New Developments

Delaware Supreme Court on good faith and the duty of loyalty in a Revlon setting

The Delaware Supreme Court, sitting en banc, has held that the Court of Chancery erred when it ruled that liability for breach of the duty of loyalty in a bad faith context could be imposed without a showing of intent.

 

In Lyondell Chemical Co. v. Ryan, Lyondell received an unsolicited all cash all shares offer at a substantial premium to the market. Lyondell had made no effort to sell itself or seek a strategic partner and the company was economically viable. The board delegated much of the negotiating work to its board chair and CEO, Smith. The final agreement did not contain a go-shop provision but did include several deal protective measures. Ryan, a Lyondell shareholder, brought the required shareholder suit challenging whether the board met its Revlon duties. The board was independent and not interested and Lyondell’s Certificate of Incorporation contained a 102(b)(7) exculpatory clause.

 

Justice Berger, speaking for a unanimous court, first described the Disney case on bad faith and Stone’s adoption of Caremark’s duty to monitor and its imposition of an intent requirement to a finding of a breach of the duty of good faith. She then held that the Vice Chancellor erroneously applied Revlon before the board actually decided to sell the company. Thus, many of the facts showing the directors did nothing to maximize the company’s value were irrelevant to the Revlon claim because Revlon did not yet apply. Justice Berger held that when one focused on the board’s actions after it decided to sell the company, it could not be accused of nearly complete inaction. In my earlier post on the Court of Chancery opinion in this case I said I thought the Vice Chancellor was clearly right about Revlon’s application. However, I didn’t consider the timing question and Justice Berger may well be correct on this point. All agree that Revlon applied at some point and that plaintiff’s claim is that Revlon wasn’t met but it’s obviously important to determine when Revlon applied before looking at facts that show whether the board complied with its Revlon duties.

 

She then held that the Vice Chancellor took too narrow a view of the ways in which Revlon can be satisfied and that, on these facts, the Supreme Court would be inclined to hold that the directors met Revlon. However, that inclination is irrelevant, Justice Burger says, because the directors’ failure to take any particular actions could not demonstrate a conscious disregard for their known duties, which is required for a finding of breach of the duty of loyalty via bad faith. There being no evidence of an intentional disregard for their fiduciary duties, the directors cannot be liable.

 

This result is definitely correct and I’m happy to see that the court has, in a relatively succinct and well written opinion, gotten the law right. I have one small (I hope) concern, however, that Justice Berger may have been slightly imprecise and may open the door to being misunderstood.

 

One of the questions in Caremark, as it stood for ten years before Stone transmogrified it, was what the standard of review for liability would be. Chancellor Allen, Caremark’s author, used extreme language, suggesting that nothing short of a complete failure to implement a monitoring system or to monitor would be enough to impose liability. When Stone made Caremark a duty of care loyalty case, it held that the directors could only be liable for intentionally disregarding their fiduciary duties. Here in Ryan, Justice Berger brings back some of Chancellor Allen’s language about utter failure and I worry that such a standard might work its way into the standard for duty of loyalty liability in bad faith cases.

 

For example, when she first mentions the standard she writes (p.11), “We adopted the standard articulated . . .  in In re Caremark . . . [now she quotes from Caremark:] only a sustained or systematic failure . . . such as an utter failure to attempt to assure a reasonable information and reporting system exists – will establish the lack of good faith that is a necessary condition to liability.” Likewise, she later writes (p.18), “Only if they knowingly and completely failed to undertake their responsibilities would they breach their duty of loyalty”. Note the phrase, “and completely”. Further on that page she quote a Chancery Court opinion that could lend support to this analysis: “[an] extreme set of facts [is] required to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties”. Does an extreme set of facts equate with a requirement that the plaintiff show that the directors not only intended to disregard their duties but did absolutely nothing? Finally (p.19) “[T]he inquiry should have been whether those directors utterly failed to attempt to obtain the best sales price.” Note the words, “utterly failed”. All this language might be seen as imposing liability for breach of the duty of loyalty via bad faith only when there is intent and when the directors completely fail to meet their duty or perhaps completely fail to take action.

