CHAPTER EIGHT

Operating Benefit Corporations in Extraordinary Situations

Chapter 7 addressed the ways that courts may review ordinary course decisions of benefit corporation directors, and the implications for operations and board decision making. This chapter will address standards of review and board outside the ordinary course.

The analysis in chapter 7 revolved around the business judgment rule, which leaves ordinary decision making almost entirely in the hands of directors. In extraordinary situations, however, other factors outweigh those that favor business judgment protection. For example, when directors have a conflict due to an interest outside of the corporation, the business judgment rule does not apply, shareholders can challenge the substance of transactions, and courts will review the transaction in question for “fairness.” Again, this standard of review supports an important substantive concept: directors have a trustee-like obligation to pursue the interests of the corporation, not personal interests. If they put themselves in a position where their personal interests and those of the corporation conflict, then it is incumbent on the court to ensure corporate interests are protected. Because conflict transactions are relatively rare, this “interference” does not substantially reduce the effectiveness of the corporate structure in amassing and allocating capital.

Then there are intermediate, “grayer” areas, where the standard of review accommodates the important policy motivations underlying the business judgment rule but also incorporates concerns about intrinsic board biases. These intermediate standards are applied when a company is sold or when it takes defensive action to preclude a sale that a majority of shareholders might want to pursue. These standards reflect a concern that directors may be inclined in such situations to favor the desires of management and other insiders, who may be influential on the board, and who may have interests that diverge from the interests of shareholders.

Finally, courts apply particularly strict standards for situations where shareholder voting rights are threatened. This chapter will address how each of those heightened standards will likely be applied to benefit corporations, and what this implies for the decision-making process in those situations.

Benefit Corporations and Conflict Transactions

THE DEFINITION OF “INTEREST” IS NOT ALTERED

As with conventional corporations, decisions are not afforded the presumption of the business judgment rule if tainted by conflict. The entire fairness standard will continue to apply to decisions made by conflicted boards.¹

Current case law defines an interested director as one who “will receive a personal financial benefit from a transaction that is not equally shared by the stockholders.” Additionally, a director is interested in a transaction where the corporate decision “will have a materially detrimental impact on a director, but not on the corporation and the stockholders,” because, in that situation, “a director cannot be expected to exercise his or her independent business judgment without being influenced by the adverse personal consequences resulting from the decision.”² Thus, a disinterested director who receives the presumption of the business judgment rule is one who “neither stands to benefit financially nor suffer materially from the [board’s] decision.”³ Because the language found in both statutory models matches the language of the judicially created interested director standard, courts will likely interpret the phrase “disinterested” in the same manner.⁴

It is a well-settled principle of Delaware law that “a director who is also a shareholder of the corporation is more likely to have interests that are aligned with the other shareholders of that corporation.”⁵ Thus, stock ownership will not generally cause a director (or a controlling shareholder) to be interested and to lose the protection of the statutory business judgment or exculpation provisions. This is also consistent with the reference in the Principles of Corporate Governance, which refers to “personal interests of directors,” which presumably excludes stock ownership as a disqualifying criteria.⁶ In other words, even though the directors’ obligations are broader, they are still undertaken solely on behalf of the shareholders, so that stock ownership, by itself, should not be viewed as creating a conflict, except in the very limited circumstance that it might under jurisprudence for conventional corporations (as discussed in chapter 2).⁷

An argument to the contrary might be made. It could be argued that because benefit corporation directors have expanded duties that extend beyond shareholder pecuniary interests, the ownership of stock does create a conflict. That is, it might be argued, the pecuniary interest of a shareholding director may conflict with the interests of “those materially affected” by board decisions. This argument, however, misconstrues the structure of benefit corporation law. Both the PBCS and the MBCL are careful to state that no new beneficiaries are created by the new duties. Indeed, shareholders with significant levels of ownership are the only constituency that can enforce rights under the PBCS and current MBCL.⁸ The logic of benefit corporation governance—from shareholders’ continuing governance rights to their exclusive ability to bring derivative suits—recognizes that shareholders have a unique interest in the appropriate balancing among interests.⁹ For this reason, share ownership should not be considered to create a “conflict” at the board level. Accordingly, it appears that the entire fairness test will apply to a benefit corporation transaction to the same extent, and in the same circumstances, that it would apply to a transaction entered into by a conventional corporation.

