Ellisa Habbart and Lisa Stark of The Delaware Counsel Group LLP evaluate the legal responses to the global financial crisis.
The global financial crisis of 2008 raised questions about the accountability and responsiveness of corporations and boards of directors to the interests of stockholders. These questions included whether boards of directors were exercising appropriate oversight of management in financial matters and whether management and director compensation practices were fair. As a result, stockholders sought a greater say in corporate governance matters, an area which has traditionally been the responsibility of the board of directors, not the stockholders, under state corporation law.
The US federal government responded to the crisis by adopting a pervasive restructuring of corporate regulation at the federal level – the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. While Dodd-Frank primarily addressed financial reform issues, the legislation also addressed corporate governance matters. Specifically, among other things, Dodd-Frank required enhanced disclosures to stockholders of executive compensation practices, authorised the Securities and Exchange Commission (the SEC) to adopt rules regarding proxy access and “say on pay” and required stock exchanges to adopt new listing standards on the independence of compensation committee members.
DELAWARE’S RESPONSE TO DEMANDS FOR REGIME CHANGE.
In addition to regulation at the federal level, state corporation laws apply to listed companies. Delaware is the jurisdiction of choice for incorporation of US publicly traded corporations. However, the Delaware legislature did not adopt sweeping changes to its corporate statute, the General Corporation Law of the State of Delaware (the DGCL), in response to the financial crisis. In 2009, the DGCL was amended to authorise a by-law which provides for the inclusion of nominees proposed by shareholders in the corporation’s proxy statement and the reimbursement by the corporation of expenses incurred by a shareholder in a solicitation for the election of directors by the shareholders.
Beyond the adoption of the amendments discussed above, which may have been largely a signal to Congress that it did not need to step in, Delaware has relied on its court of chancery to decide cases brought by stockholders and others on corporate governance matters. A review of the corporate governance cases decided in 2011 by the Delaware court of chancery shows that the financial crisis is still having an impact on the types of corporate governance cases being brought in Delaware. The cases also show that Delaware has an effective and flexible method of regulating the relationship between the board and stockholders in matters of corporate governance, and that the traditional method of regulating corporate governance at the state level remains a viable option.
2011 CORPORATE GOVERNANCE DECISIONS: PROXY CONTESTS.
Unsurprisingly, proxy contests were at issue in approximately 30 per cent of the fiduciary duty actions brought by plaintiffs relating to corporate governance matters. In one such decision, Sherwood v ZS EDU, LP, CA No. 7106-VCP (Del. Ch. 20 Dec 2011), the Delaware Court of Chancery reaffirmed that it is not for incumbent management or a court to decide who should serve the corporation as its board of directors. Rather, the power to elect directors is vested in the stockholders.
Specifically, Sherwood involved an apparent attempt by incumbent management of ChinaCast Education Corporation to mislead ChinaCast’s stockholders about the reasons for the board’s last-minute decision to remove the plaintiff, Ned Sherwood, from the company’s slate of nominees for re-election as directors at the company’s upcoming annual meeting. Sherwood had voiced considerable disagreement with other members of the ChinaCast board over ChinaCast’s handling of a stock buyback programme, its executive compensation packages and the board’s responses to two preliminary takeover offers. Subsequently, ChinaCast commenced an internal investigation into Sherwood’s acquisition of company stock as possible insider trading, despite the fact that ChinaCast’s insider trading officer and the board approved the stock purchases. Nevertheless, ChinaCast filed a definitive proxy statement with the SEC and recommended that ChinaCast’s stockholders vote to re-elect Sherwood to the board. However, nine days before the date of the annual meeting, the ChinaCast board issued supplemental proxy materials announcing that it had decided to remove Sherwood from its slate of nominees and that it was postponing the annual meeting from 17 December until 21 December. The supplemental proxy statement identified potential insider trading and disruptive behaviour as the reasons for the corporation’s decision to remove Sherwood from the company slate.
In this action Sherwood argued that, absent the court issuing a temporary restraining order (TRO) with respect to the holding of ChinaCast’s annual meeting, ChinaCast’s stockholders would have incomplete and misleading information on the reasons for ChinaCast’s decision to pull him from the company’s slate. After reviewing ChinaCast’s proxy statement, the court found that Sherwood had raised a colourable claim that the defendants breached their fiduciary duty of disclosure by omitting any mention of the genuine policy disputes that existed between Sherwood and the other members of the board. The court found that these policy disputes would be of a material interest to ChinaCast’s stockholders in voting on the election of directors. According to the court, the manner in which the board acted (waiting to the very last moment to pull Sherwood from the company slate so that any proxy contest was thwarted) suggested that the board had acted in its own self-interest contrary to the interests of the corporation’s shareholders.
Turning to the issue of irreparable harm, the court found that the threat of an uninformed stockholder vote constituted irreparable harm. Absent an injunction, ChinaCast’s stockholders would not have sufficient time to consider corrective disclosures and plaintiffs’ competing slate of nominees. While Sherwood had already filed preliminary proxy materials with the SEC, they would not become effective until after 21 December 2011. The court also rejected the defendants’ presumption that a finding of irreparable harm was dependent on there being two properly nominated slates up for election at an annual meeting. Under ChinaCast’s plurality voting system, stockholders could mark their proxy card “withhold”, but such votes would have no legal effect on the outcome of an uncontested election. According to the court, however, such votes still represented an important form of shareholder activism.
