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CHAPTER 20: DIRECTORS, OFFICERS, AND CONTROLLING SHAREHOLDERS

INTRODUCTION

FIDUCIARY DUTIES

Directors and officers are agents of the corporation and owe a fiduciary duty to the corporation they serve. 1  Under certain circumstances, a controlling shareholder owes a fiduciary duty to other shareholders as well. 2

These duties take two basic forms: a duty of care and a duty of loyalty. Generally, the  duty of care  requires fiduciaries to make informed and reasonable decisions and to exercise reasonable supervision of the business. The  duty of loyalty  mandates that fiduciaries act in good faith and in what they believe to be the best interest of the corporation, subordinating their personal interests to the welfare of the corporation. As then Judge Benjamin Cardozo stated, many forms of conduct permissible in the business world for those acting at arm’s length are forbidden to those bound by fiduciary ties. A trustee, he said, is held to something stricter than the morals of the marketplace. Not mere honesty, but a “punctilio of an honor the most sensitive” is the standard of behavior with which fiduciaries must comply. 3  As discussed further below, directors’ duties of care and loyalty include a duty to act in good faith. 4

CHAPTER OVERVIEW

This chapter outlines the duties of directors, officers, and controlling shareholders. First, it analyzes the duty of care in terms of the most applicable judicial doctrine, the business judgment rule. Next, the chapter analyzes the duty of good faith and addresses issues arising under the duty of loyalty, including corporate opportunities. It then discusses the fiduciary duties of directors that arise when the directors must decide whether to sell the company or resist a corporate takeover bid. Legislative responses to these issues are also described. Executive compensation is discussed, as are the duties of controlling shareholders in connection with sales of corporate control and squeeze-out mergers. Finally, the chapter outlines the takeover rules in the European Union.

20-1: THE BUSINESS JUDGMENT RULE AND THE DUTY OF CARE

In cases challenging board decisions for breach of the duty of care, the courts generally defer to the business judgment of the directors, acknowledging that courts are ill equipped to second-guess directors’ decisions at a later date. Thus, under the  business judgment rule , as long as certain standards are met, a court will presume that the directors have acted in good faith and in the honest belief that the action taken was in the best interest of the company. The court will not question whether the action was wise or whether the directors made an error of judgment or a business mistake.

To take advantage of the rule, the directors must have made an informed decision with no conflict between their personal interests and the interests of the corporation and its shareholders. Courts will not respect directors’ business judgment if the directors (1) were interested in the transaction, (2) did not act in good faith, (3) acted in a manner that cannot be attributed to a rational purpose, or (4) reached their decision by a grossly negligent process. 5

If the business judgment rule does not apply to a transaction, courts generally shift to directors the burden of proving that their acts were not grossly negligent (or, in cases involving transactions in which the directors are interested, that the transaction was fair and reasonable).

20-1a: Informed Decision

The business judgment rule is applicable only if the directors make an informed decision. The general corporation law of most jurisdictions authorizes directors to rely on the reports of officers and certain outside experts. However, passive reliance on such reports may result in an insufficiently informed decision, as in the following landmark case.

CASE 20.1: A CASE IN POINT: SUMMARY

Smith v. Van Gorkom

Supreme Court of Delaware 488 A.2d 858 (Del. 1985).

FACTS

Trans Union Corporation was a publicly traded, diversified holding company engaged in the railcar-leasing business. Its stock was undervalued, largely due to accumulated investment tax credits. Jerome W. Van Gorkom, the chief executive officer and chair of the board of Trans Union, was reaching retirement age. He asked the chief financial officer, Donald Romans, to work out the per-share price at which a leveraged buyout could be done, given current cash flow. Romans came up with $55, based on debt-servicing requirements. He did not attempt to determine the intrinsic value of the company. Van Gorkom later met with Jay Pritzker, a potential buyer, and worked out a merger at $55 per share. Trans Union stock was then trading at about $37 per share.

Van Gorkom called a board meeting for September 20, 1980, on one day’s notice, to approve the merger. All of the directors were familiar with the company’s operations as a going concern, but they were not apprised of the merger negotiations before the board meeting on September 20. They were also familiar with the company’s current financial status; a month earlier they had discussed a Boston Consulting Group strategy study. The ten-member board included five outside directors who were CEOs or board members of publicly held companies, as well as a former dean of the University of Chicago Business School.

Copies of the merger agreement were delivered to the directors, but too late for study before or during the meeting. The meeting began with a twenty-minute oral presentation by board chair Van Gorkom. The chief financial officer then described how he had arrived at the $55 figure. He stated that it was only a workable number, not an indication of a fair price. Trans Union’s president stated that he thought the proposed merger was a good deal.

The board approved the merger after a two-hour meeting. Board members later testified that they had insisted that the merger agreement be amended to ensure that the company was free to consider other bids before the closing; however, neither the board minutes nor the merger documents clearly reflected this.

Plaintiff Smith, a shareholder, sued to challenge the board’s action, arguing that the merger price was too low. The Delaware Court of Chancery held that, given the premium over the market value of Trans Union stock, the business acumen of the board members, and the effect on the merger price of the prospect of other bids, the board was adequately informed and did not act recklessly in approving the Pritzker deal. In making its findings, the court relied in part on actions taken by the board after the meeting on September 20, 1980, that were intended to cure defects in the directors’ initial level of knowledge. Smith appealed.

ISSUE PRESENTED

Were directors who accepted and submitted to the shareholders a proposed cash merger at a premium over market without determining the intrinsic value of the company grossly negligent in failing to inform themselves adequately before making their decision?

SUMMARY OF OPINION

The Delaware Supreme Court reversed the lower court and held that the directors were grossly negligent in failing to reach a properly informed decision. They were not protected by the business judgment rule even though there were no allegations of bad faith, fraud, or conflict of interest. The court found that the directors could not reasonably base their decision on the inadequate information presented to the board. They should have independently valued the company.

The court found that the directors had inadequate information as to (1) the role of Van Gorkom, Trans Union’s chair and chief executive officer, in initiating the transaction; (2) the basis for the proposed purchase price of $55 per share; and, most important, (3) the intrinsic value of Trans Union, as opposed to its current and historical stock price. The court held that in the absence of any apparent crisis or emergency, it was grossly negligent for the directors to approve the merger after a two-hour meeting, with eight of the ten directors having received no prior notice of the proposed merger.

The court stated:

None of the directors, management or outside, were investment bankers or financial analysts. Yet the board did not consider recessing the meeting until a later hour that day (or requesting an extension of Pritzker’s Sunday evening deadline) to give it time to elicit more information as to the sufficiency of the offer, either from inside management (in particular Romans) or from Trans Union’s own investment banker, Salomon Brothers, whose Chicago specialist in mergers and acquisitions was known to the Board and familiar with Trans Union’s affairs. Thus, the record compels the conclusion that on September 20 the Board lacked valuation information adequate to reach an informed business judgment as to the fairness of $55 per share for sale of the Company.

The court additionally held that the directors’ subsequent efforts to find a bidder willing to pay more than Pritzker were inadequate to cure the infirmities of their uninformed exercise of judgment.

The court rejected the directors’ argument that they had properly relied on the officers’ reports presented at the board meeting. A pertinent report may be relied on in good faith, but not blindly. The directors were duty bound to make reasonable inquiry of Van Gorkom (the chief executive officer) and Romans (the chief financial officer). If they had done so, the inadequacy of those officers’ reports would have been apparent. Van Gorkom’s summary of the terms of the deal was inadequate because he had not reviewed the merger documents and was basically uninformed as to the essential terms. (Indeed, he had signed the merger agreement without reading it while at the opening of the Chicago Lyric Opera.) Romans’s report on price was inadequate because it was just a cash flow feasibility study, not a valuation study.

The court also held that the mere fact that a substantial premium over the market price was being offered did not justify board approval of the merger. A premium may be one reason to approve a merger, but sound information as to the company’s intrinsic value is required to assess the fairness of an offer. In this case, there was no attempt to determine the company’s intrinsic value.

RESULT

The Delaware Supreme Court held that the Trans Union directors were grossly negligent in making an uninformed decision regarding the proposed merger agreement. Their decision was not protected by the business judgment rule. The case was remanded to the Delaware Court of Chancery for an evidentiary hearing to determine the fair value of the shares based on Trans Union’s intrinsic value on September 20, 1980, the day when the board met to consider Pritzker’s offer. If the chancellor found that value to be higher than $55 per share, the directors would be liable for the difference.

COMMENTS

The case was settled for $23.5 million— $13.5 million in excess of the directors’ liability insurance coverage. Although the purchasers, the Pritzker family, ultimately paid the amount by which the settlement exceeded the directors’ coverage, they were not legally obligated to do so. 6

Reliability of Officers’ Reports

As Van Gorkom underscores, not every statement of an officer can be relied on in good faith, and no statement is entitled to blind reliance. The passivity of the Trans Union directors in Van Gorkom unquestionably influenced the court’s finding of gross negligence:

Here, the record establishes that the Board did not request its Chief Financial Officer, Romans, to make any valuation study or review of the proposal to determine the adequacy of $55 per share for sale of the Company. On the record before us: The Board rested on Romans’ elicited response that the $55 figure was within a fair price range within the context of a leveraged buy-out. No director sought any further information from Romans. No director asked him why he put $55 at the bottom of his range. No director asked Romans for any details as to his study, the reason why it had been undertaken or its depth. No director asked to see the study; and no director asked Romans whether Trans Union’s finance department could do a fairness study within the remaining 36-hour period available under the Pritzker offer…. [If he had been asked,] Romans … presumably would have … informed the Board of his view, and the widespread view of Senior Management, that the timing of the offer was wrong and the offer inadequate. 7

When the CEO, Van Gorkom, told the board that $55 per share was fair, no questions were asked:

The Board thereby failed to discover that Van Gorkom had suggested the $55 price to [the bidder] Pritzker and, most crucially, that Van Gorkom had arrived at the $55 figure based on calculations designed solely to determine the feasibility of a leveraged buy-out. No questions were raised either as to the tax implications of a cash-out merger or how the price for the one million share option granted Pritzker was calculated. 8

Reliability of Experts’ Reports

Two principles regarding the use of experts’ reports emerge from the cases. First, a board should engage a reputable and independent investment banking firm, aided if necessary by an outside appraiser, (1) to prepare a valuation study and (2) to give a written opinion as to the financial fairness of the transaction and of any related purchase of assets or options.

Second, directors have a duty to pursue reasonable inquiry and to exercise reasonable oversight in connection with their engagement of investment bankers and other advisers. A conclusory fairness opinion (that is, an opinion that merely states a conclusion without giving the factual grounds for that conclusion) of an investment banker, however expert, is not a sufficient basis for a board decision, particularly if the investment banker’s conclusion is questionable in light of other information known to the directors. As the directors of SCM Corporation learned in Hanson Trust PLC v. ML SCM Acquisition, Inc., 9  an expert’s opinion must be in writing and be reasoned.

SCM was the target of a hostile tender offer by a British conglomerate, Hanson Trust PLC. SCM’s board negotiated a friendly management leveraged buyout led by “white knight” Merrill Lynch. As part of this agreement, SCM granted Merrill Lynch a so-called asset lock-up option to purchase two of SCM’s key divisions, or crown jewels. A lock-up option is a kind of consolation prize for the loser in a bidding war. Thus, this option was exercisable only if Merrill Lynch was not successful in acquiring control of SCM; depending on how it is priced, a lock-up option can have the effect of deterring other bids. Merrill Lynch represented in negotiations that it would not proceed with its leveraged buyout offer without the lock-up.

SCM’s investment banker, Goldman Sachs, issued a written fairness opinion on the overall deal, stating that the sale of SCM to Merrill Lynch was fair to the shareholders of SCM from a financial point of view. A partner at Goldman Sachs also orally advised SCM’s directors that the option prices were “within the range of fair value.” However, the directors did not inquire what the range of fair value was or how it was calculated. Unfortunately for the directors, the banker had not in fact calculated the fair value of the two divisions. Although the directors knew that the two divisions generated more than two-thirds of SCM’s earnings, they never asked the investment banker why the divisions were being sold for less than half the total purchase price. The U.S. Court of Appeals for the Second Circuit held that the SCM directors’ “paucity of information” and “their swiftness of decision-making” strongly suggested a breach of the duty of care. The asset lock-up was struck down. As in the case of officers’ reports, blind reliance on the reports of experts creates a risk that the directors will not receive the protection of the business judgment rule.

In the following case, the court considered whether an investment banker could be held liable as an aider and abettor of a breach of fiduciary duty by the board of directors.

CASE 20.2: A CASE IN POINT: SUMMARY

In re Rural Metro Corporation Stockholders Litigation

Court of Chancery of Delaware 88 A.3d 54 (Del. Ch. 2014).

FACTS

In December 2010, financial advisors at RBC Capital Markets (RBC) approached directors of Rural Metro Corporation, a provider of emergency transportation and fire protection services, to discuss a merger opportunity occasioned by the sale of its competitor Emergency Medical Services (EMS). EMS was entertaining offers from private equity firms, and RBC anticipated that those potential buyers might be interested in acquiring Rural as well. With RBC positioned as a sale-side advisor to Rural, buyers could find RBC an attractive source of buy-side financing for their acquisition of Rural. RBC did not disclose to Rural its intent to provide financing to potential buyers, for which RBC would earn financing fees.

Rural created a three-person exploratory committee, which in turn engaged RBC and Moelis & Co. (MC) to act as the committee’s financial advisors in connection with a possible sale of the company. When the special committee reached out to potential buyers, it found that most were restricted from pursuing Rural because of their confidentiality agreements with EMS. One EMS bidder that dropped out early in the EMS auction process was Warburg Pincus, which turned out to be the only firm to submit a final bid for Rural. CD&R, the ultimate purchaser of EMS, communicated its interest to bid on Rural but required an extension of time due to its commitments in the EMS transaction. The Rural directors ultimately denied CD&R’s extension request because of “the risk to the Company’s sales process of waiting.”

The Rural directors asked RBC and MC to assess the fairness of the Warburg Pincus offer. Because the offer was due to expire on March 28, the bankers had little more than a day to prepare their opinions. Unlike many investment banks, which have standing fairness committees made up of senior bankers, RBC had a fairness committee that comprised “any managing directors who happen[ed] to be available and willing at the time a request for review goes out.” One of the two RBC ad hoc committee members had never served on a fairness committee before. Based on the fairness opinions from RBC and MC, the Rural board approved Warburg Pincus’s $17.25 per share offer around midnight on March 27, about nine hours before it was due to expire. Rural shareholders sued, alleging breach of fiduciary duties by the directors and aiding and abetting of that breach by RBC and MC. The Rural directors and MC settled with the shareholders for $6.6 million and $5 million respectively, but the complaints against RBC proceeded to trial.