APPLICATION OF ENTIRE FAIRNESS

As we discussed in chapter 3, when a challenged transaction is subject to the entire fairness test, a court will review the transaction and determine whether it was fair to the company and its shareholders, both substantively and procedurally. Essentially, this test requires a court to determine that the conflicted directors or controlling shareholder did not use their or its position to extract an unfair amount of value, or to extract more value than they or it might have obtained in an arm’s-length transaction.

An examination of entire fairness involving a benefit corporation is similarly likely to focus on any excess value received by the conflicted parties and not on the allocation of value among the unconflicted parties and other stakeholders. For example, if a controlling shareholder were to “squeeze out” minority shareholders in a merger in a manner that was not protected by the business judgment rule, a lawsuit would likely focus on whether the controller obtained the entity at too low a price. The “price,” however, should include any value the buyer accorded to stakeholders, such as a promise to maintain or implement environmental protections or to maintain certain employment levels.

If the court did find that the price so calculated was too low, there could be a question of how to allocate damages—should they all go to shareholders, or should some value be allocated to other stakeholders? In a situation where the operation and management of a company was to continue unchanged, a court might determine that all value should go to shareholders. On the other hand, if the controller were eliminating the company’s PBC status, and perhaps planning on major changes that might affect the community and workforce, it is possible that the relief could include some allocation of value to those stakeholders.

Change-in-Control and Defensive Situations

INTERMEDIATE STANDARDS: ENHANCED SCRUTINY

As we discussed in chapter 3, courts do not initially apply the business judgment rule when boards make decisions involving a sale of the corporation or defensive actions against hostile takeovers. Instead, courts review the substance of those decisions but the review is more deferential than it is in a pure conflict situation. Under conventional corporate law, the Revlon standard invokes a reasonableness review of the board’s efforts to maximize value for shareholders in a sale transaction, while Unocal focuses on the reasonableness of defensive actions, again through a shareholder value lens.¹⁰ Scholarship examining the result of expanding obligations under constituency statutes (a precursor to the benefit corporation statutes, which we will discuss in chapter 9) has found that, for the most part, courts applying constituency provisions have substituted the business judgment rule for enhanced scrutiny.¹¹ However, the intent of those statutes was largely focused on addressing hostile takeover and sale situations (also discussed in chapter 9).

In the case of the PBCS and the MBCL, however, there does not appear to be any evidence of an intent to regulate standards of review, except as explicitly set forth in the statute. Moreover, the policy rationale behind the common law imposing enhanced scrutiny involves the concern that directors have inherent conflicts in defensive and change-in-control situations (as we discussed in chapter 3), and it is clear that the drafters did not intend to alter the law with respect to conflicts. Thus, it appears likely that courts will apply enhanced scrutiny to both defensive and change-in-control situations for benefit corporations in jurisdictions where those standards would otherwise be applied, although their approach will be modified appropriately to reflect the expanded obligation of directors to consider stakeholder interests.

CHANGES IN CONTROL

The Revlon standard

Scholars have varying opinions on how Revlon will apply in a sale of a benefit corporation or change in control, but most agree that the “statute changes the board’s duty in the sale of control context in a fundamental manner,”¹² and that directors will no longer have a duty to achieve the highest value for shareholders.¹³ This view is not universal, however, and Haskell Murray has expressed the view that, in a Revlon situation, benefit corporations should be sold to the highest bidder. In Murray’s view, allowing the consideration of multiple constituencies in a sale process would destroy any accountability for the sale process.¹⁴ It seems likely, however, that because change-in-control transactions present unique risks, the heightened scrutiny applicable to such transactions will continue under the benefit corporation statutes.¹⁵ Even so, because PBC directors have an expanded duty to consider other constituencies, satisfaction of an enhanced reasonableness standard must be measured differently than adherence to the short-term shareholder maximization requirement for conventional corporations subject to the Revlon standard.¹⁶

