In Quadrant Structured Products Company, Ltd. v. Vertin (October 1, 2014), Vice Chancellor Laster clarified the Delaware Chancery Court’s approach to breach of fiduciary duty derivative actions brought by creditors against the directors of an insolvent corporation. Importantly, the Vice Chancellor applied business judgment rule deference to the non-independent directors’ decision to try to increase the value of the insolvent corporation by adopting a highly risky investment strategy—even though the creditors bore the full risk of the strategy’s failing, while the corporation’s sole stockholder would benefit if the strategy succeeded. By contrast, the court viewed the directors’ decisions not to exercise their right to defer interest on the notes held by the controller and to pay above-market fees to an affiliate of the controller as having been “transfers of value” from the insolvent corporation to the controller, which were subject to entire fairness review.
Posts Tagged ‘Fiduciary duties’
The Circuit Court of Cook County, Illinois yesterday [October 2, 2014] confirmed that a Delaware board may employ a single-bidder process in a cash sale governed by the Revlon standard. Keating v. Motorola Mobility Holdings, Inc., No. 11-CH-28854 (Ill. Cir. Ct. Ch. Div. Oct. 2, 2014).
The case arose from the 2011 transaction in which Google acquired Motorola Mobility for $40 per share in cash. The transaction elicited the now-conventional multiforum litigation in both Delaware (Motorola Mobility’s place of incorporation) and Illinois (its principal place of business). But the stockholder plaintiffs in Delaware dismissed their case and so only the Illinois action proceeded. Even though the merger price represented a 63% premium for Motorola Mobility’s shares and over 99% of the Motorola Mobility shares voting approved the merger, these plaintiffs attacked the deal, principally on the ground that the Motorola Mobility board should have conducted a broad auction rather than confidentially negotiate the deal with Google.
In an opinion  issued on September 9, 2014, the Delaware Court of Chancery (VC Glasscock) held that in a controlling stockholder freeze-out merger subject to entire fairness review at the outset, disinterested directors entitled under a company’s charter to exculpation for duty of care violations cannot prevail in a motion to dismiss even though the claims against them for breach of fiduciary duty are not pled with particularity; instead, the issue of whether they will be entitled to exculpation must await a developed record, post-trial. The decision once again highlights the litigation cost that will be imposed on companies engaged in controlling stockholder freeze-out mergers for failing to employ both of the safeguards that Delaware has endorsed to ensure business judgment, instead of entire fairness, review—(1) an up-front non-waivable commitment by the controller to condition the transaction on an informed vote of a majority of the minority stockholders and (2) approval of the transaction by a well-functioning and broadly empowered special committee of disinterested directors. At the motion to dismiss stage, disinterested directors effectively will be treated in the same manner as controllers and their affiliated directors.
My article, Radical Shareholder Primacy, written for a symposium on the history of corporate social responsibility, seeks to make sense of the surprising disagreement within the corporate law academy on the foundational legal question of corporate purpose: does the law require shareholder primacy or not? I argue that disagreement on this question is due to an unappreciated ambiguity in the shareholder primacy idea. I identify two models of shareholder primacy, the “radical” and the “traditional.” Radical shareholder primacy makes strong claims about both shareholder governance rights, conceiving of management as the shareholders’ agent, and also about corporate purpose, insisting that corporate law mandates shareholder wealth maximization. Because there is no legal basis for either of these claims, those who deny that shareholder primacy is the law are correct at least as to this model. However, the traditional version of shareholder primacy accords to shareholders a special place in the corporation’s governance structure vis-à-vis the corporation’s nonshareholder stakeholders, for example, with respect to voting rights and the right to bring derivative suits. Beyond this privileged position in the horizontal dimension, there is no maximization mandate and corporate law does very little to provide shareholders with the tools necessary to exercise governance powers; there is no primacy in the vertical dimension or on the question of corporate purpose. Nevertheless, this conception of shareholder primacy—modest as it is—is enshrined in corporate law. Those who deny that shareholder primacy is the law need to acknowledge this fact, but once it is understood that traditional shareholder primacy has little in common with the radical version there is no reason to be reluctant to do so.
On September 4, 2014, the Delaware Court of Chancery issued two lengthy post-trial opinions,  both authored by Vice Chancellor John W. Noble, finding that recapitalization or restructuring transactions did not satisfy the entire fairness standard of review. Although plaintiffs in each instance had received a fair price, the court found that the defendants had employed unfair processes and breached their fiduciary duties.
