Corporations: A Contemporary Approach Chapter 16 Public Shareholder Activism Slide 1 of 65 Salvador...

Corporations:A Contemporary Approach

Chapter 16Public Shareholder Activism

Slide 1of 65 Salvador Dali, "The Transparent Simulacrum of the Feigned Image" (1938)


Chapter 20Director Conflicts

Slide 2of 67


• Self-dealing transactions– Definition: director on both sides– History: void process + substance substance only

process enough (DGCL 144)– Subchapter F: statutory safe harbor

• Process – Disinterested/independent directors– Shareholder ratification

• Collective action problems• Effect: validates or shifts burden?

• Corporate opportunities– Compare to self-dealing– Definition: expectancy / line of business– ALI Principles

• Disclosure + process• Distinguish: officers / directors

Module VII – Fiduciary Duties

Citizen of world

Citizen of world

Law profession

Law profession

Corporate practice

Corporate practice

Bar examBar

exam



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Director self-dealing

Corporation A owns and leases a number of commercial buildings. Corporation A leases one of its buildings to Store X. Any problems?

When Store X faces financial difficulties, Corporation A agrees to waive “bonus rents” and past arrearages – to help Store X get back on its feet. Any problems?

X is a significant shareholder and member of the board of directors of Corporation A. X is also the owner of Store X. Any problems?

CorpA

StoreX

ShareholderX

Lease

Rent

Waive

Board

How should corporate law respond to

director self-dealing?



Slide 4of 67

Possible Approaches

• Flat prohibition: The corporation cannot enter into any transaction with any person or entity in which a director has a conflicting interest.

• Shareholder ratification. The corporation can enter into conflicting-interest transactions if the shareholders validate -- ratification or approval.

• Director ratification. The corporation can enter into conflicting-interest transactions if the disinterested directors approve.

• Fair. The corporation can enter into conflicting-interest transactions if a judge finds the transaction was fair.



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Judicial reviewCom

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Common law in age of statutes …



Slide 7of 67

Remillard Brick Co v. Remillard Dandini Co (Calif App 1952)

Brick Corp Sales Corp

Stanley / Sturgis

Majority100%

Dealings

Shareholders

Minority

Stanley and Sturgis were in the brick business. They owned a majority of Brick Corp, a brick manufacturing firm.

Stanley and Sturgis also owned all of Sales Corp, which contracted with Brick Corp to sell the bricks.

What's the problem? • Who sued? • Wasn't the deal approved by

Brick Corp board? • Didn't the Brick Corp

stockholders approve, as well?



Slide 8of 67

Del. G. Corp. L. § 144 [edited a little]

(a) No transaction between a corporation and any other corporation in which its directors have a financial interest, shall be void or voidable solely for this reason if:

(1) The material facts are disclosed and the board authorizes the transaction by the affirmative votes of a majority of disinterested directors OR

(2) The material facts are disclosed to the shareholders and the transaction is approved in good faith by vote of the shareholders OR

(3) The transaction is fair as to the corporation as of the time it is approved.

Is the statutea safe harbor?

http://wwws.wfu.edu/~palmitar/CorpLawPolicy/Conexus/CorpIE_DelawareGenCorpLaw.pdf



Slide 9of 67

"But neither section 820 of the Corporations Code nor any other provision of law automatically validates such transactions simply because there has been a disclosure and approval by the majority of the stockholders"

Even though the requirements of section 820 are technically met, transaction that are unfair and unreasonable to the corporation may be avoided. ... It would be a shocking concept of corporate morality to hold [otherwise]

Remillard Brick Co v. Remillard Dandini Co (Calif App 1952)

California Appeals Court



Slide 10of 67

Common law in age of statutes in Delaware …



Slide 11of 67

Delaware casesFliegler v. Lawrence (Del 1976)

DGCL 144 “merely removes an “interested director” cloud when its terms are met … nothing in the statute removes the transaction from judicial review”

Marciano v. Nakash (Del 1987) - dicta "... approval by fully-informed disinterested directors under Section 144(a)

(1) or disinterested stockholders under section 144(b)(2) permits invocation of the business judgment rule and limits judicial review to issues of gift or waste with the burden of proof on the party attacking the transaction.”