 

This can’t be the law. Intent is surely a requisite for finding bad faith and hence a duty of loyalty violation but there’s no case law authority and no policy reason to impose an additional test of utter failure to meet the duty or take action. Surely a director is liable who intends not to meet the duty of loyalty by only a little bit.

 

Justice Berger has much language, though, that suggests the correct rule, as well, and I’m hopeful that courts will pick up on that language and not on the looser formulations quoted above. For example, she writes in the introduction (p.3), “There is no evidence, however, from which to infer that the directors knowingly ignored their responsibilities, thereby breaching their duty of loyalty.” Later (p.17), she writes, “[B]ad faith will be found if a ‘fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.’ ” Shortly thereafter (p.18) she writes, “Thus, the directors’ failure to take any specific steps during the sale process could not have demonstrated a conscious disregard of their duties.” No mention here of anything more than that as a requisite for liability.

South Dakota Supreme Court on LLC dissolution

The Supreme Court of South Dakota has held that an LLC may be dissolved when two of four members refuse to renegotiate the terms of an agreement between the LLC and those two members.

 

In Kirksey v. Grohmann, four sisters were left equal ownership interests in a ranch when their mother died in 2001. The ranch had been in the family for over 100 years. They formed an LLC the next year to hold title to the ranch. They did so for tax advantages, to keep the land within the family, and to keep the land out of the hands of the sisters’ spouses. Ms. Grohmann, the eldest, lived on the land and was named manager. Ms. Randell, the next oldest, lived on the land, as well. All four decided that the LLC would lease the land to Grohmann, Randell, and Ms. Kirksey (a third sister), who owned grazing livestock on the land. The fourth sister, Ms. Ruby, neither lived on the land nor grazed livestock on it. The lease was for about $14,000 per year and netted about $4,000 after taxes and insurance. Grohmann and Randell quickly fell out with Kirksey and Ruby and Kirksey sold her livestock to Grohmann and Randell in 2003. Apparently, the land increased in value by a factor of six but the lease payments were fixed. The operating agreement required a majority vote to take action and the sisters were deadlocked as to any action that would change the status quo either by changing the lease terms or by dissolving. Kirksey and Ruby sued for dissolution, which the trial court denied.

 

Justice Konenkamp held that dissolution was warranted under the South Dakota LLC Act, which in pertinent part is identical to the 1996 ULLCA. That act provides for court ordered dissolution when, inter alia, “the economic purpose of the company is likely to be unreasonably frustrated” or “it is not otherwise reasonably practicable to carry on the company’s business in conformity with the articles of organization and the operating agreement”. The complaint apparently did not seek dissolution on the ground of illegal, oppressive, fraudulent, or unfairly prejudicial conduct, though it seems clear from the briefs that such a claim could at least have been made, if not ultimately proven. Nor did the complaint seek damages for breach of fiduciary duty.

 

After canvassing a number of states’ interpretation of the “not reasonably practical” standard, the court held that the economic entity of the ranch could be continued but that leaving de facto control in Grohmann and Randell, who refuse to change the terms of the lease favorable to them, is not reasonably practical in light of the operating agreement. The court suggested that Kirksey and Ruby knew of the favorable terms when they entered into the original lease and surely knew the terms of the operating agreement. Justice Konenkamp also held that that the economic purpose of the LLC is likely to be unreasonably frustrated, essentially for the same reasons.

 

Although the court does not speak in terms of fiduciary duties, the subtext seems to be that Grohmann and Randell had some sort of obligation to renegotiate the terms of the lease so that the other two sisters could share equitably (perhaps equally?) in the economics of the enterprise. It seems not to matter that Kirksey and Ruby willingly agreed both to the LLC operating agreement and to the lease terms. A deal isn’t a deal if it turns out to be too good a deal.

Delaware Court of Chancery on good faith and the duty of loyalty in a Revlon setting again

The Delaware Court of Chancery has erroneously held that it was correct in its earlier decision to permit a case to survive summary judgment under Stone v. Ritter without facts indicating that the defendants intended to violate a known duty.

