Here we go ... the Wayne County Employees' Retirement System of Michigan and the Police and Fire Retirement System of the City of Detroit have filed an application for a TRO in the Delaware Court of Chancery. (Bloomberg) The Bear Stearns shareholders are trying to stop the sale of 95 million new voting shares to JP Morgan, which is projected to close on April 8.

We discussed this proposed sale here, and we mentioned Omnicare, Inc. v. NCS Healthcare. In that case, the Delaware Supreme Court invalidated a merger agreement and two voting agreements between an acquiring company and two shareholders of the target company. The two shareholders together controlled over 65% of the target company's votes, and the shareholders agreed to vote their shares in favor of the challenged transaction. In addition, the two companies had agreed that the target board would present the challenged transaction for a shareholder vote, even if the board received a better offer. The Delaware Supreme Court held that "the merger agreement and voting agreements, as they were combined to operate in concert in this case, are inconsistent with the NCS directors' fiduciary duties."

In doctrinal terms, the merger agreement and two voting agreements were treated as "defensive measures" under Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del.1985) and Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361 (Del.1995), which prohibit measures that are "preclusive" or "coercive." The Omnicare court reasoned:

Although the minority stockholders were not forced to vote for the [challenged] merger, they were required to accept it because it was a fait accompli. The record reflects that the defensive devices employed by the [target] board are preclusive and coercive in the sense that they accomplished a fait accompli. In this case, despite the fact that the [target] board has withdrawn its recommendation for the [challenged] transaction and recommended its rejection by the stockholders, the deal protection devices approved by the [target] board operated in concert to have a preclusive and coercive effect [because they] made it "mathematically impossible" and "realistically unattainable" for the [alternative] transaction or any other proposal to succeed, no matter how superior the proposal.

In the last section of the opinion, labeled "Effective Fiduciary Out Required," the Court went out of its way to provide an alternative basis for the ruling:

The defensive measures that protected the merger transaction are unenforceable not only because they are preclusive and coercive but, alternatively, they are unenforceable because they are invalid as they operate in this case. Given the specifically enforceable irrevocable voting agreements, the provision in the merger agreement requiring the board to submit the transaction for a stockholder vote and the omission of a fiduciary out clause in the merger agreement completely prevented the board from discharging its fiduciary responsibilities to the minority stockholders when Omnicare presented its superior transaction.
...
The NCS board could not abdicate its fiduciary duties to the minority by leaving it to the stockholders alone to approve or disapprove the merger agreement because two stockholders had already combined to establish a majority of the voting power that made the outcome of the stockholder vote a foregone conclusion.

Omnicare was a divided decision, with three justices in the majority and two in dissent. And post-decision commentary has been almost universally critical. But it serves as a nice base of comparison with the Bear Stearns-JP Morgan transaction. Which board of directors was more faithful to its obligations: the board that allowed existing majority shareholders to commit themselves to a transaction that they viewed as favorable (Omnicare), or the board that is planning to issue stock to the acquiring company to make approval of the transaction over the objections of the existing shareholders much more likely (Bear Stearns)?

That is not intended to be a difficult question. Nevertheless, the lawyers have structured the Bear Stearns-JP Morgan transaction in a manner that elides the obvious pitfalls in Omnicare. That is, it is not technically a fait accompli, and the Acquisition Agreement contains a fiduciary out.

Whatever the result of that line of analysis, the plaintiffs in this initial motion are not limiting themselves to the coercive-or-preclusive standard (aka Unocal/Unitrin). They are also arguing that the "lock up stock sale is designed primarily, if not solely, to eviscerate the voting franchise of the current Bear Stearns stockholders." Sound familiar? This is language designed to invoke the dreaded Blasius "compelling justification" standard.

The Delaware Supreme Court has limited Blasius to cases involving a "contested election for directors" (MM Companies, Inc. v. Liquid Audio, Inc.), but Vice-Chanceller Strine seems to have a more expansive view of the standard, suggesting that it might be applied to any "vote touching on matters of corporate control." Mercier v. Inter-Tel (Delaware), Inc. (2007).

If Blasius applied in this case, the Bear Stearns board would be required to show a "compelling justification" for its actions. According to Strine, "When directors act for the purpose of preserving what the directors believe in good faith to be a value-maximizing offer, they act for a compelling reason in the corporate context."

Could the Bear Stearns board meet that standard? Almost certainly, since they agreed to the lock-up as part of a negotiation to quintuple the price of the deal. A deal that was brokered by the Fed at a time when the prospects of the company looked bleak, to put things charitably. They may not have acted courageously or with all of the skill Bear Stearns' shareholders might have wanted, but this doesn't look like bad faith.

UPDATE: Writing with the benefit of the actual filing, Steve Davidoff analyzes the plaintiffs' claims. Lots of interesting insights, though Steve got a bit carried away at the end:

Here’s one thought. Delaware recently announced a procedure for the Delaware Chancery Court to accept certified questions from the Securities and Exchange Commission. The Delaware court could use this principle to turn the tables and certify a question to the Fed (or even perhaps the S.E.C.) asking this question: "If the share issuance and other lock-ups are knocked out on the usual grounds, would it endanger the financial system and therefore they should still be validated." You can fiddle with the wording but you get the idea.

If the Fed is actually going to orchestrate this deal, they and the Bush administration should bear the responsibility for pushing it through without upending Delaware and its well-reasoned doctrine and rules of law.

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By now you have heard about the new deal between Bear Stearns and JP Morgan, and you may have been puzzled by this line in the NYT: "Under a Delaware precedent, where the companies are incorporated, a company can sell up to 40 percent without shareholder approval."

Um, no.

This is what is known in the law biz as "wrong." There is no 40% cutoff under Delaware law. My immediate reaction to the story was that the author of the piece (Sorkin) must have been trying to convey one of the supposed lessons on Omnicare. Steve Davidoff confirms that reaction at Dealbook (emphasis added):

In Omnicare v. NCS HealthCare, a uniformly criticized opinion, the Delaware Supreme Court by a 3-2 vote struck down a locked-up deal. There, the court held that under the Unocal standard for testing defensive measures, the agreement of 65 percent of the shareholders to vote for a transaction, together with a force-the-vote provision requiring the company to hold a shareholder vote, was preclusive and coercive. The merger protections were both preclusive and coercive because “any stockholder vote would have been robbed of its effectiveness by … [the] predetermined outcome of the merger without regard to the merits of the Genesis transaction at the time the vote was scheduled to be taken.”

Thereafter, in the Chancery Court case of Cullen v. Orman, the court upheld an agreement for a controlling shareholder to vote in favor of the merger and for 18 months after termination of the agreement to vote against any other transaction. Notably, the shareholder vote was conditioned on approval of a majority of the minority and the judge relied on this fact — that it was not a fait accompli — to make this decision. Since Orman, takeover practitioners have generally advised that as long as a deal was theoretically possible, Omnicare wasn’t implicated. Delaware practitioners have settled on the “40 percent rule” to set a limit on [how] high you could go on a lock-up. Hence the 39.5 percent figure in Monday’s deal with Bear. Of course, none of this has been tested in court.

The bottom line is that JP Morgan is trying to lock up the acquisition of Bear, but it can't be too aggressive without triggering the wrath of the Delaware courts. 39.5% plus the shares of the Bear directors who "have indicated that they intend" to vote for the revised deal should get them to about 45%, and that may be enough to bring the deal home.

Lots of other issues, but that is one mystery solved ...

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Earlier today, Ashby Jones of the WSJ Law Blog called to talk about the Bear Stearns transaction, and we discussed the possibility of a challenge by shareholders (or a new bidder, as yet unknown) under Delaware law. You can see the results of our conversation here. The interview was pretty hasty, as I was on my way to class, but this post should clarify any lingering ambiguities.

When I first saw the news of this deal on Sunday night, I assumed Bear was being sold for cash. After all, it was only two bucks a share. So I made a snarky remark about how the directors of Bear Stearns should have been trying to get the "best value reasonably available to the stockholders." (Revlon)

The only problem is that Revlon doesn't apply to stock-for-stock transactions unless they result in a change of control. Under QVC, the challenged transaction would have resulted in a shift of control to Sumner Redstone, so that deal was subject to Revlon. In the Bear Stearns-JP Morgan transaction, on the other hand, shareholders would be part of a “fluid aggregation of unaffiliated shareholders” both before and after the deal. No change of control. So it would not be a Revlon case.

