Fried Frank Discusses Where Things Stand at Year-End 2019

Corporate Focus on the “Social Good”

Importantly, the Business Roundtable (an influential group of almost 200 CEOs of America’s most influential companies) issued a “Statement on the Purpose of a Corporation,” which has intensified a developing focus on the social impact of corporate decisions. The BRT Statement contains no specific commitments or directives and does not represent a change in law, but reflects a view that there is a social responsibility component to corporate decision-making. The Statement emphasizes that directors should not be single-focused on the maximization of profits for shareholders and should weigh heavily the interests of the other stakeholders of the corporation (i.e., customers, employees, suppliers, and the community). Under Delaware law, a board has fiduciary duties to act in the best interest of the shareholders, but has wide leeway to act in the interests of other stakeholders so long as there is any rational basis to conclude that those actions will ultimately redound to the benefit of the shareholders. It remains to be seen to what extent and how the BRT Statement’s objectives may be incorporated into corporate decision-making.

The BRT Statement has received a considerable amount of attention and has stimulated widespread discussion within the corporate community and beyond. The Statement’s principles reflect the current view of many key institutional investors, as well as the “Millennial Generation” of job-seekers. At the same time, we note that the pressures (for example, the prospect of a takeover or shareholder activist attack) that in recent years have driven an emphasis on short-term returns to shareholders (and accompanying corporate governance changes, such as the dismantling of classified boards, which make companies more vulnerable to those pressures) continue in full force. It is uncertain what the result of the intersection of these competing trends will be, and what the impact of wider economic, social and political developments will have, as boards consider the objectives of the BRT Statement.

At a minimum, the ongoing debate suggests that boards should be sensitive to social impact issues, understand the views of their key shareholders in the debate, and anticipate what areas of the company’s business or their own decision-making are most likely to raise social impact issues, and be proactive in being prepared to respond to challenges in those areas.

Increase in Bidder-Initiated M&A and Change in Sale Process Mechanics

A significant number (by one report, a majority) of public M&A transactions are now initiated in some form by a bidder rather than by a target company’s decision to initiate a sale process. This trend has arisen in the context of the dismantling over recent years of takeover defense structures (most importantly, the classified board). At the same time, there has been a transformation in Delaware jurisprudence over recent years toward a narrowing of the more exacting standards of judicial review in M&A matters. As the courts have steadily eroded the potency of the Revlon doctrine (which requires that, in a “sale” of the company transaction—i.e., a sale for cash or to a new control person—the target board must seek to obtain the best price reasonably available), directors now have even broader latitude than before in crafting a sale process. Reflecting this development, few sale processes now are conducted as public auctions. Moreover, many do not include a pre-signing market check and/or are subject to a “passive”-only post-signing market check (i.e., the deal terms prohibit post-signing solicitation of competition but permit competition if it should emerge on an unsolicited basis and the deal terms provide for a not unreasonable termination fee).

Possible Retrenchment of the Corwin Doctrine

Since its issuance in 2015, Corwin has been a potent force for obtaining early dismissal of fiduciary duty claims in M&A actions. (Corwin provides for deferential business judgment review of a challenged transaction in a post-closing action not involving a conflicted controller—regardless of the standard of review that applied pre-closing—if the transaction was approved by the target stockholders in a fully informed, uncoerced vote.) Initially there was a steady stream of cases in which the Delaware courts amplified a broad view of Corwin’s applicability, readily found Corwin governed the case at issue (even in the face of non-trivial disclosure issues and/or a board that was largely not independent and disinterested), and dismissed the case at the early pleading stage of litigation (even in factual contexts involving apparent serious sale process flaws). By contrast, in 2018 and 2019, there have been only a very few cases involving Corwin and, among these, the court has found Corwin applicable and dismissed the case in only a small number of instances.

In the decisions in which the court has found Corwin inapplicable, the focus has been primarily on disclosure—that is, were the stockholders truly “fully informed” when they approved the transaction? Notably, plaintiffs have been more successful in defeating application of the Corwin doctrine at the pleading stage through the use of documents obtained under the DGCL Section 220 stockholder right to inspect books and records of the corporation. In one case (Morrison v. Berry), the court found that the disclosure to stockholders was materially incomplete and misleading (and Corwin therefore did not apply) based on the plaintiff’s line-by-line comparison of the information in board materials and emails he obtained under a Section 220 demand with the information stated in the proxy statement relating to the transaction. The case highlights the obvious importance of a company’s ensuring that its public disclosures accurately and fully reflect the information contained in corporate documents that may be obtained under a Section 220 demand.

