Power And Accountability – Chapter 3

Power And Accountability – Chapter 3

The Director’s New Clothes

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The Director’s New Clothes

The Myth of the Director’s Duty

The Convenient Mythand the More Convenient Reality

Dance with the One Who Brought You – or Else

The Empire Strikes Back: The Business Roundtable

The Roundtable on Governance, 1978 and 1990

The Roundtable Retreats: Corporate Governance in 1990

The Evolution of the Fiduciary Ideal: Above “the Morals of the Marketplace”

The Rise and Fall of the Duties of Care and Loyalty: The Morals of the Marketplace Are Good Enough

The Corporate Miranda Warning

Did We Say Marketplace? The Death of the Duty of Care

The Ravages of Time

The Death of the Duty of Care, Part II: Limited Liability and Indemnification

Did We Say Morals? What’s Wrong with These Pictures?

The Death of the Duty of Loyalty

Playing Both Sides: The MBO

UAL: A Wolf in Wolf’s Clothing

The MBO at GAF

The Death of the Duty of Loyalty, Part II: Stakeholders


The Director’s New Clothes

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A scene in Barbarians at the Gate frames the question of accountability of corporate management perfectly. Ross Johnson, the man who somewhat impetuously initiated the leveraged buyout of RJR-Nabisco, met with Henry Kravis and George Roberts of Kohlberg, Kravis, Roberts, & Co. to discuss it. There was a brief discussion of the business before Johnson’s central question came up. “Now Henry, if you guys get this, you’re not going to get into chickenshit stuff about planes and golf courses are you?” (Johnson’s perquisites included corporate jets and membership fees at 24 country clubs.1) Kravis was eager to gloss over this question, but Roberts was more candid. “Well, we don’t want you to live a spartan life. But we like to have things justified. We don’t mind people using private airplanes to get places, if there’s no ordinary way. It is important that a CEO set the tone in any deal we do.”

Johnson stated his concern more directly. “I guess the deal we’re looking for is a bit unusual.” Johnson, as it turned out, wanted to keep significant control of the company. Roberts responded even more directly: “We’re not going to do any deal where management controls it. We’ll work with you. But we have no interest in losing control.” Johnson asked why.

“We’ve got the money,” Roberts said, “We’ve got the investors, that’s why we have to control the deal.” From the look in Johnson’s eyes, Roberts could tell it wasn’t the message he wanted to hear. “Well, that’s interesting,” Johnson said. “But frankly, I’ve got more freedom doing what I do right now.”2

There’s something wrong with this picture, because it took debt to make management accountable. It should have been accountable to shareholders, to the people who have “got the money.”

What’s wrong with this picture is the discrepancy between the expectations of the law and reality. The law generally assumes that “All corporation power shall be exercised by or under the authority of, and the business and affairs of the corporation managed under the direction of, its board of directors, subject to any limitation set forth in the articles of incorporation.”3 According to Melvin Eisenberg, “All serious students of corporate affairs recognize that notwithstanding the statutory injunction, in the typical large publicly held corporation the board does not ‘manage’ the corporation’s business in the ordinary meaning of that term. Rather, that function is vested in the executives.”4 This reality is reflected in the erosion of the standard of performance for directors. Barbarians at the Gate documents in devastating fashion the way that Ross Johnson handled his boards, with a combination of lavish perquisites and meager information. While he was dazzling his hand-picked directors, who could expect them to complain about his jets and country clubs?

The corporate structure was designed to maximize profits through competition in the marketplace, but it has proven to be more successful at making profits, whether maximum or not, by imposing costs on others. Every single mechanism that has been set up as some kind of check to prevent this externalizing of costs has been neutralized, short-circuited, or co-opted. Shareholders, directors, state and federal legislatureseven the marketplace itselfall are part of the myth of corporate accountability, and all are part of the reality of corpocracy. In this chapter, we look at the convenient myth behind the mechanisms established to make sure that corporate activity was consistent with the public interest, and the more convenient reality of the failure of these mechanisms to do so.

The Essence of Business, Simplified

Business is other people’s money.

Delphine de Girardin

The Myth of the Director’s Duty

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In a corporation, management acts as agent for the owner, but they do not always have the same interests and incentives. What can we do to requireor at least encouragepeople to treat other people’s property with as much care as if it were their own?

The law has tried to answer this question of agency costs by developing its highest standard of behavior, the fiduciary standard, and applying it to those who hold and manage property on behalf of others. This standard applies to several different players in the process for establishing corporate behavior, including the board of directors. At least in theory, they are fiduciaries for the shareholders. And the law books are filled with attempts, some almost poetic, to define that duty. Their actions must be “held to something stricter than the morals of the marketplace,” with a “punctilio of an honor the most sensitive.”5

That there is a fiduciary standard is perhaps the most powerful myth underlying the corporate system. Why is it so important to make clear that directors must take extraordinary measures to make sure that they are protecting the rights of shareholders? The reason is our belief that those who exercise power should be accountable to those who are affected by it. We delegate authority to the directors of private companies because they are accountable to the shareholders, just as we delegate authority to government officials because they are accountable to the electorate. Accountability is what makes delegated authority legitimate; without accountability, there is nothing to prevent abuse.

This was the conundrum that almost stopped corporations before they began. Karl Marx and Adam Smith did not agree on much, but they both thought that the corporate form of organization was unworkable, and for remarkably similar reasons. They questioned whether it is possible to create a structure that will operate efficiently and fairly, despite the fact that there is a separation between ownership and control. Put another way, is there any system to make a manager care as much about the company’s performance as a shareholder does? Harvard Law School’s Dean Robert Clark describes this issue when he says that the major problem addressed by corporate law is how to keep managers accountable to their fiduciary duties of care and loyalty while allowing them great discretionary power over the conduct of the business.6

This is a key question, for both economic and public policy reasons. The separation of ownership and control leads to externalities, imposition of costs on othersincluding shareholders, taxpayers, and the community. For example, a company that discharges untreated effluent into a river is making the community pay some of the costs of production, through government services for clean-up or increased health care costs. A company that uses political pull at the state level to thwart a worthwhile takeover attempt is making the shareholders foot the bill, not just for the lobbying efforts, but for the lost premium, and possibly for a less competitive company. And, of course, it was the shareholders who were paying for Ross Johnson’s 24 country club memberships and (at least by one account) for his dog’s trip on a jet from the corporate fleet, to say nothing of the devastatingly expensive mistake of the “smokeless cigarette.”

The answer to this problem was supposed to be the board of directors, elected by shareholders and acting as fiduciaries on their behalf. The board is responsible for setting overall goals and making sure they are met, for hiring the CEO and monitoring his performance, and for watching corporate management on behalf of the shareholders, to make sure that the corporation is run in their interest. That’s the theoryand the myth. The reality is that directors are “merely the parsley on the fish”7 or the “ornaments on a corporate Christmas tree.”8 As Peter Drucker put it many years ago, “Whenever an institution malfunctions as consistently as boards of directors have in nearly every major fiasco of the last forty or fifty years it is futile to blame men. It is the institution that malfunctions.”9

The Convenient Mythand the More Convenient Reality

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How can we justify a system in which investors purchase shares in a company that is far too big and complex to permit any meaningful shareholder involvement in governance? In theory, the accountability in our system is the enforceable allegiance that corporate directors and managers owe to shareholders. And that allegiance is enforceable in two ways. Dissatisfied shareholders can sue for violation of fiduciary duty, or, through the electoral process (proxy voting), they can throw the bums out and vote in directors who will do better.

Although difficult to believe in today’s world, it is from the premise that shareholders can respond effectively to inadequate boards that much of corporate decision making gets its legitimacy. It is directors, after all, who appoint the officers and determine their level of compensation, and who set the long-term goals and make sure that management takes appropriate steps to carry them out. The fiduciary standard is supposed to ensure that they take all of these actions on behalf of the shareholders. But this is little more than a vestigial notion in modern times. As the creation of instruments to finance takeovers of any company, of virtually any size, has presented directors with the most demanding challenges in corporate history, they have found, as have the shareholders, that the traditional notion of a director’s dutyand authoritywas more myth than reality.

Dance with the One Who Brought You – or Else

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Barbarians at the Gate detailed Ross Johnson’s techniques for the care and feeding of his directorseverything from arranging for them to rub shoulders with celebrities to endowing chairs at their alma maters. Perquisites such as the use of corporate planes and apartments made it hard for directors to push him on tough questions. The same is true at most corporations. Directors are picked because the CEO knows them and knows that they are likely to be on his side. Many of themeven those termed “outside” directors, by the New York Stock Exchange’s definitionhave some business or personal relationship with the CEO.10 We were once informed by an investor of a prominent electronics company that the head of the board of directors’ compensation committee was the chancellor of a college. The president of the company, in turn, was the chairman of the college’s board of trustees, and the company has been a big contributor to the schoola nice, cozy arrangement.

Directors are not picked for their ability to challenge management. On the contrary, they are more often chosen for their business or personal ties, or for their ability to add symbolic luster. Compensation expert Graef Crystal describes boards as “ten friends of management, a woman and a black.”

A vice president of one of the nation’s largest conglomerates told us that during one period his company’s board included a much-loved TV personality. “He always made a hit at annual meetings, where shareholders greeted him with loud applause,” said the vice president. “After the meeting, the directors would have cocktails and lunch, and the star would regale them with anecdotes and jokes. Then, when the Chairman banged the gavel, the star would put his head down on the table and sleep until the meeting was over. Someone sitting next to him would cast his vote, when required, claiming he or she had checked the star’s position.” On another board, a Nobel Prize-winning scientist was selected by management. An observer told us that “he always made a point to ask questions during board meetings, the kind of questions that an intelligent but uninformed layman might ask, but his material contributions were nil.”

Since they are selected by management, paid by management, and perhaps most importantinformed by management, it is easy for directors to become captive to management’s perspective. Information is the key, and it is often frustrating to directors to have such limited access. Former Supreme Court justice Arthur Goldberg, a member of the board of TWA, suggested that the board form a committee to make periodic reports on the company’s operations and that it have its own staff of experts, including a scientist, an economist, a public relations expert, an auditor, and, perhaps, a financial expert. The proposal was turned down, and Goldberg resigned from the board.11

Other directors who have tried to question management have fared even worse. Those directors who cannot be shmoozed, ignored, or avoided can be silenced. Ross Perot was brought to the General Motors board just to bring the skills and experience that had made his company, EDS, so successful. When he tried to give the board the benefit of that skill and experience, CEO Roger Smith paid Perot $742.8 million$33 a share for stock that closed at $26 7/X on the day of the trade, plus another $346.8 million for contingent notes and tax compensationin order to get him off the board.12 GM even established a $7.5 million penalty to be levied if either Perot or GM criticized each other, and they set up a three-man arbitration panel to evaluate possible violations.13 So there was no opportunity for the shareholders to find out what Perot’s concerns about the company were. There was also no opportunity for them to get that kind of a price; General Motors refused to buy back other shareholders’ stock for the price they paid to Perot.

An outside director of a company that went private in an MBO told us that his every attempt to question management was thwarted. The special committee convened to oversee the deal was made up of directors selected for their history of going along with whatever management proposed. The projections for segments of the company previously expected to do well suddenly became dismal, as all of the assumptions changed to justify a low price. Even if a company is operating as a public company, it has every incentive to present its most optimistic forecasts to directors and shareholders. But a buyer and a seller have two different ways of valuing assets, and in an MBO, management switches sides. The “independent” investment banking firms hired to provide “fair” evaluations of the value of the assets owe their allegiance to management. Who owes allegiance to shareholders? In theory, it is the board of directors, who, as fiduciaries, are supposed to be better to shareholders than they would be to themselves. But the theory of fiduciary duty has given way to the reality of a duty so threadbare that it covers as little as the fabled emperor’s new clothes.

The Empire Strikes Back: The Business Roundtable

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With the birth of the Roundtable, big business in the United States may at last be said to have come of political age.14

Source: Kim McQuaid, Big Business and Presidential Power: From FDR to Reagan, William Morrow, New York, 1982, p. 308.

The Business Roundtable is an association of approximately 200 of the country’s largest publicly held corporations, who have joined together to examine public issues that affect the economy and to develop positions that reflect “sound economic and social principles. The objectives of the Roundtable include fostering economic policies conducive to the well-being of the nation and its people.”15

The Roundtable came about, indirectly, because its predecessor, the Business Council, was part of the Department of Commercea fact Kennedy’s first commerce secretary, Luther Hodges, did not appreciate. Hodges felt the council, a group that advised him as commerce secretary yet would not allow him to select its members or determine their meeting agendas, should not have a “special channel to government thinking.”16

Hodges and the council remained at loggerheads until the council went to Kennedy and told him that they would operate as a private group. Business was then represented by different umbrella organizations over the next decade, including a revived private Business Council, the U.S. Chamber of Commerce, the National Association of Manufacturers, and the National Federation of Independent Business. From the point of view of the business community, the inadequacy of its governmental relations was never more painful than during the Nixon and Ford administrations, when wage and price controls were installed, with almost no input from the business sector. According to one scholar, it was John Connally, long an ally of big business, who made it clear to prominent business leaders that “[b]usinessmen had to improve in political sophistication and techniques in Washington or else face political impotence.”17

In March 1972, Frederick Borch of General Electric and John D. Harper of Alcoa convened about a dozen corporate CEOs as “the March Group” to involve themselves directly in lobbying and influencing. The result was the Business Roundtable, a disciplined, sophisticated, and effective political fighting machine. Its success is attributable to the prestige and personal effort of the initial leaders: Harper, Irving Shapiro of Dupont, Reg Jones of GE, GM’s Thomas Murphy, Exxon’s Clifton Garvin, and, more recently, GM’s Roger Smith and Union Pacific’s Drew Lewis.

