A while back, I blogged about the Chancery decision in Coster v. UIP Cos. 

Here’s the recap: The case involved a closely-held corporation where voting power was split 50-50 between two shareholders, one being a founder of the company, the other being the widow of another founder.  After the two deadlocked, and the widow sought to appoint a custodian that would throw the company into disarray, the founder caused the company to issue a slug of new stock to a longtime employee.  That broke the deadlock; the founder and the employee sided against the widow.  The widow then alleged that the sale had been effectuated to dilute her voting power in violation of the founder’s fiduciary duties.  Chancellor McCormick concluded that the sale occurred at a price and on terms that were entirely fair; on appeal, the Delaware Supreme Court affirmed the entire fairness holding, but remanded for Chancellor McCormick to consider whether the dilution of voting control had violated Blasius Industries, Inc. v. Atlas Corp, 564 A.2d 651 (Del. Ch. 1988). 

That alone, I said at the time, was sort of weird, because it suggested that a sale could be both entirely fair and represent an inequitable interference with voting rights.  

On remand, Chancellor McCormick held that Blasius was satisfied because the widow’s actions were harming the company, and because the stock sale had long been in the works regardless.  I noted that this was unusual, not merely because it showed that Blasius‘s “compelling justification” requirement could be satisfied, but also because it appeared to be the first and only time a Delaware court had approved a stock issuance intended to dilute the voting power of an existing holder due to that holder’s threats.  Delaware, of course, permits poison pills, but pills are adopted before a hostile actor acquires a certain voting threshold and are only activated once that threshold is crossed – they are a warning shot.  Delaware had not before approved actions to dilute the voting power of someone who already had their stake at the time the controversy arose, at least as far as I could tell.

Anyhoo, long story short, on appeal, this week, the Delaware Supreme Court affirmed Chancellor McCormick’s holding.  And in so doing, it appears to have resolved a longstanding tension in Delaware law, namely, the degree to which Blasius represents its own standard of review, or whether it represents a specific application of Unocal review.  And the Delaware Supreme Court appears to have held it’s the latter.  To wit:

Experience has shown that Schnell and Blasius review, as a matter of precedent and practice, have been and can be folded into Unocal review to accomplish the same ends – enhanced judicial scrutiny of board action that interferes with a corporate election or a stockholder’s voting rights in contests for control.  When Unocal is applied in this context, it can “subsume[] the question of loyalty that pervades all fiduciary duty cases, which is whether the directors have acted for proper reasons” and “thus address[] issues of good faith such as were at stake in Schnell.  Unocal can also be applied with the sensitivity Blasius review brings to protect the fundamental interests at stake – the free exercise of the stockholder vote as an essential element of corporate democracy.

As we explained in our earlier decision in this case, the court’s review is situationally specific and is independent of other standards of review.  When a stockholder challenges board action that interferes with the election of directors or a stockholder vote in a contest for corporate control, the board bears the burden of proof. First, the court should review whether the board faced a threat “to an important corporate interest or to the achievement of a significant corporate benefit.” The threat must be real and not pretextual, and the board’s motivations must be proper and not selfish or disloyal. As Chancellor Allen stated long ago, the threat cannot be justified on the grounds that the board knows what is in the best interests of the stockholders.

Second, the court should review whether the board’s response to the threat was reasonable in relation to the threat posed and was not preclusive or coercive to
the stockholder franchise. To guard against unwarranted interference with corporate elections or stockholder votes in contests for corporate control, a board that is
properly motivated and has identified a legitimate threat must tailor its response to only what is necessary to counter the threat. The board’s response to the threat
cannot deprive the stockholders of a vote or coerce the stockholders to vote a particular way.

So there you have it.  There no longer appears to be a Blasius – there is only Unocal.  Blasius‘s key point – that directors cannot interfere with a stockholder vote solely because they think stockholders will vote wrong, even if they hold that belief in good faith – now is part of Unocal‘s first prong, namely, whether the directors have identified a threat justifying action.  The threat has to be something other than stockholders choosing to vote for against the Board, and, in Coster, that threat was the damage that a custodian would do to the corporate enterprise under the specific circumstances of this case.  Next, even if such a threat is identified, the actions taken to thwart the stockholder vote cannot be preclusive or coercive under Unocal‘s second prong.  That standard, too, was met in Coster, because, while the stock issuance broke the deadlock, it meant that in the future, the widow could perhaps have more influence by forming a coalition with the employee against the founder.  I.e., without the stock sale, the widow would be pitted against the founder with no resolution; with the stock sale, the employee – who could vote as he pleased – represented a means by which either side could exercise control.

Now, I gotta be honest, I think this analysis of what counts as “preclusive or coercive” raises more questions than it answers, but, also, it’s been almost three decades since Mendel v. Carroll, 651 A.2d 297 (Del. Ch. 1994), where a Delaware court first raised the hypothetical possibility that maybe a dilutive stock issuance against a threatening controller might be justified under some set of facts, and yet this is the first time such an issuance has in fact been approved, so it might be another 30 years or so before we have to worry about it.

Even more interesting is how the Coster decision follows naturally from Chancellor McCormick’s earlier holding in The Williams Companies, where she effectively merged Blasius and Unocal by holding that a board could not adopt an anti-activist poison pill out of fear shareholders would engage with the board in the “wrong” way.   Generally, though, commenters have noted the tension between Unocal/Unitrin – which allow boards to block shareholder sales out of fear shareholders will act out of ignorance – and Blasius, which does not allow boards to block shareholder votes out of that same fear.  Now that we know for sure Blasius is an aspect of Unocal, will Delaware confront that tension more directly?