 

In Ryan v. Lyondell Chemical Co. (Ryan II) (letter opinion dated August 29, 2008) (HT Francis Pileggi here), Vice Chancellor Noble took 26 pages to decide defendants’ motion for certification of an interlocutory appeal of his earlier decision in the litigation (Ryan I here) (read my post on Ryan I here). The core problem with Ryan I, in my view, was that the Vice Chancellor did not explicitly hold that the defendants knew that they were not discharging their fiduciary duties. I’m guessing that no evidence was presented to him or that the parties did not highlight that element for him in their briefs. In any event, the Vice Chancellor now asserts that Ryan I was correct although he does say that in Ryan I, “the Court perhaps did not expound in sufficient detail. . .” and “. . . the Court was not as clear as it might have been in this regard”.

 

The Vice Chancellor might simply have declared that Ryan I was correct but proceed in Ryan II to fix the errors of the earlier opinion. Had he done so, he wouldn’t have been the first jurist to take that rhetorical approach. However, Ryan II doesn’t correct the problem with Ryan I. Vice Chancellor Noble starts by emphasizing that the directors may well have violated their Revlon duties and then declares (emphasis original), “it is possible to draw the reasonable inference, at least for purposes of denying summary judgment on the current record, that the directors may have consciously disregarded their known fiduciary obligations. . . .” and that “the Defendants may have exhibited a ‘conscious disregard’ for their known fiduciary obligations. . . .”

 

He then “digresses briefly” (if 13 pages can be called brief) to assure us that Ryan I correctly defined “bad faith” per Disney. In this he is definitely correct. Ryan I certainly set out the correct standard, per Stone v. Ritter. I’m assuming that the reason Ryan II dwells on Disney is that the moving papers now argue that he misstated the definition of bad faith in Ryan I. He didn’t. He also correctly fits Disney with Stone and recognizes that to find a duty of loyalty violation via bad faith requires, as it were, specific intent. What he doesn’t do in Ryan II, and didn’t do in Ryan I, was point to any fact establishing director intent other than the undisputed fact that the directors knew Revlon applied, knew what their Revlon obligations required, and did nothing, which arguably (but not definitely) violated Revlon.

 

I don’t think that can be enough for plaintiff to survive summary judgment. The troubling part of Ryan II is that the Vice Chancellor makes much of the fact that this is a motion for summary judgment and, apparently, the motion was made on a record created for litigation in Texas. The defendants surely have the burden of showing that no genuine issue of material fact exists and that they’re entitled to judgment as a matter of law. The court must make every inference against the movants. Without having seen the briefs or, obviously, the underlying record, it seems to me that plaintiff hasn’t put forth any fact from which the court could legitimately infer that the defendants knew they were violating their fiduciary duties. Had there been such a fact, Ryan I would have mentioned it. Even accepting the Vice Chancellor’s explanation that he didn’t feel the need to go into great detail in an opinion denying summary judgment, that doesn’t explain why such a fact wouldn’t have been the centerpiece of Ryan II. The only conclusion I can draw is that the Vice Chancellor is making what is in my view an impermissible inference from the record. I’m guessing the defendants have canvassed the record and demonstrated that nothing therein raises a genuine issue of their intent to violate fiduciary duties. That is, the record does not show that the directors intended their inaction to violate their fiduciary duties. So, the Vice Chancellor has to fall back on the same facts he relied upon on Ryan I but now has to say explicitly, and erroneously, that those facts can support an inference of intent. They can’t.

 

I hadn’t focused on this aspect of the litigational posture, but Ryan I also denied plaintiff’s motion for additional discovery, essentially on the ground that he’d had plenty of time to develop his record. This strikes me as pretty strong circumstantial evidence that the Vice Chancellor didn’t appreciate the importance of defendants’ intent when he wrote Ryan I. Had he had the requisite appreciation, I suspect he would have permitted Ryan to take discovery at least on that point. He didn’t do so. I don’t see any motion by plaintiff to reopen that question but I would think such a motion would be well taken if the Vice Chancellor has any hope of being affirmed should the Supreme Court take the case.

 

Larry Ribstein has a post (here).