The Roundtable’s direction comes from its executive and policy committees. The organization has three unique characteristics. First, the CEOs are personally involved. Second, membership is limited to CEOs of large companies; there are no small or medium-sized businesses whose interests and priorities might be differentor inconvenient. Third, the organization carefully avoids involving itself with a single company or a single-interest pressure group. The Roundtable speaks for “big business,” and it does so through its task forces. Typically, a subject for special attention will be selected and then a “lead company” designated. Usually its CEO directs the task force, supplying the critical personnel from his or her own corporation or using people made available by other corporations. The Roundtable itself stays relatively small and discrete.

“Unable to persuade Congress to pass legislation curbing hostile takeovers,”18 the Roundtable has devised an ambitious strategy to protect its members, including the devotion of substantial attention and energy to questions of internal corporate governance as a way of allowing what is, in essence, a hostile takeover from the inside. Although a great deal of the Roundtable’s energy has been devoted to opposition to federal authority over corporate governance and support for state antitakeover legislation, one of its initiatives is noteworthy here: the recent drastic revisions of the Roundtable’s own well-researched and thoughtful 1978 Statement on Corporate Governance.

The Roundtable on Governance, 1978 and 1990

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There is no clearer indication of the Roundtable’s views on corporate governance than in its own reports on the subject. In its brief existence, the Roundtable has profoundly changed its views, as revealed by a comparison of its papers issued in 1978 and 1990.

In January 1978, the Business Roundtable issued a statement entitled The Role and Composition of the Board of Directors of the Large Publicly Owned Corporation. The paper was the culmination of a project responding to a pattern of corporate criminal behavior involving illegal campaign contributions, bribery, and illicit involvement in the elections of other countries. The CEO members of the Roundtable evaluated the way in which boards of directors of business corporations are selected, constituted, and function, in order to understand and to avoid further criminal behavior.

A distinguished scholars group was chaired by Dean David S. Ruder of Northwestern University School of Law (who later became chairman of the SEC during the last part of the Reagan administration). He reported to the Roundtable’s Committee on Corporate Organization Policy, chaired by J. Paul Austin (CEO of the Coca-Cola Company).

Their report was the state-of-the-art explanation in 1978 for the legitimacy of private power. It relies heavily on accountability as the safeguard from criminal and other activity that is contrary to the interests of society. The report describes the constraints on corporate action that are traditionally used to support its legitimacy. All of the limits listed in the report were more myth than reality, and more often breached by corporate management than observed. However, the most noteworthy one concerned accountability to boards and shareholders, because as that myth began to become reality in the 1980s, the Roundtable reversed its position. The 1990 version had the pomp of the earlier version, without the circumstanceno blue-ribbon panel of academics was brought in this time.

The 1978 report specified the accountability imposed by economic constraintsinadequate response to competition, both domestic and foreignand raised the prospect of lower share prices, higher cost of capital, vulnerability to takeover, and diminished personal job security. It also cited accountability imposed by the formidable array of legal and regulatory requirements to which corporate management is subject: “Moreover, we have witnessed in recent years an increasing rigor on the part of state courts in applying fiduciary standards to evaluate behavior of corporate management. Contrary to some misconceptions, sanctions for management misconduct are in fact imposed and constitute an impressive system of deterrence.”19

The Roundtable in 1978 was acutely conscious of the necessity of an independent board of directors. In order to have meaningful independence, the report recognized that it might be necessary to give shareholders an explicit right to nominate directors.

The BoardCEO Relationship

[T]he relation between board and the chief executive officer should be challenging yet supportive and positive. It should be arm’s length but not adversary. The Board should stimulate management to perform at the peak of its capacity not by carping, but by setting high standards and providing level headed encouragement.

Source: The Business Roundtable, The Role and Composition of the Board of Directors of the Large Publicly Owned Corporation (available from The Business Roundtable, 200 Park Ave., New York, NY 10166), 1978, p. 22.

This may be the best definition of the role of a board of directors: “The board of directors then is located at two critical corporate interfacesthe interface between the owners of the enterprise and its management, and the interface between the corporation and the larger society. The directors are stewardsstewards of the owners’ interest in the enterprise and stewards also of the owners’ legal and ethical obligations to other groups affected by corporate activity.”20 If only the Roundtable had stuck with it.

The Roundtable Retreats: Corporate Governance in 1990

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The transformation of the issues of corporate governance in the 19~0s is reflected in the revisionist approach taken 12 years later in the Roundtable’s March 1990 report, called Corporate Governance and American Competitiveness. Its basic conclusion is that American business is doing just fine and does not need interference from anyone, especially shareholders. The Roundtable responded to the threat of government involvement in 1978 by emphasizing private accountability; it responded, 12 years later, to the threat of private accountability by emphasizing CEO supremacy.

Whereas the 1978 report contemplated a board of directors directly accountable to shareholders and constructively capable of independent evaluation and monitoring of management, the 1990 statement’s version is closer to a structure of vertical authority, with the CEO on top and the board of directors one among several operating departments. The report contemplates the selection of directors who are acceptable to the CEO,21 who attend meetings presided over by the CEO, and who discuss agenda items selected by the CEO.22

As a practical matter, the board contemplated by the report is selfperpetuating; there is no more suggestion of shareholder involvement in nominations, even informally. And the essence of the report is that owners cannot be trusted and therefore should not be permitted to make the fundamental decisions concerning the corporation’s operations. “Shareholder voting on such things as acquisitions and divestitures can put immediate shareholder financial return ahead of sound longer-term growth which may have the potential of being even more rewarding to the corporation, its shareholders and its other stakeholders.”23

This begs the question. No one is in favor of an overly short-term outlook, but long term
may be a euphemism for something that never happens. The real question is whose perspective is riskier. Why aren’t shareholdersas those whose interest is at riskjust as knowledgeable and even more entitled than directors to set the overall direction of the company? Whose perspective is likely to be longer-termthe index fund24 pledged to hold the stock indefinitely or the CEO, who could lose his job in a change of control?

The critical question is on what basis directors and managers will make their choices. To the extent that directors have authority to allocate corporate resources on any basis other than long-term value enhancement, they are undermining the basis for the grant of power to private entities in a free society.

The 1990 Roundtable report, in all its essentials, is a wiring diagram for CEO monarchy. First, it cautions against direct shareholder involvement: “Excessive corporate governance by referendum in the proxy statement can also chill innovation and risk-taking.”25 Second, it diminishes the authority and independence of the board by depicting it as a necessarily self-perpetuating body (“Because effective corporate boards function as a cohesive whole, the directors are in the best position to recommend the slate of nominees for board membership which is presented to the shareholders for election at the annual meeting”26) and by implying that the chairman and presiding officer of the board must be the CEO (“To ensure continuing effective board operations, the CEO can periodically ask the directors for their evaluation of the general agenda items for board meetings and any suggestions they may have for improvement”27).

In the fall of 1990, the Business Roundtable further demonstrated its view of the role of shareholders by telling all of its members to refuse to respond to a survey of directors submitted by the California Public Employees’ Retirement System. The Roundtable responded as if merely asking questions of directors to determine their personal views was not appropriate: “Some of the questions do not lend themselves to broad generalizations because the answers depend on particular facts and circumstances, others require a more complex response than the questionnaire’s format allows, and still others suggest that directors’ responses will be used to create ‘good’ and ‘bad’ rankings for director nominees in spite of the disavowal of any such intent in the transmittal letter.”28 The letter itself provides the most telling evidence of the Roundtable’s vision of the role of shareholders, directors, and management: it assumes that when shareholders seek information about the directors they are asked to elect, managers have not only the right but the obligation to interfere.29

This is quite a departure from the earlier commitment to acting as stewards for owners. Indeed, other than a vague acknowledgment of the obligation to maximize value, shareholders are only mentioned in the context of either being incapable of providing direction or having their rights considered along with those of other “stakeholders.” This diminished role for shareholders is a startling retreat for the Roundtable. It also parallels the diminished role for the shareholders’ representatives, the board.

The Evolution of the Fiduciary Ideal: Above “the Morals of the Marketplace”

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It is worthwhile to contrast the current standards for fiduciaries with those established in early case law. In 1846, in a case called Michoud v. Girod,30 the court decided that it was improper and invalid for a fiduciary trustee to buy assets from the trust. Essentially, the court said that the trust was to be managed on behalf of the beneficial owner, and the trustee therefore could not participate in any transaction involving the trust assets, regardless of any special care taken to ensure that the purchase was at a fair price. The theory of those times was that the role of a fiduciary was so sensitive that it was better that the fiduciary forgo any kind of a transaction with the trust, to make scrupulously clear the superiority of the beneficiary’s interests over its own.

One of the most famous cases in American history is Meinhard v. Salmon,31 where the plaintiff and defendant were partners, “co-adventurers,” in reconstructing and operating a building. The plaintiff provided only capital; his partner, the defendant, also managed and operated the building. Four months before termination of the partners’ lease, the owner of the building approached the defendant, offering to lease it. The defendant did not notify his partner and instead arranged for the new lease to be made to a corporation he controlled.

In this classic interpretation of fiduciary obligation, Judge Benjamin N. Cardozo said, “The very fact that Salmon was in control with exclusive powers of direction charged him the more obviously with the duty of disclosure, since only through disclosure could opportunity be equalized. . . . He was a managing co-adventurer. For him and for those like him, the rule of undivided loyalty is relentless and supreme.”32 It wasn’t enough for the partner to behave in accordance with standard business practices; as a fiduciary, he had to do better, he had to be above “the morals of the marketplace.”

Cardozo even found that the partner’s fiduciary obligation continued, although the defendant could reasonably have believed that the partner-ship concluded at the end of the original lease and very likely acted in good faith.

The Fiduciary Code of Honor

Many forms of conduct permissible in a workaday world for those acting at arm’s length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.

Benjamin N. Cardozo

Source: Meinhard v Solomon, 249 NY 458, 464 (1928).

These cases and many others demonstrate the extraordinary conscientiousness, scrupulousness, and diligence traditionally imposed on those who owe each other a fiduciary duty. It was with this in mind that the original corporate structure was established. But, like Humpty Dumpty, who uses a word to mean whatever he wants it to mean, those who used the word fiduciary gave it an entirely different meaning in applying it to directors.

The Rise and Fall of the Duties of Care and Loyalty: The Morals of the Marketplace Are Good Enough

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Although the courts wanted directors to be fiduciaries, they did not want them to be hamstrung by worries that every decision would be reviewed in hindsight by a court, after the fact. So the business judgment rule was established, providing that a court will not second-guess the merits of a business decision. If it is a business decisionnot outside the scope of the appropriate conduct of the corporation’s affairsand undertaken with disinterestedness, due care, good faith, and without abuse of discretion,33 the court will not interfere.

The business judgment rule begins with the reasonable assumption that directors should not be judged in hindsight, so we should not ask that all of their decisions be the right ones. All even the strictest fiduciary standard asks is that decisions be undertaken with care, good faith, disinterestedness, and without abuse of discretion. As one court has said, “The entrepreneur’s function is to encounter risks and to confront uncertainty, and a reasoned decision at the time made may seem a wild hunch viewed years later against a background of perfect knowledge.”34 In essence, the business judgment rule provides that if any rational purpose exists for the directors’ or officers’ decisions, they are not liable for errors in judgment, even when the decisions turn out to be wrong.

The business judgment rule can be traced as far back as 1829.35 In that case, the court seems to have held that directors have no particular duty to try to find out if the company is being managed honorablyremarkably consistent with the claims made today by lawyers defending directors of failed banks and savings and loans. Although it goes pretty far, even by today’s standards, the reasoning in the decision reflects another set of agency costs, those created as the board sets overall policy and leaves it to management to carry out. The business judgment standard was refined over the next century and a half, and it has recently been more vigorously redefined, as courts have been forced to apply it to grapple with the more complex issues of corporate control.

In general, fiduciary duty has two components: the duty of care and the duty of loyalty. We will begin with the fiduciary duty of care. It contains two elements: alertness to potentially significant corporate problems and deliberative decision making on issues of fundamental corporate concern. The duty of care is generally interpreted as a “reasonable director standard.” In other words, we expect more from a director than from a simply “reasonable man”; we expect the director to behave reasonably according to the experience and expertise a director should have. We might not expect a reasonable man to be familiar with generally accepted accounting principles or earnings per share, but we do expect that of a director.

