Should a board's decision-making process change in response to less frequent judicial review?
In this recorded webinar, Graham Robinson and Paul Lockwood of Skadden, Arps, Slate, Meagher and Flom LLP, will:
- Discuss these changes
- Review whether they have worked as intended
- Make recommendations for how directors should consider litigation risk as they make decisions moving forward
Disclaimer: Please be advised that this recorded webinar has been edited from its original formal which may have included a product demo. To set up a live demo or to request more information please complete the form to the right. Or if you are currently not on CSC Global there is a link to the website in the description of this video, thank you.
Annie: Hello everyone, and welcome to today's webinar, "Judicial Review and Recent Impacts on Board Decision Making." My name is Annie Triboletti and I will be your moderator. Joining us today are our guest speakers, Graham Robinson and Paul Lockwood from Skadden Arps. And with that, let's welcome Paul and Graham.
Paul: Hello, everyone. This is Paul Lockwood from Skadden Arps. I'm a corporate litigator from Wilmington, Delaware. So my practice is mostly focused in Delaware and the Court of Chancery and M&A related litigation there as well as securities litigation in federal courts around the country. And I'll turn it over to Graham for him to introduce himself.
Graham: Yeah. Sure. This is Graham Robinson. I'm an M&A partner in the Boston office at Skadden and I focus on representing acquires and targets, mostly public companies, some private company, M&A as well as in activism and other related governance matters.
Paul: So to start our story here, I think we have to go back to where things were in corporate board rooms and the interaction with litigation and the courts from just a few years ago, because there's been a significant transformation that's been driven mostly by Delaware and has spread to other states and to the federal courts. But if we go back three, four, five years, you had a situation where plaintiffs’ law firms were filing suit on every merger. It was something that would often be called a merger tax. You knew if you did a merger there would be litigation and that you have set something aside to settle that litigation.
Oftentimes, there were multiple lawsuits around the country. I think that the statistics really verged on over 90% of the mergers had lawsuits and often in many states you get sued in Delaware, you get sued where the headquarters were, you might get sued in some other places where some entrepreneurial lawyer thought they might establish a beachhead and be able to pursue litigation.
The lawsuits were typically focused on the process that the board used to approve the merger such as a failure to adequately shop the transaction or consider alternatives and there was also a focus on the disclosures that were issued in connection with the merger because under Delaware law mergers have to be approved by the stockholders. I think that’s really true under corporate law in every state that there would be a requirement that there would be a vote of the stock holders and that vote has to be fully informed.
So, again, shareholders and more particularly plaintiffs’ lawyers would contend that the disclosures to the stockholders were inadequate. And therefore, the vote was not fully informed. And then you would also have transactions involving controlling stockholders. So where there might be a shareholder or a group of shareholders who own more than 50% of the company and they're buying out the remainder. Those types of transactions, basically a 100% would draw litigation because it was a real opportunity for a lawsuit that would get past the initial stages. And they were very difficult, those types of claims, to resolve at the pleading stage or on summary judgment.
And as a result, those kinds of cases really would really would require a trial to resolve which made them very attractive for plaintiffs’ lawyers because corporations and their boards wouldn’t want to get tied up for years in litigation and they would seek to resolve those lawsuits through settlement. But all these lawsuits really would ultimately be resolved through settlements. The ones that were typical "arm’s length" transactions would be resolved through amendments to the disclosures and then settlement. I think one case many years ago referred to it as the peppercorn and a fee settlement process. But there would be a disclosure only settlement. There'd be changes to the proxy statement that was sent out to stock holders, then there would be a negotiation over how much to pay the lawyers for their work.
But another aspect of this that I think there's emphasis is that it would not only involve correcting disclosures and settling the lawsuit, but at the time, it was very difficult to avoid discovery in lawsuits like this. The standard in Delaware at least was you had to have a colorable claim in order to get expedited discovery and a colorable claim means just that. It has to have some colorable basis.
It doesn’t have to be a good claim. It doesn’t have to be, you know, a claim that's legally valid or provable. It essentially has to be, you know, something that's plausible. And that would get you off to the races in terms of serving document requests, searching the emails of the directors and the senior officers and searching around for a claim as a result. And also allow the plaintiffs’ lawyers to take depositions of directors and officers and financial advisers.
That would actually make this process, one, expensive. It just costs a lot of money to produce documents. And also quite unnerving to directors. Nobody likes their emails searched. Nobody likes to be subject to depositions. And it was even in situations where they would be . . . the lawsuits would be resolved, and they almost always would be resolved without any money coming out of the directors’ pockets or any really serious resolution that affected the directors in any way, it was quite an uncomfortable process and something that drew the attention of boards.
So one other things as a result and, Graham, you could weigh on this one if you’d like to since you're advising boards but it was our experience that the directors would often ask how does this going to look in court and what's going to happen when I'm asked to testify, what's going to happen when we’re before the judge and we're defending our actions here. And that was a very real, you know, kind of palpable risk because, as I said, the documents would have to be produced to the plaintiffs’ lawyers.
