The Delaware Law Series


A Framework for Management and Board of Directors Consideration of ESG and Stakeholder Governance

Martin Lipton is a founding partner, and Steven A. RosenblumWilliam Savitt are partners at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton memorandum by Mr. Lipton, Mr. Rosenblum, Mr. Savitt, and Karessa L. Cain. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here), and Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here).

As directors and shareholders become increasingly attuned to ESG considerations and stakeholder-oriented governance, they have sought guidance about how to incorporate these imperatives into the board’s decision-making process—particularly regarding decisions that entail trade-offs or an allocation of resources between and among stakeholders and ESG objectives. Our answer to this question is rooted in the classic bedrock of board functioning: directors must exercise their business judgment. This is not only the practical answer—it is the essential animating principle of Delaware law.

Recently, many who continue to advocate for shareholder primacy, and therefore reject stakeholder governance, have sought to portray stakeholder interests in a zero-sum competition, arguing that it is impossible to properly exercise business judgment to reconcile such diverging interests. In their view, stakeholder governance is not only a radical departure from Delaware corporate law but also corrosive of the very essence of capitalism.

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An Alternative Paradigm to “On the Purpose of the Corporation”

Peter A. Atkins, Kenton J. King, and Edward B. Micheletti are partners at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on a Skadden memorandum by Messrs. Atkins, King, Micheletti, and Cliff C. Gardner. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here) and Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here).

Recently a definition of corporate purpose has been proposed and elaborated on in a post on this Forum titled “On the Purpose of the Corporation” (the Corporate Purpose Memo). This post offers commentary on various aspects of the Corporate Purpose Memo, including three key takeaways:

  • The Corporate Purpose Memo’s proposed universal definition of corporate purpose for publicly traded business (for-profit) corporations—which rests on directors addressing ESG (environmental, social and governance) and stakeholder interests by “reasonably balanc[ing] the interests of all constituencies” without giving primacy to the shareholder constituency—rejects the basic fiduciary responsibility of directors of Delaware business corporations (and directors of corporations in other states that tend to follow Delaware law) under existing law to measure their actions by what is in the best interests of shareholders as a whole (the shareholder primacy governance model).
  • Moreover, in reaching for this new corporate purpose definition—prompted by the perceived need to push back those who “advocate a narrow scope of corporate purpose that is focused exclusively on maximizing shareholder value”—the Corporate Purpose Memo ignores the reality that the shareholder primacy governance model as it has evolved in fact embraces the ability of directors of Delaware business corporations to consider a broad array of ESG/stakeholder issues.
  • Directors of Delaware companies who chose to address ESG/stakeholder-oriented decisions pursuant to the stakeholder interests balancing act contemplated by the proposed new purpose definition—untethered from their overarching fiduciary responsibility to shareholders to act in their best interests—run the risk of losing the valuable protection of the business judgment rule.

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Sharpening the Tools at Hand: New Rulings Provide Sensible Balance to Section 220 Litigation

Gregory V. Varallo is a partner and Andrew Blumberg and Alla Zayenchik are associates at Bernstein Litowitz Berger & Grossmann LLP. This post is based on their BLB&G memorandum and is part of the Delaware law series; links to other posts in the series are available here.

Section 220 of the General Corporation Law of the State of Delaware is the statute allowing shareholders of a Delaware corporation to seek books and records for various purposes, including to investigate potential corporate wrongdoing, among other things. When properly utilized, stockholder use of the Section 220 remedy should help avoid litigation where corporate records can correct misconceptions about how and why questionable events took place, resulting in a higher quality of the claims that are actually pursued to litigation.

Over the last decade or more, the courts of Delaware at first suggested, and then nearly insisted, that plaintiffs utilize the statute to conduct pre-filing investigations prior to bringing cases challenging fiduciary misconduct in transactions and other contexts. The response has been the widespread use of Section 220 among Plaintiffs’ counsel to conduct pre-filing investigations.

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Material Adverse Effect Clauses and the COVID-19 Pandemic

Robert T. Miller is a Professor of Law at the University of Iowa College of Law. This post is based on his recent paper. Related research from the Program on Corporate Governance includes Allocating Risk Through Contract: Evidence from M&A and Policy Implications by John C. Coates, IV (discussed on the Forum here) and The New Look of Deal Protection by Fernan Restrepo and Guhan Subramanian (discussed on the Forum here).