ISSUE PRESENTED

Did the Rural directors breach their fiduciary duties to the shareholders? If so, did the financial advisors aid and abet that breach?

SUMMARY OF OPINION

The Delaware Court of Chancery explained that corporate fiduciaries must abide by a standard of conduct defined by duties of loyalty and care. The court acknowledged that there were potential upsides to the rushed sale, such as piquing the interest of EMS buyers, who could account for a future acquisition of Rural in their bids for EMS, and the historically high value of the Rural stock in December 2010. Nonetheless, the court found that the Rural directors failed the enhanced scrutiny test applicable to a sale of a corporation for cash. The special committee had initiated the sales process without board authorization; RBC had failed to disclose to the committee that the parallel sales process with EMS benefitted RBC; the board had pursued the sale of Rural while EMS was still in auction mode; and the board had approved the Warburg Pincus bid even though the directors did not obtain a valuation of Rural at any point during the three-month sale process until the night before the Warburg Pincus offer was due to expire. As a result, the circumstances surrounding the board’s approval of Warburg Pincus’s bid fell outside the range of reasonableness.

The court explained that “directors cannot be passive instrumentalities during merger proceedings.” 10  They must provide “active and direct oversight” by “becoming reasonably informed about the alternatives available to the company” and by “acting reasonably to learn about actual and potential conflicts faced by directors, management, and their advisors.” The directors failed to place any meaningful restrictions on RBC. For example, the board provided no guidance for when the buy-side financing discussions should commence or cease. It also did not impose any “practical check on RBC’s interest in maximizing its fees.”

As for RBC, it was liable for aiding and abetting the directors’ breach because it knowingly created an informational vacuum regarding the corporation’s value, thereby misleading the board. RBC failed to disclose its interest in obtaining a role in financing the acquisition of EMS. “Most egregiously,” RBC never disclosed to the board its continued interest in buy-side financing and its plans to engage in “last minute lobbying” of the buyer.

RESULT

RBC was liable for aiding and abetting the Rural board’s breach of its fiduciary duties. Damages would be set after the submission of additional briefs on the subject.

COMMENT

The court acknowledged that “[d]irectors are not expected to have the expertise to determine a corporation’s value for themselves, or to have the time or ability to design and carry out a sale process. Financial advisors provide these expert services. In doing so, they function as gatekeepers….” This role makes it especially important for the advisors to disclose any potential conflicts of interest to their clients.

20-1b: Duty to Exercise Reasonable Supervision

As fiduciaries, directors have a responsibility to exercise reasonable supervision over corporate operations. In the leading case In re Caremark International Inc. Derivative Litigation, 11  the Delaware Court of Chancery held that directors cannot satisfy their obligation to be reasonably informed concerning the corporation’s compliance with the law and its business performance unless they assure themselves that the organization has in place reasonably designed information and reporting systems to provide senior management and the board itself with timely and accurate information as a matter of ordinary operations. The level of detail required is a question of business judgment. Although even a rationally designed information and reporting system will not eliminate the possibility that the corporation will violate laws or regulations, the board is required to exercise a good faith judgment that the corporation’s information and reporting system is, in concept and design, adequate to assure the board that appropriate information will come to its attention in a timely manner. 12  Failure to exercise adequate supervision may, in theory at least, render a director liable for losses caused by noncompliance with applicable legal standards. 13

In the following case, the court considered whether the board of Citigroup could be held personally liable in a shareholder derivative suit for the bank’s massive losses on its subprime mortgage portfolio. (A  shareholder derivative suit  is a suit brought by a shareholder on behalf of the corporation.)

CASE 20.3: A CASE IN POINT: SUMMARY

In re Citigroup Inc. Shareholder Derivative Litigation

Court of Chancery of Delaware 964 A.2d 106 (Del. Ch. 2009).

FACTS

In late 2005, housing prices, artificially inflated by speculation and easily available credit, began to plateau and then to deflate. Adjustable-rate mortgages began to reset, leaving homeowners with higher monthly payments, which led to an increase in defaults and foreclosures.

During this period, Citigroup, a global financial services company, was exposed to the sub-prime lending market through its involvement in collateralized debt obligations (CDOs), which are repackaged pools of lower-rated securities created by obtaining asset-backed securities like residential mortgage backed securities (RMBSs) and then selling rights to the cash flows from those securities in classes with different levels of risk and return. Citigroup was also exposed to the subprime mortgage market through its use of structured investment vehicles (SIVs), which are created by selling short-term debt and buying longer-term debt to yield higher returns.

Without making a pre-suit demand, a group of plaintiffs, including Montgomery County Employees’ Retirement Fund and City of New Orleans Employees’ Retirement System, sued a number of Citigroup directors who were members of the Audit and Risk Management Committee and considered audit committee experts. The plaintiffs alleged that from as early as 2006, the defendant directors and officers caused and allowed Citigroup to engage in subprime lending that ultimately left the bank exposed to massive losses by late 2007. In particular, the plaintiffs alleged that the defendants breached their fiduciary duty by (1) failing to adequately oversee and manage Citigroup’s exposure to the problems in the subprime mortgage market, even when there were obvious “red flags,” and (2) failing to ensure that Citigroup’s financial reporting and other disclosures were thorough and accurate. They also alleged a waste of Citigroup’s corporate assets.

ISSUE PRESENTED

What do shareholders have to allege to demonstrate that it would be futile to demand that the board sue the directors for failure to adequately protect the corporation from exposure to the subprime lending market?

SUMMARY OF OPINION

The Delaware Court of Chancery began by explaining the procedure whereby shareholders can bring a shareholder derivative action to recover damages to the corporation caused by a breach of fiduciary duty by the directors. Because the board of directors is usually responsible for deciding when the corporation should bring a lawsuit, shareholders must either make a pre-suit demand that the board authorize the lawsuit or show that such a demand would be futile. To show futility, the allegations must raise a reasonable doubt that “(1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.”

The plaintiffs in this case did not question the independence of the directors. Nor did they attack a specific business decision of the board. Instead, the plaintiffs asserted that a pre-suit demand would have been futile because the directors’ failure to oversee Citigroup’s business subjected them to the risk of personal liability. The court rejected this assertion and explained that the possibility of personal director liability excuses a plaintiff from making a demand on the board only when the plaintiff can show director conduct that is so egregious on its face that substantial director liability exists.

The court then applied the Caremark standard to determine whether the Citigroup directors were liable for failure to oversee the business. Under Caremark, plaintiffs must show that the directors knew they were not discharging their fiduciary obligations or that the directors displayed a conscious disregard for their responsibilities—that is, something close to bad faith.

The burden is on the plaintiffs to rebut the presumption of good faith. A plaintiff can plead bad faith by alleging with particular facts that a director knowingly violated a fiduciary duty or failed to act in accord with a known duty to act, which demonstrates a conscious disregard for his or her duties. The court recognized that corporate directors have a duty to implement and monitor a system of oversight, but it explained that this obligation does not eviscerate the protections of the business judgment rule. Those protections are designed to allow corporate directors and managers to pursue risky transactions without being held personally liable if their decisions turn out poorly. The court noted that it is almost impossible, in hindsight, to determine whether directors properly evaluated risk and thus made the “right” business decision.

After analyzing the complaint, the court concluded that the allegations were insufficient to show that the defendants faced a substantial likelihood of personal liability that would prevent them from considering a demand impartially. The plaintiffs’ waste claims were also found insufficient in this respect.

RESULT

The court dismissed the shareholder derivative suit. The allegations in the complaint were insufficient to show that a demand on the directors would have been futile.

COMMENTS

Although shareholders have the right to bring derivative suits for breach of fiduciary duty by the directors, “[i]n practice, … many corporate lawyers will tell you that ‘these rights are so limited as to be almost nonexistent,’ given the internal authority wielded by boards and managers and the expansive protections afforded by the business judgment rule.” 14

The U.S. District Court for the Central District of California refused to dismiss failure-to-supervise claims against inside and outside directors who served on the Finance, Credit, Audit & Ethics, and Operations & Public Policy Committees at Countrywide Financial Corporation. 15  The plaintiffs alleged that the defendant directors ignored red flags related to the deteriorating quality of the mortgages underwritten by Countrywide, including increasing delinquency rates, exponentially rising negative amortizations, and other signs of loan nonperformance. The plaintiffs alleged that “a pervasive ‘culture’ encouraged underwriters to grant risky loans to unqualified borrowers.” Because “ongoing access to the secondary mortgage market requires the consistent production of quality mortgages and servicing of those mortgages at levels that meet or exceed secondary mortgage market standards,” the defendant directors allegedly “either knew, or proceeded with deliberate recklessness with respect to, the fact that originating loans to borrowers who could not pay back their mortgages would ultimately be counterproductive, lucrative as it was in the short term.”

Responsibility for SEC Filings

The Securities and Exchange Commission (SEC) has emphasized the affirmative responsibility of officers and directors under the federal securities laws to ensure the accuracy and completeness of public company filings with the SEC, such as annual and quarterly reports and proxy statements. 16  In addition, as discussed further in  Chapter 21 , the Sarbanes–Oxley Act of 2002 requires the chief executive officer and the chief financial officer to certify the accuracy of public companies’ SEC filings and the adequacy of internal controls.

Officers and directors are required to conduct a full and informed review of the information contained in the final draft of SEC filings. If an officer or director knows or should have known about an inaccuracy in a proposed filing, he or she has an obligation to correct it. An officer or director may rely on the company’s procedures for determining what disclosure is required only if he or she has a reasonable basis for believing that those procedures are effective and have resulted in full consideration of those issues.

If an inaccuracy in a filing requires a restatement of earnings, then officers can be required, pursuant to Sarbanes– Oxley’s  clawback provision,  to pay back bonuses or other incentive compensation received during the year after the erroneous filing. Yet, in practice, clawbacks are rare. 17

If a director or officer is aware of facts that might have to be disclosed, he or she must go beyond the established procedures to inquire into the reasons for nondisclosure. Officers and directors cannot blindly rely on legal counsel’s conclusions about the need for disclosure if they are aware of facts that seem to suggest that disclosure is required. They must raise the issue specifically with disclosure counsel, telling counsel exactly what they know and asking specifically whether disclosure is required. If they are not satisfied with the answers provided, they should insist that the documents be revised before they are filed with the SEC.

20-1c: Disinterested Decision

Even when the board makes an informed decision, the business judgment rule is not applicable if the directors have a financial or other personal interest in the transaction at issue. 18  For example, if a board dominated by inside directors (that is, directors who are also officers of the corporation) sets executive compensation, they can be required to prove to a court that the transaction was fair and reasonable. To be disinterested in the transaction normally means that the directors can neither have an interest on either side of the transaction nor expect to derive any personal financial benefit from the transaction (other than benefits that accrue to all shareholders of the corporation, which are not considered self-dealing).

Even if one or more individual directors have an interest in the transaction, the board’s decision may still be entitled to the protection of the business judgment rule if the transaction is approved by a majority of the disinterested directors. If the board delegates too much of its authority or is too much influenced by an interested party, however, then the entire board may be tainted with that individual’s personal motivations and lose the protection of the business judgment rule.

INTERNATIONAL SNAPSHOT

In 2012, the ninety-two-year-old Japanese optical-equipment maker Olympus Corporation sued nineteen current and former executives for $47 million a  in connection with “one of the biggest and longest-running loss-hiding arrangements in Japanese corporate history.” b  The fraud, which started in the 1990s, was designed to hide more than $1.5 billion of speculative investment losses. c  In a practice called tobashi, which means “to send something flying away,” d  generations of Olympus executives transferred bad assets from Olympus’s books to other firms at inflated prices with the expectation that the deals would be secretly unwound over time. A report described the firm as “rotten” at the core with “a lot of yes-men among the directors.” e  The company was fined $7 million in July 2013, f  shortly after it settled its first shareholder suit for $2.6 million. g  It later set aside $166 million to settle three other lawsuits and publicly recognized a fifth suit in April 2014 from six banks seeking $273 million. h

a. Jonathan Soble, Olympus Sues 19 Executives for Damages, FIN. TIMES, Jan. 10, 2012.

b. Kana Inagaki & Phred Dvorak, Olympus Admits to Hiding Losses, WALL ST. J., Nov. 8, 2011.

c. Daisuke Wakabayashi & Phred Dvorak, Panel Calls Olympus “Rotten” at Core, WALL ST. J., Dec. 11, 2011, at B1.

d. Id.

e. Id.

f. Sophie Knight et al., British Prosecutor Charges Japan’s Olympus over Accounting Scandal, FORBES (Sept. 4, 2013).

g. Olympus Reaches First Shareholder Settlement over Accounting Scandal, JAPAN TIMES (Sept. 27, 2013),  http://www.japantimes.co.jp/news/2013/09/27/national/olympus-reaches-first-shareholder-settlement-over-accounting-scandal/#.U0lTGPldW1g .

h. Sophie Knight, Olympus Says Being Sued by Six Banks for $273 Million over 2011 Scandal, REUTERS (Apr. 9, 2014),  http://www.reuters.com/article/2014/04/09/us-olympus-lawsuit-idUSBREA3809C20140409 .

In some jurisdictions, a relevant factor in determining whether a board is disinterested is whether the majority of the board consists of outside directors. The fact that outside directors receive directors’ fees but not salaries is viewed as heightening the likelihood that the directors were not motivated by personal interest. Application of these rules in the context of takeovers, mergers, and acquisitions is discussed later in this chapter.

20-1d: Statutory Limitations on Directors’ Liability for Breach of Duty of Care

Cases such as Van Gorkom had a devastating impact on the market for directors’ and officers’ liability insurance and on the availability of qualified outside directors. In response, Delaware adopted legislation in 1986 to allow shareholders to limit the monetary liability of directors for breaches of the duty of care (but not the duty of loyalty or good faith) in any suit brought by the corporation or in a shareholder derivative suit. Most other states followed suit. Delaware and most other states require that the limitation be contained in the original certificate of incorporation or in an amendment approved by a majority of the shareholders. The statutes do not affect directors’ liability for suits brought by third parties; they merely allow the shareholders to agree that, under certain circumstances, they will not seek monetary recovery against the directors. The directors’ liability for breach of the duty of loyalty may not be limited. Also, most states do not allow officers (as opposed to directors) to be exonerated from liability for breach of the duty of care or the duty of loyalty.

