On My Mind
Professor Ann E. Conaway
Widener University School of Law
Wilmington, DE

In recent months, I have had the opportunity to re-examine a longstanding Delaware corporate equitable principle – that of piercing the corporate veil on the basis of alter ego. My opportunity was sparked by an expert case in South Carolina that arose in the context of several Delaware LLCs organized as parent-subsidiaries in a real estate condominium conversion. In my research, I found three Delaware Chancery Court opinions that each assumed, without any explanation or supportive reasoning, that Delaware corporate alter ego principles should apply in toto to Delaware LLCs. After extensive research and thought on the matter, I respectfully disagree with the Delaware Courts and advocate instead the abolition of the veil piercing doctrine in favor of a test of fraud or illegality in the case where a Delaware LLC franchise is being sought to be pierced.

First, the Delaware corporate cases are in a somewhat confused state. The Delaware Courts appear to apply the alter ego test to corporations in two circumstances: (1) when trying to impose liability on a natural person who is the sole or dominant shareholder of a corporation; and (2) in a parent-subsidiary context. In most jurisdictions, alter ego is properly applied in the first scenario since the corporate shield is being used as an “alter ego” for the natural person’s individual, non-business activities. In the second scenario, traditional corporate dogma does not apply an alter ego test since: (1) control is always present; (2) transferring funds from the sub to the parent is legal; (3) corporate formalities are more likely to be present between separate legal entities; and (4) capitalization alone is never dispositive for piercing. Instead, as between two independent legal entities, the test is generally proof of fraud or illegality. Indeed the Delaware Courts, after paying lip service to the terms alter ego, avoid application of the factual tests of that theory and move directly to a determination of fraud, illegality or injustice in the use of the corporate franchise.

In an unusual Chancery Court opinion, VC Parsons pierced the veil of a Delaware corporation to reach a natural, individual shareholder in Midlands Interiors, Inc. v. Burleigh, 2006 Del.Ch. LEXIS 20 (Dec. 19, 2006). Without citing the equitable theory of alter ego, the Court found that there was clear evidence of fraud where an administratively dissolved corporation continued to conduct the exact same business with creditors notwithstanding its known dissolution. The case, when it first was published, caused some concern among the Delaware Bar. However, some comfort could be gained from the fact that the elements of alter ego did not sustain the Court’s holding. Rather, an egregious set of fraudulent facts led the Court to its finding – a standard higher than “alter ego.”

So, what’s on my mind? In light of the recent Delaware Supreme Court opinion in CML V v. Bax, the Supreme Court made clear that investors have a “choice” between a corporation and an unincorporated entity. That choice, according to the Supreme Court, affects the law that applies to the entity. As the Supreme Court made obvious in CML V, corporate law has no place in Delaware LLCs. Specifically, as regards to the “alter ego” test: (1) LLCs have no “corporate formalities” and to the extent an operating agreement imposes “formalities,” those formalities are meant solely for the parties to the agreement and do not affect limited liability; (2) the “dominant shareholder” factor is irrelevant in LLC law where a “dominant” member may be a non-economic member; and (3) “undercapitalization” by shareholders is also a non-relevant concept in LLC law, since members in an LLC are not required to make contributions to become members. In sum, the alter ego theory of corporate law is premised on pro rata ownership of stock and other mandatory corporate organizational and operational rules. Virtually no “mandatory” rules exist in LLC law.

Further, an “alter ego” test for piercing should never be used to ignore the internal shields of a Delaware “series” LLC. Unlike a regular LLC, a “series” LLC permits an allocation of property, obligations or assets of the LLC into “cells” or “units” if the certificate of formation gives notice of the series and its internal limitation on liability. A Delaware series may then grant any rights, duties, profits, losses or management rights to be associated with any particular series. Separate books must be kept for each series. Each series may have an independent business or investment purpose. According to the 2007 amendments to the series, a series may sue, be sued, or contract in is own name and may grant security interests or liens. A series under Delaware law is not an entity. A series is, however, a person under the statute. If a creditor gets a judgment against a series and the assets are insufficient to pay the judgment, it is suggested in some commentary that veil piercing is available. The notion is that the veil is pierced to reach the “assets” of the series. Yet, this argument is misleading. The judgment reaches the assets. A veil piercing action ostensibly seeks to pierce the internal wall of liability limitation and impose personal liability on those persons associated with the series whether they are members, managers or other persons named under the operating agreement. If veil piercing is available in this context, it makes even less sense to use “alter ego.” The only fair test must be clear evidence of fraud or illegality – with an attempt to avoid liability not constituting fraud or illegality. In any event, veil piercing in the circumstance of a series should never permit a judgment to leap from one series to another – that concept is consolidation and is best left to the bankruptcy courts.