Significantly, one of the cases involved a recognizable set of facts: various plaintiff stockholders challenged a recapitalization that was approved at the same time the company conducted an “insider” round of financing as the company was running out of cash. The recapitalization and financing were approved by a five-member board of directors, three of whom were designated by venture capital funds that either participated in the financing or were said to have received a special benefit, with no participation by the company’s other stockholders. While the company received an informal and insider-led valuation of $4 million at the time of the recapitalization, the court found that the company’s equity at that time actually had a value of zero. However, as a result of the recapitalization, the company was able to acquire new lines of businesses. Four years after the recapitalization, the company was sold for $175 million. Following the sale, six years of litigation unfolded.
Financial reports should provide useful information to both shareholders and creditors, according to U.S. accounting principles. However, directors of corporations have fiduciary duties only toward equity holders, and those fiduciary duties normally do not extend to the interests of creditors. In our paper, Does Corporate Governance Make Financial Reports Better or Just Better for Equity Investors?, which was recently made publicly available on SSRN, we examine whether this slant in corporate governance biases financial reports in favor of equity investors. We show that the likelihood that firms will manipulate their reporting to circumvent debt covenants is higher when directors owe fiduciary duties only to equity holders, rather than when they owe fiduciary duties also to creditors. Covenants limit the amount of new debt that the firm issues, for example, and by that reduce bankruptcy risk, and allow creditors to avoid bankruptcy costs, and to recover more from the borrowing firm in case it approaches insolvency. When managers manipulate financial reports to circumvent these debt covenants, they transfer wealth from creditors to shareholders. Our results suggest that when corporate governance is designed to protect only equity holders, firms’ financial reports serve equity holders’ interests at the expense of other stakeholders. We find that when the legal regime requires directors to consider creditors’ interests, firms are less likely to use structured transactions designed to skirt debt covenant limits, particularly if the board of directors of the firm is independent.
Shareholder voting has undergone a remarkable transformation over the past few decades. Institutional ownership of shares was once negligible; now, it predominates. This is important because individual investors are generally rationally apathetic when it comes to shareholder voting: value potentially gained through voting is outweighed by the burden of determining how to vote and actually casting that vote. By contrast, institutional investors possess economies of scale, and so regularly vote billions of shares each year on thousands of ballot items for the thousands of companies in which they invest.
Leo Strine, Chief Justice of the Delaware Supreme Court Review and a Senior Fellow of the Harvard Law School Program on Corporate Governance, and J. Travis Laster, Vice Chancellor, Delaware Court of Chancery, recently issued an essay that is forthcoming in Elgar Handbook on Alternative Entities (Eds. Mark Lowenstein and Robert Hillman, Edward Elgar Publishing 2014). The essay, titled The Siren Song of Unlimited Contractual Freedom, is available here.
The abstract of Chief Justice Strine’s and Vice Chancellor Laster’s essay summarizes it briefly as follows:
One frequently cited distinction between alternative entities—such as limited liability companies and limited partnerships—and their corporate counterparts is the greater contractual freedom accorded alternative entities. Consistent with this vision, discussions of alternative entities tend to conjure up images of arms-length bargaining similar to what occurs between sophisticated parties negotiating a commercial agreement, such as a joint venture, with the parties successfully tailoring the contract to the unique features of their relationship.
The last thing hedge funds need is another wake up call about the risks of liability for trading on the basis of material nonpublic information. But if they did, a July 17 article in the Wall Street Journal would provide it. According to the article, the SEC is investigating nearly four dozen hedge funds, asset managers and other firms to determine whether they traded on material nonpublic information concerning a change in Medicare reimbursement rates. If so, it appears that the material nonpublic information, if any, may have originated from a staffer on the House Ways and Means Committee, was then communicated to a law firm lobbyist, was further communicated by the lobbyist to a political intelligence firm, and finally, was communicated to clients who traded. According to an April 3, 2013 Wall Street Journal article, the political intelligence firm issued a flash report to clients on April 1, 2013 at 3:42 p.m.—18 minutes before the market closed and 35 minutes before the government announced that the Centers for Medicare and Medicaid Services would increase reimbursements by 3.3%, rather than reduce them 2.3%, as initially proposed. Shares in several large insurance firms rose as much as 6% in the last 18 minutes of trading.
Recently issued SEC staff guidance addresses concerns that have been raised about proxy advisory firms by emphasizing that the investment adviser that retains and pays a proxy advisory firm is uniquely positioned to monitor the proxy advisory firm and is required to actively oversee the firm if it wants to benefit from the firm’s services to discharge its fiduciary duty. As a result of the greater oversight exercised by all of their investment adviser clients, the proxy advisory firms will presumably respond by enhancing their policies, processes and procedures, as well as the transparency of these policies, processes and procedures. In turn, the corporate community may indirectly benefit to some degree.