Delaware Court of Chancery on good faith and the duty of loyalty in a Revlon setting

The Delaware Court of Chancery has erroneously permitted a case to survive summary judgment under Stone v. Ritter without showing facts indicating that the defendants intended to violate a known duty.

In Ryan v. Lyondell Chemical Co., (HT Francis Pileggi here) Lyondell received an unsolicited all cash all shares offer at a substantial premium to the market. Lyondell had made no effort to sell itself or seek a strategic partner and the company was economically viable. The board delegated much of the negotiating work to its board chair and CEO, Smith. The final agreement did not contain a go-shop provision but did include several deal protective measures. Ryan, a Lyondell shareholder, brought the required shareholder suit challenging whether the board met its Revlon duties. The board was independent and not interested and Lyondell’s Certificate of Incorporation contained a 102(b)(7) exculpatory clause.

Vice Chancellor Nobel concluded, on a motion for summary judgment, that Ryan might show that the board’s actions were not reasonably designed to secure the highest value reasonably obtainable, thus violating Revlon. The Vice Chancellor then held that the deal protective measures (termination fee, matching rights, no-shop, and pill), in the aggregate, might be preclusive (especially the no-shop) and thus violate the enhanced scrutiny required under Omnicare.

The more interesting part of the opinion is next (see p. 54, et seq.) in which the Vice Chancellor had to face the argument that, even if the Revlon and Omnicare claims were viable, the 102(b)(7) provision will negate any recovery. This, of course, squarely raises Stone. Vice Chancellor Noble noted that the board “made no discernible effort at salesmanship either before or after the Merger was announced” and that the board hadn’t, at this stage, proved that it had adequate information about the company’s market price. Because the current record did not show that the directors discharged their Revlon duties, they might not have acted in good faith. If they did not act in good faith, then they have violated their duty of loyalty, which negates the 102(b)(7) protection.

I think Vice Chancellor Noble has been insufficiently attentive to Stone’s requirement of intent. To be liable under Stone, the plaintiff must show that the defendants knew they were not discharging their fiduciary duties. Vice Chancellor Noble does not address that requirement. Instead, he focuses on a salient aspect of Revlon, which is that its duties are quite clear. Revlon certainly applies to these facts and, presumably, the board knew it. The Vice Chancellor held that, at this stage, the board can’t show that its actions met the Revlon standard. However, what the court doesn’t address, and what is absolutely key, is whether there’s any evidence that the directors intended not to comply. Assuming (and I think it must almost certainly be true) that the board knew it was under Revlon duties and knew what those duties required, where is the evidence that they intended not to comply with Revlon? Is there any evidence other than that they arguably didn’t meet the standard? That surely can’t be enough to impose liability and without that possibility, summary judgment should be entered for defendants.

Stone was decided in a case involving a Caremark claim; this case is a Revlon claim. The theories of Caremark and Revlon are quite different but these facts present one critical similarly: liability is predicated on the board’s inaction. Caremark claims are always posited against a board’s inaction, either in not establishing an appropriate monitoring system or in not adequately monitoring. Revlon cases typically involve, inter alia, challenges to the board’s actions, which are usually many; in most Revlon cases the board has been anything but inactive. It is quite unusual to see a Revlon claim (especially where Revlon’s application was clear) predicated on board inaction. Regardless of whether a Revlon claim is based on board action or inaction, if the claim is one of duty of loyalty rather than duty of care, a plaintiff must show either that the directors were interested, or not independent, or that they intended their actions (or lack of actions) to violate a known duty. It is that analysis that is missing here and that, ultimately, leads Vice Chancellor Noble into error. See my earlier post on Stone (here).

This could be taught in Chapter 11 after Stone v. Ritter.

In addition to Francis Pileggi, Jeff Lipshaw (here), Larry Ribstein (here), and Dale Oesterle (here) have good comments on the case.

Delaware Supreme Court on stockholder adopted bylaws

The Delaware Supreme Court has held that that a stockholder-proposed bylaw that requires reimbursement to dissidents who elect a short slate of directors is a proper subject for stockholder action and might cause the company to violate Delaware law.