The Duty of Care

A director shall discharge his duties as a director, including his duties as a member of a committee:

  1. in good faith

  2. with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and

  3. in a manner he reasonably believes to be in the best interests of the corporation .

The Model Business Corporation Act [Sec. 8.30(a)]

Reasonableness varies according to the circumstances. A director who is a lawyer or an accountant is expected to bring his expertise to bear on the issues presented to the board and thus may be held to a higher standard than a director who does not have that training. Corporate officers who are also directors are sometimes held to an even stricter standard, because they know more about the day-to-day operations of the company. Similarly, directors of large companies are sometimes held to a stricter standard than directors of small companies, because directors of large companies are expected to be more familiar with complex corporate finance and governance issues.

There is no way to establish a clear standard for the duty of care; courts must examine the facts of each case. It is the duty of care that has been most troubling to corporations, and the one that has been cut back the most by judicial opinions (the business judgment rule) and state legislatures (limiting liability and permitting indemnification). If one examines the cases that apply fiduciary standards to boards of directors, it is difficult to connect them to the high principles of the decisions quoted previously.

In theory, the rule can be seen as another way of determining “reasonableness.” Reasonableness generally relates to process. What was the basis for the decision? What experts were consulted? What research was done? But in practice, many people believe that the courts (especially the most recent decisions of the Delaware courts) have used the business judgment rule to virtually eliminate any real duty of care.

The business judgment rule gives directors a rebuttable presumption of correctness, meaning that anyone challenging a business decision has the burden of proving that it violated fiduciary standards. The courts will go to the greatest possible lengths to defer to directors’ business judgment, unless there is a clear showing of fraud or bad faith.

A woman who “never made the slightest effort to discharge any of her responsibilities as a director” was found to have violated the duty of care in Francis v. United Jersey Bank.36 She had never attended a single board meeting or read any of the financial statements, which clearly revealed that her sons (corporate officers) were embezzling funds. In Hoye v. Meek,37 a president and CEO who stopped attending board meetings after he retired and moved away was found liable for over $1.4 million. But, as Woody Allen said, 80 percent of life is just showing up, and directors who do show up get a lot of deference.

In Shlensky v. Wrigley,38 a court upheld the decision not to install lights in Chicago’s Wrigley Field, despite the fact that lights for night games were the industry standard and that the decision resulted in loss of revenues from attendance, concessions, and broadcast rights.

The business judgment rule has even been applied in cases of clear shareholder opposition, as in American International Rent A Car v. Cross.39 It became clear at the annual meeting that the shareholders would not support a proposed bylaw amendment. The directors called a recess and adopted the amendment themselves. The court acknowledged that the board’s action “had the effect of withdrawing a vote from the stockholders,” but that alone did not “automatically override” the other factors (such as the need for additional capital) that the board considered in deciding to approve the amendment.

Courts do not always allow directors to thwart shareholder actions. Directors who try to change the rules on voting find that “in circumstances where corporate fiduciaries appear to have acted out of self-interest, it is particularly appropriate to give scrutiny to the question whether they discharged their duty of the exercise of care.”40

When Blasius Industries attempted to take over and restructure Atlas Corp. in 1987, it proposed a consent solicitation to put eight Blasius candidates on the board. Atlas expanded its board from seven to nine members, appointing two new members to the board to ward off the attempt. In Blasius Industries, Inc. v. Atlas Corp.,41 the plaintiffs charged that the action by the Atlas directors was “motivated solely by an attempt to retain control of the corporation and violated the directors’ duty of good faith.” The Delaware Chancery Court disagreed that self-interest was involved, stating that the Atlas board found the Blasius restructuring proposal faulty and that the bond’s action was “a good faith effort to protect its incumbency, not selfishly, but in order to thwart implementation of the recapitalization that it feared, reasonably, could cause great injury to the company.”42 The court did, however, refuse to defer to the business judgment of directors who interfered with the voting rights of shareholders, finding that “even though defendants here acted on their view of the corporation’s interest and not selfishly, their December 31 action constituted an offense to the relationship between corporate directors and shareholders.”43

The court also added that “the deferential business judgment rule does not apply to board acts taken for the primary purpose of interfering with a stockholder’s vote, even if taken advisedly and in good faith.”44 Although the plaintiffs lost their second suit, alleging that the consent election results were improperly computed, Blasius represents a milestone in defining board responsibility to the shareholders’ right to vote.

The business judgment rule does not protect directors if their “sole” or “primary” purpose is self-perpetuation. But that level of protection is not consistent. The takeover battles of the 1980s subjected a lot of defensive maneuvers to “business judgment” scrutiny, and at first the courts tried to limit its application when management’s interest might conflict with the shareholders’ interest. Later, as these decisions led corporate managers to consider changing to another state of incorporation, the courts quickly reversed this trend.45

The Corporate Miranda Warning

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In the landmark case Smith v. Van Gorkom, 46 directors were found to have violated their fiduciary duty over the sale of Trans Union. The CEO of Trans Union, Jerome William Van Gorkom, suggested to potential buyer Jay Pritzker that $55 per share (a substantial premium over the market) would be a good offer for his company, without consulting anyone on his board. When the board did meet to discuss the deal, Van Gorkom did not tell them that it was he who had suggested that figure to Pritzker, and he did not tell them how he had arrived at it. He did not ask the board whether it was the best price, just whether it was a fair price. After about two hours, the board approved the deal, subject to two conditions: First, the company could accept (but not solicit) another offer during a “market test” period, and second, to facilitate other offers, the company could share proprietary information with other potential bidders. Van Gorkom executed the merger agreement that evening, although the court found that at the time the agreement was executed neither Van Gorkom nor any other director had read it.47 Trans Union issued a press release announcing a “definitive” merger agreement, “subject to approval by stockholders.”

The shareholders did approve the deal. The lower court upheld the actions of the directors, but the Delaware Supreme Court reversed, finding the Trans Union directors “grossly negligent” in failing to inform themselves whether Van Gorkom did a complete job of evaluating the price and negotiating the terms of the merger agreement, and in failing to understand the transaction themselves. The issue was not the substance of the decision; the court never said whether $55 per share was too low or too high. But the court did find that the directors had not taken adequate steps to evaluate it. The substantial premium over the market price, the “market test” period for entertaining other offers, the fact that investment bankers had unsuccessfully tried to get other offers before Van Gorkum approached the Pritzkers, the advice of counsel that they might be violating their duty as fiduciaries if they failed to approve the merger, and the approval of the shareholders were not sufficient to make up for the board’s failure to evaluate the deal independently. This was a close case. Although it was not an easy case to decide – two justices dissented, finding the directors’ actions reasonable – Van Gorkom became the litmus test for directors’ duty.

The primary impact of the Van Gorkom case has been on the process for arriving at decisions, not on the substance of the decisions themselves. Courts have been very careful not to substitute their business judgment for that of boards. The result is a kind of corporate Miranda warning. However, the warning has little meaning, with routine checklists considered just to make a strong record for the court, rather than for any substantive purpose. And sometimes the record does not even need to be very strong, as in the Time-Warner case, where all the steps taken to establish due care and deliberation were taken in consideration of a deal that was different in every major respect (except management compensation) from the deal that went through.

In the Unocal case,48 the court said that the “omnipresent specter” that a board would act to protect its own interests when faced with a takeover offer, would subject those actions to special scrutiny.

Directors have to show “good faith and reasonable investigation” before they can be protected by the business judgment rule. They also have to show that, unlike the actions of the Trans Union directors, their decisions were “informed.” The decisions must also meet another test: They must be “reasonable in relation to the threat posed.”49 Directors are not supposed to use an atom bomb to fight a squirt gun; if they do, it has to be assumed that their primary interest is their own job security.

When Revlon adopted a poison pill in reaction to Pantry Pride’s offer of $45 a share, that was “reasonable in relation to the threat posed.”50 When Pantry Pride increased its offer to $53, the defensive measures were no longer reasonable. At that point, according to the court, “it became apparent to all that the break-up of the company was inevitable” and “the directors’ role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company.”51 Granting favorable treatment to a white knight whose offer was only $1 per share more than Pantry Pride’s was wrong. “[T]he directors cannot fulfill their enhanced Unocal duties by playing favorites with the contending factions. Market forces must be allowed to operate freely to bring the target’s shareholders the best price available for their equity.”52

Most of these cases have been decided by the Delaware courts because most big companies are incorporated there. Some other courts have addressed the business judgment rule, holding, for example, that issuing a block of stock to an ESOP and a wholly controlled subsidiary, just to avoid a takeover, violates the duty of loyalty.53 But, in general, Delaware has a lock on the Fortune 500, and when it seemed that decisions limiting the protection of the business judgment rule might lead companies to incorporate elsewhere, the Delaware courts began to back off.

Did We Say Marketplace? The Death of the Duty of Care

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The first relaxation of a director’s duties as defined by Revlon, Unocal, and Moran came in 1989 with Barkan v. Amsted Industries.54 In that case, the purchase of a block of stock by an investor led management to consider defensive actions. It adopted a poison pill and then decided that its best alternative was a management-led leveraged buyout involving an ESOP. After creating the ESOP, it convened a special committee. The court found that “although the Special Committee was given the power to evaluate the fairness of any acquisition proposal made by a third party, the Committee was instructed not to engage in an active search for alternatives to an MBO.”55 The company then terminated its pension funds, except those covering employees subject to collective bargaining agreements, so that it could use the $75 million surplus. The ESOP trustees and members of senior management then submitted an MBO proposal, which was challenged in four separate lawsuits. After some negotiation, the board accepted the MBO offer, which was later revised upward in settlement negotiations. The court found that “although difficult questions were raised by the course of events leading to the settlement, the settlement was fundamentally fair.”56

Amsted attempted to define a director’s duty of care in an auction involving only one bidder. But just because someone puts a price on a company does not mean that is the best price. How and to what extent must directors pursue the best price in the absence of other bidders? Since no bidder wants a company to be free to pursue other bids, a fundamental conflict will arise between the acquirerwho wants to close the deal as quickly as possible, and the target, whose fiduciary duties require it to take the highest bid over a certain period of time. Thus, an acquirer will attempt to engage the target in a “no shop” clause, preventing the directors from actively seeking other bids.

The rulings in Van Gorkom and Revlon implied that, in the absence of information to judge the adequacy of the offer, the directors should shop before accepting the first bid. Amsted allowed directors to use a “market check” or “window shopping” clause, in which a board accepts an offer but retains the right to passively receive other bids and provide information to other bidders. The court ruled that “Revlon does not demand that every change in the control of a Delaware corporation be preceded by a heated bidding contest…. When, however, the directors possess a body of reliable evidence with which to evaluate the fairness of a transaction, they may approve that transaction without conducting an active survey of the market.”57 Amsted allowed directors to accept an initial bid without actively “shopping” and without triggering an auction, because the Chancellor found that “the investment community had been aware that Amsted was a likely target,” and yet no bids had been made.58 While the court raised concerns about the “no-shop” restriction on the special committee, because it “gives rise to the inference that the board seeks to forestall competing bids” and it suggests that “a judicious market survey might have been desirable, since it would have made it clear beyond question that the board was acting to protect the shareholders’ interests,” these concerns were outweighed by other indicators (“timing, publicity, tax advantages, and Amsted’s declining performance”) of good faith.59 Practical on the surface, this ruling nonetheless permitted Amsted directors to accept an offer quickly and quietly, inviting conflicts of interest between executives and shareholders.

The Ravages of Time

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The Time-Warner case represents probably the greatest incursion in U.S. business history into the rights of shareholders. The Delaware Supreme Court allowed the directors of Time to completely redesign its proposed business combination with Warner, just to keep the decision away from the shareholders.

Time and Warner originally negotiated a stock-for-stock merger in which the shareholders of Time would have the chance to vote whether to exchange their Time shares for new pieces of paper worth approximately $125 per share. Paramount entered the situation with a cash bid of $175 per Time share, later raised to $200. Time and Warner, concerned that shareholders would not support their merger, revised their deal to no longer require shareholder approval. The revision also meant that the new companyand its shareholderswould have an enormous debt burden, at least $7 billion of new debt, and possibly more than $10 billion. Reported earnings were essentially eliminated, because $9 billion of goodwill had to be amortized.

What this means is that Time’s management (1) devised and began to put into place a plan that was at least $50-$75 per share below the market’s valuation of the stock, (2) refused to meet with Paramount to discuss its offer, and (3) completely restructured the deal, in a matter of days, along lines considered and rejected in favor of the original merger, to prevent shareholder involvement. They demonstrated their utter disregard for the rights of shareholders even further by establishing the line of succession for managing and directing the company, a decision that is supposed to be made by future boards of directors elected by shareholders. All of this was permitted by the Delaware Supreme Court’s decision.

