsoflias, Widener Law School Class of 2013:

Section 524(g) of the United States Bankruptcy Code purports to provide relief to debtors facing waves of asbestos, silica, benzene and other mass tort related claims. To be sure, section 524(g) allows Chapter 11 debtors to establish a trust and an injunction which channels present and future mass tort claims to the trust. As would be expected, liability insurance is often the primary asset funding such trusts. Due to the fact that insurers are affected by reorganization plans encompassing section 524(g) trusts, affected insurers often seek to challenge the confirmation of such plans.

In order to challenge the confirmation of a reorganization plan, an insurer must meet the standing requirements prescribed by the Constitution as well as the Bankruptcy Code. The Third Circuit’s jurisprudence is fairly well developed with respect to the issue of insurer standing in the bankruptcy context. To this effect, the Third Circuit first dealt with insurer standing in In re Combustion Engineering. After closely examining the reorganization plan at issue, the Combustion court noted that the plan adequately preserved the insurers’ pre-petition contractual rights and defenses; therefore, the plan was deemed “insurance neutral”. In so noting, the court held that the insurers faced no injury by the plan and, consequently, did not have standing to challenge the plan’s confirmation.

Subsequent Third Circuit decisions followed suit—closely examining each reorganization plan at issue to determine whether each plan’s language was insurance neutral. In a prior writing (found here), I took issue with the Third Circuit’s most recent holding concerning insurer standing in the bankruptcy context—In re Global Industrial Technologies (hereinafter “GIT”).

The debtors in GIT sought bankruptcy relief in order to address over 235,000 asbestos related claims and 169 silica related claims then pending against the debtors. The debtors’ plan, which included a section 524(g) trust, purported to preserve the insurers’ pre-petition rights and defenses post-confirmation (i.e., insurance neutrality language). Despite the plan’s insurance neutrality language, the Third Circuit reversed the lower court decisions and held that the insurers had standing to challenge the plan’s confirmation. Notably, the court did not base its holding on whether the debtors’ plan adequately preserved the insurers’ rights and defenses. Rather, the court focused on the “suspect circumstances” surrounding the silica claims. In particular, the Third Circuit found that the number of silica claims surged shortly after the debtors filed bankruptcy. The court found these claims to be “suspect” because they were allegedly products of collusion between the attorneys representing the asbestos and silica claimants. The Third Circuit held that investigating these suspect claims created a new class of administrative expenses that the insurers would be called to bear. Such an increase in administrative expenses increased the insurers “quantum of liability”, therefore constituting an injury sufficient for bankruptcy standing.

In my Note, Insurance Neutrality: Affecting an Insurer’s Right to Bankruptcy Standing, (see link above) I sided with the GIT dissent, arguing that the Third Circuit should not have focused on any increase in the insurers’ “quantum of liability.” Doing so frustrates the intent of the Bankruptcy Code and undermines basic principles underlying contract and constitutional law. Further, I articulated a two prong test for courts to apply when addressing the issue of insurer standing in the bankruptcy context. First, as a threshold matter, courts should determine whether the plan at issue adequately preserves insurer’s pre-petition rights and defenses (i.e., includes insurance neutrality language). In making this determination, courts should not look beyond the four corners of the plan (as the court did in GIT). Second, courts should determine whether the plan at issue threatens to undermine the integrity of the bankruptcy court. If this is found, a more searching look into the plan’s validity is warranted. This standard serves several objectives (as discussed in my Note)—most notably, it is in agreement with basic contract principles. To this end, I argue that if a plan adequately preserves an insurer’s pre-petition rights and defenses (as was the case in GIT) the insurer suffers no contractual injury. By granting an insurer standing in this context (as the Third Circuit did in GIT), the court is giving an insurer more rights than the insurer initially bargained for.