Does this line make sense? The usual justification for the line is that the target company shareholders have not been deprived of their ability to receive a control premium. As a result, the market still has the chance to compensate them adequately for their shares, even if the current compensation is not adequate.

The opposing view is that the sale of the company is so important that it should be subject to enhanced scrutiny, not the deferential business judgment rule. Leo Strine seems to endorse this view in a 2001 article, where he remarked on the different treatment of cash and stock sales: "What is striking is how trivial this economic difference is compared to the great difference in the nature of the judicial standard that some practitioners would contend applies to each."

So would the Bear Stearns-JP Morgan merger be subject to business judgment review? Probably not. The key here is whether the Delaware courts would treat the now-famous Section 6.10 as a deal protection device. (The provision is quoted here.) It sure looks like one, though I believe this provision would be new to Delaware. If Section 6.10 (and perhaps 6.11 -- Morgan's option to buy the Bear Stearns building) were treated as deal protection devices, the Delaware litigation would invoke the Unocal-Unitrin standard, as developed in Quickturn, Omnicare, and other cases. I offered some thoughts on those cases in yesterday's post.

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Here is a question I have been pondering for a while: Why do Delaware judges write so many law review articles? For example, I have sitting on my desk a stack of 14 articles by Norman Veasey former Chief Justice of the Delaware Supreme Court.  On closer examination, most of these are speeches rather than articles.  But still the question remains why do the judges write these pieces and why do the law reviews publish them?

The question arises as part of my research into the mechanisms for crafting corporate law in the U.S.  Because Delaware judges play a central role in the process, it seems important to determine how they play their role, what motivates them, and to whom they are accountable. 

Many scholars have noted the prolific nature of Delaware's judiciary.  Professors Marcel Kahan and Ed Rock counted 22 recent articles published by Delaware judges. Professor Lawrence Hamermesh has published a helpful chart as an appendix to his Columbia Law Review article, The Policy Foundations of Corporate Law. Yet nobody seems to have persuasively explained this phenomenon.  Presumably judicial opinions provide judges with an adequate forum to explain and justify their decisions.  Why then would judges feel compelled to supplement their legal opinions with further explanations, elaborations or justifications in the academic literature?  More importantly are these extra-judicial exhortations helpful, harmless or insidious?

One purpose of these articles and speeches could be to provide guidance to corporate managers, attorneys and commentators as to the substance and meaning of Delaware corporate law.  Thus judges are supplementing their law-making role, moving beyond ex-post assessment of corporate conduct to ex-ante guidance for practitioners and their clients.  Such motivation can be viewed as positive, but also potentially  problematic.  The message may be lost in translation and, because judges cannot be bound by these extra-judicial comments, advice gleaned from their comments may be of dubious value.

Another view is that the constant commentary has a political purpose: to shore up the legitimacy of the state's role in setting corporate policy.  On this view, Delaware judges not only seek to explain their approach to corporate controversies, but promote their own superior abilities to act as arbiters in these disputes.  Certainly, many articles by Delaware jurists fit this mold.  If this is the motivation, we might want to take the message conveyed with a grain of salt.  If part of the motivation for the articles and speeches is preserving the state's (and the judges') sphere of influence, then readers and scholars should consider such when evaluating the arguments the judges present.   

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Just what proportion of the cases in the Delaware Chancery and D C Circuit play to the strengths of those expert judges in corporate and administrative law?  I've heard law clerks on both courts express some wonder at how many will disputes or sentencing guidelines reviews find their way onto the dockets of the specialist courts.

It called for a laughably informal empirical study - the kind one can do over the lunch hour, and I was eating quickly. 

In 2006, the five judges on the Chancery court issued 207 opinions or orders picked up by Westlaw - of those, only 29 were adjudged by West to be related to corporate law.  It's about the same for the D C Circuit.  Of the 541 decisions or orders issued by the court in 2006, only 53 cited to the Administrative Procedure Act.

Perhaps, then, it would be best to call our specialized courts 10 to 15% specialized.  UPDATE:  Or 60 to 70 percent specialized, if you're in Delaware.  See the comments.

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Gordon Gee, currently Chancellor and Professor of Law at Vanderbilt University, is returning to Columbus for a second stint as President of The Ohio State University. Gee may be the best-known Mormon law professor in the U.S., though his fame is not based primarily on his work in law.

He began his academic career as Assistant Dean for the University of Utah College of Law, and he later became Associate Dean and Professor at my new law school, the J. Reuben Clark Law School of Brigham Young University. After serving as Dean of the West Virginia University College of Law, Gee moved into the President's office, and he has worked in university administration ever since.

Though he has gained notoriety as a university president, some of you may know Gordon Gee for his important role in Delaware corporate law. The case of In re Limited, Inc. raised the issue of director independence with respect to Gee, who was a member of The Limited's board of directors when it approved a Contingent Stock Redemption Agreement that benefited CEO Leslie Wexner. You see, Wexner was an alum of Ohio State, and he had donated $25 million to establish The Wexner Center for the Arts during Gee's tenure as President. In response to the directors' motion to dismiss, Vice-Chancellor Noble addressed the following issue: "if a director is the head of a charitable or educational institution, under what circumstances may his independence be called into question by the charitable giving of the allegedly dominating person, in this instance, Mr. Wexner?"

VC Noble answered that question as follows:

The determination of whether a particular director is "beholden" to an allegedly controlling person is not limited to the power to affect the director in the future. One may feel "beholden" to someone for past acts as well. It may reasonably be inferred that Mr. Wexner's gift of $25 million to Ohio State was, even for a school of that size, a significant gift. While the gift was not to Gee personally, it was a positive reflection on him and his fundraising efforts as university president to have successfully solicited such a gift. In this context, even though there can be no "bright line" test, a gift of that magnitude can reasonably be considered as instilling in Gee a sense of "owingness" to Mr. Wexner. For that reason, I conclude that the plaintiffs have successfully alleged a reasonable doubt as to Gee's independence from Mr. Wexner's domination.

This decision is interesting for many reasons, but perhaps most importantly, it is interesting to note the behavioral assumption on which it is based, namely, that Gee might feel a sense of obligation to Wexner for a past gift to a university for which Gee was (then) no longer president. How does VC Noble know that Gee might have such feelings? Hmm.

The Delaware courts are required to make all sorts of behavioral assumptions with regard to corporate directors, but evidence about director behavior is largely anecdotal. If any young professors out there are looking for a research agenda, "director behavior studies" is ripe for the harvest.

By the way, Gee is still a member of The Limited board of directors, and Wexner is still the CEO.

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Here is the new amendment to Delaware's Constitution (bold):

Section 11. The Supreme Court shall have jurisdiction as follows:

...

(8) To hear and determine questions of law certified to it by other Delaware courts, the Supreme Court of the United States, a Court of Appeals of the United States, a United States District Court, the United States Securities and Exchange Commission, or the highest appellate court of any other state, where it appears to the Supreme Court that there are important and urgent reasons for an immediate determination of such questions by it. The Supreme Court may, by rules, define generally the conditions under which questions may be certified to it and prescribe methods of certification.

This is huge! It could be the most important development in Delaware corporate law since Woodrow Wilson convinced the New Jersey Legislature to pass the Seven Sisters Acts. (See here.) By agreeing to entertain questions certified by the SEC, Delaware enables shareholders to frame specific questions about Delaware law without regard to an underlying dispute. So entrepreneurial corporate governance activists like Lucian Bebchuk can get answers to questions about the extent of the shareholders' bylaw amendment power. Among other things. (See my post about Bebchuck v. CA Inc. here.)

For more, see Francis Pileggi, Peter Lattman, and Steve Bainbridge.