Benihana of Tokyo v. Benihana, Inc (Del 2006)DGCL Section 144 provides a safe harbor for interested transactions, like

this one, if "[t]he material facts as to the director's . . . relationship or interest and as to the transaction are disclosed or are known to the board of directors ... and the board ... in good faith authorizes the transaction by the affirmative votes of a majority of the disinterested directors...."

After approval by disinterested directors, courts review the interested transaction under the business judgment rule.

http://www.lexis.com/research/buttonTFLink?_m=dfacfcf6dedcd9d34d84054f843927c6&_xfercite=%3Ccite%20cc=%22USA%22%3E%3C!%5BCDATA%5B2006%20Del.%20LEXIS%20445%5D%5D%3E%3C/cite%3E&_butType=4&_butStat=0&_butNum=18&_butInline=1&_butinfo=8%20DEL.%20CODE%20ANN.%20144&_fmtstr=FULL&docnum=1&_startdoc=1&wchp=dGLbVlb-zSkAW&_md5=d1073a9c69563e9c284a31406b77e3a1

Benihana (Del 2006)Benihana in middle of family imbroglio

and needs capital. Bank loan not attractive.

Board approves issuance of $20 mm preferred stock to finance company, in which Abdo (Benihana director) is 30% shareholder and director/vice chair.

Board knew that Abdo was negotiating for finance company. “Abdo did not use confidential information, set the terms deceive the board, dominate any directors.”



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MBCA Subchapter F - Hypothetical

Fred, the favorite cousin of Director A and principal legatee of A’s estate, sells Blackacre to Corporation XYZ. The board approves and shareholders ratify.

How does Subchapter F handle this transaction?

What if Fred is Director A’s son? How does that change things?



Slide 14of 67

Subchapter F

§ 8.60 Definition“DCIT”?• direct interest• indirect interest

(2) § 8.63SH action• maj “qualified shs”• notice / req’d discl• review: no substance

(1) § 8.62 Board approval• maj “qualified Ds”• required disclosure• review: manif unfav ?

§ 8.61(b) Safe Harbor• not challenge DCIT• if (1) or (2) or (3)

§ 8.61(a) Exclusive• can’t challenge tx• if not DCIT

(3) “fair” (Note)• review: tx terms + corp benefit• BOP on defendant

No

Yes



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Pop quiz



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1. B owns Blackacre and also sits on the board of Corp X. If B sells Blackacre to X, the transaction is:a. Insider trading b. Director self-dealingc. Usurpation of corporate

opportunity

2. B’s sale to Corp X is:a. Void (or voidable)b. OK, if approved by

independent directorsc. OK, if approved by majority of

shareholdersd. OK, if judge determines to be

“fair”

3. “Fairness” means:a. Transaction is within

corporation’s line of businessb. Transaction reflects market price

/ termsc. Transaction reflects director’s

“reservation price”

4. In shareholder suit challenging Corp X’s purchase of Blackacre:a. Burden in on shareholder to

show unfairness

b. Burden is on shareholder to show inadequate approval

c. Burden is on Corp X (and B) to show fairness – process or substance

Answers:



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5. DGCL 144:a. Simply prevents automatic

voidability of DCITb. Requires fairness showing

even if board/Shs approvec. Applies BJR if defendant

shows proper board approval

6. When Benihana Inc raised capital from director, Del Sup Ct said DGCL 144: a. Did not apply because director

did not explain his roleb. Did not apply because court

must determine fairnessc. Provided safe harbor since

“qualified” directors OK’d deal

7. Under DGCL 144:a. BJR applies if DCIT approved

by informed directors

b. BJR applies if DCIT approved by disinterested directors

c. BJR applies if DCIT approved by independent directors

8 . MBCA Subchapter F:a. Covers all situations of DCIT

b. Ensures judicial review of DCIT under fairness standard

c. Creates BJR safe harbor, beyond judicial scrutiny

Answers:



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Board “cleansing”

When are directors – disinterested?

independent?

Effect of such approval



Slide 19of 67

Contexts“Disinterested” and “independent” director

Board reviews DCIT

(Cullman v. Orman)

Board reviews Sh demand

(Disney I)

SLC reviews Sh lawsuit(Oracle Corp)



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What is “disinterested”and “independent”?



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“Cleansing” DCIT

If a plaintiff alleging a duty of loyalty breach is unable to plead facts demonstrating that a majority of a board that approved the transaction in dispute was interested and/or lacked independence, the entire fairness standard of review is not applied and the Court respects the business judgment of the board.

