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Chapter 18 Board Decision Making

Module VII – Fiduciary Duties. Chapter 18 Board Decision Making. Bar exam. Corporate practice. Law profession. Business judgment rule Wrigley case: judicial abstention Reasons for BJR Exceptions to rule: fraud, illegality, conflicts (and waste / gross negligence)

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Chapter 18 Board Decision Making

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  1. Module VII – Fiduciary Duties Chapter 18Board Decision Making Bar exam Corporate practice Law profession Business judgment rule Wrigley case: judicial abstention Reasons for BJR Exceptions to rule: fraud, illegality, conflicts (and waste / gross negligence) Informed decision making Smith v. Van Gorkom background of case: company situation surprising result: explain? Causation and reliance Avoiding director liability Exculpation: § 102(b)(7) Indemnification: mandatory / permissive D&O insurance (who pays?) Citizen of world Chapter 18 Board Decision Making

  2. Business Judgment Rule Procedural / substantive presumption “Rule” vs. “doctrine”? Source / justifications for BJR? Chapter 18 Board Decision Making

  3. Night baseball at Wrigley Field?[you’re on the Cubs board] Chapter 18 Board Decision Making

  4. Night baseball at Wrigley Field? Answer: NONE BASEBALL TRIVIA (as of 1968) How many teams play all of their home games during the daytime, no night baseball? What percentage of major league games are played at night? What is Cub attendance, compared to White Sox's? What is Cub attendance on the road, compared to home games? Why did the Cubs' board adopt a "daytime baseball" policy? Can the Cubs afford lights for night baseball? Chapter 18 Board Decision Making

  5. Night baseball at Wrigley Field? Answer: 57.5% BASEBALL TRIVIA (as of 1968) How many teams play all of their home games during the daytime, no night baseball? What percentage of major league games are played at night? What is Cub attendance, compared to White Sox's? What is Cub attendance on the road, compared to home games? Why did the Cubs' board adopt a "daytime baseball" policy? Can the Cubs afford lights for night baseball? Chapter 18 Board Decision Making

  6. Night baseball at Wrigley Field? Answer: White Sox weekday higher BASEBALL TRIVIA (as of 1968) How many teams play all of their home games during the daytime, no night baseball? What percentage of major league games are played at night? What is Cub attendance, compared to White Sox's? What is Cub attendance on the road, compared to home games? Why did the Cubs' board adopt a "daytime baseball" policy? Can the Cubs afford lights for night baseball? Chapter 18 Board Decision Making

  7. Night baseball at Wrigley Field? Answer: Higher on road BASEBALL TRIVIA (as of 1968) How many teams play all of their home games during the daytime, no night baseball? What percentage of major league games are played at night? What is Cub attendance, compared to White Sox's? What is Cub attendance on the road, compared to home games? Why did the Cubs' board adopt a "daytime baseball" policy? Can the Cubs afford lights for night baseball? Chapter 18 Board Decision Making

  8. Night baseball at Wrigley Field? BASEBALL TRIVIA (as of 1968) How many teams play all of their home games during the daytime, no night baseball? What percentage of major league games are played at night? What is Cub attendance, compared to White Sox's? What is Cub attendance on the road, compared to home games? Why did the Cubs' board adopt a "daytime baseball" policy? Can the Cubs afford lights for night baseball? Answer: Philip K Wrigley Chapter 18 Board Decision Making

  9. Night baseball at Wrigley Field? Answer: Everybody else can BASEBALL TRIVIA (as of 1968) How many teams play all of their home games during the daytime, no night baseball? What percentage of major league games are played at night? What is Cub attendance, compared to White Sox's? What is Cub attendance on the road, compared to home games? Why did the Cubs' board adopt a "daytime baseball" policy? Can the Cubs afford lights for night baseball? Chapter 18 Board Decision Making

  10. Compare to other duties … Chapter 18 Board Decision Making

  11. TORT LAW Phillip, an automobile driver always drives at night without headlights, even though 99.7% of other drivers use theirs. Phillip externalizes the costs of his driving penchant – hurting many pedestrian-strangers and other roadway objects.  Is he liable to those he hurts because he drives without "reasonable care and prudence"? ADMINISTRATIVE LAW The Public Works Administration (PW) is charged with bringing modern infrastructure to as many people in the valley as is feasible. PW wires none of the houses, even though power administrations in other valleys have wired 97.5% of their houses.  Can a court enjoin PW for acting in a way that is "arbitrary and capricious"? Duties Chapter 18 Board Decision Making

