I had so many choices for what to blog about this week.  The dispute about Donald Trump’s Truth Social SPAC?   Chancellor McCormick’s conclusion that the Activision/Microsoft merger might have violated Delaware law?  VC Laster’s Moelis decision?  Musk’s lawsuit against OpenAI? 

I ultimately decided to go with Moelis and OpenAI because they actually are fundamentally kind of the same thing, and this way I kill two birds with one stone.

So, earlier this week, it seemed like the big business law news was VC Laster’s holding in West Palm Beach Firefighters’ Pension Fund v. Moelis, issued last Friday, invalidating the shareholder agreement that Ken Moelis reached with Moelis & Co. when he took it public, and that allowed him to functionally remain in control of the business even when his voting stake dropped below a majority.  VC Laster held that the contract violated DGCL 141(a), which requires that corporations be managed by their boards of directors.

VC Laster recognized that every time a corporation enters into any kind of contract at all, the board’s choice set becomes more limited, but – using a word that I personally had never heard before and don’t know how to pronounce – concluded that there is a spectrum, starting with ordinary commercial contracts and ending with arrangements that ultimately intrude so far into corporate governance that they leave the realm of the commercial and raise a Section 141(a) issue.  Relying on Abercrombie v. Davies, 123 A.2d 893 (Del. Ch. 1956), he explained that the validity of a contract therefore depends on two inquiries: first, is it a governance arrangement at all?  If not, we’re done.  A number of factors go into determining whether the contract implicates corporate governance, including whether the contract involves some kind of commercial exchange, and whether it restricts the actions of internal corporate actors, namely, boards and shareholders.  

If the contract does implicate corporate governance, it will be invalid if it substantially restricts the board’s ability to manage the company.   In this case, the Moelis contract fit both bills: there was no commercial exchange, and the contract limited the board’s choices at every turn.  (My personal fave: The board was not permitted to discard the “Moelis” name without Moelis’s approval, even though name changes aren’t usually subject to a shareholder vote at all).

Among other interesting questions raised by the opinion are – what are the nondelegable functions of a corporate board?  DGCL 141(a) requires that corporations be “managed by or under the direction of a board of directors,” but in practice boards take advantage of the “under the direction of” piece and delegate most of those responsibilities to others.  What are the definitional board responsibilities that must remain with the board itself?  Certainly, merger negotiations fall into this category.  And in the Caremark context, Marchand v. Barnhill’s concept of “mission critical” risks is, functionally, a delineation of compliance responsibilities that are definitionally part of the board’s job and cannot be delegated to others.  The Moelis case also circles around the idea of core board functions that cannot be outsourced without violating Section 141(a).

Laster explains, however, that – though there are still outer limits imposed by the DGCL – many restrictions that would be prohibited in a stockholder agreement may still be permissible if they are contained in the corporate charter, or even in a new preferred stock issuance whose terms become part of the charter by operation of law.  And that’s the thing that grabs me.

Why does it matter whether something is in a shareholder agreement, versus a preferred share issuance?

Well, we can talk about transparency, and procedures for amendment – topics covered by Jill Fisch in her paper, Stealth Governance: Shareholder Agreements and Private Ordering.  I can also point out that now, after Moelis is already listed on the New York Stock Exchange, issuing new preferred stock that undermines the governance rights of existing shareholders may not be possible (does it count as a disparate reduction or restriction on shareholder rights if a shareholder agreement that existed at the IPO stage was invalidated and reconstituted in the form of a preferred share issuance?  I dunno).  But also, as I explain in my paper, Inside Out, preferred share terms are treated as internal affairs matters, subject to the law of the state of incorporation.  But shareholder agreements are ordinary contracts, and subject to ordinary choice of law.  Indeed, it’s not uncommon for shareholder agreements to contain a choice of law provision that is different from the state of incorporation.  (Yeah, that’s right, I answer to “Cassandra” now).

So the difference between putting it in a shareholder agreement and a preferred share issuance may be choice of law.

EXCEPT.

VC Laster, when explaining how to test for whether a shareholder agreement addresses governance matters (again, remember the mere fact that it addresses such matters does not invalidate it; you need to go to the second step of degree of constraint), he repeatedly referred to “internal affairs” and “internal governance.”  He didn’t mention choice of law, but the implication? was kind of? that a contract containing such restrictions might not, in fact, be subject to ordinary choice of law after all?  And might be deemed to be subject to the law of the state of organization? 