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On Friday, in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, the Delaware Supreme Court cleared up some confusion about directors' fiduciary duties in distressed firms.  The most important thing to know about the case is that the court cited me in passing (JK), as well as fellow corporate law bloggers Steve Bainbridge and Larry Ribstein.      

In its principal holding, the court held that for a firm in the zone of insolvency (ZOI), its creditors have no direct breach of fiduciary duty claims against the firm's directors. 

Perhaps more interesting, language in the opinion also casts serious doubt about whether creditors can even bring ZOI derivative claims:

When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change:  directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.  (Emphasis supplied).

By contrast, discussing actually insolvent firms later in the opinion, the court confirms the long standing view that creditors replace shareholders as the firm's residual claimants:

Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties.  (Emphasis in original).

The opinion suggests, therefore, that the ZOI concept famously described in Credit Lyonnais will no longer have any continuing relevance as a legal concept.  On balance, this is probably the right result.  It's hard for directors to know when they're in an ill-defined "zone" of insolvency.  So for purposes of "providing directors with definitive guidance," as the Gheewalla court attempts to do, doing away with ZOI is probably a good thing.

OTOH, drawing the line at insolvency seems somewhat arbitrary, and ZOI is not without some conceptual basis.  As I wrote in Gap Filling in the Zone of Insolvency,

Insolvency is not some magic event that triggers perverse incentives for managers that do not exist before insolvency. Instead, the agency cost of debt is increasing in the percentage of outside financing comprised of debt versus equity.

Insolvency, then, is just the extreme case of perverse managerial incentives to make inefficient investment decisions on behalf of equity.  What ZOI does--under any reasonable definition--is simply capture a larger share of those states of the world in which managers may have these perverse incentives.  For a legal rule, though, it's pretty vague.  Of course, one might suggest drawing a different line--say, when the debt-equity ratio hits 9:1.  The valuation issues are probably no worse at 9:1 than at insolvency (and the factual issues for equitable insolvency are likely to be even more intractible).  OTOH, the insolvency line may be defensible as a sort of focal point?

Finally, the court held that even for insolvent firms, creditors could not assert direct claims, but only derivative claims.  The court expressly overruled the Chancery Court's Production Resources decision in this regard.

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Over the past two days, I have seen a couple of commentators suggesting that the board of directors of Dow Jones might be forced to auction the company. For example, Elizabeth Nowicki poses the questions nicely here.

This is a question that has intrigued corporate law scholars (and courts!) for some time. Note this passage from Chancellor Allen's opinion in TW Services, Inc. v. SWT Acquisition Corp. (March 2, 1989):

But what of a situation in which the board resists a sale? May a board find itself thrust involuntarily into a Revlon mode in which it is required to take only steps designed to maximize current share value and in which it must desist from steps that would impede that goal, even if they might otherwise appear sustainable as an arguable step in the promotion of "long term" corporate or share values? Revlon did not address that subject but implied that a board might find itself in such a position when it said that the duty it spoke of arose "when the break-up of the company is inevitable."

More specifically for this case, what of a situation in which the holders of some 88% of the Company's stock in effect declare (by supporting the SWT tender offer either as offeror or as a tendering shareholder) that they do seek a current share value maximizing transaction now? Does a director's duty of loyalty to "the corporation and its shareholders" require a board, in the light of that fact alone, to enter a Revlon mode? In those Delaware cases that have factually involved preponderant shareholder acceptance of a hostile tender offer, boards have, responding to their own view of their duty, proposed an alternative transaction -- a management endorsed breakup transaction that, realistically viewed, constituted a functional alternative to the resisted sale. Those cases, however, offer no judicial opinion on the question when, if ever, will a board's duty to "the corporation and its shareholders" require it to abandon concerns for "long term" values (and other constituencies) and enter a current share value maximizing mode. This, however, is the question referred to above that is raised by this case but need not now be decided in light of the particularities of the circumstances the directors of TW face.

So tantalizingly close to getting an answer! Just months later, however, the Delaware Supreme Court decided Mills Acquisition Co. v. Macmillan, Inc. (May 3, 1989), stating:

Clearly not every offer or transaction affecting the corporate structure invokes the Revlon duties.   A refusal to entertain offers may comport with a valid exercise of business judgment. Circumstances may dictate that an offer be rebuffed, given the nature and timing of the offer; its legality, feasibility and effect on the corporation and the stockholders; the alternatives available and their effect on the various constituencies, particularly the stockholders; the company's long-term strategic plans; and any special factors bearing on stockholder and public interests.

Nevertheless, the Macmillan Court implied that "a subjective disinclination to sell the company will not prevent [the Revlon] duty from arising where an extraordinary transaction including, at a minimum, a change in corporate control is involved." Paramount Communications Inc. v. Time Inc. (Del. Ch. July 14, 1989). That last quotation is from Chancellor Allen's Time opinion, which has an interesting role in the question at hand. Chancellor Allen ultimately concluded that Revlon is triggered by the board's decision to pursue a change of control transaction. He rejected the plaintiff's argument that the Paramount bid triggered Revlon duties, observing, "Plaintiffs can cite no authority compelling or commanding this expansion, which would dramatically restrict the functioning of the board whenever an offer was made."

Allen's opinion was not immediately embraced by the Delaware Supreme Court. Whereas Chancellor Allen held that the Time-Warner merger did not constitute a "change of control," Justice Horsey  wrote, "we premise our rejection of plaintiffs' Revlon claim on different grounds, namely, the absence of any substantial evidence to conclude that Time's board, in negotiating with Warner, made the dissolution or break-up of the corporate entity inevitable." Of course, the Supreme Court backtracked on this formulation in QVC, embracing Allen's earlier opinion, but in Time the Court added, "we decline to extend Revlon 's application to corporate transactions simply because they might be construed as putting a corporation either 'in play' or 'up for sale.'"

Though Time might be read as an endorsement of "just say no," some commentators have suggested that it is not a pure test of that notion because Time's board of directors was pursuing a pre-existing merger with Warner. In other words, Time's board did not just say no to Paramount, but said no in furtherance of an alternative transaction. What if no alternative transaction exists, as with Dow Jones?

The usual citation here is Moore Corp. Ltd. v. Wallace Computer Services, Inc., 907 F.Supp. 1545 (D. Del. 1995), but that is a federal district court decision. And it involved the decision not to redeem a poison pill, which seems quite different from Dow Jones, where members of a single family, albeit with various strands, is resisting the bid.

You may have noticed that I did not refer to the Bancroft family as a "controlling" shareholder. This interesting background from the W$J should make it clear why such a designation is not inevitable in this case:

The company's board consists of 16 members, four of whom represent the Bancroft family. Michael Elefante, the Boston-based trustee who directly represents 46% of the family's voting power and influences even more, has played an active role in recent weeks as the intermediary between the family and the company, according to people familiar with the matter.

There are three branches of the Bancroft family. They come largely from the descendants of Jane Cook, Jessie Cox and Hugh Bancroft Jr. Ms. Cook's branch includes Martha Robes; her sister, Jean Stevenson; and Elizabeth Steele, who is a Dow Jones director. The second branch, descended from Ms. Cox, includes William Cox and his sister, Jane MacElree, and their children. The third branch, represented by Chris Bancroft, who also serves on the board, includes Elisabeth Goth, who voiced her opposition to Dow Jones's management a decade ago.

Within the three branches there are sub-branches and a number of trusts. Unlike the trusts controlling New York Times Co., the Bancroft family trusts are under no obligation to vote together. "This family can be split," said a person familiar with the family's history.

With all of that as background, let's conclude by considering Elizabeth's questions regarding Dow Jones:

What happens if the water starts churning with hungry bidders?  At what point does the Board need to say to the 52% block "you are walking away from a super deal"?  Does the Board ever need to say that?  What about the minority s/h?  Who, if anyone, needs to advocate for them?

The answers here probably do not depend on whether the Bancroft family is a "controlling shareholder." Note that this is not a case in which the controlling shareholder has proposed a self-interested transaction. Rejecting an unsolicited bid for the company is quite different from proposing a squeeze-out of minority shareholders. Thus, News Corp's proposal does not place the Bancroft family in a position of conflict vis-a-vis the minority shareholders. Nor does an unsolicited bid, without more, trigger Revlon duties, for the reasons discussed above. Therefore, in my view, the board of directors of Dow Jones could "just say no" to News Corp's proposal. And if the minority shareholders sued, the decision of the board of directors would be subject to review under business judgment rule.