Delaware’s Statute

Section 102(b)(7) of the Delaware Corporation Code permits the certificate of incorporation to include a provision limiting or eliminating the personal liability of directors to the corporation or to its shareholders for monetary damages for breach of fiduciary duty. Such a provision cannot, however, eliminate or limit the liability of a director for (1) any breach of the director’s duty of loyalty to the corporation or its shareholders, (2) acts or omissions that are not in good faith or that involve intentional misconduct or knowing violation of law, (3) unlawful payments of dividends or stock purchases, or (4) any transaction from which the director derived an improper personal benefit.

California’s Statute

Section 204(a)(10) of the California Corporation Code, which applies to corporations organized under California law, is more restrictive. In addition to the four exceptions contained in the Delaware statute, California prohibits the elimination or limitation of director liability for (1) acts or omissions that show a reckless disregard for the director’s duty to the corporation or its shareholders in circumstances in which the director was aware, or should have been aware, of a risk of serious injury to the corporation or its shareholders and (2) an unexcused pattern of inattention that amounts to an abdication of the director’s duties to the corporation or its shareholders.

Although other states apply their corporate governance rules only to corporations incorporated there, California imposes its pro-shareholder provisions on so-called privately held  quasi-foreign corporations . Such corporations are incorporated elsewhere but (1) have more than 50% of their stock owned by California residents and (2) derive more than 50% of their sales, payroll, and property tax from activities in California. As a result, a privately held quasi-foreign corporation will be subject to California’s more restrictive limits on monetary liability even though the state of incorporation (for example, Delaware) is more permissive.

20-2: DUTY OF GOOD FAITH

Allegations of failure to act in good faith take on special significance in cases involving corporations that have eliminated directors’ personal liability for breaches of the duty of care. Because the statutes authorizing such limitations list failures to act in good faith separately from breaches of the duty of loyalty, courts frequently focus more directly on good faith, especially when the directors had no personal interest in the transaction at hand.

In certain cases, the duty of good faith may be subsumed within the duty of loyalty. As the Delaware Supreme Court remarked, “ [a] director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation’s best interest.” 19

Mere gross negligence is not enough to constitute the lack of good faith that would subject disinterested directors to personal monetary liability, however. The Delaware Supreme Court explained that

“issues of good faith are (to a certain degree) inseparably and necessarily intertwined with the duties of care and loyalty….” But, in the pragmatic, conduct-regulating legal realm which calls for more precise conceptual line drawing, the answer is that grossly negligent conduct, without more, does not and cannot constitute a breach of the fiduciary duty to act in good faith. The conduct that is the subject of due care may overlap with the conduct that comes within the rubric of good faith in a psychological sense, but from a legal standpoint those duties are and must remain quite distinct. Both our legislative history and our common law jurisprudence distinguish sharply between the duties to exercise due care and to act in good faith, and highly significant consequences flow from that distinction. 20

Accordingly, a plaintiff may not invoke an exception to a section 102(b)(7) exculpatory provision unless plaintiff makes “a strong showing of misconduct,” 21  such as “intentionally acting ‘with a purpose other than that of advancing the best interests of the corporation,’ acting ‘with the intent to violate applicable positive law,’ or ‘intentionally fail[ing] to act in the face of a known duty to act.’” 22

In Stone v. Ritter, 23  the Delaware Supreme Court recognized that “good faith may be described colloquially as part of a ‘triad’ of fiduciary duties,” but ruled that the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty. Only the latter two duties, where violated, “may directly result in liability, whereas a failure to act in good faith may do so, but indirectly.” 24  As a result, in Delaware, a failure to act in good faith, taken alone, does not appear to give rise to liability.

Nonetheless, as seen in the following case, directors who consciously ignore known risks of noncompliance may lose the protection of both the business judgment rule and any exculpatory provisions in their corporate charter.

CASE 20.4: A CASE IN POINT: IN THE LANGUAGE OF THE COURT

In re Abbott Laboratories Derivative Shareholders Litigation

United States Court of Appeals for the Seventh Circuit 325 F.3d 795 (7th Cir. 2003).

FACTS

In 1999, Abbott Laboratories, an Illinois corporation, entered into a consent decree that required it to pay a $100 million fine, at the time the largest penalty ever imposed for a civil violation of Food and Drug Administration (FDA) regulations. The FDA also required Abbott to withdraw 125 types of medical diagnostic test kits, destroy certain inventory, and make a number of corrective changes in its manufacturing procedures after six years of quality control violations. Abbott shareholders brought a shareholder derivative suit alleging that the directors had breached their fiduciary duties when they failed to take necessary action to correct repeated noncompliance problems brought to Abbott’s attention by the FDA in the period from 1993 until 1999.

The FDA had sent Abbott a Form 483 noting deviations from the requirements set forth in the FDA’s “Current Good Manufacturing Practice” after each of its thirteen inspections of Abbott’s Abbott Park and North Chicago facilities. In addition, the FDA sent four formal certified Warning Letters to Abbott. The first was addressed to David Thompson, president of Abbott’s Diagnostics Division (ADD), on October 20, 1993. The letter stated that the FDA had found adulterated in vitro diagnostic products and warned: “Failure to correct these deviations may result in regulatory action being initiated by the Food and Drug Administration without further notice. These actions include, but are not limited to, seizure, injunction, and/or civil penalties.” A second Warning Letter was sent to Thompson on March 28, 1994, with a copy to Duane Burnham, Abbott’s CEO and board chair.

On January 11, 1995, the Wall Street Journal reported that the FDA had uncovered a wide range of flaws in the quality assurance procedures used in assembling Abbott’s diagnostic products. In July 1995, the FDA and Abbott entered into a Voluntary Compliance Plan to work together to correct Abbott’s deficiencies. In February 1998, after finding continued deviations from the regulations, the FDA sent Abbott the equivalent of a Warning Letter closing out the plan. In 1999, the FDA sent the fourth and final Warning Letter to Miles White, a member of Abbott’s board and the current CEO. White had replaced Burnham as CEO in April 1999.

Plaintiff shareholders brought a shareholder derivative suit against the Abbott board of directors. The plaintiffs did not demand that the members of Abbott’s board institute an action against themselves for breach of their fiduciary duties, arguing that such a demand would be futile. 25

ISSUE PRESENTED

Is it a breach of directors’ duty of good faith for them to fail to follow up on repeated notices of regulatory noncompliance?

OPINION

WOOD, J., writing on behalf of the U.S. Court of Appeals for the Seventh Circuit:

Plaintiffs in Abbott allege facts that the directors were aware of known violations, providing evidence that there was direct knowledge through the Warning Letters and as members of the Audit Committee. Under proper corporate governance procedures—the existence of which is not contested by either party in Abbott—information of the violations would have been shared at the board meetings. In addition, plaintiffs have alleged that, as fiduciaries, the directors all signed the annual SEC forms which specifically addressed government regulation of Abbott’s products. The Abbott case is clearly distinguished from the “unconsidered” inaction in In re Caremark. 26

. …

The district court noted, correctly, that the plaintiffs did not allege that Abbott’s reporting system was inadequate…. Where there is a corporate governance structure in place, we must then assume the corporate governance procedures were followed and that the board knew of the problems and decided no action was required….

. …

Delaware law states that director liability may arise from the breach of the duty to exercise appropriate attention to potentially illegal corporate activities or from “an unconsidered failure of the board to act in circumstances in which due attention would, arguably, have prevented the loss.” The court held that “a sustained or systematic failure of the board to exercise oversight … will establish the lack of good faith that is a necessary condition to [director] liability.” …

Given the extensive paper trail in Abbott concerning the violations and the inferred awareness of the problems, the facts support a reasonable assumption that there was a “sustained and systematic failure of the board to exercise oversight,” in this case intentional in that the directors knew of the violations of law, took no steps in an effort to prevent or remedy the situation, and that failure to take any action for such an inordinate amount of time resulted in substantial corporate losses, establishing a lack of good faith. We find that six years of noncompliance, inspections, 483s, Warning Letters, and notice in the press, all of which then resulted in the largest civil fine ever imposed by the FDA and the destruction and suspension of products which accounted for approximately $250 million in corporate assets, indicate that the directors’ decision to not act was not made in good faith and was contrary to the best interests of the company. With respect to demand futility based on the directors’ conscious inaction, we find that the plaintiffs have sufficiently pleaded allegations, if true, of a breach of the duty of good faith to reasonably conclude that the directors’ actions fell outside the protection of the business judgment rule….

The directors contend that they are not liable under Abbott’s certificate of incorporation provision which exempts the directors from liability [for breach of the duty of care]. Directors are not protected by that provision when a complaint alleges facts that infer a breach of loyalty or good faith. [Author’s note: The court stated that the burden of establishing good faith rests with the director seeking protection under the exculpatory provision.]

Plaintiffs in Abbott accused the directors not only of gross negligence, but of intentional conduct in failing to address the federal violation problems, alleging “a conscious disregard of known risks, which conduct, if proven, cannot have been undertaken in good faith.”

RESULT

The plaintiffs pleaded sufficient facts to prove that the directors were not entitled to the protection of the business judgment rule. In addition, the plaintiffs’ claims were not precluded by Abbott’s charter provision, so they could proceed with the derivative action.

COMMENTS

The directors were not protected by the charter provision eliminating liability for breaches of the duty of care even though a majority of the board was independent and there were no allegations of self-dealing. In a subsequent case dealing with defective intravenous fluid pumps manufactured by Baxter International, 27  the court reiterated the principle that “‘where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties,’ such conduct establishes a failure to act in good faith.”

CRITICAL THINKING QUESTIONS

1.

Would Abbott’s independent directors have been liable if the CEO and board chair had not given them copies of the FDA Warning Letters?

2.

If you had been an independent director on Abbott’s board, how would you have responded after receiving notice of the second FDA Warning Letter?

20-3: DUTY OF LOYALTY

To comply with their duty of loyalty, directors and managers must act in good faith and subordinate their own interests to those of the corporation and its shareholders. As a result, when a shareholder attacks a transaction in which managers or directors are engaged in self-dealing, have a self-interest other than that of a corporate fiduciary, or favor noncontractual interests of preferred shareholders over the interests of common shareholders, the courts will closely review the merits of the deal. Traditionally, such a transaction has been voidable unless its proponents could show that it was fair and reasonable to the corporation.

20-3a: Corporate Opportunities

One central corollary of the fiduciary duty of loyalty is that officers and directors may not take personal advantage of a business opportunity that rightfully belongs to the corporation. This is known as the  corporate opportunity doctrine . For example, suppose that a copper-mining corporation is actively looking for mining sites. If an officer of the corporation learns of an attractive site, the officer may not buy it for himself without first offering it to the corporation. If the officer attempts to do so, a shareholder can block the sale or impose a  constructive trust  on any profits the officer makes from the acquisition—that is, force the officer to hold the profits for the benefit of the corporation and pay them over to the corporation on request.

The courts have devised several tests for determining whether an opportunity belongs to a corporation. Perhaps the most widely used is the  line-of-business test . Under this test, if an officer, director, or controlling shareholder learns of an opportunity in the corporation’s line of business, a court will not permit the officer, director, or controlling shareholder to keep the opportunity for himself or herself.

For example, the Delaware Supreme Court ruled in a classic case that the president and director of Loft, Inc., a company engaged in manufacturing candies, syrups, beverages, and foodstuffs, could not set up a new corporation to acquire the secret formula and trademarks of Pepsi Cola. 28  He had unsuccessfully sought a volume discount for Loft’s purchases of syrup from the Coca-Cola Company and was contemplating substituting Pepsi for Coke.

If an officer or director develops an idea on company time using company resources, a court will be more likely to find a breach of fiduciary duty if the officer or director then leaves to pursue the idea. If the officer or director has signed an assignment of inventions, then the idea will usually belong to the company under the terms of that agreement. Even without such an agreement, if the officer or director used company time or resources, then courts are more likely to define the corporation’s line of business more broadly.

Courts may also consider whether (1) it would be fair for the fiduciary to keep the opportunity, (2) the corporation has an expectancy or interest growing out of an existing right in the opportunity, or (3) the interference by the fiduciary will hinder the corporation’s purposes. Because different states apply different tests, a corporate fiduciary should always consult local counsel if there is any question of the fiduciary’s usurpation of a corporate opportunity.

An officer or director presented with a corporate opportunity is required to disclose it to the disinterested directors, who may then accept or reject the opportunity. Disclosure is required even when the officer or director could have prevented the corporation from pursuing the opportunity in any event. For example, Thorpe v. CERBCO Inc. 29  involved two brothers who were officers, directors, and controlling shareholders of CERBCO. When a potential acquirer brought up the possibility of buying one of CERBCO’s subsidiaries, the brothers instead proposed to sell their own shares to the acquirer. Because the brothers (in their capacity as controlling shareholders) could have blocked the sale of the subsidiary, CERBCO could not have taken advantage of the opportunity without their approval. Thus, CERBCO suffered no damages as a result of the lost opportunity. Nevertheless, the brothers were fiduciaries of CERBCO and, as such, had the duty to present the sale opportunity to CERBCO. The court held that the brothers were not entitled to the profit gained by their breach of this duty. As a result, they were not entitled to keep the profit they made on the sale of their stock to the potential acquirer of CERBCO’s subsidiary and had to disgorge all of their gains to the corporation.

20-4: DUTY OF CANDOR

When requesting shareholder action, directors have a duty to disclose “fully and fairly” all material facts. 30  The directors of First Niles Financial violated this duty when they stated in a proxy statement that “[a]fter careful deliberations, the board determined in its business judgment [that a merger] proposal was not in the best interests of the Company or our shareholders,” when in fact the board had not objectively considered the merits of the merger proposal. 31  Indeed, whenever directors disseminate information to shareholders, the fiduciary duties of care, loyalty, and good faith apply, even if no shareholder action is sought. 32  As a result, “directors who knowingly disseminate false information that results in corporate injury or damage to an individual stockholder violate their fiduciary duty, and may be held accountable in a manner appropriate to the circumstances.” 33

20-5: DUTIES IN THE CONTEXT OF MERGERS, ACQUISITIONS, AND TAKEOVERS

The decision whether to merge or sell a corporation is generally protected by the business judgment rule. 34  In deciding whether to sell a company and on what terms, directors should consider seven key factors: (1) the company’s intrinsic value, (2) the appropriateness of delegating negotiating authority to management, (3) nonprice considerations, (4) the reliability of officers’ reports to the board, (5) the reliability of experts’ reports, (6) the investment banker’s fee structure, and (7) the reasonableness of any defensive tactics. As explained earlier, the directors must act in good faith and be adequately informed.