My one standard joke would be that if you're in a board room and you're taking notes in an M&A process, you know, you might as well write exhibit A up in the corner of your notes because they're going to end up in court relatively soon. And that was absolutely true. So there was a tendency to think about how the litigation is going to affect the process as much as thinking about the process itself.
Graham: Yeah. And, Paul, I will go ahead and inject on that. We’ll come back to this later when we get to talking about some of how we do advise boards now. But I think one the things that made this regime that Paul is describing, the regime that existed just a few short years ago suboptimal was that it naturally resulted in directors, and unfortunately sometimes even their counsel, focusing a lot, maybe even as much on the litigation as the more important question of what should directors be doing, what's the question before the directors, and how can they make the best possible decision fir shareholders.
And so I think we would sometimes see directors focused a lot of attention on that question of how do I manage my litigation profile here, which is not what you would ideally want directors to be focused on. And I also think that sometimes counsel would allow their own thinking to sleep so that when they would describe to directors what their fiduciary duties are, it would sometimes sound like they were describing to directors how to avoid litigation risk rather than the real question which is what it is that they are supposed to be doing for shareholders. And so all of that was, I think, a byproduct of this system of directors facing litigation without regard to the quality of the decision they made that caused them to perhaps naturally focus on the litigation. And I think everyone involved except perhaps for the plaintiffs’ attorneys, but even some of them, recognized this was not an optimal system.
Paul: Okay. So let's talk about how the litigation was reduced over the past four to five years. There really are three significant decisions that came out of the Delaware courts that have reduced really the intensity of the litigation, I would say, even more than the amount of litigation. And the first of those was a case called Trulia In re Trulia Stockholders litigation from 2016 from the Delaware Court of Chancery.
And what the court there said after probably a few years of criticism of these disclosure-only settlements where a lawsuit would be filed, the plaintiffs would take discovery, they would get documents, they would take a deposition or two and then instead of pursuing the claim that they said they were going to push, which is to attach the fairness of the merger and the process of the merger, they would reach an agreement that some enhanced disclosures, basically some additional statements would be included in the proxy materials. And then the defendants would get a release and the plaintiffs would get attorney's fees.
And what the court determined in Trulia was it was no longer going to approve those settlements. And one of the keys to that is that the defendants were no longer getting a release in those settlements. One aspect of this that it wasn’t necessarily irrational from the defense perspective was that even though this process was harassing and annoying, there was an insurance type aspect to it that the courts were aware of which is that ultimately you would present a settlement to the court and the court would sign off on it. That would have a binding effect on all of the stockholders who would then release all of their claims relating to the merger or the disclosures relating to the merger. And that release would have some tangible value from a defense perspective.
The court determined that it was no longer going to be in that process, it was not going to approve these settlements, it was not going to approve the fee awards, it was not going to approve the releases. There was still a possibility that plaintiffs’ lawyers could get a claim if they could show that they actually had a very strong claim and one worth settling. But there really has been almost none. Disclosure-only settlements completely ended in Delaware as a result of this. They're still alive in certain states.
I had one that we got approved in North Carolina two years ago. North Carolina has slightly embraced Trulia. The judge expressed some skepticism and awarded a fairly low fee but actually gave us the settlement and we got the releases as a result. But for the most part that's gone by the wayside. The Delaware courts have said that they could consider a mootness settlement where you don’t get a release and you get much lower fees, essentially that if corrective disclosures are sent out as a result of litigation and the claims are mooted as a result, there won't be a settlement approved, no stockholder will be bound by it. The plaintiffs can apply for a relatively small fee in those circumstances.
The mootness settlements, these are usually $100,000 or less as opposed to the $500,000 range that they were getting previously. And as a result there's just a lot less interest from the plaintiffs bar in pursuing those claims and certainly not in the Delaware courts at all because the courts are frankly somewhat hostile to these claims at this point. I think it tends to reduce the reputation of the lawyers bringing them if this becomes their bread and butter because the courts look with some disdain on it so those cases have not been brought nearly as frequently.
And as I said before, one of the keys to it is they would get discovery that they could show a colorable claim so the production of emails and the searching of director records, that has really slowed down or stopped because it's now the very rare case that moves into substantial discovery as opposed to the typical process. And as important as Trulia is, there's really another case that came out of Delaware Supreme Court that I think is actually more important and it's a case called Corwin versus KKR Financial Holdings and what Corwin has done is focused on the stockholder approval of a transaction.
As I said before, there's a statutory requirement under Delaware law for stockholders to vote on a merger. And what the Delaware Supreme Court has said in Corwin is that that vote is a critically important process, that it has in fact a ratification of the conduct that led to the merger. And therefore if there's a fully informed vote in connection with the merger, the courts also extended tender offers that the claims against the stockholders are not extinguished but the standard of review is dropped to the business judgment rule. I think we're going to discuss that soon but the business judgment rule is a very deferential standard. It has the effect of eliminating the claims in my view, because once you have a business judgment rule standard then it's extremely difficult for plaintiffs to pursue those claims.