Permalink | Corporate Governance| Corporate Law| Delaware | Comments (3) | TrackBack (2)

Vice-Chancellor Strine's opinion in In re Netsmart Technologies, Inc. Shareholders Litigation was issued a month ago, and I have been pondering it ever since. This case has a lot of interesting features, and I hope to blog about some others later. For this post, however, I concentrate on Leo's attempt to distinguish the Revlon standard from the business judgment rule:

What is important and different about the Revlon standard is the intensity of judicial review that is applied to the directors' conduct. Unlike the bare rationality standard applicable to garden-variety decisions subject to the business judgment rule, the Revlon standard contemplates a judicial examination of the reasonableness of the board's decision-making process. Although linguistically not obvious, this reasonableness review is more searching than rationality review, and there is less tolerance for slack by the directors. Although the directors have a choice of means, they do not comply with their Revlon duties unless they undertake reasonable steps to get the best deal.

The distinction between rationality review and reasonableness review has been around for awhile. Vice-Chancellor Strine first articulated the difference in In re Toys 'R' Us, Inc. Shareholder Litigation (2005), and he took his cues in that case from Revlon itself and from QVC, both Delaware Supreme Court opinions.

The interesting part of the contrast between rationality and reasonableness is not what it says about the Revlon standard, but what it says about the business judgment rule. Outside of opinions by Vice-Chancellor Strine, it's hard to find Delaware cases that refer to the business judgment rule as a "rationality standard" or "rationality test." There is, of course, the oft-quoted statement from Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del.1971): "A board of directors enjoys a presumption of sound business judgment, and its decisions will not be disturbed if they can be attributed to any rational business purpose." But the reference to rationality in that context is pretty clearly a reference to the substance of the board decision, not the process by which the decision was made. The distinction between substance and process is evident in the Supreme Court's Unitrin opinion:

The effect of a proper invocation of the business judgment rule, as a standard of judicial review, is powerful because it operates deferentially. Unless the procedural presumption of the business judgment rule is rebutted, a "court will not substitute its judgment for that of the board if the [board's] decision can be 'attributed to any rational business purpose.'" (quoting Unocal, which was quoting Sinclair)

In my quick search of the Delaware cases, I found only one instance other than Vice-Chancellor Strine's opinions in which the courts has referred to the rationality of the process. That case was Chancellor Allen's Caremark opinion:

What should be understood, but may not widely be understood by courts or commentators who are not often required to face such questions, is that compliance with a director's duty of care can never appropriately be judicially determined by reference to the content of the board decision that leads to a corporate loss, apart from consideration of the good faith or rationality of the process employed. That is, whether a judge or jury considering the matter after the fact, believes a decision substantively wrong, or degrees of wrong extending through "stupid" to "egregious" or "irrational", provides no ground for director liability, so long as the court determines that the process employed was either rational or employed in a good faith effort to advance corporate interests. To employ a different rule-one that permitted an "objective" evaluation of the decision-would expose directors to substantive second guessing by ill-equipped judges or juries, which would, in the long-run, be injurious to investor interests. Thus, the business judgment rule is process oriented and informed by a deep respect for all good faith board decisions. (emphasis added)

Chancellor Allen's dismissal of substance is only slightly hyperbolic, but the more important point is that even here, the business judgment rule is not a "bare rationality standard," but a standard predicated on the good faith of the board of directors.

I am curious to see whether Vice-Chancellor Strine's characterization of the business judgment rule as a rationality standard catches with the other Delaware judges. As with so many issues relating to the duties of directors, however, the exact formulation of the business judgment rule may not matter much because the important point is the directors are (almost) never liable.

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I was reading Usha's article tonight and I came across the word "acquirer" in a section on freezeout mergers in Delaware corporations. Normally, I expect people to use the alternate spelling ("acquiror") when discussing Delaware corporate law, even though "acquirer" is viewed in some circles as the proper form. (Indeed, Microsoft Word automatically changes "acquiror" to "acquirer.") So I wondered whether my expectation of "acquiror" was grounded in practice, and I turned to Westlaw.

"Acquiror" appears in exactly double the number of Delaware cases as "acquirer" (222 v. 111). In cases decided after 2000, however, the margin narrows (53 v. 47). In the JLR database, "acquirer" is more common than "acquiror," and the trend favors the latter. I searched documents published prior to 2001 (2558 v. 2740) and documents after 2000 (1384 v. 2172), and you can see the results.

Oh, in case you were wondering, the Delaware Code uses the term only once -- in Title 18 (Insurance) -- and it spells the word "acquirer."

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In a recently published article, David Rosenberg of the Zicklin School of Business at Baruch College cited this blog while noting that I had changed my mind about Disney. He's right, and I actually use that point to argue for the value of blogs and blogging in my forthcoming essay from the Bloggership Conference.

Here I go again.

In commenting on Stone v. Ritter, I expressed some confusion about the need to place the "fiduciary duty of good faith" under the duty of loyalty, but I didn't object to the notion that Caremark was essentially a "good faith" case, as that concept had been defined under Disney. Later, in a separate post on Caremark, I characterized the facts underlying a recent decision by Vice-Chancellor Strine (ATR-Kim Eng Financial Corp. v. Araneta) as a "model Caremark claim (failure of oversight)." I was wrong. Caremark has been distorted.

This is how Vice-Chancellor Strine described the standard of liability in Araneta:

Under Delaware law, it is fundamental that a director cannot act loyally towards the corporation unless she tries -- i.e., makes a genuine, good faith effort -- to do her job as a director. One cannot accept the important role of director in a Delaware corporation and thereafter consciously avoid any attempt to carry out one's duties.

That case was decided in December 2006, so it is no accident that the language at the end sounds like a combination of "bad faith" under Disney ("consciously and intentionally disregarded their responsibilities" (2003) or "intentional dereliction of duty, a conscious disregard for one's responsibilities" (2005)) and lack of oversight under Caremark ("only a sustained or systematic failure of the board to exercise oversight –- such as an utter failure to attempt to assure a reasonable information and reporting system exists –- will establish the lack of good faith that is a necessary condition to liability"). After all, Stone v. Ritter taught us the month before Vice-Chancellor Strine's opinion that Disney and Caremark were roughly equivalent standards: "a showing of bad faith conduct, in the sense described in Disney and Caremark, is essential to establish director oversight liability."

Here's the problem: the oversight duty described in Caremark did not require a conscious disregard of duty. Quite the opposite, in fact. This is what Chancellor Allen wrote in Caremark:

[This case belongs to a] class of cases in which director liability for inattention is theoretically possible [when] a loss eventuates not from a decision but, from unconsidered inaction.

I am fine with the notion that "consciously avoid[ing] any attempt to carry out one's duties" constitutes "bad faith," and if the Delaware courts are more comfortable treating "bad faith" as a form of disloyalty rather than as a separate breach of duty, that's ok, too. But why did they need to drag a distorted view of Caremark into this?

Do plaintiffs still have a Caremark claim under the duty of care for "unconsidered inaction"? Given the success rate of such claims (zero), maybe it doesn't matter.

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We have had a few things to say about Chancellor Allen's well-known Caremark decision, but this post is about the new Caremark case, which is called Louisiana Municipal Police Employee Retirement System v. Crawford. If you are too busy to read the case, you might want to try the summary and critique from the Delaware law firm, Potter Andersen & Caroon.

Crawford involves the proposed "merger of equals" of Caremark and CVS. According to Chancellor Chandler, "Neither party would receive a premium. The board of directors would be evenly split between Caremark and CVS shareholders, and management positions would be divided between the two companies."

Unfortunately for the betrothed companies, Express Scripts wants to disrupt the union and has made an unsolicited offer for Caremark's shares. Express Scripts's offer values Caremark at about $26 billion -- more than $3 billion higher than the CVS merger valuation. Of course, the deals are not identical, and the CVS merger had some advantages, including the fact that it had received HSR clearance.