So what is the answer to this conundrum? Because Delaware has consistently required proof of fraud and illegality in addition to the “true” alter ego cases, it only makes sense to eliminate the corporate paradigm from LLC law and instead to replace it with the consistent Delaware standard of factual proof of fraud or illegality in the use of the LLC franchise (or series thereof) to perpetuate social injustice.

— Prof. Paul L. Regan, Widener University School of Law, Wilmington, Delaware

Newly installed Vice Chancellor Sam Glasscock has issued an opinion dismissing a shareholder derivative action that the shareholders of Goldman Sachs attempted to bring on behalf of the company against its directors and officers arising from the company’s compensation plan during the recent mortgage crisis and its aftermath. In In re The Goldman Sachs Group, Inc. Shareholder Litig., C.A. No. 5215-VCG (Del. Ch. Oct. 12, 2011), the shareholders of Goldman Sachs alleged that the company’s directors breached their fiduciary duties by establishing a compensation structure that assertedly encouraged highly “risky trading practices and over-leveraging of the company’s assets.” The plaintiffs also alleged a Caremark claim, asserting the Goldman directors failed to fulfill their oversight responsibilities with regard to the firm’s compensation plan which in turn, according to the plaintiffs, led to unethical and illegal business practices as well as overly-risky business decisions.

The defendants successfully moved to dismiss the complaint under Court of Chancery Rule 23.1 for failure of the plaintiffs to allege with particularity that pre-suit demand was excused. With regard to the decision of the Goldman board to approve the firm’s compensation structure, Vice Chancellor Glasscock applied a straightforward Aronson analysis and concluded that the complaint failed to allege (1) that the board was interested or lacked independence when it approved the compensation scheme or (2) that the board did not otherwise validly exercise its business judgment in this regard. On the Caremark claim, the Court applied the Rales test and ruled that the complaint failed to allege with particularity that the Goldman directors faced a substantial likelihood of personal liability on their asserted failure to fulfill their oversight responsibilities. Thus demand was not excused because the plaintiffs did not allege facts creating a reasonable doubt that the Goldman directors would be deemed personally interested in responding to a demand that such an oversight claim be brought.

As noted the Court’s application of the Aronson test was fairly straightforward. Of note here is the Court’s Caremark analysis. The plaintiffs asserted that the Goldman directors failed to fulfill their fiduciary duty of oversight both with regard to monitoring compliance with applicable law and the company’s business performance and risk. The Court’s rejection of the complaint’s legal compliance/oversight claim conventionally followed Caremark and Stone v. Ritter. On the issue of monitoring business risk (as opposed to legal compliance), Vice Chancellor Glasscock noted that “this Court has not definitively stated whether a board’s Caremark duties include a duty to monitor business risk.” Goldman Sachs, slip op. at 60. Ultimately however, the Court declined to reach this interesting legal issue, ruling that the complaint failed to allege that the Goldman directors “acted in bad faith or consciously disregarded their oversight responsibilities in regards to Goldman’s business risk.” Id. at 64. As in the Citigroup case decided in 2009 by then Chancellor William Chandler, Vice Chancellor Glasscock signaled very little patience for the plaintiffs’ attempt to recast a claim attacking a business judgment over employee compensation into a oversight claim concerning business risk. Emphasizing the traditional judicial inquiry into the process but not the substance of board decision-making, the Court in Goldman Sachs emphasized: “If an actionable duty to monitor business risk exists, it cannot encompass any substantive evaluation by a court of a board’s determination of the appropriate amount of risk.” Id. at 62.

