“Red Flags” and the Duty of Oversight

Sarah Baker

Under Delaware law, the fiduciary duty of oversight imposes several obligations on boards of directors, including the responsibility to oversee companies and their employees by implementing compliance systems designed to detect and report corporate misconduct.  Courts have uniformly held that a claim for breach of the duty of oversight is “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.”

In Caremark and Stone v. Ritter, the Delaware Supreme Court held that to state a claim for breach of the duty of oversight, plaintiffs must allege one of two scenarios: (1) that a board completely failed to implement any reporting system or controls, or (2) that a board, having implemented such systems or controls, consciously failed to monitor or oversee operations and disabled itself from becoming informed of risks or problems that would require its attention.  In either scenario, plaintiffs must further allege that a board knew it was not discharging its fiduciary responsibilities, i.e., that directors acted in bad faith.

This challenging pleading standard was reaffirmed by the Delaware Court of Chancery’s recent decision in Reiter v. Fairbank, where Chancellor Bouchard dismissed a claim for breach of the duty of oversight in the demand excusal context, holding that the “plaintiff has failed to plead with particularity that a majority of [the Company’s] ten-member board acted in such an egregious manner that they would face a substantial likelihood of liability for breaching their fiduciary duty of loyalty so as to disqualify them from applying disinterested and independent consideration to a demand.”  The Court held that “the standard under Delaware law for imposing oversight liability on a director is an exacting one that requires evidence of bad faith, meaning that ‘the directors knew that they were not discharging their fiduciary obligations.’”

In Reiter, the plaintiff, a stockholder of Capital One Financial Corporation (the “Company”), alleged that the Company’s directors breached their fiduciary duty of oversight by failing to adequately monitor both the Company’s check-cashing service and compliance with Bank Secrecy Act and anti-money laundering regulations (“BSA/AML”).  The Bank Secrecy Act of 1970 “requires financial institutions in the United States to assist government agencies to detect and prevent money laundering activities” by, for example, “maintaining a system of internal controls to ensure ongoing BSA/AML compliance and independent testing for compliance.” 

Between June 2011 and January 2015, the Company’s Audit and Risk Committee received reports from management discussing its BSA/AML compliance system and regulatory developments.  Through 2013 and 2014, the Company internally audited its BSA/AML compliance regime.  Internal reports initially described the Company’s compliance program as “needs strengthening,” and later as “inadequate.”

In late 2013-early 2014, the Company discontinued its check-cashing business following a New York State investigation “concerning the Company’s [BSA/AML] controls and check cashing clients.”  During the New York State investigation and a subsequent investigation by the United States Department of Justice, “it was found that [the Company] had ‘failed to adopt and implement a compliance program that adequately covers the required BSA/AML program elements due to an inadequate system of internal controls and ineffective independent testing.’”

Before the Court of Chancery, the plaintiff alleged that “defendants breached their fiduciary duty of loyalty as members of [the Company’s] board by ‘purposefully, knowingly, or recklessly causing or allowing the Company to violate the BSA/AML, as well as other applicable law.’”  “More specifically, plaintiff contends that, despite the Company’s statutory obligation to maintain BSA/AML controls and procedures, its directors consciously ignored ‘numerous red flags demonstrating the statutory inadequacy of those controls and procedures.’”

The Court considered each of the red flags, but ultimately found that because nothing indicated that “the Company’s BSA/AML controls and procedures actually had been found to violate statutory requirements at any time or that anyone within [the Company] had engaged in fraudulent or criminal conduct[,]” plaintiff’s “core factual allegations . . . do not amount to red flags of illegal conduct.”  The Court stated that there is a difference between “an inadequate or flawed effort to carry out fiduciary duties and a conscious disregard for those duties.”  Chancellor Bouchard described “red flags” as incidents that should put directors on notice of misconduct or a weaknesses within the corporation through its implemented compliance system.  Nonetheless, a “red flag” is only useful when it is “waived in one’s face” or displayed so visibly that the directors must have had notice—either actually or constructively—of misconduct.  Here, the “red flags” were visible to the Company and its board.  The Company received at least twenty-five reports that not only explained its compliance risk but also explained the initiatives that management was taking to ameliorate that risk.

Moreover, the Court noted that these “red flags” would be better referred to as “yellow flags of caution,” as the plaintiff failed to present evidence that would illustrate that the Company engaged in illegal behavior or that “the directors must have known they were breaching their fiduciary duties by tolerating a climate in which the Company was operating part of its business in defiance of the law.”  The Court reasoned that the reports that were delivered to the board ultimately led to the company taking responsive action: exiting the check-cashing business, which was the root of the company’s compliance issues.  This exploit stands in stark contrast to a claim of “inaction” or that the directors were not discharging their duty of oversight.

In sum, the Court’s reasoning in Reiter reaffirms the stringent threshold that plaintiffs must meet in order to prove an oversight breach: claims must be supported with sufficient evidence that a board consciously failed to discharge its fiduciary duties.  The Court’s opinion clarified the concept of “red flags” which provide notice of problems that must be addressed at the board level.  If a board is aware of red flag incidents and consciously chooses to ignore them and take no further action, it has likely breached its duty of oversight.  If, however, the board affirmatively acts in responding to red flags—even if that response fails to entirely limit liability—it is unlikely that the board will have breached its duty of oversight.

Sarah is a second year student at Widener University Delaware Law School and a Staff Member on the Delaware Journal of Corporate Law

Suggested Citation: Sarah Baker, “Red Flags” and the Duty of Oversight, Del. J. Corp. L (Mar. 15, 2017), www.djcl.org/blog. 

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Rule 23.1: Take it to the Board or the Court, Not Both

Kevin Packer

In its recent decision in Zucker v. Hassell, the Court of Chancery addressed when a shareholder can have standing to pursue derivative actions in the demand refusal context. In Zucker the stockholder plaintiff argued that he had derivative standing, under Rule 23.1, because the board’s denial of his request that certain claims be pursued directly by the corporation was grossly negligent.  In Kops v. Hassell, a contemporaneously issued Letter Opinion dealing with the same facts as in Zucker, the court addressed two additional claims regarding the board’s alleged gross negligence along with a claim for violation of the fiduciary duty of loyalty.    

Stockholders can pursue claims for corporate misconduct in two ways.  They may demand that the board of the corporation act directly in pursuing certain claims or bring a derivative action on behalf of the corporation.  If stockholders take the latter option, they must show that the first option, demand on the board, would have been futile.  A demand is futile when the “board would have been unable to exercise its business judgment on behalf of the corporation to evaluate the demand.”  In considering demand futility, the court balances the various interests implicated by allowing the stockholder to pursue derivative claims on behalf of the corporation.

However, if stockholders first make a demand upon the board, and the board in turn refuses to act, the stockholders’ burden to secure derivative standing is greater.  By making the demand stockholders “impliedly conceded that a majority of the directors are disinterested and independent, and that the board could have brought its business judgment to bear on the issue.”  Rule 23.1 requires that for stockholders to overcome this burden, they must plead facts sufficient to raise a reasonable doubt that in declining to pursue claims directly, the board either violated its duty of loyalty by acting in bad faith, or violated its duty of care by acting with gross negligence.

The circumstances surrounding both Zucker and Kops arise from The Bank of New York Mellon Corporation’s (“BNYM”) foreign currency exchange practices.  BNYM claimed that its Standing Instruction service for non-negotiated foreign currency exchanges followed “best execution standards.”  “However, contrary to representations by clients that BNYM offered ‘best rates,’ [BNYM] gave [Standing Instruction] clients prices that were at or near the worst interbank rates during the trading day or session.”  The issue resulted in numerous lawsuits against BNYM and, in March 2015, settlements in the amount of $714 million with the Department of Justice (“DOJ”) and the New York Attorney General’s office.

In Zucker, Plaintiff’s standing claims arose out of a litigation demand made on March 9, 2011 to BNYM’s board of directors requesting investigation of an alleged breach of fiduciary duty.  On April 6, 2011, Plaintiff was informed that the board created a special investigation committee (the “Special Committee”) and hired Cravath, Swain, and Moore LLP (“Cravath”) to assist in the investigation.  On December 14, 2011, Plaintiff received a refusal letter in which “[t]he Special Committee concluded that based on its investigation and deliberations, there was ‘no sound legal basis to assert claims’ and that in any event, ‘such litigation would not be in the best interests of [BNYM].”  The letter indicated that in investigating Plaintiff’s claims Cravath reviewed 10,000 internal documents involving the foreign exchange practices, conducted thirteen interviews of BNYM directors and (current and former) officers, communicated with the Special Committee on multiple occasions and through multiple means, conducted in-person meetings with the Special Committee on October 31, 2011 and December 5, 2011, and assisted the Special Committee in presenting the investigation to the board of directors on December 13, 2011. 

In Zucker, Plaintiff pursue two arguments. “Plaintiff’s primary argument is a species of res ipsa loquitor; because, years after the demand was refused, wrongdoing and liability were admitted by BNYM in connection with a settlement, the investigation by the Board and Special Committee —which failed to turn up wrongdoing—must have been negligent. Plaintiff also argued that the “particulars of the Cravath investigation and the Special [Committee’s]” determination not to pursue certain claims were grossly negligent.

The court determined that Plaintiff’s res ipsa argument was a “non-sequitur” and failed to meet the pleadings standard, whereby “a board’s decision to refuse a plaintiff’s demand is afforded the protection of the business judgment rule unless the plaintiff alleged sufficient facts that raise a reasonable doubt as to whether the board’s decision to refuse the demand was the produce of a valid business judgment.”  The court reiterated that “the decision of an independent committee to refuse a demand should only be set aside if particularized facts are pled to support an inference that the committee, despite being comprised solely of independent directors, breached its duty of loyalty, or breached its duty of care, in the sense of having committed gross negligence.”

Here, the court held that because the Special Committee took sufficient steps to inform itself of any wrongdoing related to its non-negotiated foreign currency exchange practices, it was not grossly negligent in refusing Plaintiff’s demand.  The court recounted Cravath’s investigative efforts and the Special Committee’s diligence in communicating with Cravath regarding the investigation, ultimately holding that the “steps . . . taken by the Special Committee are not consistent with a conclusion that the Special Committee failed to inform itself, or that the investigation was inadequate in scope.”  Plaintiff also argued that “the sampling of documents reviewed by the Special Committee evinces gross negligence.” Plaintiff contended that the Special Committee was grossly negligent because it only reviewed 28 documents and became aware of “damning” information in at least one of the documents it reviewed.  Plaintiff also suggested that evidence produced by Cravath’s investigation and presented to the the Special Committee does not support the Special Committee’s conclusion that “assuming actionable wrongdoing, it was nonetheless not in the Company’s interests to pursue and action.”

The Court found that the special committee through delegating the investigation to Cravath took proper steps to evaluate the documentation relating to the demand, that one “damning” document, although troubling, does not speak to the investigation as a whole, and the redactions should have been handled at an earlier hearing and the Court will not assume, in lieu of well-pleaded facts, that it shows the board did not adopt the special committee and Cravath’s recommendation.  Additionally, the Court held corporations have no duty to revisit past demand refusals following changes to the situation, but the stockholder may re-demand investigation to the board (which was not done by Plaintiff here).  The court ultimately held that “even with all reasonable inferences in Plaintiff’s favor” Plaintiff failed to meet the Rule 23.1 pleading burden, and thus, dismissed Plaintiff’s claims.

In Kops, the Court addressed two separate issues stemming from the same facts as in Zucker: whether a New York Times advertisement by BNYM constituted implied demand refusal and whether the board’s relied entirely on the Zucker investigation in 2011, in addressing Kops’s litigation demand over a year later, on May 24, 2012.  First, the court found that BNYM’s New York Times advertisement proclaiming innocence falls short of implied refusal of demand unless a plaintiff could show the board or special committee was “involved in drafting, preparing, or authorizing such an advertisement.”  Here, Plaintiff did not.

Second, the court reviewed the actions of the special committee between the demand refusal in Zucker and subsequent demand refusal here in Kops. Because the court found in Zucker that “the Board acted within its fiduciary duties when it rejected the Zucker demand[,]” the court’s consideration of the refusal in Kops “turn[ed] on whether intervening developments following the Zucker refusal, and the corresponding actions by the Special Committee, raise a reasonable doubt as to the Board’s compliance with its fiduciary duties in rejecting the Kops demand.”  The court found, however, that, in meetings with Cravath, the Special “Committee discusses ‘whether any developments subsequent to [the Zucker] investigation might affect the validity of the Committee’s prior conclusions.”

The court ultimately dismissed the complaint, finding that Plaintiff failed to meet her burden under Rule 23.1.  In both Zucker and Kops, the court reinforced the heightened burden placed on a stockholder following demand refusal. A stockholder taking demands to the board furthers the goal of efficiency and to achieve the “salutary results of director control” hoped to be established by Rule 23.1.  The issue to overcome the pleadings stage if stockholder’s demand to the board is denied, is incredibly high. Unless there is blatant mishandling of the demand to the board, the plaintiff is in a position where they may feel they have just chosen the wrong alternative.  This realization defeats the purpose of demanding the board to rectify issues and makes the path of demand futility a more attractive option to stockholders.  At this time, the Court’s decisions may deter stockholders from seeking board approval and in substitution try their hand with the Court’s and argue demand futility as a more viable option, and therefore leaves the process in contradiction with the purpose of Rule 23.1.  At this point, there is no real showing of what steps by corporations will not qualify as enough to be above grossly negligent or taken bad faith to at least overcome the pleadings stage.

Kevin is a second year student at Widener University Delaware Law School and a Staff Member on the Delaware Journal of Corporate Law

Suggested Citation: Kevin Packer, Rule 23.1: Take it to the Board or the Court, Not Both, Del. J. Corp. L (Feb. 28, 2017), www.djcl.org/blog. 

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Direct and Derivative Claims in El Paso v. Brinckerhoff

Melaina Hudack

In its recent decision in El Paso v. Brinckerhoff, the Delaware Supreme Court reversed the Court of Chancery’s decision and, in doing so, helped to clarify how to determine whether a stockholder claim is derivative, direct, or both.

This case before the Court of Chancery comes out of two dropdown transactions in which El Paso Corporation transferred ownership interests down to El Paso Pipeline Partners, L.P.—one in the spring and one in the fall of 2010.  The transactions involved the plaintiff, Brinckerhoff, a limited partner of the Partnership, and defendants El Paso Pipeline Partners, L.P., a master limited partnership (the “Partnership”), El Paso Pipeline GP Company, L.L.C. (the “General Partner”), and El Paso Corporation (the “Parent”). During both transactions, as required by the Limited Partnership Agreement (the “LPA”), the General Partner formed a committee to approve both dropdowns. The committees approved the dropdowns and the General Partner closed the transactions. In August 2011, Kinder Morgan, Inc. (“Kinder Morgan”) acquired the Parent.

In December of that year, Brinckerhoff challenged the spring dropdown “derivatively on behalf of [the Partnership].”  Brinckerhoff brought suit against the Parent and the General Partner, alleging breach of express and implied duties, aiding and abetting, tortious interference, and unjust enrichment arguing that they overpaid.  Brinckerhoff then challenged the fall dropdown early the next year. After several motions, the court dismissed all claims except Brinckerhoff’s breach of duty claim against he General Partner.

In July 2014, Kinder Morgan again wanted to merge—this time with the Partnership (the “Merger”). Taking into account Brinckerhoff’s derivative litigation, the a new merger committee still recommended that the Partnership accept Kinder Morgan’s offer to acquire.  The merger committee thought that the value of Brinckerhoff’s claim was “not sufficiently material to impact the Merger consideration” and in November of that year, Kinder Morgan successfully acquired the Partnership.  Brinckerhoff declined to challenge the Merger.

After the Merger, the defendants moved to dismiss Brinckerhoff’s claims, arguing that he lacked standing because he no longer had ownership because of the Merger.  The court, however, denied the defendants’ motion and held that “because the claim for breach of the LPA was not exclusively derivative, Brinckerhoff could enforce the liability award irrespective of the Merger.”

Here, the Delaware Supreme Court addressed the threshold issue of whether or not Brinckerhoff had standing.  The Court wrote, “in corporate derivative litigation, loss of a plaintiff’s status as a shareholder generally extinguishes the plaintiff’s standing.”  The Court of Chancery improperly addressed the standing question with too broad a reading of NAF Holdings. The Court of Chancery treated the LPA as if it were a separate commercial contract rather than the constitutive contract of the Partnership.  The court believed that a plaintiff’s status as a limited partner meant that every claim arising from the LPA was a direct claim.  The Court explained that this application of NAF Holdings was too broad, and the Court of Chancery should have applied the two-pronged Tooley test to determine whether Brinckerhoff’s claim was derivative or direct.

The Tooley test asks, “whether a claim is solely derivative or may continue as a dual-natured claim ‘must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suit stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?’”

In its analysis, the Court determined that the answer to the first question was that Brinckerhoff claimed that the Partnership suffered the alleged harm.  Brinckerhoff claims that the defendants overpaid and, thus, caused a reduction in the Partnership’s overall value.  The Court wrote, “[w]here all of a corporation’s stockholders are harmed and would recover pro rata in proportion with their ownership of the corporation’s stock solely because they are stockholders, then the claim is derivative in nature.”

For the claim to be derivative under the second-prong of Tooley, “the benefit of any recovery must flow solely to the Partnership.”  The Court concluded that the claim was derivative because “[w]ere Brinckerhoff to recover directly for the alleged decrease in the value of the Partnership’s assets, the damages would be proportionate to his ownership interest.  The necessity of a pro rata recovery to remedy the alleged harm indicated that his claim is derivative.”  Thus, the Court concluded that Brinckerhoff’s claim satisfied both prongs of the Tooley test and was exclusively derivative.

The Court makes a distinction for dual-natured claims—claims that are both derivative and direct.  In Gentile, the Court described a dual-natured claim as one that “requires a controlling shareholder and transactions that resulted in an improper transfer of both economic value and voting power from the minority stockholders to the controlling stockholder.”  Brinckerhoff argues that the distinction between economic value and voting power is “immaterial,” and that just an improper transfer of economic value is a direct claim.  The Court, however, declined to expand the purview of dual-natured claims, writing that “to do so would deviate from the Tooley framework and ‘largely swallow the rule that claims of corporate overpayment are derivative’ by permitting stockholders to ‘maintain a suit directly whenever the corporation transacts with a controller on allegedly unfair terms.’”

Furthermore, in his concurrence, Chief Justice Strine argued that the Court’s decision in Gentile v. Rossette doesn’t fill any gaps in Delaware corporate law and “cannot be reconciled with the strong weight of our precedent and it ought to be overruled.”

Finally, the Court followed the rule from Lewis v. Anderson that a plaintiff loses standing to continue a derivative suit when a merger occurs because the claim is transferred to the acquiring company.  Therefore, Brinckerhoff’s claims transferred to Kinder Morgan and Brinckerhoff lost standing to sue when the two companies merged.  The only remedial option Brinckerhoff had was to challenge the merger, but he declined to do so. The Supreme Court reversed the Court of Chancery’s decision because of Brinckerhoff’s lack of standing.

Melaina is a second year student at Widener University Delaware Law School and a Staff Member on the Delaware Journal of Corporate Law

Suggested Citation: Melaina Hudack, Direct and Derivative Claims in El Paso v. Brinckerhoff, Del. J. Corp. L (Feb. 14, 2017), www.djcl.org/blog. 

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In re OM Group, Inc. Stockholders Litigation: The Value of a Vote

Caneel Radinson-Blasucci

In its recent In re OM Group, Inc. Stockholders Litigation (“OMG”) opinion, the Court of Chancery addressed an interesting wrinkle in determining the appropriate standard of review for assessing stockholder’s fiduciary duty claims regarding directors’ conduct in negotiating and closing corporate transactions.   In OMG, the court responded to a claim made by Plaintiffs, OM Group, Inc. (the “Company” or “OM”) stockholders, against the Company’s directors (the “Board”).  The stockholders alleged that the Board rushed to sell the Company “on the cheap” to avoid an embarrassing battle with its activist investors.

OM was a Delaware chemical and technology corporation comprised of five discrete units.  OM was acquired by Apollo Global Management, LLC (“Apollo”) and Platform Specialty Products Corporation (“Platform”) on October 28th, 2015.  Prior to the acquisition, OM faced financial troubles after a ten-year period (2005–2015) of unsuccessful growth strategies.  Between 2014 and 2015, the value of the Company’s shares had fallen nearly 28% and analyst reports indicated that the Company’s low return on investment was a product of operational mismanagement.   In 2013, OM was confronted by FrontFour, an activist shareholder that owned roughly 5.8% of OM’s outstanding stock.  FrontFour requested specific operational changes that they believed would dramatically increase OM’s share price, and nominated three candidates for board positions with the Company.  The Board initially “refus[ed] to entertain, FrontFourt’s proposals[,]” but eventually issues a press release indicating that it was “in the process of implementing most of FrontFourt’s proposals.”

In 2014, after receiving overtures from activists, the Board engaged BNP Paribas (“BNP”) to “assess potential value creation options” out of “concern that ‘activists could derail the execution to [OM’s] strategy’ by calling for ‘change[s] in capital priorities’ and an ‘externally driven change of board members.’”   After receiving presentations from BNP as to the limited market for a sale of the entire Company, OM retained BNP to conduct a confidential market survey with payment contingent on the consummation of a merger.

OM engaged a second financial advisor, Deutsche Bank, “on a fully contingent basis, conditioning a payment of $5.32 million on the delivery of a fairness opinion and the closing of a transaction.”   Ultimately Apollo acquired OM at $34.00 per share, below both BNP and Deutsche Bank’s suggested fair values, and the plaintiffs contended that the company was sold hastily to avoid a proxy fight with unhappy shareholders.  Plaintiffs argue that in an attempt to “rush to the closing table” the Board violated its fiduciary duties.   

As a threshold matter, the court discussed the applicable standard of review.  The choice between standards of review is a crucial one as the court’s selection can be outcome determinative.  The court noted three potentially applicable standards: the business judgment rule, enhanced scrutiny under Revlon, and entire fairness.

The court summarily disclaimed entire fairness review as Plaintiffs did not allege that the board operated under any conflict of interest.  Plaintiffs contended that the merger should be subjected to Revlon enhanced scrutiny, which requires the court to determine whether fiduciaries acted “reasonably to pursue [a] transaction that offered the best value reasonably available.”  Revlon scrutiny is less deferential to director’s decisions than the business judgment rule, which “insulate[s]” boards’ decisions “from all attacks other than on grounds of waste,” as such decisions are presumed to have been made with good faith and an honest belief that they are in the best interest of the corporation and its stockholders.

In determining the appropriate standard of review the court first noted that the Company’s stockholders were cashed out in the merger with Apollo, which might implicate the Revlon standard. However, before engaging in a Revlon enhanced scrutiny analysis the court notes that the merger was approved by “qualified decision makers”: the Company’s stockholders.  The Delaware Supreme Court in Corwin v. KKR Financial Holdings, LLC held that if a corporate action is approved by a fully informed, uncoerced stockholder, then the business judgment rule applies.  In such cases, the court presumes that the stockholders voted with their own best interest in mind, and will not interfere with the stockholders’ judgment.

Here, Plaintiffs attempted to avoid a shift to business judgment rule review under Corwin by arguing that the stockholder vote was uninformed.  Plaintiffs alleged that (1) the Board failed to provide information regarding a competing bid for the Company by Advanced Technology & Materials Co., Ltd. (“Advanced”); (2) the Board failed to address an alleged conflict of interest held by one of its members; and (3) the board failed to disclose materially relevant information about Deutsche Bank.

Plaintiffs argued that the Board failed to disclose that Advanced made a written proposal for $35.00 to $36.00 per share (compared the $34.00 per share that Apollo ultimately paid in the merger) and that the board refused to consider a request by Advanced for extra time to submit a proposal.  Plaintiffs further argued that, because of such omissions, they were mislead by information that the board disclosed about Advanced’s bid, including “references to defined terms within the Merger Agreement that place the potential proposal in context[.]”  Despite Plaintiffs’ arguments, the court found that the Board’s omissions did not render its disclosures regarding Advanced’s bid materially misleading.

Plaintiffs also argued that the stockholder vote was tainted by the Board’s non-disclosure of one of its members’ alleged conflicts of interests.  Steven Demetriou, a member of the Company’s Board, was also the chairman and CEO of a company partially owned by Apollo, and had lunch with an Apollo employee during the sales process.  In assessing Plaintiffs’ claims the court noted that Plaintiffs must, “allege facts from which the Court may reasonably infer that ‘there is a substantial likelihood that a reasonable shareholder would consider [the omission] important in deciding how to vote.’”  The court found that the Board’s failure to disclose Demetriou’s relationship with Apollo did not inhibit a fully informed stockholder vote and was not materially relevant to stockholders during the sales process.  Specifically, the court noted that Plaintiffs’ did not allege that Apollo influenced Demetriou or that Demetriou influenced any other Board members.  That court found that, notwithstanding his relationship with Apollo, Demetriou did not engage in interested dealings about which the stockholders ought to have been informed.

Plaintiffs further alleged that the stockholder vote was uninformed because the Board failed to disclose that its investment bank, Deutsche Bank received 140 Euro from Apollo in years preceding the transaction and was originally hired on a flat-fee basis, which was later changed to a contingency fee basis to be paid at the consummation of the merger.  The court found neither non-disclosure compelling.   The court noted that the Proxy statement stockholders received prior to the vote indicated that Deutsche Bank had received “significant fees” from Apollo prior to the merger.  Though the Board did not disclose the amount of such fees until the day of the vote, its disclosure of the relationship between Deutsche Bank and Apollo was adequate.

Additionally, the court found the terms upon which the Company employed Deutsche Bank throughout the merger process were clearly expressed in the proxy statement and that prior terms of engagement were the type of “play-by-play” information not subject to disclosure.  Having addressed and dismissed Plaintiffs’ arguments as to problems with the stockholder vote, the court determined that the vote was fully informed and uncoerced. Applying Corwin, the court applied the business judgment rule standard of review.  Under the business judgment rule, the court noted that the only question remaining was whether merger constituted waste. Because Plaintiffs failed to allege that the merger was waste, the court dismissed the complaint.

Caneel is a second year student at Widener University Delaware Law School and a Staff Member on the Delaware Journal of Corporate Law

Suggested Citation: Caneel Radinson-Blasucci, In re OM Group, Inc. Stockholders Litigation: The Value of a Vote, Del. J. Corp. L (Jan. 31, 2017), www.djcl.org/blog. 

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Post-Close Disclosure Claims in Nguyen v. Barrett

John Brady

Nguyen v. Barrett deals with post-close claims of breach of fiduciary duty and improper/partial disclosure arising out of a Merger Agreement between Millennial Media, Inc. (“Millennial” or “The Company”) and AOL through which AOL would acquire Millennial through a tender offer.  An Nguyen (“Plaintiff”), a Millennial shareholder, brought this action, on his behalf and behalf of Millennial shareholders, against Millennial to challenge the Merger Agreement.

This action originated as a pre-close complaint (“Pre-Close Action”), where the Plaintiff initially asserted several claims alleging “inadequate price and process, as well as some thirty disclosure violations.”  The Plaintiff sought preliminary injunctive relief, which the Court of Chancery denied.  After the Court of Chancery and the Delaware Supreme Court denied an interlocutory appeal and the shareholders accepted AOL’s tender offer, the Plaintiff submitted a Second Amended Complaint asserting post-close claims (“Post-Close Action”) against the Millennial Board. 

Vice Chancellor Glasscock began his analysis by summarizing the different standards applied to pre-close and post-close claims.  Pre-close claims, when seeking preliminary injunction relief, require a plaintiff to “…demonstrate ‘a reasonable likelihood of proving that the alleged omission or misrepresentation is material.’”  Post-close claims, on the other hand, require a Plaintiff to “allege facts making it reasonably conceivable that there has been a non-exculpated breach of fiduciary duty by the board in failing to make a material disclosure.”  Where, as here, a corporation has a validly adopted § 12(b)(6) provision, a plaintiff must demonstrate post-close, “that a majority of the board was not disinterested or independent, or that the board was otherwise disloyal because it failed to act in good faith, in failing to make the material disclosure.”   

In the Post-Close Action, the Plaintiff sought “damages for breach of duty in regard to two alleged mal-disclosures.”  The Plaintiff alleged: (1) Millennial failed to fully disclose financial information, specifically the Unlevered, After-Tax Free Cash Flow Projections (“UFCF”); and (2) Millennial failed to fully disclose (and explain) the contingent fee arrangement of its financial advisor, LUMA Securities LLC.  “The Defendants move[d] to dismiss under…12(b)(6) for failure to state a claim.”

The Court found that the Plaintiff failed to meet its burden for both claims.  The Plaintiff’s first claim, insufficient disclosure of material financial information, had been subsumed in the Pre-Close Action, where the Court denied preliminary injunctive action.  In denying the Plaintiff’s request for a preliminary injunction, the court determined that the information was not material.  Vice-Chancellor Glasscock opined that “[e]ven if I were to find that the UFCF disclosures—contrary to my earlier determination on the record at the preliminary injunction hearing—constitute a material lack of disclosure, Plaintiff’s UFCU claim must fail.”  He continued, stating that “The Plaintiff has failed to plead facts such that it is reasonably conceivable the alleged incomplete disclosure was made by the board disloyally or in bad faith, as is required to sustain this claim post-close.”

The Court stated that, “[u]nder Delaware law, directors are presumed to be independent, disinterested, and faithful fiduciaries” and that the Plaintiff “does bear the burden to allege facts that rebut [that] presumption[,] that is, to demonstrate that it is reasonably conceivable that the board acted in bad faith or disloyally.”  Here, the Plaintiff relied on the Board’s accelerated vesting of stock options as evidence of disloyalty.  However, the court rejected this proposition, stating that “[i]t is well-settled that where the interests of directors and stockholders are aligned, as here, the accelerated vesting of options does not create a conflict of interest.”  The court held that the Plaintiff failed to sufficiently allege that a majority of the Millennial board was conflicted.

The Plaintiff’s second claim did not fare any better.  First, the court considered whether the Plaintiff’s second claim, incomplete disclosure of contingent fee agreements, should even be considered, or if the plaintiff had waived the claim.  The Plaintiff included the claim in his first complaint, but later abandoned it during subsequent proceedings.  The Court stated that, “where a plaintiff has a claim, pre-close, that a disclosure is either misleading or incomplete in a way that is material to stockholders, that claims should be brought pre-close, not post-close.”  The Court provided two reasons for pursuing such a claim pre-close, namely the stockholder’s right to a fully informed vote and potential damages.  “The preferred method for vindicating truly material disclosure claims is to bring them pre-close, at a time when the Court can insure an informed vote.”

Notwithstanding the issue of waiver, Vice-Chancellor Glasscock found that the Plaintiff’s second claim failed on the merits.  Here, Millennial disclosed in the proxy that LUMA Securities would “receive a fee of $3.6 million for its services, a substantial portion of which is contingent upon the completion of the merger.”  Plaintiff argued that “substantial portion” vaguely defined the substantial nature of the contingency and that such ambiguity supplied inadequate information for shareholders to vote.  The Court disagreed, stating that “[t]his Court has repeatedly held that such a disclosure regarding advisor fees, absent some indication that the fee was exorbitant or unusual, or otherwise improper, is sufficient.”  Here, the Plaintiff failed to allege that the fee was exorbitant, unusual, or otherwise improper.

Additionally, the Court found that the Plaintiff failed to allege that, even if the board’s disclosure of the advisor’s fee was insufficient, the board’s “allegedly incomplete disclosure was made in bad faith.”

The Court’s discussion throughout Nguyen provides a useful summary of the pleading requirements for both pre and post-claim disclosure violations.

John Brady is a Staff Member on the Delaware Journal of Corporate Law, and a member of the Moot Court Honor Society.  John works as a pre-trial clerk at the Chester County District Attorney’s office.

Suggested Citation: John Brady, Post-Close Disclosure Claims in Nguyen v. Barrett, Del. J. Corp. L. (Jan. 23, 2017), www.djcl.org/blog.

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Genuine Parts Requires Genuine Jurisdiction: Protecting Our Economy Through Constitutional Principles

Brittany Giusini       

The Delaware Supreme Court’s recent opinion in Genuine Parts Co. v. Cepec gives clarity to long-standing personal jurisdiction principles by acknowledging an unfettered exercise of judicial power over businesses creates constitutional and economic concerns.

In Genuine Parts, a Georgia corporation registered to do business in Delaware.  Plaintiff sued the corporation alleging claims, which did not involve actions taken in Delaware.  The Superior Court held the corporation consented to general jurisdiction simply because it registered to do business in Delaware and obtained an in-state agent to accept service of process on its behalf.  Thus, the lower court allowed the case to go forward. Reviewing the action on an interlocutory appeal, the Delaware Supreme Court reversed in a majority opinion with Justice Vaughn dissenting.  The Court held, in light of two recent United States Supreme Court decisions, any use of service of process provisions for registered corporations must involve an exercise of personal jurisdiction over the putative defendant.  This was because such an exercise of jurisdiction must be consistent with the United States Constitution’s Due Process Clause. Given that the plaintiff could not show specific or general jurisdiction, the Delaware Supreme Court dismissed the action.