Although conventional corporate law prohibits directors from considering any interest that fails to lead to monetary gain for shareholders, especially in a change-in-control setting, the benefit corporation expressly allows directors to consider all constituencies. Thus, a benefit corporation board will be required to balance a multitude of interests in a sale of the company.¹⁷ Traditional directors already balance numerous shareholder considerations when financially valuing bids for a company, and the broad stakeholder proposition of benefit corporation governance adds to the considerations benefit corporation directors should bear in mind when valuing bids.

Thus, the substantive requirement of Revlon—maximizing value for shareholders—is likely to change and to become an obligation to find the “best” transaction for all stakeholders as a group, but directors still may be subject to enhanced scrutiny and required to show that they pursued a reasonable path toward maximizing collective value for all relevant constituencies—the total value to be received by shareholders, stakeholders affected by the corporation’s operations, and specific beneficiaries, if any. For both practical and conceptual reasons, this is unlikely to be enforced on a mathematical or pseudomathematical basis, in which the sum of all benefits to all stakeholders is calculated and the transaction yielding the highest sum becomes the one that must be chosen. First, such mathematical precision is not possible. Second, and more importantly, such an interpretation would run counter to the business judgment concepts inherent in the statutes with respect to balancing and considering stakeholder interests.

Instead, the court is likely to examine the same issues involved in traditional Revlon situations, such as market checks and deal protections, to ensure that all likely transactions emerge, and subject such provisions to Revlon’s reasonableness standard. On the other hand, a board’s rational choice among bids that allocate value among stakeholders differently should not be subject to heightened scrutiny under Delaware’s Section 365(b), which mandates the application of the business judgment rule for all allocation decisions.¹⁸ Case law interpreting protective mechanisms involving corporations subject to constituency statutes suggests this will be the case.¹⁹

However, when a board does allocate value to stakeholder interests, the court could use Revlon to apply a reasonableness test to the board’s actual efforts to ensure that stakeholder value is achieved. For example, the court could focus on “the extent to which, once a sale of the company occurs, any meaningful, enforceable undertaking exists that assures the seller’s board and shareholders that the public benefit will be achieved once the merger is accomplished.”²⁰ Thus, directors should understand that the courts may apply heightened scrutiny to efforts to ensure future achievement of postmerger public benefits. As with most nonconflict transactions, however, a reviewing court is still most likely to focus more on process than on substantively reviewing the board decision.²¹ The next section offers guidance for selling a benefit corporation in compliance with the expanded fiduciary duties of a benefit corporation.²²

The sale process

Because sale transactions will be subject to heightened scrutiny, and because the calculus of value will be so different, corporations will need to adopt clear procedures to reasonably address stakeholder interests. This task may be less onerous than it sounds. Presumably, a benefit corporation involved in a sale process has already established the standards by which it is addressing stakeholder concerns, including through adopting third-party standards (required under the MBCL, permitted under the PBCS) and through setting objectives and standards. The task of the board of a benefit corporation being sold may well be to make sure the sale does not unduly interfere with those objectives or negatively affect performance against the third-party standard. In this sense, the board will need to investigate the plans of the buyer, something that would be of very limited importance in a Revlon context for a conventional corporation.

Confidence that the buyer will maintain the status quo may well be sufficient to meet a board’s public benefit obligations, but that confidence may require some combination of due diligence, contractual obligation, and corporate governance structure, as we will see in the next section on documentation. The critical concern during the sale process will be surfacing these issues, and making sure that management and outside professionals involved in the process understand the importance of addressing stakeholder concerns.