Following the Court of Chancery’s decisions in Goldman Sachs and of course Citigroup, it remains unsettled whether Caremark’s early reference to the possibility of an oversight claim arising from a board’s monitoring of business risk is viable. Outside of Delaware, the Model Business Corporation Act suggests such a possibility, at least with regard to “major risks” facing a publicly owned company. See MODEL BUSINESS CORPORATION ACT, Section 8.01(c)(2) (“In the case of a public corporation, the board’s oversight responsibilities include attention to … major risks to which the corporation is or may be exposed”.) The early returns from Delaware case law suggest a different emphasis in policy on the question of director accountability for business risk — i.e., protecting the board’s managerial authority under our director-centric model of corporate governance; encouraging entrepreneurial risk taking; encouraging qualified directors to serve; avoiding the unfairness of hindsight bias for decisions that turn out badly; and avoiding second guessing of business decisions by ill-equipped members of the judiciary. Thus far at least, the Delaware Court of Chancery has concluded that a conventional business judgment rule analysis should apply to such “oversight” business risk claims. Diversified stockholders who are unhappy with what they regard as unreasonable levels of business risk can always exit by selling their shares or otherwise seek to replace the directors in a contested election.

In the recent back and forth on the question of the continued utility of the annual meeting, I’ve been remiss in failing to refer to Professor William Sjostrom Jr.’s article on the subject, “The Case Against Mandatory Annual Director Elections and Shareholders’ Meetings,” which is available here

In reminding me of this article, Professor Sjostrom appropriately laments that it didn’t get a great deal of attention when it was published. This supplemental post is an attempt to remedy that, belatedly, and to suggest that perhaps Professor Sjostrom was just ahead of the rest of us. In any case, I’m glad to join him in focusing on whether the stockholder voting process could be improved.

The “money” lines from Professor Sjostrom’s article, as far as I was concerned, are these:

“There simply is no strong justification for requiring director elections and shareholder meetings annually. Annual elections provide at most a minimal check on management, a check that is not dependent on the frequency of elections. Nor are annual elections critical to the exercise of corporate democracy. Likewise, annual shareholders’ meetings provide little if any opportunity for shareholder deliberation … .”

It’s always a treat for a professor to be discussed by a widely read authority, and an especially rare treat to be credited by such a person with saying something clever. So I was pleased to see that Jim McRitchie commented on a couple of my recent postings.

As to the asserttion that I was being “clever,” I respectfully disagree: all I did was present evidence that changing the Delaware default rule for the voting standard in director elections wouldn’t have much formal effect, in light of how frequently Delaware corporations appear to adopt controlling bylaw provisions that make the default standard moot. McRitchie doesn’t challenge this evidence, and I stand on my criticism of the factual assertion that many Delaware corporations adopt the plurality vote standard by default.

More usefully, McRitchie makes the potentially plausible point that a change to the Delaware standard might have an informal impact by encouraging companies to amend plurality vote bylaws and replace that standard with a majority vote standard. That may or may not be so – seems fairly speculative to me – but I didn’t intend to take a position on whether changing the default voting standard would be a good or bad thing. In any event, McRitchie says I’m guilty of “status quo thinking,” which I take to be intended as a pejorative comment. As to that, I have two responses:

First, my post on reframing shareholder voting and potentially eliminating a knee-jerk adherence to having annual shareholder meetings is anything but “status quo thinking;” one could accuse McRitchie of status quo thinking in dismissing my suggestions as wrong ideas, rather than exploring whether reducing the frequency of meetings and voting might be worth it to shareholders if they were given greater power and influence in connection with less frequent meetings.

Second, “status quo thinking” may to some extent simply be a recognition of the reality that some ideas just aren’t in the cards, in any foreseeable future. Example: McRitchie agrees that annual meetings are mostly meaningless, but he partly blames shareholder apathy on the fact that a lot of voting is on merely precatory resolutions. But addressing the meaninglessness of annual meetings by making precatory resolutions mandatory just isn’t going to happen, and shouldn’t. We have a director-centric model of corporate governance, I see no serious support for turning every 14a-8 shareholder proposal into a binding referendum. I suggest that my approach is much closer to the realm of possibility, as long as management and shareholder representatives are willing to recognize that the system could be improved if they both could at least discuss and then maybe agree on acceptable trade-offs that make the shareholder voting system more effective. Those potential trade-offs, by the way, include some sort of enhancement of proxy access.

