Defending Director Discretion

In this year’s Foreword, Dougherty examines three developments that increasingly impact director discretion: the threatened demise of derivative court case protections; increasing judicial skepticism toward settlements of challenges to corporate disclosure; and the potential intrusion of SEC whistleblower protocols into corporate arenas.

The Impact of Funds

Of all the forms of institutional investor, mutual funds have become the dominant owners of U.S. corporations, largely due to invested 401K personal pension capital. Mutual funds currently hold approximately 30 percent of U.S. corporate shares, versus less than 10 percent twenty-five years ago. Yet, those families and complexes of mutual funds, with rare exception, do not assert control over corporate governance of the businesses they invest in.

Index funds are the extreme case of passive ownership. Vanguard’s ownership is index-determined and not concentrated, rarely passing the SEC Schedule 13D or 13E 5 percent threshold. Others, such as Fidelity, Capital Research, or Barclays Global Investors (via iShares ETFs) do concentrate share ownership more heavily at times, and do, through their investment advisers, direct the proxy votes controlled by their funds.

A change in SEC regulations in 2003 made proxy votes by large mutual fund families a matter of record. Since then, studies have been conducted on the degree to which one fund family or another tends to vote for incumbent directors, or against shareholder proposals. Other studies have investigated whether a fund’s vote correlates with pension business the fund does with large corporations that contend with the various “shareholder proposals de jure” submitted to corporations in which the funds are invested.

Surprisingly, the most interesting observations concern the funds’ practice of voting with their feet, exiting positions rather than voting for, and awaiting, change. A rough ballpark estimate for large fund families is that about a quarter of their larger positions are held for less than two years and about two-thirds are exited before five years. As a result, ownership in American corporations is somewhat concentrated, rather liquid, temporal and relatively passive. After all, the expenses of activist efforts are borne by the proponent and benefits spread to others, including passive fund competitors. For mutual funds, exit is self-protective. This capitalist model is very different from other settings where, for example, German banks, Korean chaebol or Japanese cross-holding keiretsu exercise degrees of control, as is discussed in Chapter 8 of the complete publication.

Enter the Activists

High mutual fund ownership combined with its preference for passive positioning and exit rather than change-advocacy provide activist funds their catalysts. The leveraged, unsolicited hostile takeover phenomena of past decades largely have been replaced by activists’ positional investing and pressure for change. An entire governance consultancy, led by ISS and Glass Lewis, has arisen in tandem with these dynamics, as is discussed at length in the complete publication. Less attention, however, has been paid to parallel legal developments that increasingly impinge on director discretion in various, often indirect, ways. Three developments worthy of director attention are: the threatened demise of derivative court case protections; increasing judicial skepticism toward settlements of challenges to corporate disclosure; and the potential intrusion of SEC whistleblower protocols into corporate arenas.

Derivative Lawsuit Developments

One of the long-standing protections of director decision-making has been the principle that a shareholder may not run to court to second-guess director business judgments, on the ground that the director(s) breached a fiduciary duty qua director when taking corporate action. Instead, a shareholder must first make a written demand on the corporation or board requesting that the corporation itself take the action that the shareholder claims is needed. Rather than run “directly” to court, if you will, the shareholder must first ask the company in writing to take corrective action. Only if that request is denied (or is demonstrably futile), may the shareholder then sue the directors in court to redress the alleged breach of duty. Otherwise, every time any shareholder disagreed with the directors’ business judgment, a new court case could be filed, resulting in needless litigation.

Requiring that the shareholder first make a demand on the corporation or the board before bringing suit is known as a “derivative” claim demand. The shareholder’s claim is derivative of the right of the corporation itself to take the action, to right the wrong, to bring suit (corporation as plaintiff against wrongdoer) in order to recover for a wrong done to, or injury incurred by, the corporation.

That fundamental framework of American corporate law, and right (or at least long-held expectation) of directors to be free of lawsuits second-guessing director actions absent a pre-suit demand on the board and opportunity for the board to address the matter, is being subjected to substantial judicial erosion in key states, such as Delaware and New York. Yet, Delaware especially, and New York to a significant but lesser degree, are the states of incorporation (and hence applicable director duty regimes) of an overwhelmingly large percentage of major (and minor) U.S. corporations. In contrast, other states, such as Massachusetts, North Carolina, Ohio, and Texas have taken legislative actions to protect director discretion, and to preserve the pre-suit “derivative” case demand requirement, all to the considerable benefit of directors of corporations incorporated in those states.

The split among states’ approaches to shareholder criticism of board actions arose in 2004 and became pronounced in 2015. In 2004, Delaware, through judicial opinions, went in one direction—much less protective of director discretion—followed by New York in 2015. Over the same period, Massachusetts, North Carolina, Ohio, Texas and Virginia took a very different approach by enacting legislation that requires judges to follow legislatively-set standards and procedures for shareholder challenges to director action. In those states, statutes mandate that shareholders must first make a demand on the corporation or board to consider an accusation of director wrongdoing, and to allow the board to take prescribed steps to review the shareholder criticism.

By 2015, there was a clear difference between those states which had followed the Delaware judicially adopted and less predictable path, and those states that adopted a legislatively defined (judicially unavoidable) set of standards. So complex had the Delaware (and New York) judicial approach become that even the federal appeals court in New York, when called upon to apply the Delaware judicial test, decided it could not confidently do so, and wrote a special request to the Delaware Supreme Court to ask for a ruling. That is both burdensome and an indication of continued unpredictability, a decade after initial adoption of the judicially-adopted Delaware standards.

