LASTER, Vice Chancellor.
Plaintiff Lawrence Treppel is a stockholder of nominal defendant EZCORP, Inc. He brought this action derivatively to challenge the fairness of three advisory services agreements between EZCORP and defendant Madison Park LLC, an entity affiliated with defendant Phillip Ean Cohen, who is EZCORP's controlling stockholder (together, the "Challenged Agreements"). Treppel regards the agreements as an unfair means by which Cohen extracted a non-ratable return from EZCORP.
The complaint originally named as defendants the individuals who served on EZCORP's board of directors (the "Board") when the Challenged Agreements were approved. The complaint also named as defendants Madison Park, Cohen, and the two entities through which Cohen controls EZCORP. Since then, Treppel has dismissed all the individual defendants except Cohen and Thomas C. Roberts, one of the directors who approved two of the Challenged Agreements while serving on the Board's Audit Committee.
The remaining defendants moved to dismiss the complaint (i) pursuant to Rule 12(b)(6) for failure to state a claim on which relief can be granted and (ii) pursuant to Rule 23.1 for failing to plead demand excusal. This decision grants the Rule 12(b)(6) motion in part, holding that Count IV of the complaint does not state a viable claim. Count III is dismissed as to Cohen on the same basis. Otherwise the motions are denied.
The facts for purposes of this decision are drawn predominantly from the Verified Amended Stockholder Derivative Complaint (the "Complaint") and the documents it incorporates by reference. Some additional facts are drawn from documents which the defendants identified as subject to judicial notice. See In re General Motors (Hughes) S'holder Litig., 897 A.2d 162, 169 (Del. 2006). Despite having introduced and relied on those documents in their opening briefs, the defendants contended that Treppel could not refer to them in his answering brief, claiming that for him to do so would be to permit a plaintiff to rely on material outside the complaint. By making this inequitable argument, the defendants hoped to eat their cake (by going beyond the pleadings to rely on documents they chose and introduced) while still having it (by preventing Treppel from citing or arguing for inferences from the same documents).
The rule barring a plaintiff from introducing new material in an answering brief seeks to limit the extent to which the basis for a judicial decision can shift during briefing and guards against unfair prejudice to the defendants. These considerations do not apply when the defendants themselves introduce documents with their opening brief and argue persuasively that the materials are subject to judicial notice. At that point, the plaintiff and the court can rely on them as well.
The allegations of the Complaint and the documents suitable for consideration at the pleadings stage could support inferences that would favor either the plaintiff or the defendants. At this procedural stage, the plaintiff receives the benefit of all reasonable inferences. See Parts II & III, infra.
EZCORP is a Delaware corporation with its headquarters in Austin, Texas. It provides instant cash solutions through a variety of products and services, including pawn loans, other short-term consumer loans, and purchases of customer merchandise.
EZCORP has two classes of stock: Class A Non-Voting Common Stock and Class B Voting Common Stock. The Class A stock trades publicly on NASDAQ under the ticker symbol "EZPW." Defendant MS Pawn L.P., a Delaware limited partnership, owns all of the Class B stock.
MS Pawn L.P. is controlled by its sole general partner, MS Pawn Corp. Cohen is the sole owner of the stock of MS Pawn Corp. Through MS Pawn L.P. and MS Pawn Corp. (together, "MS Pawn"), Cohen controls EZCORP.
One consequence of EZCORP's capital structure is that Cohen controls 100% of EZCORP's voting power despite owning only a minority of its equity. As of June 30, 2014, there were 50,612,246 shares of Class A stock outstanding, but only 2,970,171 shares of Class B stock outstanding. Except for voting rights carried by the Class B shares, the rights, powers, privileges, and preferences of the two classes of stock are functionally identical. The Class B shares through which Cohen controls EZCORP thus represent only 5.5% of the outstanding stock.
As control rights diverge from equity ownership, the controller has heightened incentives to engage in related-party transactions and cause the corporation to make other forms of non-pro rata transfers. Economists call this "tunneling." See Simon Johnson et al., Tunneling, 90 Am. Econ. Rev. 22 (2000). The basic insight is a simple one: by virtue of its control over the firm, the controller can direct how that firm deploys its capital. As an equity owner, the controller participates in the resulting benefits (and losses) in proportion to its equity stake, effectively gaining or losing on a pro rata basis with other stockholders. By contrast, in a related-party transaction, the controller receives 100% of the benefit while only funding the payment to the extent of its equity stake. The balance of the payment is funded by the unaffiliated equity holders. The economic incentive to tunnel varies inversely with the controller's equity stake. All else equal, as the controller's equity stake declines, the relative benefit from a direct payment increase.
To use a simple example, assume that EZCORP had sufficient net profits available to pay a dividend of $0.10 per share. The total cost of the dividend would be $5.36 million ($0.10 * 53,582,417 total shares outstanding). If Cohen owned 100% of the outstanding shares, then there would be no difference (ignoring tax effects) between having EZCORP declare the dividend on all shares versus paying Cohen $5.36 million directly under a services agreement or other form of contract. But as Cohen's assumed level of equity ownership declines, so does his share of a dividend, making the alternative of direct contractual compensation more attractive. At 51% equity ownership, Cohen would receive just over half of a dividend ($2.7 million), but he would receive all of a contractual payment. EZCORP's dual class structure makes the difference even more dramatic. Through the Class B shares, Cohen would receive only $297,017 from the dividend ($0.10 * 2,970,171 Class B shares) with the other 94% of the value going to the Class A shares. If EZCORP deployed the same $5.36 million of available cash to pay for advisory services from a Cohen entity, then Cohen would receive the entire $5.36 million while only indirectly bearing 5.5% of the cost through his equity stake. He would come out ahead by $5.065 million.
EZCORP's market capitalization is not large. On September 8, 2015 (the date of oral argument on the motions to dismiss), the Class A stock closed at $6.10 per share. The trading price implied an equity value of $326 million. As of January 21, 2016, the Class A stock closed at $3.29 per share. That figure represents a substantial discount from the shares' peak at $35.58 per share in May 2011.
EZCORP has a history of entering into advisory services agreements with entities affiliated with Cohen. From 1996 through 2004, EZCORP entered into a series of services agreements with non-party Morgan Schiff, an investment firm founded by Cohen. Under these agreements, EZCORP paid $33,333 per month to Morgan Schiff, which by 2004 had increased to $100,000 per month ($1.2 million annually). After an expense review, EZCORP discovered it had overpaid Morgan Schiff by $400,000. EZCORP recovered the overpayment and elected not to renew its arrangement with Morgan Schiff.
For part of the period covered by the agreements with Morgan Schiff, EZCORP paid a dividend to its stockholders. According to EZCORP's public filings, the Board declared an annual dividend of $0.05 per share in cash, payable quarterly, on August 25, 1998. EZCORP continued making a quarterly dividend payment of $0.0125 per share through March 31, 2000. Since then, EZCORP has not paid any dividends, and the Board has stated consistently that it does not anticipate paying any dividends in the future. Based on the number of shares currently outstanding, an annual dividend of $0.05 per share would cost $2.68 million. As previously noted, an annual dividend of $0.10 per share would cost $5.36 million.
In 2004, shortly after terminating its relationship with Morgan Schiff, EZCORP entered into a services agreement with a different Cohen affiliate, defendant Madison Park. The initial services agreement called for EZCORP to pay Madison Park $100,000 per month ($1.2 million annually) for a period of three years. Beginning in September 2007, when the initial services agreement expired, EZCORP and Madison Park entered into a series of annual services agreements. In the 2007 agreement, Madison Park's monthly fee increased by 50% to $150,000 ($1.8 million annually). In 2008, it increased by 33% to $200,000 ($2.4 million annually). In 2009, it increased by 50% to $300,000 ($3.6 million annually). In 2010, it increased by 33% to $400,000 ($4.8 million annually).
On September 30, 2011, EZCORP entered into the first of the Challenged Agreements, which was to cover EZCORP's 2012 fiscal year (the "2011 Agreement"). In return for payments of $500,000 per month ($6 million annually), Madison Park agreed to provide advisory services relating to EZCORP's business and long term strategic planning, including
Compl. ¶ 54. The payments to Madison Park under the 2011 Agreement represented approximately 5% of EZCORP's net income for that year. Id. ¶ 80.
The 2011 Agreement was approved by the Board's Audit Committee, comprising at the time defendant Roberts and previously dismissed defendants William C. Love and John Farrell. Each was an outside director. According to the Complaint, they rubber-stamped the 2011 Agreement without serious analysis because of their cozy positions as directors at Cohen's company. Roberts had been a director since 2005 and was paid $239,040 in that capacity in 2011. Love had joined the Board earlier in 2011 and was paid $209,040 for his service as a director in that year. Farrell had recently joined the Board and received $15,285 for serving as a director in 2011. For purposes of calling into question the independence of directors of a Delaware corporation, those allegations are palpably thin.
On October 1, 2012, EZCORP and Madison Park entered into the second of the Challenged Agreements, which covered EZCORP's 2013 fiscal year (the "2012 Agreement"). Under that agreement, Madison Park's fee increased by 20% to $600,000 per month ($7.2 million annually). In return, Madison Park agreed to provide the same services covered by the 2011 Agreement, plus three new items:
Id. ¶ 55. The payments to Madison Park under the 2012 Agreement again represented approximately 5% of EZCORP's net income for that year. Id. ¶ 80.
The Complaint alleges that the 2012 Agreement was approved by the Audit Committee, which again comprised Roberts, Love, and Farrell. The Complaint again asserts that they rubber-stamped the agreement without serious analysis because of their cozy positions as directors at Cohen's company.
By this point, Roberts had served for another year as a director of EZCORP, for which he was paid $261,076. Roberts also received an unidentified sum for his service as a director of Albemarle & Bond Holdings, plc ("Albemarle & Bond"), an EZCORP affiliate. The same was true for Farrell, who was paid $216,076 for serving as a director of EZCORP and received an additional unidentified amount for serving as a director of Albemarle & Bond. Love too had served another year as a director of EZCORP, for which he was paid $234,076. He also served as a director of a different EZCORP affiliate, Cash Converters International Limited ("Cash Converters"), for which he received an unidentified amount.
