The Latest Research in Corporate Governance: Law

1. The Latest Research inCorporate Governance:Law Paul Graf Professor of Law

2. “Good Faith”—Is it anything? • Chancellor Chandler - Disney “By virtue of his Machiavellian (and imperial) nature as CEO, and his control over Ovitz’s hiring in particular, Eisner to a large extent is responsible for the failings in process that infected and handicapped the board’s decision-making abilities. Eisner stacked his (and I intentionally write ‘his’ as opposed to ‘the company’s’) board of directors with friends and other acquaintances who, though not necessarily beholden to him in a legal sense, were certainly more than willing to accede to his wishes and support him unconditionally than truly independent directors.”

3. Bad Faith ≠ Gross Negligence • Duty to act in good faith is “intertwined” with the duty of care, but it is different. • Good faith is “shrouded in the fog of hazy jurisprudence.” (Chandler) • It is grounded in the duty of loyalty, but it does not involve self dealing. • It is more culpable than a breach of the duty of care—gross negligence.

4. Disney—Delaware Supreme Court • “A failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. There may be other examples of bad faith yet to be proven or alleged, but these three are the most salient.” • But “only a sustained or systematic failure to attempt to assure a reasonable information and reporting system will establish the lack of good faith that is a necessary condition to liability.” (Caremark - Chancellor Allen)

5. Commentators Weigh in on Good Faith • Nowicki - The courts are wrongfully focusing on bad faith as opposed to not acting in good faith, but notions of good faith are evolving. • Rosenberg - Good faith is an “interpretive device” and a “gap filler.” • Ibrahim - Good faith is an appropriate “vehicle” to address the new universe of fiduciary misconduct that goes beyond notions of disloyalty in the classical sense. • Griffith - Good faith is a rhetorical device, not a substantive law. It loosens corporate law doctrine and increases judicial review of board decision making in response to corporate scandals (“thaumatrophic”). • Hill and McDonnell - On the continuum of liability from duty of care to duty of loyalty, good faith occupies the vast middle ground.

6. The Problem: Ryan v. Lyondell • Allegations of breach of the duty of care dismissed at the pleading stage because of 102(b)(7)… • BUT alleged breaches of the duty of good faith withstand a motion to dismiss. • Ryan was a Revlon case where the plaintiff alleged a breach of the Revlon duties for failure to do a market check or to have a “body of reliable knowledge” regarding the valuation. • Pursuant to Disney and Stone, plaintiff alleged that the directors knew that they had a known duty to act in accordance with Revlon; they chose not to act, and therefore good faith was implicated for purposes of the motion to dismiss.

7. Duty of Care Morphing into the Duty of Good Faith • Stone v. Ritter - “Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious dis-regard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.” • Ryan v. Lyondell is a duty of care case—a breach of the Revlon duties—but the allegation that the board failed to act in the face of a known duty moved the case on the liability continuum from gross negligence to notions of greater culpability: good faith. • The problem: The board did not act with gross negligence and yet the court moved the case into a new category of good faith.

8. “Failure to Act in the Face of a Known Duty to Act” • What does it mean? • What does it mean to “act?” • Most decisions are made by management, not by the board. • Does it mean that the board is confronted with a red flag? • What makes a flag red? Arousing suspicion?

9. Which of the Following are Red Flags? • Deviations from standard practices (e.g., Countrywide credit standards) • Deviations from the norm • Consistent deviations from the norm • Must the board connect the dots? • Diagnostic tools exist to uncover red flags • Employee survey indicates a deterioration in morale • Two key vice presidents leave the company in the same week • Things are too good to be true • The board hasn’t found any red flags in years

10. Failure to Act in the Face of a Known Duty: A “Conscious Disregard for Responsibilities” • Deliberately indifferent • Egregious • Intentional disregard • Extreme recklessness • Hillary Sale - Scienter in this case would include obvious infractions of corporate rules or governance standards, or failure to create such standards. Also includable would be failure to perform assigned tasks and failure to set up mechanisms to assure that they were aware of such tasks. But good faith reliance on reports or information of others would not be actionable.

