by Cydney Posner
While there has certainly been a lot of debate about the merits and demerits of dual-class stock, one interesting angle was raised by Charles Elson, director of the University of Delaware’s John L. Weinberg Center for Corporate Governance Delaware Law. In an interview reported in Bloomberg BNA, Elson predicts that expanded use of dual-class corporate structures will lead the Delaware courts to reconsider the business judgment rule. For companies with no- or low-vote classes of shares, is the business judgment rule in jeopardy?
SideBar: The business judgment rule is a standard of judicial review of corporate director conduct. Generally, under the business judgment rule, a court will not substitute its own business judgment for that of a company’s directors—even if, in retrospect, the directors’ decision ultimately proves to be an unfortunate one—so long as the requirements of the rule are met. As described in Drexler, Black and Sparks, Delaware Corporation Law and Practice, a
“decision by a board of directors (i) in which the directors possess no direct or indirect personal interest, (ii) which is made (a) with reasonable awareness of all reasonably available material information, and (b) after prudent consideration of the alternatives, (iii) which is in good faith, and (iv) which is in furtherance of a rational corporate purpose, will not be interfered with by the courts, either prospectively by injunction, or retrospectively by imposition of liability for damages upon the directors, even if the decision appears to have been unwise or have caused loss to the corporation or its stockholders. Rather than placing directorial decisions beyond judicial scrutiny, the business judgment rule is in reality a black-letter formulation of the factual and legal issues to be reviewed in determining whether judicial interference with a directorial decision is warranted. Only after the court has concluded—depending upon the circumstances, from either a failure of a challenger to prove otherwise or an affirmative showing by the directors of appropriate disinterest and care—that all of the prerequisites for judicial non-interference have been met does the inquiry terminate. On the other hand, if evidence discloses that one or more of the elements underlying application of the business judgment rule is missing—viz, there has been self-dealing, failure to exercise the requisite degree of care, or an irrationality of purpose—other judicial rules come into play to determine whether and to what extent the court will employ its injunctive powers or impose personal liability upon the directors.”
In Elson’s view, no- or low-vote classes of shares eviscerate a basic tenet underlying the business judgment rule that, through their votes, shareholders are able to hold directors accountable for the business decisions they make. If a goal of Delaware law is to protect investors, he argues, and the vote “doesn’t do it,” the courts will need to step in: “Delaware courts generally are very reluctant to overturn the business judgment of boards, because shareholders have the power to do so through an election…. However, where elections become ‘meaningless’ because shareholders have a limited vote or cannot vote at all, the courts ‘may have to take a more active role.’ And that’s ‘really problematic vis-à-vis Delaware law and how Delaware law is structured,’ Elson said. ‘It might either call into question how Delaware approaches dual-class companies, or ultimately,’ whether Delaware allows non-voting or dual-class stock.” According to Elson, when it comes to dual-class structures, “‘Delaware law’s fundamental concept of the shareholders responding to business issues appropriately through the ballot box disappears…, so you’re really taking away a fundamental underpinning of Delaware law.’”
But is ballot-box accountability really the basis for the deference accorded director decisions under the business judgment rule? Rick Alexander of Morris, Nichols, Arsht & Tunnell in Delaware and Head of Legal Policy for B Lab (see this PubCo post) believes that the policy underlying the business judgment rule is more comprehensive. In Alexander’s view, David Yosifon best described that underlying policy in The Law of Corporate Purpose, 10 Berkeley Bus. L.J. 181: “Since somebody has to have the last word on what corporate decisions are legitimate, the business judgment rule sees to it that, per the statute, it is the directors who decide, not complaining shareholders, not other stakeholders, and not indifferent courts. Directors are likely to know more about the particulars of problems their firms face than are relatively ignorant shareholders, stakeholders, and judges.”
Alexander does not “really think that governance structure is likely to directly affect standards of review—there have been dual class and majority-controlled companies for years, and there has never been a distinction as to the protection that directors receive in situations where shareholders (or some shareholders) are essentially disenfranchised. I can’t see courts stepping into non-conflicted and fully informed decisions, even where shareholders can’t throw out directors whose decisions they disagree with.”
In his view, the underlying policy “is deeper than that.” However, he does believe “that the presence of a controlling shareholder may come to be seen as creating conflicts in many situations that might not involve a conflict where control is dispersed throughout the market. I think that is a more likely place to see the law develop—expanding the type of transaction viewed as involving a conflict.”
SideBar: In his presentation, Elson even went so far as to blame a company’s alleged consumer fraud and operational compliance catastrophe, in part, on its dual-class stock structure, arguing that the officers, as the controlling shareholders, were free to pursue their own goals with no fear of having to account. Of course, while there may be less accountability to shareholders through the ballot box, the ensuing consumer, shareholder and governmental litigation in that case would appear to contravene the notion that there was no accountability. Moreover, as reported in The Deal, a panelist at The Deal‘s Corporate Governance 2017 conference in New York, contended that the market itself provides accountability: “shareholders aren’t ultimately the force that exerts control on a company’s management team—instead that comes from the market. The share price serves as a disciplining measure for board members and executives, he argued….” In effect, shareholders can “vote” by selling their shares.