Which brings us, hilariously, to Elon Musk’s suit against OpenAI.  The gravamen of which, as I understand it, is that Sam Altman had an idea for developing AI for the benefit of “humanity,” pitched this to Musk, and Musk donated a bunch of resources while Altman organized multiple (Delaware) entities to effectuate the vision.  Generally speaking, those entities consist of a Delaware nonprofit corporation, OpenAI, Inc., which has a number of Delaware for-profit LLC subsidiaries.  Musk now advances various California breach of contract and analogous claims because, in his view, OpenAI, Inc. and its subsidiaries have failed to operate in accordance with the original humanity-focused set of promises. “This case is filed to compel OpenAI to adhere to the Founding Agreement and return to its mission to develop AGI for the benefit of humanity,” is an actual allegation at ¶33.

I will leave it to the nonprofit folks to talk about the standing of a donor to sue when a nonprofit fails to operate in accordance with expectations, though the fact that the complaint cites the relevant statute as “E.g. Cal. Bus. & Prof. Code § 17510.8” does not inspire confidence (the “eg” means “for example,” which I interpret as, there is no direct statute on point).  I will leave it to the contract folks to talk about whether promises of benefitting humanity are enforceable, or whether you can even cobble together a contract from the multiple conversations, emails, and organizational documents Musk cites.

Instead, I’ll talk about the fact that, in addition to disgorgement and damages, Musk seeks specific performance in the form of:

1. An order requiring that Defendants continue to follow OpenAI’s longstanding practice of making AI research and technology developed at OpenAI available to the public, and
2. An order prohibiting Defendants from utilizing OpenAI, Inc. or its assets for the financial benefit of the individual Defendants, Microsoft, or any other particular person or entity;

In other words, Musk claims that he has a contract, formed under California law, that allows Musk to dictate the governance choices of a Delaware organized (nonstock) corporation, and further, that a California court should order that this Delaware corporation conduct itself in accordance with his contract. 

Now, as a nonprofit, OpenAI is subject to jurisdiction not only of the Attorney General of its state of organization, but also the Attorney General of the states where it operates.  And I have no idea whether it has violated the legal rules governing nonprofits in those states – that’s up to the AGs.

But Musk is not invoking AG authority; he’s claiming a contractual right to dictate the governance of a Delaware-organized (nonstock) corporation.  So, especially in light of Moelis, if OpenAI wanted to take this as a serious threat, it could file a declaratory judgment action in Delaware to the effect that these “contracts” – if they even exist – are in fact contracts concerning internal affairs matters governed by Delaware law.  And, under Delaware law, at least at the corporate (OpenAI, Inc.) level, they are illegal intrusions into the board’s authority. (Though, I suppose, it might have difficulty getting personal jurisdiction over Musk in Delaware these days)

Senator Sanders recently released the Majority Report for the Senate’s Health, Labor, Education, and Pensions Committee.  That report has some grim findings about American retirements.  About half of people 55 and older have no retirement savings.  As we all know, defined-benefit pensions have become increasingly rare.  Unfortunately, defined-contribution pensions are often unavailable for a huge chunk of the workforce.  About 50 million workers don’t have a way to save for retirement through their payroll.

The report and its figures has to be part of any conversation now about how to think about efforts to improve the quality of financial advice and retirement savings.

There is much more in the report than this quick summary, and if you write or think about retirement issues, you should check it out.

A while back, I posted about an eyebrow-raising opinion out of the Second Circuit holding that clean audit opinions may not be material to investors because they use generic language.  Happily, the Second Circuit has agreed to take a second look at the issue, and invited the SEC to file an amicus brief, which it did.  (Alison Frankel has a column on the case here; the brief is linked here)

The brief is simple and makes the obvious point that the language of a clean audit opinion may be standardized, but its use reflects an industry understanding regarding the procedures used in the audit and the auditor’s conclusions.

One thing worth highlighting: As I explained in my original post, the way we seem to have gotten here is that the defendant auditor conducted a shoddy audit, but then argued that there was no link between its own audit deficiencies and the actual flaws in the underlying financial statements – i.e., even a proper audit would not have caught the problems.

The SEC argues that, even if true, that would not make the audit opinion immaterial; it might, however, affect the analysis of loss causation.  The distinction matters a lot to the SEC, because loss causation is only an element for private litigants; materiality, however, is an element that the SEC must prove in its own enforcement actions.

I agree with the SEC: a claim that the auditor would have issued a clean opinion – and missed the problems in the underlying financials – even if it had used proper procedures, is more properly characterized as a claim about loss causation, i.e, whether the false statement resulted in losses to the shareholders.