In that decision, the court examined the history of the Time-Warner merger as initially proposed and concluded that because it had been under discussion for more than two years, it was proper to proceed with it, even as radically revised in a very short time, and even in the face of a legitimate alternative. This approach is consistent in process but not in substance with the Van Gorkom case and the factors that the Delaware courts consider in other cases in evaluating maneuvers that may be characterized as defensive. It is appropriate to consider the motives of directors to determine whether such actions are taken in good faith and therefore deserve the broad protection of the business judgment rule. But it is not appropriate to give weight to an action just because it has been considered for a long time. First, this does not address the obligation to respond to something like the Paramount offer, which could not be predicted. Second, it creates a very perverse incentive for boards to have their lawyers simply read aloud a list of every possible defensive action and every possible business combination at each board meeting, just to make sure that it is on the record as having been considered, but leaving entirely open the question of whether that consideration has been at all meaningful.

The Paramount v. Time case presents a clear question. The court put it this way: “Did Time’s board, having developed a strategic plan of global expansion to be launched through a business combination with Warner, come under a fiduciary duty to jettison its plan and put the corporation’s future in the hands of its shareholders?”60 The Delaware courts answered no, a result that must be viewed against an offering price of $200 in cash versus a price on August 23, 1990, little more than a year later, of $767/s. When I asked Michael Dingman, an outside director of Time, Inc., whether he thought there was a problem in giving managers such broad discretion in a deal where their own compensation played such an important role, he was characteristically direct: “To put it bluntly, I believe that the directors of Time did an extraordinary job of preventing the shareholders from getting screwed.”

Monks-Dingman Exchange on Time-Warner

Original Letter, 21 July 1989

Dear (Time Shareholders):

Delaware’s Chancellor William Allen, in his decision to permit the merger of Time and Warner, has not just missed the forest for the trees; he has missed the forest for the bark.

As the Delaware Supreme Court prepares to hear oral argument in the challenge to the Time decision he issued last Friday, we wanted to let you know how we see the issues. We believe that Chancellor Allen missed the central issue, which is this: Can we justify a transaction that presents directors with a conflict of interest, by protecting their employment and compensation, but denies shareholders the opportunity to express their views?

As you know, Time and Warner negotiated a stock-for-stock merger in which the shareholders of Time would end up with new pieces of paper worth approximately $125 per share. Paramount entered the situation with a cash bid of $175 per Time share, later raised to $200. Time and Warner, concerned that shareholders would not support their merger, revised their deal so that it would no longer require shareholder approval. The revision also meant that the new companyand its shareholderswould have an enormous debt burden, at least $7 billion of new debt and possibly more than $10 billion. Reported earnings will be essentially eliminated, because $9 billion of goodwill will have to be amortized. The equity deal was based on both industrial and financial logic. The debt was justified by the same industrial logic, but there was no longer any financial justification for the deal.

What this means is that Time’s management (1) devised and began to put into place a plan that was at least $50-75 per share under the market’s evaluation of the stock, (2) refused to meet with Paramount to discuss its offer, and (3) completely restructured the deal, along lines considered and rejected in favor of the original merger, to prevent shareholder involvement. Their utter disregard for the rights of shareholders was demonstrated even further by the line of succession they locked in for directing the company. This is one of the most important rights reserved to shareholders. All of this was permitted by Chancellor Allen’s decision. He also concluded that because the merger had been under discussion for more than two years, it was proper to proceed with it. But the deal he allowed to go forward was not the one they designed during that period of deliberation; it was one they rejected and then put together quickly to obstruct Paramount. Furthermore, the original deal was developed without reference to Paramount’s offer. At the very least, that offer should have forced the board to determine why it was so much higher than the share value realized in their merger. Chancellor Allen said, in one of a series of double negatives, “I am not persuaded that there may not be instances in which the law might recognize as valid a perceived threat to a ‘corporate culture’ that is shown to be palpable (for a lack of a better word), distinctive, and advantageous.” The facts suggest that it was not the “corporate culture” that Time management was planning to preserve but the extremely favorable employment and compensation schemes they had negotiated with Warner. Chancellor Allen notes that the “Time culture” issue was of concern in setting the compensation for Time executives, but that this was resolved by paying them at a higher level, though still on the same basis, rather than revising it along the formula used at Warner.

The Time board has not fulfilled its critical role in coordinating the restructuring in an objective, independent manner, for the benefit of those to whom it owes the most scrupulous fiduciary duty, the shareholders. The court has not objected. The issue is the same one as that presented by management buyouts, a question of conflict of interests. The “Revlon mode” should be triggered whenever such a conflict arises, because that is the key issue, not some formal notion of whether the company is “for sale.” At that point, the board must step back and preside over an orderly evaluation of all alternatives to decide which will provide the best long-term return for the shareholders.

When directors, due to the impact various alternatives will have on their compensation and employment, have a conflict of interest that prevents their fulfilling their obligation as fiduciaries to protect the interests of the shareholders, then the decision should be made by the shareholders. That is the critical issue ignored by the court. We hope that the Supreme Court will reverse this decision. If not, shareholders have the choice of seeking legislative change, either in Delaware or at the federal level, or using their ownership rights to reincorporate the companies they hold in states with more respect for the interests of shareholders.

We will continue to keep you posted. In the meantime, if you have any comments or questions, please do not hesitate to call.

R. A. G. Monks

Dingman’s Reply, 15 August 1989

Dear Bob,

Your letter of July 21st has been brought to my attention.

As you know, when it comes to shareholder value, I’ve believed, espoused, and supported many of the same things as you. In fact, in cases like Santa Fe, I’ve earned a reputation as an opponent of poison pills and entrenched management. But with the Time-Warner merger, we part company. In the main, I find your opinions to be ill-informed and off-target.

Paramount’s highly conditional offer of $175 or $200 per share was not only ludicrously low but transparently cynical. In making it, Mr. Davis (Chairman and CEO of Paramount Communications Inc.) had two motives. The first was tactical. He wanted to sabotage Time Inc.’s carefully considered merger with Warner and thereby destroy or weaken a competitor that would dwarf his own newly created media/entertainment company. The second was opportunistic. If his public relations campaign succeeded, Mr. Davis saw a chance to panic the board into letting him pick up Time Inc. for a song.

He wasn’t that lucky. Unlike the role played by Paramount’s board in ratifying the tender offer to Time Inc., we weren’t about to rubber-stamp a managerial fait accompli. That’s not the way the Time board works. We had been looking at the merger with Warner for over two years and had considered the long-range payoff for shareholders, as well as the strategic and financial implications.

In the media coverage surrounding Paramount’s tender offer, it was the universal consensus that the Time board was composed of eight outside directors with reputations as hard-nosed individualists, men and women equally unwilling to do the bidding of either Time Inc.’s management or Mr. Davis. In this, at least, the media were on the money.

As a participant in the board’s deliberations, I was a witness to the demanding independence of the other seven outside directors. They lived up to their reputations as mavericks, asking all the tough questions and looking without sentiment or illusion at the offers on the table. In the end, all of us, without a single dissent, voted to proceed with the Time-Warner deal.

I have no regrets about that decision. None. We’ve created the strongest and potentially most profitable media/entertainment company in the world. And if Mr. Davis succeeded in changing the terms of the original deal, nothing he said or did changed its rationale. It remains an extraordinary opportunity to improve dramatically the value of Time Inc. stock.

Frankly, I find it more ridiculous than insulting for you to accuse me and the other outside directors of a “conflict of interest.” No onenot even Paramount’s lawyersraised this as an issue. In fact, if you really think I’m worried about my “employment” (sic) as a Time director or depend in any way on the compensation it entails, then you are probably beyond the reach of rational argument.

The ultimate outcome of the Time-Warner situation will be decided in the near future as the managements come together to build what they set out to. Despite whatever speculative losses some investors may have incurred in betting on Paramount’s bid, I do hope you and others try to make an honest appraisal of the values represented by this new company.

There’s no question in my mind that the eventual outcome will resemble what happened at Disney after Saul Steinberg was paid his greenmail of $19.25 per share. Michael Eisner and his management team left the employ of Martin Davis and Paramount and brought a whole new energy and direction to Disney. At some point you may wish to examine for yourself why Eisner and other creative managers left Paramount, but this much is already certain: They have revived the company’s fortunes. Disney stock is now selling at $120 per share.

Dick Munro, Steve Ross, and Nick Nicholas have proven records of attracting and holding the best talent in the media/entertainment business. They have shown that they can create substantial value for shareholders, and now that the fight with Paramount is over, they will make an immense success out of their new venture.

I don’t mean to oversimplify all the issues that surrounded the Time Warner deal. It was a complex transaction that required some very tough judgments. And, in my opinion, the press did such a miserable job of covering the facts and issues involved that I can’t really blame you and your colleaguesnever mind the ordinary shareholderfor being confused.

To put it bluntly, I believe the directors of Time did an extraordinary job of preventing the shareholders from getting screwed. And except for a few major shareholders like Capital Researchwho understood the real values at stake and stood by their beliefsthey did it alone.

I look forward to seeing you in the future and discussing this at greater length. In the meantime, I felt it necessary to express my personal opinion concerning your previous letters.


Mike Dingman

Monks’ Reply, 23 August 1989

Dear Mike,

I very much appreciate your thoughtful response of August 15, to my letter about the Time-Warner decision issued by Chancellor Allen, and since then upheld by the Delaware Supreme Court. Although you described my “opinions to be ill-informed and off target,” I think we agree more than we disagree. I can support many of the points you made, and still think that the courts (and the board of Time) were wrong to disregard the rights of the shareholders. And I suspect that both of our positions lead to the same ultimate diagnosis, even the same solution.

I agree with you that the directors of corporations should have the power to consummate mergers; however this must be done in a way that recognizes the clear conflicts of interest that exist for top management in such situations. Even though it imposes an additional burden on the “outside” director, I see no alternative to their taking over the merger process, much in the same way and for the same reason that they have been required by this same Delaware court to take over the “auction” process, as in RJR and Macmillan. The chief advantage of outside directors is that they can bring some objectivity and discipline to the process. (I agree with your characterization of the Time Board. Indeed, I have frequently cited your involvement as conclusive evidence that the problem is systemic and not personal.)

Here is where I think we disagree. To my way of thinking there is a world of difference between “outside” and “inside” directors. The Time Board apparently chose to conduct the merger (acquisition) negotiations without limiting the participation of the “inside” directors. That the “outside” acquiesced in and supported direction of the transactions by “insiders”and not that I am “beyond the reach of rational argument”is why I refer to a conflict of interest by the Board.

Corporate reorganizations ultimately devolve into a question of who gets how much. There is no objective standardno Mosaic decalogue that proscribes how much to shareholders, how much to management and how much to other corporate constituencies the total consideration should be allocated. When, as I am sure you will agree was the case with Time, the consideration to be paid the principal executives is not immaterial, isn’t it better practice to limit their role in leading the negotiations? Should anybody be in the position of being the ultimate arbiter of his or her own entitlement? Should those with the largest personal stake continue to select and direct the professional advisers and thus the information reaching the Board? I think of the transaction as one in which the top management took the top dollar for itself, whether or not it was in the long term best interest of the company and the shareholders as parties whose interest is far more genuinely long term than that of the people who put this transaction together.

Let’s look at the transaction for a moment. It is ironic that the original proposal required shareholder approval, under the rules of the New York Stock Exchange, while the revised plan, far worse from the shareholders’ perspective because of the debt burden, did not. Time was easily able to take the choice away from the shareholders, by redesigning the deal to make it much worse for them, and the shareholders did not have any way to get it back.

The court gave great deference to the fact that the merger with Warner was negotiated over a period of two years. However, the business combination that was actually executed was put together in days, in response to the Paramount offer, on terms that were explicitly considered and rejected during that two-year period of deliberation, terms that left the company with a gigantic burden of debt. The fact that the record showed compensation and succession of the top management to be the most contentious issues (apparently the only contentious issues) did not suggest to the court that perhaps self-interest might have been the primary factor in setting the terms of the merger. It does suggest it to me.

You could very well be right that the merger between Time and Warner makes more sense than a merger between Time and Paramount. The question is who makes that decision. You suggest that it should not be shareholders, because they are uninformed and only look to the short term. I suggest that it should not be top management, acting without meaningful accountability, because they have a fundamental conflict of interest. I have the same problem with MBOs. There simply cannot be a level playing field when one party has all of the resources and all of the information. In this case, Time’s management also had all of the power.

I do not think that institutional shareholders are irretrievably short term in their orientation. If they take short term gains, they then have to find another place to invest them, and that is a real problem. Furthermore, most institutions have highly diversified portfolios, with major investments in thousands of companies. Many of our clients were investors not only in Time, but also in Warner and Paramount, not only in stocks, but also in bonds. They must look to the net impact of any proposed transaction, as fiduciaries and as prudent investors. This militates against a short-term orientation.