In CA, Inc. v. AFSCME Employees Pension Plan (listen to oral argument here), AFSCME submitted a shareholder proposal to CA, Inc., a public company. The proposal would amend CA’s bylaws to require the board to cause the company to reimburse stockholders for their reasonable expenses incurred in a successful contested election for a short slate of directors.

CA requested a no-action letter from the SEC on the grounds that the proposal could be excluded under Rule 14a-8(i)(1) and (2). The SEC, in turn, certified two questions of law, which tracked the Rule, to the Delaware Supreme Court. That is, the SEC asked first whether the proposal is a proper subject for action by stockholders and, second, whether the proposal would cause the company to violate any Delaware law.

Justice Jacobs, speaking for a unanimous, en banc, court, held “yes” and “yes”. On the first question, Justice Jacobs framed the inquiry as determining the reach of stockholder power to amend bylaws under §109(a) given that the DGCL does not give the stockholders the same kind of broad management power it gives to the board in §141(a). He started by observing that both the board and stockholders may amend the bylaws under DGCL §109(a). But the DGCL does not give the stockholders the same kind of broad management power it gives to the board in §141(a), suggesting that the difference in management power affects the scope of the stockholders’ power to amend bylaws. Thus he held that the stockholders’ power to amend bylaws is not coextensive with that of the board, even though reading §109(a) alone suggests that both groups have identical power to amend.

From here, Justice Jacobs relies on implications from caselaw and citations to several provisions in the DGCL (§§141(b); 141(f); 211(a), (b), and (d); 216; and 222) to conclude that a (not the) function of bylaws is to comprise the process and procedures by which substantive corporate decisions are reached. The discussion at page 13 of the opinion is a very nice one that marshals the DGCL sections dealing with permissible bylaw provisions. With admirable, though slightly indirect, honesty, Justice Jacobs acknowledges that this dichotomy doesn’t resolve the issue because each side plausibly argues that the proposal here is either substantive or procedural. The touchstone for categorizing the proposal is its intent and effect. Both the intent and the effect of the proposal are to regulate the process of electing directors so the proposal is a proper bylaw provision, which may be adopted by the stockholders. The intent is to promote the integrity of the director election process by making it easier for dissident stockholders to nominate directors and that intent is realized by the proposal’s requirement for reimbursement.

On the second question, though, Justice Jacobs held that the proposal would cause the company to violate Delaware law. Because this is a certified question rather than actual litigation, the court must decide whether any possible set of circumstances could render the proposal invalid. There is, indeed, such a set of circumstances. Where the board determines that the dissident stockholders who nominated a successful short slate of directors did not honestly believe that their actions were in the best interest of the corporation, then the board would breach its duty of loyalty if it reimbursed the dissidents. The board would only be relieved of liability if the reimbursement requirement were in the Certificate of Incorporation rather than in the bylaws.

Footnote 14 declines to locate the bright line between the stockholders’ power to make bylaws and the board’s plenary power under 141(a). It is a wonderful tenure-generating footnote and surely the currently untenured corporate law profs will make much of this opportunity relatively quickly. One intriguing question is whether this case is the Erie of corporate law. Will bylaws now be subject to challenge because they contain substantive rules rather than procedural regulations? Justice Jacobs is clear that defining the processes and procedures by which decision are made is a function, not the function of bylaws but he gives no real clue about what other functions the bylaws may properly serve.

On the merits of this decision, I’m not at all sure that the court is correct when it holds (p.14) that the purpose and effect of the bylaw is to regulate the process of electing directors. It’s difficult for me to believe AFSCME’s intent is to reform process rather than to reduce the risk of running a short slate of directors. My guess is that AFSCME want to run (or has a sense that other CA shareholders would run) a short slate but would be much more assured in doing so if it would recoup at least some of its costs should they prevail. It’s not process reform, but substantive reform that the dissidents want. However, the court is not wrong in the way it describes the mechanism by which that reform is to be implemented.