I like to use a little rule of thumb on the distinction between transaction causation (materiality) and loss causation.  Transaction causation asks, what would have happened if investors knew the truth?  Loss causation asks, what would have happened if the lie had been true? 

If investors would have done nothing differently, even had the truth been disclosed, the lie is immaterial. (This is, by the way, precisely what the Second Circuit has previously said about materiality). 

If the same losses would have occurred even if the allegedly false statements had been truthful – i.e., if there was some intervening cause that tanked the stock price – there is no loss causation.

In this case, it is impossible to believe that investors would have had no reaction had they been told the company was incapable of presenting a clean audit opinion.  Therefore, the Second Circuit should hold that the opinion was material.

And okay fine since I can’t resist…

As Ben Edwards blogged on Thursday, VC Laster came down with his long-awaited opinion in TripAdvisor.  The case was fascinating enough as it was – could it be a violation of fiduciary duty for a Delaware corporation to leave Delaware? – but in light of Elon Musk’s latest threats, it took on a heightened significance.

Most interestingly, VC Laster found, first, yes, a controller’s choice to relocate to a state that scrutinizes conflict transactions less closely than Delaware may itself be a conflict transaction.  And, second, damages rather than an injunction would almost certainly be the correct remedy.  Damages, he claimed, could be assessed by watching stock price movements; and not even necessarily at the moment of a shareholder vote, but even upon announcement of an intention to hold one.  (Which works for a public company, I guess; I assume we won’t see these disputes in private companies but that context would make a damages remedy much harder to fashion).

But here’s the thing.  To get there, he had to distinguish some prior cases that concluded that the elimination of litigation rights did not state a claim for breach of fiduciary duty.  This issue had come up, for example, in the context of charter amendments adding an exculpation clause under Section 102(b)(7), and in a reincorporation to California.  VC Laster was pretty clear that he simply thought some of them were wrongly decided, but his main point was that in those cases, the amendments were immaterial – i.e., it was not clear that the change conferred a non-ratable benefit on existing directors.  By contrast, he held, in this case, the differences between Nevada law and Delaware law are sufficiently plain – and the controller’s reasons for wanting the move sufficiently blatant – that the stockholder plaintiffs had at least, for pleading purposes, established they were losing a valuable right.

So … Texas?  As I previously wondered, Texas’s law might be different than Delaware’s but it is not obvious that it is so different – especially with respect to conflict transactions – that plaintiffs would be able to plead the same case.  And Musk may believe the Texas judges will less receptive to stockholder claims than Delaware judges, but, in TripAdvisor, VC Laster held that stockholders’ loss of access to any particular forum does not confer a material benefit on fiduciaries.

But!  If plaintiffs were able to plead that the move to Texas conferred a material benefit on Elon Musk, and then they had to prove damages via stock price movements – well, Musk gave them quite a boon by tweeting on January 30, in the middle of a dramatic slide in Tesla’s stock price due to the Tornetta verdict, that he hoped to reincorporate out of state.  That will sufficiently muddy the waters about price impact so as to give plaintiffs plenty of runway. 

Once again, foiled by bad tweets.

But finally, I think it will take quite a while to get that far, because if Tesla ever files a proxy statement for a shareholder vote, we will see some truly popcorn-worthy litigation over the completeness of the disclosures.  Will the proxy admit – or deny – the move was based on a Twitter poll?  How will the purposes of the move be characterized?  What was the board’s process for recommending the move, and how independent were the directors?  According to the WSJ, the directors intentionally keep concerns about Musk’s drug use out of the board minutes – can shareholder plaintiffs use §220 to get emails, then?  Etc, etc.

Vice Chancellor Laster has issued his opinion in the TripAdvisor case.  I’m still digesting it, but the overall framework does not surprise me.  As I can’t improve on the opinion’s recitation of the basic factual situation, here it is:

A Delaware corporation has two classes of stock. The CEO/Chair owns highvote shares carrying a majority of the outstanding voting power, giving him hard majority control. The board decides to convert the Delaware corporation into a Nevada corporation, and the CEO/Chair delivers the necessary stockholder vote. The board does not establish any protections to simulate arm’s length bargaining. The conversion is not conditioned on either special committee approval or a majority-ofthe-minority vote.

