Delaware Director Liability in Related Party Transactions

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You might want to take a look at recent developments in the Delaware law relating to the liability of corporate directors in case of a freeze out merger or other self-interested transaction. You can start by taking a look at my recently published article on this subject in New England In-House, which can be accessed at http://newenglandinhouse.com/reprints/2015/08/24/the-care-and-protection-of-the-independent-director/.

Three days after publication, the Delaware Chancery Court issued another opinion which extends the learning set forth in the article. The article correctly stated the Delaware case law that the “entire fairness test” is indeed met if the deal is expressly conditional on both independent committee approval and affirmative vote of majority of independent shareholders. In the August 27th Delaware Chancery decision In re Dole Food Co. Inc., interested directors nonetheless were held personally liable for inadequate price paid in a freeze-out merger even though these two conditions were present. The reason: in spite of following the formalities of the Delaware law, the controlling Dole shareholders defrauded the independent committee in various ways, including knowingly misrepresenting financial projections and purposely depressing stock price.

I’ve Been Thinking: SEC, Trump and Gifford

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Why do Republican SEC commissioners continue to criticize last week’s formal regulation requiring disclosure of ratio of CEO comp to median employee comp? The regulation, long overdue, is mandatory under a Federal statute (Dodd-Frank) and is no doubt watered down in final form from the spirit of the statute itself. With majorities in both houses, why don’t they try legislation to upend the law? Even Democrats ought to understand the regulation is useless and wasteful.

When will the SEC promulgate another long-overdue regulation which permits crowd funding by non-accredited investors in exchange for stock? Many States have already enacted such legislation, although the Federal exemption for such State initiatives is so narrow as to make State schemes difficult to follow and typically inappropriate for many new-economy ventures. “Dumb money” (as characterized by critics) may not be a great investor base, but here again there is that pesky little thing called a Federal statute….

Why is the SEC facing such headwinds on a couple of initiatives designed to in fact deliver the kind of individual accountability (people not companies liable for violations of law) that so many commentators deem necessary? Pressure against the Commission seeking to salvage its internal adjudicatory process, pressure against the Commission for pushing its historical definition of insider trading. Attorneys rightly point out significant issues with both internal adjudication and demanding tippers profit before tippees can be liable for tipped trades, but: there is appeal out of the Commission adjudications; and, the new judicial standard of tippee liability is not logical if the wrong to be remedied is the misuse of information that the tippee knew or should know to be confidential.

Does anyone agree with me that Donald Trump (who, disclosure here, is very far from my favorite person or politician) is getting excoriated for the wrong sins? Does his comment that you need to be a bit askew to take existential offense at his clearly ill-articulated remark strike at least some chord of credibility? Or: they desperately need to take him out, and if the McCain remark did not do it (wonder of wonders), then they have to jump on the next palpable gaffe real quick….

Finally: Frank Gifford passed away this weekend. Growing up in New York, he was my hero, the all-American two-way football player who was clean-cut, articulate, durable and relate-able. As Tittle’s key target he was unstoppable for several years. In the halcyon days of the Giants, he was the nuts. Dead at 84, likely unknown to many, or remembered only for his broadcasts with Howard Cosell who (unkind final cut by the media) is reported to have disliked Frank, the first negative mark in my memory on the poor departed(is it really twenty years?) Howard (a recovering lawyer for most of his life and thus entitled to special dispensation).

SEC Pay Gap Rule Coming Today

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All over the morning press, and the buzz in morning email traffic: the SEC is slated to adopt today a disclosure rule requiring larger domestic public companies to disclose the ratio of the compensation of their CEO to the median earnings of all employees.

It has been so long under discussion that I had to go back to the books to recall the exact statutory mandate for this new rule.  It is the Dodd Frank Act of 2010.  It took the SEC five years to swallow hard and adopt this meaningless rule.  The SEC tried to address added disclosure cost by allowing estimates and statistical samplings, which no doubt will help, although one can imagine the boring written disclosure explaining the statistical methodology.