So what this means now is it would put pressure on the plaintiffs’ lawyers to seek to enjoin transactions rather than let the vote go forward because after the vote, unless there's problem with the disclosures, they don't have a case. I had not seen them seeking to enjoin transactions with any increase compared to how they used to do it. It really would require a lot of work and a good case with little discovery. So they more often challenge the quality of the disclosures. The might try to pursue a case by saying that the disclosures were inadequate. And that becomes a focus in the post closing litigation sphere. But to a very large degree Corwin has reduced litigation risk, particularly after the deal closes because now you have a business judgment standard and that's a very director-friendly standard.
And then there's a third avenue that developed in 2004 and this applies to a special group of M&A transactions which are controlled transactions. And controlled transactions, as I said before, if there's a stockholder who owns more than half of the company then they’re considered to be a controlling stockholder. They can owe fiduciary duties to the minority stockholders in that circumstance and for decades, really since the '60s, Delaware law has been very focused on what they call squeeze-out transactions, transactions where the controlling stockholder buys out the minority.
And the concern has always been that in those circumstances the controlling stockholder, because it elects the board, all the directors are effectively appointed by the controlling stockholder and because the controlling stockholder can influence the company in all sorts of other unofficial ways that that transaction is not subject to a deferential business judgment rule but it follows a very strict test called “Entire Fairness” which has to have fair price and fair dealing. And the Entire Fairness standard is very factually intensive. And as a result, these challenges and these circumstances were effectively impossible to dismiss without a trial.
You didn’t have a way to say, "Hey, we did it right. We did a good job here and therefore, you don’t have to take a close look at this judge. You can just approve this transaction." Instead it would require, you know, people, human beings coming into court and testifying, looking the judge in the eye and saying, "We did a good job here." As you can imagine, that's both expensive and it's distracting and it's always a gamble if you're trying a case. I’ll say that as a litigator.
So these cases inevitably settled. And this was a difficult process to get through without significant litigation risk. Well, a framework was developed in a case called MFW Worldwide Corp. It's a case where Skadden Arps did the legal work and came up with the idea of pitching the structure as a safe harbor and the safe harbor that the Delaware Supreme Court approved says that if there's an independent special committee that bargains at an arm's length for the minority, there's approval of a fully informed majority, the minority, the stockholders, and this process is in place from the outset from before any economic bargaining takes place that that is a transaction that can get the business judgment rule even if there is a controlling stockholder.
And the reason for that is that there's really two touchstones of arm’s length bargaining that you've created in this process. The first is there's an independent special committee, so you have directors who form a special committee who have their own advisers, their own counsel and they are directors who aren't beholden to the controlling stockholder. They were voted onto the board by the controlling stockholder but they're independent in every other sense and they have, you know, good counsel and good advisers so they're bargaining for the interest of the minority. And further, instead of having a stockholder vote, it’s guaranteed to approve the merger because the controlling stockholder has more than half the vote, in these circumstances you have a majority to minority requirement. So even minority stockholders have the opportunity to reject the transaction if the majority of the non-controlling stockholders vote against the deal.
And as I said, this has to begin at the outset. You have to start from the very beginning from this format. That way, the existence of the format is not part of the bargaining. It's put in place in the first instance. And this has really changed these transactions tremendously because now as a litigator, if the corporate folks have put it up this way, we can go into court and get the case dismissed on a motion. And therefore the prospect of lengthy and difficult litigation has been greatly reduced. And there's now a straightforward recipe to get these transactions approved by the Delaware courts and it really has changed this area of the law as well.
Graham: And, Paul, maybe just to add to that a little bit thinking from beyond the procedural aspect of it, under the old world, but not that old, really just before this MFW transaction, case, I'm sorry, the reality in any of these transactions that involved controlling stockholders was that a buyer had to hold meaningful money back on an assumption that they were going to pay a settlement. And by meaningful I mean, you know, it could be hundreds of millions of dollars. The settlements in the former case when we were talking about unconflicted boards were relatively small costs. They were frustrating costs but they were small costs. In this conflict situation the settlement costs were substantial enough that buyers really had to hold back very large amounts of money and directors faced a real risk, particularly the conflicted directors, that they could wind up having to write checks and pay money out of pocket.
So this standard of review was very difficult for people to bear because it had a real cost on shareholders of the target since if the buyer has to hold back that much money, who knows whether the amount of buyer would really have been willing to pay the target winds up in the target's hands or not that's based on the outcome of litigation. And directors going through this process, you know, bore substantial legal risk that I think was difficult and, to be candid, unfair. And the MFW standard totally changed that by creating a regime that replicates an arm's length transaction.
Buyers are really in a position now where they can feel comfortable putting a price on the table that will stick. And I think a buyer generally now in this situation can feel comfortable bidding its last dollar if it needs to do so with the confidence that the transaction will get approved. And directors in situations like this can feel confident that if they act appropriately just like they would in an independent transaction situation, a non-conflicted situation, that the really face, you know, trivial to no risk of paying out of pocket damages, which is I think the outcome that the Delaware courts were looking to achieve.
Paul: Yeah. I'd say one other thing about it which is that the reason why this framework was approved is because it really does focus on returning the bargaining power to the directors who are the fiduciaries and not leaving it in the hands of litigants who might show up in court to squeeze those last dollars out of the transaction and that's really, you know, where the control over the bargaining process should be.