  12. TORT LAW Phillip, an automobile driver always drives at night without headlights, even though 99.7% of other drivers use theirs. Phillip externalizes the costs of his driving penchant – hurting many pedestrian-strangers and other roadway objects.  Is he liable to those he hurts driving without "reasonable care and prudence"? ADMINISTRATIVE LAW The Public Works Administration (PW) is charged with bringing modern infrastructure to as many people in the valley as is feasible. PW decides not to wire any houses in the valley, even though power administrations in other valleys have wired 97.5% of their houses.  Can a court enjoin PW for acting in a way that is "arbitrary and capricious"? Duties Chapter 18 Board Decision Making

  13. Return to lights inWrigley Field … Chapter 18 Board Decision Making

  14. Plaintiff’s allegations "It is charged that ... such arbitrary and capricious acts constitute mismanagement and waste of corporate assets, and that the directors have been negligent in failing to exercise reasonable care and prudence in management of corporate affairs." Philip K Wrigley “baseball is a daytime sport” Chapter 18 Board Decision Making

  15. Defendant’s response "... the courts will not step in and interfere with honest business judgment of the directors unless there is a showing of fraud, illegality or conflict of interest ..."  Chapter 18 Board Decision Making

  16. Court's dismissal … "... it appears to us that the effect on the surrounding neighborhood might well be considered by a directors who was considering the patrons who would or would not attend the games ... the long run interest of the corporation in its property value at Wrigley Field might demand all efforts to keep the neighborhood from deteriorating ... "There ... is no allegation that there will be a benefit to the corporation from [night baseball] considering all increased costs ..." "No mention was made of operation and maintenance of the lights .. and we cannot speculate as to what other factors might influence the increase or decrease of profits if the Cubs were to play night home games ... Are these points appropriate for dismissal of complaint? Chapter 18 Board Decision Making

  17. Justifications for BJR … Chapter 18 Board Decision Making

  18. Likely outcomes Option A Option B 10% $60 $1000 80% $50 $0 10% $40 ($400) Expected value $50 $60 Chapter 18 Board Decision Making

  19. "Hopefully, it's not a business move gone wrong. We'll have to wait and see what happens. If it doesn't backfire, I won't have a lot to say. If it does backfire, I will have a lot to say." Shaquille O'Neal (on trade of teammate) Chapter 18 Board Decision Making

  20. 1977: Philip K Wrigley dies – on deathbed, “never sell” 1981: Son sells team to Chicago Tribune 1988: Chicago ordinance banning night baseball rescinded August 9 - First night game Chapter 18 Board Decision Making

  21. Smith v. Van Gorkom Trans Union board decision? What did court say was wrong? Can you explain Trans Union? Chapter 18 Board Decision Making

  22. A nagging tax problem Trans Union owns and leases rail cars -- a great business in the 1970s.  The company garners 20% return on equity, with cash flow of 3 times earnings.   Too much of good thing: Trans Union has more depreciation than it can use. Moreover, the company can't use its investment tax credits since it has no taxable income to offset.  Some competitors (with less cash flow than Trans Union) can take all the tax breaks. What are the options? Chapter 18 Board Decision Making

  23. Problems / Solutions • Get Congress to pay for unused investment tax credits • Acquire businesses to generate taxable income • Sell to a public company that wants tax benefits • Sell to a private company that wants tax benefits • Sell in a management buyout (management borrows to buy the company) Chapter 18 Board Decision Making

  24. September 20, 1980 Board meeting Chapter 18 Board Decision Making

  25. Jerome W. Van Gorkom • Born: 1918 (age 62) raised in Depression by mother on welfare • 1939 - Univ.. of Illinois (BS, business) • 1941 - Univ. of Illinois (law degree) • 1941-1945 - Navy (engineering officer) • 1945-1947 - private law practice • 1947-1955 - Arthur Andersen (tax lawyer, CPA) • 1955-1963 - Union Tank Car (controller) • 1963-present - Trans Union (CEO and director) Chapter 18 Board Decision Making

  26. Jerry Van Gorkom : "Thank you, gentlemen, for making it on such short notice to this special Saturday board meeting. We got an offer to sell the company for $55 per share. This is a 50% premium over the current trading price of $38.75. And it's 62% better than the average of our high and low prices this year. The offer comes from Jay and Tom Pritzker -- the Hyatt Billionaires. They're serious. We have until tomorrow PM to say yes or no.“ I negotiated Jay down on a stock lock-up – he wanted 1.75 million shares, I gave him one million. Jay Pritzker Chapter 18 Board Decision Making