CVS responded to the Express Scripts' offer by proposing a modification of the merger agreement, which would allow Caremark to declare a special $2.00 dividend to be paid either at the time of or immediately after the merger. The Caremark board endorsed the amended merger agreement. Caremark and Express Scripts then proceeded to wage a proxy contest over their respective plans.

While the proxy contest was pending, CVS and Caremark agreed to increase the special dividend from $2.00 to $6.00 per share. That special dividend lies at the heart of the most interesting aspect of the opinion.

The plaintiffs in this case sued for an injunction, arguing that Caremark's board of directors breached their fiduciary duty of disclosure. Chancellor Chandler's opinion addresses each of the plaintiffs' disclosure claims, concluding that most of the disclosure defects were not material. Nevertheless, Chancellor Chandler enjoined the vote of the Caremark stockholders so that the Caremark's board of directors could "properly disclose to shareholders (a) their right to seek appraisal and (b) the structure of fees paid to Caremark’s bankers."

That may not seem very interesting, but embedded in the first part of that ruling is the judge's conclusion that the special dividend was part of the merger consideration to Caremark's stockholders. (Only if the special dividend were considered part of the merger consideration would the Caremark stockholders have appraisal rights. Otherwise, this stock-for-stock merger would be subject to the "market out" provisions of Section 262 of the DGCL.) According to Chancellor Chandler:

Plaintiffs contend the $6 special cash dividend triggers appraisal rights under 8 Del. C. § 262. Defendants respond that the special dividend has been approved and will be payable by Caremark and, thus, has independent legal significance preventing it from being recognized as merger consideration. Thus, according to defendants, dissenting Caremark shareholders will have no appraisal rights after the CVS/Caremark merger.

Section 262 of the DGCL grants appraisal rights to stockholders who are required, by the terms of the merger, to accept any consideration other than shares of stock in the surviving company, shares of stock listed on a national securities exchange, or cash received as payment for fractional shares. The $6 "special dividend," although issued by the Caremark board, is fundamentally cash consideration paid to Caremark shareholders on behalf of CVS.

Defendants are unsuccessful in their efforts to cloak this cash payment as a "special dividend." ... [D]efendants specifically condition payment of the $6 cash "special dividend" on shareholder approval of the merger agreement. Additionally, the payment becomes due upon or even after the effective time of the merger. These facts belie the claim that the special dividend has legal significance independent of the merger. CVS, by terms of the CVS/Caremark merger agreement, controls the value of the dividend. Defendants even warn in their public disclosures that the special cash dividend might be treated as merger consideration for tax purposes. In this case, the label "special dividend" is simply cash consideration dressed up in a none-too-convincing disguise. When merger consideration includes partial cash and stock payments, shareholders are entitled to appraisal rights. So long as payment of the special dividend remains conditioned upon shareholder approval of the merger, Caremark shareholders should not be denied their appraisal rights simply because their directors are willing to collude with a favored bidder to "launder" a cash payment. As Caremark failed to inform shareholders of their appraisal rights, the meeting must be enjoined for at least the statutorily required notice period of twenty days.

According to the lawyers at Potter Andersen & Caroon, "The Court’s ruling is a surprise to many practitioners and seems contrary to the well-settled Delaware corporate law doctrine of independent legal significance." They also assert that the decision was "startling to some practitioners."

Here are a few thoughts on this aspect of the decision. First, if you are interested in the doctrine of independent legal significance -- and who wouldn't be? -- you might check out my article on the subject, which you can download here.

Second, if you read that article, you will note that the doctrine has been used in only a few contexts. The most common is the "de facto merger," a concept that the doctrine of independent legal significance rejects by maintaining the distinction between a sale of assets and a merger. The doctrine also has been used to maintain the distinction between an amendment of the corporate charter and a merger. But I am reasonably certain that the doctrine of independent legal significance has never been used in a context like the one proposed in Crawford. (I did a quick check of Westlaw and didn't find anything close, but I can't claim to have done a thorough job of it.)

Third, what prevents a dividend from being treated as merger consideration? The defendants argue that the doctrine of independent legal significance should require the $6 payment to be treated as a dividend, not as merger consideration, but nothing in Section 262 of the DGCL precludes a "dividend" from being part of the merger consideration. So when Chancellor Chandler writes that the dividend was "fundamentally cash consideration," we could understand him to be saying that the payment is both a dividend (in form) and merger consideration (in substance).

The important point is that the doctrine of independent legal significance only matters when two characterizations of a transaction are mutually exclusive. A merger and a sale of assets are mutually exclusive because the statute provides different rights with respect to the two transactions, and the same goes for a chater amendment and a merger. Stated another way, the two transactions have different implications. But this is not true for a dividend and merger consideration. The $6 payment could be both.

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The AALS has posted podcasts from the Annual Meeting. You can browse the sessions from this page. If you would like to listen to the Section on Business Associations program on Disney, click here. By the way, I was the first speaker in that session.

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Jay Brown from the University of Denver Sturm College of Law has a new blog call "Race to the Bottom," which is a "proSOXblog" -- and, by implication, an "antiDEblog." I can see that we will have plenty to argue about!

In his most recent post, Jay criticizes the Delaware courts for their "inadequate" review of executive compensation and "ranks executive compensation as the #1 area of state corporate governance most likely to be preempted." This argument is a pretty good example of what I was talking about in my post-AALS regarding those who are critical of fiduciary law. You need a theory about what fiduciary law should accomplish before you haul off and claim that it's failing. In my view, regulating the size of executive compensation packages is not on the fiduciary law to-do list, so I'm not sure it makes sense to even think about federal legislation as "preemptive." In any event, Jay has a much longer version of his argument in a paper on SSRN.

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Francis Pileggi has blogged a recent decision by Vice-Chancellor Strine entitled Sample v. Morgan. The case involves the issuance of 200,000 shares of stock of Randall Bearings, Inc. to three senior officers of the company, who together comprised the majority of the company's five-member board of directors. The grant was made pursuant to a stock incentive plan (and accompanying charter amendment) that had been approved by the company's stockholders. The Compensation Committee that approved the grant was comprised of the two "independent" directors on Randall Bearings's board of directors. Perhaps the most important fact: the "200,000 shares represented a 46% increase in the number of shares that were issued and outstanding, from 431,680 as of the time the board approved the Charter Amendment and Incentive Plan, to 631,680 if all the Plan shares were issued."

Yikes!

Vice-Chancellor Strine's opinion denies the defendants' motion to dismiss -- a pretty easy call -- but it contains some interesting nuggets. Here are some quick takes on the case:

• Darian Ibrahim is writing a paper about individual v. collective liability of directors, and he discusses In re Emerging Communications, Inc. S'holders Litig., 2004 WL 1305745, *38 (Del. Ch.2004) at length. In Emerging Communications, then-Vice-Chancellor Jacobs wrote: "The liability of the directors must be determined on an individual basis because the nature of their breach of duty (if any), and whether they are exculpated from liability for that breach, can vary for each director." As Darian observes, Chancellor Chandler noted in his Disney opinion the tension between this view and the collective liability view espoused by Smith v. Van Gorkom. Vice-Chancellor Strine's new opinion comes down squarely on the side of individual liability: "Each director’s motivations and actions must be assessed individually before any finding of liability can be made." (citing Emerging Communications)

• Vice-Chancellor Strine uses the phrase "just ducky" (all of the directors of Randall Bearings "share the same counsel and have filed one brief taking the un-nuanced position that everything that was done was just ducky"). A Westlaw search reveals that this is the first use of this phrase in any opinion in the "allcases" database. It appears in three other cases, but in each case as a product or store name.