Paul: So next I'll talk about the current day. So we have these three fundamental changes that occurred all within a five-year period. The combination of them makes directors far less likely to be sued. And when they are sued, those cases are far more likely to be dismissed at the early stages. And in particular, they’re far less likely to be discovered which can be very unnerving, harassing, bothersome. So the likelihood of the directors turning over vast amounts of email and text messages and the like, in most cases or most mergers it doesn’t happen these days, whereas just a few years ago it was routine, it was absolutely unexpected. You’d see it almost every time.
There are still lawsuits that get filed but they’re mostly filed in federal court and they're mostly just looking for low dollar mootness fees now without discovery. And the overall personal liability for directors, while it was never great, you always had D&O Insurance, you had other protections provided by Delaware law. You know, there's always been a theoretical risk of personal liability for directors. But outside the context of a controlling stockholder transaction which Graham just discussed in a normal third party merger context, there was never a great risk, I would submit, that the directors were going to be personally liable but you still felt it was a tangible threat in the sense that you were called before people to testify. You had your documents turned over. And that is far less likely to happen these days.
Graham: All right, so I will pick it up . . .
Graham: Sorry, go ahead, Paul.
Paul: No, go ahead, Graham.
Graham: Okay. So I'll pick it up here on slide 13. So this change, and it's really a dramatic one, I often, when I'm talking to boards in M&A context, now I will often say to them, “If any of you have been involved in public company M&A deals and it wasn't in the last two or three years, you really need to assume we're starting from a blank sheet of paper because what you learned before about the law, the way that litigation would play a role in this transaction, whatever you experienced before doesn’t apply anymore. And so it's a new ballgame.”
That change, and it's really a radical, dramatic and beneficial change in Delaware has brought impact. As the slide shows, overwhelmingly the large public companies in the United States are incorporated in Delaware and even those that aren't, even those that are incorporated in other jurisdictions, many of those jurisdictions have policies that their courts will look to the well-developed case law in Delaware as they apply their own state laws. And so, for example, Massachusetts where I live, although we work with very few Massachusetts corporations, Massachusetts has a principle like that that they will look to Delaware corporate law when they're looking for cases.
So these changes have a huge impact on public companies throughout the United States. It's important to note, and I touched on this a little bit before, the directors’ duties haven’t changed. So the question that we M&A lawyers are supposed to remind directors of at the outset of a process, which is what are your duties as you go through it, they should be the same as they were before and those are the phrases that every director here is over and over the duty of care, the duty of loyalty. The duty of care is the duty to try hard, that's really what it means. I get a lot of information, try hard, try to do a good job, and the duty of loyalty which is the duty to put the company before anything else. Those duties are the same.
I think that the way they're received by directors feels different because they used to get framed very much in a litigation context. And I think not in a way that was good for directors or for the process, that a standard routine for the lawyers advising boards was to almost try to scare the directors into complying with their fiduciary duties by describing the duties and sort of, you know, identifying some of the threads that Paul identified from the old regime of, you know, you'll inevitably face litigation, you could face personal liability risk if, and as Paul said, and I might say it more strongly, the reality was directors in unconflicted situations really faced no risk at all of personal liability under the old regime nor do they under the new regime.
It was not a real risk that they face in conflicted transaction situations. Where the boards had conflicts of interest where they were controlling stockholders, it was completely different. But in unconflicted situations directors didn’t face that risk. However, and this is the reason I think the courts saw that it was important to make this change, when directors don’t really face that risk but they still know their names are going to appear in the captions of cases, they may get deposed, as Paul said, very unpleasant process. I’ve seen some wonderful directors really shaken by that process and understandably so.
That their emails and text messages may be reviewed in great detail as a sort of matter of course, it's hard for them to square that with the idea that they don’t face any legal risk because it feels like they're in the crosshairs and that isn’t going to lead to the kind of decision making that we want. We did still have, if you look at the next slide, we did still have then and we have now the business judgment rule. And the principle of the business judgment rule, I think, really also explains why Delaware adapted the Corwin change that Paul described.
The principle of the business judgment rule is that the Delaware courts, the judges who sit on those courts are not people who are skilled at making business decisions. And so if they are looking at a group of independent directors, in other words, people who have no reason to make a decision other than one that's in the best interest of stockholders, there isn’t something else tugging at them like they are affiliated with the counterparty to the transaction and so they might wish to see that counterparty get a better deal or they're, you know, they have a special interest like they need desperately to sell their shares in order to wind up a private equity or venture capital fund. If they don’t have a conflict of interest like that, there's really no reason to imagine why they would make any decision other than one that's in the best interest of stockholders.
And although they can make wrong decisions—people do that in life with frequency, they can make wrong decisions—they're at least probably less likely and maybe dramatically less likely to make wrong business decisions than the judges themselves. And so if the judges get into the business of second guessing the decisions made by the boards, we will probably wind up with more bad decisions both because the directors will generally get it right more often than the judges will and because if the directors think they're going to get second guessed, they will be conservative and we don’t particularly want judge directors to be conservative. We want them to be down the middle, maybe some academics even argue we want them to be risk takers. And I think that might be right.