20-5a: The Company’s Intrinsic Value

The ability to make an informed decision as to the acceptability of a proposed buyout price requires knowledge of the company’s intrinsic value. Determining intrinsic value entails more than an assessment of the premium of the offering price over the market price per share of the company’s stock. When, as in Van Gorkom, it is believed that the market has consistently undervalued the company’s stock, evaluating the offered price by comparing it with the market price is, according to the Delaware Supreme Court, “faulty, indeed fallacious.” 35

Thus, the directors must do more than assess the adequacy of the premium and compare it with the premiums paid in other takeovers in the same or similar industries. They must also assess the intrinsic or fair value of the company (or division) as a going concern and on a liquidation basis.

Accurate assessment of the company’s intrinsic value by the directors is particularly important when there are no comparable companies from which a valuation for the target can be inferred. In one case, for example, a court determined that a sales price derived from discounted cash flows and expert analysis was fair and that the directors of the company had satisfied their fiduciary duties in arriving at the price. 36

Practitioners have read Van Gorkom as virtually mandating participation by an investment banker if directors are to avoid personal liability. Although the Van Gorkom court expressly disclaimed such an intention, for all practical purposes, directors should look to both internal and external sources for guidance. The most reliable valuation information will consist of financial data supplied by management and evaluated by investment bankers knowledgeable about the industry and recent merger and acquisition activity.

The Hanson Trust  37  decision discussed earlier makes it clear, however, that the mere presence of investment bankers in the target’s boardroom will not shield its directors from personal liability. In that case, the Goldman Sachs partner’s oral opinion that the option prices were “within the range of fair value” did not withstand the scrutiny of the Second Circuit on appeal.

20-5b: Delegation of Negotiating Authority

If members of management are financial participants in the proposed transaction, the delegation of negotiation responsibilities to management or inside directors will expose the board to greater risks of liability. The Second Circuit observed in Hanson Trust:

SCM’s board delegated to management broad authority to work directly with Merrill to structure an LBO proposal, and then appears to have swiftly approved management’s proposals. Such broad delegations of authority are not uncommon and generally are quite proper as conforming to the way that a Board acts in generating proposals for its own consideration. However, when management has a self-interest in consummating an LBO, standard post hoc review procedures may be insufficient…. SCM’s management and the Board’s advisers presented the various agreements to the SCM directors more or less as faits accompli, which the Board quite hastily approved…. In short, the Board appears to have failed to ensure that alternative bids were negotiated or scrutinized by those whose only loyalty was to the shareholders. 38

20-5c: Nonprice Considerations

In evaluating a buyout proposal, directors have a fiduciary duty to familiarize themselves with any material nonprice provisions of the proposed agreement. Directors are duty bound to consider separately whether such provisions are in the best interest of the company and its shareholders or, if not, whether the proposal as a whole, notwithstanding such provisions, is in the best interest of their constituencies.

In Van Gorkom, for example, several outside directors maintained that Pritzker’s merger proposal was approved with the understanding that “if we got a better deal, we had a right to take it.” 39  The directors also asserted that they had “insisted” on an amendment reserving to Trans Union the right to disclose proprietary information to competing bidders. However, the court found that the merger agreement reserved neither of these rights to Trans Union. In the court’s view, the directors had “no rational basis” for asserting that their acceptance of Pritzker’s offer was conditioned on a market test of the offer or that Trans Union had a right to withdraw from the agreement in order to accept a higher bid.

Directors should therefore ensure not only that they correctly understand the nonprice provisions of a proposed merger agreement but also that the provisions find their way into the definitive agreement. They should verify this by reading the documents prior to execution.

20-5d: Takeover Defenses

The business judgment rule creates a powerful presumption of validity in favor of the directors of a corporation. As noted earlier, the business judgment rule does not apply if the directors have an interest in the transaction being acted on. If a hostile raider is successful, it is probably going to replace the company’s management and board of directors as its first step after assuming control. Thus, the directors arguably have a personal interest whenever a board takes defensive action to oppose a hostile takeover.

Unocal Proportionality Test

Unocal Corporation v. Mesa Petroleum Co. 40  established the principle that the business judgment rule applies to takeover defenses, provided that the directors can show that they had reasonable grounds for believing that the unwelcome suitor posed a threat to corporate policy and effectiveness and that the defense was a reasonable response to that threat. This enhanced judicial scrutiny is designed to guard against “the omnipresent specter that a board may be acting primarily in its own interests, rather than those of the corporation and its shareholders.”  41

The Delaware Supreme Court further explained:

If a defensive measure is to come within the ambit of the business judgment rule, it must be reasonable in relation to the threat posed. This entails an analysis by the directors of the nature of the takeover bid and its effect on the corporate enterprise. Examples of such concerns may include: inadequacy of the price offered, nature and timing of the offer, questions of illegality, the impact on “constituencies” other than shareholders (i.e., creditors, customers, employees, and perhaps even the community generally), the risk of nonconsummation, and the quality of securities being offered in the exchange. While not a controlling factor, it also seems to us that a board may reasonably consider the basic stockholder interests at stake, including those of short term speculators, whose actions may have fueled the coercive aspect of the offer at the expense of the long term investor. 42

If the directors succeed in making this initial showing, then they are entitled to the protection of the business judgment rule. Under those circumstances, the Delaware Supreme Court stated:

[U]nless it is shown by a preponderance of the evidence that the directors’ decisions were primarily based on perpetuating themselves in office, or some other breach of fiduciary duty such as fraud, overreaching, lack of good faith, or being uninformed, a court will not substitute its judgment for that of the board. 43

Two-tier offers, in which a hostile bidder offers cash consideration in the first stage to gain control and then offers securities in a second-step merger, are deemed particularly coercive, especially when coupled with the threat of greenmail.  Greenmail  occurs when a raider acquires stock in a target company and then threatens to commence a hostile takeover unless the stock is repurchased by the target at a premium over the market price. (It is discussed further later in the chapter.) Even if shareholders consider the price inadequate, they might well feel coerced 

into tendering in the first stage for fear of receiving securities of even less value in the second stage. As discussed below, defensive tactics, including shareholder rights plans (also called poison pills), can protect shareholders from coercive tender offers.

20-5e: Duty to Maximize Shareholder Value under Revlon

Once the judgment is made that a sale or breakup of the corporation is in the best interests of the shareholders or is inevitable, directors have a fiduciary duty to obtain the best available price for the shareholders. This rule was first articulated in a case involving a hostile takeover bid for Revlon, Inc. by Pantry Pride. 44

After initially resisting the takeover attempt, the Revlon board elected to go forward with a friendly buyout from another company at a lower price than that offered by the hostile bidder. The Revlon board sought to justify the lower price by pointing out the benefits of the friendly buyout for other corporate constituencies, such as the Revlon noteholders. The hostile bidder sued to enjoin the friendly buyout.

The Delaware Supreme Court required the Revlon board to seek the highest price for the shareholders. The court defined the duty of the directors as follows:

The Revlon board’s authorization permitting management to negotiate a merger or buyout with a third party was a recognition that the company was for sale. The duty of the board had thus changed from the preservation of Revlon as a corporate entity to the maximization of the company’s value at a sale for the stockholders’ benefit…. The directors’ role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company. 45

Not every change of corporate control necessitates an auction, however. 46  If fairness to shareholders and the minimizing of conflicts of interest can be demonstrated, the added burden of having an auction may not be necessary. The Delaware Supreme Court declined to make a specific rule for determining when a market test (or “market check”) is required. The court simply stated: “[I]t must be clear that the board had sufficient knowledge of relevant markets to form the basis for its belief that it acted in the best interests of the shareholders.”  47

It is doubtful that the directors’ failure to consider every conceivable alternative would in itself amount to a breach of fiduciary duty. Such a rule would be unduly harsh. In hindsight, a complaining shareholder could almost always conjure up at least one alternative that the directors failed to consider. As the Delaware Supreme Court stated, “No court can tell directors exactly how to accomplish” the goal of maximizing shareholder value. 48  Thus, a fully informed board might reasonably conclude that delaying the signing of a merger agreement to do a premarket check was not worth the risk of losing an attractive offer. 49  In contrast, the failure of a board to consider any alternatives at all, or the unwillingness of a board to negotiate with anyone other than its chosen white knight (or with the initial offeror), would be a breach of fiduciary duty unless there were special circumstances.

When Is a Company in Revlon Mode?

The case of Paramount Communications, Inc. v. Time Inc. 50  examined the question of what constitutes an event triggering the Revlon duty to maximize shareholder value. (A company with such an obligation is deemed to be in  Revlon  mode .) Time had entered into a friendly stock-for-stock merger agreement with Warner Communications. Under that agreement, roughly 60% of the stock of the new combined entity Time–Warner would be held by former public shareholders of Warner. The merger agreement was subject to the approval of Time’s shareholders.

Shortly before the Time shareholder vote was to take place, Paramount Communications made a hostile, unsolicited cash tender offer for all Time shares. In response, Time proceeded with its own highly leveraged cash tender offer to acquire 51% of Warner, to be followed by a back-end, second-step merger of the two companies. This tender offer, which would preclude acceptance of the Paramount tender offer, did not require approval by the Time shareholders. Paramount challenged the actions of Time’s directors in opposing its offer, arguing that the Time board had put Time in the Revlon mode when it agreed to the stock merger with Warner.

The Delaware Supreme Court held that this transaction did not trigger Revlon duties because there was no change in control. Majority control shifted from one “fluid aggregation of unaffiliated shareholders” to another and remained in the hands of the public. As a result, the Time board could properly take into account such intangibles as the desire to preserve the Time culture and journalistic integrity in deciding to reject Paramount’s hostile tender offer, which was arguably worth more to shareholders than the Time–Warner combination. The court considered this to be a strategic alliance, not a sale of Time to Warner, which would have triggered the Revlon duty to maximize shareholder value.

Relying heavily on the precedent established by the Paramount v. Time case, Paramount entered into a friendly merger agreement with Viacom, Inc. in September 1993. At the time Paramount agreed to merge with Viacom, control of Paramount was vested in the “fluid aggregation of unaffiliated stockholders,” and not in a single person, entity, or group. Sumner Redstone was the CEO, chair, and majority shareholder of Viacom. After the proposed merger, he would be the controlling shareholder of the combined Paramount–Viacom entity. When QVC Network, Inc. made a hostile unsolicited offer for Paramount that was worth $1.3 billion more than Viacom’s offer, the Paramount board refused to negotiate with QVC and instead stood by its merger agreement with Viacom.

QVC then sued the Paramount directors, arguing that the Paramount board had put Paramount in the Revlon mode when it committed to a transaction that would shift control of Paramount from the public shareholders to Redstone. The Paramount board argued that it had no duty to maximize shareholder value because it was pursuing a strategic alliance with Viacom, not a breakup of the company. The Delaware Supreme Court rejected this argument and ruled that the Paramount directors had an obligation to continue their search for the best value reasonably available to the stockholders. 51

The court ruled:

[W]hen a corporation undertakes a transaction which will cause: (a) a change in corporate control; or (b) a break-up of the corporate entity, the directors’ obligation is to seek the best value reasonably available to the stockholders. This obligation arises because the effect of the Viacom– Paramount transaction, if consummated, is to shift control of Paramount from the public stockholders to a controlling stockholder, Viacom. 52

Regardless of the present Paramount board’s vision of a long-term strategic alliance with Viacom, once the Paramount–Viacom deal was consummated, Redstone would have the power to alter that vision. Furthermore, once control shifted to Redstone, the current Paramount stockholders would have no leverage to demand a premium for control at some later time.

The Delaware Supreme Court was highly critical of the process the Paramount board followed:

The directors’ initial hope and expectation for a strategic alliance with Viacom was allowed to dominate their decisionmaking process to the point where the arsenal of defensive measures established at the outset was perpetuated (not modified or eliminated) when the situation was dramatically altered. QVC’s unsolicited bid presented the opportunity for significantly greater value for the stockholders and enhanced negotiating leverage for the directors. Rather than seizing those opportunities, the Paramount directors chose to wall themselves off from material information which was reasonably available and to hide behind the defensive measures as a rationalization for refusing to negotiate with QVC or seeking other alternatives. 53

In In re Lukens Inc. Shareholders Litigation, 54  the Delaware Court of Chancery concluded that a merger of Lukens with Bethlehem Steel triggered Revlon duties even though more than 30% of the merger consideration consisted of shares of common stock of Bethlehem, a widely held company with no controlling stockholder. Because 62% of the consideration was cash, the court concluded that “for a substantial majority of the then-current shareholders, ‘there is no long run.’” 55  The Delaware Court of Chancery also applied Revlon to a merger in which public shareholders received half their merger consideration in stock of the acquirer and half in cash. 56  The fact that a shareholder has filed a Schedule 13D disclosing its right to acquire 8% of the target’s stock and its interest in possibly acquiring the target does not put the target in Revlon mode, however. 57  (As discussed further in  Chapter 21 , section 13 of the Securities Exchange Act of 1934 generally requires any person who acquires beneficial ownership of more than 5% of the equity shares of a reporting company to file a Schedule 13D within ten days after crossing the 5% mark.)

The “ In Brief ” on the next page provides a decision tree for analyzing how the business judgment rule applies to board decisions.

20-5f: Deal Protection Devices

Often, the parties to a friendly merger will use  deal protection devices , such as no-talk provisions, to dissuade other bidders and thereby protect the consummation of the friendly merger transaction. The Delaware Supreme Court will uphold such provisions as long as they (1) are reasonable, (2) are not coercive or preclusive, and (3) do not impair the board’s ability to exercise its fiduciary duties. Thus:

Any board has authority to give the proponent of a recommended merger agreement reasonable structural and economic defenses, incentives, and fair compensation if the transaction is not completed. To the extent that defensive measures are economic and reasonable, they may have become an increased cost to the proponent of any subsequent transaction. 58

No-Talk Provisions

Delaware courts are highly skeptical of agreements that purport to limit directors’ ability to fulfill what they in good faith perceive their fiduciary duties to be. For example, the Court of Chancery refused to enforce a no-talk clause in a stock-for-stock merger agreement between Capital Re Corporation and ACE Limited. The  no-talk clause  permitted Capital Re to engage in discussions with and provide information to other bidders only if the board concluded, based on the written opinion of outside legal counsel, that engaging in discussions or providing information was required to prevent the board from breaching its fiduciary duties to its stockholders. 59  Although Capital Re’s counsel opined that negotiating with other bidders was consistent with the board’s fiduciary duties, counsel did not state that the board was required to discuss an offer by another bidder. The court indicated that a provision that purports to prevent a board from talking with other bidders, even if the directors determine that they have a fiduciary duty to do so, is “particularly suspect when a failure to consider other offers guarantees the consummation of the original transaction, however more valuable an alternate transaction may be and however less valuable the original transaction might have become since the merger agreement was signed.”  60

The court did suggest that a no-talk clause with no  fiduciary out  (a clause allowing the board of directors to negotiate with other bidders or to terminate a merger agreement) might be permissible if (1) the stockholders could freely vote for or against the existing merger agreement and choose among the present merger, a subsequent merger, or no merger at all or (2) the board agreed to the provision as a way to end an auction for sale of a company after a thorough canvass of the market. While acknowledging the tension between a vested contract right and the board’s duty to determine what its own fiduciary duties require, the court concluded that a contract right must give way when (1) “the acquirer knew, or should have known, of the target board’s breach of fiduciary duty”; (2) the “transaction remains pending”; and (3) “the board’s violation of fiduciary duty relates to policy concerns that are especially significant.” 61

Courts are more likely to permit  no-shop agreements , whereby the target agrees not to actively solicit other bidders but retains the right to negotiate with parties that submit unsolicited bids to the target. Once again, such devices are more likely to withstand attack when they are put into place after a canvass of the market and as a condition to a bidder’s willingness to make a favorable bid.