• Waste cases are almost as rare as Caremark cases, but just as Vice-Chancellor Strine found a viable Caremark claim in December, he has found what may be a viable waste claim in this case. His discussion is characteristically insightful:

Claims of waste are sometimes misunderstood as being founded on something other than a breach of fiduciary duty. Conceived more realistically, the doctrine of waste is a residual protection for stockholders that polices the outer boundaries of the broad field of discretion afforded directors by the business judgment rule. The wording of the test implies as much, as it condemns as wasteful a transaction that is on terms so disparate that no reasonable person acting in good faith could conclude the transaction was in the corporation’s best interest. When pled facts support an inference of waste, judicial nostrils smell something fishy and full discovery into the background of the transaction is permitted. In the end, most transactions that actually involve waste are almost found to have been inspired by some form of conflicting self-interest. The doctrine of waste, however, allows a plaintiff to pass go at the complaint stage even when the motivations for a transaction are unclear by pointing to economic terms so one-sided as to create an inference that no person acting in a good faith pursuit of the corporation’s interests could have approved the terms.

• Vice-Chancellor Strine refers to Santa Claus: "Even in an era when many scholars believe that compensation committees perhaps misunderstand the pertinence of Santa Claus to their work, the grants to the Insider Majority are extraordinary." This is the first reference to Santa Claus by a judge on the Court of Chancery (Vice-Chancellor Strine quotes a Texas court's reference to Santa Claus in Allied Capital Corp. v. GC-Sun Holdings, L.P., 910 A.2d 1020 (Del.Ch. 2006).) Could this signal a new line of cases in Delaware? Perhaps a law review article is in order.

• Vice-Chancellor Strine discusses the plaintiffs' "abdication" claim. This is not a Caremark/Stone claim (under which a director "consciously avoid[s] any attempt to carry out one's duties"), but a claim that the board has given away crucial powers. In this case, the plaintiffs claimed that the directors had abdicated their power to issue equity. Vice-Chancellor Strine wasn't buying that argument: "Although it is undoubtedly correct that a board of directors’ authority to issue equity is an important, statutorily-authorized power, that does not mean that a board cannot, for proper business reasons, enter into contracts limiting its ability to exercise that power." Again, that seems exactly right.

• Finally, Vice-Chancellor Strine offers a provocative footnote, re-interpreting a couple of famous Delaware Supreme Court opinions, Quickturn and Omnicare. Both opinions were authored by Justice Holland and suggested that certain actions of a board of directors were "invalid under Section 141(a)"  or "per se invalid," rather than breaches of fiduciary duty. Both of the opinions were adventurous and incoherent, and Vice-Chancellor Strine attempts to make sense of them by bringing them under the fiduciary umbrella:

I understand that certain Supreme Court decisions have purported to address board decisions that limit the future flexibility of the board in a starker manner, reflecting a view that such decisions were illegal, not just inequitable. The decision in Quickturn Design Systems, Inc. v. Shapiro, 721 A.2d 1281 (Del.1998), involving a board’s unilateral adoption of a slow-hand poison pill, is an example. But it is easy to reach the same result – namely, a holding that a slow-hand poison pill should be condemned – employing the more nuanced tool of equity. Certainly, that is rather obviously the case in the more extreme instance of a dead-hand poison pill, the only equitable justifications of which would seem to reside in sentiments commonly expressed by dictators seeking to justify their retention of permanent authority in the face of electoral risk (i.e., only they can protect the citizenry). The more controversial majority decision in Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del.2003), also condemned as per se invalid certain actions. But that was in part precisely the reason that the decision was so controversial and drew two well-reasoned dissents. Those actions were specifically authorized by statute and therefore could not be condemned except on equitable grounds.

For present purposes, it is worth noting that both of these decisions were rendered in cases involving board conduct in the mergers and acquisitions context, in which the concern arises that directors may seek to restrict their own authority (or that of their successors) in order to retain control or favor a particular bidder. The Delaware General Corporation Law does not contain provisions that prevent directors from entering into contracts with third-parties for legitimate reasons simply because those contracts necessarily impinge on the directors’ future freedom to act. If the judiciary invented such a per se rule, directors would be rendered unable to manage, because they would not have the requisite authority to cause the corporation to enter into credible commitments with other actors in commerce.

The opinion also has a discussion of ratification, though I found that more mundane than the points highlighted above. If you would like to read the opinion, you can download an edited version here.

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Last week I wrote a post entitled "Good Faith, Care, and Loyalty in Delaware" in anticipation of the Disney panel at AALS. In that post, I tried to explain how the Delaware Supreme Court came to embrace Caremark as the standard by which the duty of good faith would be measured. Just prior to the panel, I discovered a new Caremark decision by Vice-Chancellor Strine. Decided on December 21, 2006,  ATR-Kim Eng Financial Corp. v. Araneta may be an important marker of future developments.

The case involved a claim by minority shareholders (ATR) that a majority shareholder (Carlos Araneta) had " caused the corporation to transfer its key assets -- its ownership of several businesses worth over $35 million ... -- to members of his family in violation of his fiduciary duties." That's a straightforward duty of loyalty claim. The more interesting part of the case was the claim against the other two directors (Bonilla and Berenguer) for failing to stop Araneta. Vice-Chancellor Strine refers to those two directors as Araneta's "stooges," a conclusion that is supported by the following facts:

[B]oth Berenguer and Bonilla testified that they entirely deferred to Araneta in matters relating to the [corporation]. Berenguer is, as mentioned, Araneta's niece and served as the CFO for the [subsidiary companies] worldwide. She testified that she would not insert herself into a disagreement between ATR and Araneta about how the [corporation] should proceed on an issue because such a disagreement would be between those parties and would not affect her as a director of the [corporation]. Similarly, she stated that she would take Araneta's word as authoritative if he claimed that he had agreed with ATR to take certain actions.

Bonilla, the head of Araneta's U.S. operations, was more explicit--explaining that to him Araneta and the [corporation] were basically one and the same and that he took the word of Araneta as being the word of the company. Moreover, when pressed regarding whether he would undertake an independent inquiry if told to act by Araneta, Bonilla responded, "Why should I ask him all these questions? He's telling me they have already agreed .... It's not like I'm going to go out there and check on him, doesn't make sense."

This looks like model Caremark claim (failure of oversight). Vice-Chancellor Strine, citing his own opinion in Guttman (which I discuss in my prior post), describes a director's duty of oversight as follows:

Under Delaware law, it is fundamental that a director cannot act loyally towards the corporation unless she tries--i.e., makes a genuine, good faith effort--to do her job as a director. One cannot accept the important role of director in a Delaware corporation and thereafter consciously avoid any attempt to carry out one's duties.

Notice that a director must "consciously avoid any attempt to carry out one's duties." Such a director is so hard to find, at least after a trial, that (if I am not mistaken) this is the first successful Caremark claim ever in Delaware. (Even the plaintiffs in Caremark were not successful on their Caremark claim.)

At the Disney panel, I described this as an intentionality requirement that was designed to distance the duty of good faith from the duty of care. Hilary Sale observed that the standard could include "recklessness," though I am not sure what that adds to the Court's other descriptions of bad faith. Recklessness is simply a way of shading the intentionality requirement, and my main point is that the Delaware courts are eager to confine fiduciary liability to extreme cases.

Notice the language used by Vice-Chancellor Strine later in ATE: "Their behavior was not the product of a lapse in attention or judgment; it was the product of a willingness to serve the needs of their employer, Araneta, even when that meant intentionally abandoning [their] important obligations...." (emphasis added) This case was a first, and I think we will not have many more like it.

By the way, Vice-Chancellor Strine found all three directors jointly and severally liable for damages, but he clearly felt that Araneta's breach of loyalty was more reprehensible than the loyalty breaches of the other directors ("to the extent it is later important, if Bonilla and Berenguer pay any or all of the judgment, Araneta should be required to make them whole, to the extent that is consistent with applicable law"). This tends to reinforce my understanding that the "good faithy version of loyalty" created by the Delaware Supreme Court in Stone v. Ritter is really just a second-class version of loyalty. Indeed, the only reason to call it "loyalty" is to send a message to plaintiffs and legal academics that the duty of good faith is not an extension of the duty of care.

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Later today, I will participate on the "Teaching Disney" panel. Last night, I had dinner with Justice Jack Jacobs, who wrote the Disney opinion. He also joined Justice Holland's opinion in Stone v. Ritter, in which the Delaware Supreme Court held that "good faith" was part of the duty of loyalty. What motivated the Court to decide Stone in the way it did?