So the principle of the business judgment rule is once you establish that the board is independent, the court should get out of the way. Even if it looks to the court like the decision was wrong, in some cases the courts have even said the decision looked really wrong to the court, the court says, "It doesn’t matter. It's not our job to decide whether the board made the right decision even if we think they got it really badly wrong, if they're independent, it's their decision not ours and we let it stand." And the principle of Corwin was to extend that even further and say if it's in an independent board that made good disclosure, we’re not even going to let the litigation proceed. And so you can see the two as sort of connected in that sense.
An important point, and I think from some directors’ perspective sake, if they could challenge whether the entirety of what we've described is as radical as it is but I think it is—I’ll explain why—is that books and records request have increased. And so what a book and records requests is a stockholder of a Delaware corporation has a right to get access to the company's books and records, meaning internal papers, which include at the very least things like board minutes but they can include other things like emails depending on the context. They have a right to get those for a proper purpose. And the proper purpose could be investigating whether there's been a breach of fiduciary duty by the directors in connection with an M&A transaction.
And we have seen more and more, it's an understatement, we've seen a lot of books and records cases, they've almost become routine in connection with public company M&A transactions and the courts have encouraged this. They've said, "Instead of the old way, when you've filed a case with really no sort of basis for your claims and then sought to do discovery, why don't you use the books and records rights that you already have to get access to some of the company's documents and see whether you can actually put together a claim with some underlying substance to it that you think there's a breach of fiduciary duty so that if you file a claim it's not just a fishing expedition it's actually based on something?"
And so that's what the plaintiffs have started to do with regularity. The reason I think that that shouldn’t be viewed as just sort of translating the old litigation for the new, the reason I think it is a much better path is first that there are substantially greater limitations on the scope of that discovery and I don’t just mean that from the perspective of someone who generally represents companies and therefore would like to see as little as possible. I mean it's just a more rational regime. I think plaintiffs can still get access to the things they should get access to but it's not as sort of broad and unfettered a discovery regime as used to exist under the old litigation regime. And so I think for that reason it’s better. And second, honestly, it's a litigation against the company and not against the directors individually and I think that matters.
Okay. So what are the takeaways? And then Paul and I are going to jump into talking a little bit about sort of how this applies practically as we advise companies and boards. The takeaways are there's less litigation aimed at directors and much higher hurdles for plaintiffs that are seeking to make fiduciary duty claims against the directors. That's, I think, the heart of what Paul and I have been saying.
In unconflicted transactions, again, meaning transactions where a majority of the board does not have a conflict of interest, where they're independent not just in the NASDAQ or New York Stock Exchange sense, but independent of the counterparty, the likelihood of a fiduciary duty litigation is trivial to maybe non-existent at this point. There, as Paul said, may be proxy litigation but fiduciary duty litigation extremely unlikely. And once you've had a stockholder vote, that's basically it unless you really did something wrong and it gets discovered later, that's a different issue. We work under the assumption that our directors are all good, well-meaning people who don’t do the wrong thing and so I don't generally worry about this but if they did then, of course, something could happen.
And then finally, the process still matters. In particular, if you relax my assumption that a majority of the board's independent is you get into the type of transactions where there controlling stockholders or where a majority of the board otherwise has a conflict of interest, you move into a . . . we've moved into a dramatically different litigation system, one that was frankly broken before, fundamentally broken before and very difficult for people to navigate into what's now an extremely rational and thoughtful legal regime.
So Paul and I are going to talk a little bit now about some of the practical side of these and I'll start, Paul, with a question for you. How do you advise boards differently now than you did before this set of cases that we've just been talking about?
Paul: You know, Graham, I think like you said earlier, right, the duties haven’t changed, right? So we emphasize that. But the message is less from a perspective of do this or you'll face liability, do this or you'll be sued. There still is the discussion of litigation risks that come up at every board meeting. It's prudent to have that discussion. But it's really a backend part of the discussion and it does bring the directors to think about their duties in the context of the obligations they have to the stockholders, and not the fear they have of being sued or being questioned in court about the decisions that they're making.
Graham: Yeah, I agree completely with that. In fact, I think that one of the jobs of a good lawyer, I guess I'll focus on the type of work I do in the M&A context but what I'm about to say could probably apply to other contexts as well but I think one of the important jobs of a lawyer in the M&A context is to help the board push out of its mind the fear of litigation because I think the fear of litigation causes directors, if you really think about it, to be essentially self-interested, to be focused on protecting their own interest rather than advancing the interest of stockholders. It's natural that they would think that way if they are expected to have, you know, a virtual certainty of a lawsuit filed against them.
And so I think this new case law in Delaware has allowed us to do what I'm describing, which is to make a real effort to say to directors, "You shouldn’t be worried about litigation. There could be some litigation along the way, you know, proxy litigation whatever it is that comes up, a book and records case may come up. It's not going to result in you facing personal liability. It's not going to disturb the transaction unless anybody does something wrong and I know that you won't do something wrong. The important thing is that we are upfront about what it is that we're doing."