While the Court expressed multiple reasons for its decision such as United States Supreme Court precedent and an interpretation of Delaware case law, the most noteworthy consideration was the micro and macro economic effects on corporations and our country as a whole.  In explaining its rejection of the Superior Court’s decision, the Court relied on financial concerns by stating “[a]n incentive scheme where every state can claim general jurisdiction over every business that does any business within its borders for any claim would reduce the certainty of the law and subject business to capricious litigation treatment as a cost of operating on a national scale or entering any state’s market.”  If businesses were subject to general jurisdiction in every state in which they operate, constitutional principles would be violated.

The Court also recognized Delaware’s interest in having corporations registered here by explaining Delaware relies on corporations’ services.  However, the Court made it a point to explain the looming economic risk if businesses were subject to general jurisdiction in a way inconsistent with the United States Constitution.  The Court stated that if corporations were subject to such loose jurisdictional thresholds, legal certainty for businesses would decrease.

The economic considerations by the Court are significant in light of the current climate involving United States’ businesses and companies. Recent studies have shown small businesses are failing at a higher rate than they are opening.  In addition, influential companies are moving their operations overseas—hurting American job growth and GDP in the process. 

While these actions can be attributed to a variety of factors, it is clear the threat of litigation and decreased predictability in legal outcomes would further stifle American businesses and economy.  “Delaware’s courts offer litigants a forum with an extensive and well-developed jurisprudence that creates predictability and expediency in adjudication, allowing for efficient business planning.” (emphasis added).  If corporations were subject to litigation in every state in the United States and compelled to appear in courts with unpredictable corporate law, our economy would certainly suffer. Corporations would undoubtedly face higher economic risk.  “The decisions of the Delaware Supreme Court and the Court of Chancery establish precedents that provide the predictability needed for businesses to act with confidence.”

The Court’s decision in Genuine Parts sheds light on constitutional issues arising in the context of general and specific personal jurisdiction, but it does more by recognizing how overreaching and unpredictability can produce harmful results. The opinion’s underlying tones make clear Delaware law is essential to the well-being of our nation’s jobs, industries, businesses and financial institutions. The Delaware Supreme Court’s ruling protects corporations by making evident that predictability in the law as well constitutional limitations must be respected.

Suggested Citation: Brittany Giusini, Genuine Parts Requires Genuine Jurisdiction: Protecting Our Economy Through Constitutional Principles, Del. J. Corp. L (Jan. 18, 2017), www.djcl.org/blog. 

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Annual Review of Key Delaware Corporate and Commercial Decisions

Francis Pileggi

 This is the twelfth year that I am providing an annual list of key Delaware corporate and commercial decisions. In some of my past annual reviews, I listed only three key cases, and in other years I listed a few dozen. This year I am taking the middle ground and selecting eleven cases that should be of widespread interest to those who engage in corporate and commercial litigation in Delaware, or to those who follow the latest developments in this area of law. In preparing this list, I eschewed some widely-reported 2016 cases that have already been the subject of extensive commentary in other legal publications. Thus, the list this year may omit one or more blockbuster cases that readers likely have already read about elsewhere. This list is an admittedly subjective exercise, and I invite readers to contact me with suggestions for cases that they believe should be added to–or deleted from–this list. (Unlike last year, this year I don’t have the benefit of adopting the list of cases that a member of the Delaware Court of Chancery publicly described as the 2015 opinions that he thought were most noteworthy.)

Delaware Supreme Court Decisions

Hazout v. Tsang. This opinion changed the law that prevailed for the last 30 years regarding the basis for imposing personal jurisdiction in Delaware over corporate directors and officers. The accepted case law for the last three decades limited jurisdiction over directors and officers of Delaware corporations, if that position was the only basis for imposing jurisdiction, to claims such as breaches of their fiduciary duties. Now, however, Delaware courts can impose personal jurisdiction over directors and officers if they are “necessary or proper parties” to a lawsuit even if there are no fiduciary duty claims or violations of the DGCL. This opinion from Delaware’s high court features a new interpretation of Section 3114 of Title 10 of the Delaware Code, which provides that when a party agrees to serve as a director or officer of a Delaware entity, she thereby consents to personal jurisdiction in Delaware. This opinion also provided a new application of the registration statutes found at Section 371 and 376 of Title 8. A more detailed discussion of the case appeared previously on these pages.

Genuine Parts Co. v. Cepec. In contrast to the foregoing Hazout case, which made it easier to impose personal jurisdiction in Delaware over certain parties to a lawsuit, this opinion did the opposite. Again departing from thirty years of prior Delaware case law, in connection with Delaware’s long-arm statute found at Section 3104 of Title 10 of the Delaware Code, this ruling reasoned that: “In most situations where the foreign corporation does not have its principal place of business in Delaware, that will mean that Delaware cannot exercise general jurisdiction over the foreign corporation.” A prior overview of this case appeared on these pages.

OptimisCorp v. Waite. This ruling provides indispensable insights from Delaware’s high court on the duties and limitations imposed on directors who are appointed by particular stockholders. These board members, sometimes referred to as “blockholder directors,” are often torn between their allegiance to the corporation and their ties to the stockholder that appointed them–often by written agreement as a condition to an investment in the company. Although it reads like an opinion, the format of this ruling is an Order of the court. (The name of the plaintiff is not a typo; it’s a conjoined name with no space but with a capital in the middle.) Most readers know that transcript rulings and Orders can be cited in briefs as authority in Delaware, and this Order contains many eminently quotable gems. The decision affirmed a 213-page opinion by the Court of Chancery, but provided slightly different reasoning and more authoritative insights. Specifically, the Court expressed displeasure with a “Pearl Harbor-like . . . ambush” of a stockholder board member when that stockholder had the ability to remove the directors that ambushed him if he had known of their insurgent intentions prior to the meeting. Highlights of this ruling previously appeared on these pages.

El Paso Pipeline GP Co., LLC v. Brinckerhoff. This decision features a relatively rare reversal of a Court of Chancery decision on the perplexing issue of whether a stockholder claim is derivative or direct–or both. It should be encouraging, even for those who follow this area of the law, that this issue can be so nuanced and difficult to understand that even the Chancellor could be mistaken, though his friends on the Supreme Court called his reversed decision “thoughtful.” In sum, this ruling rejected the Chancery Court’s conclusion that a merger occurring after trial but before the decision of the court had been issued, did not extinguish the plaintiff’s derivative claims. Because the claims were only derivative, the claims were extinguished.

In a concurrence, the Chief Justice argued that the Delaware Supreme Court’s 2006 decision in Gentile v. Rossette should be overruled because it “cannot be reconciled with the strong weight of our precedent.” He argues that Gentile is wrong “to the extent that it allows for a direct claim in the dilution context when the issuance of stock does not involve subjecting an entity whose voting power was held by a diversified group of public equity holders to the control of a particular interest….”

Court of Chancery Decisions

Marino v. Patriot Rail Company LLC. This Court of Chancery opinion is noteworthy for providing the most detailed historical analysis, doctrinal underpinning and legislative exegesis of the statutory scheme that requires corporations under certain circumstances to provide advancement to former directors and officers that has come along in many years. The decision also explains why companies are barred from terminating such advancement for former directors and officers unless certain prerequisites are satisfied. An overview of this decision previously appeared on these pages.

In Re Trulia Inc. Stockholder Litigation.  This Court of Chancery decision has been the subject of such extensive commentary that virtually every reader of this blog has already read about it. This decision sharply curtailed (but did not entirely eliminate) the viability of stockholder class actions based on claims that insufficient disclosures were made in the context of a challenged merger. This decision was issued in January 2016. The Chancery Daily reports that the number of lawsuits filed in the Delaware Court of Chancery during the year 2016 subsequently declined substantially. Of course, some of these disclosure suits might be filed in other states. Extensive expert commentary is available at this link, including from Professor Stephen Bainbridge, a good friend of this blog and a nationally prominent corporate law scholar often cited in Delaware court opinions addressing corporate law issues.

Amalgamated Bank v. Yahoo! Inc. This opinion provides a treasure trove of corporate law jewels. Those who need to keep abreast of this area of the law should read this scholarly 74-page gem. This decision will likely be cited often, and it belongs in the pantheon of seminal Delaware decisions because it is the first opinion to directly and comprehensively discuss directors’ obligations to produce electronically stored information (ESI) in connection with a stockholder’s request for corporate books and records pursuant to DGCL Section 220. The court also required the production of relevant personal emails of directors and officers from personal email accounts. Additionally, the court provided exemplary guidance in how to fulfill fiduciary duties when considering and approving executive compensation proposals. A synopsis of the case appeared on these pages.

Though not related in any way to my recommendation that this opinion is a must-read, as an added bonus, at page 20, the court’s opinion cited to a law review article recently co-authored by yours truly in which it was argued that ESI should be included within the scope of DGCL Section 220.

Obeid v. Hogan. This Court of Chancery opinion will be cited often for fundamental principles of Delaware corporate and LLC law, including the following: (1) even in derivative litigation when a stockholder has survived a motion to dismiss under Rule 23.1, for example where demand futility pursuant to DGCL Section 141 is in issue, the board still retains authority over the “litigation assets” of the corporation, and if truly independent board members exist or can be appointed to create a special litigation committee (SLC), it is possible for the SLC to seek to have the litigation dismissed under certain circumstances; (2) if an LLC Operating Agreement adopts a form of management and governance that mirrors the corporate form, one should expect the court to use the cases and reasoning that apply in the corporate context; (3) even though most readers will be familiar with the cliché that LLCs are creatures of contract, the Court of Chancery underscores the truism that it may still apply equitable principles to LLC disputes; (4) a bedrock principle that always applies to corporate actions is that they will be “twice-tested,” based not only on compliance with the law, such as a statute, but also based on equitable principles. This opinion is also noteworthy because it provides a roadmap for how a board should appoint an SLC with full authority to seek dismissal of a derivative action against a corporation. Additional highlights about this decision were previously noted on these pages.

Medicalgorithmics S.A. v. AMI Monitoring, Inc. This opinion earns a place among my annual list of noteworthy cases for its counterintuitive finding that a non-signatory was bound by the agreement at issue. Although other Delaware opinions have found that non-signatories were bound by the terms of an agreement, in this decision, the non-signatory was an affiliate of the signatory, and was controlled by the signatory; moreover, the agreement applied to affiliates. Additionally, the non-signatory also accepted the benefits of the agreement. See generally provisions of the Delaware LLC Act that bind non-signatory members of an LLC Operating Agreement to the terms of that agreement, and amendments by a majority of members that do not include the non-signatory. A prior overview of this case appeared on these pages.

Bizzarri v. Suburban Waste Services, Inc. This decision should be read by all those who advise directors or their corporations on what corporate records a director is entitled to–or not. This opinion provides an excellent recitation of the many nuanced prerequisites for demanding corporate books and records and when the otherwise unfettered right of directors to corporate records can be circumscribed and restricted. In addition to being noteworthy for providing corporations with defenses to demands for corporate records from directors and stockholders, this ruling explores the types of data that one can demand in connection with asserting the proper purpose of valuation of an interest in a closely-held company. A fuller discussion of this case appeared previously on these pages.

Larkin v. Shah. This Court of Chancery decision should be read by those interested in one of the most pithy restatements in any recent opinion of basic corporate governance principles such as the: (1) articulation of the fiduciary duties of directors; (2) presumption of the BJR as a standard of review; (3) when the BJR applies; and (4) how the BJR is rebutted. This opinion also provides an eminently clear articulation and application of the various permutations of one-sided or both-sided controlling stockholder transactions, and what standard of review applies in those circumstances, as well as the standard that applies in this case, where there is no controlling stockholder, but there is stockholder approval. An overview of the opinion appeared previously on these pages.

Supplemental Bonus: For the last twenty years, I have published a bimonthly column on legal ethics for the American Inns of Court. Because of the importance of legal ethics, which of course apply generally to the corporate and commercial litigation focus of this blog, and in particular in light of a controversial proposal by the ABA to amend the Model Rules to make it unethical to oppose, notwithstanding good faith religious reasons, certain behavior that until a few months ago was completely legal, I include a link to my recent article that quotes the views of nationally prominent legal scholars on a new ABA rule of professional conduct.
In addition, in honor of the passing in 2016 of U.S. Supreme Court Justice Antonin Scalia, I include a link to highlights that appeared on these pages of a concurrence by Justice Alito and Justice Thomas in the recent Caetano case that emphasizes the importance of the natural right of self-defense and in which those members of this country’s highest court rebuke Massachusetts’ highest court for flagrantly ignoring the clear authority expressed in the U.S. Supreme Court decisions in Heller and in McDonald regarding each person’s natural right to self-defense.

Francis Pileggi is a graduate of Widener University Delaware Law School and the former Internal Managing Editor of the Delaware Journal of Corporate Law.  Presently, he is the managing member of the Wilmington, Delaware office of Eckert Seamans Cherin & Mellot, LLC.  He regularly publishes content on his website, the Delaware Corporate & Commerical Litigation Blog.  Francis is also the first alumni author to publish an article on the Delaware Journal of Corporate Law Blog.

Suggested Citation: Francis Pileggi, Annual Review of Key Delaware Corporate and Commercial Decisions, Del. J. Corp. L (Jan. 6, 2017), www.djcl.org/blog. 

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Rebutting Fairness in Business: A Look at In Re Books-A-Million

Lindsay Killian

In its recent decision in In Re Books-A-Million, Inc. Stockholders Litigation (“BAM”), the Delaware Court of Chancery addressed a basis for challenging a shift from entire fairness review to the business judgment rule that the Delaware Supreme Court did not contemplate in Kahn v. M&F Worldwide (“MFW”).

Prior to the Delaware Supreme Court’s ruling in MFW, mergers in which a controlling stockholder purchased a corporation’s remaining shares were subject to Entire Fairness review, even where such deals were facilitated by independent committees.  Independent committees bore the burden of proving that they bargained at “arms-length,” uninfluenced by the controlling stockholder.


In MFW, the Supreme Court noted that although Entire Fairness review is the default standard for reviewing controlling stockholder squeeze-out merger transactions,
it is not the appropriate standard in every merger of this type.  The Court held that when the controlling stockholder sufficiently removes itself from the outcome of the merger, the Business Judgment Rule, not Entire Fairness, is the operative standard of review unless the transaction is “so extreme as to constitute waste and thereby support an inference of subjective bad faith.”

Pursuant to the Court’s holding in MFW, Entire Fairness review gives way to the Business Judgment Rule if a controlling stockholder satisfies six elements: (1) the controller approval of the transaction is conditioned on approval by a special committee and the vote of a majority of the minority stockholders; (2) the special committee is independent; (3) the special committee is free to reject the transaction; (4) the duty of care to negotiate a fair price is met; (5) the stockholder vote is informed and; (6) the stockholder vote is not coerced.  Compliance with all six elements results in the grant of a motion to dismiss a complaint challenging the transaction.

In BAM, plaintiffs, minority stockholders in Books-A-Million (the “Company”), alleged that the Company’s directors, controlling stockholders, and certain officers breached their fiduciary duties in approving a squeeze-out merger proposed by the Company’s controlling stockholder (the “Merger”).  The Merger was structured to comport with the MFW standard.  Plaintiffs argued, among other things, that the independent committee created to assess the Merger (the “Committee”) breached its fiduciary duties when it accepted the controlling stockholder’s bid over a “substantially superior offer” from a third party.

In BAM, the Court of Chancery faced the issue of whether plaintiffs pleaded sufficient facts to establish that the Merger did not satisfy the MFW framework, so as to prevent a shift from application of the Entire Fairness standard to the Business Judgment Rule.    After analyzing each of the six elements discussed in MFW, the court determined that “[t]he plaintiffs’ complaint ha[d] not pled grounds to take the transaction outside of the [MFW] framework” and that “the business judgment rule applie[d].”

The BAM decision is significant in that the court was forced to address a challenge to MFW that was not explicitly contemplated by the Supreme Court when it decided MFW.  In attacking the second MFW element , i.e., the special committee’s independence, plaintiffs argued that two members of the Committee “approved the Merger in bad faith, thereby displaying a lack of independence in fact.” To support their claim, plaintiffs alleged that the Committee’s acceptance of the controlling stockholder’s offer, rather than a third party’s offer at $0.96 more per share, was irrational. Plaintiffs suggested that by accepting the controlling stockholder’s offer, the Committee did not act independently, but rather “disloyally favored the interests of the [controlling stockholder].”  Plaintiffs argue that because the Committee recommended the lower bid, it contravened its duty to advance the best interest of the stockholders, and thus acted with subjective bad faith. 

In MFW, the Supreme Court found that when special committee members are shown to be independent, there is no basis to infer subjective bad faith by the special committee.  Citing this language, the court in BAM found that “the difficult route of pleading subjective bad faith is [a] theoretically viable means of attacking the [MFW] framework.”  To support this finding the court noted that under Delaware law, “pleading facts sufficient to support an inference of subjective bad faith is one of the traditional ways that a plaintiff can establish disloyalty sufficient to rebut the Business judgement rule.” 

The court ultimately determined that plaintiffs failed to sufficiently plead that the Committee acted with subjective bad faith in approving the Merger, and that the Merger satisfied the MFW standard.  The court stated that in order to find that the Committee acted with subjective bad faith, it must determine that the Committee acted with “intent to harm” or engaged in an “intentional dereliction of duty.”

Addressing plaintiffs’ arguments, the Court stated that a recommendation by the Committee that the merger proceed at a lower price did not necessarily give rise to an inference of subjective bad faith.  The Court cited Mendel v. Caroll for the proposition that directors can not dilute the shares of a controlling block to secure control of a company.  Such a dilution is permissible, however, if directors act with a good faith belief that the dilution is necessary to prevent the controlling stockholder from using its power to the disadvantage of minority shareholders. 

Here, the court was unconvinced that the controlling stockholder in the Company attempted to exploit its control the the detriment of minority stockholders.  The Court noted that the market affords different discount rates depending on the shares the acquirer already has in the company.  Generally, when a prospective buyer has a substantial ownership interest in a company, its offer to purchase additional equity in such company comes with a higher discount rate, and thus, a lower purchase price.  The inverse is true for prospective buyers with little or no ownership interest in a company. 

In BAM, the court reasoned that because the prospective third party buyer sought to purchase control of the company, its price included a control premium.  The controlling stockholder’s offer did not require a control premium as it, unlike the third party offeror, sought to purchase a minority stake in the Company.  Thus, the court held that, although lower, the controlling stockholder’s offer rationally reflected the value of the interest it sought to purchase and, therefore, that it was not improper for the Committee to recommend the sale to the Anderson family.  Moreover, the court noted that the solicitation of a third party offer by the committee was a legitimate exercise in assessing the value of the Anderson offer.

After determining that plaintiffs failed to plead subjective bad faith by the committee, and thus failed to prevent a shift to entire fairness, the court applied the business judgment rule.  In so doing, the court found that the merger provided the stockholders a 90% premium over the trading price of BAM stock.   Moreover, the court noted that the transaction was approved by a majority vote of fully informed stockholders.  Thus, the court found that the business judgment rule applied and dismissed the complaint challenging the Merger.

Lindsay is a second year student at Widener University Delaware Law School and a Staff Member on the Delaware Journal of Corporate Law

Suggested Citation: Lindsay Killian, Rebutting Fairness in Business: A Look at In Re Books-A-Million, Del. J. Corp. L (Nov. 27, 2016), www.djcl.org/blog. 

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The Chancery Court Strictly Adheres to the Proper Purpose Requirement in 220 Actions in Two Recent Decisions

Katelyn Tuoni

Section 220 of the Delaware General Corporation Law provides a process for stockholders to request access to a corporation’s books and records for inspection.  Section 220 requires that stockholders comply with certain procedural and substantive requirements for making books and records demands. Pursuant to Section 220, stockholders must state a “proper purpose” for their demands. The two main purposes for which inspections are sought are to value a stockholder’s shares and to investigate mismanagement or wrongdoing by the board of directors.  Delaware courts have determined that a proper purpose to investigate mismanagement is established when stockholders articulate a “credible basis” that their investigation is reasonably related to furthering their interests as stockholders.  Section 220’s requirement of a credible basis is a lower burden than a preponderance of the evidence, and is designed to strike a balance between stockholders’ rights and corporations’ interests in avoiding frivolous claims.

If a corporation denies an inspection request, Section 220 empowers stockholders to apply to the Court of Chancery for an order to compel inspection.  Except where the materials requested for inspection are the stock ledger or list of stockholders, if the stockholder does not meet the burden of proving proper purpose, the inspection must be denied. Even where a proper purpose is established, the court has discretion to impose limitations on the scope or use of records to be inspected.

The Court of Chancery has repeatedly suggested and encouraged the use of Section 220 in order to plead demand futility.  Although no longer an absolute requirement, the court had even held that if pursuing inspection of corporate records under Section 220 is a prerequisite to filing a derivative complaint.  In all events, the Delaware Supreme Court has strongly encouraged the use of inspection rights under Section 220 prior to bringing a derivative action. 

Section 220 access to books and records provides a valuable investigative tool, because derivative plaintiffs are not entitled to discovery. Section 220 is a means of gathering information that will allow stockholders to develop and plead more thorough claims.

On August 30 and 31, 2016, Judge LeGrow, sitting as a Vice Chancellor by designation, decided two Section 220 actions. In both cases, defendants challenged plaintiffs’ compliance with the substantive requirements of Section 220. The court’s decisions indicate its continued focus on the substantive sufficiency of books and records demands in regard to Section 220’s proper purpose requirement.

In the first case, Bizzari v. Suburban Waste Services Inc. (“Bizzari”), plaintiff and his wife were the sole owners of Suburban Waste Services (“Suburban Waste”). Over time, the company faced financial and managerial difficulties.  In an effort to rehabilitate the business, plaintiff and his wife brought on a third owner.

Plaintiff was described as being volatile, and regularly made damaging remarks about Suburban Waste. Due to his behavior, plaintiff took a leave of absence to avoid harming Suburban Waste. Over time, it became clear to plaintiff that he was not welcome at the company and that his wife and the third owner were involved in an extramarital affair.  Plaintiff began working for a competitor owned by his father.

Plaintiff, a director and stockholder of Suburban Waste, demanded to review Suburban Waste’s books and records pursuant to Section 220. He asserted three purposes for seeking inspection: (1) to value his interest in Suburban Waste; (2) to investigate possible mismanagement or wrongdoing by Suburban Waste’s two other stockholders; and (3) to fulfill his fiduciary duties as a director of Suburban Waste.  After Suburban Waste denied plaintiff’s demand, plaintiff filed an action in the Court of Chancery claiming that he was entitled to inspect the books and records in his capacity both as a stockholder and as a director of Suburban Waste.

The court granted in part and denied in part plaintiff’s request. The court permitted plaintiff to inspect high-level financial information, bound by a confidentiality order, to value his shares. The court denied plaintiff’s demand with respect to investigation of mismanagement or wrongdoing, holding that such investigation was not a proper purpose because plaintiff failed to establish a credible basis for his claimFirst, he did not provide evidence to suggest or allow the court to infer that possible mismanagement or wrongdoing occurred.  Second, plaintiff conceded that the documents he sought to inspect were not essential to his interest in investigating wrongdoing or mismanagement.  After trial, but before the court resolved plaintiff’s demand, plaintiff filed a separate claim for breach of fiduciary duty against the other stockholders, alleging that they removed him as director and attempted to sell corporate assets without his consent. By filing the claim plaintiff conceded that he already had sufficient information to bring a claim of wrongdoing and mismanagement and, therefore, did not require access to or investigation of Suburban Waste’s books and records. The potential for discovery in the separate action negated plaintiff’s need to investigate mismanagement and wrongdoing through an inspection.  Therefore, the court held that plaintiff did not articulate a “credible basis” for his demand.

Additionally, the court denied plaintiff’s demand to inspect Suburban Waste’s books and records in his capacity as a director of Suburban Waste. Although it is a general principle that directors should have unfettered access to corporations’ books and records, the unusual circumstances of this case elicited an uncommon judicial response. The court permitted plaintiff to inspect only those records essential to valuing his shares, and required that he do so under a confidentiality order. The court believed that plaintiff had an ulterior motive and that further inspection would likely constitute a breach of his fiduciary duty, not, as he claimed, a fulfillment of his entitlement to do so.  Suburban Waste had the burden to prove that plaintiff’s motives were improper.  The court held that Suburban Waste met its burden by demonstrating that plaintiff’s actions during the last year were not consistent with Suburban Waste’s interest.  Suburban Waste presented evidence that plaintiff damaged Suburban Waste’s reputation with employees and banks by claiming the corporation had financial difficulties, plaintiff worked directly with a competitor, and plaintiff allowed his emotional distress concerning the other two owners “cloud his judgment.”  Plaintiff failed to rebut Suburban Waste’s evidence therefore, the court held that plaintiff’s purpose for inspection as a director was improper. 

In the second case decided by Judge LeGrow, Beatrice Corwin Living Irrevocable Trust v. Pfizer, Inc. (“Corwin”), the trustees of the Beatrice Corwin Living Irrevocable Trust (the “Corwin Trustees”) sought to inspect Pfizer, Inc.’s (“Pfizer”) books and records in order to value the trust’s interest in Pfizer and investigate alleged mismanagement or wrongdoing.  One of the Corwin Trustees read a New York Times article indicating that certain large public companies, including Pfizer, were not calculating repatriation tax for investments overseas because the calculation was “not practicable.”  The Corwin Trustees then sent a Section 220 demand to Pfizer seeking to review books and records stating that the failure to calculate the tax was mismanagement and possible breach of fiduciary duty.  Pfizer denied their demand. Upon such denial, the Corwin Trustees applied to the Court of Chancery to compel access to Pfizer’s books and records.

The court determined that the Corwin Trustees’ demand was substantively deficient in that it failed to demonstrate a proper purpose and establish a credible basis for investigating mismanagement. The sole purpose of the Corwin Trustees’ demand was to evaluate potential litigation.

Without reaching the parties’ arguments as to whether the tax calculation was practicable, the court stated that the Corwin Trustees failed to present evidence to support their allegations of wrongdoing. The court explained that, without more, statements of “mere suspicion” or “subjective belief” are insufficient to establish a proper purpose under Section 220.

Additionally, based on one of the Corwin Trustees’ own testimony, the documents sought to value the trust’s interest in Pfizer were not essential to such valuation because he admitted that he would not likely understand such documents without the assistance of an expert.  He conceded that he typically used publicly available records to value his shares and that such records had been sufficient.  Additionally, the only evidence presented regarding the effect of the deferred tax liability and the company’s value was a news article about G.E.’s plan to repatriate foreign earnings and incur a repatriation tax.  The difference between G.E. and Pfizer is that G.E. repatriated earnings and incurred tax while Pfizer did not repatriate earnings or owe tax.  The court held that the evidence presented was “vague” and there was a “gap” between information cited and the case at bar, therefore plaintiffs failed to show that an accurate valuation depended on inspection of the books and records sought. 

In conclusion, the court’s opinions in Bizzari and Corwin make clear that it will not grant Section 220 demands that fail to sufficiently articulate proper purposes for inspection of corporate books and records.

Katelyn is a second year student at Widener University Delaware Law School and a Staff Member on the Delaware Journal of Corporate Law

Suggested Citation: Katelyn Tuoni, The Chancery Court Strictly Adheres to the Proper Purpose Requirement in 220 Actions in Two Recent Decisions, Del. J. Corp. L (Nov 14, 2016), www.djcl.org/blog. 

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Contractual Versus Statutory Rights In Books And Records Demands On Delaware Statutory Trusts

Jason Rigby

In Grand Acquisition, LLC, v. Passco Indian Springs DST, the Delaware Court of Chancery determined a beneficial owner of a Delaware Statutory Trust (“DST”) had the right to inspect the books and records of the DST based on the language in the structure’s governing instrument.  This case of first impression exhibits Delaware’s deference to the freedom of contract and allowing parties to define their own contractual relationships.

A DST is a business association form created by a governing instrument that conveys property to trustees to hold and manage for the benefit of all beneficial owners.  DST’s are favored because of their ease to form, low maintenance costs, and the contractual freedoms they provide.  Similar to LLC operating agreements, DST governing instruments allow parties the freedom to form their relationship as they see fit.  This can include creating different classes of beneficial owners, limiting any fiduciary duties a trustee may owe, and enacting provisions that indemnify owners and trustees, among other things.

In Grand Acquisition, beneficial owners of Passco Indian Springs DST (“Trust”), sent a letter to the Trust demanding to inspect its books and records.  The demand letter called for the ability to make copies of the current list of the Trust’s beneficial owners, contact information for those beneficial owners, and the current ownership interest that each beneficial owner held in the Trust.  The Trust denied the demand letter, requesting that Grand Acquisition provide a reasonable basis for the information they were seeking as required under the Delaware Statutory Trust Act.

The Delaware Statutory Trust Act, 12 Del. C. § 3819 codifies the documents that a beneficial owner of a DST can inspect, which include:

  1. A copy of the governing instrument and certificate of trust and all amendments thereto, together with copies of any written powers of attorney pursuant to which the governing instrument and any certificate and any amendments thereto have been executed;
  2. A current list of the name and last known business, residence or mailing address of each beneficial owner and trustee;
  3. Information regarding the business and financial condition of the statutory trust; and
  4. Other information regarding the affairs of the statutory trust as is just and reasonable.

Grand Acquisition made a statutory demand under Section 3819 and also made a contractual demand under Section 5.3(c) of the Trust’s governing instrument.  Section 5.3(c) of the Trust’s governing instrument provides beneficial owners the right “to inspect, examine, and copy the Trust’s books and records.”  The only condition of Section 5.3(c) is that the inspection, examination, and copying must be done “during normal business hours.”

The Court of Chancery focused on whether the Trust’s governing instrument granted Grand Acquisition an independent right to inspect the books and records not subject to, and not incorporating, any preconditions or defenses found in Section 3819.  The court reached its decision using settled law regarding limited liability companies and limited partnerships which recognizes a contractual books and records right written into the governing instrument as independent from any default statutory right.

Section 5.3(c) grants the right to inspect the Trust’s books and records but does not expressly include any statutory preconditions or defenses found in Section 3819.  There is no mention in the contractual right that a “reasonable basis” must be shown for the requested books and records inspection.  The court concluded that Grand Acquisition had an unqualified, unconditional right to inspect the records it requested because no express sections of Section 3819 were included in Section 5.3(c) of the governing instrument.

Grand Acquisition is important because it is a case of first impression deciding an issue on the right to inspect the books and records of a DST.  The decision shows the deference the court will give to terms found in a DST’s governing instrument absent some express language defaulting to the DST statute.  The court’s indicated preference for, and deference to, the freedom of contract is similar to the deference shown to operating agreements in LLCs and partnership agreements in LPs.  The lesson for DST planners is not to assume that the parallel statutory framework governs the interpretation of a DST agreement provision that does not adopt that framework by contract.

Jason Rigby is a 4ED student at Delaware Law School and an Articles Editor with the Delaware Journal of Corporate Law.

Suggested Citation: Jason Rigby, Contractual Versus Statutory Rights In Books And Records Demands On Delaware Statutory Trusts, Del. J. Corp. L (Oct. 24, 2016), www.djcl.org/blog. 

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Calesa Associates: Recognizing an Anomaly of Corporate Law Pleadings

Matthew Goeller

In Calesa Associates, L.P. v. American Capital, Ltd., Vice Chancellor Glasscock denied defendants’ motion to dismiss plaintiffs’ claims alleging that directors of Halt Medical, Inc. (“Halt”) and its alleged controller American Capital, Ltd. (“American Capital”) had engaged in an unfair financing transaction. In doing so, Vice Chancellor Glasscock acknowledged an interesting nuance of the pleading stage in Delaware corporate law. Suits alleging that a director’s breach of loyalty resulted in a dilution of stockholder value in favor of an insider may be brought either derivatively or directly. This option affords shareholders pursuing such a claim a choice between two different pleading standards: the particularized pleading standard required for derivative suits by Court of Chancery Rule 23.1 or the more lenient Court of Chancery Rule 12(b)(6) standard for direct suits. It is not difficult to predict which pleading standard plaintiffs would choose.

The plaintiffs’ claim in Calesa fits within the interesting set of shareholder grievances that share features of both a derivative claim and a direct claim. In their complaint, plaintiffs allege that Halt’s directors and American Capital, a 26% shareholder of Halt, orchestrated an unfair and deceptive financing transaction between American Capital and Halt. As part of the transaction, American Capital would loan Halt up to $73 million, gain four board seats, and receive new shares of preferred and common stock, increasing American Capital’s equity position from 26% to 66%, thus diluting the other stockholders’ positionsThe transaction also called for a new compensation plan, in which the compensation of Halt’s CEO, who was also a director, doubled.