In addition, in our view, the apparently somewhat more restrictive standard for “materiality” of disclosure applied at the beginning of the Corwin era has now subsided—and this (together with findings of coercion of the stockholder vote in a small number of cases) appears to suggest something of a retrenchment in the Corwin doctrine, broadly speaking. Corwin was a reaction to the phenomenon of virtually every public M&A transaction being challenged in litigation. It appears that the pendulum may be in the process of moving gently back—possibly reflecting concerns that Corwin may provide the potential for even serious misconduct by directors to be insulated and thus may have been an over-correction of the problems associated with M&A litigation. While we expect that Corwin will continue to be a powerful defense tool, it will perhaps be utilized with less blunt force so as to permit judicial consideration where, in egregious factual contexts, viable fiduciary duty claims are made.

Conflicted Controlling Stockholder Transactions

The Delaware courts have long expressed concern about the potential for “coercive influence” by controllers—“800-pound gorillas,” as Chief Justice Strine has characterized them—over directors (who the controller typically can remove or not reappoint) and unaffiliated stockholders (who the controller potentially may harm through retributive acts such as a squeeze-out merger or the cutting of dividends). The 2019 Delaware decisions clarify that the courts’ “reflexive skepticism” of conflicted controller transactions applies even when the controller has no intention to be coercive, the transaction is negotiated by “outside” putatively independent directors, and/or the transaction is stockholder-approved.

In one case (Tornetta v.Musk), the Court of Chancery applied an “entire fairness” standard of review to a board’s decision on executive compensation for a controlling stockholder and stated that business judgment review would have applied if the MFW prerequisites had been satisfied. (MFW provides for business judgment, rather than entire fairness, review of a conflicted controller transaction if, from the outset, the transaction was irrevocably conditioned on approval by both an effectively-functioning special committee of independent directors and by a majority of the minority stockholders in a fully-informed, non-coerced vote.) Previously, business judgment deference generally has been accorded to executive compensation decisions made by an “independent” compensation committee or board and MFW compliance has been required for business judgment review of conflicted controller transactions only in the context of transactions that were “transformational” for the corporation (such as a merger). Tornetta suggests the possibility for further expansion of the MFW doctrine outside the M&A context to a board’s day-to-day decisions that involve or affect a controller.

In another case (Olenik v. Lodzinski), the Delaware Supreme Court undercut the notion that there could be considerable leeway for controllers in the extent to which deal discussions could occur between the parties to a transaction before the controller had to make a determination whether or not to structure the transaction to be MFW-compliant. The Supreme Court confirmed that, in order to satisfy the requirement that the MFW-prescribed conditions be imposed “from the outset” (the “ab initio requirement”), those conditions must be imposed before “economic horse trading”—but, further, the Supreme Court indicated that it is not only specific price discussions that would cross the “economic horse trading” line and suggested that MFW conditions should be imposed “early” in the process. In Olenik, the controller and the company engaged in eight months of what they contended were “preliminary” and “exploratory” discussions before a formal offer (which included the MFW dual conditions) was made. The Supreme Court viewed the “preliminary discussions” as having crossed the line to “substantive economic negotiations” when the parties engaged in a joint exercise to value the target and the acquirer (which, in the court’s view, set the stage for the future price negotiations). The Supreme Court stated that its analysis was “informed” by its 2018 Synutra decision, in which it found compliance with MFW where the MFW conditions were imposed “at the germination stage of the Special Committee process, when [the controller was] selecting its advisors, established its method of proceeding, [and] began its due diligence….”

Diminished Importance of Appraisal

The Delaware courts now emphasize a deal-price-less-synergies approach to determining “fair value” in the appraisal context (e.g., Aruba)—other than where the court views the deal price as “unreliable” because a conflicted controller is involved or there were serious flaws in the sale process, in which case the court relies on the traditional discounted cash flow methodology to determine fair value. Notably, because the court generally has applied a low bar to a finding that a sale process was sufficient for primary reliance on the deal price, the appraisal result can be (and in several cases has been) below the merger price even in cases in which the court has viewed the sale process as having been flawed. The appraisal determination has in some cases been well below the merger price in cases involving significant expected synergies or a merger price that reflected a premium well above the market price. Unsurprisingly, there has been a marked decline in the filing of appraisal petitions—and a significant lessening of appraisal risk in most deals.