This case could be taught in Chapter 15 after the third full paragraph on page 544. This opinion presents a You Draft It possibility. Redraft the following bylaw to make it clear that it regulates only the procedural aspects of electing directors:

The board of directors shall cause the corporation to reimburse a stockholder or group of stockholders (together, the “Nominator”) for reasonable expenses (“Expenses”) incurred in connection with nominating one or more candidates in a contested election of directors to the corporation’s board of directors, including, without limitation, printing, mailing, legal, solicitation, travel, advertising and public relations expenses, so long as (a) the election of fewer than 50% of the directors to be elected is contested in the election, (b) one or more candidates nominated by the Nominator are elected to the corporation’s board of directors, (c) stockholders are not permitted to cumulate their votes for directors, and (d) the election occurred, and the Expenses were incurred, after this bylaw’s adoption. The amount paid to a Nominator under this bylaw in respect of a contested election shall not exceed the amount expended by the corporation in connection with such election.

This case has generated commentary by Steve Bainbridge (here, there, over there, around here, and right here), Larry Ribstein (here and there), Francis Pileggi (here), and Lisa Fairfax at The Conglomerate (here and there).

Eric Chiappinelli named Dean at Creighton University School of Law

I am delighted and honored to report that I have been selected to be the next Dean of the Creighton University School of Law, effective next July.

Here is the Creighton University press release

Delaware Court of Chancery on inspecting books and records before share ownership

The Delaware Court of Chancery has held that a shareholder may inspect books and records related to acts occurring before the shareholder owned shares where the purpose is to assemble facts showing demand futility rather than to investigate misdeeds the stockholder would have no standing to assert. In Melzer v. CNET Networks, Inc., plaintiff filed a derivative complaint in federal court. The District Court dismissed without prejudice for failure to plead demand futility and stayed the proceedings to allow a books and records request under DGCL § 220. Mr. Melzer filed an action in the Court of Chancery when CNET resisted his demand as to documents related to facts that pre-date Mr. Meltzer’s share ownership. CNET’s primary argument against inspection is that plaintiff would not have standing to assert any claims uncovered by documents predating his share ownership.

Chancellor Chandler permitted inspection. He premised his decision on the idea that, “A stockholder must be given sufficient access to books and records to effectively address the problem of backdating through derivative litigation.” Under Stone v. Ritter, one way to show demand futility is to allege a Caremark claim. The standard of review for such a claim is a sustained or systematic failure to exercise oversight. To allow plaintiff to effectively address that claim, he is entitled to inspect documents that pre-date his stock ownership.

This opinion is noteworthy because it’s a nice synopsis of the Delaware Court of Chancery’s approach to books and records requests. It’s a good applied example of the Supreme Court’s recent Seinfeld decision, which was primarily theoretical. It also suggests that Caremark claims may be more useful that one might think at first blush. In Caremark and Stone, and perhaps other opinions, the Delaware courts have observed that a failure to monitor claim is extraordinarily difficult to maintain, in large part because the standard of review is so high. The board is liable only if it intentionally engaged in a sustained or systematic failure to monitor. However, this opinion suggests that plaintiff might be able to use a colorable Caremark claim to inspect books and records beyond those the plaintiff might ordinarily inspect because those broader records are germane to whether the board exhibited a sustained or systematic failure to monitor. Obviously the real effect of this opinion will depend on how the Court of Chancery bench shape their orders permitting inspection. I suspect this will be a subject of warm contention for a while until an aesthetic of inspection for Caremark claims emerges.

The Chancellor was clearly annoyed with CNET’s resistance. He began the opinion by observing, “This should have been a very easy case.” With wonderful symmetry, he ends with another pithy statement: “It is about time defendant … gets ‘going, going / back,

back / to Cali, Cali,’ ” citing, of course, to The Notorious B.I.G.

This case could be taught in Chapter 15 along with Seinfeld. Francis Pileggi was kind enough to send me this case and, as ever, had a good post here.

Supreme Court of Missouri on cancelled shares

The Supreme Court of Missouri has erroneously held that put options may be exercised even after the underlying shares have been cancelled. In Weinstein v. KLT Telecom, Inc., Weinstein obtained an option in December 2000 to put shares of DTI Holdings, Inc. to KLT Telecom, Inc. at $15 million. The option was exercisable beginning September 1, 2003. Weinstein gave the share certificates to an escrow agent to hold. DTI entered bankruptcy in 2001 and in June 2003 the bankruptcy court cancelled all DTI equity securities. On September 2, 2003 (September 1 was Labor Day), Weinstein sought to exercise the option. KLT refused and Weinstein filed suit. KLT’s primary defense was failure of consideration because the shares had ceased to exist at the time of exercise.