Plaintiffs brought suit seeking to enjoin the transaction, alleging that five of Halt’s directors were under the control of American Capital and that the transaction unfairly diluted the plaintiffs’ shares and extracted value from the company. For this type of claim, Vice Chancellor Glasscock recognized that plaintiffs could pursue two distinct approaches to litigation. Under one approach, plaintiffs could pursue their claims derivatively because the alleged extraction of value and overcompensation of interested directors harms the corporation. Under the other approach, plaintiffs could pursue the claims directly because their equity positions were diluted by the transaction. Even though they are based on the same facts, however, the two approaches implicate different pleading requirements.

Shareholders suing derivatively on behalf of the corporation must comport with Court of Chancery Rule 23.1 and Aronson to survive a motion to dismiss. Specifically, plaintiffs must allege particularized facts to support an inference that the directors were not disinterested and independent or that the transaction was not the product of a valid exercise of business judgment. Shareholders suing directly must satisfy a much lower pleading standard. To survive a motion to dismiss under Rule 12(b)(6), the shareholders’ complaint must raise a “reasonable conceivability” of recovery. Given that shareholders have a choice of pleading standards, it is not difficult to predict which path they would choose.

In Calesa, neither party argued that the heightened pleading standard of Rule 23.1 was appropriate, and, in fact, defendants moved to dismiss the complaint under Rule 12(b)(6). Accordingly, Vice Chancellor Glasscock analyzed the complaint under the “reasonable conceivability” standard—i.e., whether based on the allegations in the complaint it is reasonably conceivable that plaintiffs are entitled to relief. Whether the allegations would entitle plaintiff to relief depends on the level of scrutiny with which the Court reviews the allegations. The business judgment rule presumes that directors have acted in good faith and in the best interests of the company. However, plaintiffs can overcome that presumption by adequately alleging facts to support a reasonable inference that “(1) a controlling stockholder stands on both sides of a transaction or (2) at least half of the directors who approved the transaction were not disinterested or independent.” If plaintiffs allege facts supporting such inferences, then the Court of Chancery will examine whether the transaction was entirely fair. Here, Vice Chancellor Glasscock found that plaintiffs had alleged facts to show that American Capital, despite owning only 26% of the outstanding shares, was a controlling stockholder in Halt and that a majority of Halt’s directors were controlled by American Capital.

Although in this particular case defendants moved to dismiss the complaint under 12(b)(6), Vice Chancellor Glasscock recognized that it could have been “self-evidently reasonable and efficient” to require the particularized pleading standards of Rule 23.1. The existence of these two different pleading standards for the same claim raises this question: does the heightened pleading standard of Rule 23.1 have continuing utility?

The answer seems two-fold. First, Rule 23.1 will undoubtedly continue to apply outside of cases, like Calesa, in which the shareholders’ allegations implicate that narrow space of Delaware law that has accommodated two pleading standards for the same set of facts. That the particular set of facts at issue in Calesa allowed plaintiffs to avoid Rule 23.1 in favor of a less onerous pleading standard does not suggest the total impracticality of Rule 23.1. As Vice Chancellor Glasscock noted in his opinion, Rule 23.1 still guards against strike suits involving actions or transactions not involving dilution of existing shares. Second, the Court of Chancery’s opinion in In re El Paso Pipeline Partners, L.P. Derivative Litigation discusses the consideration of “how a dual-natured claim should be treated for purposes of Rule 23.1” and how “Delaware law can and should prioritize the derivative aspects of the claim.” Even though the defendants in Calesa failed to argue that plaintiffs’ claims were subject to Rule 23.1 and, instead, moved to dismiss under Rule 12(b)(6), the Court of Chancery on two occasions now has opined that, for claims which are both derivative and direct, it is perhaps “self-evidently reasonable and efficient” to require the particularized pleading standards of Rule 23.1. The Court of Chancery, in future cases dealing with dual-natured claims, may more formally adopt its own dictum and apply the heightened pleading standards of Rule 23.1 for situations in which plaintiffs have alleged that a director’s breach of the fiduciary duty of loyalty resulted in a dilution of stockholder value in favor of an insider. In such situations, director-defendants should not merely argue that plaintiffs’ claims are derivative. They must also argue that to the extent the claims are direct, they are nonetheless also subject to Rule 23.1.

Matthew Goeller is a 3L student at Delaware Law School and an Articles Editor with the Delaware Journal of Corporate Law.

Suggested Citation: Matthew Goeller, Calesa Associates: Recognizing an Anomaly of Corporate Law Pleadings, Del. J. Corp. L (June 3, 2016), www.djcl.org/blog. 

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In re Appraisal of Dell Inc.: Eliminating the Tension Between a Share-Tracing Requirement and the Continuous Record Holder Requirement

Ashley Callaway

The Delaware Chancery Court caused quite a stir with the issuance of the opinion for In re Appraisal of Dell, Inc. last summer.  Articles with titles such as “Dell Stockholders Lose Appraisal Rights as Custodial Bank’s Common Back-Office Procedures Result in Technical Failure of Continuous Holder Requirement,” “Appraisal Claims Dismissed to Custodial Banks’ Technical Acts,” and “Custodial Bank’s Technical Failure Results in Dell Stockholders Losing Appraisal Rights” fill the internet, echoing a rather obvious and common opinion – the interpretation of the Continuous Holder Requirement is too strict. Even Vice Chancellor Laster, the author of the opinion, agrees.  He writes “Were I writing on a blank slate, I would account for the federal policy of share immobilization by interpreting the term “stockholder of record” as used in Section 262(a) to parallel its content under the federal securities laws.”  Being that judges, attorneys, and law students alike seem to agree that the interpretation is too strict and leads to unfavorable outcomes, what needs to be done to fix it?

An extremely simplified version of the Dell opinion is required before continuing.  Dell investors, known as the Funds, attempted to exercise their right to appraisal after Dell announced a merger.  Similar to most investors post share immobilization, the Dell shares were held in bulk by DTC so Cede & Co. was listed on the certificates.  When the Funds sought appraisal, DTC re-titled and issued the shares in the name of the custodial banks pursuant to its office procedures.  Due to the office filing procedure, the Funds lost their appraisal rights because they were unable to satisfy § 262 of the Delaware General Corporation Law.  Under § 262, a stockholder seeking appraisal must “continuously hold such shares through the effective date of the merger,” and “stockholder” is defined as “a holder of record of stock in a corporation.”  The simple name change, without any change in beneficial ownership, resulted in a failure to satisfy the Continuous Holder Requirement set forth in the statute.

At first glance, it would appear an easy fix exists to prevent this unfavorable outcome from occurring in the future – change the meaning of “holder of record.”  One way to make that change could be by changing the statute.  Adding a short subsection that defines “holder of record” to include DTC, custodial banks, and other nominees of the beneficial owner would allow the beneficial owner to overcome the strict interpretation of the Continuous Holder Requirement.  Simple back office filing procedures would thus no longer cause a failure on the part of beneficial owners to satisfy that requirement.  Unfortunately, there are multiple problems with this remedy.  First, it is unlikely to happen: the statute and the courts’ interpretation of it have been in place for many years; there has been no proposal to amend it in a relevant way; and the court in Dell advocated change through judicial interpretation rather than legislation.  Second, and as explained below, if the definition of record holder were to be expanded, the requirement that the stockholders not vote in favor of the merger would have little to no meaning.

Section 262(a) requires that in order to perfect appraisal rights, stockholders must not have “voted in favor of the merger or consolidation nor consented thereto in writing.”  In multiple cases, parties have attempted to argue that this language requires a “share-tracing requirement.”  A share-tracing requirement would require parties seeking appraisal to show that the shares they own on the record date as well as the shares purchased after the record date were voted against the merger.  However, the Delaware Court of Chancery has rejected that requirement and only requires that those seeking appraisal rights show that they had not voted for the merger.

So what is the fix?  Vice Chancellor Laster stated that “the question of what constitutes the records of the corporation for purposes of determining who is a ‘holder of record’ is a quintessential issue of statutory interpretation appropriate for the judiciary to address.”  Perhaps, a rule set out by the judiciary would be the best avenue to prevent further tension between the Continuous Holder Requirement and the share-tracing argument.  The courts should interpret the Continuous Holder Requirement so that simple back office filing procedures such as switching the name on the certificate from Cede to the custodial bank nominee does not ruin the beneficial owner’s opportunity to exercise appraisal rights.  The courts could explicitly limit this interpretation so that Cede and other custodial brokers are not granted more rights, nor is the statute expanded in any way.  Rather the court could quite simply say that where the facts of an appraisal case show a technicality identical to the one in Dell, the right to appraisal is not lost.

More specifically, the court could hold that where the beneficial owner remains the same, and the only change is the retitling of the certificate from Cede to the beneficial owner’s custodial bank, the Continuous Holder Requirement may still be satisfied.  The court is completely within its power to interpret § 262(a) as allowing for these types of situations. The exercise of judicial power requires courts to construe and apply statutes to specific cases.  Courts use multiple approaches to judicial interpretation, one being labeled “intentionalist-based” method of interpretation.  Intentionalist-based means of interpretation means the court considers legislative history and other extrinsic considerations.  Section 262(a) sets forth the process to perfect appraisal rights.  Appraisal rights are provided to minority shareholders to allow them to dissent from corporate actions that will adversely affect their interests.  Therefore, the court can construe § 262(a) in above-said manner without offending the policy behind the Continuous Shareholder Requirement.

Ashley Callaway is a third-year extended division student at Widener University Delaware Law School.  She is a staff member on the Delaware Journal of Corporate Law, a member of the Moot Court Honor Society, and a member of the Alternative Dispute Resolution Society.  She previously worked as a paralegal at the Delaware Department of Justice.

Suggested Citation: Ashley Callaway, In re Appraisal of Dell Inc.: Eliminating the Tension Between a Share-Tracing Requirement and the Continuous Record Holder Requirement, Del. J. Corp. L (May 23, 2016), www.djcl.org/blog. 

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Does the Equitable Mootness Doctrine Apply to Appeals from Chapter 7 Liquidations?

Jennifer Penberthy Buckley

When implementation of a confirmed Chapter 11 plan proceeds while an appeal is pending, the District Court or the Court of Appeals may be presented with a dilemma. First, reversing the confirmed plan may detrimentally impact third parties, such as those who invest in the reorganized debtor.  Second, providing effective relief may be impossible once the restructuring has proceeded so far that the proverbial egg cannot be unscrambled.

In such circumstances, the equitable mootness doctrine permits the court to deny review notwithstanding the merits.  Distinct from constitutional mootness, equitable mootness is “a judge-made abstention doctrine that allows a court to avoid hearing the merits of a bankruptcy appeal because implementing the requested relief would cause havoc.”  Indeed, courts have suggested that the term “mootness” in this context is a misnomer, and a term such as “equitable bar” or “prudential forbearance” would be more appropriate.  Nevertheless, several United States Courts of Appeals have applied the equitable mootness doctrine under appropriate circumstances, particularly where disturbing a consummated plan would “unduly impact innocent third parties.”

In the Third Circuit, to prevail on a claim of equitable mootness, the appellee must demonstrate that: (1) the plan has been “substantially consummated” and (2) providing relief will “fatally scramble the plan and/or . . . significantly harm third parties who justifiably relied” on it.  This framework for analysis is the product of compromise among competing public policies, such as assuring the reliability of bankruptcy orders, encouraging investment in reorganized entities, and maximizing review of meritorious appeals.  These concerns generally arise in the context of confirmed Chapter 11 plans.

However, in In re Nica, the United States Court of Appeals for the Eleventh Circuit considered a claim of equitable mootness in the context of a Chapter 7 appeal.  The debtor, Nica Holdings, Inc. (“Nica”), executed an Assignment for the Benefit of Creditors (“ABC”) to Welt, as assignee, under Florida law.   Nica’s assets included shares in Nicanor, which owned a fish farm. Five years later after the ABC proceeding commenced, the assignee Welt filed a voluntary Chapter 7 petition for Nica.

The bankruptcy court approved settlement of two pending lawsuits, which constituted Nica’s sole remaining assets, the stock in Nicanor having become worthless.  Another shareholder of Nicanor appealed from those orders.  The shareholder also sought dismissal of the chapter 7 case on the ground that Welt had no authority to file it.  The district court affirmed, and the shareholder again appealed, renewing his argument for dismissal of the chapter 7 case.  The Eleventh Circuit began its analysis by considering whether the appeal was equitably moot.  The Court acknowledged that the equitable mootness doctrine was of questionable relevance outside the Chapter 11 context. Nevertheless, the Court assumed the doctrine could apply for the purposes of its analysis.

Unlike the Third Circuit’s more straightforward formulation mentioned above, the Eleventh Circuit applies a multi-factor test to determine whether an appeal is equitably moot.  These factors are: (1) whether the appellant obtained a stay in the court below and, if not, the basis for its failure to do so; (2) whether the plan was substantially consummated and, if so, the nature of the transactions involved; (3) the type of relief sought and its potential effect on nonparties; and (4) whether granting this relief would impede the debtor’s viability post-bankruptcy.

Applying these factors, the Eleventh Circuit concluded that the appeal was not equitably moot for several reasons. First, the court observed that the appellant made reasonable efforts to obtain a stay.  Second, the settlements had not been substantially consummated because the settlement proceeds had not been distributed.  Third, the approved settlements in the chapter 7 liquidation proceeding were simple, reversible transactions, unlike the Chapter 11 plans, with respect to which the Eleventh Circuit had previously found appeals equitably moot.  Given these considerations, the Court determined that it could provide effective relief and that the appeal was not equitably moot.   Because the equitable mootness determination in Nica was straightforward, the Eleventh Circuit did not decide whether equitable mootness should apply generally to Chapter 7 appeals.

The Eleventh Circuit found, though, that the assignee had no authority to file a chapter 7 bankruptcy petition for Nica under Florida ABC law or the terms of the assignment. Accordingly, the court ordered dismissal of the Chapter 7 petition.

The equitable mootness bar to review can and should be exercised by a Court of Appeals on the right set of facts, in light of the policy considerations supporting the doctrine. First, modifying on appeal a settlement order or other judgment in a Chapter 7 liquidation case might harm innocent third parties.  Unraveling a transaction in which a third party purchased a debtor’s assets, for example, could undermine third parties’ willingness to transact with bankruptcy estates generally. The equitable mootness doctrine is designed to prevent this outcome.

Second, one can easily conceive a scenario where the debtor’s assets have been distributed to creditors and unwinding those transactions would be overly burdensome to the bankruptcy court.  As noted by the Nica Court, one concern of appellate review over a consummated Chapter 11 plan is that the Court of Appeal’s order “would knock the props out from under the authorization for every transaction that has taken place and create an unmanageable, uncontrollable situation for the Bankruptcy Court.”  The concern that overturning various orders in on appeal will impose an intolerable oversight burden on the bankruptcy court applies equally to the Chapter 7 context as to a Chapter 11 case.

Given the right set of facts, a Chapter 7 appeal may merit application of the equitable mootness doctrine.  Of course, the analysis would differ slightly based on the differences between Chapter 7 and Chapter 11 proceedings.  For instance, there would be no need for the Eleventh Circuit to consider the disposition of the appeal’s impact on the debtor’s ability to survive after emerging from bankruptcy, since a Chapter 7 debtor no longer exists after bankruptcy.  In any event, given the doctrine’s purposes of protecting innocent third parties and avoiding the difficulty in unscrambling complex transactions, the equitable mootness bar to appellate review may apply in the context of Chapter 7 appeals, just as it does with Chapter 11.

Jennifer Penberthy Buckley is a third-year law student at Widener University’s Delaware Law School and an Articles Editor for the Delaware Journal of Corporate Law. She also serves as a Josiah Oliver Wolcott Fellow to the Honorable Karen L. Valihura of the Delaware Supreme Court.

Suggested Citation: Jennifer Penberthy Buckley, Does the Equitable Mootness Doctrine Apply to Appeals from Chapter 7 Liquidations?, Del. J. Corp. L (May 7, 2016), www.djcl.org/blog. 

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Section 141(k) Mandatory Prohibition of For-Cause Removal of a Declassified Board

Kendra Rodwell

On December 21, 2015, in In re Vaalco Energy Shareholder Litigation, the Delaware Court of Chancery granted the plaintiffs’ motion for summary judgment, invalidating a provision included in Vaalco Energy’s bylaws and charter that purported to make directors of a non-classified board removable only for cause.  The Court ruled that this provision directly conflicted with the default rule of § 141(k) of the Delaware General Corporation Law (“DGCL”) and was therefore invalid.

This case highlights the rigid interpretation and lack of interplay of § 141(k) and § 141(d). Section 141(d) provides the statutory basis for stockholders to adopt a classified or “staggered” board. Under this provision, the directors are elected to serve two or three-year terms for each class, with only one class facing election each year.  Accordingly, members of classified boards may not be removed without cause unless the certificate of incorporation contains a provision permitting such removal.  Implicit in § 141(k), in contrast, is a requirement that directors be removable without cause in the case of a declassified board (where the director is elected on an annual basis), either at a meeting of stockholders, or without a meeting through written consent (§ 228(a)), unless the certificate of incorporation includes a provision eliminating stockholder action by written consent. 

Vaalco argued, inter alia, that a technical application of § 141(d) permits a director, serving a one-year term, to be removed only for cause, as members of a board “divided into 1” class, per the language of § 141(d).  In support of their argument, Vaalco’s counsel offered that there is no policy reason that would prohibit such a phenomenon, even though Vice Chancellor Laster described it as an “oxymoronic concept.”

While the Court gave Vaalco some credit for the novelty of that argument, Vice Chancellor Laster, nonetheless, rejected it based on three independent grounds.  The Vice Chancellor used the historic interpretation of § 141(k) to conclude that Vaalco’s “new discovery” “would cut against what [Vice Chancellor Laster] thinks has been the standard analysis of 141(k).”  To further support this conclusion, Vice Chancellor Laster used the comments to the 1974 Amendments to the Delaware Corporation Law to show that the language of § 141(d), “divided into 1, 2, or 3 classes,” was included to clarify in the instances where the certificate of incorporation elected special directors for the purpose of being holders of any class or series of stock, that they were not to be considered an additional class of directors for the purposes of creating a staggered board.  And lastly, the Vice Chancellor stated that if this were a case where the directors called a meeting with its stockholders announcing the declassification from three classes into one class, the issue of the appropriate interpretation of what “1, 2, or 3 classes” means would be proper in the case.  But because Vaalco had a declassified straight board, Vice Chancellor Laster was not inclined to let the defendants use the provisional language under § 141(d) to justify the invalid provision that was at issue.

The transcript was riddled with the assertions that § 141 allows corporations to contract around the default rules by including alternative rules in the corporation’s charter.  It is true.  The certificate of incorporation may take away the shareholder right to remove directors from the board by written consent.  It is also well established in Delaware that the certificate of incorporation may provide that only the board can call for special meetings of stockholders.  Based on that, it can be inferred that stockholders could only remove directors at annual meetings, which requires fewer votes than the majority required for removal under § 141(k).

There are no stockholders’ governance rights that need protection given the ability to eliminate action by written consent and the right to call special meetings of stockholders corporate action.  Ordinarily, when a shareholder is not pleased with management, they have three possible resolutions: 1) sell their shares; 2) campaign to vote for new directors; or 3) sue its directors through a derivative action, hold directors personally liable for damages, or seek a preliminary injunction to prevent a transaction from being consummated.  The DGCL provides for the certificate of incorporation to opt-out of written consent and the right to call special meetings of stockholders for corporate action.  So long as the corporation went through the proper procedure of obtaining shareholder approval to opt-out of these rights, the shareholder franchise has not been compromised.  

Assuming that the right to remove a director from a board without cause was eliminated along with the right to written consent and calling special meetings for corporate action, shareholders stand to lose the flexibility the DGCL afforded them.  Without those rights, the shareholders lose the ability to change ownership of a majority shareholder and the directors gain guaranteed tenure afforded to them by the common law.  To remove a director for cause, the targeted director must be given adequate notice and afforded the opportunity, at the corporation’s expense, to address the accusations at a judicial proceeding.  Under these sets of circumstances, the right of removal is predicated on the director’s conduct. In addition, the burden to remove a director for cause is higher than removing a director without cause.  If there were a director who disagreed with the shareholders on corporate policy or desired to take over control of the corporation, the shareholders would be stuck with that director until he was up for election.  Taking that into consideration, directors’ awareness of their obligations to serve the interest of the stockholders might be diminished. Conflicts between the wishes of management and that of the shareholders are more likely to occur.  The certificate of incorporation should not restrict or be “so pervasive as to intrude upon” shareholders’ rights, because it diminishes the shareholders’ role in corporate governance.  It follows that a line should be drawn to ensure that directors of corporations are not using the rules of DGCL arbitrarily to limit shareholder’s rights.                  

One contention that Vaalco asserted was that a large number of corporations with similar provisions that Vaalco had will be affected if that sort of provision were invalidated.  To discredit this argument, the Court asserted that those corporations were misreading the statute.  In addition, the Court reasoned that even if this is true, only a small percentage of corporations, in the grand scheme of things, are being affected by this ruling.

Even though the Vice Chancellor disagreed with Vaalco’s arguments, he offered a solution that would help those corporations avoid being sitting ducks for shareholder litigation. The Court suggested that those corporations, Vaalco included, should go back to the drawing board.  The Vice Chancellor stated that the boards should “issue some new disclosure” statements “and do whatever it thought it had to do as a matter of Delaware disclosure law and the federal securities laws.”  One can surmise that when the Vice Chancellor said “do whatever,” that entails proposing to amend those invalid provisions and putting them out for a stockholder vote.  And, if the directors receive the required majority vote, then the corporation would need to file an amendment to the certificate of incorporation reflecting the revised provisions in accordance with Delaware law.

While the Court does not specifically address how those steps would minimize litigation cost or fee applications, it can be inferred that those steps may decrease the likelihood of shareholders exercising their fundamental right to sue the corporation when invalid provisions are used in the corporate charters and bylaws that are in direct conflict with Delaware law.  By following the steps offered by Vice Chancellor Laster, corporations have effectively limited the cost of defending these types of claims because the certificate of incorporation will be compliant with Delaware law.  Secondly, there are costs associated with amending a certificate of incorporation.  While the total cost to amend may be relatively small compared to the value of the company, the fee application coupled with the litigation cost and the time wasted defending these types of claims could be completely avoided by heeding Vice Chancellor Laster’s suggestion to amend the certificates of incorporation in accordance with the ruling of this case.

Kendra Rodwell is a fourth-year evening division student at the Delaware Law School and Staff Editor of the Delaware Journal of Corporate Law.  She is also a Member of the Delaware Law Transactional Law Honor Society.

Suggested Citation: Kendra Rodwell, Section 141(k) Mandatory Prohibition of For-Cause Removal of a Declassified Board, Del. J. Corp. L (May 3, 2016), www.djcl.org/blog. 

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One of These Things is Not Like the Other: Student Bar Loan Distinguished from Traditionally Nondischargeable Student Loan Debt

Kaitlin E. Maloney 

In a recent turn of events regarding the dischargeability of student loan debt, the United States Bankruptcy Court for the Eastern District of New York ruled that a law school graduate’s loan taken for the purpose of her studying for the bar exam was dischargeable in bankruptcy.  In Campbell v. Citibank, Chief Judge Carla Craig distinguished bar loans from student loan debt that is nondischargeable absent “undue hardship,” and held that because bar loans are not considered an “educational benefit” under § 523(a)(8)(A)(ii) they are dischargeable.

Lesley Campbell, a 2009 graduate of Pace University School of Law, obtained a $15,000 bar loan from Citibank to finance her bar review course and living expenses while studying for the bar exam.  After failing the bar exam, Campbell took an administrative position at a hotel management company and made payments on the bar loan until 2012.  With nearly $300,000 in student loan debt, Campbell filed for Chapter 7 bankruptcy protection in 2014.  Campbell then filed an adversary proceeding against Citibank, seeking a determination that the unpaid portion of the bar loan was dischargeable.

Specifically, Campbell argued that none of the exceptions to discharge set forth in § 523(a)(8) was applicable to the bar loan, making it dischargeable.  That section states:

(a) A discharge under section 727. . . of this title does not discharge an individual debtor from any debt–

(8) unless excepting such debt from discharge under this paragraph would impose an undue hardship on the debtor and the debtor’s dependents, for—

(A)(i) an educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or nonprofit institution; or

(ii) an obligation to repay funds received as an educational benefit, scholarship, or stipend, or

(B) any other educational loan that is a qualified education loan, as defined in section 221(d)(1) of the Internal Revenue Code of 1986, incurred by a debtor who is an individual . . . .

Because the parties agreed that Campbell did not meet the statute’s demanding “undue hardship” standard and that the bar study loan was not excepted from § 523(a)(8)(A)(i) or § 523(a)(8)(B), Campbell’s sole basis for discharge depended on whether the bar loan was an “educational benefit” within the meaning of § 523(a)(8)(A)(ii), a term that is not defined in the Bankruptcy Code. 

Other Bankruptcy Court decisions have defined “educational benefit” to mean “any loan which relates in some way to education.”  Such “reflexive knee-jerk reaction” makes nondischargeable any loan that resembles a student loan in the slightest way.  In Campbell, Citibank took a similar approach, urging that the bar loan was an “educational benefit” because Campbell’s eligibility in obtaining it depended on her being a law student.  The court disagreed, however, and determined the bank’s underwriting standards “[did] not turn an arm’s-length consumer credit transaction into a ‘benefit’ within the meaning of § 523(a)(8)(A)(ii).”

In concluding that the bar study loan was a consumer credit transaction and not an “educational benefit,” the court relied on a traditional canon of statutory construction and the statute’s legislative history.  The canon of noscitur a sociis instructs that “when a statute contains a list, each word in that list presumptively has a ‘similar’ meaning.”  “Educational benefit” would thus have a similar meaning as “scholarship” and “stipend,” both of which the recipient does not have to repay.  Accordingly, the court determined that “educational benefit” must be interpreted to mean something other than a consumer loan, especially because the word “loan” is used elsewhere in § 523(a)(8), but not specifically in § 523(a)(8)(A)(ii).

The legislative history and purpose of § 523(a)(8) further supported the conclusion that “educational benefit” should not be read to mean merely a consumer loan, such as the bar loan at issue in Campbell.  Section 523(a)(8) was enacted “to safeguard the financial integrity of the education loan programs,” especially due to the unique nature of government-backed educational loans, which “are made without business considerations, without security, without cosigners, and rely[] for repayment solely on the debtor’s future increased income resulting from the education.”

Consumer loans offered though for-profit institutions, however, do not carry those same concerns.  In fact, Campbell’s bar study loan application stated that it was a “consumer credit application” that would be “evaluated through a credit-scoring model.”  In this regard, Campbell’s bar loan differed greatly from government-backed loans and other loans taken to obtain a degree.  Because Campbell’s bar study loan was “a product of an arm’s-length agreement on commercial terms,” the court determined that it was not an “educational benefit” under § 523(a)(8)(A)(ii) and thus was dischargeable.

Campbell’s attorney described his client’s outcome as what many believe to be “a seismic development” for student loan dischargeability.  As attorneys from the New York Bankruptcy Assistance Project, MFYY Legal Services, Inc., and the New York Legal Assistance Group argued in their amicus brief in support of Campbell, this case affects more than just those borrowing bar study loans.  The overly broad interpretation of “educational benefit” offered by other courts “threatens to deny . . . many other debtors struggling with ineligible student loans, the fresh start to which they are entitled under the Bankruptcy Code.”  After all, the primary purpose behind Chapter 7 bankruptcy protection is to protect individuals from being plagued indefinitely by their unfortunate financial positions.  To this end, Campbell recognizes that such a broad interpretation of “educational benefit” would only add to the immense amount of student loan debt that debtors are unable to discharge. 

Due to the uncertainty created by Campbell in how courts will assess the dischargeability of bar loans, some express concern that lenders will be hesitant to extend such loans for those studying for the bar exam.  This is unlikely, however, because “the vast majority of people who get those loans get a law degree, pass the bar and don’t file for bankruptcy.”  Bar loans are “low risk for the lender.”  The student already has received her law degree and needs only to pass the bar exam in order to seek employment as a lawyer, so the potential adverse effects of the Campbell ruling are low. 

The Campbell decision came down “amid increasing concerns raised by state and federal lawmakers in regard to the ballooning nationwide student debt,” and only a few months after the United States Supreme Court denied certiorari in Tetzlaff v. Educational Credit Management Corp.  In doing so, the Supreme Court declined to answer which test is appropriate for determining “undue hardship” in discharging student loan debt under § 523(a)(8) —the flexible totality of the circumstances test, or the more demanding Brunner test.  A law school graduate’s bar loan will also be dischargeable if repayment poses an “undue hardship,” but the hurdle under either test is incredibly high. 

Only time will tell as to whether other bankruptcy courts will adopt the same approach taken in Campbell, and how it will affect the dischargeability of student loan debt as a whole.  Until the Supreme Court resolves the current split as to what constitutes “undue hardship,” a law school graduate’s best hope may be to rely on the Campbell decision and argue that her bar loan is not an “educational benefit” under § 523(a)(8)(A)(ii). 

Kaitlin E. Maloney is an Articles Editor of the Delaware Journal of Corporate Law and served as a judicial extern to the Honorable Kent A. Jordan on the Third Circuit Court of Appeals.  Upon graduation Kaitlin will work as an associate attorney in the Wilmington office of Skadden, Arps, Slate, Meagher & Flom LLP.   

Suggested Citation: Kaitlin Maloney, One of These Things is Not Like the Other: Student Bar Loan Distinguished from Traditionally Nondischargeable Student Loan Debt, Del. J. Corp. L (May 2, 2016), www.djcl.org/blog. 

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Applying Omnicare and Protecting Investors Under § 11 of the ‘33 Act

Nicholas D. Picollelli, Jr.

In order for a company to offer securities in interstate commerce, it must comply with the requirements of the Securities Act of 1933.  The Securities Act “protects investors by ensuring that companies issuing securities . . . make a ‘full and fair disclosure of information’ relevant to a public offering.”  An issuer makes relevant disclosures in a registration statement filed with the Securities and Exchange Commission (“SEC”) prior to issuing the securities.  If the company makes the required disclosures, then it may issue securities and raise capital.  If however, the disclosures are false or misleading, the issuer may be subject to litigation as a result.  Section 11 of the Securities Act, for instance, is one avenue of litigation for potentially misled investors. Section 11 provides in relevant part:

In case any part of the registration statement, when such part became effective,     contained an untrue statement of a material fact or omitted to state a material fact             required to be stated therein or necessary to make the statements therein not          misleading, any person acquiring such security . . . [may] sue.

According to the United States Supreme Court’s recent opinion in Omnicare Inc. v. Laborers Dist. Council Const. Industry, § 11 creates two different ways for an investor to hold an issuer liable for a registration statement’s contents – “one focusing on what the statement says and the other on what it leaves out.”  In Omnicare, investors complained that the company omitted material facts in its registration statement regarding legal compliance, citing subsequent lawsuits filed by the Federal Government.  The investors alleged that officers and directors were warned about the possibility of litigation but omitted warnings in the company’s registration statement.  According to investors, these omissions made the registration statement “materially misleading” and subject to § 11 liability.  Thus, the relevant question presented by the investors’ allegation was whether an omission of fact could render a statement of opinion in a registration statement “materially misleading.”

Although the language of § 11 requires a statement or omission of “fact,” the Court in Omnicare recognized that there are some instances where a statement of “opinion” can convey a statement or omit a “fact.”  For example, the Court acknowledged that “every statement [of opinion] explicitly affirms one fact: that the speaker actually holds the stated belief.”  If an opinion is truly believed, without more, it cannot constitute an untrue statement of fact.  However, if the maker knows the opinion is false, then it would constitute an untrue fact – “namely, the fact of [the maker’s] own belief.”  The statements at issue in Omnicare do not fall into this category. Rather, they are statements of pure opinion and can be simplified to state, “we believe we are obeying the law.”  Furthermore, the investors did not claim the company made the statements with a false belief. This realization, however, did not end the Court’s analysis.

The Court’s analysis continued because investors also “rel[ied] on § 11’s omissions provision, alleging that Omnicare ‘omitted to state facts necessary’ to make its opinion on legal compliance ‘not misleading.’”  First, the Court recognized that a reasonable person typically distinguishes between a statement of fact and a statement of opinion when reading a registration statement.  Because an investor can distinguish between opinion and facts, “a statement of opinion is not misleading just because external facts show the opinion to be incorrect.”  However, the Court also acknowledged that an omission of fact can be misleading because a reasonable investor may interpret a statement of opinion “to convey facts about how the speaker formed the opinion . . . .”  For instance, a statement such as “we believe our conduct is lawful,” may be misleading if the maker did not consult an attorney.  The potential to mislead is increased particularly in the context of securities offerings, where the process is highly regulated and complex.  Due to extensive regulation, investors are more likely to rely on an issuer’s statements and the investor is reasonable to assume that the issuer’s statements are based on some knowledge of relevant facts.  As the Court held, “if a registration statement omits material facts about the issuer’s inquiry into or knowledge concerning a statement of opinion, and if those facts conflict with what a reasonable investor would take from the statement itself, then § 11’s omissions clause creates liability.”