It may also be the case that simply maintaining the status quo is not sufficient. This could be because the buyer does not plan to treat the stakeholders as well or because the buyer is paying a large premium, some of which the board determines should be shared with stakeholders. An example can make this concrete: a buyer may plan to combine workforces, which will lead to extensive layoffs, and may be able to pay a large premium because of the efficiency gains from that combination. In a cash sale by a conventional corporation, all of that financial gain goes to shareholders—and the board does not even have an obligation to investigate what the transaction will mean for its workforce. In a benefit corporation, however, the board will need to determine how these stakeholders will be treated, and, when learning of the layoffs, devise a strategy that takes their interests into account. This might mean any number of things, such as negotiating severance, retraining, and similar provisions. Where a large premium results from efficiencies that do not hurt stakeholders—such as the ability to use the sales forces to sell the products from the combined companies, the board might also consider asking that some of that premium go to workers in the form of bonuses or other compensation.

Readers who have a background in mergers and acquisitions might note that many of these provisions are already included in merger negotiations for traditional corporations, often under the guise of protecting value for shareholders. For example, severance programs are often created in cash sales, because they are necessary to preserve value through the sales process. In fact, many considerations will not be different in a sale—what may be different will be the emphasis.

Documentation

Merger agreements may have to address postmerger conduct because of a need to protect stakeholder interests. In some situations, agreements will need to be drafted to ensure both the continuation of the benefit provisions in the corporation’s charter and the continued implementation of the benefit principles.

One technique to accomplish these goals would be to include a provision that specifically describes how the company will operate postmerger. Still, companies will have to skillfully negotiate this point, as buyers will generally oppose any postmerger constrictions on their business management. However, the more a benefit corporation compromises on this point and offers the buyer greater postmerger flexibility, the more challenging the provision will be to enforce. Another provision that would assist PBC sellers is one that authorizes injunctive relief to enforce mission-preserving provisions. Furthermore, in order to resolve any potential standing issues, a provision could be included that expressly gives the sellers the ability to enforce the public benefit provisions, or the contract could designate certain stakeholders as third-party beneficiaries.

Another contractual provision that a benefit corporation might bargain for in a sales process would be some element of ongoing control over the acquired entity. One well-known example of this phenomenon is the terms of the transaction negotiated when Ben & Jerry’s was sold to Unilever. There, although the seller was not a benefit corporation, the controlling shareholders were able to insist on an ongoing level of control.²³

There may be alternative means to protect stakeholders. For example, a benefit corporation being sold in a transaction that will result in a loss of jobs in a community might fund a trust to provide assistance to the community, including job training and local business development. Or a company may simply favor a buyer that has a strong reputation for operating in a responsible manner.

DEFENSIVE SITUATIONS

Benefit corporations, like traditional Delaware corporations, can take defensive actions in response to a takeover threat. These defensive tactics are likely to be evaluated against the same standard that applies to conventional corporations, which requires that the defensive measures be reasonable in relation to the threat posed.²⁴

Significantly, however, traditional corporations can only deploy these devices to protect shareholders from a very specific threat: a situation that jeopardizes shareholder value.²⁵ In contrast, because a benefit corporation board must account for a much broader range of considerations, the range of possible threats that can be addressed by defensive measures will be broader than in traditional corporations.²⁶ In that sense, directors will be given greater discretion to employ defensive devices in order to protect the company and its sustainable mission.²⁷ This is how the courts have applied Unocal under constituency statutes, which give directors the right, but not the obligation, to consider stakeholder interests. Additionally, because the threats PBCs face will be distinctly different than the financial threats traditional Delaware corporations often face, different defensive devices could be created, or alterations could be made to common devices. Nevertheless, any device deployed must still be reasonable in relation to the threat posed, even if the business judgment rule applies to the balancing of broad stakeholder interests.²⁸

The cases applying Unocal to defensive action taken by conventional corporations have permitted boards to discriminate against shareholders who represent a particular threat to shareholder value. This suggests, by analogy, that the board of a benefit corporation may be able to take defensive actions directed at shareholders (or others) that pose a particular threat to other stakeholders. For example, a board might adopt a rights plan (a corporate mechanism boards can deploy to prevent acquisitions of large blocks of shares without board approval, as discussed in chapter 3) that was triggered not simply by a level of ownership but also by a level of ownership by the type of shareholder that threatens the interests of certain stakeholders.