Judge Limbaugh held that the consideration should be measured when the option contract was entered into and thus the option was supported by consideration, even though the shares later became worthless. To the extent KLT was arguing failure of performance by Weinstein, Judge Limbaugh held that

The shares, though worthless, do in fact exist, and they were tendered to [KLT] through the escrow agent.

Judge White, in dissent, pointed out the distinction between worthless shares and nonexistent shares. If the value of the DTI shares had simply been zero, the option could be exercised. However, the shares were cancelled; they ceased to exist. Thus there was a failure of consideration.

Judge White must be correct in this interpretation. Missouri’s corporations statute does not contain a cognate to MBCA § 6.03(a): “Shares that are issued are outstanding shares until they are reacquired, redeemed, converted, or cancelled.” Nonetheless, the common law concept of cancelling shares is that the shares cease to exist. Obviously the certificates for cancelled shares simply represent nothing. This case could be taught in Chapter 6 at page 197 in connection with the concept of “outstanding”.

Minnesota Court of Appeals on de facto LLC and LLC-by-estoppel

The Minnesota Court of Appeals has held that the de facto LLC doctrine does not exist in Minnesota and that the LLC-by-estoppel doctrine is inapplicable where a party’s intention to deal solely with an LLC is induced by fraud.

In Stone v. Jetmar Properties, LLC, Ortega gave Hammond an unsecured $200,000 loan to develop property that Ortega had planned to sell to Jetmar, Hammond’s LLC. The sale was not completed because Hammond could not obtain sufficient funds. Although the loan was to be repaid in three days, Hammond never repaid it. A few months later, Hammond met Stone and convinced him to invest more than $50,000 in Jetmar projects. Hammond convinced Stone to quitclaim a rented duplex to Jetmar so that Jetmar’s balance sheet would show sufficient assets to obtain further financing. Hammond promised to reconvey the property in sixty days and told Stone he could continue to keep the rent from the tenants.

Hammond recorded the deed the next day and mortgaged the duplex to Ortega the day after that in exchange for Ortega’s agreement to extend the $200,000 loan. Ortega recorded the mortgage a few days later after confirming that Jetmar had title. Ortega foreclosed on the duplex about seven months later, sending notice to the tenants who forwarded it to Stone. Relying on Hammond’s assurances that all would be well, Stone did not contact Ortega to assert his interest in the duplex. A couple of months later Ortega conducted a foreclosure sale at which he purchased the duplex in return for his $200,000 loan to Jetmar. About a week later, Hammond filed Jetmar’s articles of organization. Apparently neither Ortega nor Stone knew that Jetmar had not been formed. Stone filed suit against Jetmar, Hammond, and Ortega seeking damages and a declaratory judgment that he owned the duplex. Jetmar and Hammond defaulted.

Judge Lansing held that Stone’s quitclaim dean to Jetmar was void because Jetmar did not exist at the time. Neither the de facto entity doctrine nor the entity-by-estoppel doctrine prevented Stone from reclaiming title to the duplex. Judge Lansing held that an element of the de facto doctrine was not met because Hammond made no colorable attempt to form the LLC at the time Stone conveyed the duplex. She further held that the de facto entity doctrine cannot apply to LLCs. Minnesota’s corporations act, which is based, in pertinent part, on the MBCA of 1950, abolished the de facto corporation doctrine. The reporter’s notes to the Minnesota LLC statute state that corporate law should apply to analogous portions of the LLC statute. Because the LLC statute’s section stating that an LLC’s existence begins at filing is based on a similar corporations act section, the de facto entity doctrine cannot apply to LLCs.

The entity-by-estoppel doctrine was not abolished by statute but does not allow Ortega to retain the duplex. Although Stone intended to deal only with Jetmar, not Hammond, that intention was induced by fraud, which allows the court to decline to apply the entity-by-estoppel doctrine. Thus Stone cannot be estopped from seeking to recover the duplex.