I agree that the institutional shareholders have a way to go before they can persuade those, like you, who are convinced that they look no further than the quarterly returns. In this regard, it is important to note the escalating portion of institutional investments today are de facto
or de jure indexed. Over the last few years, the index funds have performed better than the managed funds, which makes them hard for any “prudent and diligent” asset manager to ignore. Earlier in the year before the Markey subcommittee, I recommended that indexed investments be deemed, per se, prudent under ERISA. It is essential to take some step to encourage (possibly, even, to ensure) that the largest class of institutional investor one for whom liquidity serves no private or public objectiveto be a genuine “long term” holder and source of “patient capital,” and, therefore, begin to function as a permanent shareholder. I recognize that a gap exists today between my desired world of a solid core of long-term institutional shareholders and the arbitrageur driven world of contemporary takeovers.

If the arbs were the only institutions, I would find it difficult to argue that a governance system be organized for their benefit; on the other hand, I see no reason to disqualify ownership as the fundamental object of governance just because arbs are involved. No one has suggested that newly elected CEOs have any less authority because of the brevity of their tenure, nor are directors required to serve an apprenticeship period.

I suggest that to the extent that the institutions have a short term orientation, it is in large part attributable to the failure of the governance system. If you were an investment manager with a large holding in Time, your alternatives would be quite limited, even under the terms of the original deal with Warner. But if you had a real voice, a real relationship with management based on real accountability, to give you confidence in the long term, there would be no incentive to go for a short term gain.

Under the current system, managers and boards and shareholders face real impediments to making the best long term decisions on these issues. But the obstacles to shareholders can be removed, while the essential conflicts presented to managers and boards will always be there. As Professor Roberta Romano has noted, “we focus on enhancing shareholder value because when looking at a corporation, it is difficult to conceive of who else’s interests would be appropriate for determining the efficient allocation of resources in the economy.” That is why it makes more sense to entrust these decisions to shareholders than to the people whose employment and income is at stake.

I am not at all convinced that the Delaware Courts consider these issues fairly. (You and I have been in agreement on this point in times past!) I am certain that the “Delaware interest” factor played an important role in the Time decision, as it did in Polaroid and many others. Delaware risks losing its title as champion of the race to the bottom. The Pillsbury and Macmillan decisions led to Marty Lipton’s call to reincorporate elsewhere, and the Supreme Court’s CTS decision gave the domicile states’ authority a boost. Pennsylvania and other states are moving quickly to pass laws even more accommodating than Delaware’s, with the “stakeholder” laws being the latest fad.* I testified before the Delaware state legislature, arguing against adoption of the antitakeover law, along with every other shareholder representative. When the parade of CEOs came in, saying that they sure would hate to have to reincorporate elsewhere, it was no contest.

In order to protect Delaware’s economic interest in accommodating the Fortune 500, the courts have created a special language of takeovers that has no base in law or economics, and they make that language go through all kinds of acrobatics to make precedent appear to apply. This gives us the “Revlon” and “Unocal” modes. And it gives us the contortions that Chancellor Allen went through to keep Time out of those modes.

Another element of Delaware’s special language is the “business judgment” rule. Certainly, managements need and deserve the widest indulgence of courts in deferring to their “business judgment.” No one thinks that they should second-guess these decisions. But the courts should be there to make sure there is a process in place that promotes fair treatment or at least one that does not impede it. Shareholders deserve a level playing field, too. The original Time-Warner proposed transaction can and should be supported. This represents a determination by management that ownership values can be maximized within the framework of a merger company, virtually debt free, that can be the aggressive competitor in a multinational world. The Time management has made three judgments for its owners: (i) the business of Time can best be carried out in tandem with Warner; (ii) the merged businesses can best be conducted with a solid equity base, permitting capital investment and acquisitions on a global basis; and (iii) that this merger is the best way to bridge the “value gap” for Time shareholders. At this point, the Paramount offer gave some public indication of the exact size of the “value gap.” Paramount offered $200/share and was willing to offer more; Time management dismissed this as inadequate notwithstanding that the market valued common stock in its proposed merger at $120/share. Time then decided to buy Warner. While this preserved the face of the “business logic” of the merger, clearly a “debt encumbered” survivor is not going to be able to pursue the course of multinational aggressive dominance that was the apparent keystone of the original merger. Management thus has turned 180 degrees from an equity heavy company to one drowning in debt.

Should there not be some common sense limit to the extent of deference paid to “business judgment” when deference is paid both to a business strategy based on all equity and then it is paid again to a strategy based on all debt? Conceivably, one of these is correct. Both cannot be, and yet deference is paid to both. And, can the courts ignore arithmetic? How many years, and at what implicit rate of return, does a holder of Time common have to wait until his stock will achieve the levels that Paramount offered in 1989 in cash? Should there be any limit to this, or should deference extend indefinitely? Chancellor Allen conjures up only the most unsatisfactory “red herring” of limits based on fraud.

What is to be done? The Time-Warner decision represents a real failure of the system of governance. America cannot simply give over the assets and power of the private corporation system to managers who are not meaningfully accountable to anyone. I personally have little appetite for the federalization of corporate law, and yet I recognize that “Delaware interest” decisions like Time-Warner will tend to make federal preemption more appealing.

What I have been interested in for the past several years is fortuity of large fiduciary ownership. What seems to me to be a beginning point is to require that institutional owners act as such; that those with long term interests be required to be long term investors; that we stop regulating institutional fiduciaries in the interest of service providers and that we elevate the interests of the beneficiaries, who constitute an adequate proxy for the national interest.

Of one thing do I feel certain, had Michael Dingman been a large shareholder of Time, the transaction would not have been consummated without the meaningful involvement of owners.

I look forward very much to the opportunity to spend a few hours together to talk of this and so many other things of mutual interest.

With respect,

Your Friend,
R.A.G. Monks

* This is a standard to which one cannot he held accountable. He who is responsible to many is responsible to none. “We hope more states, especially Delaware, where so many major corporations are incorporated, will explicitly adopt broader constituency laws.” Jay W. Lorsch with Elizabeth MacIver, Pawns or Potentates. The Reality of America’s Corporate Boards, Harvard Business School Press, Boston, 1989, p. 187.

Dingman’s Reply, 31 August 1989

Dear Bob,

Thank you for your letter of August 23, 1989. If we keep this up, we’ll be able to publish a bookThe Monks-Dingman Correspondence!

You’re right. We agree on more than we disagree. But not on everything. For example, you believe that once a corporate merger comes under consideration, management and the inside directors should at some point turn the process over to the outside directors. (In your words, “Even though it imposes an additional burden on the ‘outside’ director, I see no alternative to their taking over the merger process….”) Then, at some later pointagain unspecifiedthe outside directors should step aside and let the shareholders decide.

I believe this would turn corporate governance into a muddle. More to the point, it has little bearing on the case of the Time-Warner merger. The outside directors were in charge. Every step was reviewed and approved by us, and we weren’t the empty vessels you seem to believe we were, filled with whatever ideas and information management cared to pour in our ears. We challenged management every step of the way. We asked the kind of questions that we would ask of our own employees, and we didn’t settle for stock answers. In the end, we agreed that the merger was a magnificent opportunity that should be pursued.

You use the word “acquiesce,” i.e., “to accept quietly or passively.” We did a lot of things in the unfolding of the merger. Argued. Probed. Questioned. Inquired. Cross-examined. It went on and on until we were satisfied. But we never acquiesced.

One final thing. The central issue in the Time-Warner deal was neither debt nor compensation. Paramount would have loaded on more debt than Time’s acquisition of Warner, and provided a far less significant cash flow with which to service it. And Michael Eisner and Frank Wells were offered an extraordinary package by Disney, and they’ve proved themselves worth every dime. If Steve Ross can deliver the same return to Time-Warner that he has for Warner, a company he built from scratch, his compensation will be more than justified.

The board wanted to build Time Inc. so it could provide the very best return for shareholders. I think we did.

You raise a number of interesting points in your letter and, if I had the time, I’d like to look at them all. But I don’t. The reality of creating shareholder value doesn’t leave much space for dwelling on theories. Sometime in the future, when we can manage it, I look forward to sitting down and discussing the whole matter of Time-Warner, as well as its wider implications. I hope that we’ll both learn something.

There is one thing I am absolutely against and that is the federalization of corporations and/or the establishment of more government rules concerning how businesses, managements, shareholders, et al. interact. I hope we agree on this point as well, and please stay away from Mr. Metzenbaum.

Again, thank you for your thoughtful response to my letter.



A great deal of financial data was introduced to the court with various extrapolations of projected long-term value. It boils down to this: The Warner transaction valued Time stock at $125, and the Paramount offer was $200. It almost makes one feel the need to suspend disbelief to understand how an investor could not do better with $200 cash, which she would be free to invest in any venture of her choice, than with a $125 investment in Time-Warner, even with the most competent management ever known. How could any factfinder ignore the simple fact that starting with 60 percent more capital is virtually certain to make more money? What this suggests is that the case is not about money; the Delaware courts have devised a language to resolve disputes that does not include a vocabulary for maximizing owners’ value. What are owners left with after Time? Michael Klein, who argued as special counsel for Bass Brothers in this case, put it: “When the marketplace has put a 25-percent or 30-percent premium on one answer as opposed to another, why should the legal system be constructed so as to deny institutional and other shareholders the opportunity to accept that premium? What’s heinous about this case is the manipulation of the corporate machinery by the directors of Time to accomplish an avoidance of the shareholder franchise.61

In this case, as in Household, management deliberately structured the transaction to avoid having to seek shareholder approval. The issue here was not merely the difference between antitakeover provisions; it was the very essence of the transaction. Time conceived of the deal as providing a capital base that would give it the capacity to be an aggressive worldwide competitor. As the Supreme Court of Delaware found: “Time representatives lauded the lack of debt to the United States Senate and to the President of the United States. Public reaction to the announcement of the merger was positive. Time-Warner would be a media colossus with international scope.”62

Following Paramount’s initial $175 a share offer,

“[C]ertain Time directors expressed their concern that their stockholders would not comprehend the long-term benefits of the Warner merger. Large quantities of Time shares were held by institutional investors. The board feared that even though there appeared to be wide support of the Warner transaction, Paramount’s cash premium would be a tempting prospect to these investors. In mid-June, Time sought permission from the New York Stock Exchange to alter its rules and allow the Time-Warner merger to proceed without shareholder approval. Time did so at Warner’s insistence. The New York Stock Exchange rejected Time’s request. 63

Thereafter, “Time’s board decided to recast its consolidation with Warner into an outright cash and securities acquisition . . . to provide the funds required for its outright acquisition of Warner, Time would assume 7-10 billion dollars worth of debt, thus eliminating one of the principal
transaction-related benefits of the original merger agreement.”64 The decision utterly to alter the capital structure of the surviving company to heavy leverage was made in a matter of days and appeared to undercut the purported rationale of the entire transaction.

Furthermore, Time’s commitment to the merger with Warner was less than its commitment to making sure Ross had a fixed retirement date. Negotiations were broken off for several months, until Ross was induced “to reevaluate his position and to agree upon a date when he would step down as co-CEO.”65 The agreement reached was that Ross would retire five years after the merger and that Nicholas would then become the sole CEO of Time-Warner. (So much for the role of shareholders and the boards they elect in selecting management.) The decision found that “[o]ther aspects of the agreement came easily.”66 Despite the evidence about the importance of compensation and succession (these parts of the deal remained as the rest of it was completely restructured), somehow Chancellor Allen found that “there is no persuasive evidence that the board of Time has a corrupt or venal motivation in electing to continue with its long-term plan even in the face of the cost that course will no doubt entail for the company’s shareholders in the short term.”67 The concerns he referred to as “corporate culture” seemed to be focused only on compensation.

An enterprise and its equity securities are a function of two componentsthe businesses and their capitalization. There is an enormous difference between an equity-funded worldwide communications colossus and a debt-ridden venture. That the courts would base a decision on the long-standing plan respecting the businesses and ignore the quickly cobbled-together complete change with respect to capitalization means that Delaware courts will endorse any action of management, even if self-interested. “Finally, we note that although Time was required, as a result of Paramount’s hostile offer, to incur a heavy debt to finance its acquisition of Warner, that fact alone does not render the board’s decision unreasonable so long as the directors could reasonably perceive the debt load not to be so injurious to the corporation as to jeopardize its well being.”68 Rarely has the irrelevance of shareholder interest been so clearly articulated.

Why pretend that there is such a thing as shareholder rights? In the lower court decision, the chancellor stated, “I am not persuaded that there may not be instances in which the law might recognize as valid a perceived threat to a ‘corporate culture’ that is shown to be palpable (for lack of a better word), distinctive and advantageous.”69 Of course there is an instance in which the law recognizes the validity of a “corporate culture.” The instance is in the value that corporate culture provides to shareholders. Time shareholders want the company to be able to reap the benefits of its culture, whether alone or in a productive synergy with another company. But it is difficult for Time to claim that its culture and editorial independence could not have been preserved with Paramount, since they did not even meet with Paramount to discuss it.