Although marginally thicker than what the Complaint offered regarding the directors' incentives for purposes of the 2011 Agreement, the allegations regarding the 2012 Agreement remain meager. Noticeably absent was any quantification of the payments that the directors received from EZCORP affiliates.
On October 9, 2013, EZCORP and Madison Park agreed to extend the 2012 Agreement for another year (the "2013 Renewal"). The services that Madison Park agreed to provide and the compensation it received remained the same, but because revenue fell, the payments ended up representing approximately 21% of EZCORP's net income. Id. ¶ 80.
The Complaint alleges that the 2013 Renewal was approved by the Audit Committee, which at this point consisted of Love, Farrell, and Joseph J. Beal. The Complaint again alleges that they rubber-stamped the extension to preserve their cozy positions as directors. In 2013, Love was paid $250,345 for his service as a director of EZCORP, plus an additional $81,127 for serving as a director of Cash Converters. Farrell was paid $230,345 for his service as a director of EZCORP, plus an additional $69,174 for serving as a director of Albemarle & Bond. Beal had been a director since 2009 and joined the Audit Committee in August 2013. He was paid $245,345 for his service in that year, plus $81,127 for serving as a director of Cash Converters. The quantification of the additional payments that the Audit Committee members received for serving as directors of other Cohen entities makes these allegations stronger.
Treppel contends that the Challenged Agreements were not legitimate contracts for services but rather a means by which Cohen extracted a non-ratable cash return from EZCORP. Madison Park was a small firm with limited resources, and EZCORP was its only publicly traded client in the United States. None of EZCORP's peer companies had retainer agreements with similar service providers.
During the period when EZCORP was paying Madison Park to provide advisory services related to core management functions, EZCORP had an experienced and highly compensated team of senior managers whose jobs included the tasks mentioned in the Challenged Agreements. For example, Paul E. Rothamel served as EZCORP's CEO. He had significant executive experience as a CEO and a history of leadership positions at large public and private companies. In its Form 10Ks, EZCORP described him as having executive management and expertise in the areas covered by the Challenged Agreements, including strategic planning, financial planning, risk management, and business development. See id. ¶ 39. Rothamel's job description covered similar areas. See id. ¶ 40. During the period covered by the Challenged Agreements, EZCORP paid Rothamel more than $12.2 million in total compensation. In 2012, Rothamel and EZCORP's named executive officers were in the 72nd percentile of peer companies in terms of compensation. In 2013, Rothamel was in the 75th percentile of peer companies in terms of CEO compensation. See id. ¶ 46.
Also during the period covered by the Challenged Agreements, Mark E. Kuchenrither served as EZCORP's CFO. He had previously served in other executive capacities at EZCORP, as an executive at a major private equity firm, and as the CFO of two smaller companies. See id. ¶ 42. As with Rothamel, Kuchenrither had a job description that covered many of the areas where Madison Park ostensibly was being paid for its services, including planning, implementing, managing, and controlling EZCORP's financially related activities. See id. ¶ 43. During the period covered by the Challenged Agreements, EZCORP paid Kuchenrither approximately $7.89 million in total compensation.
Other members of EZCORP's senior management team had substantial backgrounds in finance, planning, and strategic development. Many had decades of experience in related fields and with other companies. As a group, the management team was well paid, receiving compensation that ranked in the 66th percentile for senior management among peer companies in 2012.
The Complaint observes that despite having an experienced and sophisticated management team, EZCORP paid Madison Park millions in fees under the Challenged Agreements. To reiterate, none of EZCORP's peer companies employed an outside firm to provide the kinds of advisory services that Madison Park purportedly provided to EZCORP. Indeed, according to the Complaint, the sum that EZCORP paid Madison Park "far exceeds what EZCORP or any of its comparable companies have paid its full-time executives for providing the same services over the same period." Id. ¶ 2. As Treppel sees it, the services that Madison Park purportedly provided "were substantially, if not entirely duplicative of the services provided to [EZCORP] by Rothamel, Kuchenrither, and the rest of EZCORP senior management." Id. ¶ 77.
Treppel argues that the 2013 Renewal was all the more suspect because the amounts due to Madison Park remained the same even though EZCORP's net income went down.
Id. ¶ 67. During 2013, the Compensation Committee refused to pay Rothamel or Kuchenrither a bonus because of EZCORP's poor performance. Two of the three members of the Compensation Committee (Beal and Love) also served on the Audit Committee, yet the Audit Committee continued to pay Madison Park at the same rate.
Treppel and his counsel do not contend that directors of a publicly traded company act questionably if they hire an external consulting firm. Far from it, they recognize that hiring a consulting firm can be entirely legitimate and prudent. The Complaint is factually and situationally specific: it questions one particular firm's hiring of a consulting company affiliated with its controller given the qualifications and capabilities of the firm, the circumstances associated with the hiring, the terms of the services agreement, the compensation provided, and the interested nature of the relationship.
On May 20, 2014, the Audit Committee terminated the 2013 Renewal. The members of the Audit Committee at the time were Love and Beal. The effective date of the termination was June 19, 2014. The Complaint supports a reasonable inference that Love and Beal terminated the relationship because they had concerns about the fairness of the relationship.
The termination of the 2013 Renewal prompted responses from both the plaintiff and Cohen. On July 9, 2014, Treppel sent a letter to EZCORP pursuant to 8 Del. C. § 220 (the "Section 220 Demand") in which he sought to examine the services agreements and related documents. On July 17, 2014, EZCORP refused to provide any of the requested documentation. Among other things, EZCORP claimed that the Section 220 Demand failed to set forth a credible basis to infer any wrongdoing.
Cohen's response had more immediate and dramatic effect. On July 18, 2014, he used his voting power to clean house. First, he removed Rothamel, Love, and Beal from the Board. To reiterate, Love and Beal were the members of the Audit Committee who had voted to terminate the services agreement with Madison Park, and Rothamel was the CEO at the time. A third director, Charles A. Bauer, resigned that same day.
Cohen filled one of the Board vacancies with Lachlan P. Given, who had been a managing director at Madison Park and was still a paid consultant to the firm. Given became the non-executive Chairman of the Board. Cohen filled another vacancy with Kuchenrither, EZCORP's CFO, who became its interim CEO and President. After the changes, the Board comprised Kuchenrither, Given, Santiago Creel Miranda, and Pablo Lagos Espinosa. Miranda and Espinosa were outside directors. Roberts had retired from the Board in January 2014.
Treppel commenced this action by filing his initial complaint on July 28, 2014 at 3:02 p.m. At that time, the Board still comprised Kuchenrither, Given, Miranda, and Espinosa. Treppel alleged that the Board could not impartially consider a litigation demand because at least two of the directors—Kuchenrither and Given—were insiders who were not independent from Cohen and Madison Park.
Approximately one hour after Treppel filed suit, EZCORP issued a press release announcing that the Board had "expanded its size to seven" and elected "Joseph L. Rotunda, Thomas C. Roberts, and Peter Cumins to serve as directors." Compl. ¶ 9. EZCORP issued the announcement through several media outlets, each after 4:00 p.m. GlobeNewswire and The Wall Street Journal published the announcement at 4:01 p.m. and 4:06 p.m., respectively.
Treppel filed the currently operative Complaint on September 23, 2014. It contains four counts:
All of the defendants moved to dismiss the Complaint and filed their opening briefs. Treppel proposed to dismiss voluntarily his claims against Rothamel, Espinosa, and Brinkley without prejudice, and this court approved the dismissal by separate order. After Treppel filed his answering brief, he proposed to dismiss voluntarily his claims against Love, Beal, and Farrell without prejudice. By separate opinion and order, this court dismissed the claims with prejudice as to Treppel only. At this point, the remaining defendants are Cohen, Madison Park, MS Pawn, and Roberts.
The remaining defendants have moved to dismiss the Complaint pursuant to Rule 12(b)(6) for failing to state a claim on which relief can be granted. When considering such a motion,
Savor, Inc. v. FMR Corp., 812 A.2d 894, 896-97 (Del. 2002) (footnotes and quotation marks omitted).
The Complaint's allegations described a series of related-party agreements, initially between EZCORP and Morgan Schiff and subsequently between EZCORP and Madison Park. When it addressed the Challenged Agreements, the Complaint did so in a jumbled way, as if the drafters originally targeted the 2013 Renewal and only later decided to add the 2011 and 2012 Agreements. The counts of the Complaint did not single out the Challenged Agreements. The reader must draw that inference from the relatively greater level of detail that the Complaint provided when dealing with those contracts. Not surprisingly, the defendants interpreted the Complaint as purporting to challenge every agreement it mentioned, and they raised defenses such as laches designed to limit the scope of the Complaint.
At oral argument, Treppel's counsel represented that the Complaint only attacked the Challenged Agreements. To eliminate any doubt, this decision holds that laches bars any claims relating to conduct predating July 28, 2011.
"[T]he limitations of actions applicable in a court of law are not controlling in equity." Reid v. Spazio, 970 A.2d 176, 183 (Del. 2009). Nevertheless, because equity generally follows the law, "a party's failure to file within the analogous period of limitations will be given great weight in deciding whether the claims are barred by laches." Whittington v. Dragon Gp., L.L.C., 991 A.2d 1, 9 (Del. 2009). The analogous limitations period for the claims in this case is three years. See 10 Del. C. § 8106; Wal-Mart Stores, Inc. v. AIG Life Ins. Co., 860 A.2d 312, 319 (Del. 2004). Although a laches analysis is often fact-intensive, the doctrine can be applied at the pleadings stage if "the complaint itself alleges facts that show that the complaint is filed too late." Kahn v. Seaboard Corp., 625 A.2d 269, 277 (Del. Ch. 1993) (Allen, C.).
