While seemingly quiet, the last few months have in fact comprised one of the most active periods in the annals of Delaware corporate law.
I’ll review here significant developments affecting aggrieved minority shareholders in M&A transactions; expansion of fiduciary duties of directors; and the wide-ranging attack on current understandings of the role of the American corporation by none other than the chief justice of the Delaware Supreme Court.
It used to be that almost every M&A transaction involving public companies spawned class actions on behalf of allegedly aggrieved shareholders, typically claiming both inadequate disclosure of material facts and short-changing of equity holders.
In the Trulia case in January 2016, the Delaware Chancery Court closed the door on the industry of some plaintiffs’ counsel to bring suits for M&A non-disclosure and then promptly settle those suits by providing non-beneficial additional disclosures in the proxy solicitation. Counsel would then receive substantial fees for their efforts.
That cynical practice was embraced by the very companies being sued, because entering into a global settlement would protect the companies from future liability; the process consequently represented inexpensive “deal insurance.”
Delaware was the location of much of the litigation. (See my December 2017 column commenting on Trulia and also noting that appraisal was often unwise as courts frequently held that “the deal price was the most reliable indication of fair value.”)
Not surprisingly, the number of state lawsuits based on alleged improper disclosure has fallen markedly. Ever-resourceful plaintiffs’ lawyers have therefore attempted to end-run Delaware jurisprudence by bringing the same cases, challenging disclosure and fairness of equity return, to federal courts all over the country.
Federal judges, inexperienced in handling such cases, have not always adopted the Delaware view. According to published statistics, state court actions of this sort fell 34 percent during 2018, while federal court challenges surged.
In a related development, Delaware Chancery drove another nail into the coffin of appraisal by holding that sophisticated shareholders who agree, at the start of a transaction, to waive future appraisal rights can be denied subsequent appraisal.
In Manti Holdings, the court held that appraisal rights were not mandatorily required by statute, in that shareholders can elect not to pursue appraisal; they are just an available shareholder remedy.
The court ruled that a pre-closing waiver of appraisal by unambiguous contract language would be enforced, at least where the waiving parties were sophisticated, held all the equity in the target, and negotiated away rights of appraisal in exchange for other contractual benefits.
Until recently, although Delaware courts theoretically imposed an obligation on corporate directors to supervise the business of their corporations (based on the Caremark case), proving that a director had failed in supervisory obligations proved too high a burden in virtually all asserted litigation.
However, in derivative litigation determined on Oct. 1 (In re: Clovis Oncology), Chancery found that board members could be held liable for breach of the duty of care for permitting misleading public reporting that inflated the success of company drug trials.
The touchstone liability under Caremark must be under one of two theories: either the failure of a board structurally to institute appropriate “oversight systems” to monitor company performance, or a conscious disregard for red flags about improper company actions.
Mere negligence, perhaps even stupidity, on the part of directors does not necessarily create liability. Thus, at least under Caremark, it is possible to be inept and not be held liable for breaching any director duty by reason of making a costly mistake.
There is a tenuous balance here. Mere negligence, perhaps even stupidity, on the part of directors does not necessarily create liability. Thus, at least under Caremark, it is possible to be inept and not be held liable for breaching any director duty by reason of making a costly mistake.
In Clovis, the court held that establishment of relevant committees engaged in oversight was sufficient to meet the mechanical elements of the oversight obligation. However, members of the board in Clovis were sophisticated, having deep experience in clinical drug trials. The board nonetheless signed the annual report and a prospectus containing inflated drug trial results.
The blind eye of those directors was construed by the court as of necessity conscious and intentional, given the level of their sophistication. Chancery, therefore, let stand a claim that liability against directors under Caremark could be asserted by the company derivatively by reason of knowing acquiescence in improper company reporting.
It is unclear whether “gross negligence,” which in some litigation settings is treated as the equivalent of willful action, will sustain future Caremark claims.
New corporate paradigm?
However, the most startling recent news to come out of Delaware was in the form of pronouncements by soon-to-retire Delaware Supreme Court Chief Justice Leo E. Strine Jr.
In press interviews and in a research paper delivered to the University of Pennsylvania and Harvard law schools, Strine proposed radical reformulation of the goals of corporations. If those goals become the “law,” management and directors must manage toward their realization.
Strine’s suggestions would alter the role of American corporations, public and private, by emphasizing the corporate obligations to advance employee interests and social and human values of shareholders.
While substantial public attention has been afforded recently to the corporate role in support of values other than the attainment of profit (witness the exhortation of the Business Round Table proposal for good governance and the sudden buzz about corporate obligations concerning environmental, social and governance — or ESG — issues), Strine’s suggestions were so specific that one interviewer began questioning by asking: “Are you a socialist?”
The scope of Strine’s recommendations can be garnered from a simple list:
- Large companies should create board-level committees focused entirely on the interest of employees;
- Strine contends: “We don’t have an approach to running our economy where we treat the people who create the profits — the workers — with due regard and give them a good pay”;
- Workforce interests should apply not only to employees but also to contractors;
- Asset managers should consider the social interests of their investors when voting shares;
- Since most public investors have a longer timeline than one year (through 401k Plans and 529 Plans, for example), the long-term capital gains holding period should be five years, not one;
- Annual “say on pay” votes in public corporations, mandated by the SEC, are absurd as we should not be compensating or rating CEOs based on such a short timeline;
- These rules should apply based on size of company and not whether a company is publicly or privately held;
- We should tax financial transactions in order to fund social change;
- We should change accounting rules to require narrative disclosure of investments in “human capital”;
- Public companies could not undertake political spending without a 75 percent shareholder vote.
Strine bases his recommendations on his avowedly “liberal” belief that the country must be brought together, and that freedom can occur only in the presence of economic justice. He traces this view to Franklin Delano Roosevelt and the New Deal, and sees his recommendations as tending to heal rifts in our society.
There is a populist underpinning to Strine’s views. In the details of his research paper, he notes that Americans owe much of their wealth to their jobs. That is not just true for the poor but rather, he asserts, for 99 percent of Americans: “On average, Americans get 64% of their income from wages and another 15% from either retirement payments or other transfer payments.” Those percentages climb as one moves up the socio-economic ladder.
Therefore, the role of corporations is to conduct business in a way that creates good jobs, wage growth and “a fair share of the wealth that businesses generate.”
Maximizing corporate profits is not the only driving goal. Board employee committees are needed, as less than 11 percent of the workforce is protected by unions. Policing these reforms would be achieved through increased disclosure: reporting annually on impact on workers, communities, the environment and the country.
A particular question of fiduciary duty arises for institutional investors, which are typically obligated to maximize investor economic return. Strine recommends a change of focus: the requirement to understand the goals of investors in different funds within the same fund family. Today, those funds generally invest the same way without regard to the fact that investors in specialized funds have different timelines, which should be reflected in investment choice.
There is a lot more detail beyond my scope or space. Proposals to establish a federal trust fund with the proceeds of a new financial transaction tax would be used to repair infrastructure.
Strine also would return to the states power over prohibiting mandatory consumer arbitration clauses, rather than imposing the Federal Arbitration Act, and he proposes making union elections easier for organizers.
Finally, buried deep in the details of the research paper, he seeks closing the “carried interest loop hole,” which allows managers to have their share of gain taxed at capital gains rates.
Strine brings our national debates about income disparity, political alienation and the proper functions of corporations to the forefront, seeing them as part of a single issue, one of social justice. Regardless of one’s politics, a look at the research paper is recommended as a glimpse at our possible future.
Stephen M. Honig practices at Duane Morris in Boston.