And this is one of the things I think has been really beneficial about this because these new case is focus on disclosure because, you know, access to Corwin getting this beneficial legal standard where directors are able to say to themselves, "I don’t even really face a risk of getting sued personally in this transaction," that all depends on all of the important facts being disclosed. And so that means that we can focus a lot with boards on its critical that we know everything. It’s not going to get disclosed unless the lawyers know about it. And that means side conversations, secret conversations, that sort of thing generally aren't going to happen because directors want to get access to this very protective legal regime, and I think that advances everybody's interests.
Paul: So Graham, I mean, it sounds like you think this is a just fundamentally positive change for companies. Are there negative consequences to it from your point of view?
Graham: Well, I think that remains to be seen. You're certainly right that I am a cheerleader for this direction in Delaware case law. I will say I initially was watching it closely and wondering what would happen because for all of my professional life and I guess yours as well, Paul, the old regime existed and although it wasn’t optimal, I think directors spent a lot of time in this context wanting to make sure that they avoided risk and litigation. And so I wondered, as maybe it would be natural to wonder, when the Delaware courts said, "Look, these are independent directors, they don’t have any reason to do," at least if we're talking about the Corwin issue, "they don’t have any reason to do the wrong thing, let's get out of their way and let them focus on stockholders’ interest." You might worry are they going to pay less attention altogether to their fiduciary duties?
And my experience with it in the first few years has been that not only has there been no risk of that but what I think the chief justice was hoping would happen which is that good, diligent, independent boards would continue to focus on shareholder and would be relieved by having their litigation risk reduced is exactly what's happened. I think directors have been able to become even more focused on making good decisions and pushing the protective behavior around avoiding litigation out of their minds. So I think that's great and I haven't seen really any degree to which the boards have said, "Well, now that I know I'm not going to get sued I guess I don’t need to care.
So that's great but, of course, we’re only a few years in. So if you say, "Are there any negative impacts?" I think we will still want to keep a close eye on whether there turn out to be either over time, you know, a relaxation that goes further than we would hope. And if we do, I'm sure the Delaware courts will react.
And then I think probably there could be some situations where the current regime might, and I'm not sure because we haven’t seen it all played out yet, might leave a compelling plaintiff without a remedy. And if they do, I'm pretty sure the Delaware courts will find a way to address that and so I think there maybe some really narrow situations where you have what, you know, comes out to be very bad behavior by, you know, someone involved in it in a process and it gets discovered and therefore disclosed by the board and I think the courts will want to be sure they find a way not to let Corwin cleansing cause the plaintiffs, I'm sorry, the stockholders to have no access to damages in that situation. So that's probably one area where I think we continue to keep an eye on how things evolve.
Paul: And I think one thing that . . .
Graham: So, Paul, go ahead.
Paul: . . . lessens my concern on that, just to add that, is that the course in Delaware . . . one of the reasons why Delaware doesn't have a statute that says, "Here are your fiduciary duties and here are the things you're supposed to do in particular circumstances," and there are some states that have enumerated fiduciary duty language that applies in particular circumstances and Delaware doesn’t have that. It's all judge-made law. I think that the court still has the flexibility to deal with all of those future circumstances where the boundaries and the edges of Corwin and MFW are going to be applied. I would note within the last year, and there's been a handful of cases in which the court has rejected Corwin and not applied it on the grounds that the disclosures were inadequate as to particular issues.
And I think the court, in the end there's always a bit of a smell test that gets applied by judges and if there's a case that has some ugly facts to it, it's very unlikely that they're just going to sweep it away and cleanse it under these doctrines. I think what it does do is protect the sort of standard good faith transactions from a lot of harassment but I think the courts still have the flexibility to deal with wrongdoing.
Graham: I agree with you completely and I guess I would also throw out just a reminder, I know I said this before when we talked about the business judgment rule but, you know, this is all a balancing exercise and that the Delaware judiciary has been quite upfront about this. Whichever of the choices you pick, whether it's the old regime where there's a litigation every time and so that gives the court a chance to take a close look at every single transaction, or the new regime where they're basically saying, "I don’t want to see you in court unless you really have found something," under either regime you wind up with, you know, sort of mistaken litigation or non-litigation. In other words, the old way, far too many cases were in court and so the inefficiency was lots of deals that had no problem with them, spending money and time in court.
Under the new regime you run the risk that some things that maybe could have been corrected by the court and corrected both in that individual case and then, of course, in other cases because the court decisions affect future behavior could get missed. They could get missed because there's not as much litigation. And the question is, "Which is worse?" And I think the Delaware judges have been upfront that in the unconflicted situations it's probably the case that we are far better off getting rid of all of the spurious litigation that we faced before and running the risk of what is probably a remote and far, you know, far less common situation where that behavior just doesn’t get discovered, though there maybe some of that and that's just a possible sort of loss to the system and I do agree with you that discovery of those facts later would of course open up Corwin because it would be a disclosure issue.
So, Paul, maybe a question to you, what litigation, we’ve touched on this a little bit, but what litigation do you still see in the M&A context and what impact does that litigation have on the deal on board process and on directors individually?