In this case, Treppel filed his initial complaint on July 28, 2014. Any cause of action that accrued before July 28, 2011, is therefore presumptively barred by laches. There are no tolling doctrines that might apply. Accordingly, any claims addressing the services agreements that pre-dated July 28, 2011, are dismissed. The Challenged Agreements post-date July 28, 2011, with the 2011 Agreement having been executed on September 30, 2011, so those claims survive.
Count I of the Complaint alleges that by entering into the Challenged Agreements and making the payments they contemplated, the defendants breached their fiduciary duties. This count states a claim against Cohen, MS Pawn, and Roberts.
As originally plead, Count I contended that all of the members of the Board who served during 2011, 2012, and 2013 breached their fiduciary duties, but it did not contend that Cohen breached his fiduciary duties as a controlling stockholder. Count I thus identified as its targets the "Director Defendants," which it defined as Love, Beal, Farrell, Espinosa, Roberts, Miranda, and Brinkley. Based on the allegations of the Complaint, however, the full Board never acted on any of the Challenged Agreements. Only the Audit Committee did, and its members during those years, in varying combinations, were Love, Beal, Farrell, and Roberts. As noted, Treppel subsequently dismissed voluntarily Rothamel, Espinosa, and Brinkley, and this court dismissed Love, Beal, and Farrell. Roberts is now the only named Director Defendant. There is no dispute that Roberts is a proper defendant for purposes of Count I, assuming the count states a claim.
For reasons that are comprehensible, but which in my view are neither legally sound nor persuasive, Treppel sued Cohen for aiding and abetting the breaches of duty committed by the Director Defendants, rather suing Cohen for breaching the fiduciary duties he owed as a controlling stockholder. In making this observation, I intimate no view as to whether Cohen actually breached his fiduciary duties. The question is the appropriate legal vehicle for seeking to hold him accountable. At oral argument, Treppel's counsel explained that he did not perceive Cohen as having taken action regarding the Challenged Agreements and hence did not believe Cohen could be sued in a fiduciary capacity. He therefore went the aiding-and-abetting route.
An ultimate human controller who engages directly or indirectly in an interested transaction with a corporation is potentially liable for breach of duty, even if other corporate actors made the formal decision on behalf of the corporation, and even if the controller participated in the transaction through intervening entities. Breach of fiduciary duty is an equitable claim, and it is a maxim of equity that "equity regards substance rather than form." Monroe Park v. Metro. Life Ins. Co., 457 A.2d 734, 737 (Del. 1983); accord Gatz v. Ponsoldt, 925 A.2d 1265, 1280 (Del. 2007) ("It is the very nature of equity to look beyond form to the substance of an arrangement."). Liability for breach of fiduciary duty therefore extends to outsiders who effectively controlled the corporation. See, e.g., S. Pac. Co. v. Bogert, 250 U.S. 483, 488 (1919); Sterling v. Mayflower Hotel Corp., 93 A.2d 107, 109-10 (Del. 1952). And because the application of equitable principles depends on the substance of control rather than the form, it does not matter whether the control is exercised directly or indirectly. The United States Supreme Court's explanation of how a controller exercised control in Southern Pacific is illustrative:
250 U.S. at 491-92.
Delaware corporate decisions consistently have looked to who wields control in substance and have imposed the risk of fiduciary liability on that person. In a seminal decision, Chancellor Wolcott imposed personal liability on the individual owners of a corporation that received a management fee from another corporation they controlled. See Eshleman v. Keenan, 187 A. 25 (Del. Ch. 1936). In that decision, defendants Keenan, Marvin, and Brewer controlled Consolidated Management Corp., which in turn owned a majority of the voting stock of Sanitary Company of America. The individual defendants received salaries as officers of Sanitary, and they also caused Sanitary to pay a monthly management fee to Consolidated. The stockholder plaintiffs complained that this amounted to "double compensation" and was constructively fraudulent, using that term in its early and mid-twentieth century sense as a synonym for breach of fiduciary duty. Chancellor Wolcott agreed and ordered restitution. Notably, he did not require Consolidated to disgorge the payments. He looked instead to the humans behind the transaction and held Keenan, Brewer, and Marvin jointly and severally liable.
The Delaware Supreme Court affirmed. Keenan v. Eshleman, 2 A.2d 904 (Del. 1938). Like Chancellor Wolcott, the high court ruled that the individual defendants were liable to Sanitary; that Consolidated was the formal corporate vehicle behind the transactions did not matter:
Id. at 908. Like Chancellor Wolcott, the high court held the individual defendants—and not Consolidated—jointly and severally liable.
Since Keenan, Delaware cases consistently have looked to who wields control over the corporation and have imposed the risk of fiduciary liability on that individual.
In my view, the MS Pawn entities likewise are appropriate defendants for a breach of fiduciary duty claim. The limited partnership and the corporation were the vehicles through which Cohen controlled EZCORP. The limited partnership was EZCORP's immediate controller. The corporation controlled the limited partnership and was EZCORP's indirect controller. Cohen controlled the corporation and was EZCORP's ultimate controller. As discussed below, the MS Pawn entities alternatively can be sued for aiding and abetting. As I see it, the breach of fiduciary duty claim is more straightforward.
These rulings create a procedural problem, because the plaintiffs technically did not sue Cohen or MS Pawn for breach of fiduciary duty. The defendants view this as a clean winner that necessarily results in dismissal with prejudice under Rule 15(aaa). I do not believe that the plaintiff's pleading choice is fatal. "So long as claimant alleges facts in his description of a series of events from which [a claim] may reasonably be inferred and makes a specific claim for the relief he hopes to obtain, he need not announce with any greater particularity the precise legal theory he is using." Michelson v. Duncan, 407 A.2d 211, 217 (Del. 1979). The factual allegations in the Complaint give rise to a claim for breach of fiduciary duty against Cohen and MS Pawn. The alternative would be to grant the plaintiffs leave to re-plead for good cause shown, but that seems unnecessary, as they simply would add Cohen's and MS Pawn's names to Count I.
"When a transaction involving self-dealing by a controlling shareholder is challenged, the applicable standard of judicial review is entire fairness, with the defendants having the burden of persuasion."
If a controller agrees up front, before any negotiations begin, that the controller will not proceed with the proposed transaction without both (i) the affirmative recommendation of a sufficiently authorized board committee composed of independent and disinterested directors and (ii) the affirmative vote of a majority of the shares owned by stockholders who are not affiliated with the controller, then the controller has sufficiently disabled itself such that it no longer stands on both sides of the transaction, thereby making the business judgment rule the operative standard of review. M & F Worldwide, 88 A.3d at 644. If a controller agrees to use only one of the protections, or does not agree to both protections up front, then the most that the controller can achieve is a shift in the burden of proof such that the plaintiff challenging the transaction must prove unfairness. Ams. Mining, 51 A.3d at 1240.
Under current law, the entire fairness framework governs any transaction between a controller and the controlled corporation in which the controller receives a non-ratable benefit. This is because "Delaware is more suspicious when the fiduciary who is interested is a controlling stockholder." Leo E. Strine, Jr., The Delaware Way: How We Do Corporate Law and Some of the New Challenges We (and Europe) Face, 30 Del. J. Corp. L. 673, 678 (2005). A controlling stockholder occupies a uniquely advantageous position for extracting differential benefits from the corporation at the expense of minority stockholders. See id. There is also "an obvious fear that even putatively independent directors may owe or feel a more-than-wholesome allegiance to the interests of the controller, rather than to the corporation and its public stockholders." Id.
Tremont II, 694 A.2d at 428 (citations omitted). "For that reason, when a controlling stockholder is on the other side of the deal from the corporation, our law has required that the transaction be reviewed for substantive fairness even if the transaction was negotiated by independent directors or approved by the minority stockholders." Strine, supra, at 678.
The entire fairness framework clearly governs squeeze-out mergers, but Delaware courts also have applied it more broadly to transactions in which a controller extracts a non-ratable benefit. In several decisions, the Delaware courts have expressly rejected the contention that the entire fairness framework only applies to squeeze-out mergers.
In other decisions, Delaware courts have applied the entire fairness framework to a variety of transactions in which controlling stockholders have received non-ratable benefits, implicitly rejecting the view that the framework only applies to squeeze-outs.
Of particular relevance to this case, Delaware decisions have applied the entire fairness framework to compensation arrangements, consulting agreements, services agreements, and similar transactions between a controller or its affiliate and the controlled entity. One precedent is the T. Rowe Price decision, discussed previously, in which Vice Chancellor Lamb applied the entire fairness standard to a services agreement and rejected the argument that the business judgment rule applied because the contract was "not a merger but a `business transaction.'" 770 A.2d at 551. The following additional cases are illustrative:
The defendants have found three rulings that did not apply the entire fairness framework to transactions through which a controller extracted a non-ratable benefit: Dolan, Tyson, and Canal.
The defendants rely most heavily on Dolan, a recent case which stated that "[e]ntire fairness is not the default standard for compensation awarded by an independent board or committee, even when a controller is at the helm of the company." 2015 WL 4040806, at *5. As support for that proposition, the Dolan decision cited Tyson. Id. at *5 nn.34 & 36. Consequently, this decision begins with Tyson, moves to Dolan, and finishes with Canal, which appears to stand alone as a relatively isolated precedent.
In the Tyson case, stockholder plaintiffs filed "a lengthy and complex complaint that include[d] almost a decade's worth of challenged transactions" involving Tyson Foods, Inc., the members of the Tyson family who controlled the company and served as its senior managers, and their fellow directors. 919 A.2d at 570. By virtue of Tyson's dual class structure and an investment partnership, family patriarch Don Tyson controlled over 80% of Tyson's voting power despite owning only approximately 30% of its equity. Don's son John served as Tyson's CEO and Chairman. With evident frustration at the plaintiffs' blunderbuss pleading and the parties' extensive submissions, the court observed that
Id.