The statutory requirement for this rule goes back to the fall-out from the 2008-9 crash.  But since public shareholders get to vote (albeit in nonbinding fashion) on CEO comp under the “say on pay” rule, and since proxy advisers have gotten much more granular with recommendations based on specific analysis, it is hard to understand the functionality of new rule.

And more importantly, the rule is useless.  CEO comp is market driven and the comparables are other C-suite executives.  That has nothing to do with the median pay of, say, a company with employees around the world, who may be paid $10 as a robust daily wage in a place where bread is a dime a loaf.  And more importantly, to the extent the rule is designed to control through shame, higher comp is rather a CEO badge of pride.  The psychology is simplistic and wrong.

The real solutions to growth of income disparity, to the extent one views the current situation with disfavor, are more fundamental and politically charged: change the minimum wage; change the tax rate; ultimately take the wholly un-American, anti-free-enterprise step of an absolute C-suite pay cap.   At least today,these solutions range from unlikely to, well, unimaginable.

In the Stone Age when I got to college, the Federal marginal tax rate (under a Republican administration) was 91%.  All those in favor of the good old days, raise your hands….

Death of Delaware??

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Rumors of the impending death of Delaware as the State of choice for forming business entities are, as they say, greatly exaggerated.  This notwithstanding the petulant piece on the front page of WSJ yesterday where some larger corporations, incorporated in Delaware and faced with expensive shareholder litigation based on alleged inadequacy of acquisition price, sounded off about how Delaware law and courts do not protect their companies from such baseless litigation.

While it is true that almost all acquisitions of size are met with litigation which often recovers cash only for lawyers (as if that were a bad thing!), the alternative is equally as untenable: if you give no recourse to minority shareholders, there is no cop on the beat to police pricing.  Some of the complaints revolve around Delaware’s legislative failure this year to enact a law fixing costs of litigation on shareholders bringing suit if those shareholders lose.  But this result is violative of the American rule that parties bear their own litigation costs.

Delaware is not likely to lose its place as primary business domicile for a variety of reasons, including: current incorporation there of so many major corporations; clarity of corporate law and practice in so many other areas; comfort of investors with putting their money into Delaware entities.

Part of the problem lies with the Bar.  It cannot be that 93% of all deals (assuming the WSJ statement in that regard is accurate) deserve to give rise to litigation.  One possible fix is for Delaware courts to hold that price cannot be questioned either by fiduciary claims or appraisal (judicial re-determination of fair price) if it is negotiated by an independent directors’ committee, and ratified by a super-majority of minority shares (independent directors already are protected from fiduciary claims if the committee was truly independent, a majority of disinterested shareholders voted in favor, and the deal was conditioned up front on meeting those standards).  But somewhere within the operation of the legal system there has to be a rational adjuster short of moving companies to another State domicile; that kind of movement will simply encourage States to engage in a race to the regulatory bottom.

Insider Trading Redefined?

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Long time without a post; summer doldrums and vacations.  However while some of us bask in the sun, the SEC never sleeps.  Those who follow the case law about insider trading know that recent court decisions have been confusing about what constitutes illegal insider trading, but at least one major case held that the tippee (the actual trader) had to know that the tipper was receiving something of real value for the tippee to be guilty.  Not so, held another recent case.  The SEC, sorely vexed by the earlier decision, says it will seek cert before the US Supreme Court to settle the issue.

The Supreme Court does not have to grant cert, of course, but may be well inclined to do so in this case, upon request of a major regulatory agency and with a split among the courts on the proper standard to apply in a volatile legal area.  We may not hear from the Supreme Court for some time; in the meanwhile, those trading on information are best advised to be comfortable with its provenance.  The SEC has high priority on this area, after absorbing major criticism for its failure to chase individual miscreants in a wide variety of cases including but not limited to insider trading.

SEC Activity

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The SEC is active today on the regulatory side, although they still have not delivered some key items on their overdo agenda, notably Federal crowd funding.  The States are stealing their thunder on that front, although usually under the intra-state Federal exemption so mostly we are talking small local deals.