Breakup Fees and Options

In exchange for providing a fiduciary out, a bidder will usually demand that some predetermined amount of money be paid to it if the deal fails to close because the target terminates the agreement.  Termination fees , or  breakup fees,  are sometimes characterized as liquidated damages provisions, and they are often 2% to 3% of the value of the deal. They are usually intended to help make the bidder whole for its out-of-pocket expenses (for attorneys, investment bankers, and the like) and lost opportunity costs.

For example, in December 2011, AT&T agreed to pay Deutsche Telecom, T-Mobile’s parent, a breakup fee of $4 billion—$3 billion in cash and $1 billion in other assets— after AT&T abandoned the deal due to antitrust concerns. 62  In mergers of equals, where there is no clear buyer or seller, there are often reciprocal termination fee provisions. For example, the 2009 merger agreement between Black & Decker and Stanley Works contained a $125 million termination fee for either party. 63  Although courts in Delaware and elsewhere have upheld termination fees in the 1% to 3% range under either the business judgment rule or the standard of reasonableness applied to liquidated damages provisions, fees that are so large as to constitute “showstoppers” are much more likely to be struck down. 64

The Delaware Supreme Court struck down the put option Paramount granted to Viacom, which would have given Viacom an additional $1 billion if its deal with Paramount fell through. 65  The court upheld the 1.5% breakup fee as a valid liquidated damages provision, however. As noted earlier, the U.S. Court of Appeals for the Second Circuit also struck down the asset lock-up agreement SCM Corporation had given Merrill Lynch. 66

Agreements to Submit a Merger Agreement to a Stockholder Vote

Sometimes, a board can breach its fiduciary duties if it makes a deal “bulletproof.” For example, the Delaware Supreme Court held that the directors of NCS Healthcare, Inc., an insolvent publicly traded corporation, breached their fiduciary duty when they agreed to submit a merger agreement to a stockholder vote, knowing that two stockholders with a majority of the voting power had agreed unconditionally to vote all their shares in favor of what turned out to be an inferior offer. 67

Omnicare, Inc. had initially made an offer for the assets of NCS at a price that did not include any payment to the stockholders. Thereafter, Genesis Health Ventures, Inc. indicated its willingness to make a superior offer that included $24 million in value for the NCS common stock. Genesis insisted, however, on an exclusivity agreement that prevented NCS from negotiating with other bidders for a short time. Genesis also required that (1) the holders of a majority of the NCS stock enter into agreements to vote in favor of the Genesis deal and (2) the NCS board commit to put the Genesis deal to a vote of the NCS stockholders regardless of whether the board continued to recommend the merger.

After Omnicare made a new proposal that included $3 cash for the common shares, Genesis improved its offer by, among other things, increasing the payment to the stockholders by 80%, but it stipulated that the transaction had to be approved by midnight the next day. The NCS board concluded that the only reasonable alternative was to approve the Genesis transaction, including the voting agreements whereby the two majority stockholders agreed to vote for the Genesis deal. Shortly thereafter, however, Omnicare made an irrevocable offer to acquire the NCS stock for $3.50 per share in cash. The NCS board then withdrew its recommendation that the stockholders vote in favor of the NCS–Genesis merger agreement, and Omnicare sued to prevent the consummation of the Genesis transaction.

The Delaware Supreme Court ruled that the NCS board had breached its fiduciary duties, so the agreement to put the Genesis to a vote of the NCS stockholders was invalid. The court explained that a board’s management decision to enter into and recommend a merger transaction becomes final only when ownership action is taken by a vote of the stockholders. As a result, “a board of directors’ decision to adopt defensive devices to protect a merger agreement may implicate the stockholders’ right to effectively vote contrary to the initial recommendation of the board in favor of the transaction.” Given the “omnipresent specter” of conflicts of interest when a board acts to prevent stockholders from effectively exercising their right to vote contrary to the will of the board, deal protection devices must withstand enhanced judicial scrutiny under the Unocal standard. First, the NCS directors had to establish that the devices adopted in response to the threat of losing the Genesis deal were not “coercive” or “preclusive.” Second, the directors had to demonstrate that their response was within a “range of reasonable responses” to the perceived threat.

The court concluded that the deal protection devices were both preclusive and coercive because they made it “mathematically impossible” and “realistically unattainable” for the Omnicare transaction or any other proposal to succeed, no matter how superior the proposal. Although the minority stockholders were not forced to vote for the Genesis merger, they were required to accept it because it was a fait accompli.

Furthermore, the court held that the NCS board did not have authority to accede to the demand by Genesis for an absolute lock on its deal with NCS. Because the directors of a Delaware corporation have a continuing obligation to discharge their fiduciary responsibilities as future circumstances develop, the NCS board should have negotiated a fiduciary out clause to protect the NCS stockholders if the Genesis transaction became an inferior offer. Although the NCS controlling stockholders “had an absolute right to sell or exchange their shares with a third party at any price,” the NCS directors had a supervening responsibility to discharge their fiduciary duties on a continuing basis.

In a dissenting opinion, Chief Justice Veasey pointed out that the NCS board had conducted a lengthy search and engaged in an intense negotiation process in the context of insolvency and creditor pressure. “Omnicare’s best proposal at that stage would not have paid off all creditors and would have provided nothing for stockholders…. Negotiations with Genesis led to an offer paying creditors off and conferring on NCS stockholders $24 million— an amount infinitely superior to the prior Omnicare proposals.” But, the dissent noted, “there was, understandably, a sine qua non”—namely, assurance that the Genesis merger would close. Given that that the Genesis deal was the “only game in town,” the dissent argued that the NCS directors had fulfilled their fiduciary duties, so the agreements were valid. 68

20-6: ALLOCATION OF POWER BETWEEN THE DIRECTORS AND THE SHAREHOLDERS

A key issue that emerges from cases involving hostile takeovers and defensive tactics is who gets to decide whether the corporation should be sold—the board of directors or the shareholders. Theoretically, the board of directors is the guardian of the shareholders’ interests, but the interests and obligations of the two groups sometimes conflict.

Frequently, a hostile takeover attempt presents such a conflict. Sometimes the proposed terms are attractive to the shareholders because the acquiring corporation offers to pay a substantial premium for their stock. The board of directors, however, may believe that the acquiring company’s plans for the corporation are ultimately destructive, as in the case of a  bust-up takeover , in which the acquired corporation is taken apart and its assets sold piecemeal. The directors may have legitimate concerns about the effect of such a takeover on the company’s employees or on the community where the corporation is located. Or the directors might believe that the long-term value of the company is greater than the price being offered. Of course, directors might oppose a transaction just so they can remain on the corporation’s board, in violation of their legal obligation to put the corporation’s interests before their own.

20-6a: Poison Pills

One of the first cases addressing the allocation of power between the directors and the shareholders in deciding whether the corporation should be sold involved a  poison pill , or  shareholder rights plan , a plan that would make any takeover not approved by the directors prohibitively expensive. 69  In 1984, the directors of Household International, fearing that Household might be taken over and busted up, adopted a poison pill in the form of a Preferred Share Purchase Rights Plan without first securing shareholder approval. This plan provided that, under certain triggering circumstances, common shareholders would receive a “right” for every common share of Household. In the event of a merger in which Household was not the surviving corporation, the holder of each common share of Household would have the right to purchase $200 of the common stock of the acquiring company for only $100. If these rights were triggered and exercised, they would dilute the value of the stock of the acquiring company, making a takeover prohibitively expensive for the acquirer.

The Delaware Supreme Court upheld the board’s power to adopt the plan. The court found that the plan did not usurp the shareholders’ ability to receive tender offers and to sell their shares to a bidder without board approval of the sale. Household’s poison pill left “numerous methods to successfully launch a takeover.” For example, a bidder could make a tender offer on the condition that the board redeem the rights—that is, buy them back for a nominal sum before they were triggered. A bidder could set a high minimum of shares and rights to be tendered; it could solicit consents to remove the board and replace it with one that would redeem the rights; or it could acquire 50% of the shares and cause Household to self-tender for the rights. In a  self-tender , the company would agree to buy back the shareholders’ rights for a fair price.

The court also found that the plan did not fundamentally restrict the shareholders’ right to conduct a proxy contest. In a  proxy contest , someone wishing to replace the board with his or her own candidates must acquire a sufficient number of shareholder votes to do so. Such votes are usually represented by proxies, or limited written powers of attorney entitling the proxy holder to vote the shares owned by the person giving the proxy. The court found that a proxy contest could be won with an insurgent ownership of less than 20% (the threshold for triggering distribution of the rights) and that the key to success in a proxy contest is the merit of the insurgent’s arguments, not the size of his or her holdings.

The court concluded that the decision to adopt the poison-pill plan was within the board’s authority. Because the directors “reasonably believed Household was vulnerable to coercive acquisition techniques and adopted a reasonable defensive mechanism to protect itself,” they had discharged their fiduciary duties appropriately under the business judgment rule.

In the following case, the Delaware Court of Chancery considered whether the board of directors had breached its fiduciary duty when it adopted a two-tiered stock rights plan in response to an activist hedge fund’s increased holdings in the company’s stock.

CASE 20.5: A CASE IN POINT: SUMMARY

Third Point LLC v. Ruprecht

Court of Chancery of Delaware 2014 WL 1922029 (Del. Ch. May 2, 2014).

FACTS

William F. Ruprecht is the chairman of the board and CEO of Sotheby’s, a Delaware corporation that operates the world’s oldest auction house. The unstaggered Sotheby’s board comprises twelve directors, ten of whom are independent. The board members collectively own 0.87% of the company’s outstanding stock. Daniel Loeb is the CEO of Third Point LLC, an investment manager for a series of investment funds. Between May 2013 and October 2013, Third Point increased its stake in Sotheby’s to about 9.4% of the common stock; two other firms were increasing their positions in Sotheby’s at the same time. All three firms were characterized as “activist hedge funds.” Such funds try to change the business policies or capital structures of the companies in which they invest. As of October 3, 2013, the three funds’ ownership of Sotheby’s collectively approximated 19% of the voting stock. The funds disclosed their holdings and acquisitions of the Sotheby’s stock by filing the forms required by the Securities Exchange Act of 1934, including Form 13F (disclosure of institutional investment holdings), Schedule 13D (beneficial ownership greater than 5%), and Schedule 13G (ownership disclosure filed by persons who have not acquired securities with the purpose or effect of changing or influencing control of the issuer and who own less than 20% of the issuer’s stock). Sotheby’s directors were aware of the increases in the holdings of these funds.

On October 2, 2013, Third Point filed an amended Schedule 13D to which it attached a letter from Loeb to Ruprecht outlining Loeb’s concerns about Sotheby’s “chronically weak margins and deteriorating competitive position relative to Christies,” Sotheby’s main competitor; Sotheby’s “lack of alignment with shareholders”; Ruprecht’s “generous” compensation package; and a “sleepy board.” Loeb’s proposed solution was to bring in “the right technicians”— specifically, to bring in Loeb, several new directors chosen by Loeb, and a “designee” from another large shareholder. At a Sotheby’s board meeting the next day, the directors discussed the letter, with the company’s financial advisors and outside legal counsel present. The board considered the adoption of a shareholder rights plan as a response to the letter. After the directors engaged in extensive discussion as to whether the recent stock accumulations “posed a threat” to Sotheby’s and whether adopting the Rights Plan was “an appropriate response,” the board unanimously adopted the plan on October 4.

The Rights Plan had a one-year term unless extended by the stockholders. It included a “qualifying offer” exception whereby it would not apply to an “any-and-all” shares offer that cashed out all of the stockholders and provided them at least one hundred days to consider the offer. The Rights Plan had a “two-tiered structure.” An entity reporting its stock ownership pursuant to Schedule 13G (the report filed by so-called “passive investors”) could acquire up to a 20% interest without triggering the Rights Plan. For all other stockholders—including those reporting stock ownership pursuant to Schedule 13D, such as Third Point—a 10% stake would trigger the plan.

Third Point and Sotheby’s subsequently unsuccessfully sought to negotiate a mutually acceptable arrangement to avoid a proxy contest. Third Point eventually asked for a waiver of the 10% trigger to allow it to purchase up to 20%, but Sotheby’s denied the waiver request. Third Point and other stockholders then sued Sotheby’s and the directors, alleging that they had breached their fiduciary duty by adopting and enforcing the Rights Plan. The plaintiffs also sought a preliminary injunction to postpone Sotheby’s annual meeting pending an expedited trial.

ISSUE PRESENTED

Did the Sotheby’s board of directors breach its fiduciary duties by either (1) adopting the two-tiered Rights Plan or (2) refusing to grant Third Point a waiver from the plan’s 10% trigger?

SUMMARY OF OPINION

The Delaware Court of Chancery began by outlining the three elements a plaintiff must demonstrate to obtain a preliminary injunction: (1) the plaintiff has a reasonable probability of success on the merits; (2) without injunctive relief, the plaintiff will suffer irreparable harm; and (3) the balance of the harms weighs in favor of the plaintiff.

A contested rights plan is reviewed under the two-prong standard established by Unocal Corp. v. Mesa Petroleum Co. 70  The court concluded that Sotheby’s directors had made a good faith and reasonable investigation into the threat posed by Third Point. The board comprised a majority of outside directors and had engaged legal and financial advisors. The court found that Third Point did pose a legally cognizable threat—specifically, the ability to attain “creeping control,” whereby it rapidly accumulated stock, along with other funds, without paying a premium above the market price for control.

