The best part of a Delaware Chancery Court opinion is the first 30 or so pages. In most important cases, the opinion typically starts by telling a story – a detailed account of the people who figure in the dispute, what they did, their motives and personalities, and how this character-driven narrative resulted in the dispute the court must resolve. Often there is drama: exposition, crisis and denouement. The recent decision over the validity of a poison pill invoked to disadvantage Third Point’s effort to dislodge Sotheby’s management is a great example. The interest and importance of the case is in not in the legal analysis but in the story the Vice-Chancellor tells about a board that had doubts about its own performance, about a challenger who apparently acted as if he had already won, and about a CEO whose vitriol got in the way of analysis. Had the threatened proxy fight actually taken place, shareholders could understandably have wanted to vote for none of the above.
Delaware corporate governance rests on two conflicting premises: on the one hand, the board of directors and the management the board selects run the corporation’s business, but on the other the shareholders vote on who the directors are. The board needs discretion to run the business, but the shareholders decide when the board’s performance is so lacking that it (and management) should be replaced. All of the most interesting issues in corporate governance arise when these two premises collide – when the board’s assessment of how the company is doing is different than the shareholders’, and each claims that their assessment controls. These collisions work out within a predictable range when, unexpectedly, new governance initiatives shift the underlying plate tectonics and disequilibrate the settled patterns. Whether the particular earthquake is caused, as was the case in the 80s, by the emergence of a hostile tender offer or, as now, by activist investors seeking to change management, policy or both through a threatened proxy fight, the underlying question is the same: when does the board’s discretion end and the shareholders’ power begin? The boundary is the corporate governance ring of fire.
The Sotheby’s case is important not because it breaks new legal ground. The court’s legal analysis is carefully ambiguous. On the one hand, Sotheby’s wins something because the facts can be characterized, with some effort, as really about a takeover of control not a proxy fight, and Third Point wins something because the court candidly acknowledges that the case might have come out differently if it really was just about a proxy fight. Not surprisingly, the case then settles largely on Third Point’s terms.
Commentators on both sides will find something to crow about in the opinion. Those working the pro-management side of the street will announce proudly that the poison pill remains powerful, protecting board discretion against activists as it did against raiders; those favoring a broader role for shareholders will point to both a court that is openly sympathetic to shareholders and a road map for how an activist might avoid their proxy contest being reframed as a takeover or how to comport oneself so as to avoid the purported pursuit of “negative control.” But that account of the case, a simple retelling of the two sides of what is after 30 years an exhausted debate, misses the point. We are about to see the management and shareholder plates of corporate governance geology collide sharply. The Sotheby’s story reflects the coming earthquake in Delaware corporate governance. Here’s why.
Delaware law’s current framework is based on a belief about the distribution of public shareholders – they are largely small shareholders who have neither the skills nor the time to really assess what management is doing. Central to Delaware’s embrace of the poison pill was the belief that these shareholders would be taken in by hostile raiders because they did not really understand the corporation’s value. So a corporation could deploy a pill because of the threat that small shareholders were too dumb to reject an underpriced hostile offer.
The key to understanding the Sotheby’s case is that the assumption about shareholder distribution baked into Delaware corporate governance law is now simply wrong. Institutional investors own on average 70 percent of the equity of the top 1000 US public corporations, with something more than half of that owned by mutual funds. These are smart people. The 1980s claim by target boards and endorsed by the Delaware courts that the shareholders will be taken in by those challenging a board’s discretion is not even remotely viable. Management defenders now try to recharacterize the debate by calling institutional investors “short-termist” rather than dumb, but the argument is the same. Boards require discretion because shareholders can be expected to make incorrect decisions about company value.
The Delaware courts never had to confront the cognitive contradiction between their attitude toward hostile bids (boards can intervene to protect ignorant shareholders) and proxy contests (boards cannot challenge the electoral power of the same shareholders, presumably still ignorant), because proxy contests were (mostly) an empty threat to managerial control. Diffuse shareholdings not only reduce shareholders’ direct governance power, but they also reduce the potential for shareholder activists to acquire a reputation for useful governance intervention. In every insurgent proxy solicitation, the question of the activist’s motivation is always front and center: is the battle about the activist’s private benefits (greenmail a classic example) or about earning a return on the activist’s toehold investment? If shareholdings are diffuse, how is management to be disputed in its motive-slinging?
The change in the ownership distribution makes all the difference, because large investment intermediaries have both a significant ownership stake in their portfolio companies and sufficient diversification to allow for knowledgeable observation of an activist’s behavior across many governance targets. Institutions, unlike diffuse shareholders, can observe repeat play. Activists can acquire a reputation that reverses the prior presumption about the pursuit of private benefits. All of a sudden, proxy contests, the corporate governance step-child, have become Cinderella at the ball. The cognitive contradiction can no longer be ignored.
It is the change in ownership distributions, and the implication for proxy contests, that the Sotheby’s court’s narrative of the fight between Third Point and Sotheby’s so strikingly illustrates. The court explains that, as the proxy fight developed, the Sotheby’s board debated when it should speak to Blackrock, the world’s largest asset manager. Ultimately, it spoke to Blackrock and Vanguard. Both told Sotheby’s they were going to lose. In the new world of capital markets, the game was then effectively over, and ultimately Sotheby’s settled largely on Third Point’s terms. The capital market lesson is that institutional investors now are the central players in the activist game. The shareholder activists are the advance scouting party. The poison pill is a sideshow, as the ultimate outcome in Sotheby’s dramatically demonstrates.
Looking ahead, this is going to be a fascinating and disruptive period in Delaware law, as the tectonic plates of board discretion and shareholder power realign themselves in light of the new landscape of shareholder ownership. The old rules do not work well in the new geology, as the Vice Chancellor plainly understood in the Sotheby’s case. He rather artfully straddled the fault line by allowing the case to be reframed as a takeover case and therefore resolvable with the old rules, while at the same time giving credence to the growing practical importance of the shareholder franchise by voicing sympathy for Third Point. Bringing Delaware corporate governance law in line with the new capital market reality will take up a good deal of the Delaware Supreme Court’s attention in the next few years. And to make it more interesting, the Supreme Court is led by a new chief justice whose writings demonstrate that he understands the tectonic shift that has taken place. Corporate governance observers need to hold on to their hats. This is going to be one heck of a ride.
Ronald J. Gilson is Stern Professor of Law and Business, Columbia Law School, Meyers Professor of Law and Business, Stanford Law School, and Fellow, European Corporate Governance Institute. Jeffrey N. Gordon is Richman Professor of Law and Co-Director of the Millstein Center for Global Markets and Corporate Ownership, Columbia Law School; Fellow, European Corporate Governance Institute.