Chancellor Allen was correct in saying, “Directors may operate on the theory that the stock market valuation is ‘wrong’ in some sense, without breaching faith with shareholders.”70 But they may only operate on that theory if they base it on fact. Let them demonstrate to the shareholders that they can do better. Without that, we abandon any pretense of a market test, in favor of “expert opinion” paid for by management, usually with a contingent “success factor.” Even Chancellor Allen was appalled at the company’s estimated valuation of $208-$402 for Time-Warner stock in 1993, calling it “a range that a Texan might feel at home on.”71 Are there any limits, short of explicit fraud or corruption, to the deference that the court will give to management’s determination of value? Is there any level to justify, even require, judicial intervention?

The obvious reluctance of courts to involve themselves in second-guessing management of enterprises is understandable, even justifiable. But the result denied owners both the right to vote on the merger of Time with Warner and the right to sell their shares to a willing buyer at a mutually agreeable price.

The Time board did not fulfill in an objective, independent manner its critical role of coordinating the restructuring for the benefit of those to whom it owes the most scrupulous fiduciary duty, the shareholders. The court did not object. As Michael Klein pointed out, the Time-Warner decision theoretically allows companies to “create a high threshold of risk, and then do everything deliberately to deprive shareholders of any alternative. The Time-Warner directors did not even need to confront, evaluate, or compare alternatives.”72 The “Revlon mode” (requiring directors to preside over an auction) should be triggered whenever a conflict of interests between shareholders and management arises, because that is the key issue, not some formal notion of whether the company is “for sale.” At that point, the board must step back and preside over an orderly evaluation of all alternatives to decide which will provide the best long-term return for the shareholders.

The Death of the Duty of Care, Part II: Limited Liability and Indemnification

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Cases like Van Gorkom triggered huge increases in insurance premiums for directors if, in fact, coverage was available. Increasingly, companies confronted an inability to purchase E&O (errors and omissions) insurance for fiduciaries at any price. To protect themselves, directors passed bylaw amendments limiting the amount for which they could be held liable. First, of course, state legislatures had to authorize such caps on liability. Delaware did so immediately after the Van Gorkom decision, and other states soon followed suit, in yet another example of state legislatures accommodating managers. A number of states have adopted very broad laws limiting the liability of directors, even for negligent acts. This effectively eliminates a duty of care. Nevada, New Jersey, and Virginia permit limitations on the monetary liability of officers, in addition to directors. New Mexico even allows limited liability for gross negligence. Some states allow the corporation to cover a director’s legal expenses, plus damages, even if the court finds that the director violated his duty. In states where indemnification provisions are overly broad, a significant problem arises since shareholders who challenge directors are in effect picking their own pockets. An unsuccessful defense by an indemnified director can lose the shareholders more through recovery and reimbursement than they had originally suffered in damages.

Did We Say Morals? What’s Wrong with These Pictures?

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In 1989, the board of Occidental Petroleum voted to spend $86 million of the corporation’s funds to build a museum for Dr. Armand Hammer’s art collection. Many people believed that this was an inappropriate use of the corporation’s assets, especially since only part of it was a deductible charitable contribution, and also since Dr. Hammer reneged on his commitment to donate the collection to the Los Angeles County Art Museum, considerably diminishing any goodwill from the construction of a museum at the corporate headquarters. But what was even more clearly an outrage was the lawsuit brought by “the usual suspects” of the Delaware bar. They tried to settle it quickly. The settlement would have provided no benefits for the shareholders, would have given the museum at least $96 million from the corporate treasury (more than the original allocation), and would have paid the attorneys $1.4 million for a few weeks of work.

This settlement would have gone through immediately but for the intervention of plaintiffs Alan Kahn, a money manager, and two public pension funds, the California Public Employees’ Retirement System and the Pennsylvania Public School Employees’ Retirement System. Kahn noted that the shareholders had now been abused twice, once by Occidental directors and once by the lawyers who were supposed to be representing the shareholders. The settlement was stalled, and discovery was allowed to go forward. Discovery produced many additional revelations, including the fact that some of the artwork in Dr. Hammer’s personal collection was paid for by the corporation and the fact that at least one of the members of the committee of “independent” directors who approved the museum expenditures had no understanding of the financial consequences of the deal. Nevertheless, the same lawyers came forward with the same settlement, only now for up to $120 million. This included payment of seven years’ worth of Dr. Hammer’s salary directly to the museum after his death, a sort of “coffin parachute.”

Despite the protests of many major shareholders, and the court’s finding that the benefits to shareholders were “meager,” the Delaware Chancery Court approved that settlement. Although the judge expressed strong reservations about its terms, he said that the likelihood that the museum expenditures would be approved under the business judgment rule made it impossible for him to do anything else. The judge took the unusual step of expressing his concerns about the outcome by cutting the attorney’s fees nearly in half. He also said that “If the Court was a stockholder of Occidental it might vote for new directors, if it was on the Board it might vote for new management and if it was a member of the Special Committee it might vote against the Museum project.”73 But he said that, because the expenditures would likely be upheld under the business judgment rule, the case had to be settled. The business judgment rule has now been extended so broadly that it can bar a trial on the merits, despite evidence that corporate funds were used for personal acquisitions. If a clerk did that, it would be called embezzlement. If Armand Hammer does it, it is business judgment.

This demonstrates shareholders’ utter helplessness under Delaware law in suits for breach of directors’ duty. A small group of lawyers, representing “shareholders” with token investments, file almost daily lawsuits, with complaints that are photocopies of yesterday’s suits against other companies, based on whatever is reported in the financial press. Then they settle, quickly, for small awards and high attorney’s fees.

The majority of shareholder lawsuits are brought by a small group of people, who hold a small group of shares, working with a small group of law firms, and the conclusions are generally favorable only to the lawyers. For example, in the recent settlement of a shareholder lawsuit against CBS, the plaintiff, who held 12 shares, received $15,000, or $1,250 per share. His attorneys got $1.5 million. CBS got about $4.5 million from its own insurer; we do not know whether that sum covered more than its expenses.

To make things worse, corporations sometimes welcome these suits because they can be settled quickly and cheaply, extinguishing the claims of all shareholders. Insurers push for settlement. According to a letter we received from CBS, “neither CBS nor the individual defendants participated in those (settlement) negotiations.” Buying off the “Delaware regulars” is a small price for directors to pay to protect themselves from a serious lawsuit. Even if they do not think so, their insurers do. One disadvantage of indemnifying directors is that decisions such as these are then made by the insurance companies.

In the Occidental case, even the protests of shareholders with millions of dollars invested in the company were not enough to stop an outrageous settlement. If the Delaware courts cannot find enough merit in a challenge to a $120 million expenditure for a personal monument that is a twentieth century equivalent to the pyramids to even allow it to go to trial, despite evidence of improper use of corporate funds, then Delaware does not deserve to be the jurisdiction for these challenges. Shareholders should insist that the companies they invest in incorporate in states that will give them a chance to challenge directors who violate the duties of care and loyalty.

The Death of the Duty of Loyalty

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Although “care” is vague and hard to define, loyalty is a concept that is simple to understand and enforce. Courts examining violation of this duty have occasionally held that a transaction undertaken by directors who have a conflict of interest is void, even if the corporation and shareholders are not harmed (for example, if the CEO buys equipment the company was planning to sell, and he pays a fair market price). More often, the court will let these transactions stand if there is no harm. The burden is on the party claiming a breach of the duty of loyalty to prove that there was a conflict of interest (in the preceding example, that the shareholders had an interest in getting the highest price for the equipment, and the CEO had an interest in buying it for the lowest price). Then the burden is on the director or officer to show that the transaction was fair (that he bought the equipment for the same price as it would have realized on the open market).

For example, Marriott Corporation decided to acquire some companies who were owners or lessees of real property leased or subleased to Marriott. The owners of these companies were members of the Marriott family. The payment (313,000 shares of Marriott stock) was established by independent appraisers, evaluated by independent analysts, unanimously approved by outside directors, and then approved again by the shareholders. The transaction was upheld by the court. That was appropriate. The evidence showed that the directors had the opportunity to use their advantage to profit at the expense of shareholders, but the directors showed that they took every possible step to assure scrupulous fairness. Therefore, the duty of loyalty was not breached.

Playing Both Sides: The MBO

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An MBO is a transaction where management sits on both sides of the table, on one side representing shareholders, on the other side representing itself. Management claims that they will run the company better when they are running it on their own behalf. But isn’t fiduciary duty supposed to make them run it better for shareholders than they would for themselves? And buying out the company does not necessarily mean that they will be running it on their own behalf. When Edward K. Finklestein took Macy’s private at $68 a share, he took a $9,755,280 profit on his stock options. Of that, he put $4,375,000 back in. He ended up with less of his own money in the company than he had before.

Management controls the timing and the information and then submits the deal to the board they have selected. The Macy’s board initially asked for $70 a share but backed down later to Finklestein’s proposal of $68, even though the stock had risen in the interim, and even though the company’s own projections showed that investments of several hundred million dollars were about to pay off. Macy’s had listed eight shopping malls as worth $100 million. Finklestein’s group valued them at $250 million. Three months after the buyout, he sold them for $555 million.74 Can anyone claim that it was his newly revived entrepreneurial spirit that gave him this idea only after the MBO? Can anyone claim that this money did not rightfully belong to the shareholders?

The MBO is practically the definition of a conflict of interest. As long as management is free to be involved as a principal in an MBO, it has an interest in the company having a low stock price. Management can make sure there is a gap between “real” and “market” value. If management’s participation in LBOs is to be justified by the increase in values attributable to its initiative, management has the strongest possible incentive to time its MBO when values are the lowest. What remains of the duty of loyalty when managers can buy companies from shareholders at just about any price above market? Management’s significant advantages make any effort to “shop” the company around to get a competitive price almost meaningless.

A classic example of unintended consequences (i.e., management’s use of its insider status to make money for individual managers rather than the company or the shareholders) can be traced back to Mary Wells in the early 1970s. Wells took her advertising companyWells, Rich, Greene, Inc.public in 1968 at $17.50 a share and sold a new offering in 1971 at $21.75. When she went private in 1974, the stock was at $5.50 in the aftermath of the 1973 recession. Shareholders got $3 cash per share and $8, 10-year debentures.75 The SEC, concerned with managers taking such blatant advantage of depressed stock prices, responded with Rule 13e. This rule, by explicitly prohibiting certain types of actions, gave legitimacy to all others, allowing fiduciaries to feel secure that, as long as they complied with 13e, they were being fair and just and were protected from charges of breach of their duty as fiduciaries. Rule 13e, instead of a warning, became a blueprint.

The result has been a string of abuses, with some particularly disturbing examples. Loral Corporation sold two of its divisions to its own CEO, Bernard L. Schwartz, despite a higher bid from an outside company, Banner Industries. Banner’s complaint in its lawsuit against Loral says that it first expressed interest when Loral acquired the two divisions in 1987; Banner was told that Loral did not want to sell them and that it would contact Banner if it ever decided to sell. When Banner read in the press that the divisions were being acquired by Loral’s CEO, it offered a higher bid. Banner says that it was denied access to the information about the divisions necessary for due diligence in submitting a formal bid, however, and was never permitted to meet with the special committee of the board convened to oversee the “auction” of the two divisions. Banner’s complaint also charges that it obtained additional information demonstrating that the two divisions are worth even more than it originally thought, and that would have supported even a higher bid. The CEO and the special committee were both aware of this information.

Schwartz has stayed on at Loral while he runs his two units, renamed K&F Industries. In addition to his $1.7 million salary from Loral, Schwartz and four Loral executives split $200,000 a month in “advisory” fees, for work Schwartz himself estimated takes him 10 hours a month.76

UAL: A Wolf in Wolf’s Clothing

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The UAL MBO attempt that failed in October 1989, prompting a minor stock market crash, in many ways perfected the breach of trust by taking the process to the next logical step: total protection of management and its team of lawyers and bankers. According to the National Review of Corporate Acquisitions, “The original unsuccessful transaction will long be remembered as a glaring case of overreaching greed and questionable judgment.”77 Management at UAL acted on its own behalf, at shareholder expense, on two fronts: management compensation and exorbitant legal and financing fees, both vital parts of the MBO plan to support management interests. Stephen Wolf, CEO of UAL, followed the example of Steve Ross at Warner and included in his MBO a healthy compensation package totaling $22.5 million in shares plus $54.176 million in unexercised stock options, fully protected in the event of a change in control.78 The new company that Wolf would head was designed to keep UAL out of play. Wolf and John Pope, CFO of UAL, stood to gain $114.3 million in a successful MBO, although UAL executives planned to reinvest only $15 million in the new company.79 Taking into consideration that all of these managers also have lavish golden parachutes, it becomes apparent that MBOs have become a vehicle for guaranteeing extraordinary rewards for management while protecting them from any risk.

Adding insult to injuryand adding further injury, tooit is the shareholders who must pay the bills of the lawyers and investment bankers hired to carry out the MBO, even if it is designed to benefit management at shareholder expense, and even if it fails. In the case of UAL, the bill was more than $50 million. Lazard Freres alone took over $8.25 million.