The court next addressed whether the balance of the equities favoured the issuance of a TRO. The court stated that “the corporate election process, if it is to have any validity, must be conducted with scrupulous fairness and without any advantage being conferred or denied to any candidate or slate of candidates.” Because Sherwood would essentially be excluded from the election process unless a TRO were issued, the court found that the balance of the equities favoured the plaintiff. Accordingly, the court enjoined the holding of the meeting for 20 days.
2011 CORPORATE GOVERNANCE DECISIONS: EXECUTIVE COMPENSATION
Executive compensation was at issue in approximately 30 per cent of the corporate governance decisions involving claims of breach of directors’ fiduciary duties. One such decision, In re The Goldman Sachs Group, Inc. Shareholder Litig., C.A. No. 5215-VCG (Del. Ch. 12 Oct 2011), involved a challenge to Goldman Sachs’s compensation of its management and employees. The Delaware court of chancery dismissed plaintiffs’ claims for failure to make a pre-suit demand on the corporation and to demonstrate that making a demand would be futile. Under Delaware law, the demand requirement is excused if the complaint creates a reasonable doubt as to whether the corporation’s directors were disinterested and independent or acted in good faith and on an informed basis in approving the challenged action. Here, a majority of the directors were independent and disinterested, and the plaintiffs’ own pleadings indicated that the board’s approval of the firm’s compensation practices was the product of an informed business judgement. The compensation practices were tied to employee performance and competitors’ compensation practices, information that the board reviewed prior to making compensation decisions. In fact, the board had also re-evaluated and lowered its compensation to employees and officers during the recession in response to changes in public opinion.
The outcome of the Goldman Sachs case reflects a fundamental tenet of Delaware law: that management decisions, such as executive compensation decisions, are to be made by the board, not the stockholders. A Delaware court will not disturb the decision of the board unless the plaintiffs are able to show that the board acted disloyally, in bad faith, or in an uninformed matter. The plaintiffs did not meet this burden. The stockholders have other recourse – they may remove and elect directors. As evidenced by the Sherwood decision, the Delaware courts will protect the stockholder franchise. These are the fundamental underpinnings of Delaware’s corporate governance regime.
2011 CORPORATE GOVERNANCE DECISIONS: DISSOLUTION AND RECEIVERSHIP
The highest percentage of cases involving the interpretation of Delaware’s business statutes in 2011 involved companies in financial crisis and, in particular, dissolution or receivership. One of the most interesting cases, Williams v Calypso Wireless, Inc., C.A. No. 7140-VCL (Del. Ch. 8 Feb 2012), was decided in early 2012. In Calypso, the Delaware court of chancery took the extraordinary step of appointing a receiver to dissolve a publicly traded corporation under the authority of Section 322 of the DGCL. Section 322 of the DGCL allows the Delaware court of chancery to appoint a receiver to take charge of a corporation’s affairs where a corporation fails to follow a court order, but does not specify what powers the receiver may be granted. Calypso Wireless, Inc had failed to hold an annual meeting since 2002 despite being ordered to hold a meeting in 2008, pursuant to an earlier action initiated by plaintiff David Williams. Subsequently, Williams was appointed to fill a vacancy on the board and continued to press Calypso to hold an annual meeting at which all directors would stand for re-election. However, Calypso’s counsel continued to assert that Calypso was prohibited from holding an annual meeting under federal securities laws since it did not have audited financial statements, despite an exemption for corporations ordered to have an annual meeting under state corporation law.
After being removed from the board, Williams initiated this action to challenge his removal. Williams also sought the appointment of a receiver to take charge of the company’s affairs and hold a meeting of stockholders. However, the court ordered a receiver to be appointed to dissolve Calypso because of its flagrant violation of Delaware and federal law. Calypso had not filed an annual report on Form 10-K or a quarterly report on Form 10-Q in nearly four years, had no income or revenues, and was likely insolvent on a balance sheet basis. The court also found it unconscionable that Calypso’s management, including Williams, made anonymous internet postings that painted a rosy picture of the company and were designed to increase Calypso’s stock price by misleading investors.
Based on the foregoing, the court determined that there was not a realistic possibility that Calypso could comply with the meeting order even if a receiver were appointed. Therefore, the court appointed a receiver to dissolve the company. In support of its decision to take the extraordinary step of appointing a receiver to dissolve Calypso, the court stated that Delaware has a strong interest in preventing Delaware corporations from being used as vehicles for fraud. Because Calypso held a single asset (a patent) and had no ongoing operations, the corporation’s stockholders would not be sacrificing any going-concern value if Calypso’s assets were liquidated.
Recent decisions issued by the Delaware court of chancery reflect the lingering effects of the market downturn. The cases also reflect the efficacy and flexibility of Delaware’s corporate governance regime, making a case for the primacy of state level regulation of the relationship between corporations and their stockholders.