The Third Point, LLC v. Ruprecht case suggests that such tactics might be permitted. In Third Point, a company adopted a rights plan because the board determined that share acquisitions by a hedge fund threatened the interests of shareholders. The plan operated by imposing severe economic and voting dilution on any shareholder who crossed a certain ownership threshold. In this respect, the plan operated in the same manner as any other such plan. However, the plan had one distinct feature that had not been previously litigated: it distinguished between shareholders who filed a Form 13D with the SEC from those who filed Form 13G. Each form is to be filed when a shareholder of a public company surpasses the 5 percent ownership threshold, but the latter requires a statement that the shareholder has no intent to exercise control. The plan adopted by the company in Third Point permitted 13G filers to buy up to 20 percent of the company’s outstanding shares, while the cap for 13D filers was 10 percent. The hedge fund asked for a waiver of the 13D threshold, but the company refused. The company successfully defended its refusal, distinguishing between the hedge fund and 13G filers on the basis that the hedge fund principal threatened the value of the company’s shares by taking certain actions that, together with its significant ownership, indicated that it could exercise negative control over the company through its stake. The court found that these actions could be reasonably perceived as threatening value, because of concern the hedge fund would be able to exercise influence sufficient to control certain important corporate actions, such as executive recruitment.²⁹

The decision in Third Point suggests that a benefit corporation might adopt a rights plan that treats shareholders who represent a threat to stakeholder value differently from other shareholders. However, it is important to distinguish between a threat from the ownership itself and a threat from a valid exercise of voting rights. Since the advent of the rights plan, courts have been careful to ensure that imposing the plan does not interfere with the shareholder franchise. Thus, litigation over whether a rights plan is a reasonable reaction to a threat has often focused on whether ownership below the triggering threshold of a rights plan permits a shareholder to wage a proxy contest—either because the level allows the shareholder to have sufficient “skin in the game” to spend the resources a proxy contest requires or because the bloc acquired could potentially compete with an existing insider bloc. Accordingly, the triggering percentage of rights plans rarely dip below 10 percent. However, where there is a threat to value from mere ownership below that level, courts have permitted triggers as low as 5 percent.³⁰

In addition to guarding the ability of shareholders to wage proxy contests, courts have also generally looked for threats other than simply losing such contests. However, courts seem to have permitted boards to treat insurgent shareholders as “threats” as long as the use of the rights plan does not make it impossible for the shareholder to run a successful contest. This background suggests that there will be considerable room for case law development with respect to benefit corporations and defensive actions. Will a board be able to adopt a rights plan that discriminates against certain holders if their mere ownership might taint the company’s reputation in a way that harmed broad stakeholder interests? For example, suppose a company known for questionable environmental practices acquired a significant stake in a benefit corporation that focused on “clean energy” solutions. Could that ownership, standing alone, threaten the company’s strategy to improve the environment through long-term, trust-based relationships? What if the threat were not the reputational one but merely the fact that the stake might allow the shareholder to lead a successful proxy campaign that would replace the board with directors who were not going to pursue the same environmentally friendly strategy? What if the threat of such a contest made it difficult for the company to create long-term relationships with suppliers and customers focused on environmental issues?

These questions suggest that the ability to defend the interests of all stakeholders will raise interesting questions, and it is likely to strain the distinction between the Unocal standard discussed in this section and the franchise standards discussed in the next section.

The foregoing discussion only addresses the legal standard that will apply in a defensive takeover situation. In addition to the alteration of the legal standard, benefit corporation status may have a second and more important effect: the status may attract shareholders who have a greater interest in long-term value creation and less focus on short-term share price: “Attracting directors and investors who believe in the corporation’s mission may serve as a powerful defense against hostile corporate raiders who desire to focus more strictly on short-term profits.”³¹

Proxy Contests and Franchise Rights

Courts are particularly solicitous of shareholders voting rights because they underpin the legitimacy of the directors’ authority. This dynamic is not changed by the benefit corporation statutes; the directors are still elected by shareholders, and, indeed, it is only shareholders who have the right to enforce the expanded obligations of directors.³²

It thus seems unlikely that being a benefit corporation would have a material effect on the strict standards applied in litigation involving significant threats to the shareholder franchise. This conclusion is consistent with most cases involving the shareholder franchise decided under constituency statutes.³³ That said, there are many situations in which franchise concerns are addressed under Unocal’s reasonableness test (as we discussed in chapter 3), and in such a situation, consideration of the interests of stakeholders may have increased legitimacy.

