Category Archives: News

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.

Central Mortgage, Cambium, Plausibility, and Conceivability

Stephanie Habelow of Smith, Katzenstein & Jenkins submits the following observations on the fallout from the Delaware Supreme Court’s 2011 opinion in Central Mortgage Company v. Morgan Stanley Mortgage Capital Holdings LLC, 27 A.3d 531 (Del. 2011):

The standard on a motion to dismiss is a familiar one, well-known to virtually all Delaware lawyers: Well-pleaded allegations shall be accepted as true. Conclusory allegations shall not be. Only allegations that suggest recovery under a reasonably conceivable set of circumstances survive. Or is the standard plausibility?

In its decision in Central Mortgage Company v. Morgan Stanley Mortgage Capital Holdings LLC, the Delaware Supreme Court emphasized that reasonable conceivability is the only standard Delaware courts should apply in reviewing a motion to dismiss: “the governing pleading standard in Delaware to survive a motion to dismiss is reasonable ‘conceivability.’” This decision reviewed the Court of Chancery’s application of what appeared to be a plausibility standard in dismissing a complaint.

Chancellor Strine, whose use of just such a standard provided the impetus for the decision, explained his perspective on this issue in a detailed footnote in Winshall v. Viacom International, Inc. Seeing little difference between “conceivability” and “plausibility”, the Chancellor questioned the utility of the Supreme Court’s decision and puzzled over the direction of Delaware’s procedural law on this point. The Supreme Court, perhaps by way of tacit reply, released an order recently in Cambium Ltd. v. Trilantic Capital Partners III LP, in which the Court again emphasized that the standard to be applied on a motion to dismiss is one of conceivability. This order reversed Vice Chancellor Laster’s apparent application of a plausibility standard in dismissing a complaint (the order notes that the Vice Chancellor ruled from the bench and used the word plausibility nine times during the hearing). These two judges are not the only ones applying a “plausibility” standard – other members of the Court have done so, as well, and on several occasions, the Court has cited to Bell Atlantic Corp. v. Twombly when setting forth the standard. So how did we get here?

The Court of Chancery’s use of a plausibility standard (or at least, the Court’s use of the word “plausibility”) can be traced back to 2007 in Desimone v. Barrows which cited Twombly and made the following observation: “our nation’s high court has now embraced the pleading principle that Delaware courts have long applied, which is that a complaint must plead enough facts to plausibly suggest that the plaintiff will ultimately be entitled to the relief she seeks.” This suggests that plausibility has always been the standard Delaware courts apply on a motion to dismiss – at the very least it suggests that the Court of Chancery does not distinguish between a conceivability standard versus a plausibility standard. According to the Delaware Supreme Court, the standard has always been one of conceivability and Delaware courts should continue to apply this standard until the Supreme Court has the occasion to determine whether Twombly and Ashcroft v. Iqbal have any bearing on Delaware’s standard. That said, there seems to be a disconnect between the Delaware Supreme Court’s and the Court of Chancery’s view of the direction of Delaware law in this area. As noted, the Court of Chancery had seemed to recognize the federal plausibility standard as following in Delaware’s footsteps (as noted in Desimone). However, in Central Mortgage, the Delaware Supreme Court seemed to find that the opposite was true – that Delaware courts were following their federal counterparts and that they should not be, absent some express affirmation of that standard articulated in Twombly and Iqbal.

Does any of this matter? Is there anything really wrong with applying a slightly higher plausibility standard than a conceivability standard? First, this matters for the obvious reason: lawyers and judges alike appreciate knowing that Delaware Supreme Court’s position and having known standards to apply. However, the Chancellor has a point: there does not seem to be a significant difference between conceivability and plausibility. Admittedly, there does seem to be a perceptible difference between the two (not everything that is conceivable is plausible), however, the Supreme Court’s distinction of the two words seems to elevate conceivability a bit (Central Mortgage described conceivability as similar to “possibility” whereas plausibility is somewhere between possibility and probability). Second, the Central Mortgage opinion stated that vague allegations will be considered well-pleaded if they give the defendant notice of the claim. Although Delaware’s notice pleading standard is clear and well-established, the use of “vague” allegations to accomplish this seems to be a departure. How can vague allegations be considered well-pleaded? Well-pleaded allegations are non-conclusory allegations grounded upon facts that state a cause of action. It seems that because a vague allegation would likely lack any specificity, this would means that a conclusory allegation might in fact be a step up from a vague allegation. Yet, conclusory allegations are not accepted as well-pleaded for purposes of a motion to dismiss.