The court ruled that the Rights Plan was not coercive because it did not include provisions that would “outright force” a stockholder to vote in favor of the current directors; nor did it allow the board to obtain votes in its favor through “more subtle” means. Thus, the stockholders could vote their shares as they chose without any adverse consequences. The plan was not preclusive, either, because it was “undisputed” that Third Point’s proxy contest with the board was “eminently winnable by either side”—that is, even with the 10% cap, there was no credible argument that Third Point’s success in the proxy battle was “realistically unattainable.”

The court next concluded that the board had a reasonable probability of showing that the Rights Plan was a proportionate response to the creeping control threat posed by Third Point. The directors collectively owned less than 1% of the stock, which allowed the activist investors to possess a substantial ownership position even with the 10% cap. The court reasoned: “A trigger level much higher than 10% could make it easier for a relatively small group of activist investors to achieve control, without paying a premium….”

With regard to the two-tiered structure of the plan, the court acknowledged that the plan was discriminatory: It allowed Schedule 13G filers, who might be more likely to vote with management, to acquire up to a 20% interest without triggering the rights. That alone did not make the plan unreasonable, however, because there were no Schedule 13G filers who owned more than 10% of Sotheby’s stock. As a result, this disparate treatment was a “complete nonissue” based on the current ownership holdings.

The court also concluded that the board would likely be able to show that it undertook a good faith and reasonable investigation in response to Third Point’s request that it waive the 10% trigger, noting again the composition of the board and the use of outside legal and financial advisors. While characterizing it as a “much closer question,” the court concluded that the board had a reasonable basis for concluding that denying the waiver was a reasonable response to the threat that Third Point might obtain effective “negative control” if it acquired a 20% stake. Given Loeb’s “aggressive and domineering manner” and the fact that Third Point would be Sotheby’s single largest stockholder if it owned 20% of Sotheby’s stock, the directors had a legitimate concern that Third Point could exert sufficient influence to control certain corporate actions, such as executive recruitment. Because there was a reasonable probability that the board would succeed in defending its actions at trial, the plaintiffs’ motion for an injunction was denied.

RESULT

Because the plaintiffs had not shown that there was a likelihood they would prevail on the merits of their claims, the injunction did not issue.

COMMENT

After the decision and prior to the stockholders’ meeting, Sotheby’s and Third Point settled. The Sotheby board was increased from twelve to fifteen members. Loeb was given a director’s seat, and two more seats were set aside for his “allies.” Loeb’s stock ownership was capped at 15%, but it was agreed that he will play a “central role” when Sotheby’s strategically reviews its business. 71

Although the Delaware Supreme Court has upheld the adoption of poison-pill plans, it has left open what the Delaware Court of Chancery called “one of the most basic questions animating all of corporate law”: namely, “when, if ever, will a board’s duty to ‘the corporation and its shareholders’ require [the board] to abandon concerns for ‘long term’ values (and other constituencies) and enter a current share value maximizing mode?” 72  More specifically, “[May] a board ‘just say never’ to a hostile tender offer?” In response to this question, the court stated:

Only a board of directors found to be acting in good faith, after reasonable investigation and reliance on the advice of outside advisors, which articulates and convinces the Court that a hostile tender offer poses a legitimate threat to the corporate enterprise, may address that perceived threat by blocking the tender offer and forcing the bidder to elect a board majority that supports its bid. 73

Thus, the question of whether a board must redeem a pill is fact-specific—a court will look at all of the circumstances in making its decision. Certain factors will favor keeping the pill in place. These include (1) a tender offer that is only slightly above the market price of the stock; (2) a tender offer for less than all of the shares; (3) an active attempt by the board to solicit other offers; (4) a conscious effort by the board to allow its outside directors, deemed more disinterested, to make the decisions in this area; and (5) the fact that the tender offer is only in its early stages.

The Delaware Court of Chancery struck down a so-called dead-hand pill, which could be redeemed only by the directors in office before the hostile bidder gained control or by their designated successors. 74  The court held that the dead-hand provision violated the requirement under section 141 of the Delaware General Corporation Law that the directors manage the business and affairs of the corporation, because it gave one category of directors distinctive voting rights that were not shared by the other directors. Although the Delaware statute permits different directors to be given distinctive voting rights, those rights must be set forth in the certificate of incorporation, which was not the case here.

The dead-hand feature also violated the directors’ duty of loyalty, because it purposefully disenfranchised the company’s shareholders without any compelling justification. In particular, “even in an election contest fought over the issue of the hostile bid, the shareholders will be powerless to elect a board that is both willing and able to accept the bid.” Instead, the shareholders “may be forced to vote for [incumbent] directors whose policies they reject because only those directors have the power to change them.” In addition, the dead-hand feature was not proportionate to the threat. It was preclusive because it eliminated shareholders’ ability to wage a proxy contest to gain control of the corporation.

The Delaware Supreme Court also struck down a so-called no-hand pill, which could not be redeemed for six months even if the insurgent’s slate of directors was elected and wanted to redeem it. 75  The delayed redemption feature would have prevented a new board of directors from redeeming the plan to facilitate a transaction that would serve the stockholders’ best interests, even when the board would be required to redeem the plan to satisfy its fiduciary duty to stockholders. Because the delayed redemption provision impermissibly circumscribed the board’s statutory power to manage the business and affairs of the company and the directors’ ability to fulfill their concomitant fiduciary duties, the delayed redemption provision was invalid.

20-6b: Protecting the Shareholder Franchise and the Blasius Standard of Review

A number of takeover cases have drawn a distinction between the exercise of two types of corporate power: (1) the power over the assets of the corporation and (2) the power relationship between the board and the shareholders. 76  As explained earlier, directors have broad power over the assets of the corporation. Such decisions are generally protected by the business judgment rule or subjected to Unocal’s proportionality analysis if they relate to defensive tactics or deal protection devices. As Delaware Chancellor William Allen explained in Paramount Communications, Inc. v. Time Inc., “[t]he corporation law does not operate on the theory that directors, in exercising their powers to manage the firm, are obligated to follow the wishes of a majority of shares.” 77  Thus, the Time directors had the power to acquire Warner Communications even though the holders of a majority of Time’s stock would have preferred to take Paramount’s offer. Or, as the Delaware Court of Chancery later put it, “[d]irectors are not thermometers, existing to register the ever-changing sentiments of stockholders.” 78

If a board’s unilateral decision to adopt a defensive measure or deal protection device touches on issues of voting control, however, then further judicial scrutiny is required to protect the shareholder franchise essential for corporate democracy. In particular, the court must decide whether the board purposefully disenfranchised its shareholders (that is, interfered with their right to elect the directors or to approve a deal). If so, then under the standard first articulated by the Delaware Court of Chancery in Blasius Industries, Inc. v. Atlas Corporation, 79  the action is strongly suspect and cannot be sustained without a compelling justification. 80

Because the business judgment rule provides the directors and officers with great latitude in managing the day-to-day affairs of the corporation, it is important to ensure that the directors do not impair the shareholders’ franchise rights. Shareholders who are displeased with the corporation’s business performance generally have only two options: sell their shares (the so-called Wall Street walk) or vote to replace the incumbent board members. The corporate governance system loses a key control if unhappy shareholders cannot vote the current directors out of office.

For example, in Chesapeake Corp. v. Shore, 81  the Delaware Court of Chancery held that a supermajority bylaw provision adopted by the board of Shorewood Packing Corporation to thwart a hostile bid by Chesapeake Corporation was “a preclusive, unjustified impairment of the Shorewood stockholders’ right to influence their company’s policies through the ballot box.” The provision increased the number of Shorewood shares needed to amend the bylaws from a simple majority to 60%. Because Shorewood’s management controlled almost 24% of its stock, the supermajority provision made it virtually impossible for Chesapeake to garner enough votes to amend the bylaws to eliminate the classified board so that it could unseat the current directors and install a new board amenable to its offer.

Although the court acknowledged that the price offered might be inadequate, it held that the supermajority bylaw was “an extremely aggressive and overreaching response to a very mild threat.” 82  Instead, if the board truly believed that price inadequacy was the problem, it could have taken Chesapeake up on its offer to negotiate price and structure.

20-7: DUTY OF DIRECTORS TO DISCLOSE PRELIMINARY MERGER NEGOTIATIONS

Directors can face a difficult decision when deciding whether they must disclose an offer to buy the company or the company’s participation in merger negotiations. As discussed more fully in  Chapter 22 , disclosure can be required even if the parties have not reached an agreement in principle on the price and structure of the transaction. The U.S. Supreme Court held in Basic Inc. v. Levinson 83  that such “soft information” can be material.

Managers planning a management buyout of a company face a conflict of interest in deciding whether to disclose their offer to the public, because disclosure will often bring forth competing bidders. Prudent directors will often require public announcement of the bid even if it puts the company “in play.”

20-8: EXECUTIVE COMPENSATION

A number of actions have been taken in response to the compensation excesses of the late 1990s and the early 2000s. The Sarbanes–Oxley Act (SOX) of 2002 84  required more timely disclosure of executive pay deals, prohibited loans to officers and directors, and required CEOs and CFOs to return performance-based pay or profits from stock sales following restatements of financial results that involve misconduct (clawbacks).

20-8a: Say-on-Pay and Shareholder Proposals Related to Executive Compensation

The Dodd–Frank Wall Street Reform and Consumer Protection Act’s “Say on Pay” provision gives shareholders of public companies an advisory, nonbinding vote on company payment practices for top executives. 85  These votes must occur at least once every three years. In 2013, shareholders approved the vast majority of pay packages submitted to them for their nonbinding approval. 86  Companies must also hold a “frequency” vote at least once every six years during which shareholders can decide whether they want annual, biannual, or triennial advisory votes on executive pay. These votes are also only advisory, not binding. 87  In addition to the votes required by Dodd-Frank’s “Say on Pay” provisions, the 2013 annual meeting season generated eighty-three shareholder proposals related to executive compensation, representing 31.6% of the total number of shareholder proposals related to corporate governance. 88

In May 2014, owners of more than 75% of the shares of Chipotle Mexican Grill voted “no” in a nonbinding vote on the company’s executive pay. 89  Steve Ells, founder and co–chief executive of Chipotle, was paid $25.1 million in cash and stock in 2013. Montgomery F. Moran, Chipotle’s other co–chief executive, received $24.4 million. 90  Since 2011, Ells and Moran have made more than $100 million each in addition to their salaries through a “complex mix” of stock awards. A Chipotle Mexican Grill employee earning the average annual starting salary of $21,000 would have to work for more than a thousand years to earn as much as one of the co-CEOs. 91

INTERNATIONAL SNAPSHOT

Swiss Social Democrats advocated a measure that would have ensured that top wage earners in a company could not earn more in a month than what other employees earn in a year. In 2013, 65% of Swiss voters rejected the “1:12 initiative for fair pay” measure, largely due to concerns over its potential impact on the country’s economy and enforcement challenges.

SOURCES: Caroline Copley, Swiss Voters Reject Proposal to Limit Executives’ Pay, REUTERS (Nov. 24, 2013),  http://www.reuters.com/article/2013/11/24/us-swiss-vote-pay-idUSBRE9AN0BW20131124 ; Jack Ewing, Swiss Voters Decisively Reject a Measure to Put Limits on Executive Pay, N.Y. TIMES, Nov. 25, 2013, at B3.

Public companies must also hold a shareholder advisory vote on executive change-of-control benefits (so-called  golden parachutes ). Although the espoused purpose of golden parachutes is to encourage executives to entertain deals that would force them from their leadership positions, they have ballooned into packages decried by some as excessive, especially when generously compensating low-performing executives. 92

20-8b: Equity Compensation

It has been the prevailing wisdom for decades that an executive will be more motivated to perform to the best of his or her ability if the executive is a shareholder of the company. Equity compensation plans are seen as a flexible way to share ownership with employees, reward them for performance, and attract and retain a motivated staff. There is not, however, a consensus as to the most appropriate way to achieve such a result, nor is there a consensus as to what is the best balance between equity ownership and nonequity forms of compensation.

Stock Options

A  stock option  gives the person to whom it is granted (the  optionee ) the right to buy a certain number of shares at a fixed price for a fixed number of years, but usually no more than ten years (the  exercise period ). The price at which the optionee can exercise the options by purchasing the stock is called the  exercise price . The Internal Revenue Code assesses a steep penalty on stock options granted with an exercise price less than the fair market value of the stock on the date of grant. 93  Stock option plans provide benefits to the executive only if the stock price rises above the stock option exercise price. Companies are required for accounting purposes to expense stock option awards.

Although stock options gained popularity as a means of aligning the interests of executives with those of the shareholders of their companies, critics believe that options have backfired. They argue that at best, options have promoted a short-term focus, and at worst, they have created an incentive for executives to inflate company earnings and make irresponsible forecasts. In some cases, executives have even fraudulently manipulated earnings in an attempt to keep stock prices high while they exercised their options and sold their stock at inflated prices.

Studies have also found an inverse relationship between the number of options that key executives hold and the success of their corporations. Interestingly, however, studies have also shown that broad-based employee stock ownership appears to increase sales, employment, and productivity. 94

Restricted Stock Plans

In the context of executive compensation,  restricted stock  usually means stock subject to vesting restrictions. Restricted stock plans are frequently used in the private company context where the stock is sufficiently inexpensive that the executive can afford to purchase a substantial portion of it. In the publicly traded company context, however, generally the company’s stock is “too expensive” for the executive to purchase and hold a substantial portion. Accordingly, a publicly traded company will more often give restricted stock to the executive without payment by the executive other than the requirement for continued service for the employer.

For example, an employee might be given stock, or be allowed to purchase stock (sometimes at a discount from fair market value), but be required to forfeit the stock if his or her employment ends before the restrictions have been removed (for example, when the stock vests either after the employee has worked for the company for a certain period of time or after certain performance goals have been met). Some plans allow the restrictions to lapse gradually (for example, 25% of the shares might vest at the end of the first year of employment and the remainder might vest monthly thereafter for the next thirty-six months). Other plans provide that the restrictions do not lapse until the end of the period (for example, all of the shares vest after the employee has worked for the company for four years).

20-8c: SEC Disclosure Requirements

The SEC requires public companies to provide comprehensive disclosure about executive compensation and requires the board of directors to approve and be legally responsible for their company’s report on pay practices. According to former SEC Chairman Richard C. Breeden, “the best protection against abuses in executive compensation is a simple weapon—the cleansing power of sunlight and the power of an informed shareholder base.” 95

Each public company must provide in the proxy statement for its annual meeting of stockholders (or in its annual report on Form 10–K, if not incorporated by reference from the proxy statement) detailed tabular and narrative disclosure relating to total compensation, holdings of equity-related interests, pension plans, and other retirement and postemployment compensation. The Summary Compensation Table  96  must present compensation data for the company’s principal executive officer, the principal financial officer, and the three most highly compensated other executive officers for each of the company’s last three completed fiscal years.