It should remain clear, however, that benefit corporation directors cannot act with the “primary purpose of preventing or impeding” a shareholder vote.³⁴ Thus, even if the board conducts a balancing of interests in accordance with their fiduciary duties, the board should not do anything to purposefully disenfranchise the shareholders.³⁵ Moreover, even where the vote is not “thwarted,” some commentators have suggested that courts may, under Unocal, take an especially hard look at board actions affecting the franchise in the context of benefit corporations, because of the subjective nature of the board’s balancing task: “It could be argued that since the balancing required for PBCs is inherently subjective, the shareholders’ vote on a merger (expressing their judgment on the balance) is as, if not more, important than the directors’ decision. Thus there should be little or no hindrance to the stockholders of a PBC making the ultimate balancing decision by their votes on a proposed merger.”³⁶

All of the foregoing suggests that actual conduct in proxy contests—scheduling meetings, setting record dates, and all the other board powers related to voting— will be subject to the same limitations as they are in proxy contests involving conventional corporations. Of course, board considerations and the arguments that directors make to convince shareholders may be very different for a benefit corporation. For example, in a situation where shareholder activists seek to replace some or all board members, because they believe that a company is overinvesting in capital expenditures, a conventional corporation can only respond by arguing that it will produce a greater shareholder return over time by making such investments. Although a benefit corporation board may well make the same argument, it is also free to point out that the capital expenditures will create jobs, reduce toxic emissions, or have other positive effects on the community. And these arguments may actually be persuasive for universal owners (discussed in chapter 4), who conceive of themselves as stewards not only of individual companies but also of the systems in which those companies—and the shareholders—are embedded and invested.

Decisions Affecting Security Holders of Different Classes Differently

As we noted in “Multiple Investor Constituencies” (chapter 2), Delaware courts have extended the ideas of shareholder primacy to encompass the relationship between common shareholders and investors with greater priority, such as preferred shareholders and lenders. This is indeed the logical extension of the idea that common shareholders have no contract rights and are merely the residual risk bearers, entitled to what remains after others (including creditors and preferred shareholders) get what they bargained for. This idea, however, can lead to results that seem irrational from a broad perspective.

Robert Bartlett notes that a company with a deteriorating cash position might undertake a risky plan with a risk-adjusted value well below what the assets of the company would be worth in a sale, if, in that sale, most of the proceeds were to go to the creditors and preferred shareholders. The rationale behind such a perverse decision would be that the common shareholders are the beneficiaries of all the upside but share little of the downside risk in such a situation. As Bartlett says:

That directors might be forced to pursue socially suboptimal investments in these situations is peculiar to say the least. Those familiar with corporate finance theory no doubt find this outcome especially perplexing…. More generally, this approach would also seem to require as a matter of complying with the directors’ fiduciary duties the type of reckless go-for-broke gambles known to plague leveraged firms nearing financial distress and commonly associated with the lead up to the financial crisis.³⁷

However, by eliminating shareholder primacy and allowing boards to consider the interests of all their stakeholders, including preferred shareholders and lenders, directors will be freed from the obligation to take risks that look particularly unappealing from the point of view of the firm as an entirety. Benefit corporation directors may be able to weigh the interests of all investors in their decision processes, returning the law to that described in the Credit Lyonnais Bank Nederland, N.V. v. Pathe Commc’ns Corp. decision, which we mentioned in chapter 2.

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We have now completed our survey of the new law of benefit corporations. Part 3 addresses alternative methods that businesses might use to achieve stakeholder governance.