It is hard to see the import and practicality of applying a standard of reasonable conceivability – if anything, this somewhat lower standard may allow more cases –possibly weak cases – to survive a motion to dismiss, progress farther in litigation, and expend limited judicial resources. Moreover, the Court of Chancery’s apparent use of a plausibility standard on several occasions may have just been a semantic difference instead of a true misapplication of a different standard.

Ruby R. Vale Corporate Moot Court Competition, March 15-18, 2012

Next week marks the return of the annual Ruby R. Vale corporate moot competition. We obviously hope that the event provides a worthwhile educational experience for the competitors, who hail from 22 law schools throughout the country. But there’s also a little bit of guilty pleasure on my part in watching the final oral arguments, with members of the Delaware Supreme Court and Court of Chancery presiding. It’s a chance to tease out their reactions to knotty legal issues that my colleague Paul Regan or I gin up every year. Next week’s all-star cast of good sports includes Justices Jack Jacobs and Henry Ridgely, Vice Chancellors John Noble and Sam Glasscock, and our distinguished visitor Richard Climan, of Dewey & LeBoeuf in Palo Alto. Along the way to the finals, competitors will encounter daunting questioning from a bevy of Delaware corporate practitioners and academics, including me and my fellow semi-finals judges, former Chief Justice E. Norman Veasey and senior Skadden partner Edward Welch.

This year’s problem (available here) raises an issue I trot out periodically in my business organizations class. We all know at least two things about Delaware corporate law: (1) it’s designed to be flexible and to accommodate a broad range of departures from default legal rules, especially when those departures are specified in the certificate of incorporation; and (2) directors’ fiduciary duties require them to obtain the highest current value reasonably available when the company is sold. What happens when these two principles collide? Specifically, can a charter provision validly require directors to consider nonstockholder interests, and even explicitly permit them to accept a lower takeover bid based on such consideration? Put more succinctly, is Revlon’s key holding a mandatory aspect of Delaware corporate law?

This year’s competition also raises another issue – whether the Delaware Supreme Court’s 2003 ruling in Omnicare should be overruled, particularly in light of subsequent cases limiting its reach and recognizing the validity of mergers approved by rapid written consent by controlling stockholders.

Unfortunately, the only ruling that comes out of the final oral argument is which team wins. But it’s fun to hear the judges kick around the issues. Got an issue you’d like to see mooted next year? Write to Regan – it’s his turn to write the problem next year.

Professor Conaway on Auriga

Auriga Capital Corporation v. Gatz Properties, LLC

It is with regret that I find myself compelled to respond to Chancellor Strine’s unfortunate opinion in Auriga v. Gatz. I do so as a result of serving as a legislative drafter for partnerships, limited liability companies and other alternative entities both in Delaware and as a Life Member with the Uniform Law Conference for over two decades.

It is a well-known legal axiom that bad facts make bad law. Following this axiom, in Auriga Chancellor Strine was faced with bad facts – a devilish manager of an LLC who acted every bit the part of Lord Voldemort determined to “do in” his members. Regrettably, the Court defined the legal issue in Auriga as whether default fiduciary duties existed in a Delaware manager-managed LLC, which is not the default form for a Delaware LLC. As provided at 6 Del. Code § 18-101(6), a Delaware limited liability company is defined as “a limited liability company formed under the laws of the State of Delaware and having 1 or more members.” Thus, in the first instance, for the Court to attempt to resolve the important question of the existence of default fiduciary duties for members or managers of Delaware LLCs upon the facts of this case must necessarily muddy the waters of any judicial analysis.

In the second instance, Chancellor Strine relied upon a well-known “catch-all” phrase originally found in UPA (1914) as crafted by the drafters of the Uniform Law Conference as the basis for his finding of a default fiduciary duty in Delaware’s LLC Act. However, in the Comment to § 104 of the Revised Uniform Partnership Act (1997) (“RUPA”) from which all the ULC alternative entity Acts derive the same “law and equity” clause upon which Chancellor Strine places his emphasis, the following is noted:

”The principles of law and equity supplement RUPA unless displaced by a particular provision of the Act . . . Those supplementary principles encompass not only the law of agency and estoppel and the law merchant mentioned in the UPA, but all of the other principles listed in UCC Section 1-103: the law relative to capacity to contract, fraud, misrepresentation, duress, coercion, mistake, bankruptcy, and other common law validating or invalidating causes, such as unconscionability. No substantive change from either the UPA or the UCC is intended.” (Emphasis is added)

From the Comment to § 104 of RUPA, it is clear that the phrase, “Unless displaced by particular provisions of this [Act], the principles of law and equity supplement this Act,” was never intended to address, much less impose, fiduciary duties on owners or managers in partnerships or limited liability companies.