Omnicare does not require issuers to disclose every fact that “cuts the other way,” because “[r]easonable investors understand that opinions sometimes rest on a weighing of competing facts ….”  Omnicare also urges that a statement should not be viewed in a vacuum because registration statements are not viewed in a vacuum.  Instead, investors view registration statements holistically “in light of all its surrounding text, including hedges, disclaimers, and apparently conflicting information.”  Finally, even though Omnicare expands the Court’s understanding of what constitutes a misleading omission, it emphasizes that the issuer is not without protection:

The investor must [still] identify particular (and material) facts going to the basis   for the issuer’s opinion – facts about the inquiry the issuer did or did not conduct or the knowledge it did or did not have – whose omission makes the opinion statement at issue misleading to a reasonable person reading the statement fairly and in context.

Following Omnicare, the Second Circuit decided Tongue v. Sanofi and applied Omnicare’s interpretation of § 11.  Tongue concerned declarations in a registration statement concerning the development of a new pharmaceutical drug.  The success and approval of the drug was tied to financial instruments that rewarded investors at certain milestones.  The milestones at issue concerned the expected timing of FDA approval, timing of the launch of the drug, and the drug’s trial results.  The FDA did not approve the drug by the date specified, and the value of the financial instruments plummeted. Accordingly, investors filed suit, alleging that the pharmaceutical company “misled investors by failing to disclose that the FDA had repeatedly expressed concern with [the pharmaceutical company’s] use of single-blind studies and had encouraged [the pharmaceutical company] to use double-blind studies in its clinical trials.”

In regard to the expected timing of FDA approval, the Second Circuit did not find that omitted facts “conflict[ed] with what a reasonable investor would take from the statement itself.”  Although the FDA expressed numerous times that it preferred double-blind studies and that it was concerned with the pharmaceutical company’s “methodology,” it also stated “that any deficiency could be overcome if the result showed an ‘extreme and large effect.’”  The parties did not dispute that the testing results concerning the drugs effectiveness were, in fact, significant. Moreover, the Second Circuit heeded the Supreme Court’s advice and observed the facts holistically.  In this case, investors included pension funds and other sophisticated investors who should have been aware of the constant dialogue between the pharmaceutical company and the FDA.  In the Second Circuit’s view, the investors could not claim ignorance because they are sophisticated parties and should be capable of protecting themselves.  Nor were investors protected simply because the pharmaceutical company failed to disclose facts that “cut against” the company’s registration statement’s declarations. Omnicare imposes no such burden.

For similar reasons, the Second Circuit found that statements relating to the timing of the launch of the pharmaceutical drug and the pharmaceutical drug’s trial results failed to support a claim under § 11.  Specifically, it explained that “no reasonable investor would have inferred that mere statements of confidence suggested that the FDA had not engaged in industry-standard dialogue with Defendants about potential deficiencies in either the testing or methodology or the drug itself.”  Plaintiffs failed to state a claim regarding the trial results of the pharmaceutical drug because the pharmaceutical drug was already approved for distribution in at least thirty other countries.  Thus, according to the Second Circuit, “Plaintiffs’ argument that the [pharmaceutical company] had no reason to comment on [the drug’s] success except to build investor anticipation about FDA approval has no merit – [the pharmaceutical company] had an interest in building global interest in [the drug].”  Again, an issuer is not liable for failing to disclose a fact that “cuts the other way.”

Omnicare and Tongue are instructive because they both demonstrate the importance of proper drafting.  Even though Omnicare does not require disclosure of each and every fact that “cut[s] the other way,” a careful drafter should include every relevant fact in order to avoid litigation.  For instance, in Omnicare, the issuer could have potentially avoided litigation if it had just disclosed that an attorney warned of possible litigation, but after careful review with other counsel, the company was assured that litigation was unlikely. Optimism in the face of conflicting information is not an omission subject to § 11 liability, but failing to disclose the conflicting information could be. Similarly, the pharmaceutical company in Tongue could have potentially avoided litigation by disclosing the FDA’s concerns about using single-blind studies.  The facts showed that single-blind studies were more conducive to the particular drug, but the company failed to disclose such facts and failed to disclose that the FDA might make an exception under certain circumstances. The pharmaceutical drug was eventually approved, but the damage was already done. Regardless of whether statements are an “opinion,” both cases make clear that statements must be informed and disclose all pertinent facts.  This requirement might increase the cost of preparing registration statements, but compliance with the requirement should protect issuers from subsequent litigation.  Proper drafting can be costly, but litigation can be extravagant.

Nicholas D. Picollelli, Jr. is a third-year student at Widener University Delaware Law School and a Senior Staff Member on the Delaware Journal of Corporate Law.  Nick also serves as a judicial intern to the Honorable Kevin J. Carey in the United States Bankruptcy Court for the District of Delaware.

Suggested Citation: Nicholas D. Picollelli, Jr., Applying Omnicare and Protecting Investors Under § 11 of the ‘33 Act, Del. J. Corp. L (April 26, 2016), www.djcl.org/blog.

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EZCorp Deems Entire Fairness Standard Appropriate When Controlling Shareholder Receives Non-Ratable Benefits

Helene Episcopo

In the Court of Chancery’s recent opinion, In re EZCorp Inc. Consulting Agreement Derivative Litigation (“EZCorp”), the court grappled with the appropriate standard of review for business transactions between a controlled company and a controlling shareholder.  In this extensive opinion, Vice Chancellor Laster confronts the parameters of the Delaware Supreme Court’s holding in Aronson v. Lewis.  Ultimately, he found that allegations of self-dealing by a controlling shareholder withstand the entire fairness standard of judicial review and refused to extend the holding in Aronson beyond the demand futility context.

EZCorp is a Delaware corporation with two classes of stock. Holders of Class A stock have no voting rights, while holders of Class B stock retain all of the voting rights.  MS Pawn LP, a Delaware limited partnership, owned 100% of the EZCorp Class B stock.  Phillip Ean Cohen was the sole owner of stock in MS Pawn LP’s general partner, MS Pawn Corp.  Thus, through MS Pawn, Cohen owned 100% of EZCorp’s Class B voting stock through the two MS Pawn entities, which amounted to 5.5% of the company’s equity.

EZCorp had a history of entering into advisory service agreements with Cohen.  Between 1996 and 2004, EZCorp entered into agreements with Morgan Schiff, Cohen’s investment firm. The company eventually discovered it overpaid the firm by $400,000. Subsequently, EZCorp decided not to renew the agreements. After terminating the agreements with Morgan Schiff, EZCorp entered into new agreements with Madison Park, another Cohen associated firm. The agreements provided that EZCorp would pay Madison Park $100,000 per month for three years. Starting in 2007, Madison Park’s monthly fee drastically increased each year.  In 2011, EZCorp entered into service agreements with Madison Park where the firm received $500,000 per month for its services.  The complaint alleged that EZCorp’s Audit Committee “rubber-stamped” the service agreements with Madison Park due to their “cozy positions as directors at Cohen’s company.”  The plaintiff alleged that the challenged agreements “were not legitimate contracts for services but rather a means by which Cohen extracted a non-ratable cash return from EZCorp.”  Consequently, the “[b]oard could not impartially consider a litigation demand because at least two of the directors . . . were insiders who were not independent from Cohen and Madison Park.”

Before the court parsed the applicable standard of review, it affirmed that Cohen and MS Pawn were proper defendants. The court explained that it is deeply embedded in Delaware law that those who “wield control over the corporation” are subject to breach of fiduciary duty claims.

It is a fundamental concept of corporate law that the management and business decisions rest in the hands of a corporation’s board of directors.  Under the business judgment standard, the court presumes that the board “acted on an informed basis, in good faith and in the honest belief that the action was taken in the best interest of the company” while making a business decision.  Affirming this concept, the Delaware Supreme Court in Aronson established the demand excusal test to determine whether or not a stockholder derivative suit should survive a Rule 23.1 motion.  The Aronson court rejected the plaintiff’s contention that a controlling stockholder dominated the board of directors regarding an employment agreement.  The court held that “the entire question of demand futility is inextricably bound to issues of business judgment and the standards of that doctrine’s applicability.”

With Aronson well embedded in Delaware law, the defendants in EZCorp argued that the court should apply the business judgment standard when reviewing the transaction between EZCorp and Madison Park.  The defendants reasoned that the parameters of the entire fairness standard apply only to squeeze-out-mergers and not the situation at issue.  Vice Chancellor Laster cited several decisions where Delaware courts expressly rejected this argument, as well as decisions where the courts applied the entire fairness framework to a “variety of transactions in which controlling stockholders have received non-ratable benefits.”

Although defendants did not rely on Aronson as a controlling case, the Court of Chancery found that the crux of defendants’ arguments relied on the same principles established in that decision.  He noted that In re Tyson Foods, Inc., Friedman v. Dolan, and Canal Capital Corp. By Klein v. French all stemmed from Aronson’s precedent that the business judgment rule is the proper standard of review in situations where the controller receives a benefit from a transaction approved by a “board or duly empowered committee with an independent majority of outside directors.”  Noting that there is “tension” within the applicable case law, the court grappled with two issues concerning the application of Aronson.  First, it questioned which “policy judgments about the demand futility context were intended to extend to the substantive law that would apply if demand was excused or if the claim was direct.”  Second, it questioned which aspects of the Aronson decision were intended to be “immune to further common law development.”

Vice Chancellor Laster explained that Aronson pre-dates many of the key decisions in this area of law, including Unocal Corp. v. Mesa Petroleum Co. and Revlon Inc., v. MacAndrews & Forbes Holdings, Inc., as well as three decades of “development in the law regarding controlling stockholder transactions.”  Thus, with these considerations in mind, Vice Chancellor Laster ultimately held that the entire fairness standard applies to transactions where a controlling stockholder obtains a non-ratable benefit.  He also suggested that Aronsonlimited its analysis to the issue of demand futility.”

The Court of Chancery emphasized that it is ultimately the Delaware Supreme Court’s decision to “apply Aronson more broadly and limit the substantive application of the entire fairness framework.”  However, the court explained that case law supported the application of the entire fairness standard.  Further, the court highlighted that this decision does not imply that the plaintiff’s claim for breach of fiduciary duties will necessarily be successful.  Rather, the plaintiff’s claim survives the Rule 12(b)(6) motion. Ultimately, EZCorp implicates the question whether the Delaware Supreme Court will agree with the Vice Chancellor’s analysis regarding his suggested limitation of Aronson’s application. However, until there is clarity from the Court, companies should be careful when a controlling shareholder obtains a non-ratable benefit from a transaction with the controlled company.  Until the affects of EZCorp are discernible, the other option to avoid this type of litigation is to completely forgo transactions with a controlling shareholder.

Helene is a third year student at Widener University Delaware Law School and Senior Staff Member on the Delaware Journal of Corporate Law.  Helene is also the Moot Court Honor Society Ruby R. Vale Chairperson.  After graduation, Helene will be clerking for the Honorable Calvin L. Scott, Jr. in the Superior Court of Delaware.

Suggested Citation: Helene Episcopo, EZCorp Deems Entire Fairness Standard Appropriate When Controlling Shareholder Receives Non-Ratable Benefits, Del. J. Corp. L (April 23, 2016), www.djcl.org/blog.

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In Re Trulia, Inc. Stockholder Litigation: End to Disclosure Settlements?

Erin Rogers

In January 2016, the Court of Chancery issued an opinion in In re Trulia, Inc. Stockholder Litigation that will surely have an impact on the amount of disclosure settlements and merger-related litigation. The court expressed three concerns regarding disclosure settlements: (1) the supplemental disclosures often provide no real benefit to stockholders; (2) through a broad release, shareholders waive claims that have not been rigorously investigated and which could confer an economic benefit; and (3) it is hard for the court to evaluate the benefit conferred by the supplemental disclosures at this stage in the non-adversarial context.  After discussing these concerns, the court made clear that in the context of disclosure settlements, in which the sole or predominant consideration for plaintiffs’ release of claims is supplemental disclosures, “the Court [of Chancery] will be increasingly vigilant in scrutinizing the ‘give’ and ‘get’ of such settlements.”

In the opinion, the court set a high standard that disclosure settlements must meet in order to be approved. First, the supplemental disclosures must be “plainly material.” The court stated that supplemental disclosures would be considered “plainly material” “if, from the perspective of a reasonable stockholder, there is a substantial likelihood that it [the supplemental disclosure] ‘significantly alters the “total mix” of information made available.’” Secondly, the release of claims cannot be a broad release of claims. Rather, the release of claims must be narrowly circumscribed to include nothing more than disclosure claims and fiduciary duty claims relating to the sale process. Unless the settlement meets the two above criteria, the settlement will be disfavored and will fail to receive approval by the court.

After setting such a high standard, the question has become whether settlement disclosures and related deal litigation will end or decrease significantly. At first glance, the answer would be an obvious yes. Disclosure settlements were extremely attractive because plaintiffs’ lawyers could file complaints with relatively little risk, the settlements were approved, and the lawyers would collect a large amount of fees. However, after Trulia, that seems no longer possible. Now, there is more risk involved, as the settlements must meet two criteria in order to be approved. Plaintiffs’ lawyers may be less willing to file such complaints after the announcement of a merger or acquisition, as it seems there is a strong possibility that any proposed settlement will be rejected. A rejection of a settlement means more money and more time tied up in litigation. Plaintiffs’ lawyers may not be willing to take such a risk in litigation with no guarantee of an award of attorneys’ fees.

Additionally, not only is more risk involved due to longer litigation and no guarantee of an award of attorneys’ fees, but plaintiffs’ lawyers have also lost their main bargaining chip. Plaintiffs will not have as much leverage to negotiate fees, as they can no longer stipulate to a broad release of claims. Without their main bargaining chip, plaintiffs’ lawyers may be deterred from filing such complaints.

However, a closer look reveals that the impact of Trulia’s heightened standard on the frequency of disclosure settlements, and in turn merger-related litigation, depends on several different factors. First, that impact will depend on how hard it will be for disclosures to meet the “plainly material” standard. The court stated that supplemental disclosures must be “plainly material,” that is, they must address a plainly material misrepresentation or omission. Recent cases imply, however, that many different types of disclosures may be “plainly material.” Thus, it may not be overly difficult for disclosures to meet the standard. In a recent hearing, Havermill Retirement System v. Richard Kerley, et al. and The Providence Service Corp., the court concluded that disclosures of conflicts of interests satisfy the “plainly material” standard. Although the disclosures satisfied the “plainly material” standard, the court did not approve the settlement due to an issue with the release of claims and the case involving a partial settlement.

Additionally, in In Re BTU International, Inc. Stockholder Litigation, the court recently approved a disclosure settlement. The court found that the disclosures of management free cash flow projections were “plainly material.” The court went on to approve the disclosure settlement, finding that the release of claims was narrowly circumscribed as required under the Trulia standard.

The two above-mentioned cases are the first applications of the Trulia standard, and it is notable that in both of the cases, the court found that the disclosures satisfied the “plainly material” standard. Such a result suggests that disclosures may meet the “plainly material” standard more often than one would think despite the nominally high standard established in Trulia.

Moreover, in its opinion in Trulia, the court stated, “[w]here the supplemental information is not plainly material, it may be appropriate for the Court [of Chancery] to appoint an amicus curiae to assist the [c]ourt in its evaluation of the alleged benefits of the supplemental disclosures, given the challenges posed by the non-adversarial nature of the typical disclosure settlement hearing.” This statement seems to imply that even if the supplemental disclosures are not “plainly material,” the court will perhaps still approve the settlement if it can evaluate the alleged benefits of the disclosures, and it finds that the “give and get” of the settlement is “fair and reasonable.” If this is the case, then it may be easier for plaintiffs to have their disclosure settlements approved by the court, which in turn would minimize any decrease the frequency of disclosure settlements or merger related litigation.

Other factors that may affect whether or not there is a significant decrease in settlement disclosures is whether other jurisdictions follow Delaware’s lead and adopt heightened scrutiny in disclosure settlements, and whether corporations begin to adopt forum selection bylaws (for those that do not already have such bylaws). If other jurisdictions do not follow Delaware and do not look at disclosure settlements with greater scrutiny, plaintiffs may find more favorable venues. If this occurs, there will not likely be a significant decrease in settlement disclosures, as plaintiffs will move to more favorable venues.

However, if jurisdictions do not follow Delaware’s lead, defendant corporations may choose to adopt forum selection bylaws, if the corporations do not already have them. Such bylaws would require plaintiffs to meet Delaware’s heightened scrutiny and may deter plaintiffs from filing complaints. This would lead to a significant decrease in settlement disclosures, and in turn, merger related litigation.

A final factor to consider is the ease of obtaining attorneys’ fees through mootness dismissals. The court in Trulia made clear that the preferred avenue for resolving claims of inadequate disclosures is mootness dismissals. If plaintiffs’ lawyers have a relatively easy time in obtaining attorneys’ fees through mootness dismissals, there may not be a substantial decrease in merger related litigation. To the contrary, if plaintiffs’ lawyers do not have easy access to attorneys’ fees through mootness dismissals, and are unable to find more favorable venues, then there would most likely be a substantial decrease in merger related litigation.

There is no question that the heightened standard set forth in Trulia will decrease settlement disclosures and merger related litigation to some extent. However, a closer look at recent Court of Chancery decisions, and other factors, indicate that Trulia may not significantly decrease settlement disclosures and merger related litigation, and it undoubtedly will not put an end to settlement disclosures in the future.

Erin Rogers is a third year law student at Widener University Delaware Law School, and a Senior Staff Member on the Delaware Journal of Corporate Law.  Erin worked for the Delaware Public Defender’s Office in New Castle County during the summer of 2015. She was also a certified legal intern, under Delaware Supreme Court Rule 56, in the Delaware Civil Clinic in the Fall 2015, where she helped victims of domestic violence obtain protection from abuse orders and with custody issues.

Suggested Citation: Erin Rogers, In Re Trulia, Inc. Stockholder Litigation: End to Disclosure Settlements?, Del. J. Corp. L (April 13, 2016), www.djcl.org/blog.

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The Impact of Obergefell on Employee Benefits in Delaware

Elizabeth Miosi

On June 26, 2015, the United States Supreme Court issued its historic ruling in Obergefell v. Hodges, holding that the right to marry is a fundamental right inherent in the liberty protected by the Fourteenth Amendment. The opinion also mandates that states recognize a same-sex marriage that was lawfully licensed and performed out of state. Although same-sex marriage activists and supporters have reason to celebrate, the impact of Obergefell on businesses and employee benefits has yet to be fully understood. The administration of employee benefits will likely be simpler because the definitions of “marriage” and “spouse” no longer vary among the states, and, importantly, between state laws and federal laws. However, employers will need to conduct an in-depth review of all policies, forms, handbooks, and other such documents to ensure that they are consistent with these new, expanded definitions. This article provides a limited discussion of how Obergefell will impact Delaware businesses and their employee benefits plans by way of two examples.

Private Employer – Christiana Care

Christiana Care is one of the nation’s largest health care providers and is headquartered in Wilmington, Delaware. Christiana Care is also the largest private employer in the state with over 11,000 employees. The aspects of Christiana Care’s employee benefits package examined here are: (i) group health insurance; (ii) retirement plan; and (iii) Family Medical Leave Act.

Christiana Care has a group health insurance plan that covers an employee’s spouse. Christiana Care has an employer-sponsored health insurance plan, a benefit which is usually excludable from an employee’s gross income. This exemption also extends to the employee’s spouse.

After the Supreme Court’s ruling in United States v. Windsor, the IRS issued a Revenue Ruling finding that any reference in the United State Tax Code to any variation of “spouse,” “marriage,” and “husband and wife” are understood to apply to same-sex couples as well. Windsor also had an impact on the taxation of private employers, who, although not legally required to, provided welfare and health benefits to same-sex spouses. After the decision in Windsor, employers were not required to impute income to same-sex spouses for federal income tax reasons where a state recognized same-sex marriage, and an employee in a same-sex marriage enjoyed the increased health savings account contribution limits and the ability to use that account and a flexible spending account to pay expenses of the individual’s same-sex spouse. Now in a post-Obergefell world, employers who provide health and welfare benefits to homosexual spouses will not have to impute income for state income tax reasons.

Christiana Care’s employee retirement plan is a 403(b) Matching Contribution Program. A 403(b) plan is “a retirement plan for certain employees of public schools, employees of certain tax-exempt organizations, and certain ministers.” There are both non-spousal beneficiaries and spousal-beneficiaries of a retirement plan and non-spousal beneficiaries are subject to stricter guidelines, such as minimum distribution rules. Now under Obergefell, same-sex spouses are entitled to spousal benefits. Although plans that were updated pursuant to Windsor may not have to be changed, there will be an increase in the employees who are eligible for spousal benefits. Christiana Care should reconsider its spousal benefits plan if the term “spouse” is explicitly defined under the plan as referring to an opposite-sex spouse.

A February 2015 Department of Labor rule change made the Family Medical Leave Act (“FMLA”) consistent with Windsor before the Obergefell decision, which meant that same-sex spouses’ eligibility for FMLA protection was dependent on the law of the place of celebration. Christiana Care’s Residents/Fellows are eligible for FMLA protection. Its policy provides that eligible residents/fellows may take up to 12 weeks of unpaid leave during a 12-month period for various reasons, including among other things, caring for a spouse. After the 2015 rule change, the terms “marriage” and spouse” in Christiana Care’s FMLA policy were no longer limited to opposite-sex marriages for the purposes of federal law.

Public Employer – State of Delaware

The State of Delaware (the “State”) is Delaware’s largest employer with approximately 13,000 employees in 2013. The State offers a variety of employee benefits, which include a multi-faceted health insurance plan and various retirement plan options. All of the employee benefit documents the State provides include gender-neutral “spouse” terms (as in, “husband” and “wife” are not used).

Because the State also has group health insurance plan options, the implications of Obergefell are more predictable. The State is now required to interpret “spouse” to include same-sex spouses and if it had not offered coverage to same-sex spouses it now must do so.

Regarding its retirement plan options, the State offers 457(b) and 403(b) plans. A 457(b) plan is “to provide a vehicle through which all employees of the [State] may, on a voluntary basis, provide for additional retirement income security by deferring a portion of their current earnings into a tax-deferred investment/savings account.” Like in a 403(b) plan, spousal beneficiaries have less stringent requirements/guidelines than a non-spousal beneficiary. But now, in light of Obergefell, same-sex spouses have the same spousal beneficiary status.

        Looking Forward

The two companies discussed in this post are only limited snapshots of the impact Obergefell has on Delaware businesses. Though employers may find that administering employee benefits is simpler, there is still very little guidance from the legislature or courts about how Obergefell will affect them. Delaware employers should also be mindful that even though homosexual marriage is legal now, not every same-sex couple will choose to get married. Employers would be prudent to not quickly eliminate any employee benefits extending to domestic partnerships because Windsor and Obergefell do not extend to domestic partnerships.

Furthermore, the effect of Obergefell trickles into other areas of employment law as well even though it was not an employment case. For example, Title VII of the Civil Rights Act of 1964 still does not prohibit discrimination based on a person’s sexual orientation or gender identity; however, in a July 15, 2015 decision, the United States Equal Employment Opportunity Commission ruled on its own that Title VII prevents employment discrimination based on sexual orientation. Nevertheless, the Supreme Court has yet to rule on the issue. Although currently there is no federal law prohibiting sexual orientation discrimination, the Delaware Discrimination in Employment Act “protects individuals against employment discrimination on the basis of sexual orientation, . . . marital status, . . . [and] genetic information.

In conclusion, Delaware employers should do a full examination of all of their policies, forms, and handbooks to ensure that they and their vendors are in compliance. Employers should also look for additional direction from state and federal agencies, and also be mindful that the effects of Obergefell are not fully understood yet and it could possibly affect other employee benefits as well.

Elizabeth is a third-year student at Widener University Delaware Law School and is currently completing the Business Organizations Law Certificate.  Along with serving as a Judicial Extern for the Honorable Mary Pat Thynge of the United States District Court for the District of Delaware, she is the Secretary of the Student Bar Association; President of OUTLaw, the LGBT-Straight alliance; and Treasurer of the Public Interest Law Alliance, as well as a member of the Moot Court Honor Society.

Suggested Citation: Elizabeth Miosi, The Impact of Obergefell on Employee Benefits in Delaware, Del. J. Corp. L (April 8, 2016), www.djcl.org/blog.

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Puerto Rican Debt Crisis: A Proposal to Amend Federal Bankruptcy Law

Ashley B. DiLiberto

Puerto Rico is deeply in debt, and this United States territory is in desperate need of help.  Puerto Rico owes approximately $72 billion to its creditors, and the financial avalanche is creating chaos in the lives of millions of Americans.  Although the devastating effects are not limited to those on the island, citizens living there are uprooting their lives to other cities in the United States, schools are closing, and the labor force is continually dwindling.

There have been several proposals to try to get Puerto Rico back on its feet, such as allowing Puerto Rico’s public utilities to declare bankruptcy.  Although Chapter 9 of the U.S. Bankruptcy Code allows a municipality, with its state’s permission, to restructure its debts through bankruptcy, a 1984 amendment to the bankruptcy laws “define[s] Puerto Rico as a state for every purpose except filing for Chapter 9, which governs municipal bankruptcy.” 

This means that although Puerto Rico has admitted it is unable to pay back its creditors, neither Puerto Rico nor any of its public agencies (which owe much of the debt), cities or other municipalities has access to United States bankruptcy protection.  A whopping one-eighth of the island’s $72 billion total debt is due to a single Puerto Rican public company, PREPA (the Puerto Rico-owned electric company).  PREPA likely could file for Chapter 9 bankruptcy if Puerto Rico were considered a state.  However, as the law currently stands, Puerto Rico is not a state for purposes of permitting its municipalities to file for Chapter 9 bankruptcy.  Therefore, without a prompt federal amendment to the bankruptcy law to give Puerto Rico equal rights as states for purposes of Chapter 9 bankruptcy, the world may be forced to watch Puerto Rico’s economy crumble, and the 3.5 million U.S. citizens of Puerto Rico, as well as the entire U.S. economy at large, will feel the effects of this catastrophe. 

There are arguments that we must uphold the idea that we all have a responsibility to pay our debts, and that a “bail out” is simply unacceptable.  Many creditors resent bankruptcy protection as unfair and seeming to reward irresponsible behavior and breaches of promises to pay one’s debts, because the losses suffered by creditors who encounter bankrupt and impecunious debtors can sometimes be passed on to responsible financially honest consumers, whose costs increase to make up for those losses.  However, Puerto Rico’s financial crisis is not simply a result of overspending or irresponsibility.  The circumstances that left Puerto Rico in this desperate need of financial restructuring were to a great extent out of Puerto Rico’s control.

Financial troubles began in Puerto Rico when the United States government offered major tax breaks to corporations working in Puerto Rico.  In 2006, Congress ended these tax breaks, and since then, Puerto Rico has experienced the following vicious cycle that led to its recession: people began fleeing from the island in search for better economic opportunities, which led to less people paying taxes, which forced Puerto Rico to increase tax rates and cut back public services, which then caused even more people to flee the island.  To make matters worse, other United States tax breaks had allowed Puerto Rico to issue triple tax-free debt, which was exempt from federal, state and local taxes.  Institutional investors and bond mutual funds were particularly drawn to this kind of debt, and made loans to Puerto Rico in more generous amounts and for a much longer duration than they would have without this tax break.

Finally, while “the typical state . . . [only] spend[s] about 5 percent of its tax revenue on payments of interest and principal to bondholders, . . .  in Puerto Rico, . . . payments on this type of debt [are] now consuming an unsustainable 36 percent of the island’s tax revenues.”  Without a solution that would forgive, or at least restructure, the debt of Puerto Rico’s municipalities, this impossible and crushing amount of debt service will ultimately ruin the island.  Puerto Rico should not be forever destroyed by this one poor financial chapter in its existence, especially considering that the island’s debt is due to a multitude of circumstances, many of which were outside of its control.

After all, Congress’s intent in enacting the Bankruptcy Code was to give the bankrupt party an opportunity to have a “fresh start,” restructure its debt, and move on with new business or personal ventures in an effort to allow continued commerce and business relationships without eternally being ruined by an unfortunate economic period.  The Code was intended to allow entities to have their debts forgiven or diminished significantly, while allowing the creditors to respectively recover amounts owed to them in diminished percentages if the bankrupt party has assets remaining.

Congress intended to protect the entities within the United States.  It gave bankruptcy protections to the municipalities of all fifty states, and “[t]here is no basis for . . . unequal treatment” of those in Puerto Rico (a United States territory).  Puerto Rico deserves to be considered a “state” under the Code so that its municipalities are afforded the equal protection of the laws given to the municipalities of the fifty states for several reasons.

First, to hold otherwise reeks of discrimination and bias to our island brothers and sisters.  Second, Puerto Rico must be given the chance to regain its financial health in order to protect millions of citizens who call Puerto Rico home.  Over “3.5 million Puerto Ricans residing on the island, and about 5 million living stateside, are U.S. citizens who have contributed immeasurably to this nation.”  These citizens and their ancestors have “given their lives for the U.S. when it has needed protection” and it is now our turn to offer them protection in return.

Third, the economic impact of Puerto Rico “going out of business” would have ripple effects in every state of the United States whose citizens rely on Puerto Rican exports and benefit from importing goods to Puerto Rico.  The United States is a major trading partner to Puerto Rico, with the island exporting chemicals, electronics, apparel, canned tuna, rum, beverage concentrates and medical equipment.  Puerto Rico had estimated exports of over $69 billion of products and imports of over $47 billion in 2013.  Puerto Rico also has four medical schools accessible to United States citizens.  Finally, Puerto Rico is a major tourism center for citizens of the United States and the world.

If the Code is not amended to permit Puerto Rico’s municipalities to file for Chapter 9 bankruptcy protection and restructure their debt, millions of people will continue to be laid off, educational institutions will continue to shut down, social services will be cut, important Puerto Rican exports will terminate, the tourism industry will be demolished, and the island will ultimately cease to exist as we know it.

The federal government must act now to redefine Puerto Rico as a state for the purposes of Chapter 9 of the Code.  America cannot sit back and watch one of its own territories crumble.  It is implicit in our country’s name that we must be united and supportive of our several states and territories in times of need.  It is time we do just that.

Ashley B. DiLiberto is a third year student at Delaware Law School and the Copy Editor of the Delaware Journal of Corporate LawShe also serves as President of the Delaware Law School Food and Drug Law Association.  Ashley will sit for the Delaware Bar Examination in July.

Suggested Citation: Ashley B. DiLiberto, Puerto Rican Debt Crisis: A Proposal to Amend Federal Bankruptcy Law, Del. J. Corp. L (March 28, 2016), www.djcl.org/blog.

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Affordable Care Act Creates Incentives for Small Businesses to Provide Health Benefits

Samantha Darrow Osborne

Recently, the Affordable Care Act (“ACA”) has substantially increased individual penalties, which create an incentive for small businesses to partake in offering insurance to their employees.  In 2015, the penalty for failing to obtain health coverage was determined by the higher of either 2% of household income or $325 per adult and $162.50 per child under eighteen.  However, in 2016 the penalty has substantially increased to either 2.5% of household income, or $695 per adult and $347.50 per child.  These penalties double the 2015 fees, which can be a substantial burden on individuals and families.  Moreover, it is important to note that close to half of the uninsured in the United States are small business owners, employees or their dependents.  Therefore, many individuals looking for employment want to find a job that provides some sort of health insurance benefit.

Attracting and retaining qualified employees is not only necessary to keep a competitive edge in the current economy, but in order to capture potential employees’ interest, many employers need to provide health insurance.  As a recent study showed, “[health] benefits are a very important reason [employees] joined and or stayed with their company.” Likewise, many employees say they would accept better benefits in lieu of a higher salary.  Additionally, employee wellness is a key aspect in having more productive employees and increasing overall profits.   Preventative care helps employees avoid having to take long periods of time off due to illness.  By keeping employees healthy and able to come to work, they are more productive overall.

Furthermore, small businesses now have an opportunity to pass along lower health insurance costs to employees through the ACA Small Business Health Options Program (“SHOP”).  To qualify as a “small business,” a business must employ fifty or fewer full-time employees.  SHOP creates a more level playing field for small businesses by allowing them to purchase insurance at a lower rate through the marketplace, therefore allowing them to pass those advantageous costs onto employees.  Offering benefits to employees may also be beneficial to the small business owners, who may be able to get their personal benefits for less money than if they had purchased them privately.