According to Justice Jacobs, this was the Court's attempt to clarify some doctrinal points and to distance "good faith" from the duty of care. In light of that latter goal, the Court's decision to embrace Chancellor Allen's classic language from Caremark as one standard for measuring bad faith may seem strange because that case was expressly about the duty of care. The second sentence of Caremark reads: "The suit involves claims that the members of Caremark's board of directors (the 'Board') breached their fiduciary duty of care to Caremark in connection with alleged violations by Caremark employees of federal and state laws and regulations applicable to health care providers."

References to the duty of care are sprinkled throughout the case, which mentioned loyalty only once: "The complaint thus does not charge either director self-dealing or the more difficult loyalty-type problems arising from cases of suspect director motivation, such as entrenchment or sale of control contexts." Nevertheless, in Stone v. Ritter the Court associates Caremark with the duty of loyalty:

It is important, in this context, to clarify a doctrinal issue that is critical to understanding fiduciary liability under Caremark as we construe that case. The phraseology used in Caremark and that we employ here – describing the lack of good faith as a "necessary condition to liability" – is deliberate. The purpose of that formulation is to communicate that a failure to act in good faith is not conduct that results, ipso facto, in the direct imposition of fiduciary liability. The failure to act in good faith may result in liability because the requirement to act in good faith "is a subsidiary element[,]" i.e., a condition, "of the fundamental duty of loyalty." [citing Guttman v. Huang, 823 A.2d 492, 506 n. 34 (Del.Ch.2003).] It follows that because a showing of bad faith conduct, in the sense described in Disney and Caremark, is essential to establish director oversight liability, the fiduciary duty violated by that conduct is the duty of loyalty.

How did the Court get from point A to point B? The key is Leo Strine's opinion in Guttman. In that case, Strine tied the notion of "good faith" to loyalty. He focused on this oft-quoted paragraph from Caremark:

Generally where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation ... in my opinion only a sustained or systematic failure of the board to exercise oversight--such as an utter failure to attempt to assure a reasonable information and reporting system exists--will establish the lack of good faith that is a necessary condition to liability. Such a test of liability--lack of good faith as evidenced by sustained or systematic failure of a director to exercise reasonable oversight--is quite high. But, a demanding test of liability in the oversight context is probably beneficial to stockholders as a class, as it is in the board decision context, since it makes board service by qualified persons more likely, while continuing to act as a stimulus to good faith performance of duty by such directors.

Notice the repeated reference to "good faith." According to Strine, Chancellor Allen was really talking about the duty of loyalty:

Although the Caremark decision is rightly seen as a prod towards the greater exercise of care by directors in monitoring their corporations' compliance with legal standards, by its plain and intentional terms, the opinion articulates a standard for liability for failures of oversight that requires a showing that the directors breached their duty of loyalty by failing to attend to their duties in good faith.

The footnote quoted in Stone v. Ritter reads in whole as follows:

A director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation's best interest. For this reason, the same case that invented the so-called "triad[ ]" of fiduciary duty, see Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del.1993) ("Cede II"), also defined good faith as loyalty. See In re Gaylord Container Corp. S'holders Litig., 753 A.2d 462, 475 n. 41 (Del.Ch.2000) (explaining the origins of this oddment of our law, i.e., the "triad[ ]").

It does no service to our law's clarity to continue to separate the duty of loyalty from its own essence; nor does the recognition that good faith is essential to loyalty demean or subordinate that essential requirement. There might be situations when a director acts in subjective good faith and is yet not loyal (e.g., if the director is interested in a transaction subject to the entire fairness standard and cannot prove financial fairness), but there is no case in which a director can act in subjective bad faith towards the corporation and act loyally. The reason for the disloyalty (the faithlessness) is irrelevant, the underlying motive (be it venal, familial, collegial, or nihilistic) for conscious action not in the corporation's best interest does not make it faithful, as opposed to faithless.

The General Assembly could contribute usefully to ending the balkanization of the duty of loyalty by rewriting § 102(b)(7) to make clear that its subparts all illustrate conduct that is disloyal. For example, one cannot act loyally as a corporate director by causing the corporation to violate the positive laws it is obliged to obey. See 8 Del. C. § 102(b)(7)(ii). Many recent events have only emphasized the importance of that obvious component of the duty of loyalty. But it would add no substance to our law to iterate a "quartet" of fiduciary duties, expanded to include the duty of "legal fidelity," because that requirement is already a subsidiary element of the fundamental duty of loyalty. The so-called expanded "triad [ ]" created by Cede II, I respectfully submit, is of no greater utility.

This is a fine enough argument, though I have a hard time understanding why it would be necessary in 2006. In the most recent Disney opinion, the Delaware Supreme Court effectively distinguished the "duty of good faith" from the "duty of care": "grossly negligent conduct, without more, does not and cannot constitute a breach of the fiduciary duty to act in good faith." Why was it necessary to take the additional step of placing the "duty of good faith" under the "duty of loyalty," especially after Chancellor Chandler and Justice Jacobs had taken such pains to define the "duty of good faith"?

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In 1993 Justice Horsey of the Delaware Supreme Court penned this unfortunate sentence in the second major Technicolor opinion: "To rebut the [business judgment] rule, a shareholder plaintiff assumes the burden of providing evidence that directors, in reaching their challenged decision, breached any one of the triads of their fiduciary duty -- good faith, loyalty or due care."

Triads?

In Gaylord, Vice-Chancellor Strine tweaked the Delaware Supreme Court for its use of the plural "triads" and for identifying "good faith" as a separate fiduciary duty: "Indeed, the very Supreme Court opinion that refers to a board's 'triads [sic] of fiduciary duty [sic] -- good faith, loyalty [and] due care,' equates good faith with loyalty."

In subsequent opinions, the Delaware courts and commentators charitably reduced the number of triads to one, but confusion remained about the role of "good faith" in fiduciary litigation. We had a lot to say here about the Disney litigation, and if you were following that conversation, you might remember a lingering issue from the Supreme Court's most recent opinion: does the duty of good faith provide an independent basis for director liability?

My initial take on the Disney opinion was unequivocal:

The Court clearly embraces the duty of good faith as a distinct duty, separate from care and loyalty. For example, "grossly negligent conduct, without more, does not and cannot constitute a breach of the fiduciary duty to act in good faith."

In a subsequent post, I addressed Footnote 112 of Disney, which reads as follows:

[W]e do not reach or otherwise address the issue of whether the fiduciary duty to act in good faith is a duty that, like the duties of care and loyalty, can serve as an independent basis for imposing liability upon corporate officers and directors. That issue is not before us on this appeal.

I argued that "footnote 112 was an afterthought designed to secure a vote for the opinion in pursuit of unanimity." I speculated privately to several colleagues that Justice Holland had demanded the footnote, though what he intended to do with it I wasn't sure.

Now I know. The triad is dead.

Yesterday, the Delaware Supreme Court issued a unanimous, en banc opinion that seems to drive a stake in the heart of "the fiduciary duty of good faith." The following comes from Stone v. Ritter:

It is important, in this context, to clarify a doctrinal issue that is critical to understanding fiduciary liability under Caremark as we construe that case. The phraseology used in Caremark and that we employ here—describing the lack of good faith as a "necessary condition to liability"—is deliberate. The purpose of that formulation is to communicate that a failure to act in good faith is not conduct that results, ipso facto, in the direct imposition of fiduciary liability. The failure to act in good faith may result in liability because the requirement to act in good faith "is a subsidiary element[,]" i.e., a condition, "of the fundamental duty of loyalty." It follows that because a showing of bad faith conduct, in the sense described in Disney and Caremark, is essential to establish director oversight liability, the fiduciary duty violated by that conduct is the duty of loyalty.

This view of a failure to act in good faith results in two additional doctrinal consequences. First, although good faith may be described colloquially as part of a "triad" of fiduciary duties that includes the duties of care and loyalty, the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty. Only the latter two duties, where violated, may directly result in liability, whereas a failure to act in good faith may do so, but indirectly. The second doctrinal consequence is that the fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It also encompasses cases where the fiduciary fails to act in good faith. As the Court of Chancery aptly put it in Guttman, "[a] director cannot act loyally towards the corporation unless she acts in the good faith belief that her actions are in the corporation's best interest."