After an extensive discussion of the facts, the court concluded that demand was futile under Rule 23.1 for purposes of all of the challenged transactions but that certain claims were barred by the statute of limitations. The court then examined the merits of a challenge to a revised consulting contract between Tyson and Don, which the board approved in July 2004. The revised agreement increased Don's compensation from $800,000 to $1.2 million annually, provided for his payments to continue until 2011, and called for the payments to be made to his children in the event of his death.
For purposes of determining the standard of review, the Tyson decision stated: "As the consulting agreement does not fall outside the bounds of business judgment, Count I can only withstand a motion to dismiss by sufficiently alleging that a majority of those who approved the transaction were dominated or otherwise conflicted." Id. at 587. As support for this statement, the decision cited Aronson v. Lewis.
As described in this section of the opinion, when the board approved Don's consulting agreement, it had ten directors: four were not independent (John Tyson, Barbara Tyson, Bond, and Tollett), and six were outsiders (Hackley, Kever, Jones, Smith, Zapanta, and Allen). Finding that there was an independent board majority, the court cited Brehm v. Eisner, 746 A.2d 244 (2000), for the proposition that "a board's decision on executive compensation is entitled to great deference." Tyson, 919 A.2d at 588 & n.61. The Brehm decision was arguably distinguishable in that it involved a corporation without a controlling stockholder that had a supermajority-independent board, and the challenged decisions involved the hiring and firing of a second-in-command, not the approval of direct compensatory benefits for the controlling stockholder. See Brehm, 746 A.2d at 248-49, 254-58.
By applying the business judgment rule to a controlling stockholder transaction, the Tyson decision ran contrary to the approach that other Delaware cases had taken, including decisions addressing consulting agreements. See, supra, Part II.B.2 & II.B.3.a. The Tyson decision did not grapple with the possibility that entire fairness might apply. In other decisions issued both before and after Tyson, the author of that opinion held that entire fairness did apply as the baseline standard of review for transactions other than mergers between the corporation and its controlling stockholder.
Until Dolan, in the eight years since Tyson, no Delaware decision had cited Tyson for the proposition that the business judgment rule applied at the outset to a consulting agreement between a controlling stockholder and the controlled corporation. Cases instead applied the entire fairness framework. See, supra, Part II.B.2. The Dolan decision, however, applied the business judgment rule, citing Tyson. And like Tyson, the Dolan decision relied on Brehm, this time for the proposition that "[i]t is the essence of business judgment for a board to determine if a particular individual warrant[s] large amounts of money." 2015 WL 4040806, at *5 (quoting Brehm, 746 A.2d at 263). That is true when the business judgment rule applies, but it elides the threshold question of whether the business judgment rule applies.
The plaintiffs in Dolan challenged the compensation that Cablevision Systems Corporation paid to Charles F. Dolan, its founder and its Executive Chairman since 1985, and to his son James L. Dolan, who had served as CEO since 1995 and had been a director since 1991. 2015 WL 4040806, at *1. By virtue of their ownership of supermajority voting shares, the Dolans controlled 73% of Cablevision's voting power, despite owning a fraction of the equity. See id. at *2. The super-voting shares also held the right to elect three quarters of the Cablevision board. Cablevision identified itself as a controlled company for purposes of the New York Stock Exchange Rules. A three-member compensation committee approved the Dolans' compensation packages.
Unlike Tyson, the Dolan court discussed the argument that entire fairness applied ab initio. Relying on Tyson, the court held that the business judgment rule provided the operative standard of review. The court rejected the plaintiffs' reliance on non-merger cases that had applied the entire fairness framework, explaining its rational as follows:
Id. at *6 (footnote omitted). In a footnote, the opinion continued:
Id. at *6 n.40.
These policy arguments assert contestable propositions that depend on debatable empirical claims. Numerous authorities identify, describe, and discuss the informational advantages that controllers and senior managers have over directors, particularly on the issues of compensation, performance, and the value of their services.
Delaware Supreme Court decisions have recognized the risk that directors laboring in the shadow of a controlling stockholder face a threat of implicit coercion because of the controller's ability to not support the director's re-nomination or re-election, or to take the more aggressive step of removing the director. The two leading cases are Lynch and Tremont II. In Lynch, the Delaware Supreme Court held that entire fairness governed a squeeze-out merger, even if a special committee of independent directors or a majority-of-the-minority vote is used, because of the risk that when push came to shove, directors who appeared to be independent and disinterested would favor or defer to the interests and desires of the majority stockholder. 638 A.2d at 1116-17.
In re Pure Res., Inc., S'holders Litig., 808 A.2d 421, 436 (Del. Ch. 2002) (Strine, V.C.). In Tremont II, the Delaware Supreme Court agreed with Chancellor Allen that the entire fairness framework applied generally to transactions in which a controller extracted non-ratable benefits and not just to squeeze-out mergers. The Delaware Supreme Court explained that the controller's influence created the risk "that those who pass upon the propriety of the transaction might perceive that disapproval may result in retaliation by the controlling shareholder." Tremont II, 694 A.2d at 428. "Entire fairness remains applicable even when an independent committee is utilized because the underlying factors which raise the specter of impropriety can never be completely eradicated and still require careful judicial scrutiny." Id. In other words, there is a risk of coercion. See Citron v. E.I. Du Pont de Nemours & Co., 584 A.2d 490, 502 (Del. Ch. 1990).
Delaware decisions have not given unqualified support to the ability of outside directors to monitor, oversee, and make judgments regarding the behavior of controlling stockholders. As Chancellor Allen recognized, a controlling stockholder transaction "of course is the context in which the greatest risk of undetectable bias may be present." Tremont I, 1996 WL 145452, at *7. Even in a squeeze-out, where the board typically forms a special committee that hires its own advisors, the men and women who populate the committees are rarely individuals "whose own financial futures depend importantly on getting the best price and, history shows, [they] are sometimes timid, inept, or . . ., well, let's just say worse." In re Cox Commc'ns, Inc. S'holders Litig., 879 A.2d 604, 619 (Del. Ch. 2005) (Strine, V.C.) (ellipsis in original). This creates a meaningful risk "that the outside directors might be more independent in appearance than in substance." Id. Because of concern about the judgment of outside directors in this context, Delaware law requires that the defendant prove that an independent committee was effective, unless the additional protective measure of a disinterested stockholder vote is deployed. See, infra, Part II.B.4.
Leading scholars contend that judicial review of interested transactions does offer significant benefits, not only to controlled corporations and their stockholders but as a foundational component for vibrant securities markets.
Ronald J. Gilson & Jeffrey N. Gordon, Controlling Controlling Shareholders, 152 U. Pa. L. Rev. 785, 786-89 (2003). "A significant body of scholarship links capital market development and public shareholder protection."
Leading scholars also take the position that the same standard of judicial review should apply to the different types of transactions by which controllers can extract non-ratable benefits, and that entire fairness should not be limited to squeeze-out mergers or other transformative transactions. Applying a consistent standard to controlling stockholder transactions reflects the reality that "[m]anagers and controlling shareholders (insiders) can extract (tunnel) wealth from firms using a variety of methods."
Law and Tunneling, supra, at 6. The term "stealing" has criminal implications. A more appropriate verb for a civil case would be "wrongfully taking."
Cash flow tunneling "removes a portion of the current year's cash flow, but does not affect the remaining stock of long-term productive assets, and thus does not directly impair the firm's value to all investors, including the controller." Id. at 5 (quotation marks omitted). "One major form of cash flow tunneling involves transfer pricing, where the firm either sells output to insiders for below-market prices, or purchases inputs from insiders at above-market prices. The inputs can be either goods or services." Id. at 6-7 (footnote omitted). "A second major form is above-market current-year executive salaries, bonuses, or perquisites. . . ." Id. at 7. A third example involves "small-scale sales or purchases of replaceable assets at off-market prices." Id. "Cash flow tunneling primarily affects the income statement and statement of cash flows and captures the flow of firm value." Id. at 6. The extraction can be repeated year after year or occur episodically, and the fraction of cash flow extracted can change over time. "Often, cash flow tunneling transactions are not directly with insiders, but instead with firms that the insiders control (or simply have a larger percentage economic ownership than in the subject firm)." Id. at 5. Delaware cases involving claims of cash-flow tunneling include Nixon, Trans World Airlines, Monroe County, Carlson, Harbor Finance, Quadrant, and Dweck. See, supra, Part II.B.2. If proven wrongful, the Challenged Agreements in this case would be a form of cash-flow tunneling.
Asset tunneling involves "the transfer of major long-term (tangible and intangible) assets from ([or] to) the [controlled] firm for less ([or] more) than market value." Law and Tunneling, supra, at 5 (quotation marks omitted). "Tangible asset tunneling includes sales (purchases) of significant assets. . . ." Id. at 7 (quotation marks omitted). Another form involves investing in an affiliate on terms the affiliate could not obtain from third party sources. "Asset tunneling differs from cash-flow tunneling because the transfer has a permanent effect on the firm's future cash-generating capacity." Id. at 5. Delaware cases involving claims of asset tunneling include Tremont, T. Rowe Price, MAXXAM, and Shandler. See, supra, Part II.B.2. The challenges to drop-downs by sponsors of master limited partnerships also involve allegations of asset tunneling. See, e.g., In re El Paso Pipeline P'rs, L.P. Deriv. Litig., 2015 WL 1815846 (Del. Ch. Apr. 20, 2015).
"Equity tunneling increases the controller's share of the firm's value, at the expense of minority shareholders, but does not directly change the firm's productive assets or cash flows." Id. (quotation marks omitted). Examples include dilutive equity offerings, freeze-outs of minority shareholders, and selective repurchases of equity at inflated prices. Delaware cases involving claims of equity tunneling include Levco, Loral, New Valley, Strassburger, Dairy Mart, and Flight Options. See, supra, Part II.B.2.