11. Importance of Record Keeping • If the consequences of failing to act in the face of a known duty are severe, then all the more reason to document “actions” taken. • If the board “acts,” then its actions are reviewed under the favorable business judgment rule.

12. A Board Acts in Bad Faith if it Does Not Imple-ment a Reporting or Information System(Stone) • How is the system designed? What does it look like? • Should it be customized? • Should it be recalibrated periodically? • Can a board monitor effectively if it does not have interaction with line officers? • Macro and micro monitoring? • What went wrong at Countrywide? • What went wrong with CDO’s?

13. Board Negotiations—Good or Bad? • Yahoo/Microsoft - “They didn’t put the $33 bid in writing…” • Different? Through agents or do board members negotiate? In re Lear - CEO Rossiter (“short leash”) • Training? • Ryan v. Lyondell - Is acting through an agent a failure to act?

14. Board Negotiations – Special Challenges • Leaks • Planning • Time • Negotiating mandate - In reTelecommunications • Others involved - ZOPA • Leverage - Paramount v. QVC • Reporting - Revlon - maximizing shareholder value? • Constituents

15. Board Negotiations - Techniques • Strategy • Planning - “BATNA” • Framing

16. Disclosure Traps • Failure to disclose all material facts is a breach of a director’s fiduciary duty. • An omission of a material fact can also be a breach of the fiduciary duty to disclose. • “Materiality” = Reliability

17. Disclosure Traps (cont.) • In In re Lear, the failure of the board to disclose all of the DCF iterations was not regarded as a breach because no evidence was introduced to show that the particular DCF was more meaningful than the ones actually disclosed.

18. Disclosure Traps (cont.) • However, in In re Topps, when Lehman changed the parameters for the valuation fairness opinion and did not have a reasonable explanation (“not confidence inspiring”), then the court found a breach.

19. Disclosure Traps:The Truth is Not Enough • Disclosure: The officers and directors were warned not to have discussions with the private equity company. • Non-disclosure: The principal of the private equity company told the officers on many occasions that he planned to keep them in place following the merger.

20. Disclosure Spinning - In re Topps • Disclosure: The company was willing to entertain offers. • Non-disclosure: The CEO, Shorin, stated that a “quick fix” [sale] was not in the best interests of shareholders.

21. Disclosure Spinning – In re Lear • Disclosure: The CEO, Rossiter, was appointed as the sole negotiating agent for the company to negotiate against Eisner. • Non-disclosure: Rossiter had expressed an interest in being cashed out on this retirement account [fear of company bankruptcy] and a private equity deal was most likely to give him what he wanted. Also, Icahn frequently told Rossiter that he fully intended to keep him in place following the acquisition.

22. Stoneridge…Time Bombs? • “Plaintiffs also do not allege that [Vendors] were responsible for, or were involved with the preparation of Charter’s allegedly false or misleading financial statements.” • “Plaintiffs also do not allege that any of the misleading statements listed in the amended complaint were made, seen or reviewed by the vendors.”

23. Stoneridge • If, in the transaction, Scientific-American recommended the transaction structure to Charter, would that make S-A involved? • If S-A provided a warranty that Charter would enjoy the accounting benefit, would that make it involved? • If Charter asked S-A to appear for a press conference when it announced the transaction, would that be perceived as S-A making a statement to Charter shareholders regarding the validity of the transaction, including the accounting? • If Charter asked S-A to review a statement to Charter’s shareholders for its accuracy, would that be reviewing the misleading statement?

24. Stoneridge (cont.) • Prentice - “Stoneridge involved a flagrant fraud of the worst type.” The court ignored the reach of common law fraud—joint tortfeasors. • Grant and Sabella - The opinion “left behind enough loose ends for future plaintiffs to latch onto in efforts to sue participants in fraudulent schemes who have not made a public statement. Section 10b-5(a & c) do not require a misstatement, just the employment of any device or scheme to defraud or to engage in any act that operates as a fraud. [SEC v. Zandford, 535 U.S. 813 (2002)]

25. Stoneridge (cont.) • Gomm - “Reliance could have been presump-tively imputed in Stoneridge under the fraud-on-the-market doctrine.”

26. The Latest Research inCorporate Governance:Law Paul Graf Professor of Law