Merger Agreement Developments

  • Numerous contract interpretation cases. With the decline in M&A fiduciary litigation, the focus of Delaware decisions in the past couple of years has turned to contract interpretation. There is continued judicial emphasis on the “plain language” of agreements and the “plain meaning” of words (often, as determined by reliance on dictionary definitions). In addition, in these cases, “technical” failures to comply with the specific language has had far-reaching consequences in terms of, for example, termination and indemnification rights. The 2019 examples include the Court of Chancery’s decisions in Vintage Rodeo v. Rent-a-Center (where the court held that the seller had the right to terminate a $1.57 billion merger after the parties had discussed, and their conduct reflected that they had assumed, that an extension would be made, but the buyer “simply forgot” to formally provide the written notice for the extension that was required under the merger agreement); Absalom v. Saint Gervais (where the court held—based on its interpretation of the word “voidable” rather than “void”—that no equitable defenses were available with respect to the transfer of an LLC interest that was prohibited under the LLC agreement); and NASDI v. North American Leasing (where the court’s interpretation of a right to indemnification depended on its view of the meaning of the word “but”).
  • Regulatory. We have seen more emphasis in merger agreement negotiations on regulatory risk. Regulatory provisions are now more often tailored to the specific circumstances of a given deal. Where there are significant regulatory issues, the regulatory commitment is typically strong and can be far-reaching. Moreover, often, very significant reverse termination fees are tied specifically to termination for regulatory reasons.
  • MeToo and cybersecurity. There has been an increased focus on seeking to secure disclosure in due diligence of MeToo issues (including current complaints and history) and cybersecurity issues. Where there are significant concerns relating to these topics, they now are sometimes specifically addressed in the merger agreement (e., with tailored representations and warranties, covenants and/or indemnification provisions rather than a reliance on the general provisions).
  • “Material adverse change.” Last year, the Court of Chancery, for the first time that we are aware of, found that a “material adverse change” sufficient to trigger a right of termination of a merger agreement had occurred (Akorn v. Fresenius). It is to be noted that, in Akorn, the changes that occurred were dramatic; the changes affected the long-term value of the company; and the overall factual context was egregious. Akorn serves as a strong reminder that careful consideration should be given to the drafting of a MAC clause. All reasonably anticipatable developments of possible significance—given the specific industry, business, company and transaction at issue—should be considered. Where there are specific concerns—for example, because there is a high degree of likelihood of a certain important development occurring or not occurring, or a certain development could have a significant impact—consideration should be given to drafting the MAC clause to cover these specific developments explicitly. Furthermore, the agreement could provide hypothetical examples for added clarity as to what would or would not constitute a MAC.
  • Earnouts. Earnouts, while often used to bridge valuation differences between parties to an agreement to acquire a private company, frequently lead to post-closing disputes. A common disagreement relates to a seller’s contentions that, during the earnout period, the buyer did not take appropriate actions to support the realization and maximization of the earnout. The courts have consistently endorsed a very limited approach to application of the implied covenant of good faith and fair dealing (which adheres to every contract) and have found that a buyer did not meet its obligations only when the buyer did not satisfy its express contractual commitments or acted purposefully to frustrate realization of the earnout (such as by artificially moving revenues to a period outside the earnout period). The 2019 decisions on earnouts (e.g., Glidepath v. Beumer) reaffirm that, during an earnout period, a buyer has no obligation to seek to maximize the amount of earnout consideration that will be triggered, absent an express contractual commitment to the contrary.