Paul: So I've had two trials in the Court of Chancery in the last year that were both M&A focused and so that gives us two examples of the kind of cases that are still going forward. One of them that I just tried last week was an appraisal action. We could do a whole other seminar. We would need to to weigh into it on appraisal and how that works. But generally, in Delaware law if there's a cash deal then stockholders have a right to essentially dissent from the merger and to ask for a court preceding that appraises the value of their shares independently. The judge determines the value.
In that context where the law is trending is that the process, whether it was a good process that led to arm's length bargaining, is very important in determining whether the judge just accepts the deal price as the appraised value or looks to financial experts who do various valuation methodologies, mostly a discounted cash flow analysis. So in that context actually the board process still matters a lot because if the board did a good process then the court is much more likely to say the deal price is the fair value. Even if the board didn’t reach their fiduciary duties it doesn’t rise to the level of the claim but they had a, you know, a poor process, one that gives the judges now belief that there's a reliable transaction price, then they may look to other measures of value.
And if you've ever seen an appraisal case you usually find, you know, one expert looking at the same data says the value is one, and the other expert says it's, you know, 200 billion. That's a bit of an exaggeration but they’re never close to each other by any stretch which is one of the reasons why the courts have looked to the deal price in the first instance. But the process employed by the board and the directors is important to the outcome of those cases.
Another area of litigation which will always live on is fraud-related litigation. So the other case that I had was a trial in which our client which was a public company bought a privately-held company. It turned out that the privately-held company had a particular way of doing business that was a not consistent with their legal duties. It was not something that came up in diligence. It was something that was discovered after they bought the company. They had to, you know, correct the way the business operated. They had to make a lot of new arrangements with their customers and they filed a lawsuit for breaches of reps and warranties and for fraud.
And I've seen a lot of cases of that sort because a lot of times no matter how good you do diligence, if you're buying a company in the same space, a lot of times they're not going to let you, you know, go deep into their factories and find out exactly how they do business because of the risk that you're just taking a peek and trying to learn how they do things. So there's limits to diligence and that was . . . so we see lawsuits of that type with some frequency. And we certainly see, you know, securities fraud lawsuits where there's allegations that the directors or officers made false statements or approved financial statements that include false statements and it really cycles back to the disclosure point that we’ve talked about throughout. But those are examples of the kind of cases that we're seeing now.
Graham: And I would add as a related point on your last note that what we are seeing, we’ve touched on this previously, but what we are seeing now routinely and probably with about the same frequency that we used to see the Delaware, the so-called strike suit from Delaware are the proxy claims which are once again, you know, sort of mostly nonsubstantive, I'll call them bogus, you know, disclosure claims by a plaintiff seeking to get a mootness fee. What a mootness fee is is a fee awarded to a plaintiff's lawyer to reward them for value-delivered to stockholders in connection with a claim where there's not actually any damages that would give that plaintiff's lawyer a payment.
And so the plaintiff argues your disclosures weren’t good, if you make the following changes then I'd be satisfied, and the company makes those changes and the court gives a small mootness fee to the plaintiff's lawyer on the theory that they've done a service for stockholders.
Those claims in a certain sense don’t look very different from the disclosure-based settlements that existed in Trulia and they're occurring with pretty close to the same frequency. But the reason I wouldn’t view them as just one substituting for the other or reasons I wouldn’t are sort of several fold. One is those claims are claims against the company. They don't have the same, you know, flavor of even though as I said before, for unconflicted directors at least they were able to feel confident if someone was willing to them that they really faced no risk, not low risk but no risk of personal liability. It's much easier for people to understand that in the proxy context. So that's the first issue.
The second is these cases are settling for much smaller amounts. So the fees used to be 500,000, sometimes larger for the disclosure-based settlements. And now they're much lower than that, there are a fraction of that, and so then cost is lower. And third, there's no release to the directors which is not good for the directors, but probably for the system overall an improvement. But those cases we do see all the time. People should not be surprised by them if they get involved in an M&A process. Those are now occurring with a very high frequency.
Paul: So Graham, what about in the controlling stockholder context? This MFW safe harbor, is it universally applied now or are there circumstances where boards or controlling stockholders chose not to go the MFW route?
Graham: You know, it's an interesting question because remember, as you're saying, MFW is a safe harbor so analytically it's an option. A controlling stockholder could still go down the old route of having the Entire Fairness standard applied to their transaction. That's the very onerous standard that MFW gets them out of and they could still do that and I think undoubtedly there are some circumstances probably where they will. I don’t want to make an absolute statement that they never will choose to do that. But I think that should be viewed as something that would be extraordinarily exceptional.
The judges in Delaware have been clear off the bench that although MFW is an option to controllers, it's an option they expect the controllers to take and that the controller who chooses to complete one of these transactions without taking advantage of MFW, in other words, without agreeing that an effective special committee will be created and that the transactions would be submitted to a non-waivable vote of the unconflicted stockholders, the so-called majority of the minority vote, a controller who chooses not to take advantage of that path may be looked at with suspicion. In other words, why would you choose to forgo this new path?