Judicial limitations on the methods by which controllers can extract non-ratable benefits "must be determined simultaneously, or at least consistently, because they are in substantial respects substitutes." Gilson & Gordon, supra, at 786. If a lower standard of review applies to one type of transaction, such as recurring payments under a consulting agreement, then controllers will use that route to move value. See John C. Coates IV, "Fair Value" As an Avoidable Rule of Corporate Law: Minority Discounts in Conflict Transactions, 147 U. Pa. L. Rev. 1251, 1329 (1999) (arguing against a ban on freeze-outs because, among other things, controllers likely would shift to and achieve the same results through "substitute forms of self-dealing (either one large or many small transactions)").
Importantly, it is the controller, not the court, who creates the scenario calling for substantive fairness review. If a controller does not want to assume fiduciary obligations, then it can choose not to issue stock to the public, or not to acquire a dominant stake in a publicly funded firm. If a controller wants to use other people's money, it can do so using debt, which establishes a contractual relationship that does not carry fiduciary obligations. Or a controller can use an alternative entity vehicle and eliminate or restrict fiduciary duties. If a controller chooses the corporate form and issues equity, then the controller need not serve as a compensated executive or consultant. Even at that point, the controllers can obtain business judgment review by following M & F Worldwide, having a committee approve the compensation arrangement, and then submitting it to the disinterested stockholders for approval at the next annual meeting. Only if the controller makes choices in a way that invites entire fairness review will that framework come into play.
This decision already has collected some of the many Delaware precedents applying the entire fairness framework to controlling stockholder transactions other than squeeze-out mergers, including compensation arrangements and consulting agreements, See Part II.B.2. The Dolan opinion did not follow these authorities, choosing instead to follow Tyson. This section similarly has collected some of the authorities that undercut the policy arguments that compensation decisions between a corporation and its controlling stockholder are neither significant nor deserving of scrutiny. The literature is vast, many more authorities (pro and con) could be cited, and additional policy arguments also could be raised.
This leaves Canal. That case involved a challenge to an investment services agreement between Canal Capital Corporation, a firm controlled by Asher B. Edelman, and A.B. Edelman Management Co., Inc., another affiliate of Edelman's. 1992 WL 159008, at *1. The plaintiff advanced two duty of care theories and a waste theory, all of which the court rejected. The plaintiffs also advanced a loyalty theory, contending that the services agreement was an interested transaction that benefited Edelman by (i) paying his affiliate excessive fees and (ii) enabling him to use Canal's capital to advance his own interests in other ventures. The company had eight directors; two were Canal officers.
The court commented that it was "not at all clear that the complaint adequately state[d] a claim for breach of the duty of loyalty." Id. at *5. Assuming for the sake of argument that it did, the court held that demand was not futile under Aronson. The court reasoned that the complaint made only conclusory allegations about the outside directors' ties to Edelman, which were insufficient to call into question the independence of a majority of the board. The court then stated that "[t]he business judgment rule will protect the board's decision unless a majority of the board was interested or disabled by a lack of independence." Id. at *6. The decision does not appear to have considered the possibility that entire fairness might apply because the case involved a transaction with a controlling stockholder.
The Canal decision pre-dated the many more recent Delaware cases that have applied the entire fairness framework to transactions with a controlling stockholder, including services agreements and consulting agreements. Although Canal has been cited by subsequent decisions, it does not appear to me that any case has relied on it for the proposition that the business judgment rule applies to a non-ratable transfer to a controlling stockholder. Given the weight of precedent, Canal is unpersuasive.
At bottom, Tyson, Dolan, and Canal relied on Aronson for the proposition that the business judgment rule and not the entire fairness framework provided the standard of review for a transaction in which a controller received non-ratable benefits, at least where the transaction involved compensation or a consulting agreement and was approved by a board or a duly empowered committee with an independent majority of outside directors. Other Delaware Supreme Court cases, particularly Lynch and Tremont II, have taken a different approach.
There is considerable tension between these lines of authority.
Read literally, the Aronson decision limited its analysis to the issue of demand futility. 473 A.2d at 814. The crux of Aronson's holding was to reinforce the requirement that a plaintiff allege particular facts that would call into question the ability of the board to consider a demand. In the words of a leading scholar, "[e]mphasis upon this principle seems to have been taken to extreme lengths by the Delaware Supreme Court in Aronson v. Lewis." Robert C. Clark, Corporate Law 643 (1986).
The plaintiff in Aronson sought to recover on behalf of Meyers Parking Systems, Inc. for harm that the entity allegedly suffered due to generous compensation arrangements that the board approved for an insider and 47% stockholder, Leo Fink. The Delaware Supreme Court described the underlying transactions as follows:
473 A.2d at 808-09. The plaintiff contended that demand was futile because Fink dominated and controlled the board. The plaintiff based this allegation on
Id. at 815.
By rejecting these arguments, Aronson marked a sea change in Delaware law. On the question of whether demand was futile when a board would have to sue over a transaction involving a controlling stockholder, the case departed from longstanding precedent, such as McKee v. Rogers, 156 A. 191 (Del. Ch. 1931) (Wolcott, C.). The same was true for Aronson's treatment of the ability of directors who participated in the challenged decision to consider a demand, which departed from cases such as Fleer v. Frank H. Fleer Corp., 125 A. 411 (Del. Ch. 1924) (Wolcott, C.), and Miller v. Loft, Inc., 153 A. 861 (Del. Ch. 1931) (Wolcott, C.). Other pre-Aronson precedents consistent with McKee, Fleer, and Miller could be cited. After describing the Aronson court's conclusion that the complaint has not pled sufficient facts to raise a reasonable doubt about demand, Professor Clark commented that "the court might be argued to have blinded itself to reality." Clark, supra, at 643.
Why the big shift? The historical context suggests that Aronson may have been a reaction to the contretemps over Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981). Many commentators had responded to Zapata by expressing fear that it undermined the business judgment rule.
Id. at 813-14. It was in this context that Aronson sought to reinforce the bulwark of Rule 23.1 as a pleading-stage limitation on weak derivative claims.
To place the decision in context is not to question its legitimacy. The choice to raise the bar for pleading demand futility was undoubtedly the type of public policy judgment that the Delaware Supreme Court was and is empowered to make. The Aronson court openly made at least one other public policy judgment. It held that demand would not be futile as long as the board had a majority of disinterested and independent directors. 473 A.2d at 815. The high court explained its rationale as follows:
Id. at 815 n.8.
What is not clear to me is the extent to which the Delaware Supreme Court's policy judgments about the demand futility context were intended to extend to the substantive law that would apply if demand was excused or if the claim was direct. Nor is it clear to me the degree to which those assessments were intended to persist in crystallized form, immune to further common law development. There have been significant developments since Aronson.
As noted above, the Aronson decision appears to have responded most directly to practitioner concern about the reasonableness analysis in the second prong of Zapata's test for reviewing a special litigation committee's decision to dismiss a derivative action, a test which marked the Delaware Supreme Court's first deployment of something akin to the two-step standard of review that later emerged as enhanced scrutiny.
The Aronson decision also pre-dated further development in the law governing controlling stockholder transactions, both in terms of decisions addressing the standard of review, see Part II.B.3.a, supra, and the degree to which applying entire fairness leads to a finding of liability. On the latter point, experience since Aronson has shown that the application of entire fairness is not outcome-determinative and that defendants prevail under this standard of review with some degree of frequency.
In my view, the subsequent evolution of the law undermines the case for extending Aronson beyond the demand-excusal contest. Indeed, given how Delaware law has evolved since 1984, there is even reason to think that demand futility could operate in a more nuanced fashion that does not discount entirely the involvement of a controlling stockholder. There are decisional hints that in its pure form, Aronson is counter-intuitive. The second prong of Aronson, for example, contemplates that demand is futile if the transaction is not otherwise governed by the business judgment rule. Aronson, 473 A.2d at 815. After Tremont II and Lynch, one might think that demand would be futile for a transaction that was subject to entire fairness ab initio. Writing as a Vice Chancellor, Chief Justice Strine once said as much, commenting that demand would be futile for transactions involving a majority stockholder that were governed by the entire fairness standard.
Another example of how far Delaware law has evolved post-Aronson is demand futility for Unocal claims. As then-Vice Chancellor Strine explained, there are powerful reasons to debate whether and when Unocal claims should be characterized as derivative. In re Gaylord Container Corp. S'holders Litig., 747 A.2d 71, 75-85 (Del. Ch. 1999). Ultimately, however, the derivative-individual distinction is "of no practical importance" because "[s]o long as the plaintiff states a claim implicating the heightened scrutiny required by Unocal, demand has been excused under the [Aronson] demand excusal test."
As these examples illustrate, the rulings in Aronson—at least in their pure form— stand out amidst other Delaware decisions. Personally, therefore, I would continue to limit Aronson's scope to demand futility, and I would fold its teachings in that area into the more holistic approach contemplated by Delaware County Employees Retirement Fund v. Sanchez, 124 A.3d 1017 (Del. 2015). I would not use Aronson as a springboard for cutting back on post-Aronson case law governing entire fairness transactions. But that is the view of just one trial court judge. Ultimately, the choice between Aronson and other precedents is something only the Delaware Supreme Court can resolve. If the Delaware Supreme Court chooses to apply Aronson more broadly and limit the substantive application of the entire fairness framework, then its ruling obviously will control. Absent further guidance from the high court, however, this decision hews to the weight of precedent regarding how Delaware law approaches transactions in which a controlling stockholder receives a non-ratable benefit.
Based on the foregoing analysis, the operative standard of review for the Challenged Agreements is entire fairness, with the involvement of the Audit Committee operating potentially as a basis for shifting the burden of proof to the plaintiff. Under this standard, the Complaint states a claim for breach of fiduciary duty.
The Complaint supports a reasonable inference that the Challenged Agreements were not entirely fair and represented a means by which Cohen extracted a non-ratable return from EZCORP. Factors that support this inference include:
The defendants correctly observe that in the abstract, there is nothing wrong about a public company hiring a consulting firm to provide services. It may well be shown at a later stage of the case that hiring Madison Park was appropriate here. For pleading purposes, however, it is reasonably conceivable that the Challenged Agreements were a form of tunneling.