New today on executive claw-backs: proposed rules to direct the exchanges to establish a listing standard requiring claw-back of executive incentive pay erroneously granted.  Arises with a financial restatement and applies to current and former executives.  NOT related to any fault on the part of the executives.   Reaches back three years from restatement.  Open for two months comment.  This under Dodd Frank, a statute merely what–  three weeks shy of five years old?

New today on audit committee disclosures: SEC announces it will issue a “concept release” seeking comment on current audit disclosures, particularly oversight of independent auditors.  Would reach criteria used by committee to evaluate, and also to select auditors.  Also two month comment period after publication.  Hard to imagine this will help investors, more likely to result in expanded disclosure requirements eliciting platitudes.

Post M&A Integration

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Diligence is complete and your acquisition deal has been signed and closed. Your company has acquired its target. What do you do next? This was the second topic discussed by the panel at the NACD/New England M&A program held June 9th in Boston.

Even if your plan is ultimately to fully integrate the target into the acquiror, it may make some sense to take some time, understand what makes the target tick from the inside, and evaluate the depth and quality of the management team. Sometimes an acquisition is designed to bring more energetic technology or operational approaches to a larger and more staid company. Letting the target run by itself may allow it to retain its entrepreneurial culture. You have acquired not only technology, contracts and physical assets; you have acquired the human beings who have built the target enterprise into the company you have identified as providing strategic strength to your own company. Don’t crush those strengths immediately in a rush to obtain financial efficiency.

Part of the post-acquisition integration process is to create a joint vision, between acquiror and target management, of what the consolidated company should look like. Target management, including several levels down depending upon size of the target, should be made to feel that after the acquisition they have a place to reside, and a better path to achieve their own goals. To fail in this regard drives target management to the placement counsellors. (One anecdotal tidbit: shortly after Procter and Gamble acquired Gillette, 80% of the senior management team of Gillette headed for the hills. Likely not the very best result….

The panel agreed that no acquisition, no matter the quality of the diligence, will work exactly as anticipated. Often the synergies are interpersonal and indirect, and the acquiror has to focus on team building (even if the acquisition is of a prior competitor where initial instincts are non-collaborative).

Since culture is so hard to identify, one of the panelist said he liked to take the inquiry down one step to look at the “values” which create the culture. Are the two companies agreed that they are structured for the long term to build shareholder value and to help the customer base? Or is the culture of one company that it is a vehicle for individual success? Are decisions typically reached in each organization through a small number or a very large number of decisional tiers? Diligence beforehand had better have gotten these factors correct, or any integration will be rocky road.

Board Strategic Role in M&A

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How does a board of directors, faced with a pending acquisition which has management enthused, discharge its duties to shareholders? This discussion was one topic at the June 9th meeting of the New England Chapter of the National Association of Corporate Directors in Boston. An experienced panel of directors seemed to agree on a wide variety of approaches:

The board should first establish a strategic articulation of which kinds of acquisitions they believe will build value of the company. Proposed acquisitions should be tested back against this strategic approach, notwithstanding management impetus to the deal. Management can get very competitive, may be in love with the deal and may also want to “win” the fight to capture the target. The board must control that tendency.

But what about opportunistic acquisitions? They are the hardest to evaluate; they may indeed be valuable but if they don’t fit the prior strategic discussion, that means no preparatory work has been done. The board’s role: work really really hard because you have to drill down and do both the strategic work and the operational work to evaluate the deal. One director noted that sometimes the company will have one M&A advisor and the board will have its own separate advisor.

What is the board’s role in diligence? As with many things, the board should be performing the function of a monitor. Directors should identify the biggest issues, the biggest risks, and should ask questions that address those risk parameters. Also, questions should be asked concerning post-acquisition planning; is it in place? Has management evaluated the human talent being acquired, does management have the bandwidth to integrate the acquisition?

Finally, the board has a role in interrogating the post-acquisition financial model that is presented. That model must be based on a variety of assumptions. Those assumptions should be fully understood by the board.