In a working paper just posted on SSRN, I consider whether the COVID-19 pandemic, the governmental responses thereto, and a company’s actions taken in reaction to both of these are likely to constitute a “Material Adverse Effect” (MAE) within the meaning of a typical MAE clause in a public company merger agreement. In addition to the conclusions about COVID-19 and MAEs summarized below, the paper also reviews important Delaware caselaw on MAEs, identifies open problems in those cases, and suggests a more comprehensive theory of MAEs that rationalizes the caselaw and solves most of the open problems.

As to COVID-19 and MAEs, although in any particular case everything will depend on the exact effects on the company and the precise wording of the MAE clause, nevertheless because MAE definitions tend to follow common patterns, some general conclusions about typical MAE clauses are warranted, including the following:

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Three Is Not A Trend: Another Caremark Claim Survives A Motion To Dismiss, But Does Not Reflect A Change In The Law

Nicholas D. Mozal is counsel and David Seal is an associate at Potter Anderson & Corroon LLP. This post is based on their Potter Anderson memorandum and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? by Holger Spamann (discussed on the Forum here).

The Delaware Court of Chancery recently denied another motion to dismiss a Caremark claim in Hughes v. Hu. [1] Under In re Caremark International Inc. Derivative Litigation, [2] directors have a duty to exercise oversight and monitor a corporation’s operational viability, legal compliance, and financial performance and reporting. Hughes is now the second decision, after In re Clovis Oncology, Inc. Derivative Litigation, [3] to allow a Caremark claim to proceed beyond the pleadings stage since the Delaware Supreme Court reversed the Court of Chancery’s dismissal of a Caremark claim in Marchand v. Barnhill. [4] It would be a mistake, however, to read Hughes as an extension of those decisions and only in that context. Indeed, Hughes understandably does not even cite Clovis. The better reading is that Hughes, like the Court of Chancery’s 2013 decisions in Rich v. Yu Kwai Chong [5] and In re China Agritech, Inc. Shareholder Derivative Litigation, [6] reflects the particular accounting and oversight difficulties witnessed in certain Chinese businesses that have gained access to the United States capital markets through a reverse merger. In short, the actions of the audit committee in Hughes are in no way analogous to how the vast majority of audit committees and their advisors operate to ensure a board fulfills its Caremark duties by exercising appropriate oversight. Nevertheless, Hughes reiterates the reasons why it is important for boards and committees to continue adhering to those best practices. In addition, Hughes addresses the importance of maintaining proper records and indicates how those records may be useful in responding to stockholder demands for books and records pursuant to 8 Del. C. § 220.

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Board Oversight in Light of COVID-19 and Recent Delaware Decisions

Holly J. Gregory is partner, Thomas A. Cole is senior counsel, and Claire H. Holland is special counsel at Sidley Austin LLP. This post is based on a Sidley memorandum by Ms. Gregory, Mr. Cole, Ms. Holland, Sharon R. Flanagan, Sara B. Brody. This post is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? by Holger Spamann (discussed on the Forum here).

In times of crisis, the risk of shareholder derivative litigation rises as boards of directors face heightened scrutiny of their actions. While business judgment protection applies to good faith board efforts to navigate a crisis, boards and their advisors should be mindful of guidance that the Delaware courts have issued in the past year, including in a Delaware Chancery Court case decided on April 27, regarding the circumstances in which a claim can move forward seeking to hold directors personally liable for a failure of oversight.

The 1996 Delaware Chancery Court decision in In re Caremark Int’l Inc. Deriv. Litig. clarified that directors are responsible for overseeing that the company has in place information and reporting systems reasonably designed to provide the board and senior management with timely, accurate information sufficient to support informed judgments about compliance risk. [1] Since then, shareholder plaintiffs have tried to hold directors liable for a variety of corporate missteps on the basis that directors failed in their oversight role. These claims—known as Caremark claims—have until recently typically been dismissed in early pleading stages (before discovery) for failure to state a claim. Indeed, these types of claims are regarded as among the most difficult on which to establish director liability (although Caremark claims survived motions to dismiss in a few rare cases prior to 2019). [2] Nonetheless they are attractive to plaintiffs because an oversight failure sufficient for a Caremark claim constitutes a breach of the duty of loyalty and good faith which cannot be exculpated under Delaware law. Because most Delaware corporations provide in their charters that directors will not be held personally liable for breaches of the duty of care, this is one of the few remaining avenues to seek monetary damages from directors personally absent a conflict of interest situation.

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Recent Delaware Court of Chancery Decision Sustains Another Caremark Claim at the Pleading Stage

Meredith Kotler and Pamela Marcogliese are partners and Marques Tracy is an associate at Freshfields Bruckhaus Deringer LLP. This post is based on their Freshfields memorandum and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? by Holger Spamann (discussed on the Forum here).