The Complaint adequately pleads for purposes of a motion to dismiss that the terms of the Challenged Agreements were unfair and that EZCORP suffered harm. Allegations regarding damages can be pled generally. The Complaint details the fees paid to Madison Park and explains why they were both unnecessary and excessive when compared to EZCORP's revenue and income
At the pleading stage, the involvement of the Audit Committee does not defeat the breach of fiduciary duty claim. When a transaction involving self-dealing by a controlling shareholder is challenged, unless the corporation deploys both an independent committee and a majority-of-the-minority vote, then the most that the use of the committee can achieve is a shift in the burden of proof. The defendants can achieve that result only if they have a "well functioning" committee of independent directors. See In re S. Peru Copper Corp. S'holder Deriv. Litig., 52 A.3d 761, 789 (Del. Ch. 2011) (Strine, C.), aff'd sub nom. Ams. Mining Corp. v. Theriault, 51 A.3d 1213 (Del. 2012). Determining whether a committee of independent directors is effective is a "fact-intensive inquiry." Krasner v. Moffett, 826 A.2d 277, 285-86 (Del. 2003). Shifting the burden of proof at the pleading stage "will normally be impossible" because defendants do not have the luxury of arguing facts that would counter the plaintiffs' well-pled allegations that are assumed as true. Orman v. Cullman, 794 A.2d 5, 20 n.36 (Del. Ch. 2002). In short, "a motion to dismiss is not the proper vehicle for deciding whether the burden of proof under entire fairness should be shifted."
Count I states a claim for breach of fiduciary duty against Cohen, MS Pawn, and Roberts. The Rule 12(b)(6) motion is denied as to Count I.
Count I of the Complaint alleges that by entering into the Challenged Agreements and making the payments they contemplated, the defendants engaged in waste. According to the Complaint, "the terms of the [Challenged Agreements] constitute an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade or conduct a business transaction." Compl. ¶ 95.
"The pleading burden on a plaintiff attacking a corporate transaction as wasteful is necessarily higher than that of a plaintiff challenging a transaction as `unfair' as a result of the directors' conflicted loyalties. . . ." Harbor Fin. P'rs v. Huizenga, 751 A.2d 879, 892 (Del. Ch. 1999) (Strine, V.C.). For a waste claim to survive a motion to dismiss, a plaintiff must show "economic terms so one-sided as to create an inference that no person acting in a good faith pursuit of the corporation's interests could have approved the terms." Sample v. Morgan, 914 A.2d 647, 670 (Del. Ch. 2007) (Strine, V.C.).
In Quadrant Structured Products Co. v. Vertin, 102 A.3d 155 (Del. Ch. 2014), this court confronted a similar situation in which the plaintiff alleged that the director defendants had caused the company to transfer value preferentially to the company's controlling entity by paying excessive service and licensing fees. The court held that while improbable, it was conceivable that the "excessive fees could fall so far beyond market standards as to amount to waste." Id. at 193. The same outcome is possible here.
As a practical matter, it is unlikely that waste will be a relevant theory of relief. If the Complaint's waste theory is correct, then it will mean that the terms of the Challenged Agreements were unfair and constituted a breach of fiduciary duty. This makes the waste theory somewhat redundant. Nevertheless, as a strict pleading matter, the waste claim can proceed. See In re Citigroup Inc. S'holder Deriv. Litig., 964 A.2d 106, 139 (Del. Ch. 2009).
Count III attempts to impose liability on Cohen and MS Pawn for aiding and abetting the Director Defendants' breaches of fiduciary duty. A claim for aiding and abetting has four elements: "(1) the existence of a fiduciary relationship, (2) a breach of the fiduciary's duty, (3) knowing participation in the breach, and (4) damages proximately caused by the breach." Malpiede v. Townson, 780 A.2d 1075, 1096 (Del. 2001) (quotation marks and formatting omitted).
For reasons discussed previously, I believe that the proper claim for pursuing Cohen is for breach of his duties as a controller. As a general rule, "[i]f a defendant has acted in a fiduciary capacity, then that defendant is liable as a fiduciary and not for aiding and abetting." Quadrant, 102 A.3d at 203. Count III is dismissed as to Cohen.
The claim against MS Pawn for aiding and abetting is well pled. Although I have posited that a breach of fiduciary duty claim provides the more straightforward way of reaching MS Pawn, Delaware authority supports the proposition that the entity through which the ultimate controller exercises control can be sued alternatively as an aider and abetter of the ultimate controller's breach. In re Emerging Commc'ns, Inc. S'holders Litig., 2004 WL 1305745, at * 38 (Del. Ch. May 3, 2004). The Complaint permissibly pleads these theories in the alternative. Ch. Ct. R. 8(e).
Count IV asserts an unjust enrichment claim. Count IV presumes the existence of a breach of fiduciary duty or a finding of waste and posits that under those circumstances, Madison Park and Cohen were unjustly enriched in the amount of the fees they received under the Challenged Agreements. In either scenario, a remedy would lie for breach of fiduciary duty or waste. The unjust enrichment count adds nothing.
Alternatively, if there is no underlying breach of fiduciary duty or finding of waste, then the Challenged Agreements are valid. "This Court routinely dismisses unjust enrichment claims that are premised on an express, enforceable contract that controls the parties' relationship because damages is an available remedy at law for breach of contract." Veloric v. J.G. Wentworth, Inc., 2014 WL 4639217, at *19 (Del. Ch. Sept. 18, 2014) (quotation marks omitted).
Based on these alternatives, it is not reasonably conceivable that Cohen and Madison Park could be liable for Count IV under circumstances when they would not also be liable under Counts I and III. Count IV is dismissed.
For this decision to have recognized that EZCORP possesses a viable claim does not mean that Treppel necessarily can assert it. When a corporation suffers harm, the board of directors is the institutional actor legally empowered under Delaware law to determine what, if any, remedial action the corporation should take, including pursuing litigation against the individuals involved. See 8 Del. C. § 141(a). "A cardinal precept of the General Corporation Law of the State of Delaware is that directors, rather than shareholders, manage the business and affairs of the corporation." Aronson, 473 A.2d at 811. "Directors of Delaware corporations derive their managerial decision making power, which encompasses decisions whether to initiate, or refrain from entering, litigation, from 8 Del. C. § 141(a)." Zapata, 430 A.2d at 782 (footnote omitted). Section 141(a) vests statutory authority in the board of directors to determine what action the corporation will take with its litigation assets, just as with other corporate assets. Id.
In a derivative suit, a stockholder seeks to displace the board's authority over a litigation asset and assert the corporation's claim.
Treppel did not make a litigation demand, and the Board opposes his efforts to pursue litigation. Consequently, he can gain authority to litigate EZCORP's claims only by establishing that demand was excused as futile.
The demand requirement "is a basic principle of corporate governance and is a matter of substantive law."
A board can consider a demand properly, and a plaintiff therefore can seek to "obtain the action he desires from the directors," if a majority of the directors can exercise their independent and disinterested business judgment about whether to pursue litigation. Aronson, 473 A.2d at 808 n.1. Conversely, demand is futile when "the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand." Rales, 634 A.2d at 934.
The "reasonable doubt" standard is not intended to incorporate "a concept normally present in criminal prosecution." Grimes, 673 A.2d at 1217. "Reasonable doubt can be said to mean that there is a reason to doubt." Id. "Stated obversely, the concept of reasonable doubt is akin to the concept that the stockholder has a `reasonable belief' that the board lacks independence or that the transaction was not protected by the business judgment rule. The concept of reasonable belief is an objective test. . . ." Id. at 1217 n.17. It is "sufficiently flexible and workable to provide the stockholder with `the keys to the courthouse' in an appropriate case where the claim is not based on mere suspicions or stated solely in conclusory terms." Id. at 1217 (footnote omitted).
A plaintiff also need not "plead particularized facts sufficient to sustain a `judicial finding' either of director interest or lack of director independence" or of another disabling factor. Grobow v. Perot, 539 A.2d 180, 183 (Del. 1988). Rule 23.1 requires that a plaintiff allege specific facts, but "he need not plead evidence." Aronson, 473 A.2d at 816; accord Brehm v. Eisner, 746 A.2d 244, 254 (Del. 2000) ("[T]he pleader is not required to plead evidence. . . ."). Whether the plead facts could support a "judicial finding" that the director was not disinterested or independent is "an excessive criterion" for applying Rule 23.1. Grobow, 539 A.2d at 183. The operative standard is the "reasonable doubt test." Id.
For a trial court, "[d]etermining whether a plaintiff has pled facts supporting an inference that a director cannot act independently of an interested director for purposes of demand excusal . . . can be difficult." Del. Cty. Empls. Ret. Fund v. Sanchez, 124 A.3d 1017, 1019 (Del. 2015). When making that determination, "it is important that the trial court consider all particularized facts pled by the plaintiffs about the relationships between the director and the interested party in their totality and not in isolation from each other." Id. "[O]ur law requires that all the pled facts regarding a director's relationship to the interested party be considered in full context in making the, admittedly imprecise, pleading stage determination of independence." Id. at 1022. Evaluating a board's ability to consider a demand impartially thus requires a "contextual inquiry."
Likewise, "it cannot be ignored that although the plaintiff is bound to plead particularized facts in pleading a derivative complaint, so too the court is bound to draw all inferences from those particularized facts in favor of the plaintiff, and not the defendant, when dismissal of a derivative complaint is sought." Sanchez, 124 A.3d at 122. "The well-pleaded factual allegations of the derivative complaint are accepted as true on [a Rule 23.1] motion." Rales, 634 A.2d 931. Once a plaintiff has made particularized allegations, the plaintiff is entitled to all "reasonable inferences [that] logically flow from particularized facts alleged."
This decision accepts the defendants' position that for purposes of evaluating demand futility, the Board comprised directors Kuchenrither, Cumins, Given, Miranda, Roberts, Rotunda, and Espinosa.