In 2013, the SEC proposed an amendment to Item 402 of Regulation S-K to implement Section 953(b) of the Dodd–Frank Act, which requires disclosure of the pay ratio of the median of the annual total compensation of all employees to the annual total compensation of the CEO. 97  As of August 2014, the proposed rule was still pending.

If a company provides severance, retirement, or other change-of-control benefits to a named executive officer (golden parachutes), the company must include a narrative disclosure of the material terms of the arrangements and quantify the estimated payments for each separate triggering event. Golden parachutes and other material executive compensation events must also be promptly disclosed on SEC Form 8–K.

The compensation disclosure in the proxy statement (or annual report) must include a section called “Compensation Discussion and Analysis” (CD&A). The CD&A is a narrative overview that explains the material elements of compensation for the company’s named executive officers and is intended to provide the public with insight into the company’s compensation policies and decision-making process. It must describe the objectives of the company’s compensation program, what the compensation program is designed to reward, each element of compensation and why the company chooses to pay each element, how the company determines the amount (and, if applicable, the formula) for each element of pay, and how each compensation element and the company’s decisions regarding that element fit into the company’s overall compensation objectives and affect decisions regarding other elements. The rules also require the compensation committee report to state that the committee has reviewed and discussed the CD&A with management and that, based on its review and discussions, the committee has recommended to the board that the CD&A be included in the company’s proxy statement. 98

20-8d: Stock Exchange Requirements

Companies listed on the New York Stock Exchange must have compensation committees composed entirely of independent directors. Nasdaq requires listed companies to have compensation determined either by an independent compensation committee or by a majority of independent directors. Although the NYSE and Nasdaq requirements for compensation committees do not bind directors of nonlisted companies, they signal the standards to which courts may hold directors of all companies. 99

20-8e: Key Principles Related to Compensation

Reports issued by the Conference Board Commission on Public Trust and Private Enterprise, the Business Roundtable, and the National Association of Corporate Directors’ Blue Ribbon Commission on Executive Compensation and the Role of the Compensation Committee highlight the following key principles relating to compensation.

First, a strong and independent compensation committee should oversee and understand the entire executive compensation package and engage its own advisers and consultants. (As noted earlier, both the NYSE and the Nasdaq listing standards require independent compensation committees.) There should be no family relationships, personal friendships, or prior business or philanthropic relationships between the committee members and the executives for whom the committee is determining compensation. At a minimum, the CEO should not participate in compensation committee meetings or compensation issues considered by the board of directors. 100

Second, executive compensation should have a significant performance-based component (some part of which can be equity incentives). Many institutional investors are also calling for a clearer link between pay and performance. For example, Institutional Shareholder Services, Inc. (ISS) supports shareholder proposals advocating the use of performance-based equity awards, unless the proposal is overly restrictive or the company demonstrates that at least 50% of the shares awarded to the top five officers are already performance based. 101

Third, benchmarking should be discouraged because it facilitates what some refer to as the “Lake Wobegon Effect,” whereby all executives (and, as a result, their compensation) are deemed by their boards to be above average. 102  This leads to escalating executive compensation packages as companies seek to stay ahead of at least half of their peers. A report by former SEC Chair Richard Breeden, the court-appointed monitor for WorldCom/MCI, suggests that a logical starting point for executive compensation might be the twenty-fifth percentile, rather than the seventy-fifth percentile. 103  Benchmark data can be useful, but compensation committees need to examine competitive pay packages more carefully and sprinkle those packages with performance incentives.

Fourth, executives should be subject to acquire-and-hold policies that force them to retain a significant equity stake in their employers. Ownership guidelines have two purposes: (1) to align the long-term interests of executives and shareholders and (2) to prevent executives from focusing on short-term increases in stock price at the expense of long-term performance. Presumably, these goals could be accomplished by option terms that prohibit option exercise for a substantial period of time; the leveraged nature of options would have a bigger financial impact on executives.

Fifth, executive compensation should be transparent and conspicuously disclosed. Disclosure of executive and director compensation is very important to institutional shareholders. Companies should clearly spell out, in terms that will be understood by investors, the company’s compensation programs and philosophy, including the performance criteria on which certain compensation will be paid and the rationale for the salary levels, incentive payments, and stock option grants of top executive officers.

Thoughtful companies will respond with well-constructed, well-communicated compensation programs that place greater emphasis on performance than has been the case in the past.104 (This chapter’s “ Inside Story ” discusses some of the recent excesses in executive compensation.)

20-9: DUTIES OF CONTROLLING SHAREHOLDERS

A shareholder who owns sufficient shares to outvote the other shareholders, or to otherwise set corporate policy, and thus to control the corporation is known as a  controlling shareholder . A person owning a majority of the outstanding shares is almost always a controlling shareholder, but persons owning a lower percentage (30%, for example) may still be deemed controlling if the shares are widely dispersed and there are no other large holders. In certain situations, controlling shareholders owe a fiduciary duty to the corporation and to its other shareholders. Generally, controlling shareholders have a responsibility to minority shareholders to control the corporation in a fair, just, and equitable manner (the standard of  entire fairness ). They may not engage in a bad faith scheme to drain off the corporation’s earnings, thereby ensuring that minority shareholders are frozen out of all financial benefits. 105

In 2011, the Delaware Court of Chancery held Grupo Mexico, the controlling shareholder of Southern Peru Copper Corporation (a public company traded on the New York Stock Exchange), liable for $1.3 billion in damages after a purportedly independent special board committee agreed to merge Southern Peru Copper with Minera Mexico, a private company owned by Grupo Mexico, at an inflated price. 106  Investment bank Goldman Sachs had opined that the transaction was fair from a financial perspective to the stockholders of Southern Peru and had provided a written fairness opinion, but the special committee did not ask Goldman to update its fairness analysis at the time of the stockholder vote on the transaction—nearly five months after the special committee had voted to recommend it—despite rising Southern Peru share prices and better-than-expected performance. The court explained: “Where, as here, a controlling stockholder stands on both sides of a transaction, the interested defendants are ‘required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain.’” The court faulted both the special committee and Goldman for focusing “on finding a way to get the terms of the Merger structure proposed by Grupo Mexico to make sense, rather than aggressively testing the assumption that the Merger was a good idea in the first place.” In concluding that Grupo Mexico had breached its duty of loyalty, the court explained that a reasonable special committee would not have taken the results of Goldman’s discounted cash flow analyses “and blithely moved on to relative valuation, without any continuing and relentless focus on the actual give-get involved in real cash terms.” Thus, the special committee “turn[ed] the gold that it held (market-tested Southern Peru stock worth in cash its trading price) into silver (equating itself on a relative basis to a financially-strapped, non-market tested selling company), and thereby devalue[d] its own acquisition currency.”

20-9a: Sale of Control

The obligation not to exercise control in a manner that intentionally harms the corporation and minority shareholders spills over into a sale of control. For instance, if a controlling shareholder knows or has reason to believe that the purchaser of its shares intends to use controlling power to the detriment of the corporation, the controlling shareholder has a duty not to transfer the power of management to such a purchaser.

A controlling interest in a corporation usually commands a higher price per share than a minority interest. Does this control premium belong to the corporation or to the majority shareholder? The widely accepted rule is that controlling shareholders normally have a right to derive a premium from the sale of a controlling block of stock. 107  For instance, in Zetlin v. Hanson Holdings, Inc., 108  the New York Court of Appeals commented:

In this action plaintiff Zetlin contends that minority stockholders are entitled to an opportunity to share equally in any premium paid for a controlling interest in the corporation. This rule would profoundly affect the manner in which controlling stock interests are now transferred. It would require, essentially, that a controlling interest be transferred only by means of an offer to all stockholders, that is, a tender offer. This would be contrary to existing law and if so radical a change is to be effected it would be best done by the Legislature.

In extreme circumstances, however, courts may be willing to characterize the control premium as a corporate asset, thus entitling minority shareholders to a portion. The U.S. Court of Appeals for the Second Circuit took such an approach in the landmark case Perlman v. Feldmann. 109  Perlman involved Newport Steel Corporation, whose mills produced steel sheets for sale to manufacturers of steel products. C. Russell Feldmann was president, chair of the board of directors, and the controlling shareholder of the corporation. In August 1950, when the supply of steel was tight due to the Korean War, Feldmann and certain other shareholders sold their stock to a syndicate of end users of steel who were interested in securing a source of supply.

Minority shareholders brought a shareholder derivative suit to compel the controlling shareholders to account for, and make restitution of, their gains from the sale. The court held that the consideration received by the defendants included compensation for the sale of a corporate asset— namely, the ability of the board to control the allocation of the corporation’s product in a time of short supply.

Note that the court did not seek to prohibit majority shareholders from ever selling their shares at a premium. It was careful to circumscribe its holding with an emphasis on the extreme market conditions:

We do not mean to suggest that a majority stockholder cannot dispose of his controlling block of stock to outsiders without having to account to his corporation for profits or even never do this with impunity when the buyer is an interested customer, actual or potential, for the corporation’s product. But when the sale necessarily results in a sacrifice of this element of corporate good will and consequent unusual profit to the fiduciary who has caused the sacrifice, he should account for his gains. So when in a time of market shortage, where a call on a corporation’s product commands an unusually large premium, in one form or another, we think it sound law that a fiduciary may not appropriate to himself the value of this premium. 110

The following classic case involved elements of abuse of control and sale of control. The dominant shareholders took a series of steps to ensure that they would participate in the financial benefits of the company without letting the minority shareholders also participate.

CASE 20.6: A CASE IN POINT SUMMARY

Jones v. H.F. Ahmanson & Co.

Supreme Court of California 460 P.2d 464 (Cal. 1969).

FACTS

The shares of the United Savings and Loan Association were not actively traded due to their high book value, the closely held nature of the association, and the failure of its management to provide information to shareholders, brokers, or the public.

In 1958, investor interest in shares of savings and loan associations and holding companies increased. Savings and loan stocks that were publicly marketed enjoyed a steady increase in market price. The controlling shareholders of the United Savings and Loan Association decided to create a mechanism by which the association, too, could attract investor interest. They did not, however, attempt to render the association’s shares more readily marketable.

Instead, a holding company, the United Financial Corporation of California, was incorporated in Delaware on May 8, 1959. On May 14, pursuant to a prior agreement, certain association shareholders owning a majority of the association’s stock exchanged their shares for those of United Financial.

After the exchange, United Financial held 85% of the association’s outstanding stock. The former majority shareholders of the association had become the majority shareholders of United Financial and continued to control the association through the holding company. They did not offer the minority shareholders of the association an opportunity to exchange their shares.

The first public offering of United Financial stock was made in June 1960. An additional public offering in February 1961 included a secondary offering (that is, an offering by selling shareholders) of 600,000 shares. There was active trading in the United Financial shares. Sales of the association shares, however, decreased from 170 shares per year before the formation of United Financial to half that number by 1961. United Financial acquired 90% of the association’s shares that were sold.

A shareholder of the association brought suit, on behalf of herself and all other similarly situated minority shareholders, against United Financial and the individuals and corporations that had set up the holding company. The plaintiff contended that the defendants had breached the fiduciary duty owed by the majority shareholders to the minority. She alleged that they had used their control of the association for their own advantage and to the detriment of the minority when they created United Financial, made a public market for its shares that rendered the association’s stock unmarketable except to United Financial, and then refused either to purchase the minority’s association stock at a fair price or to exchange the stock on the same terms afforded to the majority. She further alleged that they had created a conflict of interest that might have been avoided had they offered all association shareholders the opportunity to participate in the initial exchange of shares.

ISSUE PRESENTED

Did the majority shareholders who transferred their shares to a holding corporation, then took it public without allowing the minority to exchange their shares, breach their fiduciary duty to the minority shareholders?

SUMMARY OF OPINION

The California Supreme Court began its analysis by stating that the majority shareholders, acting either singly or in concert, have a fiduciary responsibility to the minority and to the corporation. They must use their ability to control the corporation fairly. They may not use it to benefit themselves alone or in a manner detrimental to the minority. Any use to which they put their power to control the corporation must benefit all shareholders proportionately and must not conflict with the proper conduct of the corporation’s business. The court summarized the rule as one of “inherent fairness from the viewpoint of the corporation or those interested therein.”

The court noted that the controlling shareholders of the association could have taken advantage of the bull market in savings and loan stock in two other ways. They could have caused the association to effect a stock split, thereby increasing the number of outstanding shares, or they could have created a holding company and permitted all shareholders to exchange their shares before offering the holding company’s shares to the public. Either course would have benefited all of the shareholders alike, although the majority shareholders would have had to relinquish some of their control shares. Instead, the defendants set up a holding company that they controlled and did not allow the minority shareholders to exchange their association shares for shares of the holding company.

The court stated that when a controlling shareholder sells or exchanges its shares, the transaction is subject to close scrutiny, particularly if the majority receives a premium over market value for its shares. If the premium constitutes payment for what is properly a corporate asset, all shareholders are entitled to a proportionate share of the premium (citing Perlman v. Feldmann). The defendants’ exchange of association stock for United Financial stock was an integral part of a scheme that the defendants could reasonably have foreseen would destroy the potential public market for association stock. The remaining association shareholders would thus be deprived of the opportunity to realize a profit from those intangible characteristics that attach to publicly marketed stock.

RESULT

The majority shareholders who transferred their shares to a holding corporation, then took it public without allowing the minority to exchange their shares, breached their fiduciary duty to the minority shareholders. The minority shareholders were awarded damages that would place them in a position at least as favorable as the majority shareholders had created for themselves.

20-9b: Freeze-outs

The Delaware Supreme Court has held that a majority shareholder may  freeze out  the minority—that is, force the minority shareholders to convert their shares into cash— as long as the transaction is fair. 111  Sometimes a freeze-out is effected by merging a subsidiary into its parent.

The concept of fairness has two aspects: fair dealing and fair price. 112  Both must be examined together in resolving the ultimate question of entire fairness. As to fair dealing, a court will look at the timing of the transaction; how it was initiated, structured, negotiated, and disclosed to the board; and how director and shareholder approval was obtained. Regarding fair price, a court will look at such economic factors as asset value, market value, earnings, and future prospects, and at any other elements that affect the intrinsic value of a company’s stock.