  27. What do you want to know? Outside directors: • A.W. Wallis: Economist; Dean - Chicago MBA; Chanc - Univ. Rochester (director since 1962). • William B. Johnson: Law degree; CEO - IC Industries (director since 1968) • Joseph Lanterman: CPA; CEO - American Steel (director since 1976) • Graham Morgan: Chemist; CEO - US Gypsum (31 corporate takeovers) • Robert Reneker: Harvard MBA; CEO - Swift & Co (director since 1971) Chapter 18 Board Decision Making

  28. How did the board fail? [what are the lessons?] Chapter 18 Board Decision Making

  29. Delaware Supreme Court "... the party attacking a board decision as uninformed must rebut the presumption that its business judgment was an informed one. … The concept of gross negligence is the proper standard”  "... in the merger context, a director may not [leave] to the shareholders alone  the decision to approve or disapprove the agreement." Chapter 18 Board Decision Making

  30. Delaware Supreme Court "On the record before us, we must conclude that the Board of Directors did not reach an informed business judgment on September 20, 1980 in voting to “sell” the Company at $55 per share. ... The directors did not adequately inform themselves -- (1) Van Gorkom's role in "sale" (2) Intrinsic "value" of company (3) Details of deal (two hour meeting, without prior notice and without crisis) Chapter 18 Board Decision Making

  31. What about BJR deference? • 50% premium over market price – this was (in hindsight) a great price • Test market period for 90 days – GE Capital and KKR showed interest, but backed off • Collective experience of directors – these folks understood takeover “game” and its risks • Legal opinion that no need “fairness opinion” – in any event, Boston Consulting study said Trans Union = $55 Chapter 18 Board Decision Making

  32. A bad dream … Chapter 18 Board Decision Making

  33. Directors pay!! Nine blue-chip directors were ordered personally to pay the difference between the selling price and the "real" market value of the company.  They later settled at $23.5 million -- $10 million paid by D&O insurance and the remainder by Pritzker (on the condition directors would contribute $1.35 million to charities) Chapter 18 Board Decision Making

  34. Meaning of case • Judicial second-guessing: a new development in corporate common law and level of judicial review • New board procedures (rather than substance): courtroom process brought into boardroom • New role for outside directors (and lawyers): new definition of “good” corporate governance • Court reacts to “fast shuffle”: Van Gorkom (conflicted) bamboozled board • Delaware gives plaintiff’s bar some meat: Delaware continues corporate law preeminence • Delaware, looking at Washington, DC, puts itself in driver’s seat of corporate law: answers “wings effects” of threatened federalization Chapter 18 Board Decision Making

  35. Group assignment The year is 1985, the month is January. You are a members of the “Council of the Corporate Law Section” - the Delaware bar association’s special drafting committee for corporate law reforms. You have just read the Van Gorkom decision – and you’re surprised. Some have called on the legislature to respond; other not. What should be the Council’s view on the TransUnion case and what should the Council recommend to the state legislature, if anything? Chapter 18 Board Decision Making

  36. Group assignment Meaning of Smith v. Van Gorkum • Court second guesses boards: 8 • New board procedures: 5 • New role for outside directors: 2 • Court reacts to “fast shuffle”: 1 • Good for plaintiff’s bar: 1 • A federalism gambit: 2 What should Council do? • Do nothing: 3 (give courts maneuvering room / chance to clarify or reverse course) • Codify/expand decision: 6 (gross negligence / require pledge of allegiance / more time for offers / more disclosure / more liability) • Modify decision by statute: 4 (recklessness standard / proximate cause) • Reverse decision: 4 (stronger BJR / only liable for bad faith) • Allow company opt-out: 1 (limit VG) • Increase shareholder duties: 1 (institutional shareholders) Chapter 18 Board Decision Making

  37. Avoiding Director Liability Proximate cause and BJR Exculpation clause Indemnification D&O insurance Chapter 18 Board Decision Making

  38. Director liability? "Nothing in the history of development of corporations or corporation law suggests that the personal assets of directors were intended to constitute a financial safety net for stockholder or others willing to second-guess directors' decisions.“ True or false? James J. Hanks, leading practitioner on director liability avoidance (survivor of Flight 1549 (“Miracle on Hudson”) Chapter 18 Board Decision Making