Small businesses also gain tax advantages when they provide health insurance.  When an employer offers health benefits to employees, it increases the employee’s compensation package, while providing the employer with an income tax deduction for their contribution.  Employers can always deduct 100% of the premiums they pay towards employees’ health insurance.  This makes the employers’ out-of-pocket cost less than the value to the employee.  For example, if an employer offers an employee a $50,000 salary without health insurance, the employer has to pay payroll taxes on the full $50,000.  However, if an employer offers an employee a $45,000 salary with $5,000 in health insurance benefits, the employer can deduct the $5,000 from their taxable income and will only pay payroll taxes on the $45,000 figure.  This incentivizes employers to provide health insurance by permitting employers to save on payroll taxes while offering an enticing benefit to employees.

Finally, but most importantly, the ACA provides small businesses with the potential to receive a generous health care tax credit.  To claim the credit, the business must employ less than twenty-five full-time employees who make an average of less than $50,000 a year.  Additionally, the employer “must cover at least fifty percent of the cost of employee-only health care coverage for each of the employees.”  The business will also need to purchase the insurance through the SHOP Marketplace.  The amount of credit an employer can receive works on a sliding scale, with the maximum credit being fifty percent.  The smaller the business the larger the credit. The tax credit is available to eligible employers for two consecutive taxable years.  Small, tax-exempt employers meeting the stated requirements can also receive a credit of up to thirty-five percent.  

Furthermore, to illustrate how the tax credit works, if an employer has ten employees making $25,000 per employee or $250,000 overall, and the employer contributes $70,000 to employee premiums, the employer is entitled to fifty percent tax credit amounting to $35,000.  These tax credits are retroactive from 2010 on, but the claim for refund must be filed within three years from the time the return was filed.  Thus, small businesses can claim their health insurance tax credit for any year since 2012The credit is also refundable so small tax-exempt employers are eligible to receive the credit as a refund as long as it does not exceed the businesses income tax withholdings.

Although businesses with fifty employees or less are not required to provide health insurance, there are numerous advantages for them to do so.  Small businesses that choose to provide health insurance coverage can attract and retain stronger, more productive employees.  The SHOP marketplace provides a more level playing field with offering lower cost health care premiums to small businesses.  This allows the employer to pass the cost savings onto the employee, while also providing the individual employer a better rate. Additionally, the employer gains tax advantages and a generous tax credit if they choose to provide health benefits.  Thus, making the choice to provide coverage more advantageous for the employer and employee.

Samantha Darrow Osborne is a second year student at Widener University Delaware Law School and a Staff Member on the Delaware Journal of Corporate Law. Samantha has experience  in the public sector at the United States Attorney’s office.

Suggested Citation: Samantha Darrow Osborne, Affordable Care Act Creates Incentives for Small Businesses to Provide Health Benefits, Del. J. Corp. L. (March 19, 2016), www.djcl.org/blog.

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Considerations in Implementing Country-by-Country Reporting

John Brady

Introduction

On October 20, 2015, the Organization for Economic Co-operation and Development (“OECD”) released the final report on Base Erosion Profit Sharing (“BEPS”) rules to thwart aggressive transfer pricing strategies involving intercompany transactions used by companies to lower taxes.  The OECD defines BEPS as “tax planning strategies that exploit […] gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity, resulting in little or no overall corporate tax being paid in those countries.”  The OECD paints a grim picture of international commerce through the actions of large multinational enterprises (“MNEs”). 

The final report attempts to correct the apparent gaps between tax jurisdictions, principally to ensure that tax bases are not artificially reduced through MNEs’ aggressive tax practices.  The OECD proposes several initiatives to mitigate and eliminate the effects of aggressive international tax planning.  Yet, none are as crucial as Country-by-Country Reporting (“CbCR”) laid out in Action 13.  The final report attempts some lofty goals in reigning in MNEs, but the entire plan hinges on accurate, comprehensive, and automatic exchanges of MNE business information between tax authorities in different countries.

Benefits of Country-by-Country Reporting

CbCR is intended to accomplish the final report’s overarching goal of creating transparency and uniformity among countries.  This transparency permits jurisdictions to better monitor MNEs business operations within their borders.  In turn, this also permits jurisdictions greater control over and better understanding of taxable activities within their borders.  Additionally, transparency, granted through CbCR, will ensure that MNEs comply with the initiatives laid out in the final report, such as the proposed transfer pricing rules limiting value to the jurisdictions where value creating takes place.

Moreover, uniformity and better transparency among nations achieves the goal of limiting opportunities for MNEs to capitalize on gaps between jurisdictions’ tax laws.  When MNEs seize on these legally permitted opportunities, jurisdictions suffer lost tax revenue even though significant value-creating activities may occur within its borders.

Potential Pitfalls

CbCR costs to MNEs are a significant issue, producing direct and indirect costs to MNEs.  First, there are inherent direct costs associated with the production of data to comply with the CbCR requirements.  Admittedly, many U.S. MNEs already must comply with various business disclosures domestically and abroad, whether security disclosures or tax disclosures.  However, internal data mining is a burdensome and expensive proposition to be added to a business’ bottom line. 

In addition, there are indirect costs associated with providing intimate knowledge about MNE’s business information.  The dearth of information required could catastrophically disrupt business operations if it fell in the wrong hands.  Though the information is intended for “tax purposes,” there is little reassurance that this information will be adequately protected.  These reports will provide significant details about worldwide business operations and assets.  The value of this information would be immense, and thus reasonable to foresee corruptive practices exchanging data with competitors.  Business competitors could disrupt and cripple business operations with the exchanged information.  Costs to combat and recover from corporate espionage could be overwhelming, which not only would affect the entity but also any individual shareholders.

In essence, CbCR means entrusting valuable taxpayer information in the hands of foreign jurisdictions that are not beholden to American voters for ultimate review.  If CbCR is to be implemented and successful, there must be adequate safeguards in place to reasonably ensure that taxpayer information is protected from intrusive and corruptive practices.  

U.S. Status of County-by-Country Reporting

On December 23, 2015, the U.S. Treasury released a proposed regulation to adopt CbCR.  The Treasury used the model OECD template as a guide in this regulation.  In doing so, the proposed regulation will require MNEs to disclose the same information required in the final report, such as financial data, headcount, global snapshot of an MNC and its subsidiaries, and paid taxes.  In addition, the Treasury largely adopts the limitations imposed on the use of such data: (1) CbCR will not be used to conclude abusive transfer pricing, but (2) it may be used as a basis for further inquiry.  Interestingly, the Treasury does take steps to mitigate some of the direct costs in compiling these reports by bringing them in line with existing reporting code sections: 6001, 6011, 6012, 6031, and 6038.

The Treasury adopts the OECD report’s language on inter-country transfers and confidentiality.  The Treasury ensures that a “close review” of a “tax jurisdiction’s legal framework for maintaining confidentiality of taxpayer information and its track record of complying with that legal framework” will occur prior to an information exchange with foreign jurisdictions.  Thus, the receiving jurisdiction will have the “necessary legal safeguards” to protect exchanged information.  Yet, the proposed regulation does little to set any recognizable standard for confidentiality.  There is little reassurance that all foreign jurisdictions will comply under a unified, objective privacy standard.  Without some clear standard, it remains speculative whether a mere examination of legal frameworks and historical enforcement will indicate genuine protection of taxpayer data, especially among cultures that don’t value privacy as highly others.

In contrast, legislators took action to “prevent” this automatic exchange.  The House submitted a bill (“the legislation”) to prevent the Treasury from collecting or transmitting CbCR for taxable years beginning prior to January 1, 2017.  Assuming swift passage, the legislation is only a moratorium on taxable years starting prior to January 1, 2017.  Taxable years after that date could be freely exchanged, unless subsequent legislation blocks those years from exchange.  Therefore, the legislation would do little more than postpone the inevitable – CbCR is here to stay. 

Nevertheless, the legislation would impose some reporting obligations on the Treasury and IRS, and it would also provide specific circumstances where the Treasury and IRS would suspend exchanges in protection of taxpayer information.  The latter would require the Treasury and IRS to suspend exchanges of information with tax jurisdictions that either (1) abuse the master file requirements, or (2) fail to safeguard confidential information.  The bill enumerates specific abuses that would qualify a suspension, such as tax jurisdictions pursuing corporate secrets or violating “U.S. public policy.”  However, the proposed legislation falls short of establishing minimum standards of confidentiality before exchanges commence.  So at best the legislation, if passed, amounts to a temporary measure buying the U.S. time to observe CbCR take effect abroad.  While several jurisdictions implemented CbCR and others anticipate its enactment, it is too soon to tell how well the system will operate.  Some suggest that the final report and CbCR merely serve as a means to destabilize American business, and if true, issues with CbCR will not become apparent until the U.S. goes online with the automatic exchange.

Interestingly, some critics suggest that halting CbCR, even temporarily, may do more harm than good.  Some taxpayers may still need to submit CbCR to other jurisdictions if the U.S. parent entity would not be required to submit CbCR in the U.S.  This path may be less secure with CbCR suspended in the U.S. until 2017.

Recommendation

The U.S. should be prudent in examining additional privacy safeguards to further protect taxpayer data from abuse and unauthorized consumption prior to implementing the automatic exchange.  As mentioned, the current U.S. proposals fail to meet specificity in data protection.  The final report fairs no better, but does cite to prior exchange agreements for guidance, such as Multilateral Competent Authority Agreement for the Common Reporting Standard.  Under this agreement, it is at least understood that a “supplying competent authority” could require the “receiving competent authority” to comply with additional safeguards to protect taxpayer information.  Additionally, the “receiver” may also be expected to comply with the domestic privacy laws of the “supplying” jurisdiction.  This flexibility permits the U.S. to apply additional privacy safeguards to foreign jurisdictions in order to protect taxpayer data.

John Brady is a Staff Member on the Delaware Journal of Corporate Law, and a member of the Moot Court Honor Society.  John works as a pre-trial clerk at the Chester County District Attorney’s office.

Suggested Citation: John Brady, Considerations in Implementing Country-by-Country Reporting, Del. J. Corp. L. (Feb. 7, 2016), www.djcl.org/blog.

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Delaware Supreme Court Finds Third-Party Advisor Liable for the Board’s Breach

Michael Laukaitis 

The Delaware Supreme Court narrowly refined the Revlon analysis in RBC Capital Markets, LLC v. Jervis (“Rural Metro”).  The Court found that financial advisors aid and abet a director’s breach of fiduciary duties when they knowingly induce, advise, or assist the board’s breach.  The Rural Metro ruling impacts other recent Court of Chancery decisions and offers several fundamental lessons to boards and financial advisors alike.

Over time, the Delaware General Corporation Law (“DGCL”) and Delaware Supreme Court precedent have steadily decreased Revlon’s authority.  The General Assembly enacted  § 102(b)(7), which, if affirmatively adopted in the corporation’s articles of incorporation, exculpates directors from liability for duty of care violations.  If the corporation elects such a provision, plaintiffs must rely upon the director’s non-waivable duty of loyalty to bring a claim.  As a result, some opine that Revlon has few remnants left and much of the opinion has been rendered ineffective.  Although § 102(b)(7) provisions can exculpate directors, third-party advisors are afforded no similar protection.

On November 30, 2015, the Delaware Supreme Court sitting en banc issued its Rural Metro ruling, which runs 107 pages.  In late 2010, a Rural/Metro, Corp. special committee hired RBC Capital Markets, LLC (“RBC”) as a financial advisor to help facilitate the sale of the company.  RBC created informational gaps, such as failing to update their valuation of Rural at the time the board made critical decisions. Additionally, the board approved an unreasonable sale process that was proposed by RBC.  RBC’s conflict of interest, including possible financing for purchasers of Rural/Metro, further added to these informational gaps. 

Rural/Metro agreed to sell its company to a private equity fund.  Following the announcement, the stockholders sued Rural/Metro’s board of directors and its two financial advisors for breaching their Revlon duty to maximize the sale price.  All defendants except RBC settled before trial.

In order to find the third-party advisor liable for aiding and abetting, the Court required that the third-party advisor knowingly aid the breach; therefore, simply failing to prevent the breach was not enough for advisor liability.  The Court held RBC liable for aiding and abetting because: (1) a fiduciary relationship existed between the Rural/Metro board and shareholders, (2) the board breached their fiduciary duties of care and disclosure, (3) RBC knowingly participated in that breach, and (4) damages were proximately caused by the breach.

The Court focused on the third element—RBC’s knowing participation in the breach.  Since third-party advisors cannot rely on 102(b)(7) protections, the plaintiffs of an aid and abet case must prove that the third-party acted with scienter.  Specifically, the Rural Metro Court held that the third-party must have acted with “knowledge that the conduct advocated or assisted constitutes such a breach.”  The Court agreed with the Court of Chancery’s narrow holding: “[i]f the third-party knows that the board is breaching its duty of care and participates in the breach by misleading the board or creating the informational vacuum, then the third-party can be liable for aiding and abetting.”

Although Rural Metro reinforces the expansion of Revlon liability to third parties, financial advisors who disclose conflicts of interest and possible ramifications would likely not face any liability under Rural Metro.  RBC’s failure to disclose their conflict of interest directly contributed to the board’s breach of failing to be fully informed and to maximize the company’s sale price.  Had RBC disclosed their self-interest and fully disclosed the sale process, they likely would have been shielded from liability.  This protection should create an additional incentive for third-party advisors to be completely transparent with their clients.  Otherwise, an advisor could be liable for aiding and abetting a subsequent breach by the board of directors.

The Court offered an additional protection to third-party advisors by refusing to adopt the Court of Chancery’s notion that financial advisors function as gatekeepers.  In loose language, the Court of Chancery implied that the financial advisors owe a duty to the directors to oversee the sale and acquisition of a company.  The Delaware Supreme Court rejected this proposition, stating that the financial advisor relationship is contractual in nature.  Boards and financial advisors typically negotiate their arrangements at arms-length; therefore, the boards are free to negotiate with the financial advisor what role, services, and expertise the financial advisor will bring to the company.  In the absence of any specialized arrangement, the board of directors retains the oversight function and must oversee the merger or acquisition, and the financial advisor’s responsibility is not expanded beyond rendering candid and transparent advice.

Although the Court’s Rural Metro opinion focuses on the implications for third-party financial advisors, it also offers a few lessons for boards of directors.  First, Rural Metro reinforces that Revlon applies when the company commences a sale process.  Second, the board must remain adequately informed about the value of the company throughout the entire sale process.  Third, boards must attempt discovery of their advisor’s conflicts or at least require that the third-party disclose a potential conflict of interest.  Boards of directors, as well as third-party advisors, would do well to heed Rural Metro’s reminders that Revlon is alive and well.

Michael Laukaitis is a second-year law student at Widener University Delaware Law School and a Staff Member on the Delaware Journal of Corporate Law. Michael has experience working in the public sector at the Delaware Department of Justice.

Suggested Citation: Michael Laukaitis, Delaware Supreme Courts Finds Third-Party Advisor Liable for the Board’s Breach, Del. J. Corp. L. (Jan. 18, 2016), www.djcl.org/blog.

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Fine-Tuning Revlon: The Consequence of Fair and Fully Informed Stockholder Votes

Nicholas D. Picollelli, Jr.

In the context of strategic acquisitions, the Supreme Court of Delaware’s recent opinion in Corwin v. KKR Financial Holdings LLC challenges the validity of the Revlon doctrine as it applies to conflict-free mergers.  Revlon requires directors to forego anti-takeover procedures and obtain the best available price when the sale of the company becomes inevitable.  As the Court in KKR asserted, Delaware corporate law is hesitant to invoke Revlon’s heightened standards to “second-guess the judgment of a disinterested stockholder majority that determines that a transaction with a party other than a controlling stockholder is in their best interests.”  Consequently, when stockholders are fully informed and uncoerced, Revlon scrutiny is unnecessary and the business judgment rule would apply.

Revlon distinguished the Court’s earlier Unocal decision, which established enhanced standards of judicial scrutiny of defensive measures adopted by a board of directors in addressing a potential takeover.  Unocal requires such scrutiny due to the concern that directors acted in self-interest, rather than in the interest of the company and its stockholders.  The potential for conflict requires directors to show that they had “reasonable grounds for believing there was a danger to corporate policy and effectiveness.”  Directors can satisfy this burden by showing “good faith and reasonable investigation.”  Finally, Unocal requires directors to show the reasonableness of director action in relation to the threats presented by the takeover.

In Revlon, the board of directors implemented anti-takeover measures in order to prevent acquisition of Revlon, Inc. by Pantry Pride, Inc.  Revlon’s board was concerned that Pantry Pride’s strategy for financing the Revlon acquisition would lead to Revlon’s dissolution.  In response to this threat, the board implemented a “poison pill” plan: an offer to exchange newly issued notes for ten million shares of Revlon stock, a “lock-up” option, and “no-shop” provision.  Although the defenses may have been initially appropriate, the Court found that when it became apparent that Revlon was for sale, the board’s duty “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.”  As such, the merger agreement approved by Revlon’s directors did not survive judicial scrutiny because they were motivated by the fear of personal liability to holders of the notes issued in the exchange offer, rather than obtaining the best price for Revlon’s sale.

In KKR, the plaintiffs challenged a stock for stock merger between KKR & Co., LP and KKR Financial Holdings, LLC (“Financial Holdings”).  The plaintiffs claimed that the transaction should have been subjected to the entire fairness standard of review since KKR & Co., LP was a controlling stockholder of Financial Holdings.  The Court of Chancery found that the plaintiffs were not entitled to entire fairness review because there was no indication that “KKR could prevent the [Financial Holdings] board from freely exercising its independent judgment in considering the proposed merger . . . .”  As the Supreme Court noted, the Chancellor determined that “the voluntary judgment of the disinterested stockholders to approve the merger” resulted in the application of the business judgment rule.

The Court’s decision in KKR is relevant because it challenges whether Unocal and Revlon are applicable in a conflict-free merger.  As long as stockholders are truly uncoerced and fully informed, KKR seems to suggest that they are not.  In essence, the Court’s concern in Unocal and Revlon is with stockholders not getting the best deal in a merger due to directors’ self-interest.  However, whereas in KKR, an independent and fully informed stockholder determines that he is obtaining the best deal, a court should accept the stockholders’ decision instead of second-guessing it.  If anything, the assertion is eerily similar to the requirements for the business judgment standard of review in situations other than Revlon and Unocal.

Typically, under business judgment review, courts are hesitant to second-guess director decisions unless directors are shown to be conflicted or uninformed.  The Court in KKR merely replaces “director” with “stockholder.”  This policy, as the Court in KKR asserts, is intended to prevent increased litigation costs, fear of potentially beneficial risk taking, and second-guessing by judges who are in a worse position to evaluate business decisions.  These principles are especially relevant when stockholders can “protect themselves … by simply voting no.”  Since stockholders evaluate transactions for themselves, there is no need for enhanced scrutiny because the stockholders act directly, rather than indirectly through directors who might coerce the stockholders’ decision.

The Court attempted to mitigate any concerns about stockholder protection by recognizing that if “the structure or circumstances of the vote were impermissibly coercive,” or “if the corporate board failed to provide the voters with material information,” then the Court would not give protective effect to the “ratification.”  More simply, the Court requires that the vote be “fair and fully informed.”  Otherwise, the stockholders would not be in the best position to evaluate a transaction and Unocal or Revlon would be necessary protections.  The Court recently demonstrated, in RBC v. Jervis, the consequences of an uninformed vote by holding that if the stockholder vote is not fully informed and Revlon applies, directors might breach their fiduciary duties if their supervision of the sale process falls “outside the range of reasonableness,” even in the absence of gross negligence.  Consequently, a board should be motivated to ensure the vote is “fair and fully informed” in order to avoid additional scrutiny.

The Court’s additional requirements and threat of increased scrutiny thereby eliminates the concern in Revlon and Unocal that interested directors might interfere with stockholder decisions because the protections allow stockholders to evaluate a decision just as they would in any transaction.  Therefore, the application of Unocal and Revlon is less significant, if not completely unnecessary, and the business judgment rule would apply where truly independent and fully informed stockholders determine that they are obtaining the best available deal.

Nicholas D. Picollelli, Jr. is a third-year student at Widener University Delaware Law School and a senior staff member on the Delaware Journal of Corporate Law.  Nick also serves as a judicial intern to the Honorable Kevin J. Carey in the United States Bankruptcy Court for the District of Delaware.

Suggested Citation: Nicholas D. Picollelli, Jr., Fine-Tuning Revlon: The Consequence of Fair and Fully Informed Stockholder Votes, Del. J. Corp. L. (Jan. 2, 2016), www.djcl.org/blog.

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The U.S. Government and Corinthian Colleges, Inc.: Picking Winners and Losers

Christopher Kephart

Thanks to a relatively obscure federal statute, with rules written during the Clinton administration regarding the discharge of federal student loans, taxpayers must be on alert and students receiving federal student aid need to pay attention.  The 2015 Chapter 11 bankruptcy filing by Corinthian Colleges, Inc. has opened the door for a potential $3.5 billion taxpayer bailout of existing Corinthian Colleges student loans.  This story of how the voluntary filing for bankruptcy by a for-profit university appears to be more politics than process.

On April 26, 2015, Corinthian Colleges, Inc. ceased operations and suspended classes at substantially all of its facilities.  Corinthian, the nation’s largest for-profit career college, was accused of falsifying job placement statistics and graduation rates, which resulted in the Department of Education’s suspending Corinthian’s access to federal dollars.  The lack of federal funds forced Corinthian to “close its doors.”  The closures left some 16,000 students in the cold while strapping those same students with millions of dollars in student loan debt.

The Department of Education not only discontinued federal funding, but also levied fines against Corinthian in the tens of millions.  Corinthian filed a voluntary petition for Chapter 11 bankruptcy in the United States Bankruptcy Court for the District of Delaware on May 4, 2015.  The United States Trustee appointed an official committee of unsecured creditors.  The presiding Judge, the Honorable Kevin J. Carey, also ordered the appointment pursuant to Bankruptcy Code section 1102 of a separate (and far less common) official committee to represent student claimants.  Corinthian’s Chapter 11 Plan for Liquidation, which was confirmed by the Bankruptcy Court on August 28, 2015, used some of the bankrupt company’s funds to create a $4.3 million Student Reserve Fund for the benefit of those students.  The attorney for the student committee, Scott Gautier, may have been satisfied with the $4.3 million trust fund in the bankruptcy proceeding, but he indicated that this was only the beginning of the battle.  His real goal was to have the nearly $2.5 billion in estimated Corinthian student debt set aside.  According to Gautier, the $4.3 million was to be used at the direction of the student committee members to fund the anticipated fight with the federal government regarding total debt forgiveness for a broad range of former Corinthian students. 

Corinthian funded its operations with both federal and private student loans.  Contemporaneously and in conjunction with the bankruptcy proceeding, debt relief was afforded to current and former students in the form of a reduction of outstanding private loans made by Corinthian.  This occurred when Educational Credit Management Corporation Group (“ECMC”), a corporation that specializes in student debt management, purchased several of Corinthian’s campuses.  As part of the negotiations for the purchase of Corinthian, the Consumer Financial Protection Bureau (“CFPB”) secured $480 million in private loan reductions based upon the contention that these loans were a product of predatory lending.  However, the ultimate goal of an increasing number of Corinthian student activists was the realization of total debt forgiveness.  These activists, dubbed the “Corinthian 15” consisted of a group of former students who refused to pay their federal loans.  Their efforts were supported by an “Occupy Wall Street spinoff” called The Debt Collective.  As the Corinthian 15 continued to make noise, a group of democratic U.S. Senators, nine state attorneys general, and a coalition of student, educational and labor groups also pushed for the broad relief of federal student loans. 

With mounting political and populist pressure, the Department of Education made the decision to fast track debt forgiveness for those students who attended closed Corinthian campuses.  It is anticipated that this streamlined debt forgiveness will alone cost taxpayers nearly $544 million.  Additionally, Corinthian students who believed they were defrauded, regardless of whether or not their specific school closed, were able to petition the Department for debt forgiveness.  The Department of Education adopted, as their standard of review for the petition of debt forgiveness, the rarely used “defense to repayment” provision found in the administrative rules of Title 20 of the education code.  The statute allows a borrower to petition for debt forgiveness if the student believes she was “defrauded by [her] college under state law.”    

The question going forward is what would likely constitute fraud under the defense to repayment statute.  The State of California has given guidance through the review of the Corinthian petitions.  As an example, The Department of Education “determined that students who relied on misrepresentations found in published job placement rates for many [Corinthian] programs qualify to have their federal direct student loans discharged.” Therefore, the Department will likely look to predatory lending practices, misrepresentation of graduation rates, and misrepresentation of job placement statistics as a standard for considering a student’s defense to repayment.  Although reliance on the misrepresentation is part of the analysis, with the political winds blowing in favor of student debt relief, that burden of proving reliance may become nothing more than a subjective fait accompli analysis. 

So, taxpayers beware.  The Chapter 11 bankruptcy of a for-profit university has morphed into a potential student debt forgiveness Pandora’s Box.  Corinthian engaged in predatory lending with its private loans.  Those loans were partially forgiven by the private buyer of the loans and other Corinthian assets (the window of forgiveness extended back to June 2014), in connection with the purchase and sale transaction negotiated between the buyer and Corinthian.   Now, the $4.3 million student trust established by Corinthian’s confirmed liquidating plan gives hope to those students who took federal student loans or whose private loans fall outside of the June 2014 window.  The student committee has the financial ammunition to either litigate or negotiate further debt forgiveness.  Given the current negative populist sentiment surrounding student debt, there may be little to stop the momentum of the aggrieved former Corinthian students from successfully eliminating their federal student debt. 

Chris Kephart is an evening division student at Widener University Delaware Law School and a Staff Editor of  the Delaware Journal of Corporate Law He also serves as a Judicial Intern to Justice James T. Vaughn, Jr. of the Delaware Supreme Court.

Suggested Citation: Christopher Kephart, The U.S. Government and Corinthian Colleges, Inc.: Picking Winners and Losers, Del. J. Corp. L. (Nov. 29, 2015), www.djcl.org/blog.

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Director Independence Analysis Refined

Sabrina M. Hendershot

In a rare reversal of a Court of Chancery decision, the Delaware Supreme Court revived a pension fund’s derivative complaint, holding that demand on the board would have been futile.  In Delaware County Employees Retirement Fund v. Sanchez, Chief Justice Strine, writing for the court en banc, found that a director’s quarter-century friendship and significant business ties supported a pleading-stage inference that the director lacked independence.  This opinion serves as an important reminder for boards to be mindful of personal relationships in assessing director independence.

Sanchez involved a joint venture transaction between a private company, Sanchez Resources, LLC, which was owned by the family of A.R. Sanchez, Jr., and the publicly traded Sanchez Energy Corporation, in which the Sanchez family was a significant stockholder.  A.R. Sanchez is the Chairman of Sanchez Energy’s board of directors (the “Chairman”), and his son, A.R. Sanchez, III, is President and CEO of Sanchez Energy’s board.

Sanchez Energy shareholders brought a derivative suit against the company’s five directors, alleging that they approved the transaction with Sanchez Resources on unfair terms designed to benefit Sanchez Resources while depleting the assets of Sanchez Energy at the expense of its shareholders.

The plaintiffs did not make a pre-litigation demand on Sanchez Energy’s board with respect to the transaction, as is generally required under Rule 23.1, nor did they exercise their right to inspect the company’s books and records through Section 220 of the DGCL. Instead, the plaintiffs argued that demand was futile and should be excused under both prongs of the test articulated in Aronson v. Lewis.  Under Aronson, in order for demand to be excused, a plaintiff must plead particularized facts creating a “reasonable doubt” as to whether: (1) the directors are disinterested and independent; and (2) the challenged transaction was a valid exercise of business judgment.

There was no dispute that two of the five directors, the Chairman and his son, were interested because they both held ownership interests in Sanchez Resources.  Therefore, the focus was on whether any of the other three directors were interested.  Two of the directors, Gilbert A. Garcia and Alan G. Jackson, had a longstanding friendship and significant financial ties to the Sanchez family.  However, the Court of Chancery rejected the plaintiff’s claims on two independent grounds.  First, Vice Chancellor Glasscock concluded that the plaintiffs had not alleged specific facts regarding the nature and extent of the relationships between the directors or how they would impact director decision-making.  Additionally, he explained that as a minority shareholder, the plaintiffs could not meet the test of “actual control over the transaction at issue” and thus allegations that the directors exercised direct control over day-to-day management and operations of the Company were irrelevant.  For these reasons, the Court of Chancery determined that the plaintiffs could not overcome the presumption that the directors were independent.

The Delaware Supreme Court, citing their de novo standard of review, disagreed and reversed.  The Supreme Court explained that although the Court of Chancery put forth a “thorough and careful” examination of the facts, to examine those facts in isolation rather than on the whole missed the mark of an independence analysis.  The Court then focused on allegations relating to director Jackson.

The Chairman and Jackson have been friends for more than fifty years.   Consistent with that friendship, when the Chairman ran for Governor, Jackson donated $12,500 to his campaign.  Though the Court has previously announced in cases like Beam v. Stewart, that loose allegations that directors are “within the same social circles” are not enough, the Court found the instant situation distinguishable.  In this case, Jackson and the Chairman have been friends for five decades —the sheer duration of which can be characterized as “precious” and “rare.”

Additionally, the Chairman had substantial influence as both a director and the largest shareholder of a parent company that wholly owned an insurance brokerage subsidiary from which Jackson derives much his personal his personal wealth.  The subsidiary employs both Jackson —and Jackson’s brother — full time.  The subsidiary also provided brokerage services to Sanchez Energy and other Sanchez-family affiliates and Jackson and his brother both serviced that work.

The Supreme Court held that the Court of Chancery erred when it treated the facts related to Jackson and Sanchez’s longtime friendship and the facts regarding their business relationship as entirely separate issues.   Instead, when considered in their totality, the Court held that these facts supported a pleading-stage inference in favor of the plaintiffs that Mr. Jackson could not act independently of the Chairman.  Furthermore, while it would have been ideal for the plaintiffs to use Section 220 to gather more information about the transaction, the Court “cannot hold the plaintiffs’ failure to undertake additional investigation against them when, as here, the facts pled in the complaint support an inference that a majority of the board lacked independence.”

It is important to note that this opinion was decided in the context of the defendants’ motion to dismiss, thus it is still unknown how the Court of Chancery will hold on remand with a more developed record.  Moving forward, however, it is important for Delaware corporations to be aware of close personal relationships between their directors and any party with a financial stake in a contemplated transaction.  Because directors and officers often operate in overlapping social and business networks, it is important for corporations to regularly examine the composition of their boards and committees (as well as that of their subsidiaries) so they may determine which of their directors, officers, or shareholders could have a financial interest in a transaction or have ongoing personal relationships that could compromise their independence in approving a transaction.  This circumstance is most likely to occur in small boards.  Because Delaware law generally gives deference to decisions approved by a majority of independent directors, corporations should also carefully consider whether to hire a greater number of outside directors.

Sabrina Hendershot is the External Managing Editor of the Delaware Journal of Corporate Law and President of the Delaware Law Transactional Law Honor Society.  Sabrina also serves as a Josiah Oliver Wolcott Fellow to Justice Collins J. Seitz, Jr. of the Delaware Supreme Court.

Suggested Citation: Sabrina M. Hendershot, Director Independence Analysis Refined, Del. J. Corp. L. (Nov. 13, 2015), www.djcl.org/blog.

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Bargaining Away Fiduciary Duty: Considering Partnership Agreements After Kinder Morgan

Donald Huddler

The recent Dole and Kinder Morgan Court of Chancery opinions highlight the differing roles of fiduciary duties in corporations and limited partnerships.  The Dole shareholder litigation questioned the actions of corporate board members in considering an insider offer to buy the outstanding public shares to take the company private. In Kinder Morgan, limited partners were challenging the general partner’s decisions in negotiating a complex merger transaction that resulted in differing treatments for different classes of limited partners.  This post (i) summarizes the basic fiduciary duties of corporate fiduciaries and limited partnership fiduciaries, and (ii) considers how the facts in Dole would be treated if they were governed by the terms of the Kinder Morgan partnership agreement.  Thus, this analysis will probe the outer limits of permissible conduct under limited partnership agreements.

In November 2013, Dole Food Company, Inc., was a publicly traded Delaware corporation.  David Murdock, the chairman and CEO, held roughly 40% of the company’s common stock, making him the single largest shareholder.  Murdock had previously held the company privately, but had sold a portion of Dole’s equity to the public to generate capital during the 2009 economic downturn.  He aimed to return the company to his private control.  To effect his take-private plan, he pursued typical advisory and planning activities with both financial and legal advisors; however, he also launched a scheme to undermine and short circuit the independent directors and the special committee that would eventually consider his take-private proposal.  Working with Dole board member and general counsel, Michael Carter, whom the court termed Murdock’s “right-hand” man, Murdock thwarted the work of the independent directors and the special committee.  Carter actively subverted the directors, most effectively by giving them false earnings projections and other fabricated financial forecasts.  Carter’s efforts caused the special committee to undervalue the company and to eventually accept an artificially low price from Murdock. The court found that Murdock and Carter’s campaign constituted clear fraud.  The fraudulent scheme fundamentally violated the well-established entire fairness standard.  Further, Carter specifically breached his “duty of loyalty to the corporation” and acted in bad faith.  The court held Murdock and Carter jointly liable for the $148 million price differential between the price accepted by the independent directors because of their scheme and a conservative estimate of the enterprise’s potential market value at the time of the take-private transaction.