Chancellor William Chandler(Delaware Chancery Court)



Slide 22of 67

“Cleansing” DCIT

Disinterested:

“… directors can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from it in the sense of self- dealing, as opposed to a benefit which devolves upon the corporation

or all stockholders generally."

Independent:

… a director's decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences.“ Plaintiff must show particularized facts manifesting 'a direction of corporate conduct in such a way as to comport with the wishes or interests of …

persons doing the controlling.'



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Director independence in board-demand case:

“Allegations that Martha Stewart and the other directors moved in the same social circles, attended the same weddings, developed business relationships before joining the board, and described each other as “friends” even when couple with Stewart’s 94% voting power, are insufficient without more, to rebut the presumption of independence.”

Martha StewartMS Living Omnimedia



Slide 24of 67

Supreme Court distinguishes Oracle:

“Unlike the demand-excusal context, where the board is presumed to be independent, the SLC has the burden of establishing its own independence by a yardstick that must be “like Caesar’s wife” -- above reproach.”

Delaware Supreme Court



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Can directors be truly “independent”?



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Charles Elson Director – Delaware Center Corporate Governance

A solution …



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Shareholder ratification

Shareholders ratification?

Effect of ratification?

“Waste” standard as safety valve?



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Lewis v. Vogelstein (Del Ch 1997)

• What are stock options?– Why grant to directors?– Why need shareholder ratification?



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Stock options

Grant

Vest

“in money”

“out of money”

Exercise price

Expire



Slide 30of 67

Stock options

Grant

Vest

“in money”

“out of money”

Exercise price

Expire

Back-date



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Effect of informed ratification?1. Complete defense

2. Shift burden to Pl to show waste

3. Shift burden to Pl to show unfairness

4. No effect

Problems w/ ratification– Inability to negotiate – “take or leave”– Collective action problems



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What is “waste”?– “consideration so disproportionately

small as to lie beyond range at which any reasonable person might be willing to trade”

– “such a transfer is in effect a gift”

Why not dismiss complaint?



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“Safety valve” review …

(who wins argument – Allen or Strine?)



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Harbor Finance Partners v. Huizenga (Del Ch 1999)

• What was transaction?– Why interested?– Effect of ratification?

Shareholders

merger



Slide 35of 67

Harbor Finance Partners v. Huizenga (Del Ch 1999)

Waste– “I question utility of this equitable

safety valve”– “presumes stockholders are, as a

class, irrational and that they will rubber stamp outrageous transactions”

– “the corporation is not personal property of the stockholders”

– “If fully informed, uncoerced, independent stockholders approve, they have decided the tx is “fair exchange”



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Corporate Opportunities

“Corporate opportunity”? The rule?“Corporate expectancy” vs “line of business”?

“Rejection” vs “acquiescence”?Disclosure necessary?



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Entrepreneurship

"Every corporation has the power to .... renounce, in its certificate of incorporation or by action of its board of directors, any interest or expectancy of the corporation in ... specified business opportunities ... that are presented to the corporation ...

Competing spheres

Corporate expansion potential

Line of Business

Expectations(actual / inferred)

Contract /Property

Fairness

Acquiescence

Rejection / Renunciation

Contract

Inability to finance

Del GCL § 122(17)



Slide 38of 67

Approaches – corporate opportunity

Traditional - Focus on corporation– “expectancy” – “line of business” – “ability to finance”

Balance - Focus on fiduciary– Rejection (implied)– Acquiescence

Procedure - ALI Principles– Different levels: directors vs. executive officers– Require presentation and disclosure– Formal rejection by disinterested directors, shareholders, court



Slide 39of 67

Servan Land owns a 180-acre golf course and country club. Third-party Farquhar offers to sell the corporation an abutting 160-acre tract.

This idea is presented at the 1968 annual shareholders' meeting, but nothing happens. Then, within a year, Servan's principals (Serriani and Savin - majority shareholders and principal officers) buy the tract for themselves.

Four years later the country club and S&S sell the golf course and 160 acres as a $8.3 MM package: $5 MM to the club, $3.3 to S&S. Scoundrels or entrepreneurs?

Issues?

Farber v. Servan Land Co. (5th Cir 1981)



Slide 40of 67

Farber v. Servan Land Co. What is the definition of "corporate opportunity"?