The third, and most compelling, error in the Auriga opinion is its failure to address the preamble to § 18-1104 that states: “In any case not provided for in this chapter, the rules of law and equity, including the law merchant, shall govern.” According to the prefatory language of § 18-1104, if any provision in the Delaware LLC Act speaks to fill the void of “law and equity,” then § 18-1104 is rendered moot as to that issue. The Delaware LLC Act uniquely, clearly and concisely – since its adoption in 1992 – has specifically expressed the position of the Delaware General Assembly on the policy to be followed for all Delaware LLCs. That policy is found at § 18-1101(b) that unambiguously provides: “It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”

[(Emphasis added) This same language of usurpation over the “catch all” provisions referencing equity appears in each Delaware partnership act as well as the Delaware LLC Act.]

Thus, if the Court of Chancery were to find that a contractual legal issue could not be answered within the tenets of contract law, only then would the language of § 18-1104 have meaning.

It is also noteworthy that apparently Chancellor Strine believes that the failure to include “a general provision stating that the only duties owed by the manager to the LLC and its investors are set forth in the Agreement itself,” leaves the manager with default fiduciary duties, even where the Agreement in Auriga included express provisions for approval of conflicting interest transactions. Upon the Chancellor’s interpretation then, in the absence of a general fiduciary duty provision in an LLC Agreement, all Delaware LLC Agreements will, in essence, be construed as more of a trust document than a contract.

Finally, the most regrettable portion of the Chancellor’s opinion is the dicta stating that the Delaware LLC is, in essence, the same as a Delaware corporation. Delaware’s own law school devotes two independent advanced seminars to the topics of corporations and LLCs respectively in order to examine the rich diversity of these two entities. Having learned LLCs from the ground up instead of the top down, these distinctions are more readily apparent to this author.

It is with due deference to our Chancellor that I respectfully disagree with the necessity for, as well as the legal basis of, his opinion in Auriga.

Respectfully submitted,

Professor Ann E. Conaway

Chancellor Strine affirms default fiduciary duties in LLCs

In an opinion issued today addressing the fiduciary duties of managers of Delaware limited liablity companies, Chancellor Strine reiterates and elaborates on the view previously expressed in the Court of Chancery that such duties exist by default under Delaware law and the Delaware Limited Liability Company Act.  The opinion can be reviewed here. For now, it therefore appears that the Delaware Supreme Court may have an opportunity to decide the issue addressed in the on-line symposium elsewhere on this site.

The “Outer Reaches” of Allowable Conduct? Or “You Ain’t Seen Nuthin’ Yet?”

Lawrence A. Hamermesh, Ruby R. Vale Professor of Corporate and Business Law
January 17, 2012

Two ostensibly unrelated events in the last two weeks implicate deep questions about the basic role of private ordering and regulation in relation to publicly traded equity securities.

The first of these events was Vice Chancellor John Noble’s opinion in Gerber v. Enterprise Products Holdings, LLC, et al (Del. Ch. Jan. 6, 2012). The Delaware Corporation & Commercial Litigation Blog has a nice summary of the case here, but the nub of the opinion was its determination to dismiss a claims that a 2009 sale of assets to an affiliated person violated the general partner’s fiduciary duties and that a merger subsequently implemented by the general partner improperly failed to consider the value of that pre-existing derivative claim against the general partner. The reasoning underlying that dismissal was that (i) the asset sale and the merger each received one form of what the limited partnership agreement defined as “Special Approval” (approval by a special committee of independent directors), thereby eliminating any claim of breach of fiduciary duty; and (ii) the residual claim that the general partner violated its implied obligation of good faith and fair dealing was precluded by the provision in the limited partnership agreement that the general partner’s “good faith is conclusively presumed where the general partner relief on the fairness opinion of an independent consultant.” In the case at hand, the general partner had obtained and reasonably relied on fairness opinions from Morgan Stanley.