Dole highlights the duty of corporate fiduciaries to act in good faith and observe their primary loyalty to the corporation and its shareholders.   These duties are the foundation of Delaware corporate law.   To escape these duties or to weaken them to allow more flexible decision making, alternative business forms are required.  Limited partnership agreements are a means, through contract, to completely customize the fiduciary relationships and duties owed to the enterprise.

Kinder Morgan provides a concrete example of other well-settled Delaware law: Parties get what they bargain for, even if they are unhappy in the end.  In this case, the parties modified the duties of the General Partner and eliminated the common law fiduciary duty to the partnership when considering a merger or “other significant transactions.”  The Kinder Morgan partnership agreement empowered the General Partner to engage in any transaction authorized under the agreement “so long as such action is reasonably believed by the General Partner to be in, or not inconsistent with, the best interests of the Partnership.”  The court points out that the addition of  “reasonably” distinguishes the Kinder Morgan partnership agreement from those that have been interpreted to maintain the general good faith standard.  This single word insertion transforms the standard, common law duty of loyalty into a less well-defined and reduced duty of reasonable belief. 

The core allegation in the Kinder Morgan litigation is that the general partner favored the holders of the General Partnership shares over the holders of the common unit shares and that this favorable treatment stems from the fact that the general partner owned more GP delegate shares than common unit shares.  Applying the terms of the partnership agreement, in light of Norton, the court found that the merger and the consideration paid was reasonable and within the scope of the duty outlined in the agreement.  Fundamentally, the court recognized the general structural conflict that directors of the general partner confront when they make decisions for the limited partnership: They are not disinterested, independent directors.  The parties explicitly bargained for the less than common law fiduciary duty; the outcome was a reasonable decision that reduced the cost of capital for the General Partner, and provided similar consideration to all the shareholders, but distributed the gain to the limited partners yielding significant tax liability, to their unique detriment.  Further, the court noted that the primary duty under the agreement was to the partnership, not the holders of the limited partnership common units.  The court found, under the provisions of the partnership agreement, the transaction terms, despite the detriment to common unit holders, to be reasonable from the perspective of the partnership.

Considering the two fact patterns and the differing legal framework, an interesting question emerges: What are the limits of the “reasonable belief” standard in the Kinder Morgan partnership agreement?  Evaluating the Dole facts, which feature fraud and deception, under the Kinder Morgan regime may be instructive.  For this thought experiment, the Dole board will be considered general partners and the shareholders limited partners.

Murdock and Carter, the fraudulent actors, are both decision makers for the general partner.  The independent directors are the unconflicted General Partner decision makers.  The fundamental question is whether Murdock and Carter’s fraud, the false financial forecasts and efforts to depress the stock price, vitiate a reasonable belief that taking the company private may be in the best interest of the General Partner members.  Clearly, the take-private transaction is not in the interest of the Limited Partnership shareholders, but the duties here attach to the partnership proper and not the common unit shareholders.

Who benefits: Here Murdock directly benefits from his and Carter’s actions.  For each dollar the publicly traded shares are depressed, Murdock gains and the other LP shareholders lose.  Does the partnership proper gain? A close reading of Kinder Morgan suggests that if there were a reasonable belief that the depressed price take-private transaction would be in the interest of the partnership, the merger would pass muster under the reduced partnership agreement duties.  Once the Murdock offer was public, other suitors considered acquiring Dole; in the absence of the fraud, those suitors may have paid a higher price for the enterprise.  Does this possibility suggest that accepting the Murdock take-private was either not “in the best interests of, or not inconsistent with, the best interests of the Partnership?”  Unlike Kinder Morgan G.P., Dole was not facing increasing costs of capital nor other significant business headwinds.  The driver for the take-private transaction appears to mostly have been Murdock’s personal desire to completely control the company.

Despite Murdock’s fraud, it is not entirely clear that the minimal duty articulated in the partnership agreement would be violated.  Clearly, the limited partners are adversely affected, but they are not owed the fiduciary duty; the partnership proper is.   With the freedom of contract, comes the liberty to negotiate weakened duties.  Rabkin v. Philip A. Hunt Chem. Corp., illustrates the bedrock principle of Delaware business organization law, that fraud is not tolerated.   Perhaps under partnership agreements with weakened fiduciary duties, fraud may not, indeed, vitiate all.

These two recent Court of Chancery cases illustrate the two different options for Delaware business organizations: The corporation with the safeguards of independent directors and, if a conflict is present, the rubric of entire fairness or alternatively the freedom of contract, where parties may construct their own duties under a partnership agreement.  The latter case signals that the partnership investor should beware.

Don Huddler is a second-year student at Widener University Delaware Law School and a Staff Editor of the Delaware Journal of Corporate Law.  Don is also a Judicial Intern to the Honorable Gregory M. Sleet in the United States District Court, District of Delaware.

Suggested Citation: Donald Huddler, Bargaining Away Fiduciary Duty: Considering Partnership Agreements After Kinder Morgan, Del. J. Corp. L. (Oct. 18, 2015), www.djcl.org/blog.

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Chancery Court Issues Discretionary Remedy to Dole Shareholders in Fraud

Brandon Harper

In an August 27, 2015 Chancery Court opinion, Vice Chancellor Laster awarded shareholders of Dole Food Company damages upwards of $148 million for CEO David Murdock’s and President and COO C. Michael Carter’s fraudulent violation of their fiduciary duties.  The Vice Chancellor came to the particular damage amount of $148,190,590.18 by no arbitrary means.  In fact, an evaluation of the shareholders’ deserved “fair price,” when determined in light of fraud and unfair dealing, entitled shareholders to what the court declared a “fairer price.”  Vice Chancellor Laster’s standard of review and determination of remedy are both noteworthy of exploration as they seek to right the wrongs of Murdock and Carter’s breaches of their fiduciary duty.

CEO Murdock’s goal was to buy Dole, and in order to do so at a discount, he and Carter misled the Board and defrauded shareholders by understating the company’s profitability. 

On June 10, 2013, Murdock proposed a $12.00/share buyout to the board of directors (the “Board”) of all remaining common stock in Dole.  Carter conducted two key meetings where Dole’s performance and profitability were presented.  In a July 11, 2013 meeting with the Board and a committee of independent directors (the “Committee”), Carter provided falsified projections for the coming month where he showed a 20% decrease from that year’s first half numbers.  The following day, unbeknownst to the Board and the Committee, Carter held a lender meeting with Murdock’s bankers where much more positive, promising, and true figures were offered.  Amid this collective and on-going fraudulent dealing, the Board agreed with Murdock on a merger price of $13.50/share in November 2013.  These inaccurate meeting projections represented a share price discrepancy as large as $6.84, but Vice Chancellor Laster, upon his discretion and operation under the doctrine of “entire fairness,” settled on a $2.74/share award to shareholders. 

Under the entire fairness doctrine, both fair dealing and fair price are evaluated to determine if the business practice was, overall, conducted devoid of any fraud.  Fair dealing considers the following factors: timing of the transaction; how it began; how it was structured, negotiated, and disclosed to the board; and how the board and stockholders gave approval.  Vice Chancellor Laster quickly concluded that there was no fair dealing on the parts of Murdock or Carter because they both acted with fraud and misrepresentation to the Board and the Committee in communicating suppressed profit projections.  “[A] calculated effort to depress the [market] price” of Dole’s share price “until the minority stockholders [were] eliminated by merger or some other form of acquisition” is a clear indication of unfair dealing. 

Fair price is comprised of: “assets, market value, earnings, future prospects,” and any other factors that affect the value of the company.  Vice Chancellor Laster indicated that a “fair price” is not identified as a “point on a line” but rather shown as a “range of reasonable values.”  The court found that Murdock’s agreed upon $13.50 price was within the “range of fairness,” but after accounting for Carter’s fraud in the July 11 Board meeting, the price slipped below the range of fairness.

The specific areas in which Carter undercut Dole’s value and misled the Board and Committee were in cost-cutting initiatives and planned farm purchases.  First, Dole’s cost-cutting plan – which was delayed by Murdock and Carter – reached $30 million in savings, which the plaintiffs calculated as an increase in share price of $3.80.  Second, Carter presented the lender banks with a prediction of Dole’s ability to spend $100 million to purchase new farms.  The plaintiffs’ expert calculated a more reasonable expectation of future farm purchases in the amount of $28.6 million in Ecuadorian farms, which would increase the share price by $1.22/share.  Adjusting for Carter’s projection of the $100 million in farm purchases, the share price yielded would have been $3.04.

Where shareholders could have seen an adjusted share value of (at most) an additional $6.84 per share, the Vice Chancellor tapered the damages back to $2.74/share.  He came to this value by assessing that plaintiffs’ adjustments for defendants’ activity and misrepresentations in cost-cutting ($3.80) and farm purchases ($3.04) were overvalued.  He commented that the cost-saving initiative was less certain than Dole’s established business and the incremental cash flows from it were overvalued.  He therefore adopted the $1.87 cost-cutting number from the defendants’ expert as a more modest award.  For farm purchases, he fairly utilized the plaintiffs’ request as they had only accounted for $28.6 million for farms, equaling an additional $0.87/share.  Through these tweaks, the court arrived at $2.74 to be paid to shareholders.

The fiduciary breach here is evident.  From his influential seat as CEO, Murdock orchestrated the diminution of Dole’s share price in order to leverage a more attractive purchase price for his own takeover.  What is not entirely evident is how the court arrived at the remedy.

Vice Chancellor Laster explained that by engaging in fraud, Murdock and Carter deprived the Board and the Committee of their “ability to obtain a better result on behalf of the stockholders, prevented the committee from having the knowledge it needed to potentially say ‘no,’ and foreclosed the ability of the stockholders to protect themselves by voting down the deal.”  Thus, because of their fraud, they prevented Dole’s shareholders from obtaining a better price.  Therein lies the remedial issue. Perhaps the Vice Chancellor is answering the question “how much better?” when he says the plaintiffs are entitled to a “fairer price.”

Because the agreed upon merger price of $13.50  was tainted by fraud, Vice Chancellor Laster determined that plaintiffs were entitled to a “fairer price.”  It seems that the goal in reaching a remedy was for the court to analyze what merger price could have been obtained, had Murdock’s fraud never occurred.  If Carter had not fraudulently undervalued profit projections, Dole could have negotiated a better price than $13.50.  In fact, Murdock’s fraud reduced the price by 16.9%.

The Vice Chancellor awarded the remedy by taking into account the fraud exhibited by Murdock and Carter.  In assessing the original merger price range, plaintiffs’ financial advisors Lazard Frères & Co. LLC calculated a range of $11.40 to $14.08 (midpoint $13.50 agreed upon by Murdoch and the Board).  Instead of adding the $2.74 damages to the midpoint of this prior range to reach a new share price of $15.48 (only $1.98 more than original $13.50 midpoint value), Laster determined that the plaintiffs were entitled to the full incremental $2.74 value and awards plaintiffs $16.24 fairer value price.  That incremental adjustment of $2.74 more per share represents the consequential damages the shareholders deserve.

Interestingly, the court commented that the full $6.84 damage award would be “harsh, except as a form of rescissory damages,” which is elaborated in footnote 40, but muted in the body of the opinion.  The footnote explains that, due to the fraud, rescissory damages of $6.84 per share could have been appropriate.  This begs the question: Why not award rescissory damages?  One answer may be the $2.74 value better exemplified the consequential value of the effect of Murdock’s fraud.

Had the fraud never occurred, shareholders would have achieved a better price than $13.50.  That is the meaning of “fairer price.”  Based on its findings, the court believes the plaintiffs would have received  higher value for their Dole shares had Murdock and Carter never committed fraud.  It seems that by pushing the award from the $15.48 fairness midpoint to $16.24, the court is awarding consequential damages due to the fraud.  Even though $13.50 may have been within the range of fair value, a price beyond the midpoint – a fairer price – is deserved because of Murdock’s fraud.

Brandon Harper is a second year student at Widener University Delaware Law School and a Staff Member on the Delaware Journal of Corporate Law.  Brandon has experience working in the private sector in banking at JP Morgan and regulatory compliance with Freeh Group International.  He has also worked in the public sector with the Delaware Department of Justice and is a current judicial intern with the Honorable Vivian Medinilla in the Delaware Superior Court. 

Suggested Citation: Brandon Harper, Chancery Court Issues Discretionary Remedy to Dole Shareholders in Fraud, Del. J. Corp. L (October 4, 2015), www.djcl.org/blog.

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Amendments to DGCL Sections 204 and 205: Another Example of How Delaware Does Corporate Law Best

Jacob Fedechko

The recent amendments to 8 Del. C. §§ 204, 205 are prime examples of how the Delaware legislature facilitates the development of corporate law by enhancing flexibility in corporate affairs.

Sections 204 and 205 first became part of the DGCL in 2014 and were enacted in response to several decisions from the Delaware Supreme Court and Court of Chancery that held corporate acts, such as stock issuance, are void unless they strictly comply with formalities prescribed by the DGCL or other authority.  The judiciary took the approach that once an act is void it cannot be saved by subsequent measures “regardless of the equities.”  In an effort to alleviate the potentially harsh consequences created by this approach, the legislature enacted Sections 204 and 205.  Section 204, the “‘self-help’ provision,” specifically empowers corporations to cure defective acts.  Section 205 is the “court-assisted” validation provision, which permits the Court of Chancery to validate (or invalidate) a defective act upon petition.

Since these statutes are in their infancy, it is not surprising that Sections 204 and 205 have only been cited in three and five Delaware decisions respectively.  All of these decisions were from the Court of Chancery.

Short shelf life has not prevented the legislature from amending 204 and 205 to create clarity and even greater flexibility.  The following is a list of the recent amendments:

(1) Clarification that Section 204 permits directors to cure multiple defective acts in a “single set of resolutions”;

(2) Creation of section 204(b)(2), which allows “de facto” initial directors who are unnamed in the articles of incorporation or unelected (or whose election cannot be sufficiently established) to pass a resolution ratifying their election;

(3) Clarification of section 204(d), which provides that “only stockholders entitled to vote on the ratification of a defective corporate act, or be counted for purposes of a quorum for such vote, are the holders of record of valid stock as of the record date for determining stockholders entitled to vote thereon”;

(4) Clarification and streamlining of section 204(e) to create uniformity among certificates of validation;

(5) Clarification of notice requirements under section 204(g) related to stockholder ratification of defective corporate acts by written consent;

(6) Clarification of the “validation effective time” under section 204(h)(6), which was “intended to obviate logistical issues that may arise in connection with the delivery of notices in situations where multiple defective corporate acts are being ratified at the same time”; and  

(7) Structuring the 120-day challenge period under section 205(f) to reflect the amendments to Sections 204(g) and 204(h)(6) “to provide that no such action may be brought after the expiration of 120 days from the later of the validation effective time and the time that notice of the ratification is given under Section 204(g).”

The common theme among these amendments, and the original statutes themselves, is practicality.  While strict compliance with formal requirements is most desirable, it is a fact of life that mistakes happen.  There is no reason that relatively minor errors in formalities should have “disproportionately disruptive consequences” impeding a company’s ability to conduct business.  This is especially true when the parties are under the belief that the acts in question were valid and the corporation is ready and willing to ratify those acts.  The efficiency created by 204 and 205 shows the legislature’s approach to enacting these statutes was more like that of a board of directors than a group of politicians.

It is also noteworthy that these statutes will not permit corporations to ratify “acts” that never really occurred.  The Court of Chancery has made clear that not “every conversational agreement of two of three directors” is a corporate act.  The court stated in Numoda that it “looks to organizational documents, official minutes, duly adopted resolutions, and a stock ledger, for example, for evidence of corporate acts.” 

In describing the reasons why Delaware is the favored state for incorporation, Lewis Black noted, “the legislature has developed a philosophy that emphasizes the stability of Delaware corporation law.”  Sections 204 and 205 are just another example of how the legislature maintains stability by enacting laws that foster an environment conducive to efficient business administration. 

Jacob Fedechko is the Editor-in-Chief of the Delaware Journal of Corporate Law, Volume 41.  He is also a Judicial Intern to the Honorable James T. Vaughn, Jr., Justice of the Supreme Court of Delaware.

Suggested Citation: Jacob Fedechko, Amendments to DGCL Sections 204 and 205: Another Example of How Delaware Does Corporate Law Best, Del. J. Corp. L. (Aug. 17, 2015), www.djcl.org/blog.

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In El Paso the Court of Chancery Found that the Modification of Fiduciary Duties Does Not Grant carte blanche

Thibaut Lesure

This decision comes as a reminder that even though a limited partnership agreement may eliminate, expand or limit its partners’ fiduciary duties through express and unambiguous language, the duty of good faith and fair dealing remains.  Indeed, under Delaware law, fiduciary duties in limited partnerships can be modified and even eliminated, but particular care must be taken to ensure the prudent drafting of these new provisions and to ensure the strict compliance of the directors regarding the remaining duties.

In El Paso, the transaction at issue was the second of a series of dropdown transactions.  These transactions are frequent in the energy sector and entail the acquisition of assets by a corporation, followed by a contribution of those assets to a partnership.  This allows the corporation to obtain tax benefits and low cost capital via the cash paid by the controlled entity for the asset.  The El Paso Corporation (“EPC”), which is today owned by Kinder Morgan, is the parent corporation of El Paso Pipeline Partners, L.P. (“El Paso Partners”) via its sole general partner (the “General Partner”).  Since March 2010, the parent company engaged in the so-called dropdown transactions.  First, it sold a 51% interest in one of its subsidiaries (“Elba”) to El Paso Partners, another subsidiary for approximately $963 million in cash (the “Spring Dropdown”).  In November 2010, the so-called “Fall Dropdown” included the sale of the remaining 49% interest, and additionally a 15% interest i n another EPC subsidiary (“Southern”) for $1.412 billion to El Paso Partners.  This sale was a two-step “dropdown” —the “Spring Dropdown” and the “Fall Dropdown.”  However, the court had only ruled on the Fall Dropdown, having granted summary judgment in the defendants’ favor on the Spring Dropdown.

Following the procedures of the limited partnership, the transactions were reviewed and approved by a committee of three directors of the General Partner’s board (the “Committee”). This Committee was advised for each of the transactions by outside counsel and a financial adviser, Tudor, Pickering, Holt & Co. (“Tudor”).

After the completion of both transactions, limited partners sued the General Partner in 2011.  The claim was based on the alleged breach by the General Partner of the obligation under the limited partnership agreement that the Committee members have the “subjective belief” that the dropdowns were in the “best interests” of El Paso Partners.

The Court mentioned several failures regarding the committee’s task and valuation analysis.  According to Vice Chancellor Laster, it seemed that the committee members’ actions “evidenced conscious indifference to their responsibilities” to shareholders. The Court based its analysis on the exchange of emails between members where doubts regarding the transaction were expressed. Despite these doubts, committee members agreed on the price proposed, in all likelihood with the intent to please EPC management.

Moreover, the Committee did not seem to be concerned about past mistakes.  Following the completion of the Spring Dropdown, the market responded negatively—common units of El Paso Partners traded down 3.6% on the news.  The court pointed out that the Committee did not negotiate harder, failing in its duty to compare to similar transactions, in a deteriorated market. To the court, the Committee members had “consciously disregarded their own independent and well-considered views.”

The Committee members seemed to have been only concerned by the “accretion” of the transaction —that is, the increase of earnings per share.  The Court noted the irrelevant character of this element, regarding the analysis of the fair price, since the consideration used has been changed. This shortsighted analysis, forgetting the creation of value in the long term, cannot be considered being in the best interests of the MLP.

Forgetting their essential duties, the Committee’s task had not been facilitated by its financial adviser, Tudor.  With strong words, the Court found that Tudor’s work was biased and prevented any possible confidence in the Committee. He voluntarily miscalculated the risk associated with the deal in using irrelevant numbers in his Discounted Cash Flow analysis, he used a deceptive discount rate.  And ultimately, making any analysis impossible, contrary to the first dropdown, he did not divide into separate minority-acquisition and majority-acquisition groups; therefore, he “manipulated the deal process through malfeasance.”  The Committee members, who already did not seem very inclined to deepen and broaden their investigations, were duped by a financial adviser trying to make the transaction appear as attractive as possible. In the context of the transaction at issue, the members committee seemed to have consciously disregarded what they were supposed to have learned from the previous transactions and their judgments in the official transaction documents “stood in tension with their privately expressed views.” They were not convinced that this transaction was in the best interests of the Partnership and they caved in to the General partner to achieve “Parent’s goal of raising inexpensive capital.

On the basis of the analysis of the amount overpaid by the partnership for the transaction, the court came to the conclusion that the General Partner should compensate the partnership $171 million.  The lawsuit had been conducted through a derivative claim.  Thus, the money will end up in the coffers of the limited partnership.

This decision is of particular significance because partnerships are often used by parent companies as investment vehicles in order to obtain tax benefits and freely deal with the affairs of the general partners.  It confirms the idea that there is still a possibility to scrutinize compliance with contractual standards.”  The large freedom afforded by the laws of Delaware regarding the limitation of the possibilities of conflict of interests and involvement in the business through the general partner should not obscure the need to comply the general partner’s contractual obligations.  It would be a mistake to see the use of these conflicts committees as a mere formality, serving to give carte blanche to the parent company. This decision adds to the already exhaustive list of cases dealing with conflict of interests.

Thibaut Lesure is a French LLM student studying corporate law and finance at Widener University Delaware Law School.  He has a Master’s in International and European business law and will study in a French business school next year before taking the French bar exam

Suggested Citation: Thibaut Lesure, In El Paso the Court of Chancery Found that the Modification of Fiduciary Duties Does Not Grant carte blancheDel. J. Corp. L. (July 6, 2015), www.djcl.org/blog.

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Proposed Financial Firm Tax

Brian J. King

On January 17, 2015, President Obama, in a White House press release, proposed a “7 basis point fee,” or tax on the liabilities of financial institutions with assets over $50 billion (“Liability Tax”).  This tax is expected to raise $110 billion over the next ten years to fund the President’s proposed middle-class tax breaks.  It is one of many changes proposed to support “a $500 credit for families in which both spouses work; increased child care and education credits; and incentives to save for retirement.”  Another leading proposal is being championed by Dave Camp (R, Mich.), former Chairman of the House Ways and Means Committee.  Camp proposed a similar tax—the Tax Reform Act of 2014 (“Camp’s Proposal”), in February 2014.  At the time, Camp’s proposal was considered “the most significant revision to the [Internal Revenue Code] since the Tax Reform Act of 1986” if enacted.  There are problems with both President Obama’s proposal and Camp’s Proposal.

The Liability Tax hike is not the first time President Obama has proposed a new tax on financial institutions.  In January 2010, the President proposed the “Financial Crisis Responsibility Fee,” which ultimately did not come to fruition.  The 2010 proposal is very similar to his 2015 proposal in that the tax would have targeted financial institutions yielding enormous profits and offering large executive compensation packages.  President Obama’s proposed Liability Tax would not tax bank assets directly, but rather would levy a tax on their liabilities, or the amount of debt they owe, known as “leverage” in the financial services industry.

Like President Obama’s Liability Tax, Camp’s Proposal contained a tax on “systematically important financial institution[s] . . . subject to section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act,” i.e, financial institutions with assets over $50 billion.  Section 7004 of Camp’s proposal contained a 0.035 percent excise tax on the excess total consolidated assets of these important financial institutions, which was expected to raise $86.4 billion over ten years. Camp immediately met staunch opposition from members of his own party who claimed, like many financial institutions claimed, that the tax would reduce access to credit, stifle economic growth, and worsen the unemployment problem.  Furthermore, Camp may face constitutional problems with assessing a direct tax on a bank’s assets.

The White House Press Fact Sheet indicates that President Obama’s Liability Tax proposal is “consistent” with Camp’s Proposal.  Yet, though the structure of the two tax proposals may be similar, the purposes behind each are not truly “consistent.”  According to the White House Fact Sheet, the purpose of President Obama’s Liability Tax on these large financial firms is to “lead[] them to make decisions more consistent with the economy-wide effects of their actions, which would in turn help reduce the probability of major defaults that can have widespread economic costs.” In this manner, President Obama’s proposal acts more as a proverbial carrot, intended to lead financial institutions toward the desired practice of decreasing leverage, and therefore, risk. On the other hand, Camp’s office stated that “the new tax ‘would address the significant implicit subsidy bestowed on big Wall Street banks and other financial institutions’ due to the perception they are ‘too big to fail’ and would be backed by the government in a crisis.”  In this sense Camp’s Proposal, while accomplishing the same practical effect, seems to position the government as an insurance provider, collecting premiums until the time these financial institutions fail again and require further bailouts.

The Obama-proposed new tax on leverage is problematic because it cuts to the core of how banks make money—that is, by borrowing money and using it to make more money.  Some scholars have conducted studies on what could happen to the economy if a tax like the Liability Tax was imposed on banks.  These scholars have suggested that large banks are not as responsive to taxation as smaller banks.  Further, while the financial crisis of late 2008 was caused in large part by banks taking on too much debt, and a tax on this debt would serve a deterrent effect, the financial crisis was also largely caused by the quality of debt the banks undertook—namely subprime mortgages—and not just the volume of debt.

Regardless of motive, President Obama is likely to face opposition to his proposal from financial firms and politicians.  The President’s Liability Tax will affect many firms incorporated in Delaware including JPMorgan Chase & Co., Bank of America, Citigroup, Wells Fargo, Goldman Sachs, Morgan Stanley, and General Electric.  These corporations could pay “at least hundreds of millions” of dollars in taxes.  Some of these firms have already lobbied against Camp’s proposal out of fear of the repercussions of the tax. In fact, fifty-four Republicans signed a letter to Camp expressing their concerns regarding the potential negative of effect on the economy because of Camp’s proposal.

Any proposed tax on financial institutions will likely be met with this type of resistance, as well as the perpetual argument that new taxes will have a chilling effect on economic growth. Critics immediately began voicing their outrage and concern over the President’s 2015 proposal, which was released three days before the annual State of the Union Address, but which was not discussed during the Address.  According to the Securities Industry and Financial Markets Association (“SIFMA”), President Obama’s Liability Tax could have an adverse effect on the market because “banks [will be] less likely to lend,” as it will raise the cost of capital.  The lobbying group also claimed that this tax is “duplicative” of the Dodd-Frank Act, which is currently facing attacks by Republican lawmakers.  However, some critics have said that the Liability Tax will lead to banks “shrink[ing]” their liabilities and will encourage them to seek other avenues to raise money such as selling shares.

            Considering all of the competing opinions on taxing banks’ leverage, and the studies conducted on this issue, the question comes to mind: Is President Obama’s plan simply a Pigovian tax, spawn from a sincere concern for the economy, or is it a romantic Robin Hood plan to raise revenue?  It will be interesting to see how President Obama’s proposal plays out in 2015. Much like the scrutiny Camp faced from his fellow Republicans, President Obama’s Liability Tax certainty will not see overwhelming support in the Republican-controlled House.  Although President Obama was successful in encouraging the Dodd-Frank Act, it appears that his latest proposal will see the same fruitless fate as his 2010 Financial Crisis Responsibility Fee proposal, as it should.

Brian J. King is a recent graduate of Widener and a former staff editor on Volume 40 of the Delaware Journal of Corporate Law. He was also the President of the Intellectual Property Society. Brian works full time as a Business Development Manager at CSC Digital Brand Services.

Suggested Citation: Brian J. King, Proposed Financial Firm TaxDel. J. Corp. L. (June 6, 2015), www.djcl.org/blog.

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Direct Mktg. Ass’n v. Brohl: A Temporary Win for On-Line Retailers

Adam Young

In a recent decision, Direct Mktg. Ass’n v. Brohl, the United States Supreme Court held that the Tax Injunction Act (“TIA”) does not bar out-of-state retailers from challenging Colorado’s notice and reporting requirements in federal court.  In 2010, amid an explosion in online retail sales to Colorado residents from out-of-state retailers that were not liable for collecting sales tax, the Colorado legislature enacted a statutory notice and reporting requirement for non-collecting retailers.  Colorado’s notice and reporting requirement required out-of-state retailers to provide the state with information regarding all sales of $500 or more to Colorado residents if at the point of sale, they were not subject to collecting and remitting sales tax. The notice and reporting requirements impose three obligations on out-of-state retailers whose gross sales in Colorado exceed $100,000: they must (1) provide transactional notices to Colorado purchasers, (2) send annual purchase summaries to Colorado customers, and (3) annually report Colorado purchaser information to the Colorado Department of Revenue.

The issue stems from the doctrine announced in a 1992 opinion, Quill v. North Dakota, where the United States Supreme Court held that a state violates the dormant Commerce Clause if it requires an out-of-state retailer to collect and remit sales and use taxes if there is no “substantial nexus” between the out-of-state retailer and the taxing state. Quill protects out-of-state retailers from collecting and remitting sales and use taxes merely because they do not to have a brick and mortar presence in the state. Under this doctrine, currently out-of-state retailers have an advantage over in-state retailers because out-of-state retailers can sell their products at a lower total price, which excludes sales tax.

Colorado’s notice and reporting requirements were a clear attempt to work around the Quill doctrine by requiring informational reporting instead of imposing a tax. The TIA provides that federal district courts “shall not enjoin, suspend, or restrain the assessment, levy or collection of any tax under State law.” In reversing the Tenth Circuit, the Supreme Court determined that Direct Marketing Association’s (“DMA”) suit seeking to enjoin Colorado from imposing its notice and reporting requirements on out-of-state retailers without a “substantial nexus” to Colorado would not “enjoin, suspend or restrain the assessment, levy or collection” of Colorado taxes.  Specifically, the Court held that Colorado’s notice and reporting requirements were not an assessment, levy or collection when read in light of the Internal Revenue Code. The Court found that assessment, levy and collection refer to “discrete phases” of the taxation process and did not include informational reporting relevant to tax liability. Furthermore, the Court determined that DMA’s suit would not “restrain” assessment, levy or collection because “restraints” under TIA refer to orders by the federal district courts that stopped, rather than merely inhibited, acts of assessment, levy or collection.

The Court correctly reversed the Tenth Circuit and permitted DMA’s suit to remain in federal court. This decision permits online retailers to maintain challenges to similar notice and reporting requirements in federal district court rather than state court. Additionally, by permitting DMA to maintain its suit and enjoin the notice and reporting requirements, the Court has, for now, effectively protected consumers by banning the State of Colorado from forcing out-of-state retailers to submit confidential consumer information to the Colorado Department of Revenue. 

Justice Kennedy’s concurring opinion may be the most important part of the decision as it called the Quill doctrine into question and asked for an appropriate vehicle for the Court to make a decision on the merits. In his concurrence, Justice Kennedy stated that the “the legal system should find an appropriate case for this Court to reexamine Quill.”  As such, the Court put the “legal system” on notice that Quill is outdated in the technological era, since it is possible for an out-of-state retailer to have a substantial nexus to a state through the internet even if the retailer does not have a physical presence in that state.

Although not explicitly stated, the Quill doctrine gives out-of-state retailers a competitive advantage since they do not have to collect and remit sales taxes as in-state retailers are forced to collect and remit.  The decision may have been correct in 1992 when the internet was in its infancy stages, but the “physical presence” requirement of Quill was outdated in as early as 2000 when e-commerce accounted for over $29 billion in retail sale revenue nationwide. By at least 2011, Quill was entirely obsolete when “nearly 70% of American consumers shopped online.” Furthermore, Colorado’s sales and use tax losses —in 2012 alone— were estimated to be around $170 million.

The Court’s narrow definition of the TIA and Justice Kennedy’s message that the Quill doctrine should be reexamined, serves as a warning to the states to tread lightly when enacting similar notice and reporting requirements, and puts out-of-state retailers on notice that their competitive advantage over in-state retailers is coming to an end. Practitioners and courts alike should be on the lookout for the Supreme Court to take up and revise its decision in Quill so that states do not continue to lose massive revenue in the future.

Adam Young is a third year law student at Widener University School of Law and will be pursuing an LL.M. in Taxation at Georgetown University Law Center in the Fall of 2015.  During his third year of law school, Adam interned for the Honorable Christopher S. Sontchi in the United States Bankruptcy Court for the District of Delaware as well as for the Internal Revenue Service, Large Business and International Division.

 Suggested Citation: Adam Young, Direct Mktg. Ass’n v. Brohl: A Temporary Win for On-Line Retailers, Del. J. Corp. L (May 18, 2015), www.djcl.org/blog.