Although the controlling shareholder may be permitted to negotiate a deal for the sale of the entire company, the board of directors of the target must still determine the intrinsic value of the company and the maximum shareholder value reasonably attainable so that it has an informed basis for recommending the proposed deal to the minority stockholders or for suggesting that the minority stockholders vote against the deal and exercise their appraisal rights. 113  The representatives of the controlling shareholder on the target board owe the target’s minority shareholders “an uncompromising duty of loyalty.” 114  This includes an obligation to provide the minority full and accurate information about the company even if the minority has no right to vote on the deal.

20-9c: Greenmail

Greenmail, the purchase of a dissident shareholder’s stock by the issuer at a premium over market, is often paid in exchange for a  standstill agreement , whereby the shareholder agrees not to commence a tender offer or proxy contest or to buy additional shares of the issuer for a period of time, often ten years. Delaware courts analyze the payment of greenmail in the same way they analyze other defensive tactics under Unocal. If the board demonstrates that the shareholder to be bought out poses a threat to corporate policy and effectiveness and the repurchase of shares at a premium is a reasonable response to that threat, then the payment will be protected by the business judgment rule. 115

GLOBAL VIEW: Hostile Takeovers in the European Union

Takeovers in the European Union (EU) are governed by the European Union Directive on Takeover Bids (DTB). Adopted in April 2004, after thirty years of political wrangling among the EU member states, its aim was to open up European markets; harmonize the conflicting laws that regulate the economies of individual member states; and create clarity, transparency, and legal certainty through a set of common, universal rules governing shareholders’ rights and defensive mechanisms in the event of takeover bids. Originally intended as a major step toward an integrated European capital market, the legislation foundered over sharp differences between the competitive, liberal, “Anglo-Saxon” version of shareholder rights and the coordinated, protectionist, “Rhenish” model. 116

The United Kingdom and Ireland supported provisions that would ease takeover restrictions across Europe, arguing that takeovers would facilitate restructuring and prepare companies for tougher competition in the global market. Germany, Sweden, and Norway, however, pressed for the protection of their national antitakeover defenses. In an effort to reach a consensus, the European Parliament ultimately left adoption of two key articles that would have sharply limited the ability of target firms to adopt takeover defenses (Articles 9 and 11) to the discretion of individual member states. The result was a gutted and largely symbolic bill that left national antitakeover statutes mostly intact. 117

The DTB comprises twenty-three articles, which together stipulate greater transparency, a mandatory bid rule, and an optional British-style “neutrality rule.” The directive applies to takeover bids for securities of an EU company whose securities are admitted to trading on a regulated market in at least one member state, but it specifically excludes takeover bids for securities issued by member states’ central banks. 118

Article 9, the contentious neutrality rule, generally requires the target’s board of directors to remain neutral when faced with a hostile takeover bid and stipulates that once a takeover bid has been launched, the target’s board cannot adopt any antitakeover devices, such as poison pills, without first obtaining the specific approval of shareholders. 119  The mandatory bid provision prohibits coercive two-tier offers by requiring any person who acquires 30% or more of a target company’s stock to offer to buy all remaining shares at the highest price paid to acquire the 30% block. 120

The breakthrough rule in Article 11 was designed to weaken the differential voting structures common in German and Nordic companies. It enables the hostile bidder to break through pre-bid defenses, such as multiple voting rights and other measures that distribute control rights in a manner that is disproportionate to the cash flow rights, thereby ensuring that a bidder that acquires a majority of the equity can successfully mount a takeover. Germany, France, and the Scandinavian countries bitterly resisted the rule’s adoption. 121

To break the deadlock, the drafters added Article 12, which allows the member states to opt out of the neutrality rule and breakthrough rule altogether. As a result, firms in each member state can retain the antitakeover defenses legal under existing national laws. According to an EU Commission report, only 1% of listed companies in the EU will apply the breakthrough rule on a mandatory basis. 122

In 2010, Kraft Foods acquired Cadbury PLC in a controversial hostile transaction even though the UK Takeover Panel had found that Kraft did not have a “reasonable basis for making [certain] declaration[s]” about keeping a particular facility open. 123  In 2011, the Takeover Panel amended the UK Takeover Code to provide more protections for offeree companies. The amendments (1) protect shareholders against drawn-out “virtual bids,” whereby an offeror announces an intention to bid but does not commit to doing so; (2) prohibit certain types of fee arrangements; (3) require the offeror to disclose its financing and the associated fees and expenses; and (4) require the offeror to disclose its intentions about the offeree company and its employees. 124  Further, if an offeror or offeree makes a statement about a particular course of action it plans to take or refrain from taking, it is bound to act in accordance with that statement, subject to certain provisions. 125

U.S. drug maker Pfizer announced on May 26, 2014, that it did not intend to make a takeover offer for the British drug maker AstraZeneca, 126  a week after the AstraZeneca board had rejected Pfizer’s “final” offer. 127  The potential takeover by Pfizer was the first transaction subject to the 2011 “put up or shut up” provision designed to protect against virtual bids. 128  Under this provision, once a bidder is named, the offeror has twenty-eight days to state a firm intention to make an offer or to announce that it is not making an offer.

 THE RESPONSIBLE MANAGER: FULFILLING FIDUCIARY DUTIES

Officers, directors, and controlling shareholders are fiduciaries. They owe their principal (the corporation and its shareholders) undivided loyalty. They must act in good faith. They may not put their own interests before those of the corporation and its shareholders. They cannot, for example, fight off a hostile takeover just to keep their jobs. They cannot use the company’s confidential information for their personal gain.

Officers and directors also owe the corporation and its shareholders a duty of care. They should act with the care reasonable persons would use in the management of their own property. They have a duty to make only informed decisions. They cannot rely blindly on the advice of other people, even experts.

The duty to make informed decisions, which is a part of the duty of care, takes various forms. In the context of takeovers, board members cannot reject an offer without taking sufficient time to analyze its merit. Managers must be able to demonstrate that they made their decisions only after sufficient deliberation and after review of all relevant information. They should consider the possible effects of both the monetary and the nonmonetary aspects of the transaction.

A manager should never sign a document without reading it first. Ideally, each director should read the document the board is asked to approve. If that is not practical, the directors should demand and read a written summary prepared by counsel. They should also make sure that the officers who are authorized to sign the agreement have read it before signing it.

A manager should be informed as to the rules regarding the duty of care in the company’s state of incorporation. Some jurisdictions permit the shareholders to amend the articles of incorporation to relieve directors of any financial liability for violations of the duty of care. But even with such provisions in place, directors must still act in good faith and in what they honestly believe is the best interest of the corporation. Otherwise, they will breach their duty of loyalty. Such a breach not only can result in monetary liability but also can demoralize the shareholders and employees of the corporation, making it difficult to maintain a high level of ethical behavior among them.

In a situation involving a potential conflict of interest, a manager should excuse himself or herself and leave the decision to others who do not have a conflict. It is common, for example, to establish special independent committees of the board of directors, either to examine the fairness of a management offer to acquire the company or to review the merits of shareholder litigation against the directors or officers.

A repurchase of stock at a premium from a dissident (or unhappy) shareholder may violate both the directors’ duty to the corporation and the shareholder’s duty to the other shareholders. Different courts view such repurchases differently, and local counsel should always be consulted. It is often appropriate for the board not only to obtain a written opinion from counsel that such a repurchase is permissible but also to convene a special independent committee of directors to decide whether the consideration that will be paid for the stock is fair.

Any controlling shareholder engaging in a transaction such as a merger with the company it controls must be able to prove that the transaction is fair both procedurally and substantively. The use of independent committees, advised by independent financial consultants and counsel, helps show procedural fairness, as does a willingness to negotiate the proposed transaction with such a committee on an arm’s length basis. Paying a fair price for corporate assets or for shares of a corporation shows substantive fairness. The fairness of a price can be demonstrated by evidence of competing offers or independent appraisals or evaluations. The form of compensation of the appraiser or investment banker should not give that person an interest in the outcome of the appraisal or of the transaction. It is often preferable to pay the appraiser or investment banker a flat fee regardless of whether the deal goes through, rather than an incentive fee based on the value of the deal struck.

Certain acts of directors, officers, and controlling shareholders are both illegal and unethical, such as the seizing of a corporate opportunity by an officer. Other conduct may be legal yet ethically questionable, such as the payment of greenmail.

Some situations present conflicting ethical concerns. The Delaware Supreme Court has held that the directors must maximize shareholder value—that is, get the best price available—if they decide to sell control of the corporation. Yet a sale to a bust-up artist who will sell the company’s assets, or to a union buster, might adversely affect the corporation’s other constituencies, such as employees, suppliers, and the community in which the corporation does business. 129  A manager should try to select a course of action that protects the corporation’s constituencies without sacrificing the shareholders’ right to the best price. If the management team itself bids for the company, the board may find itself forced to become an auctioneer whose sole goal is to get the best price for the shareholders.

A board of directors can use various defensive measures to prevent a hostile takeover, provided that the measures are reasonable in relation to the threat posed and that the board considers it in the best interests of the company and its constituencies for the company to remain independent. Any measures designed to interfere with the shareholder franchise require proof by the directors of a compelling justification.

Similarly, if the board adopts a strategy resulting in a change of control of a corporation, it cannot use defensive tactics such as no-shop provisions (whereby the board agrees not to consider other offers) or large asset or stock lock-ups to deter competing bidders. In short, if the board agrees to a change of control, it breaches its fiduciary duties if it makes competing offers impossible by adopting a scorched-earth policy that leaves the successful bidder with a depleted target. Although legal counsel will advise managers and directors in this area, knowledge of the rules of the game is essential to good management.

A MANAGER’S DILEMMA: PUTTING IT INTO PRACTICE: SHOULD MICKEY PAY GREENMAIL?

In March 1984, a group headed by Saul Steinberg purchased more than 2 million shares of stock of Walt Disney Productions, the owner of Disneyland. Disney responded by announcing that it would acquire the Arvida Corporation for $200 million in newly issued Disney stock and would assume Arvida’s $190 million debt. The Steinberg group countered with a shareholder derivative suit in federal court, seeking to block the Arvida transaction. All of the proceeds of such a suit (less expenses) go to the corporation for the benefit of all of its shareholders.

While the shareholder derivative suit was pending, the Steinberg group proceeded to acquire 2 million additional shares of Disney stock, increasing its ownership position to approximately 12% of the outstanding Disney shares. On June 8, 1984, the Steinberg group advised Disney’s directors of its intention to make a tender offer for 49% of the outstanding shares at $67.50 a share and its intention to later tender for the balance at $72.50 a share.

Should the Disney directors offer to repurchase all the Disney stock held by the Steinberg group at a premium and to reimburse the estimated cost incurred in preparing the tender offer in return for the Steinberg group’s agreement not to purchase any more Disney stock and to drop the Arvida litigation? Is it legal or ethical for the Steinberg group to agree not to oppose a motion to dismiss the Arvida litigation? To sell its shares at a premium not offered to other Disney shareholders? 130

 INSIDE STORY: The Ascendancy of the 1%

One of the rallying cries of the leaderless resistance movement Occupy Wall Street was, “We are the 99 percent.” 131  By September 17, 2011, when the Occupy Wall Street protesters flooded into lower Manhattan, income disparity in the United States had reached the highest levels since the Great Depression. 132  Income gaps translate into larger gaps in standardized test scores between rich and poor children and gaps in completion of college as well as economic segregation, “with the rich flocking together in new exurbs and gentrifying pockets where lower- and middle-income families cannot afford to live.” 133

Although hedge fund operator John Paulson became a poster child for compensation excess (he was paid $4.9 billion in 2010 after successfully betting against the subprime home mortgage market), 41% of the top 0.1% were executives, managers, and supervisors at nonfinancial companies. 134  Sports figures and media stars comprised only about 3%. Market systems are designed to increase economic efficiency by rewarding those who are most productive to society, but this can result in a regime that “allow[s] the big winners to feed their pets better than the losers can feed their children.” 135

Some attribute high executive compensation not to good economics but to overly cozy relationships between CEOs and their boards. Consider corporate governance at WorldCom (now known as MCI) before massive fraud destroyed roughly $200 billion in shareholder value, put tens of thousands of employees out of work, and wiped out the entire value of stock held in employee retirement accounts, as well as the value of accumulated equity-based compensation. 136

According to Richard C. Breeden, WorldCom’s CEO Bernard J. Ebbers “was allowed nearly imperial reign over the affairs of the Company, without the board of directors exercising any apparent restraint on his actions, even though he did not appear to possess the experience or training to be remotely qualified for his position.” 137  The WorldCom board awarded “lavish compensation,” including more than $400 million in “loans” to Ebbers, which were unlikely ever to be repaid. It also approved a $238 million “compensation slush fund,” which Ebbers could allocate to favored executives or employees, with no standards or supervision. Citing Lord Acton’s remark in 1887 that “power tends to corrupt and absolute power corrupts absolutely,” Breeden stated that “‘backbone’ and ‘fortitude’ may be the most important qualities needed by a director of a public company.”

The subprime mortgage crisis set off renewed scrutiny of executive pay and perks. From 2009 to 2012, incomes for the top 1% of earners grew by 31.4%, while incomes for all others grew an average of 0.4%. 138  A study based on data for 2012 showed 22.5% of pre-tax income going to 1% of American families and 49.6% going to the bottom 90%. 139

At a time when working families struggled with ballooning mortgage payments, falling real estate prices, mortgage foreclosure, and job losses, the executives of companies at the center of the subprime mortgage crisis collected hundreds of millions of dollars in compensation. Angelo Mozilo, CEO of the subprime mortgage firm Countrywide Financial, received millions in executive compensation before the firm crashed and burned. Although Citigroup CEO Charles Prince technically received no severance package, he left the firm with $29.5 million in stock options, grants, and other perks after Citibank’s bets on the subprime mortgage market drove the bank to near insolvency. American International Group (AIG) CEO Martin Sullivan, whom Time later named one of the “Worst CEOs of All Time,” collected $47 million from AIG after he was fired. CEO Ken Lewis left Bank of America in 2009 with $53 million in pension benefits. Merrill Lynch CEO Stanley O’Neal collected a $160 million severance package, after leaving the bank with an $8 billion write-down. 140  JPMorgan Chase’s CEO Jamie Dimon earned an estimated $12 million in 2013, a 27% increase from 2012, 141  even though the bank paid tens of billions of dollars in legal costs and fines that year. 142  As Representative Henry Waxman, chair of the U.S. House Committee on Oversight and Government Reform, put it: “Well, the obvious question is, how can a few executives do so well when their companies are doing so poorly?” 143