– what is the expectancy test? – what is the line of business test?

Internal decision-making / notice and rejection? – must the fiduciary have offered the opportunity to the

corporation? – what constitutes corporate rejection / ratification? – is the corporation's financial ability to take the opportunity

relevant?

Remedy: what is "constructive trust"? – how are profits computed? less net purchase price? – causation defense: would corporation have realized same profits?

By the way, “majoritarian” or “tailored”?



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Acquiescence - hypothetical

The Horns and Burgs are friends in Brooklyn. The Horns had invested in low-price real estate, and they urged the Burgs to "get their feet wet" too. A slumlord venture!

Lillian Burg became a one-third shareholder with Max and George Horn in Darand Realty, an incorporated landlord operating tenements in Brooklyn. Max and George run the business. When Lillian learns that Max and George bought 9 other tenements for themselves, she is upset.

What are the arguments?



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Second Circuit... a person's involvement in more than one venture of the same kind may negate the obligation which might otherwise be implied to offer similar opportunities to any one of them, absent some contrary understanding.

Judge Hays (dissent):

... the Horns were under a fiduciary duty imposed by law not to take advantage for themselves of corporate opportunities, it is irrelevant that ... there was no agreement under which the Horns would ... offer every property they located to Darand.

Burg v. Horn (2d Cir 1967)

Aren’t fiduciary duties mandatory?



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ALI Principles …



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ALI Principles of Corporate Governance

§ 5.05 Taking of Corporate Opportunities by Directors Senior Executives

(a) General Rule. A director or senior executive may not take advantage of a corporate opportunity unless:

(1) the director or senior executive first offers the corporate opportunity to the corporation and makes disclosure concerning the conflict of interest and the corporate opportunity;

(2) the corporate opportunity is rejected by the corporation; and

(3) (A) the rejection of the opportunity is fair to the corporation; or (B) the rejection is authorized in advance following such disclosure, by disinterested directors, or, in the case of a senior executive who is not a director, authorized in advance by a disinterested superior, in a manner that satisfies the standards of the business judgment rule; or (C) the rejection is authorized in advance or ratified following such disclosure, by disinterested shareholders, and the rejection is not equivalent to a waste of corporate assets.

“Corporate Opportunity”?

Fiduciary offers to corporation

Corporation rejects • Judge: “fair”• Disinterested Ds (subject BJR)• Disinterested Shs (not waste)



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(b) Definition of a Corporate Opportunity. For purposes of this Section, a corporate opportunity means:

(1) any opportunity to engage in a business activity of which a director or senior executive becomes aware, either:

(A) in connection with the performance of functions as a director or senior executive, or under circumstances that should reasonably lead the director or senior executive to believe that the person offering the opportunity expects it to be offered to the corporation; or (B) through the use of corporate information or property, if the resulting opportunity is one that the director or senior executive should reasonably be expected to believe would be of interest to the corporation; or

(2) any opportunity to engage in a business activity of which a senior executive becomes aware and knows is closely related to a business in which the corporation is engaged or expects to engage.

Director or Senior executive

Senior executive

• Offeror expects to corporation OR• Fiduciary expects corporate interest

Fiduciary awareclosely related

to actual/expec business

ALI Principles of Corporate Governance


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1. A corporate opportunity is when …a. Corporate fiduciary deals with

corporation unfairlyb. Corporate fiduciary deals with

outside party on market termsc. Corporate fiduciary deals with

outside party unfairly

2. A business opportunity is a “corporate opportunity” when …a. Corporation has resources to take

opportunityb. Corporation has made plans to

take opportunityc. Corporate insider learns of it

through corporation

3. Corporate opportunities …a. Must be offered to corporation b. Can be taken by fiduciary if

disclosed to corporationc. Can be taken by fiduciary if

corporation rejects

4. If fiduciary usurps corporate opportunity, the remedy is …a. Damages for opportunity costsb. Damages for revenues realized by

fiduciaryc. Constructive trust as though

corporation had taken opportunity

5. If the parties in a CHC understand that the corporate managers have other outside interests …a. COD is waived completelyb. COD is waived as to those interestsc. Cannot be waived because COD is

mandatory

6. Under ALI Principles…a. Corporate directors and officers

have same COD dutiesb. Any “corporate opportunity” must

be disclosed to corporationc. COD is defined as “expectation”

Answers:Chapter 29

Planning in CHC



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The end



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Disney I

Shareholders of The Walt Disney Company claim that executive compensation package to Michael Ovitz was “waste.”