Despite the Third Circuit’s “quantum of liability” standard set forth in GIT, the Ninth Circuit in In re Thorpe Insulation Co. solely examined the express terms of the plan at issue. Similar to the plan in GIT, the debtor’s reorganization plan in Thorpe contained a section 524(g) trust and a provision stating that the plan is “insurance neutral” because it preserves all “Asbestos Insurance Defenses.” Notwithstanding this boilerplate language, the debtor’s plan contained four exceptions to the insurers’ otherwise preserved defenses. In light of these exceptions, the court held that the plan was not insurance neutral because it did not adequately preserve the insurers’ pre-petition contractual rights and defenses. Accordingly, the insurers were granted standing to challenge the plan’s confirmation.

The Ninth Circuit’s holding in Thorpe is consistent with the two prong test articulated in my prior Note. In particular, by focusing solely on the express terms in the debtor’s plan and the contract between the debtor and its insurers, the Ninth Circuit’s analysis was in accord with basic contract and constitutional principles. In order to promote consistency, reliability and efficiency in bankruptcy proceedings, courts should welcome the Ninth Circuit’s approach to analyzing the issue of insurer-standing. Two thumbs way up for the Ninth Circuit!

Certifying questions of law from bankruptcy courts to the Delaware Supreme Court

Under Article IV, Section 11, paragraph 8 of the Delaware State Constitution, the Delaware Supreme Court can entertain and respond to certified questions of law from federal district and appellate courts, and state supreme courts, as well as the Securities and Exchange Commission. For now, however, bankruptcy judges aren’t able to engage in that certification process.

At a conference held at Widener on April 16, however, a panel of state court and bankruptcy court judges tossed around the idea of enabling bankruptcy courts to certify questions of Delaware law to the Delaware Supreme Court. The judges’ reaction, from both sides of the federal/state line, was quite positive. And it looks as if the idea may be on the way to becoming law: Senate Bill 221, introduced in the Delaware General Assembly on May 16, would if adopted be the first step in amending the State Constitution to implement the idea. If adopted in this legislative session ending June 30, it would need to be re-adopted next year by the newly elected General Assembly, in order to become effective.

Celera and class action standing

A recent blog entry (“Delaware Chancery Court Chides Pension Fund for Boosting Returns”) discussed the March 23, 2012 Chancery opinion in the Celera case that didn’t get much attention when it came out. [See also Francis Pileggi’s blog entry]. I’m told that the case is on appeal now, however, and it may get a great deal more play going forward.

The blog quoted me (fairly, I might add) as questioning why the opinion was so critical of the plaintiff’s sale of its shares shortly before the challenged acquisition’s second step merger. I suggested that the plaintiff’s obligations to its own beneficiaries may have justified or even compelled that sale, and that it didn’t make a lot of sense to force a plaintiff to forego such a sale in order to maintain status as class representative.

As they say, however, it’s complicated. I still don’t see why the plaintiff’s sale ought to be viewed darkly, as an inequitable manipulation unsuited to its fiduciary status. That sort of criticism doesn’t in my view adequately acknowledge the plaintiff’s institutional obligations as a money manager. Thus, the Vice Chancellor’s ruling that the plaintiff was not barred by the doctrine of acquiescence, given that the transaction was a “fait accompli,” seems perfectly reasonable to me.

The problem, however, is that it’s unclear whether or how a stockholder who neither tenders in a first step offer nor is forced to sell in a second step merger — but who sells in the market in between those two events — could participate in any recovery on behalf of the class, which is usually defined as those who tender and those whose shares are acquired in the second step merger. And if the plaintiff doesn’t fit in either subgroup and wouldn’t be entitled to share in any recovery, can it properly represent those stockholders who would be entitled? And if it can’t, does its position as a class representative, once that mantle is seized, require it to forego a sale opportunity that its obligations to its beneficiaries might otherwise require it to pursue?

There’s an argument that the plaintiff’s sale in the market was at a price that necessarily reflects the value of the class claim, and therefore market sellers shouldn’t be entitled to participate in the class, because they reap the benefit of the litigation claims when they sell in the market. If that premise is correct, then there’s good reason to argue that the plaintiff, having asserted the right to act as a class representative, should have awaited the outcome of the litigation rather than obtaining the present-value benefit of selling in the market. That’s also a good reason for limiting the class to those who sell in the first step offer or the second step merger, but excluding those who sell in the market in anticipation of either part of transaction.