See the next blog post to address questions of integration and focus on “the culture” of the two enterprises; whatever “culture” means. . . .”

SEC Rules on CEO Pay

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You will recall that the Dodd Frank Act in 2010 charged the SEC with propounding a regulation requiring disclosure of the relative pay of reporting company CEOs to the median worker in his or her company.  This was part of the effort to shame CEOs into controlling their pay, and reflected Congressional concern about the growing wealth gap in the United States.  Observers were skeptical as to the efficacy of the requirement as a matter of policy, and most were quite sure that the value of disclosure to the investment community was nil.

So the SEC is years behind its timetable to promulgate this regulation and is still messing with it.  Just this week Senator Warren sent an open letter to SEC chair White, excoriating White for lax enforcement and citing among other things the SEC failure to complete this task.

Today the SEC, still trying to figure out what metrics make sense, posted a proposal for comment on the SEC Website; a portion of the SEC announcement is reprinted below:

“The analysis is posted on the SEC’s website as part of the comment file for rules proposed by the Commission in September 2013 that would require the disclosure of the median of the annual total compensation of all employees of the issuer; the annual total compensation of the chief executive officer of the issuer; and the ratio of the median of the annual total compensation of all employees of the issuer to the annual total compensation of the chief executive officer of the issuer. ”

The hearty among you may join the battle by repairing to the SEC site and engaging the merits….  The more cynical might come to the view that since the rule will have no effect and no value, the SEC should just adopt something/anything that doesn’t cost companies too much money for compliance, and then move on to useful tasks.

Non-Profit Director Liability

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Directors of non-profit organizations generally take their responsibilities seriously. But directors of non-profits are motivated by fulfilling the mission, often while facing serious financial pressures.

All directors, including those of non-profits, are protected from lawsuits for breach of fiduciary duty in two ways. First, virtually all states have statutory limitations on the liability of non-profit directors, reflecting a policy of encouraging people to serve non-profit undertakings. Second, the so-called “business judgment rule” protects all directors (in both profit and non-profit companies) from liability for mismanagement provided the directors use reasonable judgment and do not self-deal.

Between these legal protections and contractual exonerations from liability typically \written into charter documents, directors rightfully have felt reasonably secure from litigation risk even as they guided their organizations along the narrow path of economic viability.

Enter the Third Federal Circuit Court of Appeals, reviewing the contentions of creditors claiming in two cases that the non-profit trustees/directors breached their duty by reason of imprudent management when on the verge of insolvency. (Creditors of bankrupt entities have the power to commence an adversary proceeding against the directors or trustees of any bankrupt company, including a non-profit, for breach of the fiduciary duty of care and loyalty, where the trustees/directors may have knowingly or carelessly expended monies and incurred indebtedness while the company was sinking financially.)

All such cases are highly fact-dependent. A company is insolvent when it is unable to pay its debts as due, or when its balance sheet is under water. In these recent cases, a 130 year old home for the elderly and a well-known women’s college each filed for bankruptcy, the trustees of each were sued, and the Circuit Court in each instance has allowed the cases to go forward (no final resolution as to liability yet).

Non-profit directors may be particularly susceptible to this kind of law suit; non-profits generally lack robust independent incomes streams. They are often dependent on donations and/or fundraising events (each of which may be quixotic given the general economy or other extrinsic factors).

No standard of how board members should act, beyond “prudently” and in the reasonable interest of creditors where insolvency seems imminent, can be generally stated, as facts and the alleged degree of grievous insensitivity to financial issues will vary wildly. We can say that boards should be particularly sensitive if endowment gives no adequate cushion, and if costs have run ahead of income over time. Attention to cash flow projections as well as the balance sheet is wise. Failure to collect receivables, undertaking major new products or services, granting high pay to management, and executive self-dealings could be significant indicators of liability where the non-profit has sunk into bankruptcy and the creditors are looking backwards in time to see “who is to blame.”

Yet another reason for non-profit boards to be formally educated in their technical fiduciary duties.