A stockholder plaintiff challenges the conversion.1 The plaintiff argues that Nevada law offers fewer litigation rights to stockholders and provides greater litigation protections to fiduciaries like the directors and the CEO/Chair. The plaintiff alleges that the directors and the CEO/Chair approved the conversion to secure the litigation protections for themselves. In support of those assertions, the plaintiff cites the materials the board considered, disclosures in the company’s proxy statement, the work of distinguished legal scholars about the content of Nevada law, and public statements by Nevada policy makers about the direction Nevada law has taken.

I appreciate that the opinion gives a neutral framework under Delaware law for how to assess liability for changes in governance and litigation rights.  Although it’s Nevada today, Tesla might be jumping to Texas tomorrow.  This decision provides guidance for how to think about that problem.  This passage does a good job presenting the issue:

Holding that the plaintiffs have stated a claim on which relief can be granted does not discriminate against Nevada entities. The same reasoning would apply if a Delaware corporation converted into another Delaware entity in a transaction with comparable implications. Using the contractual freedom conferred by the Delaware Limited Liability Company Act, entity planners can implement a wide array of governance schemes that provide fewer rights to investors than what stockholders in a Delaware corporation enjoy. If a Delaware corporation converted into a Delaware LLC where the governing agreement had eliminated all fiduciary duties, then the same reasoning would hold. Entity planners could even design a Delaware LLC that mirrors the internal governance structure of a Nevada corporation. If a Delaware corporation converted into that LLC, the outcome would be the same.

After deciding that the entire fairness standard will apply, the decision also clearly charts a path to leave Delaware without any liability:

Nor does this decision mean that a corporation can never leave Delaware without litigation risk. If a board proposed a similar conversion for a corporation without a stockholder controller, and if the fiduciaries fully disclosed the consequences of the change in legal regimes, including the effect on stockholder litigation rights, then the stockholders’ approval of the conversion would be dispositive, triggering an irrebuttable version of the business judgment rule. If directors proposed a similar conversion for a corporation with a stockholder controller, and if they properly conditioned the transaction on the twin MFW protections, then the dual approvals would be dispositive, again triggering an irrebuttable version of the business judgment rule.

For some public companies, Nevada may be a better fit than Delaware simply because of the cost issue.  Controlled corporations can exit with a two-step process and corporations without a controlling stockholder can make the move with a simple shareholder vote.

Going forward, a real challenge will be deciding how to value the change in litigation rights.  The opinion sketches out a possible market method:

The standard legal remedy is money damages. It seems quite likely that the court can craft a monetary remedy in this case that would be adequate. The remedial challenge will be to quantify the extent of the harm, if any, that moving from Delaware to Nevada imposes on the unaffiliated stockholders.

One way to determine the quantum of harm would be to value the Company pre-conversion as a Delaware corporation, then value the Company post-conversion as Nevada corporation, subtract the Nevada value from the Delaware value, and calculate a per share amount. That would be hard.

But there is another way to get at the delta. The Company’s stock has a trading price. In the conversion, nothing will change except the Company’s corporate domicile. Maffei’s control will remain constant. The Company’s business will remain constant. The only independent variable is the law governing its internal affairs.

Given that set-up, the change in the Company’s trading price should help quantify the harm, if any, caused by the conversion. As long as the market for the Company’s common stock is semi-strong-form efficient, then the price reaction should be indicative. Note that the stock price need not fairly approximate a pro rata share of the Company’s intrinsic value for the price reaction to matter. As long as any pricing disconnects remains consistent across variables other than the governing law, the price impact should provide insight.

From a Nevada perspective, the state will hope that companies trade up after these moves.  I previously proposed using markets to evaluate governance changes.  Although this method might shed some light on the valuation question, it’s going to be a challenge.  Of course, this may also open the door to some disclosure gamesmanship.  It seems possible that a corporation announcing or completing this kind of move to Nevada might also selectively reveal some positive information at the same time.  That would increase the likelihood the stock would trade up and perhaps cloud or mask any impact from investors selling on the loss of their governance rights. 

It’s probably worth also taking a look at other corporations that have made this move and what happens with their stock price.  If Delaware law and Nevada law are somewhat constant, you could likely get a better sense of the effect these moves have on valuation by getting a bigger dataset together.

If we’re looking at changes in litigation rights and using this framework here when a company shifts from Delaware to Nevada or from a Delaware Corp. to a Delaware LLC, would we also use it for other governance changes?  What about a move to amend the bylaws in some way that affects litigation rights or a move to add a 102(b)(7) provision to a corporate charter?  My first thought is that the same framework should apply.  

In any event, this is going to be fun to watch.