But what if the market doesn’t perfectly value pending claims? Are market sellers adversely affected by the anticipation of challenged transactions? If so, should they have standing to pursue fiduciary duty claims against such transactions? And if so, what practical means could be used to evaluate how to allocate amounts paid in settlement or judgment among those who sell in the market and those who sell in the challenged transaction itself?

Valuation Standards in Appraisal Proceedings — a Reply to Steve Bainbridge

Steve Bainbridge was a good sport, as usual, and shared with me his recent comments on DGCL § 262(h)’s exclusion of value arising from the accomplishment or expectation of the merger. I sent him a few reactions, more or less as set forth below:

1. You say “I have always assumed that Weinberger thus allowed the chancery court to consider evidence of, among other things, control premia paid in comparable acquisitions.” As Professor Wachter and I approach it (I think our most recent article — 50 B.C. L. Rev. 1021, 1038, 1052-53 — does a better job of explaining all this), we see it differently: control has a distinct value to the person who owns or acquires it, and it cannot be viewed as belonging to dispersed public shareholders or minority shareholders. Accordingly, and in light of the statutory exclusion, and UOP’s ambiguity notwithstanding, we believe that it’s a mistake to appraise fair value under the Delaware appraisal statute by reference to transactions that reflect payment of a premium for control.

2. You also say that “The real issue, after all, ought to be whether the dissenting shareholders received a fair premium over market. In order to answer that question, one must start with the price paid in the merger and, if appropriate, work up from there.” Again, we would respectfully disagree: for one thing, and as we point out in our most recent article (50 B.C. L. Rev. at 1034), most appraisal cases arise where there is no meaningful market for the shares being appraised. We also doubt that share prices in efficient markets necessarily and systematically yield prices below “fair value,” measured by the “going concern value” standard.

3. You ask “given that appraisal is now a crap shoot in which one can end up with less than the price offered in the merger, why would any sane investor invoke appraisal rights?” Preliminarily, this isn’t the first time that an appraisal award has been less than the merger consideration. I’m too lazy to dig out earlier examples right now, but it’s definitely happened before. Anyway (and don’t blame Wachter for this opinion), I think the far greater obstacle to appraisal as a useful remedy are the procedural hurdles (opt in, no $$ until the bitter end) rather than the substantive valuation standards, which have given quite a few shareholders a real and surprising boon (windfall?).

4. Finally, you say “Likewise, the policy of giving dissenting shareholders a fair price for their shares calls for taking synergistic elements into account, while the policy of giving the shareholders the fair value of their stock in the company as a going concern calls for excluding such elements.” We’re with you 100% on the second part of this sentence, and we think that’s the governing legal rule. Again, though, we would disagree with the first half of the sentence: disaggregated shareholders don’t have control, and fairness doesn’t require that they be paid for what they don’t own.

And just a quick update: Steve’s response to this post asks how one can distinguish between future value permissibly taken into account in determining “fair value” from future value that is synergistic and disqualified for consideration. Here’s what I wrote back to him:

Fair question — I’ve always conceived of UOP’s principal contribution as overcoming a long held (and not altogether closely reasoned) antipathy to use of projections. In short, no DCF before UOP; post-UOP, practically always used. Future value encompasses the range of opportunities available to the stand-alone firm, and value of the future returns associated with those opportunities (as long as they’re not “speculative,” whatever that means — not reasonably foreseeable?). But the key words are “available to the stand-alone firm” — once the opportunity for future returns depends on a combination with a merger partner (i.e. is a synergistic value), that’s when I think 262(h) operates to require excluding any additional value associated with that opportunity.

Thanks for the opportunity to put off some more grading.