After decades of routinely dismissing such claims, Vice Chancellor Laster’s recent 41-page decision in Hughes v. Hu represents the third time since the Delaware Supreme Court’s decision last year in Marchand v. Barnhill that the Court of Chancery has sustained a Caremark duty of oversight claim at the pleading stage. It remains unlikely that these recent decisions signal some change in the law, but rather reflect allegations of unique or extreme examples of certain corporate behavior. That said, these cases serve as a reminder of the importance of active, engaged board oversight of “mission critical” risk and compliance issues, and boards should take proactive steps to ensure that directors do not face personal liability for a failure of oversight.

Marchand, Clovis, and Inter-Marketing Group

Caremark claims, which allege failures of board oversight, have long been regarded by Delaware courts as “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” To plead and prove a Caremark claim, a stockholder plaintiff must show that the board either (i) “utterly failed to implement any reporting information restrictions or controls”; or (ii) having implemented them, “consciously failed to monitor or oversee their operations, thus disabling themselves from being informed of risks or problems requiring their attention.” Not surprisingly, these claims routinely fail at the pleading stage.

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Standards of Review Applicable to Board Decisions in Delaware M&A Transactions

Robert B. Little is a partner and Steve J. Wright and Kiel Sauerman are associates at Gibson, Dunn & Crutcher LLP. This post is based on their Gibson Dunn memorandum and is part of the Delaware law series; links to other posts in the series are available here.

M&A practitioners are well aware of the several standards of review applied by Delaware courts in evaluating whether directors have complied with their fiduciary duties in the context of M&A transactions. Because the standard applied will often have a significant effect on the outcome of such evaluation, establishing processes to secure a more favorable standard of review is a significant part of Delaware M&A practice. The chart below identifies fact patterns common to Delaware M&A and provides a preliminary assessment of the likely standard of review applicable to transactions fitting such fact patterns. However, because the Delaware courts evaluate each transaction in light of the transaction’s particular set of facts and circumstances, and due to the evolving nature of the law in this area, this chart should not be treated as a definitive statement of the standard of review applicable to any particular transaction.

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Citing Thin Board Record: Delaware Court of Chancery Again Sustains Oversight Claim

William SavittRyan A. McLeod and Anitha Reddy are partners at Wachtell, Lipton, Rosen & Katz. This post is based on their Wachtell memorandum and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? by Holger Spamann (discussed on the Forum here).

The Delaware Court of Chancery has sustained another Caremark claim, pointing to the absence of documents produced in response to a stockholder’s inspection demand as evidence that the directors “face a substantial likelihood of liability” for “failing to act in good faith to maintain a board-level system for monitoring the Company’s financial reporting.” Hughes v. Hu, C.A. No. 2019-0112-JTL (Del. Ch. Apr. 27, 2020).

The case involved Kandi Technologies, a Delaware corporation headquartered in China that sells automobile parts. Kandi had a long history of inadequate internal controls, including improper insider transactions and a 2017 restatement of earnings. The stockholder plaintiff complained that the board failed to implement responsible auditing protocols notwithstanding these clear red flags.

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Purpose With Meaning: A Practical Way Forward

Robert G. Eccles is Visiting Professor of Management Practice at Oxford University Said Business School, and a Senior Advisor to the Boston Consulting Group; Leo E. Strine, Jr., the former Chief Justice of the Delaware Supreme Court, is the Austin Wakeman Scott Lecturer in Law and Senior Fellow at the Harvard Law School Program on Corporate Governance, as well as Of Counsel at Wachtell, Lipton, Rosen & Katz; and Timothy Youmans is Lead-North America, EOS at Federated Hermes. This post is based on their article published in the Harvard Business Review. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here), and Toward Fair and Sustainable Capitalism by Leo E. Strine, Jr (discussed on the Forum here).

When leading money managers embrace the need for corporations to be socially responsible and the Business Roundtable (BRT) declares that the purpose of a corporation is “to create value for all stakeholders,” it is safe to say that purpose has gone mainstream in the corporate narrative. A consensus is emerging that society and diversified investors are best served by companies that focus on sustainable value creation and respect the legitimate interests of all stakeholders, not just stockholders. But how can these high ideals be put into practice? That corporate employees and host communities have borne the brunt of the economic effects of the current pandemic only underscores the deepening sense that our corporate governance system’s empowerment of the stock market has undermined the fairness of our economy.

If companies and institutional investors are serious about responsible, sustainable wealth creation in a manner fair to all corporate stakeholders, then they must match high-minded rhetoric about purpose with accountability. This will require a new governance form that makes a company’s obligations to fulfill its purpose enforceable.

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