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Proposed Forum Selection Amendment Reinforces Boilermakers, Spells Waterworks for City of Providence and, As Always, Delaware Prevails

Kyle Wu

In the beginning, there was New Jersey.  New Jersey dominated the corporate law world at the turn of the twentieth century and was able to boast that the state was home to most of the largest corporations in the country.  Delaware, New Jersey’s next-door neighbor, did not sit back and watch New Jersey reap all the benefits that come with being the corporate law capital.  In 1899, the General Assembly amended  Delaware’s incorporation statute to reflect New Jersey’s statute with two important changes: (1) incorporation in Delaware cost three-quarters the price of incorporating in New Jersey, and (2) Delaware’s annual franchise taxes were half that of New Jersey. Since Delaware adopted the new incorporation statute and New Jersey passed the “seven sisters” laws, Delaware has become the preeminent home for corporations and, by extension, corporate litigation.

Accordingly, it comes as no surprise that Delaware is an oft chosen forum for corporate litigation.  Delaware is now home to many Fortune 500 corporations and a judicial forum uniquely tailored to hear corporate matters: the Delaware Court of Chancery.  Delaware is not likely willing to give up lightly its century-long dominance in corporate litigation, yet recent decisions by the Chancery Court have seemingly left the door open for corporations to litigate elsewhere.

In Boilermakers Local 154 Retirement Fund v. Chevron Corp., then Chancellor, now Chief Justice, Leo E. Strine ruled that a forum selection clause in a corporation’s bylaws designating Delaware courts as the exclusive forum for disputes related to the internal affairs of the corporation is valid and enforceable under the Delaware General Corporation Law (the “DGCL”).  A little over one year after Boilermakers was decided, Chancellor Bouchard decided City of Providence v. First Citizens Bancshares, Inc.  In his opinion, Chancellor Bouchard applied the same analysis then-Chancellor Strine used in Boilermakers to validate the forum selection bylaw at issue and stated that “nothing in the text or reasoning of [Boilermakers] can be said to prohibit directors of a Delaware corporation from designating an exclusive forum other than Delaware in its bylaws.”  Thus, the door was officially open for Delaware corporations to choose an exclusive forum other than Delaware.

In the wake of the Chancery Court’s rulings in Boilermakers and City of Providence, the Council of the Delaware State Bar Association’s Corporation Law (the “Council”) has proposed an amendment to the DGCL dealing specifically with forum selection clauses contained within a corporation’s certificate of incorporation or bylaws.  The proposed amendment is two-fold: (1) a Delaware corporation’s certificate of incorporation or bylaws may designate Delaware courts as the exclusive forum for any or all intra-corporate claims, and (2) a certificate of incorporation or bylaws may not prohibit bringing intra-corporate claims in the courts of Delaware.  Put differently,  a Delaware corporation may designate a forum other than Delaware in a forum selection clause, but it must also leave (or be read to leave) the Delaware courts as a permissible forum.

Practically, the impact of the proposed amendment will be very limited.  As one scholar has already noted, “[w]e already have a national corporation law.  It’s called the Delaware corporation law.”  Corporations choose Delaware largely for the benefits the DGCL provides to their directors, officers, and shareholders, and the experience Delaware courts have in handling intra-corporate disputes.  What makes the DGCL work is that it is interpreted and enforced by those best suited to do so: the Delaware courts.  Absent a drastic change in the landscape of corporate law in Delaware, businesses incorporated within the State are unlikely to bring their intra-corporate disputes to other less well-suited fora, unless Delaware is precluded by some other law. 

The impact of codifying the ruling in Boilermakers merely gives statutory force to the ruling, as opposed to precedential force.  Many non-Delaware courts already respect and enforce the ruling in Boilermakers, and the proposed amendment, if adopted, will provide non-Delaware courts with even more reason to enforce a forum selection clause that selects Delaware as the exclusive forum.  Statutory prescription for the validity of such forum selection clauses will provide stronger grounds for those courts that have not previously enforced such clauses to enforce them in future decisions.  Further, while the ruling in Boilermakers is largely viewed favorably and in no immediate danger of being overturned, its codification in the DGCL precludes the possibility of it being overturned in future judicial decisions securing Delaware’s position as the dominant forum for intra-corporate disputes.

The latter half of the proposed amendment provides that a forum other than Delaware cannot be the exclusive forum for a Delaware corporation.  The proposed amendment does not prevent other states from ever being the forum of intra-corporate disputes; rather, it simply states Delaware must be an option and it is up to the parties to decide where to litigate.  This provision does two things:  (1) it overturns the ruling in City of Providence, and (2) ensures that Delaware courts will always remain an option for intra-corporate disputes of a corporation incorporated in the state of Delaware.  This portion of the proposed amendment is also logically sound.  If a corporation incorporates in a specific state, the corporation’s constituents should always be able to utilize the courts of that state as a litigation forum.    

The natural question that follows asks, “why can Delaware be the exclusive forum but another forum cannot, and what are the ramifications?”  The answer is simple:  the purpose of incorporating in Delaware is to take advantage of the DGCL.  Allowing an exclusive forum other than Delaware effectively turns the purpose of incorporating in Delaware on its head, and deprives a corporation’s constituents of the benefits they were intended to have by choosing to incorporate in Delaware.  Thus, allowing Delaware as an exclusive forum and disallowing other fora exclusivity achieves the purpose sought by corporations who incorporate in Delaware

In his opinion in City of Providence, Chancellor Bouchard hints at the notion that other courts will be reluctant to enforce bylaws selecting Delaware as the exclusive forum, pursuant to the ruling in Boilermakers, if Delaware does not allow for other non-Delaware fora to be designated as the exclusive forum for intra-corporate disputes. This concern, however, seems tenuous as numerous other courts have enforced bylaws such as those in Boilermakers since the case was decided and before knowing the Chancellor would rule in favor of an exclusive non-Delaware forum in City of Providence.  There is no inclination that those courts, which have enforced forum selection clauses of the Boilermaker-type, will soon change their minds.  Additionally, courts throughout the country are well aware of the fact that Delaware courts, specifically the Delaware Court of Chancery, are extremely well-versed in dealing with intra-corporate disputes and the various provisions of the DGCL.  Non-Delaware courts, in the interest of justice and judicial efficiency, would be doing the parties a disservice by not enforcing forum selection clauses that select Delaware as the exclusive forum for intra-corporate disputes.  

Notably, the ruling in City of Providence will have very little impact even if the proposed amendment is not adopted for the reasons already discussed.  The purpose of incorporating in Delaware, for many corporations, is to take advantage of the DGCL.  The best way for corporations to do so is for the Delaware courts, who are charged with interpreting and enforcing the provisions of the DGCL, to be the exclusive forum or to always be an option as a forum.  Corporations and their attorneys who mean to take advantage of the DGCL are not blind to this fact.  Until other jurisdictions can lure corporations away from Delaware with more favorable corporate laws, City of Providence will not have as much of an impact as feared.  The Council has nevertheless recommended addressing the issue before it can ever come to fruition.

Ultimately, if adopted, the proposed amendment will give Boilermakers statutory force and guarantee the logical result that constituents of a Delaware corporation will always have the option to choose Delaware as a forum to litigate intra-corporate disputes.  And if the proposed amendment is not adopted, the ruling in City of Providence will remain a minimal threat to Delaware’s preeminence in corporate litigation because the majority of intra-corporate disputes among Delaware corporations will select Delaware as the forum for litigation in light of the protections the DGCL provides and the judiciary’s experience and expertise in deciding intra-corporate disputes.  Thus, regardless of whether the proposed amendment is passed or not, Delaware will prevail.  

Kyle Wu serves as a Judicial Extern to the Honorable Sherry R. Fallon of the United States District Court for the District of Delaware, and he is currently completing the Business Organizations Law Certificate Program.

Suggested Citation: Kyle Wu, Proposed Forum Selection Amendment Reinforces Boilermakers, Spells Waterworks for City of Providence and, As Always, Delaware Prevails, Del. J. Corp. L (May 11, 2015), www.djcl.org/blog.

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Miramar Police Officers’ Retirement Plan v. Murdoch: Not Bound By The Past

Justin Forcier

On April 7, 2015, Chancellor Bouchard issued an opinion holding that a subsidiary corporation is not bound by a settlement agreement entered into by the parent corporation before the subsidiary was spun off.  In 2006, News Corporation (“Old News Corp”), the parent corporation, entered into a settlement agreement with its shareholders requiring it to obtain shareholder approval to maintain a stockholder rights’ plan (the “Rights Plan” or the “Plan”) for more than one year.  In 2013, Old News Corp spun off its newspaper and publishing businesses subsidiary (“New News Corp”).  The New News Corp board adopted a one-year shareholder rights’ plan, but ten days before the Plan was set to expire, the board of New News Corp elected to extend it for another year without shareholder approval.  In the complaint, the plaintiff claimed that the extension without shareholder approval violated the Old News Corp Settlement Agreement, to which New News Corp is bound, because Paragraph 36 of the Settlement Agreement bound any transferees of assets and liabilities and because Section 2.02 of the Separation Agreement between New News Corp and Old News Corp made the Settlement Agreement binding on New News Corp.

Paragraph 36 of the Settlement Agreement binds any “transferees” or “entity into which or with which any party or person may merge or consolidate.”  However, the agreement is silent when it comes to other corporate transactions—namely, asset transfers and spin-offs.  The term “transferees” of assets failed to carry the day for the plaintiff because it is not dispositive of whether the assets and liabilities were transferred under the spin-off agreement, but it is dispositive whether those assets and liabilities are transferred under the Settlement Agreement.  A contrary reading of the term transferee would bind third parties to the settlement agreement for innocuous purchases and “would paralyze Old News Corp (and any public company with which it has done or wishes to do business) from engaging in even the most modest form of asset transfers.”

Similarly, the Court ruled that Section 2.02 of the Separation Agreement between New News Corp and Old News Corp does not bind New News Corp to the Settlement Agreement.  The plaintiff argued that the Separation Agreement was a mixed contract that transferred the Settlement Agreement’s obligation to New News Corp.  A mixed contract is defined in the Separation Agreement as anything “that inures to the benefit or burden” of the business operations of Old News Corp and the remaining business of Old News Corp.  Chancellor Bouchard reasoned that the Separation Agreement could not be a mixed contract because the Plan dealt with the internal affairs of Old News Corp and its shareholders, not business or operations of Old News Corp. Simply stated, the Settlement Agreement deals with Old New Corp’s corporate governance, not New News Corp’s publishing and newspaper business and operations.  As a matter of law, the Settlement Agreement cannot bind New News Corp and the claim for declaratory judgment had to be dismissed. 

The Court of Chancery’s holding reflects the most principled outcome for this case.  As Chancellor Bouchard showed, the interpretation of the Settlement Agreement’s Paragraph 36 would lead Old News Corp into a situation where it could not conduct even the most minor business transaction without a possible fundamental change to the corporate governance of the party with whom it intends to conduct business.  And the Settlement Agreement dealt with Old News Corp’s internal operations and corporate governance and cannot be a mixed contract under the Separation Agreement’s definitions.

Justin  Forcier is the Volume 40 Manuscript Editor for the Delaware Journal of Corporate Law. He is also the 2014-2015 President of Widener School of Law Delaware’s Transactional Law Honor Society. During his third year of law school, Justin interned for The Honorable Thomas L. Ambro on the United States Court of Appeals for the Third Circuit. Upon graduation, Justin plans to sit for the Delaware Bar Exam and clerk for The Honorable Richard R. Cooch on the Superior Court of Delaware.

Suggested Citation: Justin Forcier, Miramar Police Officers’ Retirement Plan v. Murdoch: Not Bound By The Past, Del. J. Corp. L (May 2, 2015), www.djcl.org/blog.

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Material or Not: Can Failure to Disclose Under S-K Item 303 Give Rise to a Fraud Class Action?

Sabrina M. Hendershot

A new question has arisen in the realm of securities litigation: does an alleged failure to make disclosure under Item 303 of Regulation S-K in a filing with the Securities Exchange Commission (“SEC”) give rise to a securities fraud class action under Section 10(b) of the Securities Exchange Act of 1934?  The Ninth Circuit, in its October 2014 decision in In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046 (9th Cir. 2014), held that it does not, while in January 2015, the Second Circuit, in Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2d Cir. 2015), held that it could.

Item 303 of Reg. S-K, 17 C.F.R. § 229.303 requires securities issuers to disclose known trends or uncertainties “reasonably likely” to have a material effect on operations, capital, and liquidity.  The SEC requires that this information also be disclosed in Form 10-Q and 10-K filings.  Additionally, Section 10(b) of the Exchange Act prohibits “any manipulative or deceptive device or contrivance in contravention of such rules and regulations” prescribed by the U.S. Securities and Exchange Commission. Furthermore, rule 10b–5(b) prohibits anyone from “mak[ing] any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statement made, in the light of the circumstances . . . not misleading.”

The divide on this issue dates back to a Third Circuit opinion issued by then-Judge, now Justice, Samuel Alito.  In Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000), the Third Circuit dismissed securities fraud allegations against a pharmaceutical company that did not disclose studies lamenting the adverse side effects of its diet pill product.  The court held that “materiality” for the purposes of SEC disclosure regulations was different from that for shareholder fraud claims under Rule 10b–5 and held that the studies were immaterial because they only represented a speculative risk of exposure.

The shareholders in In re NVIDIA Corp. sued the corporation after it failed to disclose liability for certain manufacturing defects in its products.  The plaintiffs alleged that the company knew about the defects long before it ultimately made its disclosure and that absent a disclosure about the product defects, NVIDIA’s statements regarding its financial condition were misleading and consequently in violation of Section 10(b) of the Exchange Act and corresponding SEC Rule 10b–5.  The Ninth Circuit rejected the plaintiffs’ argument, holding that “neither Section 10(b) nor Rule 10b–5 creates an affirmative duty to disclose any and all material information.” It also noted that the materiality standards of Item 303 and Rule 10b–5 “differ considerably” meaning that these disclosure duties are independent and a violation of Item 303 “does not automatically give rise to a material omission under 10b–5.” Instead a plaintiff must independently allege a violation under that rule. This decision makes sense because with the benefit of hindsight, it is much too easy for dissident shareholders to allege that a “known trend” was material, and that the corporation’s failure to disclose was fraudulent.  Although class actions are an important component of corporate accountability, adding an additional litigation remedy to the already exhaustive list of competing interests for corporations to consider would simply become unduly burdensome.

Conversely, the Second Circuit held that failure to make a disclosure under Item 303 in a 10–Q filing could potentially serve as a basis for a 10(b) securities fraud claim.  In Stratte-McClure, shareholders of Morgan Stanley sued the company alleging that six of its officers made misleading statements to conceal the company’s exposure to and losses from the subprime mortgage market, which ultimately resulted in substantial losses.  It is encouraging to note, however, that even though the court adopted a more liberal view of what constitutes fraud, it set the standards to win such a case fairly high. The Second Circuit dismissed this case, finding that the shareholders failed to show the bank’s fraudulent intent.

The shareholders in In re NVIDIA Corp., filed a petition for review by the United States Supreme Court on February 12, 2015, citing the Second Circuit’s reasoning in Stratte-McClure.  As it stands, Delaware corporations should carefully consider whether to provide more detail in their periodic reporting documents regarding known trends that may have the potential to materially impact the company’s financial state. Although it is unknown what result will ensue at the Supreme Court, detailed disclosure will ensure compliance with SEC rules —and avoid litigation.

Sabrina Hendershot is a second-year student at Widener University School of Law and the incoming External Managing Editor of Volume 41 of the Delaware Journal of Corporate Law.  Sabrina also serves as a Judicial Intern to the Honorable Abigail LeGrow in the Delaware Court of Chancery.

Suggested Citation: Sabrina M. Hendershot, Material or Not: Can Failure to Disclose Under S-K Item 303 Give Rise to a Fraud Class Action?, Del. J. Corp. L (April 29, 2015), www.djcl.org/blog.

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The Corporate Law Background of the Necessary and Proper Clause: A Synopsis and Practical Effect

Candice I. Walker

What exactly does the phrase “necessary and proper” mean as it pertains to Article I, Section 8 of the United States Constitution? Did the Framers intend for the doublet to be interpreted as a sort of “rhetorical flourish—” as synonymous terms merely sounding attractive, but having little independent content and thus, arguably guilty of superfluity?  Or was the clause written with an implicit understanding that the words would carry distinct meanings? Further, what other implications was the phrase intended to have?

“The Constitution itself offers little clue . . . [t]he records of the Constitutional Convention provide scant evidence as to how the Framers understood the Clause, and the ratifying debates are not illuminating. Case law has also been less than enlightening. In McCullough v. Maryland, what appears to be the first and last attempt at deciphering the perplexing Clause, the Supreme Court seemed to buckle under the challenge and instead settled on this: Congress has broad discretion to make commercial decisions so long as they are plainly adapted to a constitutionally permitted end, and the Court will not question Congress on these commerce-related issues. The McCullough Court thus concluded that “necessary and proper” is whatever the Congress says it is.

In his article, The Corporate Law Background of the Necessary and Proper Clause, Geoffrey P. Miller offers a convincing attempt at unraveling the “fantastic” age-old “jumble” and concludes the following after his examination of a series of eighteenth and nineteenth century corporate charters: the two words in the Clause do have distinct meanings, and more importantly, “proper” means that no federal law may, “without adequate justification, discriminate against or otherwise disproportionately affect the interests of particular citizens vis-à-vis others.” This interpretation raises an interesting implication with respect to equal protection under the law.

 Miller’s article begins by describing the ambiguity of “necessary and proper,” noting the lack of attention given to the clause during the Founding era.  He suggests that the Clause is “a [] provision, which, despite its importance, is not usually the subject of negotiation or debate” and likely common in usage. This “commonness” would explain why so few people saw a need for any interpretive probing or attention whatsoever, at the time of its drafting.

Next, Miller finds that the doublet “necessary and proper” was part of the standard vernacular of attorneys of the day and suggests that guidance on the origin and meaning of the Clause might be found in the conventions and usages of corporate law. After all, “the [United States] Constitution, [] is itself a corporate charter—a document creating a body corporate and defining its powers.”

After surveying a series of eighteenth and nineteenth century corporate charters, Miller observed an apparent parallel between these corporate charters from the Founding era and the U.S. Constitution. The study unearthed an overwhelming incidence of clauses including the terms “necessary” and “proper,” that defined the legislative discretion of those responsible for overseeing corporate entities. Miller determined that if the words in the Constitution are to mean what the people of the United States at that time thought the words or phrase meant, then the definitions of necessary and proper as used in the corporate charters are certainly relevant, if not dispositive.

Thus, Miller’s deconstruction of these “scope clauses,” as he named them, and analysis of their operation within the eighteenth and nineteenth century charters yielded the following findings. First, there is no evidence that the Necessary and Proper Clause, standing alone, confers any authority on Congress. The scope clauses in the early charters did not grant authority. By virtue of semantics, Miller explains, the terms were merely adjectival and simply “modif[ied] authority otherwise granted,” and that the same is true of the Constitution’s Necessary and Proper Clause.

 Miller’s main argument is that that the term proper might then convey the idea that “in carrying out a given authority, the company or its managers should design the actions taken so as to consider the effects on stakeholders in the firm.” Thus, by analogy, “proper” in the Constitution requires that laws not only serve the general interest of the country as a whole, but must also take into account the individual interests of particular citizens. Therefore, they may not disadvantage a class of citizens. And even if a law qualifies as “necessary,” it could still be outside congressional authority if, without adequate justification, it discriminates against or disproportionately affects the interests of individual citizens vis-à-vis others.

To the extent the Clause confers any authority at all, evidence from the early charters suggests that it does not confer general legislative power on Congress, but instead “limits [it] to actions that are necessary and proper for carrying into execution the powers expressly granted.” Miller extends this line of reasoning: corporate practice frequently used doublets. However, they were nearly absent in ordinary grants of corporate authority to,  for example, decide meeting times, declare dividends, hire employees, set salaries, etc. Contrarily, doublets were most observed in clauses conferring legislative powers to directors, commissioners, or trustees—clauses most like the grant of legislative authority associated with the Necessary and Proper Clause, which Miller emphasizes, suggested deliberateness on the part of the Framers to “impose a meaningful scope limitation on the exercise of such broad-ranging authority.”

Additionally, Miller maintains that the corporate law background suggests that the Necessary and Proper Clause does not bestow upon the Congress unilateral discretion to draw the boundaries of its authority. Had the Framers intended this outcome, the Clause would expressly confer authority to self-decide power. For example, Congress might have been expressly granted the power to “make all Laws which as to it shall seem necessary and proper,” as were many of the legislative bodies in the charters Miller surveyed expressly. Instead, it was granted the mere power to make all Laws which shall be necessary.

Miller concludes with the idea that the corporate law background provides support for the suggestion that “necessary” and “proper” carry distinct meanings in the constitutional context. The former “requires that there be a reasonably close connection between constitutionally recognized ends and legislative means. . . .” The latter means that federal law may not, without adequate justification, discriminate against or otherwise disproportionately affect the interests of particular citizens vis-à-vis others.” He suggests that this line of reasoning can inform views of contemporary issues and thus affect that which concerns corporate shareholders as the definition of “proper” plays a distinctive role in their interests.

Miller’s theory about the definition of proper raises an interesting implication for equal protection under the law. If Miller’s interpretation of “proper” within the context of the Necessary and Proper Clause—to mean that federal laws may not unjustifiably discriminate against or disproportionately affect the interests of certain individuals vis-à-vis others—is accepted as true,  and this interpretation was intended by the Framers, then strong argument exists that equal protection under the law existed (or at least should have existed) long before the Equal Protection Clause was passed and ratified in 1866 and 1868, respectively. Equal protection must (or should) have existed at the time of the Constitution’s ratification in 1788, and therefore, under the Commerce Clause. This would have, then, rendered any Congressional enactment at that time having a disparate impact, on, for example, minority groups, outside the bounds of congressional authority.

The Corporate Law Background of the Necessary and Proper Clause’s analysis of the Necessary and Proper Clause, and the implication of Miller’s viewpoints respecting the Clause’s purported corporate origins are at the very least, meticulously researched and compelling. Nevertheless, his definition of “proper” is likely to gain traction only if his interpretation is applicable in such a way that prohibits Congress from unfairly burdening parts of the population with laws that have a disparate impact on certain groups.

Candice I. Walker is a Staff Editor for the Delaware Journal of Corporate Law, Volume 40, and a Research Assistant to Professor Bruce Grohsgal, the Helen S. Balick Visiting Professor in Business Bankruptcy Law.

Suggested Citation: Candice I. Walker, The Corporate Law Background of the Necessary and Proper Clause: A Synopsis and Practical Effect, Del. J. Corp. L (April 27, 2015), www.djcl.org/blog.

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Amendments to Delaware’s Public Benefit Corporation Statute

John Gentile

In 2013, Delaware adopted legislation permitting the formation of “public benefit corporations.”  Delaware joined the growing number of states addressing the growing demands of business leaders, investors, social activists and others looking for an alternative to the business corporation solely operated to make money for shareholders.  Under Delaware law, a public benefit corporation is “a for-profit corporation . . . that is intended to produce a public benefit or public benefits and to operate in a responsible and sustainable manner.”

The Delaware legislature will soon be considering several amendments to the public benefits corporation statute, 8 Del. C. § 362.  The first proposed amendment would eliminate the requirement of a public benefit corporation identifier in the name of a public benefit corporation.  Instead, only notification to purchasers of shares in the corporation would be required under certain circumstances.  The second proposed amendment would provide a market out to the provisions that require appraisal in certain transactions involving public benefit corporations.  The third—and most important—proposed amendment would reduce from 90 percent to two-thirds the approval of all outstanding shares required for mergers or changes to the charters of corporations looking to convert to public benefit corporation status.

These amendments would affect all public benefit corporations but especially those looking to go public.  Delaware-incorporated Etsy Inc. has now become the first benefit corporation to go public.  Etsy, the online handmade crafts marketplace, raised $267 million in their initial public offering.  Etsy has certified B corporation certification from the nonprofit organization B Lab.  This means that Etsy has met a high standard of overall societal and environmental performance.  The company outlined in its prospectus that it intends to focus on the long-term sustainability of its business and the ecosystem at large.  But Etsy is not registered as public benefit corporation under Delaware law and that is where the conflict lies. 

Etsy faces the challenge of striking a balance between maximizing profits for shareholders and making decisions in the interest of the public good.  On one hand, going public means acknowledging the fact that the corporation’s duty is to maximize profits for shareholders.  But, on the other hand, Etsy will have to make decisions to uphold its social mission, which could affect maximizing profits for shareholders.  Becoming a registered public benefit corporation would ensure that Etsy would have to stay true to its social mission without violating its duty to pursue shareholder interests.  But, it would need to change its corporate charter, and to do so presently requires 90 percent stockholder approval.  The proposed legislative amendment would lower this shareholder requirement to two-thirds, making the approval more achievable.

Etsy’s public offering and subsequent foray into the market will be watched closely.  If Etsy decides to become a public benefit corporation, its directors will become subject to broader fiduciary duties.  Shareholders who do not vote in favor of the conversion to public benefit status get appraisal rights.  Shareholders who can sue for traditional breaches of fiduciary duties can also sue to enforce the company’s public benefit goal.  That could prove to be subjective when there are shareholders with different opinions as to the company’s social mission.  True to form, Delaware law offers significant protections to directors of public benefit corporations; they can only be forced to improve the company’s public benefit effort if sued on those grounds and monetary damages cannot be awarded.

Ultimately, a public benefit corporation will face challenges in upholding duties to both shareholders and the public good.  However, it may be just the type of entity that allows corporate directors to pursue not only shareholder value but also theoretically “doing the right thing.”  That is what makes Etsy a compelling case study.  The amendments of the public benefit corporation to be presented to the Delaware legislature show that there is a movement to make it easier for these types of entities to function in Delaware.  If Etsy becomes a public benefit corporation and operates successfully in the best interests of its shareholders, consumers, employees and society as a whole, the idea of a public benefit corporation could gain some real momentum and gain wider acceptance in today’s economy.

John Gentile is a Volume 40 Articles Editor of the Delaware Journal of Corporate Law. John serves as a Judicial Extern to the Honorable Karen L. Valihura of the Supreme Court of Delaware, and he is currently in the process of completing the Business Organizations Law Certificate Program.

Suggested Citation: John Gentile, Amendments to Delaware’s Public Benefit Corporation Statute, Del. J. Corp. L (April 23, 2015), www.djcl.org/blog.

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Accelerated Arbitration Rejuvenation: State Passes the Delaware Rapid Arbitration Act

Alexander Bonder

Besieged by legal obstacles, Delaware’s alternative dispute resolution method for business matters, 10 Del. C. § 349, came to a complete halt in 2013.  Fortunately, the General Assembly has rebounded with the passage of the Delaware Rapid Arbitration Act (the “DRAA”) and its novel provisions, which offer prompt and cost-effective benefits to parties looking to avoid litigation. 

After swiftly passing through the state House and Senate, Governor Jack Markell signed the DRAA into law on April 3, 2015.  The touted DRAA offers revamped procedures for the quick resolution of business disputes between parties and replaces the defunct 10 Del. C. § 349. Pursuant to § 349, business disputes were arbitrated, in a confidential matter, by the Court of Chancery.  But in 2013, the U.S. Court of Appeals for the Third Circuit curiously found the practice and § 349 to be unconstitutional based on First Amendment grounds in Delaware Coalition For Open Govt., Inc. v. Strine, et. al.  The Third Circuit reasoned that Delaware’s government-sponsored arbitrations essentially equated to civil trials, which are required to be open to the press and general public.  In response to the ruling, state officials immediately began work on the construction of an efficient, cost-effective way to resolve business disagreements in a manner that would be an attractive option for parties. 

The DRAA provides that sophisticated parties, one of which must be organized as a Delaware business entity, may consent by contract to have an expert arbitrator confidentially settle a dispute.  To ensure a timely resolution, the arbitrator must resolve the matter within 120 days of accepting the appointment, with a one-time extension of an additional 60 days, but only with approval of all parties.  If a final award is not entered within the allotted time, then the arbitrator’s fees may be substantially reduced or even completely eliminated.  For example, if the issuance is less than 30 days late, then the arbitrator’s fees will be reduced by 25 percent; if it is late between 30 and 60 days, then the fees will be reduced by 75 percent; and if it is more than 60 days late, the fees will be reduced by 100 percent. 

The DRAA also states that a final award may be directly appealable to the Delaware Supreme Court for limited review to vacate, modify, or correct the final award.  Notably, the Court’s review becomes public information and all confidentiality from the arbitration proceeding will be lost.  Prior to arbitration, however, the parties may contract to prohibit any appellate review of the final award, or agree to an appellate review by one or more different arbitrators in which confidentiality will remain intact.  

Currently, the DRAA appears to be an innovative and enticing alternative for parties concerned about engaging in time-consuming discovery and incurring evidentiary expenses normally associated with a trial.  The four-month deadline for an arbitrator to issue an award ensures a speedy resolution and provides an incentive to the arbitrator: quickly resolve the matter or lose your fees.  Furthermore, there should not be any apprehension about an arbitrator haphazardly issuing a final award only to comply with the deadline and receive payment because parties subject to the arbitration must be sophisticated (i.e., they know what they are getting into) and an award may be appealed to the Supreme Court subject to the parties’ agreement.  Since the DRAA pertains only to parties who contract at arm’s length (but not individual consumers), parties who favor confidentiality of the information disclosed at the arbitration—which is likely to be most parties—may retain confidentiality by specifying that any appeal of the arbitration award will be heard by a panel of different arbitrators, and not the Supreme Court. 

The DRAA’s flexible provisions for resolving issues traditionally bogged down by time, complexity, and costs, are representative of Delaware’s ability to recover from the setback of § 349 and the perseverance to remain at the forefront of regulating corporate governance. 

Alexander Bonder is a staff member of the Delaware Journal of Corporate Law.  He also serves as a Judicial Extern to the Honorable Mary Pat Thynge of the United States District Court for the District of Delaware.

Suggested Citation: Alexander Bonder, Accelerated Arbitration Rejuvenation: State Passes the Delaware Rapid Arbitration Act, Del. J. Corp. L. (Apr. 20, 2015), www.djcl.org/blog.

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Proposed Amendments to Delaware’s Appraisal Statute: How Much Do They Matter?

Jacob Fedechko

Delaware appraisal litigation has been receiving its fair share of attention from commentators and the judiciary.  Now it is time for the legislature to enter the mix.  In response to the controversy surrounding “appraisal arbitrage,” the Delaware Bar Association’s Corporation Law Council assembled a subcommittee to determine whether the State’s appraisal statute, 8 Del. C. § 262, needs to be amended to curtail the threat of ever-increasing appraisal claims.  While the Council dismissed the idea that drastic amendments are needed to bar claims by stockholders who purchase shares after the merger (or transaction) approval, it did propose two modest changes to the statute in an effort to limit frivolous claims and interest rate arbitrage.  The question is, will these modifications make any appreciable difference in practice?

The Council’s first proposal is a de minimis exception” for publicly traded shares.  This amendment would effectively lead to dismissal of any appraisal claim that (1) is brought by parties owning less than 1 percent of the total outstanding shares and (2) has a value less than $1 million.  The reasoning behind this proposal is that claims falling beneath this threshold do not warrant the substantial costs placed on the judiciary and the parties.  The reasoning is sound, but the proposal is unlikely to make any real difference in practice.

The evidence suggests that the large majority of appraisal claims easily surmount the de minimis threshold.  Only about 17 percent of the total potential appraisal claims are ever actualized, and the value of shares seeking appraisal is approximately $1.5 billion.  The vast majority of these claims obtain a premium in excess of the merger price, and it is not uncommon for the premiums to exceed 100 percent of the merger price.  Notably, the data referenced above, while instructive, does not reflect “nuisance settlements” or meritorious settlements for that matter.  Certain factors already serve as a bar to nuisance claims.  As pointed out by others, the costs of pursuing an appraisal claim (including costs for experts and other expenses) can easily surpass $1 million.  Claimants also face the risk that fair value will be declared less than the merger price.  For a nuisance claim to be effective, there must be some real chance of litigation and these factors limit that chance.  It is possible that this proposal will bar some claims, but the number of those claims will likely be minimal.  The proposal is a positive attempt to limit frivolous claims but is unlikely to have any material impact considering its limited scope.

The Council’s second proposal is the “option to pay and limit the accrual of interest.”  Unlike the de minimis exception, the option to pay proposal will likely yield practical benefits.  In light of concerns that interest rate arbitrageurs bring claims solely for the Federal Reserve discount rate plus 5 percent as set forth by statute, the Council created this proposal to give corporations the option to either pay claimants upfront, thus eliminating the benefit of statutory interest rates, or proceed as usual.  Corporations also have the option to pay a percentage greater or less than the merger price, thereby reducing the overall exposure for potential interest payments when the premium ends up exceeding the merger price (or the upfront payment).