As a policy matter, it makes sense to be consistent in applying the defective formation doctrines of de facto entity and entity-by-estoppel. The drafters of the current MBCA concluded that the 1950 MBCA’s attempt to end the de facto corporation doctrine was misguided; courts continued to provide equitable relief despite the statute. Whether the drafters were right in that conclusion is less than obvious and the survival of the 1950 MBCA provisions in a few states, such as Minnesota, suggests that the appropriate policy choice is not obvious. The entity-by-estoppel doctrine is so amorphous that perhaps the best one can say is that, if their courts are consistent, then they’ve made an appropriate choice in terms of defining the doctrine.

This case could be taught in Chapter 19 either right before or just after P.D. 2000, L.L.C. v. First Financial Planners, Inc., on casebook page 745. It would make a good contrast with P.D. 2000, L.L.C. on the entity-by-estoppel question.

One other aspect of this case caught my eye. Jetmar’s counsel was Alex W. Russell, Esq. Mr. Russell practices with, and, in fact, seems to be the only lawyer at, the firm called, “Evening & Weekend Law Offices”. This is an interesting marketing technique and I wonder whether Mr. Russell’s practice is helped or hurt on the whole by his choice of firm name.

Delaware Court of Chancery on stock options, Stone v. Ritter, and Caremark

In Desimone v. Barrows, Sycamore Networks, Inc., issued stock options to certain non-executive employees, certain officers, and the four outside directors. Desimone, a shareholder, brought a derivative suit to recover from the recipients and the two inside directors on the ground that the board breached its fiduciary duties. Vice Chancellor Strine dismissed the complaint on the grounds that plaintiff lacked standing to challenge some of the options because he was not a stockholder when some of the option grants were made, had not shown demand futility as to some claims, and did not state a claim upon which relief can be granted as to the remaining claims.

The pedagogical value of this opinion lies in Strine, VC’s discussion of the current options litigation and his discussion of the effect of Stone v. Ritter on Caremark claims. He quite lucidly describes backdating and distinguishes it from spring loading and bullet-dodging practices. But more importantly, he gives his view of Stone. I don’t read the Vice Chancellor as differing from my own interpretation of Stone (here) though he claims that my reading is not “entirely consistent” with Stone:

In this same vein, the importance and utility of the Delaware Supreme Court’s recent decision in Stone v. Ritter, reinforcing the vitality of this court’s decision in In re Caremark Int'l Inc. Deriv. Litig. should not be ignored. Some respected scholars seem to fear that Stone opens directors to new kinds of claims foreclosed by Caremark, while others read it as taking away a non-scienter based claim Caremark supposedly seemed to suggest. Neither position seems entirely consistent with the decision itself. Stone clarified one of the most difficult questions in corporate law — when directors with no motivation to injure the firm can be held responsible if the corporation incurs serious harm as a result of its failure to obey the law. What Stone makes clear is that Caremark and its progeny, such as Guttman v. Huang, are still good law. For reasons Caremark well-explained, to hold directors liable for a failure in monitoring, the directors have to have acted with a state of mind consistent with a conscious decision to breach their duty of care. Caremark itself encouraged directors to act with reasonable diligence, but plainly held that director liability for failure to monitor required a finding that the directors acted with the state of mind traditionally used to define the mindset of a disloyal director — bad faith — because their indolence was so persistent that it could not be ascribed to anything other than a knowing decision not to even try to make sure the corporation’s officers had developed and were implementing a prudent approach to ensuring law compliance. By reinforcing that a scienter-based standard applies to claims in the delicate monitoring context, Stone ensured that the protections that exculpatory charter provisions afford to independent directors against damage claims would not be eroded. Stone has obvious implications for cases like this, when a plaintiff seeks to hold directors accountable for failing to prevent backdating by corporate officers.

Professors teaching Desimone could do so at page 400 of the casebook at the end of section 4. Alternatively, one could summarize this case in the Notes and Questions following Stone, which is inserted at page 394. Both Stone and Desimone are included in the casebook Supplement.

Francis Pileggi has a characteristically good discussion of Desimone (here). Larry Ribstein also has a very good post on this case (here).