Maturing of Shareholder Activism

Shareholder activism has evolved to be a prominent, and almost certainly permanent, feature of the corporate landscape. At the same time, in our view, the “success” of activists has been overstated—both in terms of board seats won at target companies (most of which have been gained by a handful of key activists in a limited number of campaigns or have involved obtaining only one or two seats on a large board) and in terms of overall investment returns for the class (given that, but for a small number of activists, the returns have been both volatile and lackluster). At the start of 2019, activism in the U.S. already exhibited the hallmarks of a mature market; there was a dearth of companies targeted that had not previously been targeted by activists; a handful of activists in campaigns at companies of scale dominated the space; a nascent trend emerged of standstill restrictions not being imposed on activists in settlement agreements; and, in an effort to avoid activism, boards were increasingly focused on proactively addressing potential catalysts. The maturity of the activism market in the U.S. at year-end 2019 is reflected not only in overall activity levels, which are essentially unchanged relative to a year ago, but also in the infrequency of protracted public campaigns. New themes—including more aggressive tactics by activists, heightened scrutiny of workplace conduct, and changing market conditions—may create opportunities for activists going forward; but potential challenges for activists abound, particularly in the event of a market downturn.

M&A is still a primary focus of activists. An M&A-related objective was the key stated objective in almost half of the newly announced public activist campaigns in 2019 (up from about one-third of campaigns in 2017 and 2018). We expect that M&A-related activism may become more aggressive, with activists more often stimulating the sale of independent companies, including by themselves identifying and contacting particular potential buyers (likely after acquiring a toehold equity stake in the company) or by themselves submitting bids for companies. M&A deal planning must proactively take into account the possibility of an activist response. The actions of Carl Icahn-affiliated entities in this year’s ongoing Occidental-Anadarko situation underscore that, even when a merger is structured so that acquirer stockholder approval is not required, an activist may nonetheless surface to advocate against the deal, to criticize the lack of a stockholder vote and the more expensive financing typically required for deals so structured, and, post-closing, to seek to replace directors.

Increase in Section 220 Demands

There has been a significant increase in stockholder efforts, through DGCL Section 220 demands, to obtain access to the corporate books and records. These demands are made most often in the context of seeking information to support post-closing damages claims and/or to establish that Corwin is inapplicable as a defense in M&A litigation (based on deficient disclosure to or coercion of the stockholders). A stockholder must have a “proper purpose” for the inspection and access will be granted only to books and records that are “necessary or essential” to that purpose. However, given the current regime under which it is more difficult for a plaintiff to succeed in avoiding dismissal at the pleading stage in both pre-closing and post-closing M&A litigation (as noted, due to an erosion of Revlon and the advent of Corwin), the courts now encourage these demands and are increasingly willing to permit stockholders to gain access to board documents.

  • Need for more attention to emails. Importantly, the Court of Chancery has indicated a new willingness to permit access to directors’ and managers’ emails under Section 220 demands—even emails on their personal email accounts and texts on their personal cellphones—at least when key discussions were conducted or decisions were made through emails or texts and were not formally reflected in board minutes or other corporate documents (Schnatter v. Papa John’s and K24 v. Palantir). Also of note, where there were credible allegations of wrongdoing by the controlling stockholder (Redstone) and directors of CBS in connection with a specific board committee meeting, even though the plaintiff did not explicitly ask for texts or emails in its Section 220 demand, the court granted access to all of the electronic communications between Redstone and the committee members for the 14 days before and after the date of the meeting because it was “satisfied that Redstone, the Viacom board and the CBS board communicated by means of text messages and emails” (Bucks County v. CBS). Accordingly, it cannot be emphasized enough that directors and managers should be made aware, and periodically reminded, of the need for extreme care with respect to the content of emails. Further, a board generally should memorialize discussions and decisions in formal minutes and should consider adopting a policy prohibiting directors from conducting corporate business through personal email accounts or texts.
  • Section 220 demands in the context of proxy contests. In one 2019 case of note (High River v. Occidental), the Court of Chancery rejected the Section 220 demand made by entities affiliated with shareholder activist Carl Icahn in connection with their upcoming proxy contest to take control of the Occidental Petroleum Corp. board due to their displeasure with the company’s acquisition of Anadarko Inc. The court held that facilitating the prosecution of a proxy contest is not a “proper purpose” for a Section 220 demand when the stockholder seeks to obtain information about decisions made by the board as to which it simply “disagreed” but is not alleging that the board may have engaged in legally actionable misconduct. Based on High River, shareholder activists cannot expect unconstrained access to a company’s books and records to help them prosecute proxy contests in the M&A context.