One Wall Street Journal journalist calculated that UAL was paying each Lazard Freres banker $41,045 per day. Citicorp and Chase received a combined $8 million; Salomon received about $8 million, plus an additional $3 million for a bridge loan commitment; the law firms involved on the deal took over $15 million; and $16 million went to repay a fund created for an ESOP.80 All this for a group that failed to raise the $6.79 billion necessary for the MBO to occur.

The UAL deal demonstrates how far you can stretch an unfair principle when no one is watching. The shareholders are taking the risk, even paying for management’s support teams, whether they win or lose.81 Case after case demonstrates that management is taking advantage of its insider status to keep legitimate bids from shareholders. The problem is that this advantage is inherent. There simply is no way to conduct an MBO in a manner that is fair to shareholders. Although Loral and UAL are good examples of the astonishing level of abuse possible in an MBO, it is important to keep in mind that even those MBOs conducted by responsible management, making every effort to ensure scrupulous fairness, are wrong because there simply is no process that will guarantee a level playing field when one of the parties controls the information and the agenda. Management cannot bargain with itself, representing both the shareholders and its own interests. The fiduciary responsibilities of a CEO are not compatible with entrepreneurial efforts to preserve or attain individual power through corporate assets. You can’t sit on both sides of the table.

This may, in fact, have contributed to the failure of the UAL deal. Some observers believe that the original financing failed because of management’s self-centered behavior. “The bankers [who turned down the UAL proposal] said that UAL’s management and advisers pushed too hard, trying to keep too much of the potential profit for themselves.”82 It may be that the bankers realized that a good CEO is one who is not an MBO artist.

Management does not even have to bear the risks of its offer, as outsiders usually doif it fails, let the shareholders pay for it. Management has a great deal to gain and literally nothing to lose. Shareholders, on the other hand, have a lot to losenot just an adequate price for their stock, but the loyalty of directors as well.

Clearly, an MBO is not a surefire way of enhancing revenues for the company and the shareholders when it (1) involves paying over $53 million to lawyers and financiers who actually fail to complete the MBO (as in UAL), (2) depresses a stock price so that management can realize a thousandfold profit on a public-private scheme (Wells, Rich, Greene, Inc.), or (3) keeps the company from selling at the best price in order to give it to the CEO (Loral).

There have been several MBOs where the value gap between what management paid and what they shortly realized was shocking. One such transaction was the privatization of Metromedia that made John Kluge the richest man in the United States. Writes Benjamin J. Stein, “The list of cases in which management has made millions, hundreds of millions, even billions from LBOs is sadly long. Metromedia. Burlington. Amsted. Narragansett Capital Corp. Triangle. Many, many others. (Triangle’s was a particularly brilliant LBO in which management did not have to put up any money.)”83 A “fairness opinion” that underestimates realized value by 80 percent is perhaps the newest candidate for the quintessential oxymoron.

The MBO at GAF

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Sam Heyman and GAF were different. The MBO at GAF is interesting because it demonstrates that good people with all of the right values, following all of the rules, can still face significant conflicts. Heyman, after graduating from Harvard Law School, worked for Robert Kennedy and served as an assistant U.S. attorney in Connecticut, then went on to a career as a real estate developer. Heyman became involved in the management of GAF the hard way. In 1983, with just 5 percent of the stock, he waged a bitter and successful proxy contest to elect his nominees to the board. The company flourished, making over $1.5 billion over the next five years. Two bold Heyman initiatives aloneefforts to acquire Union Carbide and Borg Warnerproduced over $350 million of profit.

There can be no question that Heyman’s energy and brilliance were the principal contributing factors to the realization of this incremental value for GAF shareholders. No one who invested in Heyman lost money; indeed, some made a very great deal. GAF made $1.5 billion in increased values for shareholders during Heyman’s tenure, and the stock price increased sevenfold. Harold Simmons, later to try to take over Lockheed, invested shortly after the proxy contest and sold before the privatization. Net profitin excess of $100 million. The capacity to create value of this magnitude raises the question: From Sam Heyman’s point of view, what sense does it make to channel his energy through a public company? Ultimately one has to ask: How much money does he have to make for other people before he can be allowed to take the company private?

It is clear from the public documents that the directors’ committee and their counsel made serious efforts to get more for the outside shareholders. Indeed, it is noteworthy that these individuals, all of whom came to GAF through Heyman’s proxy contest, struggled so tenaciously that conspicuously among all the MBO transactions, this one stands for the kind of arm’s length negotiation contemplated by the lawno less, but no more. Heyman conferred with directors in August 1987, stating his intention to take the company private and quoting a possible price as “north of $75 ,,84 When he announced his bid in September, however, it was $64.00 in cash, $2.50 in debt.85 At this point, the directors became wary. One director reflects: “I think we led him to believe that since we hadn’t raised much objection when he proposed it, when we went along with who he selected as the committee, when we went along with his choice of the law firm, in essence. . . it looked like a no brainer.”

But the directors at GAF came alive, and a lengthy battle for a fair price for GAF was waged over the next year. Heyman dropped his $66.50 bid before the market opened on October 19, 1987.86 That day the stock market crashed. When Heyman submitted a new bid on December 14, 1987, it was for $40.00 cash, $8.50 in debt.87 True, it reflected a premium over the current stock price of GAF, but the intrinsic value of the company had not changed, only people’s perception of it. Until the deal closed in March 1989, the board scrapped with Heyman, inching the price up to a final bid of $46.00 in cash, $7.00 in debt.88

Managers face conflicts of interest when taking the company private, both those who are and are not participating in the buyout. When the directors interviewed the managers, one who was not invited to participate told the board that, in his opinion, one of the divisions alone was worth Heyman’s bid, which at the time was in the low $50s. He charged that Heyman, in essence, was getting the other divisions at no cost. A similar situation occurred at RJR, when the head of the Nabisco division, John Greeniaus, was cut out of Ross Johnson’s MBO plan. Greeniaus went over to the rival bidders, Kohlberg, Kravis and Roberts (KKR), and gave them accurate figures on the RJR-Nabisco operations. KKR won the bidding war, and Greeniaus still heads Nabisco.89

At GAF, the board dealt with the inherent conflicts by spending 18 months trying to find another buyer. According to one source, they wanted to find another buyer, if only to confirm that there was no favoritism. Unable to find one, they concluded that Heyman’s offer was in the best interests of the shareholders.

After the GAF deal had closed, there was the issue of the dividend, which had come due. Heyman, who would own the company in a matter of weeks, did not want to pay it, but the outside directors felt it had to be paid. From Heyman’s perspective, the directors were talking about distributing his money. The directors disagreed, believing that the money was the shareholders’ until Heyman actually assumed control. The directors voted in favor of the dividend.

The GAF MBO demonstrates the conflicts that lie at the heart of an MBO. Sam Heyman is a brilliant manager with a gift for maximizing profit. The board of GAF was a group of capable, intelligent, and honest men. Yet the CEO and the board found themselves at loggerheads when the MBO process began, when suddenly the managers were no longer working solely for the interests of shareholders.

In an MBO, the CEO, on the inside, has the advantage. He decides the parameters of the MBO: when, where, and at what price. He retains control of the corporate information machine and pocketbook and hires the experts. The imbalance tilted in management’s direction is too great for even the most diligent and energetic efforts of independent directors to correct.

The Death of the Duty of Loyalty, Part II: Stakeholders

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A previously unheard-of doctrine, the stakeholder concept, has recently taken strong hold in corporate America. In essence, it says that corporate directors owe a duty to a host of constituencies beyond shareholders: local communities, employees, suppliers, creditors, and others. This is in contrast to the traditional model of the publicly held corporation in law and economics, which says that corporate directors serve one constituency their shareholders. As James J. Hanks, Jr. of Weinberg & Green said, it is “an idea whose time should never have come.”90

The stakeholder theory is now being applied in at least three different contexts: state antitakeover legislation, public pension fund investment policy, and corporate policies in responding to takeovers.

Traditionally, one of the most important aspects of the corporate form was the directors’ and officers’ absolute fiduciary duty of loyalty to the shareholders. As Louis Lowenstein, head of Columbia University’s Institutional Investor Project, has said, shareholders should come first, “Not because you like them or hold them in high esteem, but because if you don’t, there is no bottom line, no way to measure efficiency…. The system collapses if shareholder interests are not primary”91

In the past couple of years, a number of states have adopted “stakeholder laws” to permit a board of directors to consider the impact of any proposed action on its employees, customers, suppliers, creditors, and communities, plus any other factors it deems pertinent, in addition to the impact on shareholders. Typically, these statutes “apply generally to decisions by the Board, including decisions with regard to tender offers, mergers, consolidations and other forms of business combinations.”92 The early state laws of this kind make this provision available for adoption by corporations, with shareholder approval. And most of them make it clear that the board’s authority is completely discretionary, and no stakeholder constituency is entitled to be considered.

It has always been permissible, even required, for directors and managers to consider the interests of stakeholders, in the context of the interests of shareholders. Courts have upheld a corporation’s right to donate corporate funds to charities, for example, as it was in the corporation’s long-term interests. As the American Bar Association Committee on Corporate Laws pointed out, “[T]he Delaware courts have stated the prevailing corporate common law in this country: directors have fiduciary responsibilities to shareholders which, while allowing directors to give consideration to the interests of others, compel them to find some reasonable relationship to the long-term interests of shareholders.”93 The committee also noted that Unocal, which enabled directors to analyze the effects of a potential takeover on a variety of factors, including constituencies, does not suggest “that the court intended to authorize redress of an adverse impact on a non-shareholder constituency at the expense of shareholders.”94 Although it is useful (and cost-effective) to consider the best way to meet the admittedly competing needs of the company’s diverse constituencies, it is an oversight to fail to make clear that the shareholders must have first priority.

No court, no legislature, and no shareholder has ever claimed that the duty of loyalty prevented consideration of other constituencies. Indeed, directors who fail to consider the interests of customers, employees, suppliers, and the community fail in their duty to shareholders; a company that neglects those interests will surely decline. In the past, these proposals have been occasionally submitted by shareholders, who want the board to undertake a more comprehensive analysis of proposed actions. But “stakeholder” language, in legislation o~ in corporate charters, can be camouflage for neglect, whether intentional or unintentional, of the rights of shareholders.

The danger is in allowing corporate managers to make policy trade-offs. That should be left to those who have another kind of accountabilitythrough the political process.

F. A. Hayek posed the alternatives this way:

So long as the management has the one overriding duty of administering the resources under its control as trustees for the shareholders and for their benefit, its hands are largely tied; and it will have no arbitrary power to benefit this or that particular interest. But once the management of a big enterprise is regarded as not only entitled but even obliged to consider in its decisions whatever is regarded as the public or social interest, or to support good causes and generally to act for the public benefit, it gains indeed an uncontrollable powera power which could not long be left in the hands of private managers but would inevitably be made the subject of increasing public control.95

The Business Roundtable seems to agree. In its 1990 report, Corporate Governance and American Competitiveness, it contrasts political and “economic” organizations. “Legislative bodies . . . represent and give expression to a multiplicity of constituent interests. Our political system is designed to create compromises between competing interests, to seek the broad middle ground…. This system of governance would be fatal for an economic enterprise.”96 Yet that is just what the stakeholder initiatives it supports would require.

In 1990, Pennsylvania risked the consequences Hayek warned about when it adopted the notorious Act 36 of 1990, which went far beyond other stakeholder laws in moving beyond considerationa rather benign conceptto one with more legal bite: Directors may consider “to the extent they deem appropriate” the impact of their decisions on any affected interest. They are not required “to regard any corporate interest or the interests of any particular group . . . as a dominant or controlling interest or factor” as long as the action is in the best interest ~f the corporation. 97 In the context of a potential or proposed change-of-control transaction, a determination made by disinterested directors (those not current or former employees) will be presumed to satisfy the standard-of-care requirement unless clear and convincing evidence proves that the determination was not made in good faith after reasonable investigation. This means, as a practical matter, that directors cannot be held liable for what they do, absent some element of self-dealing or fraud. This provision required no shareholder approval; it was immediately applicable to all companies incorporated in Pennsylvania, unless they opted out within 90 days.

The anti-shareholder bias of the bill was made clear during the campaign to pass the bill. In December 1989, a “fact sheet” sent to state legislators from the Pennsylvania Chamber of Commerce, which cosponsored the bill with the local AFL-CIO, contained the statement that the bill would “reaffirm and make more explicit the time-honored (and current) principle that directors owe their duties to the corporation, rather than to any specific group such as shareholders.”98 The new law does not say that directors are free to place greater importance on factors other than long-term profit maximization, but to give it any other interpretation is to violate the foremost principle of statutory construction and assume that the legislature intended its language to have no effect.