In my view, a reasonable doubt exists as to six directors: Kuchenrither, Cumins, Given, Miranda, Roberts, and Rotunda. A reasonable doubt therefore exists as to the Board as a whole.
The first director is Kuchenrither, who is a senior executive at EZCORP. After cleaning house in July 2014, Cohen made Kuchenrither the interim CEO. Kuchenrither previously served as EZCORP's CFO, and he held other executive positions with EZCORP before that. Kuchenrither derives his principal source of income from his employment with EZCORP. He received approximately $1.3 million in 2011, $1.6 million in 2012, and $4.8 million in 2013. EZCORP acknowledged in its Form 10K for its fiscal year 2013, filed on November 26, 2014, that because Kuchenrither is an "executive officer" of EZCORP, he is "not independent in accordance with the standards set forth in the NASDAQ listing rules."
Under the great weight of Delaware precedent, senior corporate officers generally lack independence for purposes of evaluating matters that implicate the interests of a controller.
EZCORP's disclosure regarding the NASDAQ listing standards points in the same direction. The independence standards established by stock exchanges and the requirements of Delaware law, such that a finding of independence (or its absence) under one source of authority is not determinative for purposes of the other,
Taken together, these facts generate a reasonable doubt as to Kuchenrither's ability to consider a demand.
The next director is Cumins. Unlike Kuchenrither, Cumins is not an employee at EZCORP. Instead, he is a managing director of Cash Converters, where he has worked since 1990. EZCORP owns approximately 33% of the equity of Cash Converters, giving it substantial influence over that entity. Cumins also sits on the board of Cash Converters. In March 2014, EZCORP and Cash Converters formed a joint venture to operate stores in Mexico, with EZCORP owning 80% and Cash Converters owning 20% of the venture. As with Kuchenrither, EZCORP has disclosed that Cumins is not independent for purposes of the NASDAQ listing standards.
Delaware decisions have recognized that when a director is employed by or receives compensation from other entities, and where the interested party who would be adversely affected by pursing litigation controls or has substantial influence over those entities, a reasonable doubt exists about that director's ability to impartially consider a litigation demand.
Sanchez, 124 A.3d at 1023 n.25.
At the very least, the pled facts suggest an inference that Cumins might feel strongly subject to Cohen's dominion as the controller of EZCORP and an individual with the ability to influence Cumins' future at Cash Converters. EZCORP's disclosure about his lack of independence for purposes of NASDAQ's listing standards reinforces that assessment. A reasonable doubt exists about Cumins' independence.
The third director is Given. He has an abundance of ties to Madison Park, Cohen, and other Cohen-affiliated entities.
For starters, Given currently serves as a consultant to Madison Park, the counterparty under the Challenged Agreements. It is not clear at this stage whether Given's role as a consultant involves a degree of obligation to Madison Park that would create a situation comparable to the dual fiduciary problem identified by the Delaware Supreme Court in Weinberger v. UOP, Inc.
Givens' ties to Madison Park go beyond his current consultancy. He previously served a managing director of Madison Park and was employed by that firm since 2004. During that period, Madison Park benefitted from the substantial payments it received from EZCORP, its only publicly traded client. The Complaint alleges that Madison Park is a lightly staffed firm with few resources. At the pleadings stage, it is reasonable to infer that Given benefited personally from the payments that EZCORP made under the Challenged Agreements, making it less likely that Given could give impartial consideration to a litigation demand concerning the Challenged Agreements.
Next, pursuant to an advisory services agreement, Given receives advisory fees from EZCORP and its affiliates through LPG Limited (HK), his personal entity. LPG received $740,000 between October 1, 2012 and June 19, 2014. LPG received another $120,000 since July 1, 2013 for consulting work on behalf of Cash Converters. The monetary amounts support a reasonable inference that Given is beholden to Cohen.
On top of these issues, Given has relationships with EZCORP affiliates. He serves as Vice Chairman of Change Capital Inc., a wholly-owned subsidiary of EZCORP, and as Chairman of Change Capital, Asia, another EZCORP affiliate. And EZCORP has acknowledged in its public filings that he is not independent under the NASDAQ listing requirements.
At this stage, it is reasonable to infer that Given is sufficiently enmeshed with Cohen, Madison Park, and other Cohen-controlled entities that he could not consider a litigation demand relating to the Challenged Agreements.
The fourth director is Miranda. The connections that Miranda and members of his family have to Prestaciones Finmart, S.A.P.I. de C.V., SOFOM, E.N.R. ("Finmart"), an EZCORP subsidiary, raise a reasonable doubt about his independence.
EZCORP owns 76% of Finmart's equity, making EZCORP its controlling stockholder. Miranda's family members are the minority equity owners, holding approximately 20% of its equity. The Complaint identifies by name a number of Miranda's family members who are employed by Finmart.
Delaware decisions have taken a realistic approach to the ability of a director to consider a litigation demand when moving forward with the litigation would have an adverse interest on a close family member.
The Complaint does not identify the compensation that Miranda's family members receive from Finmart, but that omission is not fatal. "Absent some unusual fact—such as the possession of inherited wealth—the remuneration a person receives from her full-time job is typically of great consequence to her. It is usually the method by which bills get paid, health insurance is affordably procured, children's educations are funded, and retirement savings are accumulated." In re The Student Loan Corp. Deriv. Litig., 2002 WL 75479, at *3 n.3 (Del. Ch. Jan. 8, 2002) (Strine, V.C.).
It is reasonable to infer at the pleadings stage that when considering a demand to pursue litigation against Madison Park and Cohen, Miranda would consider Cohen's ability to influence the future employment of members of his family. It is also reasonable to infer that he could consider his family's minority equity ownership in Finmart and Cohen's ability as a majority holder to take action to reduce the value of the minority stake or eliminate it. A reasonable doubt therefore exists that Miranda could consider impartially a demand to sue Cohen over the Challenged Agreements. If there were any doubt, the incremental weight of Cohen's removal of Beal and Love would tip the scales.
The fifth director is Roberts. Unlike the first four directors, he does not have a paid employment or consulting relationship with EZCORP or its affiliates, nor is he related to anyone who does. He thus starts out as an outside director who presumably could give impartial consideration to a demand. But despite his status as an outside director, the following facts when considered together establish a reason to doubt his ability to consider a demand impartially: (i) his personal participation in the decisions to approve multiple advisory services agreements with Cohen affiliates, even after indications of problems had arisen, (ii) his immediate return to the Board after Beal and Love terminated the 2013 Renewal, and (iii) the implications of Cohen's demonstrated willingness to remove outside directors who disagreed with him.
This decision need not determine whether any one of these factors would be sufficient to call Roberts' impartiality into question. It holds only that when these factors are viewed "in their totality and not in isolation from each other," a good reason exists to doubt Roberts' independence. Sanchez, 124 A.2d at 1019.
One contributing factor is the pattern of decisions that Roberts made during his prior years as a director, when he served as Chair of the Audit Committee (2004-2008) and as a member of the Audit Committee (2010-2013). Each year, Roberts approved or re-approved a multi-million dollar advisory services agreement with Madison Park, including two of the Challenged Agreements. Before embarking on this course, Roberts had reason to question the wisdom of an advisory relationship between EZCORP and a Cohen affiliate: he began approving the agreements with Madison Park shortly after the Audit Committee determined that Morgan Schiff had been overcharging EZCORP for expenses.
Generally speaking, "mere directorial approval of a transaction, absent particularized facts supporting a breach of fiduciary duty claim, or otherwise establishing the lack of independence or disinterestedness of a majority of the directors, is insufficient to excuse demand." Aronson, 473 A.2d at 817. In other words, the fact that a director previously approval a challenged transaction is one of many factors that "standing alone" or "without more" will not call into question a director's ability to consider a demand.
A factor that is not sufficiently disqualifying when evaluated alone can still play a role in the overall demand-excusal analysis. In my view, for a director to have continued to approve a series of similar transactions, after an indication that the course of action might not be in the best interests of the corporation, deserves some consideration in the Rule 23.1 analysis. One need not delve deeply into the extensive research on cognitive bias that has developed since Aronson to learn that "`the starting point of a decision process has a disproportionate effect on its outcome.'" Antony Page, Unconscious Bias and the Limits of Director Independence, 2009 U. Ill. L. Rev. 237, 260 (quoting Samuel D. Bond et al., Information Distortion in the Evaluation of a Single Option, 102 Org. Behav. & Hum. Decision Processes 240, 240 (2007)). Two straightforward forms of cognitive bias play a significant role in producing this effect: commitment bias and confirmation bias.
"Once a person has chosen a course of action, commitment bias suggests that the person will continue to act in a manner consistent with the chosen course even if later discovered information suggests that one should follow a different course." Kristin N. Johnson, Addressing Gaps in the Dodd-Frank Act: Directors' Risk Management Oversight Obligations, 45 U. Mich. J.L. Reform 55, 103 (2011) (citations omitted). "[C]onfirmation bias describes a tendency to disregard information that contradicts an established conclusion and unconsciously gravitate to information that confirms a previously articulated opinion." Id. "Groups (like boards) are particularly resistant to information indicating that they may have made a bad decision. . . . This bias deepens over time." Donald C. Langevoort, Resetting the Corporate Thermostat: Lessons from the Recent Financial Scandals About Self-Deception, Deceiving Others and the Design of Internal Controls, 93 Geo. L.J. 285, 294-95 (2004). Stated generally, "[i]f the director's starting point involves initial judgments, choices, or beliefs, several lines of research show that the cognition is more likely to be confirmed." Page, supra, at 261 (quotation marks omitted; citing Tobias Greitemeyer & Stefan Schulz-Hardt, Preference-Consistent Evaluation of Information in the Hidden Profile Paradigm: Beyond Group-Level Explanations for the Dominance of Shared Information in Group Decisions, 84 J. Personality & Soc. Psychol. 322, 323 (2003)).