The benefits of this proposal are two-fold.  First, corporations can actively use it as a mechanism to place limits on claimants solely seeking the benefit of generous interest rates, and thus reduce the number of unmeritorious appraisal claims.  Second, it increases freedom by giving corporations the ability to make a business decision as to whether it is more prudent to pay a certain sum upfront or face the potential risk of an award for interest payments on claims that may last for several years.

The legislature will likely make a decision on this issue in the near future.  If the proposed amendments are passed, then only the option to pay has a significant chance of yielding material results.

Jacob Fedechko is a student at Widener University School of Law and member of the Delaware Journal of Corporate Law. He is also the incoming Editor-in-Chief of the Delaware Journal of Corporate Law, Volume 41.

Suggested Citation: Jacob Fedechko, Proposed Amendments to Delaware’s Appraisal Statute: How Much Do They Matter?, Del. J. Corp. L. (Apr. 13, 2015), www.djcl.org/blog.

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Tax Avoidance Trends Among Multinational Enterprises: An Examination of Intellectual Property Transaction and Corporate Income Tax Avoidance

Brian J. King

It is no secret that large multinational enterprises (“MNEs”), a large percentage of which are Delaware corporate entities, have long been on the cutting edge of clever ways to minimize, if not avoid, tax liability. Information and misinformation abound with respect to how the world’s most sophisticated tax strategists plan to minimize or eliminate their tax liability. Some commentators even mistake Delaware’s attractiveness as a corporate home for being a tax shelter, when in fact it is not (Delaware’s tax rates, while competitive, are not as low as many states, some of which have no corporate income tax). However, some foreign jurisdictions have laws and programs that, either by design or out of standing tradition, facilitate beneficial tax consequences for companies savvy enough to exploit them. The scope of the problem is huge, and has far-reaching, global implications.

Tax avoidance maneuvers impact corporate income tax, and as we will see, taxable intellectual property (“IP”) transactions as well. MNEs in the tech industry often deal in IP valued in the billions of dollars. For example, the GAFA (tech companies exemplified by Google, Apple, Facebook, and Amazon) synecdoche have been known to spend upwards of $4 billion on just the patent portfolio component of an M&A deal. The four GAFA companies own brands valued (largely due to trademark value) at over $225 billion in the aggregate. When the stakes are this high, even small tax rate improvements can make huge differences.

By strategically manipulating entities and transactions, experts estimate that MNEs avoid anywhere from $50 billion to $200 billion of would-be tax revenue per year, with $50 billion being a conservative estimate for developing countries. Google, for example, became publicly known for its former “Double Irish” tax strategy, whereby through a combination of shell companies and IP licensing self-dealing, it was able to pass about 99.8% of its revenues to tax-free Bermuda by way of an entity in Ireland and a shell company with zero employees in the Netherlands. While this particular loophole is closing (albeit slowly), other opportunities abound.

This strategic tax avoidance is legal, and it should not be confused with the crime of tax evasion. President Obama summarized how many observers feel about this practice, succinctly, “I don’t care if it’s legal, it’s wrong.” To address this problem, politicians on both sides of the pond have called for tax reforms to close the gap between what MNEs should be paying and what they actually pay. The risk is taxing these multinational companies to the point where it becomes less desirable, if not impractical, to continue operating in country and losing them altogether to more favorable or opportunistic jurisdictions.

In response to this possibility, a coalition of the world’s wealthiest countries has been working diligently under the banner of the Organization for Economic Co-operation and Development (“OECD”) on a project known as Base Erosion and Profit Shifting (“BEPS”). OEDC Member countries include most of the G-20, with the conspicuous absence of developing BRICS countries: Brazil, Russia, India, China, and South Africa. The nonparticipation of these developing economies is a major hurdle to any hopes the OECD may have for global adoption of its Action Plan for addressing the “double non-taxation” of MNEs, especially as their economies continue to account for a larger part of the global economy.

Particularly in India, Ernst and Young observes that, “[t]he lack of effective legislation and gaps in information may leave the door open to simpler, but potentially more aggressive tax avoidance than is typically encountered in developed economies.” A key loophole noted by Ernst and Young is that, “the characterization of payments (i.e., business income v. royalty) has been the subject of current litigation as business income in the hands of a non-resident is generally not taxable in India in the absence of a permanent establishment (PE).” The common self-dealing practices of MNEs can be structured to take advantage of loopholes like this, as an article in The Economist noted, “[t]his is particularly popular among technology and drug companies that have lots of intellectual property, the value of which is especially subjective. These intra-company royalty transactions are supposed to be arm’s-length, but are often priced to minimise profits in high-tax countries and maximise them in low-tax ones.”

Ideas have been proposed to fix these tax avoidance schemes, and as the OECD aims, to eliminate “practices that artificially segregate taxable income from the activities that generate it.” In the US, one proposed strategy is a “carrot method” of lowering the corporate tax rate to incentivize MNEs domiciled here to keep revenues here and pay a modest tax on them. A “stick method,” which experts note has been employed in Europe to a large degree of success, involves changing the US tax structure to a territorial method. As opposed to the current system of taxing domestic entities that have done a good job of “relocating” their US source income, the territorial method would tax MNEs on their US source income. Still, as noted in the article cited above, the territorial method could still allow MNE’s to relocate revenue to territories with a lower source income tax rate.

The best resolution, which appears to be a long way from reality based on, among other hurdles, the reluctance of developing economies to participate fully with the OECD, is total global participation in programs designed to eliminate favorable tax havens like Ireland, Bermuda, and the Cayman Islands. Unfortunately, with hundreds of billions of dollars in tax revenue at stake for these venues, this problem will likely not be resolved any time soon.

Brian J. King is a staff editor on Volume 40 of the Delaware Journal of Corporate Law, and is also the President of the Intellectual Property Society at Widener. Brian is enrolled in Evening Division classes, and works full time as a Business Development Manager at CSC Digital Brand Services.

Suggested Citation: Brian J. King, Tax Avoidance Trends Among Multinational Enterprises: An Examination of Intellectual Property Transaction and Corporate Income Tax Avoidance, Del. J. Corp. L. (Apr. 6, 2015), www.djcl.org/blog.

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3M Cogent Appraisal Litigation—Stock Based Compensation as a Factor in the Discounted Cash Flow Analysis—Parsons’s Side of the Table

Alex Faris

In mid-2013, Vice Chancellor Donald F. Parsons issued an opinion regarding the fair value of Cogent, which was acquired by 3M in December of 2010. Stockholders of Cogent filed suit against the board of the newly formed 3M Cogent, claiming that the merger price of $10.50 per share was unfair and that the more appropriate valuation was $16.26 per share, quite a bit higher than the $10.12 per share calculated by 3M Cogent’s valuation experts. Utilizing a discounted cash flow (“DCF”) analysis, 3M Cogent’s experts factored in the notion that Cogent utilizes stock-based compensation. Vice Chancellor Parsons concluded that stock-based compensation was not to be treated as a cash expense in this case, and therefore it was inappropriate to use it in determining the lower fair value estimate.

Vice Chancellor Parsons pointed to research that illustrated how stock-based compensation affects a company’s cash flow. Vice Chancellor Parsons’s research stated that since stock-based compensation is not a direct cash expense, it is not apparent how it factors into the DCF analysis. The research he cited illustrates two points regarding stock-based compensation: (1) it can have a positive tax treatment for the company; and (2) it can have the effect of diluting value from the company. These two effects can potentially have an effect on the cash flow of the company as well.

While issuing stock is not a cash expense, it does cause the cash flow of the company to fluctuate. One of these fluctuations is caused by the tax treatment, or lack thereof, that the issuance of stock options receives. By not paying employees in taxable cash, companies are effectively saving money by not having to pay employment taxes on cash salaries. These tax savings are reflected in a company’s operating cash flow, and the impact of the savings varies from company to company. If it can be shown that the tax savings significantly affected a company’s operating cash flow, then it would be beneficial to figure this benefit gained from stock-based compensation into the DCF analysis.

The second way in which stock-based compensation affects a company’s cash flow is through dilution of outstanding shares. Issuing outstanding shares to employees as compensation will decrease the value of the current outstanding shares, thus causing dilution. To make up for this dilution, a company will need to conduct buybacks of shares to offset the new issuances, or the shares will trade at a lower price, which ultimately reduces the value of shares for each shareholder. Therefore, stock-based compensation can be an operating expense when done in excess.

Ultimately, Vice Chancellor Parsons ruled that stock-based compensation was not a relevant factor to be taken into account in a valuation analysis. 3M Cogent did not make a showing that the stock-based compensation would have an impact on the company’s cash flow, and therefore it was not an appropriate factor to be considered. According to Vice Chancellor Parsons, an expert would have to illustrate how stock-based compensation affects the operating cash flow of the company. If the expert was unable to opine on the correlation, then the evidence cannot be used in a DCF analysis.

Vice Chancellor Parsons ruled correctly in this case. The party seeking to have stock-based compensation used in the DCF analysis must provide evidence that illustrates the way in which stock-based compensation offsets the DCF analysis. Absent any kind of record evidence, it is impossible for the Court to make a ruling in favor of adjusting the price per share according to the impact of stock based. In another recent appraisal opinion, In re Appraisal of Ancestry.com, Inc., Vice Chancellor Glasscock ruled that stock based compensation should be factored into the discounted cash flow analysis. Respondent’s financial experts presented evidence that showed the importance of accounting for stock-based compensation when evaluating the value of a company, and Vice Chancellor Glasscock agreed. That being said, it is crucial that lawyers check on their financial experts to ensure they are presenting evidence to support their conclusion regarding the inclusion of stock based compensation in the discounted cash flow analysis. Otherwise, a court will have no way to give effect to such compensation.

Alexander Faris is a second year law student at Delaware Law School. Alex is currently a staff member on the Delaware Journal of Corporate Law, and looks forward to stepping into his new role as Internal Managing Editor of the Journal this spring. In addition to serving on the Journal, Alex is also a member of the Transactional Law Honor Society and is pursuing the Business Organizations Law Certificate. 

Suggested Citation: Alexander Faris, 3M Cogent Appraisal Litigation—Stock Based Compensation as a Factor in the Discounted Cash Flow Analysis—Parsons’s Side of the Table, Del. J. Corp. L. (Apr. 2, 2015), www.djcl.org/blog.

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Stock-Based Compensation as a Cash Expense in Appraisal Rights Litigation

John Gentile

Appraisal rights litigation has been steadily rising in both the number of petitions filed and the dollar amounts at stake. Historically, appraisal rights litigation has been considered risky due to the wide discretion the court has under statute to determine fair value. This type of litigation is seen as costly, as a trial usually involves extensive expert testimony regarding the different methods on which the court can call to determine fair value.

Appraisal rights litigation is popular in Delaware for a multitude of reasons. Delaware courts have awarded a higher determination of fair value than the merger price in seven of the nine cases from June 2010 to June 2014. Although pending legislative proposals may permit corporations to avoid this, Delaware also has awarded statutorily-prescribed interest well above market rates—5 percent above the Federal discount rate, compounded quarterly and accruing from the closing date of the transaction to the date the appraisal award is actually paid. Another key factor appears to be the rise in shareholder activism and hedge funds looking to maximize profits on mergers and acquisitions.

A point for debate in the arena of appraisal rights litigation involves the treatment of stock compensation as an expense when determining fair value. Most investment firms recognize that expense when determining fair value of a company’s shares. However, a 2013 opinion by the Delaware Court of Chancery in Merion Capital, L.P. v. 3M Cogent, Inc. excluded stock compensation as an expense when determining fair value.

Starting in 2006, the Financial Accounting Standards Board required all firms to recognize stock-based compensation as a cash expense. Essentially, even though the stock-based compensation is non-cash in nature when distributed, there will be a dilutive impact when the options are exercised. As a result, many firms in the investment world treat stock-based compensation as a cash expense because there will be a dilutive impact in the future. By treating it as a cash expense when determining fair value, a more accurate assessment of fair value is achieved.

In Merion Capital, L.P. v. 3M Cogent, Inc., Vice Chancellor Donald F. Parsons declined to count stock-based compensation in a discounted cash flow analysis because there was no showing it would have any effect on the actual cash flows of 3M Cogent. In a more recent case, In re Appraisal of Ancestry.com, Inc., the respondent, Ancestry.com, argued that a failure to account for stock-based compensation expenses with a discounted cash flow analysis might result in overvaluation. Vice Chancellor Sam Glasscock III agreed, reasoning that stock-based compensation must be accounted for somehow once it reaches a “material level.”

 Stock-based compensation must be measured, either by counting it as a cash expense or measuring its dilutive effect. Stock-based compensation is viewed by the financial industry as a cash expense since stock acts as a quasi-currency because the stockholder or employee accepts stock in lieu of actual cash. Due to this view, the financial industry’s practices are at odds with the decision in Merion Capital, L.P. v. 3M Cogent, Inc. to leave out stock-based compensation.

The financial industry includes stock based compensation as a cash expense because there will be a dilutive impact on the company’s shareholders in the future.  Because fair value should take into account all material costs, accounting for stock based compensation as a cash expense will most accurately reflect the value of the company being appraised.  In the interest of achieving the most appropriate estimate of fair value, the Court of Chancery, when faced with appraisal litigation, should account for stock based compensation as a cash expense.

John Gentile is a Volume 40 Articles Editor of the Delaware Journal of Corporate Law. John serves as a Judicial Extern to the Honorable Karen L. Valihura of the Supreme Court of Delaware, and he is currently in the process of completing the Business Organizations Law Certificate Program.

Suggested Citation: John Gentile, Stock-Based Compensation as a Cash Expense in Appraisal Rights Litigation, Del. J. Corp. L (Mar. 21, 2015), www.djcl.org/blog.

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Appraisal “Arbitrage”: Give It Another Name, But Let It Continue

Thomas H. Kramer

Two recent decisions from the Court of Chancery of Delaware have generated calls for legislative action to revise Delaware’s appraisal statute, 8 Del. C. § 262. Appraisal, once a relatively obscure statutory remedy for the loss of minority shareholder rights in majority-rules corporate mergers, now occupies a rapidly increasing portion of Delaware’s dockets. Under Delaware’s appraisal statute, dissenting shareholders may perfect their rights to appraisal even if they purchase their shares after the announcement of a merger. The Court of Chancery decisions, In re Appraisal of Ancestry.com, Inc., and Merion Capital LP v. BMC Software, Inc., permit such late arrivals to assert appraisal rights notwithstanding an inability to show conclusively that their share’s previous owners did not vote for the merger. Under these rules, savvy investment funds size up the prospects for an appraisal award after a merger announcement and buy up shares of the target company, angling for a significant increase in the value of their investment after bringing an appraisal action to obtain a judicial determination of fair market value. Such an action is now frequently called “appraisal arbitrage,” despite its lack of any real resemblance to true arbitrage.

Arbitrage is traditionally understood to involve the simultaneous buying and selling of identical (or nearly so) commodities or financial instruments in an effort to capture the difference in their prices without risk; classic arbitrage is sometimes called “riskless” arbitrage. In the context of corporate mergers, this has been achieved by taking a “long” position in the (undervalued) acquisition target simultaneously with an equivalent “short” position in the acquirer, with the expectation of capturing the difference in values upon consummation of the merger. As merger agreements can fail, this strategy bears risks, and has come to be known as “risk” arbitrage. “Appraisal arbitrage” typically involves only the purchase of shares of the acquisition target, without a counterbalancing negative position in the acquirer, and is thus not really arbitrage at all. So, the word arbitrage, having joined a long list of pejoratives applied in the description of financial pursuits–“‘insider’ trading, ‘junk’ bonds, ‘leveraged buy-outs,’ ‘hostile’ takeovers, ‘poison pill’ defenses, ‘greenmail,’ and those old favorites, ‘speculation’ and ‘profiteering,’”–is probably retained for its negative connotations by those opposed to the practice.

And opposition there is. Alison Frankel of Reuters says, “It’s easy to understand why the whole idea of appraisal arbitrage – which is increasingly the province of deeply sophisticated and well-financed hedge funds, mutual funds and insurance companies – provokes spasms of fear and skepticism among promoters of the long-term-value theory of investing. Appraisal arbitrageurs buy shares not because they believe in a company and its board but because they specifically want to sue it.” Appraisal claims in Delaware for 2013 approached $1.5 billion; having found no relief in the Court of Chancery, the targets of appraisal litigation are now asking for relief from the legislature.

The most pointed calls for change arrive, not surprisingly, at the courtesy of attorneys representing the losing side in Ancestry. On the Columbia Law School’s Blue Sky Blog, Trevor Norwitz of Wachtell Lipton asserts an “urgent need for legislative reform in Delaware to ameliorate the risk that appraisal arbitrage – now a multibillion dollar industry – poses to transactional vitality and shareholder value.” Theodore Mirvis, also of Wachtell Lipton, takes to the Harvard Law School corporate governance blog to complain of a “troubling expansion of stockholder appraisal rights” and the absence of any “legitimate policy objective” in the recent Chancery decisions. The defendants’ angst is understandable, as there is a lot of money at stake, but their arguments demand a rather narrow view of shareholder value and policy objectives.

For minority shareholders, perhaps especially those at risk of expropriation in an abusive merger transaction, appraisal litigation could provide exactly the kind of “transactional vitality” they would otherwise be missing. In a forthcoming paper, Charles Korsmo and Minor Myers analyze the results of appraisal litigation in Delaware and conclude that the practice might be more beneficial than not. Their finding that appraisal petitions tend to target mergers with low premium values and going-private transactions (a point conceded by Trevor Norwitz) suggests that “appraisal arbitrage focuses private enforcement resources on the transactions that are most likely to deserve scrutiny, and the benefits of this kind of appraisal accrue to minority shareholders even when they do not themselves seek appraisal.”

The issues at play in the recent Chancery decisions involve the minutiae of perfecting a right to appraisal when the stockholder has bought in after the record date for a merger. The defendants in Ancestry and BMC sought a holding that because the plaintiff’s shares were purchased from record holder which held shares in fungible bulk, the plaintiff could not prove the shares had not been voted for the merger; such a holding would foreclose the ability of most investors to obtain appraisal if they bought in after a merger announcement. In ruling against the defendants, the Court of Chancery stated that the plain language of the statute did not support such a finding, and that “appraisal rights are a creation of the legislature, not judge-made law, and are ‘not determined with reference to a stockholder’s purpose.’”

Chancellor Glasscock’s decision to avoid tinkering with § 262 seems right: the fundamental policy goal of § 262, namely, the protection of minority shareholders who have lost the protection of unanimous consent requirements for corporate control changes, likely never included judgments about the appropriateness of shareholder intentions beyond the obvious maximization of return on investment. Asking the legislature to change § 262 now seems premature; if Korsmo’s and Myers’ findings hold, appraisal litigation may be doing more good than harm.

Appraisal “arbitrage” could use a better name, but at this point there isn’t a strong case for another revision of § 262. Let’s watch and see what happens.

Thomas H. Kramer, Pharm.D. is a pharmacist, patent agent, and J.D. candidate at Widener School of Law.

Suggested Citation: Thomas H. Kramer, Appraisal “Arbitrage”:  Give It Another Name, But Let It Continue, Del. J. Corp. L (Mar. 8, 2015), www.djcl.org/blog.

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Putting a Stop to Appraisal Arbitrage

William J. Burton

In two recent opinions, the Delaware Court of Chancery wrestled with an important question regarding appraisal litigation. Namely, the court faced the issue of whether under 8 Del. C. § 262, a beneficial owner who acquires shares after the record date must prove that each of its specific shares, for which it seeks appraisal, was not voted in favor of the merger. This issue specifically relates to, and is of particular concern for, those who engage in what has become known as “appraisal arbitrage.” Appraisal arbitrage is a phrase that has been used to denote an investment strategy “whereby an investor acquires an equity position in a cash-out merger target with the specific intention of exercising the statutory stockholder appraisal right found in 8 Del. C. § 262.” The investor, or arbitrageur, gains a positive return on investment when, “in the subsequent appraisal action the court awards the appraisal petitioners what the court determines to be the fair value of the target,” which is over and above what was offered in the merger transaction.

In Merion Capital LP v. BMC Software, Inc., the Court of Chancery was faced with an arbitrageur, Merion Capital LP (“Merion”), who began purchasing shares of BMC Software, Inc. (“BMC”) on the public market after a merger agreement was signed between Boxer Merger Sub Inc. and BMC. The Court of Chancery held that the General Assembly did not intend to impose an additional standing requirement, or “share-tracing requirement,” for appraisal petitioners and that it was not within the judiciary’s power to create one. Such a requirement would force a beneficial owner to show that “each share it seeks to have appraised was not voted by any previous owner in favor of the merger.”

Similarly, in In re Ancestry.Com, Inc., Merion began purchasing shares of Ancestry.com (“Ancestry”), four days after the record date of a merger between Permira Advisors and Ancestry. Ancestry argued in favor of a share-tracing requirement, but the Court of Chancery held that such a requirement was not included in the appraisal statute and that to add the requirement “would be to exercise a legislative, not a judicial, function.”

Despite the findings of the Court of Chancery, I believe that a share-tracing requirement should be imposed on appraisal litigants. Properly addressing this issue requires an examination of the origin and evolution of the appraisal statute—8 Del. C. § 262. The appraisal statute has its origins at common law, where mergers could only occur upon a unanimous favorable vote of a corporation’s stockholders. The requirement of unanimity created a situation in which stockholders had a veto power that “made it possible for an arbitrary minority to establish nuisance value for its shares by refusal to cooperate.” To deal with this problem, the Delaware General Assembly provided that a merger, or fundamental change, could occur by less than a unanimous vote of stockholders. At the same time, the General Assembly created an appraisal remedy “to compensate dissenting stockholders for their loss of the ability to block mergers.”

The origin of the appraisal statute supports an implied share-tracing requirement. Such a requirement must be implied because as the Court of Chancery properly noted, “noticeably absent from [the language of the statute] is an explicit requirement that the stockholder seeking appraisal proves that the specific shares it seeks to have appraised were not voted in favor of the merger.” Without such a requirement, a potential investor like Merion could purchase most or all of the corporation’s outstanding shares after the record date and then seek appraisal for those shares, even though the record-date holder voted in favor of the merger. Essentially, without such a requirement, the appraisal statute can be used as an investment tool for arbitrageurs as opposed to a statutory safety net for objecting stockholders. Accordingly, not having an implied share-tracing requirement flies in the face of the origins of the appraisal statute because it was designed to compensate dissenting stockholders by providing them an appraisal right and not to provide third parties an investment tool. Notably, however, the Court of Chancery disregarded this concern in both Merion Capital and In re Ancestry.com as it was not before the court in either case.

There are other concerns that warrant an implied share-tracking requirement. It has been anticipated that without such a requirement, and in the wake of the recent decisions, more appraisal suits will appear. A greater number of appraisal suits is normally bad for mergers, as the cost of potential litigation has to be accounted for in determining whether to proceed with such transactions. With additional costs from seemly inevitable appraisal litigation, many companies may choose not to merge with or acquire other companies, and as a result, potential economic growth will be stifled. Similarly, many post-merger lawsuits are filed merely for their nuisance value, the prevention of which was one of the reasons why the appraisal statute was created in the first place. Additionally, those who purchase shares after the record date seemingly do so in bad faith because they know the merger price per share and willingly purchase shares with such knowledge. As a result, such shareholders should be estopped from demanding appraisal rights.

Based on the concerns inherent in appraisal arbitrage and the Court of Chancery continuously noting that any potential solution rests in the hands of the legislature, the legislature must act to right this wrong. One such solution can be found in 8 Del. C. § 327, which governs a stockholder’s right to bring a derivative suit. In this statute, bringing an action requires that it must be “averred in the complaint that the plaintiff was a stockholder of the corporation at the time of the transaction of which such stockholder complains.” Accordingly, the legislature should add a provision to the appraisal statute that requires a plaintiff bringing an arbitration action to be a stockholder at the time of the transaction and not simply a post-transaction purchaser. Alternatively, the legislature should add into the appraisal statute specific language that imposes a burden on the plaintiff to show that each share for which they seek appraisal did not vote in favor of the merger. Ultimately, the latter alternative approach is the more favorable approach, as it is possible for those who engage in appraisal arbitrage to buy one share in every company that potentially faces a merger in order to be a stockholder at the time of the transaction.

William Burton is the Volume 40 Internal Managing Editor of the Delaware Journal of Corporate Law.  William also serves as Wolcott Fellow to the Honorable Karen L. Valihura of the Supreme Court of Delaware.

Suggested Citation: William J. Burton, Putting a Stop to Appraisal ArbitrageDel. J. Corp. L (Mar. 5, 2015), www.djcl.org/blog.

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RadioShack: Only the Relevant Survive

Michael Van Gorder and Tara C. Pakrouh

On February 5, 2015, RadioShack Corporation (“RadioShack”), along with several of its affiliates, filed for Chapter 11 Bankruptcy protection.

RadioShack had considered filing for bankruptcy for quite some time. Now that RadioShack has sought the court’s protection, critics have highlighted the company’s inability to adapt to changing markets or otherwise escape the 1980s—as was remarked in jest during RadioShack’s famous 2013 Super bowl commercial.

The overarching problem was the company’s inability to effectively compete with internet-based giants like Amazon or eBay. RadioShack’s business model may have been effective in decades past, but now that consumers can purchase most electronics online, there is less of a need for a network of brick and mortar stores. What pushed RadioShack over the bankruptcy ledge was the fact that it was highly leveraged, and as a result, its creditors had a fair amount of control over the company’s decisions, including a provision in its credit agreement that permitted the closure of only 200 stores per year.

The voluntary petition lists RadioShack’s assets at $1.2 billion and debts at $1.3 billion as of November 2014. As part of its reorganization, RadioShack plans to sell between 1,500 and 2,100 of its 4,100 stores to hedge fund Standard General LP—RadioShack’s lead lender and largest shareholder. Additionally, RadioShack secured $285 million in Debtor-In-Possession financing from a syndicate of pre-petition lenders in order to sustain its operations during bankruptcy proceedings.

In addition to routine first day motions, RadioShack filed an Emergency Motion for Interim and Final Orders (the “Emergency Motion”). Specifically, RadioShack requested authorization (1) to assume an agreement with several asset liquidation firms; (2) to proceed with closing up to 2,100 RadioShack stores and liquidating those stores’ inventories (the “Store Closing Plan”); and (3) to provide pay incentives to its field-based employees who, in conjunction with the liquidation firms, are currently closing the stores in question. In support, RadioShack argued that it had a valid business justification for its request and that the Bankruptcy Court for the District of Delaware had routinely authorized store closing or liquidation sales where the debtor was a retailer. Specifically, RadioShack argued that the Store Closing Plan was imperative to its reorganization plan since the relevant stores were currently operating at a loss and the sale of the stores’ inventories would generate much needed cash.

The court held an emergency first day hearing on February 6, 2015. In an interim order granting the Emergency Motion, the court ruled “the relief requested in the Motion is necessary on an interim basis and essential for the Debtors’ reorganization and such relief is in the best interests of the Debtors, their estates and their creditors . . . .” The court found that RadioShack “advanced sound business reasons for seeking to assume the Consulting Agreement . . . and . . . is a reasonable exercise of the Debtors’ business judgment and in the best interests of the Debtors and their estates.” The court also found the closing and liquidation of certain RadioShack stores was in the best interests of the Debtors’ estates and based on sound business judgment. The interim order also required that all objections to the entry of the order on a final basis be filed on or before February 17, 2015, and scheduled the final hearing for February 20, 2015. RadioShack’s remaining first day motions were heard on February 9, 2015.

Similarly situated companies should consider RadioShack’s efforts to fight change as a reminder that to survive, companies must adapt by trimming excess “fat” (for RadioShack that meant closing non-strategic stores), continuously evaluate ways to compete in the current market, and prepare for future competitors and concerns.

Michael Van Gorder is the Volume 40 Editor-in-Chief of the Delaware Journal of Corporate Law.  Michael also serves as Wolcott Fellow to the Honorable James T. Vaughn, Jr. of the Supreme Court of Delaware. Tara Pakrouh is the Volume 40 External Managing Editor of the Delaware Journal of Corporate Law. She is a Judicial Intern to The Honorable Mary F. Walrath of the United States Bankruptcy Court for the District of Delaware.

Suggested Citation: Michael Van Gorder & Tara C. Pakrouh, RadioShack: Only the Relevant Survive, Del. J. Corp. L (Feb. 21, 2015), www.djcl.org/blog.

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Lehman Brothers Holdings, Inc. v. Spanish Broadcasting Systems, Inc.: Anything You Don’t Say or Do May Be Used Against You

Tara C. Pakrouh

In a recent order, the Delaware Supreme Court affirmed a Delaware Court of Chancery determination that Lehman Brothers Holdings, Inc. (“Lehman”), acquiesced to an alleged violation of Lehman and Spanish Broadcasting System, Inc.’s (“SBS”) Certificate of Designation (“Certificate”) by remaining silent during the alleged breaches.

At the time the complaint was filed, Plaintiff, Lehman, held a significant block of preferred shares in Defendant’s enterprise, SBS, a Delaware corporation that owns and operates Spanish-language radio and television stations in the United States. Under the Certificate, Lehman was entitled to a 10.75% annual dividend, which was to be paid quarterly.   Additionally, the Certificate provided Lehman with certain rights in the event that those dividends were in arrears and unpaid for four consecutive quarters. Specifically, the “Voting Rights Triggering Event” (“VRTE”) provided the preferred stockholder with the right to fill company board seats and limit company debt as long as the dividends remained unpaid and in arrears.

Following the 2008 financial crisis, SBS began a cash preservation program in order to sustain cash flow. As part of its cash preservation plan, SBS publicly announced in 2009 that it would defer issuing cash dividends, except for a one-time yearly issuance made payable on April 15. In 2011, SBS publicly announced plans to purchase a television station that would be financed by the issuance of a promissory note. SBS then publicly announced in 2012 its plans to issue debt as part of a refinancing plan.

Notwirthstanding claims that the VRTE was triggered, Lehman failed to assert its rights under the Certificate—that SBS breached its shareholder contract by failing to distribute preferred-share dividends and that other provisions of the VRTE were triggered. That is, until February 14, 2013. According to the Chancery Court, “the Plaintiffs never voiced an objection, exercised rights available to them upon the happening of a VRTE, or even informed SBS that they believed a VRTE had occurred, until they filed this lawsuit, almost three years later.”

In the suit, the parties disputed a contract provision regarding the interpretation of a VRTE. Specifically, they centered on what constituted four consecutive quarters of nonpayment. Lehman asserted a VRTE occurs when non-payment occurs through four consecutive quarters; SBS argued a VRTE occurs when SBS fails to make four consecutive quarterly dividend payments.

In dismissing Lehman’s claims, the Chancery Court looked to the actions of both parties. It held that, assuming a VRTE did occur, Lehman had constructive knowledge that the board both intended to, and in fact did, incur additional debt. Despite this knowledge, Lehman made no objection but rather stood by and allowed the breach to occur. As such, Lehman acquiesced and was barred from bringing any claims against SBS.

The Chancery Court noted that application of the doctrine of acquiescence was inconsistent at best. Nevertheless, the Chancery Court held that in order for the doctrine to apply, “a defendant must show that (1) the plaintiff remained silent (2) with knowledge of her rights (3) and with the knowledge or expectation that the defendant would likely rely on her silence, (4) the defendant knew of the plaintiff’s silence, and (5) the defendant in fact relied to her detriment on the plaintiff’s silence.”

In applying the law to these particular facts, the Chancery Court found Lehman’s rights existed in publicly available documents and disclosures, and therefore Lehman had constructive knowledge of those rights. Lehman had notice of SBS’s intention to take on additional debt in 2011 and to restructure its debt in 2012. Yet, Lehman remained silent throughout the entire time. SBS relied to its detriment on Lehman’s silence because had SBS known about the alleged VRTE breach it would have acted to avoid committing it or would have taken another course of action.

The Chancery Court concluded with wise advice for substantial investors: they must actively monitor their rights as shareholders. Otherwise setting Lehman’s behavior as a precedent may encourage such investors to passively wait as contract breaches occur, only to raise those issues at a later, and perhaps more opportune, time.

Key stakeholders should heed the Chancery Court’s advice and, through adoption, the Delaware Supreme Court’s advice. Remaining silent or failing to thoroughly perform due diligence when a company makes a corporate decision of consequence may result in a negative effect, as it did here for Lehman.

Tara Pakrouh is the Volume 40 External Managing Editor of the Delaware Journal of Corporate Law. She is a Judicial Intern to The Honorable Mary F. Walrath of the United States Bankruptcy Court for the District of Delaware, and she is in the process of completing the Business Organizations Law Certificate Program. 

Suggested Citation: Tara C. Pakrouh, Lehman Brothers Holdings, Inc. v. Spanish Broadcasting Systems, Inc.: Anything You Don’t Say or Do May Be Used Against You, Del. J. Corp. L (Feb. 1, 2015), www.djcl.org/blog.

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