The court’s opinion seems to chafe, to put it gently, at the contractual and legal strictures imposed by the limited partnership agreement:

The facts of this case take the reader and the writer to the outer reaches of conduct allowable under 6 Del. C. § 17-1101. It is easy to be troubled by the allegations. Alternate entity legislation reflects the Legislature’s decision to allow such ventures to be governed without the traditional fiduciary duties, if that is what the partnership agreement or other governing document provides for, and allows conduct that, in a different context, would be sanctioned. Ultimately, the investor, who is charged with having assessed and accepted the risks of putting his money in an entity without the comfort afforded by fiduciary duties, is left with contractual protections, either those that are expressed or those that are within the implied covenant of good faith and fair dealing. Here, those protections were minimal and did not provide EPE’s public investors with anything resembling the protections available at common law.

As the Vice Chancellor expressed in an extended footnote, minimal contractual protection for public investors may potentially result in one of two consequences – discounted trading of the affected securities, or regulatory intervention:

If the protection provided by Delaware law is scant, then the LP units of these partnerships might trade at a discount or another governmental entity might step in and provide more protection to the public investors in these partnerships. Those issues, however, are not ones that this Court need or should address. The General Assembly has decided that this Court has only a limited role in protecting the investors of publicly traded limited partnerships that take full advantage of 6 Del. C. § 17-1101(d), and that is a role this Court must accept.

Meanwhile, and in a superficially very different context, the Carlyle Group, L.P. filed a January 10, 2012 amendment to its Form S-1 registering a public offering of its limited partnership units. Among other things, this amendment disclosed that the Carlyle limited partnership agreement would contain a fairly unusual provision governing the resolution of disputes involving the limited partnership’s internal affairs. In broad outline, it would provide that all limited partners would irrevocably agree that disputes relating to the limited partnership – including claims of breach of fiduciary duty, breach of the partnership agreement, and violation of the federal securities laws – will be subject to arbitration, and not be litigable, and would be arbitrated before three arbitrators in Wilmington, Delaware [wait, it gets better!] who are U.S. lawyers, retired judges, or [wait for it … ]

U.S. law professors [Law professors in Delaware? Can it get any better than this??].

Would a provision like this be valid if it were in a corporation’s certificate of incorporation? Not sure on that one – but I tend to think that a charter provision selecting the Delaware courts as an exclusive forum for hearing controversies involving internal corporate affairs is probably effective, at least if it’s included in an original (pre-IPO) certificate of incorporation. If that’s right, then it should be even easier to validate such an exclusive forum provision contained in a pre-IPO limited partnership agreement. And would an arbitration selection provision be any less effective? If one believes that organizational governing documents are contracts like all others, even when applicable to (“entered into by”) public investors, the answer has to be no, so at least for non-corporate entities a provision mandating arbitration would be effective.

Is this disturbing?  That depends, I suppose, on whether you believe that, as Vice Chancellor Noble put it, the limited partnership interests (or shares of stock, if we were dealing with a corporation) would “trade at a discount” reflecting a meaningful market assessment of the value (negative, if one presupposes a discount) of the dispute resolution provision.  If one were confident that the market – including the IPO market – would accurately price such provisions (whatever the word “accurately” means), perhaps there’s no real cause for concern: people will get what they pay for. On that view of things, it may not even matter that some investors are individually unaware of what dispute resolution or other rights they may be forgoing. On that view, perhaps even corporations should be allowed to adopt provisions dispensing with fiduciary duties, just as Delaware limited partnerships and LLCs are.

If you lack such abiding faith in market efficiency, however, you are in quite a quandary, because you then have to decide which private ordering innovations to tolerate, and which to regulate. As things stand, Delaware has made that decision, at least in relation to fiduciary duties: if you buy a limited partnership interest, the fiduciary duties you are owed may be limited or eliminated by the limited partnership agreement; if you buy corporate stock, on the other hand, fiduciary duties are mandatory and can’t be eliminated, even by charter provision (although, of course, director monetary liability for breach of the duty of care can be eliminated under Delaware General Corporation Law Section 102(b)(7)).