Corporate Governance Developments

  • Continued increased importance of shareholder engagement and communications efforts. Institutional investors continue to be more involved and vocal, making thoughtful and effective outreach to them critical. Shareholder engagement efforts now do not occur only during proxy season and are more substantive and far-reaching than historically. Also, they often involve one or more directors of the company. According to a recent report, in 2019 a majority of Fortune 100 companies (up from just 29% in 2016) disclosed that board members were involved in at least some shareholder engagement discussions. Scheduling regular-course engagement with key institutional investors has become a challenge (especially for companies of less scale). It is critical that a board proactively develops a clear, persuasive, effective communications plan that delivers the company’s essential “message.” As part of this effort, there is a need for ongoing monitoring of concerns relating to the company and its industry (e., the issues being focused on in media and by analysts); development of compelling, targeted responses; and a strategy for effectively communicating these responses.
  • Continued increased focus on environmental/social issues. In 2019, for the third proxy season in a row, there were more shareholder proposals on environmental and “social” issues than on governance issues. For the past several years these proposals have been, and they are likely to continue to be, made under initiatives led by large asset managers. The Business Roundtable Statement (discussed above), and the ongoing debate it stimulates, will further increase the visibility of and pressure with respect to these issues. Notably, in 2019, there were more (but still only a few) shareholder proposals that, in response to the increasing focus on ESG and other politically progressive initiatives, advocated against the consideration of ESG factors in corporate decision-making. These proposals, while not significant in and of themselves, appear to reflect the divisions of the current national political mood and signal the possibility of new challenges for boards as they operate in the context of more deeply polarized and intense political views among the corporate stakeholders.
  • Broader readership of proxy statements. With increased general interest in ESG (environmental/social/governance) issues, proxy statements are now more often read by non-shareholder stakeholders and the media.
  • Continuing focus on board composition. Institutional investors have continued their focus on directors’ qualifications, diversity, over-boarding, tenure and retirement age.

Diversity. The following developments in 2019 followed on the heels of the 2018 California law requiring public companies headquartered in that state to have at least one woman on the board by the end of 2019 (with the number increasing in future years depending on the size of the board): (i) ISS adopted a new policy (for the 2020 proxy season) to recommend voting against or withholding votes from the chair of the nominating committee (or other directors on a case-by-case basis) at companies with no women on the board; (ii) New York City Comptroller Scott Stringer sent letters to 56 S&P 500 companies urging that they adopt policies that require that the initial lists for interviews of new director nominees and CEOs include qualified “female and racially-ethnically diverse candidates”—and also announced that he intends to submit shareholder proposals at companies “with lack of apparent racial diversity at the highest levels”; (iii) the New York City Retirement Systems announced that they will vote against members of a nominating committee if the board lacks gender and racial/ethnic diversity, including any board on which more than 80% of the members are the same gender; and (iv) we note that the board nominees of shareholder activists now routinely include women and people of color.

Over-boarding. Vanguard recently adopted an over-boarding policy that goes further than the ISS and Glass Lewis policies. The ISS and Glass Lewis policies are to vote against directors who sit on more than five boards or, in the case of a director who is the CEO (or holds certain other executive offices), more than two boards. Vanguard’s new policy is to vote against directors who sit on more than one board at which they are an executive officer; and to vote against non-executive directors who sit on more than four boards. A large majority of public companies have adopted an over-boarding policy and, among almost all of them, the policy prohibits non-CEO directors from serving on more than four and CEO-directors from serving on more than three.

Financial Advisors

The Delaware courts have long emphasized that, given the “central role” played by investment banks in “the evaluation, exploration, selection, and implementation” of a company’s strategic alternatives, there is a need for full disclosure of their compensation and potential conflicts of interest. In recent years, with the transformation in Delaware law that has made it generally more difficult for plaintiffs to succeed in M&A litigation against directors for alleged fiduciary breaches, plaintiffs have more often made claims against financial advisors that they aided and abetted director fiduciary breaches. The focus in these cases has been on purported conflicts of the adviser, especially when they were not disclosed to the board or stockholders approving a transaction. The courts have issued decisions in recent years which establish that directors have a responsibility to seek to determine whether a banker has a material conflict (even, at least in some contexts, to investigate a banker’s representation that it has none) and that a banker can have aiding and abetting liability for directors’ breaches even if the directors have no liability (due to, for example, exculpation or settlement). At the same time, the Delaware Supreme Court has confirmed, and it bears emphasis, that aiding and abetting liability for bankers continues to be rare—particularly given that a plaintiff must establish the element of “scienter” (i.e., that the advisor acted with knowledge and intent to aid and abet the board’s fiduciary breach). Moreover, to the extent that (as discussed above) the pendulum may be swinging back toward making it somewhat less difficult to bring fiduciary claims against directors, there is a correlative effect on bankers, as an aiding and abetting claim against a banker is generally only validly pled when the plaintiff validly pleads a predicate underlying fiduciary breach by directors.