So, I renew my invitation to McRitchie and other leading corporate governance authorities to explore reforms that offer both management and shareholders (but not necessarily their intermediaries) a better deal. And I reiterate that I’m not suggesting eliminating annual meetings as an isolated, unilateral measure: reducing the extent of shareholder voting depends on management’s willingness to make less frequent voting more meaningful, particularly in relation to the election of directors.

From Professor Ann Conaway
Widener University School of Law

In a case of first impression, the Delaware Supreme Court in CML V LLC v. Bax, (Del. Sept. 2, 2011,) has held that creditors do not have derivative standing to bring a fiduciary duty claim against present or former managers of an insolvent Delaware LLC under statutory provisions of the Delaware Limited Liability Company Act (DLLCA). The statutory preclusions on which the Supreme Court relied are found at 6 Del. Code §§ 18-1001-1002. In its opinion, the Delaware Supreme Court set forth the language of § 18-1002, stating that: “the plain language [of the statutory provisions] is unambiguous and limits derivative standing to “member[s] or assignee[s]” and that exclusive limitation is constitutional.” (Emphasis in the original). Indeed, § 18-1002 defines a “Proper plaintiff” as: “ In a derivative action, a plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action….” (Emphasis added)
CML had entered a loan transaction with JetDirect at a time when the company’s finances were uncertain and the company’s financial situation somewhat unclear. However, CML was always free to contract for any terms it desired if greater financial security was sought. Shortly after the loan agreement by CML, JetDirect became insolvent and failed to pay CML. CML brought suit in the Court of Chancery for derivative and direct claims, including breach of the duty of care. The Court of Chancery dismissed the derivative claims and the case was appealed to the Delaware Supreme Court.
On appeal, the Vice Chancellor’s interpretation of DLLCA §§ 18-1001-1002 was disputed. In addition, counsel for CML argued that the Vice Chancellor’s interpretation rendered the statutory provisions of DLLCA unconstitutional on the grounds that they stripped the Court of Chancery of its traditional power to do “equity.” The Supreme Court quickly disposed of the constitutionality argument on the basis that the equitable derivative suit for stockholders from English common law was grounded in corporate – not LLC law. The Supreme Court continued that the Delaware General Assembly was free to legislate exceptions from the common law and did so with the enactment of the DLLCA in 1992.
The Supreme Court’s opinion in CML v. Bax is a beacon of hope for the law of Delaware unincorporated entities for its uncontroverted stance in line drawing between Delaware corporations and LLCs. In this opinion, the Supreme Court refuses, through the doctrine of equity, to infuse corporate principles into Delaware’s unambiguous, contractually based alternative entity statutes. With this opinion comes greater clarity and lower agency costs in the law of Delaware LLCs. Hopefully, the opinion will serve as a harbinger for the abandonment of corporate principles to define the rights of members, managers and other parties to a Delaware operating agreement. Five stars to the Delaware Supreme Court!

I spoke two days ago at the 9th Annual PLI Directors’ Institute on Corporate Governance. Lots of great presentations and provocative suggestions at this event, from such luminaries as Bill Ackman, Ira Millstein, Hillary Sale, Pat McGurn, Richard Parsons, Alan Beller and lots of others. In my comments which you can find in this PDF, I asserted that stockholder meetings are too frequent and involve too many votes on too many items. Stockholder input into corporate governance is cheapened as a result, and would be more valued and valuable if voting were more selectively scheduled and targeted. Managers and investors share a common interest in having their governance dialogue include discussion of how to better focus stockholder voting and eliminate elections and resolutions that have little or no economic significance. State laws compelling the annual holding of stockholder meetings should become more flexible, but are unlikely to do so unless both management and stockholder representatives support that evolution.