In regard to fiduciary duties, Delaware could choose to stand by this approach that bifurcates between corporations and other forms of entity. Alternatively, and recognizing that publicly traded noncorporate entities are still a somewhat limited phenomenon, Delaware could at least prospectively put all publicly traded entities on the same footing, by precluding publicly traded limited partnerships and LLCs from limiting or eliminating fiduciary duties. My “alternative entity” friends might gasp at that prospect, but they need to tell me why they are confident that the IPO market for limited partnership interests fairly and accurately prices provisions that limit or eliminate fiduciary duties. And they need to be confident that Vice Chancellor Noble’s concern that “another governmental entity [who ever might he be referring to?] might step in and provide more protections for the public investors” is just remote speculation, or that such regulation would be desirable or at least acceptable.  That said, one can question whether the EPE limited partnership agreement addressed by Vice Chancellor Noble really represents the “outer reaches” of the flexibility afforded under the Delaware limited partnership statute:  the operative provision addressing conflict transactions did not purport to effect a blanket elimination of all fiduciary duties; all it did was define various forms of effective approval for conflict transactions, including approval by a special committee of directors, a form of approval generally viewed as appropriate under corporate law as well.   Likewise, the provision establishing that directors act in good faith when they rely on the opinion of an expert on a matter they reasonably believe to be in the expert’s area of competence doesn’t seem radically different than the rule embodied in Section 141(e) of the Delaware General Corporation Law, protecting directors’ good faith reliance on expert opinions reasonably believed to be within the expert’s professional competence.  Perhaps the biggest difference from the corporate statute is that the partnership agreement provision appears to eliminate the predicate that the director’s reliance be in overall good faith, and not just based on a reasonable belief in the expert’s competence.  Even if the partnership agreement provisions at issue are somewhat more protective than what is available as a matter of corporate law, however, it seems likely to me that those provisions are relatively modest in their impact, at least compared to what the limited partnership statute might actually permit.

In regard to dispute resolution matters, the law is still largely unsettled. Given the Delaware legislature’s explicit embrace of freedom of contract in noncorporate entities, will mandatory arbitration provisions like Carlyle’s be deemed valid and become commonplace in such entities that are publicly held? And do such provisions offend some mandatory aspect of corporation law such that Delaware public companies will be unable to adopt them? Is litigating in the Court of Chancery a fundamental, non-excludable right for stockholders, but litigating in a court outside of Delaware is not? Or if charter forum selection provisions for Delaware public companies become common, will arbitration selection provisions become similarly common?

Is there a comprehensive way to decide what private ordering – which may amount to no more than a take it or leave it investment choice – should allow, and what is off limits?

Reaction to Jim McRitchie’s comments on precatory proxy access proposals

Last week Jim McRitchie provided a thoughtful response to my post questioning the utility of precatory proxy access proposals.  As you’ll see from his response, he draws on analogies to political democracy, and why “let the people decide” doesn’t mean “let the people decide everything:”

Generally, the “people decide” in democracies by delegating authority to their elected representatives. As voters, we get involved directly in nominating and electing candidates but generally then hope that our representatives will work in our interest. We pass along advice and concerns. If our elected officials fail to represent us, we the people again act more directly through initiatives, recall, etc.

With regard to how “pass[ing] along advice and concerns” should work, McRitchie says: 

Directors have much to add to the debate.  Let’s hear from them.  I’m not opposed to submitting binding bylaws but what’s wrong with asking first?  If our proposals are successfully endorsed by shareholders but ignored by directors then I would be ready to escalate, not only by submitting binding bylaw proposals but also by calling on shareowners to vote against directors who ignore the will of the voters.

I certainly support the idea of constructive engagement before shots are fired, and McRitchie’s commentary certainly persuades me that the precatory aspect of United States Proxy Exchange’s strategy is a reasonable approach.  The new Latham & Watkins model proxy access bylaw and commentary remind me how devilishly complex the details of a proxy access bylaw are (not to mention related matters of advance notice bylaws and qualification bylaws).  So I agree with McRitchie that the precatory approach is a useful way “avoid getting into the weeds on company specific legal issues better left to corporate attorneys.” 

There’s still a residual problem, however, where I suspect that McRitchie and I continue to disagree, namely on how a board of directors should evaluate the results of a vote on a precatory proxy access proposal.   McRitchie is evidently ready to call on shareholders to vote out directors who “ignore the will of the voters,” but how does one discern what that “will” is, when a vote is on general principles and avoids getting “into the weeds” where critical issues lie?  If “[d]irectors have much to add to the debate,” as McRitchie correctly argues, isn’t it implicit that they need to exercise judgment and not accede to what they believe are misguided precatory proposals, especially where there’s no cost to shareholders for voting for a proposal that isn’t adequately thought through?