In a word, Delaware case law imposes fiduciary duties on directors to act in the best interests of both the corporation and its shareholders. For that reason, when assessing whether a shareholder may sue directors for allegedly wrongful action, the Delaware courts have chosen to ask (at the outset of the case, before anything is proven, and before evidence is developed, these two questions: Was the corporation injured, or were shareholders injured by the allegedly wrongful conduct? And, who would receive the benefit of any recovery? The court must make a prediction to answer those two questions. At times, the questions are easy to answer: a director is complicit in a fraudulent expenditure of company funds. The money would be recovered by the corporation. Therefore, the shareholder must first make a demand on the corporation, rather than sue the director; the claim belongs to the corporation. Other examples are not as clear: consider situations where shareholders of different classes of stock are issued different dividends, allegedly not in keeping with the company’s bylaws. Under the predicting-injury to shareholder/corporation test, there could be injury to one group of shareholders, two groups, the corporation, or all of the foregoing. More facts are required, yet the court decides that question before the case is developed, and before the locus of injury is determined on an evidentiary record.

The legislative-approach states, on the other hand, mandate a clear, unitary duty of the directors to the corporation. When exercising judgments, directors are required to act in the best interests of the corporation. In doing so, they may take into account the long and short term interests of the corporation and its shareholders, as well as other constituents, such as employees, customers, suppliers and communities. But because there is one duty, there is only one outcome: shareholders claiming that directors of corporations incorporated in those states acted wrongfully must always, before filing any suit, first make a demand on the corporation that the corporation review the question: was there a breach of duty to the corporation?

The upshot of Delaware’s approach has meant that companies incorporated in Delaware face an increasing number of class action lawsuits filed without prior demand on the board, each time testing (or retesting) the limits of the evolving, complex case law. In contrast, shareholders in the legislatively-defined states are forewarned to make demand on the board before jumping to class action modality, even to the point that failing to make the demand can trigger the statutory requirement that the corporation be reimbursed for its legal expenses.

Needless to say, this judicial vs. legislative choice and resulting director experience with it are beginning to have an impact. Perhaps more states will move to adopt legislative standards, providing better clarity for all concerned.

Disclosure Settlements

Another manner in which director discretion needs rethinking arises in judicial review of disclosures concerning transactions that directors recommend for shareholder vote. Typically, following a board determination to recommend a merger, or other initiative requiring shareholder approval, a preliminary proxy statement is prepared and filed with the SEC setting out the proposed transaction, the reasons for it, the directors’ recommendation, any financial advisor’s opinion regarding it, risks associated with the transaction, and a detailed background section summarizing how the proposed transaction came about. These SEC filings have become increasingly lengthy, and are getting ever longer each year. Once the preliminary proxy statement is filed, there is a period of time during which, appropriately, the SEC staff reviews it and typically makes comments or suggestions. That takes time, during which the preliminary proxy is on public file, but no shareholder meeting date is yet set, no solicitation of shareholder votes occurs, until the SEC review is completed. There’s the rub.

During the pendency of the SEC review, a cottage industry of plaintiff lawyers brings class action suits always asserting that this or that detail could—should—be added to the already hundreds of pages long preliminary proxy statement in order for it “not to be misleading.” The details rarely make a material difference between the proxy with and without such additions, and often involve assertions that subsidiary financial modeling assumptions (that only esoteric analysts would understand) are needed by supposed data-hungry shareholders.

The good news is that in 2016, the federal and state courts have begun to push back on these suits, pointing out that the details do not add (or don’t add much) important data, and may even subtract by overburdening shareholders in a thicket of detail. Looking at the situation more globally, it is time for the SEC to promulgate some exemplar standards, and/or for corporations to adopt a PCAOB-type (Public Company Accounting Oversight Board) approach to standardizing such disclosure content, and interdicting burdensome second-guessing of already extensive disclosures about how and why directors exercise their discretion to propose and recommend a shareholder vote on a transaction.

SEC-Whistleblower Dynamics

As described in detail in Chapter 4 of the complete publication, the SEC’s Whistleblower Office and its awards initiative raises a number of unresolved questions about the extent to which a government agency can secretly coordinate with a company employee to gather information on potentially improper executive conduct or director oversight.

Every American knows, and relies upon, the constitutional right and protection that no search by a state official or agent acting for the state can occur without a judicial search warrant being issued first, on the basis of a showing of probable cause that a crime has been, or is being, committed. Yet, the SEC Whistleblower protocols provide for SEC coordination with an employee whistleblower (whose contact with the SEC is unknown to the company). As described in Chapter 4, the SEC protocols do not stop at encouraging whistleblowers to contact the SEC privately, seeking to have the whistleblower pass internal information on to the SEC staff. Nor do the SEC protocols stop at protecting whistleblowers’ identities and at protecting whistleblowers from reprisal by their employers should their tips lead to SEC action or the tipper be discovered. There are reasons why that degree of SEC regulation is defensible.

However, the SEC protocols also permit the SEC staff to coordinate follow-up actions by the employee at the SEC’s direction, or at least with its participation, all without SEC heads-up to the corporation at any level, and all without the requirement that the SEC first go to court and get a warrant from a judicial officer who is independent and who will make a reviewable, independent, separate record of the basis for, and limits to, such secret intrusion into company affairs and internal discussions for business records or other confidential information. Although this initiative is well-intentioned, certain aspects of it are, in my view, unconstitutional. I expect court challenges in the coming year(s).