And although I think there maybe some circumstances where that's not true, it's easy to see why the court might think that. The litigation costs under the old Entire Fairness regime were staggering. I won't use numbers here but, you know, this was not a small tax on those transactions. The litigation costs in that context were a material issue for the economics of the transaction and if you add the settlement costs on top of that they were a very material cost to the transaction overall.
And taking advantage of MFW changes that. And it's not hard to imagine in a billion-dollar deal for example, you know, MFW saving the transaction 10%, 15%, 20% of the value of the deal. That's a totally plausible outcome. And so you can understand how the court might look at a controller and say, "Hey, how could you possibly forego that and for what reason?" That said, there could be some situations where a controller chooses to do it, and, Paul, I don’t know if you see any in particular.
Paul: You know, I haven't seen it done without but I've mused about it a lot and I would say this because I imagine someday I'm going to be defending some company who has not done it. So I don't want to, you know, unequivocally say it's the wrong thing to do because I imagine there are circumstances where it is a good choice. But I would say this, that because the Entire Fairness is fair process and fair price. And as I said before, when it comes to fair price, you can get two valuation experts to say anything. Right? I mean if you're looking at a fair price divorce from process that's a very difficult thing to analyze because the tools that you have for financial valuation are very flexible and there's minor assumptions that can create multibillion dollar swings in any financial model.
And then the second issue that you have is if you're going to say, "Well, we had a fair process and here was a clearly defined root that everyone calls fair process and you didn’t take it, that makes it hard to defend. So I think you'd have to have a good reason not to do it. I'm sure there'll be some case where there is good reason and it would be the right thing to do. But for the most part it would seem to be taking on extra costs, taking on a lot of risk, so it seems that for most transactions MFW is the clear way to go.
Graham: Right, and that's certainly what we've seen so far. It's we’ve seen controllers pretty much race into the MFW path. And I think, you know, my experience also has been that although I don't think they've had to do it with much vigor because I think the controllers have been eager to take advantage of this path, I've also seen special committees in this context and boards in advance in forming a special committee if necessary making clear even before there's any proposal on the table if they get wind that a proposal is coming, that from the board or committee's perspective the MFW framework would be necessary to their support for any transaction. So I think you see the buy-in really from both sides.
So, Paul, what do you think directors should take away from these cases about how best to carry out their duties?
Paul: I think they focus on the business side of things. They focus on the transactions before them whether they're in the best interests of their constituencies and the stockholders and they can take comfort. As we said before it was, and, you know, there's so few cases. You really have to go back in time along way to find any deals where outside directors are actually reaching into their own pockets, particularly given the fact that there's D&O Insurance available. So that even if there is a settlement where money, you know, is paid on behalf of the directors it's almost uniformly paid by D&O Insurance.
So they never face a significant risk in your typical arm's length transactions. But, you know, the burden on them has lessened. The ability to focus on what really matters here, I think that we’ve said this a lot during this hour, but I'll circle back to that, that it's helpful for them to focus on doing their job and not sort of, you know, doing the . . . to make an analogy, to another place where litigation could affect someone. They're not practicing defensive medicine as directors. They're really focused on doing what's needed and what's in the best interest of the company and the shareholders.
Paul: So, you know we had said a couple of times about how Corwin is really a game changer because it says that the disclosures bring you business judgment rule. How has that, Graham, changed to approach from an M&A perspective?
Graham: Well, I think it's done two things that I see from a transactional context. The first is there was a bit of a game that sometimes people played under the old regime, it was not a game that I supported but certainly one that existed in the marketplace which is that boards would, in theory, you know, deliberately give sort of 98% good disclosure or 95% good disclosure in the initial proxy to leave room for the plaintiffs to come in with something to complain about and then they give that additional 5% in the settlement. And in exchange for that, the directors get the release which assures them of no other litigation. And that sort of, you know, buy off of the directors in exchange for this fee to the plaintiffs lawyers was part of what made this look so unseemly and part of what certainly inspired the Delaware courts to eventually come around to Trulia.
And, obviously, under Corwin no one would do that. There's the idea that you would deliberately put out anything less and a 100% perfect disclosure would be crazy when you access to this very protective regime depends essentially only on the quality of your disclosure. And so I think it’s eliminated that practice that was a very, you know, counterproductive and problematic practice but that's certainly been eliminated.
Maybe more importantly and more broadly, I think there's been a really profound focus on the quality of disclosure. People are disclosing more now, in my experience, in transactions than they did before and I think both the, you know, advisers working with their boards are spending a lot of time making clear that it's critical that the advisers understand everything that's going on and that a single conversation of any substance that is kept secret could, you know, very easily be the reason that Corwin doesn’t apply and that the directors are left in a more precarious situation. And so I think that’s ensured that everything is done in a very upfront way and that's obviously very good for boards and for stockholders.
I also think that advisers have, you know, put a lot of focus. We certainly have spent a lot of time thinking about how to make sure that we’re doing the very best job we can with the quality of our disclosure because so much turns on it now. And so I think that's good too and that's again another good outcome for boards and for stockholders in this context.