It did have an effect, though perhaps not what the legislature intended. By October 15, 1990, 99 companiesnearly 33 percent of the state’s publicly traded companieshad opted out of at least some of the provisions of the bill. Over 61 percent of the Fortune 500 incorporated in Pennsylvania opted out, as did over 56 percent of those in the S&P 500.99 SO massive was the stampede out of Pennsylvania Act 36 that a Philadelphia Inquirer editorial noted: “These business decisions make it all the more clear that the law was crafted not in the best interest of the state’s businesses, but to protect Armstrong World Industries Inc. and a few other companies facing takeover attempts.”100 A company spokesman for Franklin Electronics Publishers stated that its board “believes that the Pennsylvania legislation runs counter to basic American principles of corporate democracy and personal property rights.”101

Apparently, the market agreed. Jonathan M. Karpoff and Paul M. Malatesta at the University of Washington School of Business found that from October 12, 1989 (the date of the first national newswire report of the bill), through January 2, 1990 (when the bill was introduced in the Pennsylvania House), the shares of firms incorporated in Pennsylvania underperformed the S&P 500 by an average of 6.9 percent. 102 Another study, by Wilshire Associates, linked enactment of the Pennsylvania antitakeover law with a 4 percent decline in stock prices of companies incorporated there. The study of Pennsylvania companies with a stock market capitalization greater than $5 million charted 63 companies from January 1, 1989, through August 15, 1990.103

One important question is how the “best interests of the corporation” differ from the “best interests of the shareholders.” Scholars have debated for decades just what a corporation is, but whether it is a “bundle of contracts” or an “imaginary person,” it seems fair to envision a hypothetical long-term shareholder, such as the beneficial owner of most institutional investor securities, as the ultimate party at interest. This allows all other interests to be factored in. But without a clear, direct, and enforceable fiduciary obligation to shareholders, the contract that justifies the corporate structure is irretrievably shattered.


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1 Bryan Burrough and John Helyar, Barbarians at the Gate, Harper & Row, New York, 1989, p. 93. The book also notes that “Johnson’s two maids were on the company payroll.”

2Ibid., p. 255.

3 See Committee on Corporate Laws of the Section of Corporation, Banking and Business Law, American Bar Association, Model Business Corporation Act, Prentice-Hall Law and Business, Englewood Cliffs, N.J., 1990, p. 781. “Thirty-two jurisdictions follow the language of the Model Act . . . the remaining 20 jurisdictions provide the corporation’s affairs should be managed by a board of directors,” p. 788.

4 Melvin Aron Eisenberg, The Structure of the Corporation: A Legal Analysis, Little, Brown, Boston, 1976, p. 140.

5 Benjamin N. Cardozo, Meinhard v. Salmon, 249 N.Y. 458, 464 (1928).

6 Robert Clark, Corporate Law, Little, Brown, Boston, 1986, pp. 33-34.

7 Arthur Fleischer, Ir., Geoffrey C. Hazard, Jr., and Miriam Z. Klipper, Board Games, Little, Brown, Boston, 1988, p. 3.

8 Jay W. Lorsch with Elizabeth MacIver, Pawns or Potentates: The Reality of America’s Corporate Boards, Harvard Business School Press, Boston, 1989, p. 4.

9 Peter Drucker, “The Bored Board,” in Toward the Next Economics and Other Essays, Harper & Row, New York, 1981, p. 110.

10 According to preliminary figures in the ISS Director Database, 843 out of 5,848 director positions in the ISS Director Database were “affiliated” outsiders, with some business connection to the company.

11 Lorsch, Pawns or Potentates, pp. 57-58.

12 Maryann Keller, Rude Awakening: The Rise, Fall, and Struggle for Recovery of General Motors, William Morrow, New York, 1989, p. 188.

13 Doron P. Levin, Irreconcilable Differences: Ross Perot versus General Motors, Little, Brown, Boston, 1989, p. 324.

14 Kim McQuaid, Big Business and Presidential Power: From FDR to Reagan, William Morrow, New York, 1982, p. 308.

15 Brief of petitioner The Business Roundtable, Case #99-1651, Court of Appeals, D.C. Circuit (August 22, 1989), p. ii.

16 McQuaid, Big Business and Presidential Power, p. 200.

17Ibid., p. 284.

18 Tim Smart, “Knights of the Roundtable: Tracking Big Business’ Agenda in Washington,” Business Week, October 21, 1988, p. 39.

19 The Business Roundtable, The Role and Composition of the Board of Directors of the Large Publicly Owned Corporation (available from The Business Roundtable, 200 Park Ave., New York, NY 10166), 1978, p. 3.

20Ibid., p. 8.

21 The Business Roundtable, Corporate Governance and American Competitiveness (Available from The Business Roundtable, 200 Park Ave., New York, NY 10166), 1990, p. 13 (” . . . while the CEO must be involved . . . “).

22Ibid., p. 14 (“To ensure continuing effective board operations, the CEO can periodically ask the directors for their evaluation of the general agenda items for board meetings and any suggestions they may have for improvement”).

23Ibid., p. 16.

24 An index fund is a type of “passive portfolio” that tracks an index. An example is the Standard & Poor’s Index. Investment managers do not make buy/sell decisions based on analysis of individual companies but hold the stock as long as it is in the index.

25 The Business Roundtable, Corporate Governance and American Competitiveness, p 16.

26Ibid., p. 9.

27Ibid., p. 14.

28 Letter from Bruce Atwater, chairman, Corporate Governance Task Force of the Business Roundtable, November 7, 1990.

29 “We suggest you advise your directors not to respond. . .” (ibid.).

30 45 U.S. 503 (1846).

31 249 N.Y. 458 (1928).

32Ibid., pp. 466, 468.

33 Dennis J. Block, Nancy E. Barton, and Stephen A. Radin, The Business Judgment Rule: Fiduciary Duties of Corporate Directors and Officers, 2d ed., Prentice-Hall Law & Business, New York, 1988, p. 3.

34Joy v. North, 692 F.2d 880, 886 (1982).

35Percy v. Millaudon, 8 Mart. 68 (1829). Here directors were sued because of the behavior of the staff of the bank: “If nothing has come to their knowledge, to awaken suspicion of the fidelity of the president and cashier, ordinary attention to the affairs of the institution is sufficient. If they become acquainted with any fact calculated to put prudent men on their guard, a degree of care commensurate with the evil to be avoided is required, and a want of that care certainly makes them responsible.” Quoted in Briggs v. Spalding, 141 U.S. 132, 148 (Sup. Ct. 1891).

36 432 A.2d 814, 820 (N.J. 1981).

37 795 F.2d 893 (10th Cir. 1986).

38 237 N.E.2d 776 (1968).

39 C.A. No. 7583 (Del. Ch. May 9, 1984). Unpublished case.

40Danaher Corp. v. Chicago Pneumatic Tool Co., 633 F. Supp. 1066, 1072 (S.D.N.Y. 1986). See also Danaher Corp. v. Chicago Pneumatic Tool Co., 635 F. Supp. 246 (S.D.N.Y. 1986).

41 564 A.2d 651 (1988).

42Ibid., p. 658.

43Ibid., p. 652.

44Ibid., p. 659.

45 Joseph Nocera notes that a series of proshareholder decisions in Delaware ended after “fabled New York takeover lawyer” Martin Lipton wrote, in a “conspicuously leaked memo” to clients, “Perhaps it is time to migrate out of Delaware.” Nocera concludes, “within two months the Court of Chancery began producing decisions that were more to Marty Lipton’s liking. They’ve been doing so ever since.” “Delaware Puts Out,” Esquire, January 1990, p. 48.

46 488 A. 2d 858 (Del. 1985).

47Ibid., p. 869.

48Unocal Corp. v. Mesa Petroleum Co., 493 A. 2d 946 (Del. 1985).

49Ibid., p. 956.

50Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173,181 (Del. 1986).

51Ibid., p. 182.

52Ibid., p. 184.

53Norlin Corp. v. Rooney, Pace Inc., 744 F.2d 255 (2d Cir. 1984) (applying New York law).

54 567 A.2d 1279 (Del. 1989).

55Ibid., p. 1282.

56Ibid., p. 1283.

57Ibid., p. 1286, 1287.

58Ibid., p. 1287.

59Ibid., p. 1288.

60Paramount v. Time, 571 A.2d 1140, 1149, 1150 (Del. Sup. 1990).

61 “Skewered Shareholders: Roundtable on the Time-Warner Deal,” Directors & Boards, 14(2), Winter 1990, p. 35.

62Paramount v. Time, p. 1147.

63Ibid., p. 1148.

64Ibid. (emphasis added).

65Paramount v. Time, CCH Federal Securities Law Reporter, pp. 94, 514, 93, 269 (Del. Ch. 1989).

66Ibid., p. 93, 269.

67Ibid., p. 93, 284.

68Paramount v. Time, p. 1140, 1155.

69Paramount v. Time, CCH, pp. 94, 514, 93, 267.

70Ibid., p. 93, 277.

71Ibid., p. 93, 273.

72 Interview with Michael Klein, July 6, 1990.

73Sullivan v. Hammer, CCH Federal Securities Law Reporter, pp. 95, 415, 97, 1064 (Del. Ch. 1990).

74 Michael M. Lewis, “Leveraged Rip-Off,” New Republic, November 14, 1988, p. 27.

75 John F. Berry, “SEC Proposes Shareholder Protections,” Washington Post, November 19, 1977, p. D9.

76 Charles W. Stevens, “Local Chairman’s Buyout of Two Units Gives Him a Rewarding Second Position,” Wall Street Journal, August 14, 1989, p. A5. The article notes that “if Mr. Schwartz spends the 10 hours a month he estimates will be required of him as chairman of K&F, his K&F compensation would work out to at least $4,000 an hour.”

77 Steve Mufson, “Breakdown of a Buyout: Plenty of Blame Passed around in UAL Takeover that Failed,” Washington Post, Oct. 29, 1989, p. H1.

78 “A Wolf in Wolf’s Clothing,” ISSue Alert, 4(8), November 1989, p. 5.

79 Randall Smith, Michael R. Sesit and Robert L. Rose, “British Air May Balk at Any Haste in Reformulating a UAL Buy-Out,” Wall Street Journal, October 18, 1989, p. A3.

80 Randall Smith, “Buy-Out Bomb: In a Failed Bid for UAL, Lawyers and Bankers Didn’t Fail to Get Fees,” Wall Street Journal, November 30, 1989, p. Al.

81 Courts have permitted companies to make such payments to outside biddersonly when they will increase the likelihood of superior bids, not prevent them.

82 Jeff Bailey, Asra D. Nomani, and Judith Valente, “Flawed Portent: Banks Rejecting UAL Saw Unique Defects in This Buy-Out Deal,” Wall Street Journal, October 16, 1989, p. Al.

83 Benjamin J. Stein, “Watch Dog, Awake: A Fervent Plea to the New Chairman of the SEC,” Barron’s, November 13, 1989, p. 34.

84 All quotes are taken from a July 1990 interview with a source who was a member of the GAF board of directors during the buyout.

85GAF Corporation 1989 Proxy Statement, p. 12.

86Ibid., pp. 14-15.

87Ibid., p. 15.

88Ibid., p. 21.

89 See Burrough and Helyar, Barbarians at the Gate, pp. 369-371.

90 James J. Hanks, Jr., “Non-Stockholder Constituency Statutes: An Idea Whose Time Should Never Have Come.” Insights, 3(12), December 1989, p. 20.

91 Quoted in Leslie Eaton, “Corporate Couch Potatoes: The Awful Truth About Boards of Directors,” Barron’s, December 24, 1990, p. 22.

92 Ga. Code Ann. Sec. 14-2-202.5.

93 American Bar Association Committee on Corporate Laws, “Other Constituency Statutes: Potential for Confusion,” Business Lawyer, 45(4), August 1990, p. 2261.

94Ibid., p. 2259.

95 F.A. Hayek, Law, Legislation, Liberty. Volume 3: The Political Order of a Free People, University of Chicago, 1979, p. 82.

96 The Business Roundtable, Corporate Governance and American Competitiveness, March 1990, pp. 3 4.

97 The previous version of the law, adopted in 1983, included a stakeholder provision similar to those adopted by many other states. However, the new version goes further than any other state has, so far, by expanding the list of interests may be considered and, more important, by establishing that no interest must be controlling (including the interests of shareholders), as long as the directors act in the best interests of the corporation. Other changes to the fiduciary standard include an explicit rejection of the Delaware “heightened scrutiny” test applied to directors’ actions in change-of-control situations.

98 “Outrage of the Month,” ISSue Alert, 4(9), December 1989, p. 6.

99Fact Sheet on Act 36: The New Pennsylvania Anti-Takeover Law, Klett Lieber Rooney & Schorling, October 17, 1990.

100 “A Stupid Law: If Pa.’s Anti-Takeover Bill Was So Great, Why Are So Many Companies Opting Out of It?” Philadelphia Inquirer, July 26, 1990, p. 18-A.

101 “When a State Protects a Company,” ISSue Alert, 5(6), July/August 1990, p. 1.

102 Jonathan M. Karpoff and Paul H. Malatesta, Evidence of State Antitakeover Laws, University of Washington School of Business, July/August 1990, p. 1.

103 Stephen L. Nesbitt, The Impact of ‘Anti-Takeover’ Legislation on Pennsylvania Common Stock Price, Wilshire Associates, August 27, 1990.