Ovitz received stock options and severance payments totaling $140 million – after 14 months of inept service.

What must a shareholder do to bring a derivative suit in

Delaware? The Michaels(in better days)



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Demand Requirement

Shareholders

Corporation

Board of directors

ShareholderPlaintiff

Demand requirement. “To proceed with their derivative claims, Plaintiffs must set forth in their complaint particularized facts that create a reasonable doubt that

(1) a majority of the members of Disney's board of directors are disinterested and independent or

(2) the challenged transaction was otherwise the product of a valid exercise of business judgment.”

Pre-suitdemand



Slide 50of 67

Michael Eisner

CEO (compensation baseline)

Friend of Ovitz

Disinterested!

Roy Disney

officer (compensation set by board)

Significant Disney shareholder

Independent

Not independent

Father O’Donovan

President of Georgetown University (to which Eisner contributes)

No director fees

Independent

Bowers

Principal of elementary school (Eisner’s children attend)

Payment of director’s fees

Independent

Russell

Eisner’s personal attorney

Fees significant part of law firm’s business

Not independent



Slide 51of 67

Entire Fairness

The concept of fairness has two basic aspects: fair dealing and fair price. Weinberger v. UOP (Del 1983)

Fair Dealing: • when the transaction was timed• how it was initiated, structured, negotiated, disclosed

to the directors• how the approvals of the directors and the

stockholders were obtainedFair Price: • relates to the economic and financial considerations of

the proposed merger• all relevant factors: assets, market value, earnings,

future prospects, and any other elements that affect the intrinsic or inherent value of a company's stock....



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Oracle Derivative Litigation

Oracle shareholders brought a derivative suit claiming company insiders knew December 2001 earnings would fall short of expectations, so they sold their stock – insider trading.

The Oracle board constituted a “special litigation committee” composed of two eminent Stanford professors. The SLC

said the suit should be dismissed.



Slide 53of 67

Legal standard

“The SLC must convince me that (1) Its members were independent(2) They acted in good faith(3) They had reasonable bases for

their recommendations

“If the SLC meets this burden, I can grant its motion or in my judicial “business judgment” allow the suit to proceed.”

Vice Chancellor Leo Strine



Slide 54of 67

The SLCInvestigation• SLC counsel interviewed 70

witnesses • Interviews included defendants and

Oracle senior management• Reviewed email messages • Interviewed witnesses identified by

plaintiffs

Deliberations• SLC members met with counsel 35

times for 80 hours

Report• 1,110 pages – concluded should not

sue Oracle officials accused of insider trading

Special Litigation Committee• All outside directors• None on board at time of

insider trading• All waived their SLC fees• None does any business

with Oracle• Hired SLC advisors – none

does business with Oracle



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Independent?

Joe Grundfest

• Tenured, chaired law professor at Stanford

• Senior fellow Stanford Institute for Economic Policy Research

• Not fundraiser



Slide 56of 67

“Structure”

Special litigationcommittee

Grundfest

Garcia-Molina

Stanford University Stanford Institutefor Economic

Policy Research

Ellison

Lucas

Boskin

Insidertraders



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“Structural bias”

“Delaware law should not be based on a reductionist view of human nature that simplifies human motivations on the lines of the least sophisticated notions of the law and economics movement. Homo sapiens are not merely homo economicus.”

Vice Chancellor Leo Strine



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Vice Chancellor Strine:

“… a person in Grundfest’s position [with respect to colleague and former professor] would find it difficult to assess Boskin’s conduct without pondering his own association with Boskin and their mutual affiliations.”



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Effect of ratification

Coerced?

Informed?

No effect – Defendantmust prove fairness

Shareholder ratification

Plaintiff must prove unfairness

(squeeze-outs)

No review – complete validity

Plaintiff mustprove “waste”

(executive pay)Majority of minority?

Yes

NoNo

Yes

OR

Unanimous?

Majority interested?

OR

Yes

Yes

Yes

Yes



Slide 60of 67

Apply to law professor …



Slide 61of 67

Is “independence” same in SLC as “demand” cases …

Corporations: A Contemporary Approach Chapter 16 Public Shareholder Activism Slide 1 of 65 Salvador...

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