  • Aiding and abetting. In one key 2019 case (Chester County v. KCG), the Court of Chancery, at the pleading stage, found Corwin inapplicable and refused to dismiss both fiduciary claims against the board (for failing to maximize value for the stockholders in negotiating and approving a merger) and aiding and abetting and civil conspiracy claims against the banker. The court found that the plaintiff sufficiently alleged that the banker had misled the board, created an informational vacuum, and “worked with” the acquirer to “pressure” the board to approve the merger. Among the allegations were that, in the months leading up to the acquisition, without timely (or in some cases any) disclosure to the target board, the banker, who was the target’s largest stockholder and longtime financial advisor, secretly met with the acquirer to discuss a potential sale of the target; provided the acquirer with confidential information about a key asset of the target; and agreed with the acquirer that it would support the acquirer’s offer price and, after the closing, the acquirer would sell the key asset using the advisor as its financial advisor for that deal. The case serves as a reminder that, where a plaintiff validly pleads egregious facts relating to a banker’s active participation in board fiduciary breaches, an advisor may not achieve early dismissal of (and ultimately could have liability for) aiding and abetting claims.
  • Fairness Opinions. One recent case (Regency v. Dieckman) highlights that a special committee or board, and its financial advisor, should ensure that a fairness opinion is updated to reflect the final terms of the transaction being opined on. Updating typically should occur even if the change in terms is arguably immaterial. For example, in Dieckman, the court stated that it was an open issue of fact (requiring a determination at trial) whether the change in terms was or was not material given that the value of the merger consideration could fluctuate because there was no collar on the exchange ratio.

Board Oversight (“Caremark Claims”)

Two recent Delaware cases (Marchand v. Barnhil and In re Clovis Oncology) highlight that, while it is still extremely difficult for plaintiffs to successfully plead Caremark claims, there are circumstances under which they may prevail. Both cases involved

  • an “utter failure” by the board to implement and monitor a reasonable information and reporting system to identify risks, and/or
  • the board’s consciously choosing not to address “red flags” or known risks. Both cases involved noncompliance by the company with regulatory requirements that were the “central issue” and “mission critical” to the business—in Marchand, food safety regulations for a company whose only business was making ice cream; and, in Clovis, clinical drug trial regulations for a company whose only business consisted of developing a single drug.

These cases underscore that a board should consider on a regular basis whether compliance (or other) risks exist and take steps to address them. In this regard, the following should be kept in mind: (i) A board should establish board-level systems for oversight and monitoring of the issues central to the company’s operations—and not rely only on non-board-level mechanisms such as the oversight provided by the regulators themselves, or reports from management on the company’s operations generally. (ii) The audit committee, the outside auditors, and management should keep the board focused on, and apprised of key developments with respect to, issues and risks that are central to the business. There should be regular processes and protocols requiring management to keep the board apprised of key compliance and other practices, risks or reports—and when management learns of “yellow flags” or “red flags” (including complaints or reports from regulators), the board should be told. (iii) One or more board committees should oversee and address the company’s compliance with regulations and other matters central to its business. (iv) Board minutes should reflect the board’s monitoring and oversight efforts. (v) As was articulated in another Delaware decision issued this year (In re Facebook Section 220 Litigation), there is heightened risk under Caremark where a board fails to oversee the company’s obligations to comply with “positive law” (including regulatory mandates) as opposed to the company’s efforts generally to avoid business risk; and there appears to be heightened risk when human life or health is involved.

This post comes to us from Fried, Frank, Harris, Shriver & Jacobson LLP. It is based on the firm’s recent memorandum, “Where Things Stand at Year-End 2019.”