And here’s some more explanation from my co-author Professor Wachter:

Let me add to Larry’s remarks. In Corporate Finance (at least the finance of corporate finance) we teach that the value of the firm is the value of the discounted free cash flows of its current assets plus the PVGO (present value of future growth opportunities). The PVGO, particularly for firms in appraisal is often the larger of the two. I think of it as the corporation’s existing corporate policy which normally includes several years of continuing investments. The more specific the existing corporate policy, the more likely that the petitioner can get those values included in the appraisal. The respondent can question the value of these future opportunities, but they do indeed belong to the corporation at that time. These opportunities are distinct from synergies resulting from a merger. I use the stock market’s valuation of Amazon as an example. That company’s valuation is mostly the present value of future growth opportunities.

Proxy Access Votes – 2012

Here’s a scorecard for those interested in how proxy access shareholder proposals fared in their first season (the ISS corporate governance blog has already reported some of this information, as has Francis Byrd of Laurel Hill Advisory Group, in his wonderfully titled “Byrd-Watch” page, but the numbers here are a little more comprehensive):

Download the Excel .xls version: 2012 proxy access votes

Grains of salt are in order: the sample is small (a total of nine access proposals were presented for a vote this year); in the case of KSW, moreover, the company had already adopted a proxy access bylaw (with a 5%/1 year ownership minimum). Still, and with two notable exceptions discussed below (Nabors and Chesapeake Energy), the voting was not a ringing shareholder endorsement of proxy access in any and all forms.  Apart from those two exceptions, the 2012 votes in favor of proxy access have been below 40% of the shares voting, below 35% of shares present, and below 30% of shares outstanding.

The two exceptions, however, were at Nabors Industries and Chesapeake Energy, where the access proposal garnered approval of a majority of the shares voting and of the shares present at the meeting, and substantial minorities (39.6% and 44.5%) of the outstanding shares.  What might explain these notable successes?  One possibility is both Nabors and Chesapeake had been the subject of high-visibility questions about executive compensation and related party transactions involving their CEOs, including the controversy surrounding the $100 million severance payment (subsequently waived) to the former CEO. Another possibility is that the Nabors and Chesapeake access proposals were the most restrictive of this year’s crop, with a 3%/3 year ownership requirement mirroring the framework of the SEC rule (14a-11) struck down last year. It will be interesting, in any event, to see how the Nabors and Chesapeake boards of directors respond to the favorably shareholder votes.

More on Delphi Financial Group

I recently wrote about the very interesting opinion from Vice Chancellor Glasscock in the Delphi Financial Group litigation.  The crux of the opinion was the indication that the controlling stockholder (Robert Rosenkranz) was not entitled to a premium for his Class B shares relative to the publicly traded Class A shares (the respective merger prices for the two classes are $44.875 for the Class A and $53.875 for the Class B).

 Today, Delphi announced a settlement of the litigation (the merger, although overwhelmingly approved by Delphi’s stockholders, including the Class A, will not be consummated until final regulatory approval).  The announcement, at least read superficially, looks like a total victory for the plaintiff class:  there is to be a $49 million payment to the Class A (although plaintiffs’ attorney’s fees and costs will be subtracted from that payment, if the settlement is approved).  If one assumes that this entire sum will simply be reallocated from the Class B to the Class A, the result would be elimination of the Class B premium:  with about 6.1 million Class B shares outstanding, a $49 million reallocation would reduce the B shares’ consideration to $45.875 per share, and with about 49 million Class A shares outstanding, the merger consideration for the A shares would increase by $1 per share, to $45.875.  Voila!  All is even again.

 The question the press release doesn’t quite answer, however, is what the source of the $49 million settlement payment is.  If it’s Rosenkranz only, the “truing up” will have been accomplished.  To the extent, however, that the acquirer or some D&O insurance carrier is providing some portion of the $49 million, Rosenkranz would be retaining some of the premium that the Court criticized.   It will be interesting to learn a bit more about this settlement, and one hopes that the papers submitted in support of the settlement will clarify the source of the settlement payment.

Delphi Financial Group and Regulating Terms of Investment Securities

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.