In this case, Roberts' starting point for evaluating a litigation demand would not just involve one prior decision that he had made to the effect that paying a Cohen-affiliated entity for advisory serves was a good use of corporate funds. It would involve eight prior decisions. It seems reasonable at the pleading stage to infer that Roberts could have difficulty reversing this pattern and authorizing a suit. Standing alone, this factor would not be dispositive, but it is part of the mix.
A second consideration involves the circumstances surrounding Roberts return to the Board. Roberts left the Audit Committee in September 2013, and he retired from the Board in January 2014. Four months later, in May 2014, Beal and Love terminated the 2013 Renewal. Two months after that, Cohen removed half of the Board. After cleaning house, Cohen brought Roberts out of retirement and returned him to his position as a director.
By itself, the fact that Cohen elected Roberts to the Board is not disabling. Since Aronson, Delaware law has applied the general rule that a director's nomination or election by an interested party is, standing alone, insufficient to raise a reasonable doubt about his or her independence.
Although nomination or election by an interested party, standing alone, is not dispositive, it is not necessarily irrelevant. That is particularly so where, as here, the controller returned the director to the Board under circumstances that suggest the director might be "`an easy tool, deferential, glad to be of use.'" William T. Allen, Independent Directors in MBO Transactions: Are They Fact or Fantasy, 45 Bus. Law. 2055, 2061 (1990) (quoting T.S. Eliot, The Love Song of J. Alfred Prufrock, in Collected Poems 1909-1962 (Harcourt, Brace & World 1970)). In this case, Cohen's consulting agreements had continued in place for over a decade, including during the entirety of Roberts' tenure as a director. After Roberts departed, Beal and Love terminated the 2013 Renewal. When Cohen removed them from office, he brought back the man who had approved eight consulting agreements while serving on the Audit Committee. Perhaps Roberts already had tired of retirement and was eager for a quick return to the position he left four months before. Perhaps there are other explanations. At this stage, one reasonable inference is that Cohen wanted to bring back a cooperative member of the placid antebellum regime, and another is that Roberts knew his role and remained willing to serve. Standing alone, the circumstances surrounding Roberts return to the Board would not be dispositive, but they are part of the totality of allegations that weigh in the demand analysis.
A third consideration is Cohen's demonstrated willingness to remove outside directors who challenge his arrangements. Delaware decisions have long worried about a controller's potential ability to take retributive action against outside directors if they did not support the controller's chosen transaction and whether it could cause them to support a deal that was not in the best interests of the company or its stockholders.
At the same time, Delaware decisions recognize that when controllers actually make retributive threats, that fact has legal significance.
In my view, giving pleading-stage effect to a controller's actual threats and retributive behavior has important integrity-preserving consequences. If a controller anticipates that threats will have legal consequences for demand futility and other doctrines, then he should be less likely to make and carry them out. That in turn should enable outside directors to better fulfill the meaningful role that Delaware law contemplates.
It is reasonable at this stage to infer that Cohen's demonstrated willingness to take retributive action affected all of the directors, including Roberts. Combined with the other two factors, a reasonable doubt exists as to Roberts' ability to consider a litigation demand.
The sixth director is Rotunda. He served as EZCORP's CEO and as a director from 2000 through 2010. Upon departure, he entered into a consulting agreement with EZCORP that paid him $500,000 annually plus an incentive bonus of 50% to 100% of his compensation and provided healthcare benefits. The compensation elements ended in November 2013, eight months before suit was filed. EZCORP continued to pay for Rotunda's health benefits through October 31, 2015. EZCORP has identified Rotunda as a non-independent director because he "is a former executive officer of, and consultant to, the Company," and is, therefore, "not independent in accordance with the standards set forth in the NASDAQ Listing Rules."
Delaware decisions have declined to find that past service created a reasonable doubt about a former executive's independence when the individual had severed all ties with his prior employer for a meaningfully longer period than the eight months at issue here.
In this case, Rotunda's past ties combines with Cohen retributive behavior and his lack of independence for purposes of NASDAQ listing standards. Taken together, these factors raise a reasonable doubt as to his ability to consider a litigation demand impartially.
Count IV of the Complaint is dismissed for failure to state a claim on which relief can be granted. Count III is dismissed as to Cohen on the same basis. Otherwise, the motions to dismiss are denied.
There also are decisions which have questioned whether the full entire fairness framework applies outside of squeeze-out mergers involving a controlling stockholder. See In re MFW S'holders Litig., 67 A.3d 496, 526-27 (Del. Ch. 2013) (Strine, C.) ("Outside the controlling stockholder merger context, it has long been the law that even when a transaction is an interested one but not requiring a stockholder vote, Delaware law has invoked the protections of the business judgment rule when the transaction was approved by disinterested directors acting with due care."), aff'd sub nom. Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014); Teachers' Ret. Sys. of La. v. Aidinoff, 900 A.2d 654, 669 n.19 (Del. Ch. 2006) (Strine, V.C.) (commenting that the extent to which "a line of decisions that focus on conflicted mergers with controlling stockholders. . . . applies outside that context is an ongoing subject of debate"); Orman v. Cullman, 794 A.2d 5, 20 n.36 (Del. Ch. 2002) ("Recognizing the practical implications of the automatic requirement of an entire fairness review has led our Supreme Court to limit such automatic requirement to the narrow class of cases in which there is a controlling shareholder on both sides of a challenged merger."). The comments in these decisions appear geared primarily towards the point that when an interested transaction does not involve a controlling stockholder, the use of a special committee or the receipt of disinterested stockholder approval lowers the standard of review from entire fairness to the business judgment rule. See MFW, 67 A.3d at 527 n.149 (contrasting controlling stockholder merger rule with precedents involving transactions with fellow directors); Aidinoff, 900 A.2d at 669 n.19 (controlling stockholder merger rule with "an interested transaction between a company and one or two of its directors who are not affiliated with a controlling stockholder" (quotation marks omitted)); Orman, 794 A.2d at 20 n.36 (stressing that Emerald Partners decision turned on "Hall's fiduciary status as a controlling stockholder"). At least as I read them, the cases do not necessarily suggest that the business judgment rule should apply to a transaction in which a controller extracts a non-ratable benefit.
Bebchuk & Fried, supra, at 25. There is good reason to think that the loss of a board seat is material. Id. ("In most cases, these benefits are likely to be economically significant to the director."); accord Walker, supra, at 633 (arguing that from an economic perspective, "[t]he incentive to retain a board position generally outweighs the incentive to maximize shareholder value"); see Jarrad Harford, Takeover Bids and Target Directors' Incentives: The Impact of a Bid on Directors' Wealth and Board Seats, 69 J. Fin. Econs. 51 (2003) (finding statistical evidence that a board seat is difficult to replace, because directors who lose a seat as a result of a takeover can expect to hold one fewer directorship than peers for two years following a completed merger; finding that directors suffer a net financial penalty from the loss of the directorship between zero and -$65,443); David Yermack, Remuneration, Retention, and Reputation Incentives for Outside Directors, AFA 2004 San Diego Meetings 2, 29 (Feb. 2003), http://ssrn.com/abstract=329544 (finding "statistically significant evidence that outside directors receive positive performance incentives from compensation, turnover, and opportunities to obtain new board seats" that have a direct impact on the accumulation of wealth by that director and "considering that an outside director may serve on several boards, these incentives appear non-trivial albeit much smaller than those offered to top managers"); see also Renée B. Adams & Daniel Ferreira, Do Directors Perform for Pay?, 46 J. Acct. & Econ. 154 (2008) (finding statistically significant correlation between director attendance and per meeting fees, indicating that per-meeting payments of approximately $1000 have a material influence on directors). Conversely, being supportive has benefits. Controllers and CEOs have substantial control over the firm resources, and they often have significant influence outside the firm. Bebchuk & Fried, supra, at 27-28. One study finds that companies with higher CEO compensation have higher director compensation as well. See Ivan E. Brick, Oded Palmon, & John K. Wald, CEO Compensation, Director Compensation, and Firm Performance: Evidence of Cronyism?, 12 J. Corp. Fin. 403 (2006).
To provide a sense of the magnitude of the post-Zapata furor, a search of Westlaw identifies thirty-eight post-Zapata, pre-Aronson law review articles, notes, and comments that discuss to varying degrees the implications of Zapata for the business judgment rule. A search of HeinOnline reveals approximately ninety-nine during a similar period. For examples of leading commentators who offered strong criticisms of Zapata, see Daniel R. Fischel, The "Race to the Bottom" Revisited: Reflections on Recent Developments in Delaware's Corporation Law, 76 Nw. U. L. Rev. 913, 937 (1982) ("The most significant, and most unsettling, aspect of Zapata is the court's explicit rejection of the business judgment rule as the proper standard for determining whether a derivative suit can be dismissed."); Dennis J. Block & H. Adam Prussin, The Business Judgment Rule and Shareholder Derivative Actions: Viva Zapata?, 37 Bus. Law. 28, 60 (1981) (criticizing the Zapata decision for adopting a new test "which had never before been advocated or followed, by any court" and for having "abandoned any pretext that the `business judgment rule' has anything much to do with its analysis"); id. at 63 (objecting to Zapata as "judicial legislation," "virtually unsupportable," and "a serious misstep"). Others supported the ruling or thought it did not go far enough. See, e.g., James D. Cox, Searching for the Corporation's Voice in Derivative Suit Litigation: A Critique of Zapata and the ALI Project, 1982 Duke L.J. 959, 975 (1982) ("Unfortunately, although the court held that the business judgment rule is an inappropriate standard of review, the two-tiered analysis it offered in its place provides only an illusory improvement."); John C. Coffee, Jr., The Survival of the Derivative Suit: An Evaluation and A Proposal for Legislative Reform, 81 Colum. L. Rev. 261, 330 (1981) ("On its own terms, the Zapata decision deserves recognition as a serious effort at judicial statesmanship by the Delaware Supreme Court—but one that needs legislative codification and embroidery.").
The Aronson decision did not settle the debate. A search of HeinOnline indicates that during a comparable three-year period after Aronson, there were another seventy-seven articles, notes, and comments that touched on that decision and Zapata.