Submissions and nominations of articles are being accepted for the fourteenth annual Fred C. Zacharias Memorial Prize for Scholarship in Professional Responsibility.  To honor Fred’s memory, the committee will select from among articles in the field of Professional Responsibility with a publication date of 2023.  The prize will be awarded at the 2024 AALS Annual Meeting in Washington, DC.  Please send submissions and nominations to Professor Samuel Levine at Touro Law Center: slevine@tourolaw.edu.  The deadline for submissions and nominations is September 1, 2023

Last week, I had the pleasure of attending one of my favorite conferences: NBLSC, hosted this year in Knoxville by Joan Heminway and by Eric Chafee.  While there, I took part in a panel discussion of Adam Pritchard and Robert Thompson’s new book, A History of Securities Law in the Supreme Court.

Much of the book is based on the recently-public papers of Justice Powell, and argues that his presence on the Court reshaped the direction of securities law from the deferential approach applied in the early years of the New Deal to the much more skeptical view we often see today.  In particular, the book highlights how Justice Powell, with his experience as a corporate lawyer, exhibited particular sympathy and concern for businessmen who might be caught in an uncertain liability regime (twice, Justice Blackmun accused Justice Powell of continuing to represent his corporate clients from the bench, see pp. 85, 163).

In elucidating their argument, Pritchard and Thompson highlight a string of cases authored by Justice Powell where the Court adopted narrow constructions of the securities laws, after a run of broad constructions (both at the Supreme Court and in the lower courts).  One of those cases was Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), where a securities broker had stolen his clients’ money, and the clients sued his auditor under Section 10(b), claiming its negligent audit had aided and abetted the scheme.  Justice Powell was particularly concerned about “expansiv[e]” readings of Section 10(b), p. 183, as well as its application to third parties, and so, writing for the Court, rejected negligence as a basis for 10(b) liability and held that Section 10(b) requires a higher standard of intent.

The book’s discussion of Ernst was something of a puzzle for me, because in many ways I find the logic of the opinion so compelling that it’s difficult to see how the case represents a turn towards narrow constructions of the securities laws – rather than, say, a push back against plaintiff overreaching.  The core textual argument is that Section 11 imposes strict liability, or something like liability for negligence, but only for a specific set of documents (registration statements) against a specific set of defendants (the issuer, directors, signatories, experts, and underwriters).  If Section 10(b) were read to include negligence-based false statements, it would entirely swamp Section 11, with its careful limits on negligence-like liability.

But as I was preparing my remarks for the conference, I thought more deeply about the history of the securities’ laws development.

Ernst was decided in 1976.  That was 12 years before Basic v. Levinson, 485 U.S. 224 (1988); though the Supreme Court had presumed reliance in cases of fraudulent omissions, Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128 (1972), and proxy fraud, Mills v. Electric Auto-Lite Co., 396 U.S. 375 (1970), for general affirmative misstatements, the fraud on the market doctrine was only just being developed in the lower courts (Blackie v. Barrack, 524 F.2d 891 (9th Cir. 1975) had been decided only a year earlier).

In 1968 – just 8 years prior to Ernst – the Second Circuit suggested for the first time that Section 10(b) claims might not require privity between the purchaser and seller in SEC v. Texas Gulf Sulfur, 401 F.2d 833 (2d Cir. 1968) (en banc), which created the possibility of liability to the entire universe of traders for open-market frauds.  See David S. Ruder, Texas Gulf Sulphur—The Second Round: Privity and State of Mind in Rule 10b-5 Purchase and Sale Cases, 63 Nw. U. L. Rev. 423 (1968); Donald C. Langevoort, From Texas Gulf Sulphur to Chiarella: A Tale of Two Duties, 71 SMU L. REV. 835 (2018).  In 1976, the law in that area was only beginning to get off the ground, which is why it is not surprising that, according to Pritchard and Thompson’s history, Justice Powell was troubled by the lack of privity between the plaintiffs and the accounting firm in Ernst.  See p. 183. 

In other words, in 1976, the door was still open to using privity, and perhaps an “eyeball” reliance requirement, as a basis for distinguishing Section 10(b) and Section 11, rather than the negligence/scienter distinction that the Court actually chose.  Certiorari had not been granted on that basis, however, and so Justice Powell was unwilling to make privity the foundation of his reasoning; he went with scienter instead.  See p. 183.

Viewed through that lens, yes, Ernst was something of an activist decision that was not necessarily driven entirely by the statutory text; it was a choice to narrow Section 10(b) on one particular ground, but not on an alternative ground.

So let’s imagine that alternative world, where the Court had, in fact, permitted negligence-based Section 10(b) claims.  I wonder if future courts (including the Supreme Court) would have been so quick to endorse open-market Section 10(b) actions, let alone the fraud on the market presumption of reliance.  In a world where negligence, rather than scienter, is enough to state a Section 10(b) claim, I think it’s possible courts would have been more circumspect about paving the way for securities class actions. 

In other words, the ironic implication of Pritchard and Thompson’s history is that Justice Powell, in his attempts to narrow the reach of the securities laws, ended up opening the door to the modern securities class action bar.