I will have a lot to say about this at some future date, probably in a law review article, but the first question that springs to mind is this: Has the Delaware Supreme Court been acting in good faith in its development of the duty of good faith?

Over the past decade, the Court has had numerous opportunities to "clarify" this issue, and the Court has consistently muddied the waters. As noted above in my Gaylord citation above, the Court of Chancery responded to Justice Horsey's unfortunate sentence by treating the mysterious duty of good faith as a species of loyalty violation, but the Supreme Court repeatedly emphasized the distinctiveness of "the duty of good faith." I never liked the idea that good faith was part of the duty of loyalty, but if that's where the Supreme Court wanted it, did we really need over a decade to figure that out?

We are told that the duty of good faith is connected to Caremark, which the Supreme Court has cited in three other cases, though never with the complete endorsement of the Caremark standard that appears in Stone. This makes sense to me, given the notion of "good faith" articulated in the Disney cases.

Then we are told that Caremark is really a duty of loyalty case. Not duty of loyalty in the traditional sense -- you know, those cases "involving a financial or other cognizable fiduciary conflict of interest" -- but something different. More like a good faithy version of loyalty. Ok, I think I basically get good faith after Disney, but why dilute a useful and longstanding conception of loyalty with these other fact situations? Was the post-Disney triad broken and in need of repair?

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In the past 16 years, Delaware Chancery Court judges and Supreme Court justices have collectively written around 50 articles on corporate law topics (roughly defined), and 28 on non-corporate topics (shout out to my research assistant, D.K., for compiling these numbers). 35 of the corporate articles have been published since 2000. I haven't run any kind of study, but these preliminary numbers support my intuition that Delaware produces more legal scholarship than the average state.

What’s the deal? It seems to me that Delaware judges and justices have as an institution taken pains to create a consciously public and consciously scholarly persona. Does anyone have any insights as to why this might be the case? It seems to be right in line with Ed Rock’s Saints and Sinners: How Delaware Law Works, 44 UCLA L. Rev. 1009 (1997). Rock’s article is too good for me to do justice to in a blog post, but part of the gist is that Delaware works by shaming bad actors and praising good ones, as much as by creating law. His focus is on management buyout opinions, but he has a short section about “extrajudicial utterances,” as well. To the extent that Delaware corporate law is about telling us narratives about how good and bad corporate actors behave, these judicial utterances may be a useful secondary medium to convey the message. For me this abundant judicial scholarship also raises shades of Jonathan Macey and Geoffrey Miller’s interest-group theory of Delaware corporate law: to the extent that Delaware judges are out there saying things that may or may not offer hints as to the direction Delaware law is headed, it may make Delaware lawyers more valuable as interpreters of that law. Certainly it gives them more hours of reading to bill.

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Delaware recently amended its corporation statute. Among other changes, the legislature approved this addition to § 216: "A bylaw amendment adopted by stockholders which specifies the votes that shall be necessary for the election of directors shall not be further amended or repealed by the board of directors."

Hmm.

We have discussed shareholder-adopted bylaws before. In Delaware one of the most important open questions relating to such bylaws is whether the board can amend them unilaterally. The Model Business Corporation Act expressly covers this situation: "A corporation's board of directors may amend or repeal the corporation's bylaws, unless ... the shareholders in amending, repealing, or adopting a bylaw expressly provide that the board of directors may not amend, repeal, or reinstate that bylaw." (§ 10.20(b)) The Delaware statute does not address this question directly, and the Delaware courts have not yet decided the issue.

How does this new amendment to the Delaware code affect the debate? Obviously, it allows shareholders to protect a bylaw that specifies the votes necessary for the election of directors, but does it carry a negative implication that the board is allowed to amend other shareholder-adopted bylaws? Even if a bylaw expressly provides that the board of directors may not amend, repeal, or reinstate that bylaw?

To answer these questions, we need to look at § 109 of the Delaware corporation statute, which provides that "the power to adopt, amend or repeal bylaws shall be in the stockholders entitled to vote." That section also allows corporations to include a charter provision conferring on the board of directors the power to adopt, amend or repeal bylaws, then concludes: "The fact that such power has been so conferred upon the directors ... shall not divest the stockholders ... of the power, nor limit their power to adopt, amend, or repeal bylaws."

This statute is endlessly fascinating, and I recommend papers by Brett McDonnell and Larry Hamermesh if you have a taste for such arguments. The question of the moment, however, is whether the new language changes anything about the old debate, and that depends importantly on where you started.

• If you thought, prior to this amendment, that directors had the power to amend shareholder-adopted bylaws, it's hard to see how the amendment would change anything.

• If you thought, prior to this amendment, that directors did not have the power to amend shareholder-adopted bylaws, then I would suggest that this amendment changes things.

I come at this as one who finds the statute prior to the amendment almost wholly indeterminate. Given that starting point, my sense is that the new language carries a fairly strong negative implication that the board is allowed to amend other shareholder-adopted bylaws, even if those bylaws expressly provide that the board of directors may not amend, repeal, or reinstate that bylaw.

UPDATE: In the comments, Larry Hamermesh points to the synopsis of the bill, which states:

Section 5 Amends § 216 to provide that a bylaw adopted by a vote of stockholders that prescribes the required vote for the election of directors may not be altered or repealed by the board of directors. This amendment does not address any other situation in which the board of directors amends a bylaw adopted by stockholder vote.

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One of my favorite Delaware decisions is Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988), written by then-Chancellor Bill Allen. Blasius has a narrow assignment in Delaware jurisprudence, requiring a "compelling justification" for any corporate action "intended primarily to thwart effective exercise of the franchise." Not many corporate actions over the years have been subjected to that standard, but Allen's defense of the shareholder vote is a classic:

The shareholder franchise is the ideological underpinning upon which the legitimacy of directorial power rests. Generally, shareholders have only two protections against perceived inadequate business performance. They may sell their stock (which, if done in sufficient numbers, may so affect security prices as to create an incentive for altered managerial performance), or they may vote to replace incumbent board members.

It has, for a long time, been conventional to dismiss the stockholder vote as a vestige or ritual of little practical importance. It may be that we are now witnessing the emergence of new institutional voices and arrangements that will make the stockholder vote a less predictable affair than it has been. Be that as it may, however, whether the vote is seen functionally as an unimportant formalism, or as an important tool of discipline, it is clear that it is critical to the theory that legitimates the exercise of power by some (directors and officers) over vast aggregations of property that they do not own. Thus, when viewed from a broad, institutional perspective, it can be seen that matters involving the integrity of the shareholder voting process involve consideration not present in any other context in which directors exercise delegated power.

Timeless.

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Those who saw me at the Law & Society Annual Meeting probably noticed a beautiful young girl by my side. That was my daughter, Eve. We used the conference as an excuse for some Daddy-Daughter time. As it turned out, the least expensive airline ticket we could find took us to Washington, D.C. on the day before the conference, so we toured the Capitol and visited several monuments. We also enjoyed the International Spy Museum. It requires a fair amount of reading, so young children may not enjoy it, but adults and teens should be enthralled. At least I can say that we were.

We also took a brief trip to Delaware, where Eve was born. (She had not been in Delaware since I entered academe, just prior to her first birthday.) This trip was not meticulously planned, so I didn't realize until we were well along that we would be passing through Georgetown, home to the chambers of Chancellor William Chandler in the beautiful new Court of Chancery. Of course, I was displaying the Wisconsin colors:

 
When I first suggested to Eve that we pay the Chancellor a visit, she wasn't very excited. ("He's a judge?") At the end of our trip, she cited this as one of the highlights, a tribute to the Chancellor's graciousness. Once we made it past the security guard (whose name is "Rocky Justice" ... I am not kidding), Chancellor Chandler gave us a tour of the courthouse. Among other things, Eve was allowed to sit in the Chancellor's chair and hold the gavel, but I won't publish that photo or you might be jealous.

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