  39. Protect Your Board Attend the Delaware Law Issues Update   Learn the latest on: • state and federal corporate and securities class action practice and derivative litigation • boards' fiduciary duties relating to executive and director compensation • books and records demands under Delaware law, shareholder demands that boards bring action against alleged wrongdoers • M&A trends and developments in nondisclosure agreements and standstill agreements • recent shareholder activism, including at companies like Dell, Herbalife, Agrium, Hess, Yahoo!, Sony and others • minute taking, post-meeting follow-up and Board and committee presentations Chapter 18 Board Decision Making

  40. Four-legged stool D&O Insurance Business Judgment Rule Exculpation Clause Indemnification Chapter 18 Board Decision Making

  41. (1) BJR and causation Remember Trans Union Even if the directors had been properly attentive would they have necessarily gotten a better price? What’s the harm they caused? • Some caselaw: • Barnes v. Andrews (SDNY 1924) • Francis v. United Jersey Bank (NJ 1981) • Cinerama v. Technicolor (Del 1993) Chapter 18 Board Decision Making

  42. Four-legged stool D&O Insurance Business Judgment Rule Exculpation Clause Indemnification Chapter 18 Board Decision Making

  43. Del. GCL § 102 Contents of certificate of incorporation.   • (b) ... the certificate of incorporation may also contain ... • (7) A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, ... provided that such provision shall not eliminate or limit the liability of a director: •  (i) For any breach of the director's duty of loyalty to the corporation or its stockholders;  (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law;  (iii) under § 174 of this title; or  (iv) for any transaction from which the director derived an improper personal benefit. (2) Exculpation Go back again to Trans Union. Would the directors have been liable if corporation had 102(b)(7) clause? Chapter 18 Board Decision Making

  44. How do shareholders respond to “grossly negligent” directors getting a free pass? Chapter 18 Board Decision Making

  45. Event Study Bradley & Schiapani, 75 Iowa 1 (1989) • After Trans Union D&O premiums go up - for $1MM coverage $3200 premium goes to $23,000 (from 2nd qtr to 3rd qtr 1985) • Compare DE corporations vs others: • Trans Union -- no statistical effect on Delaware corporation stock prices • Delaware's adoption of 102(b)(7) -- negative effect (minus 2.67%) on Delaware corporation stock prices • Firm-specific adoption of exculpation clauses -- negative effect (minus 0.56% ) on specific company’s stock prices Chapter 18 Board Decision Making

  46. Pleading “exculpation” clause Complaint Direct suit Derivative suit No demand required Demand excused Motion to dismiss – no BJR protection Lack due care Lack loyalty / good faith Dismiss 102(b)(7) Merits !! Chapter 18 Board Decision Making

  47. Four-legged stool D&O Insurance Business Judgment Rule Exculpation Clause Indemnification Chapter 18 Board Decision Making

  48. NC Bus Corp Act § 55-8-52 Mandatory indemnification    Unless limited by its articles of incorporation, a corporation shall indemnify a director who was wholly successful, on the merits or otherwise, in the defense of any proceeding to which he was a party because he is or was a director of the corporation against reasonable expenses incurred by him in connection with the proceeding. NC Bus Corp Act § 55-8-51 Authority to indemnify    (a)  ... a corporation may indemnify an individual made a party to a proceeding because he is or was a director against liability incurred in the proceeding if:   (1) He conducted himself in good faith; and (2) He reasonably believed ... that his conduct was in [the corporation's] best interests ... (3) Indemnification Go back again to Trans Union. (1) Could directors have insisted that corporation indemnify them? (after all they were trying to do the right thing!) (2) What about advancing their litigation expenses? Chapter 18 Board Decision Making

  49. NC Bus Corp Act § 55-8-53 Advance for expenses. Expenses incurred by a director in defending a proceeding may be paid by the corporation in advance of the final disposition of the proceeding as authorized by the board of directors in the specific case or as authorized or required under any provision in the articles of incorporation or bylaws or by any applicable resolution or contract upon receipt of an undertaking by or on behalf of the director to repay such amount unless it shall ultimately be determined that he is entitled to be indemnified by the corporation against such expenses.  (3) Indemnification Go back again to Trans Union. (1) Could directors have insisted that corporation indemnify them? (after all they were trying to do the right thing!) (2) What about advancing their litigation expenses? Chapter 18 Board Decision Making

  50. (3) Indemnification • NC BCA § 55-8-51 • Authority to indemnify •    (d) A  corporation may not indemnify a director under this section: •     (1) In connection with a proceeding by or in the right of the corporation in which the director was adjudged liable to the corporation; Shareholders “on behalf of corporation” “direct” liable Board liable Corporation cannotindemnify indemnify Chapter 18 Board Decision Making

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