Corporate Governance

Delaware Courts and the Validation of Misleading Disclosure: In re Transkaryotic (The Irrelevancy of Divided Loyalties)(Part 4)

By J. Robert Brown

In the area of director independence, Delaware courts routinely ignore evidence of obvious conflicts of interest.  In this case, the largest shareholder of Transkaryotic was Warburg Pincus, a private equity fund.  At one point, the fund owned 14% of the shares.  As the Court noted, the ownership "entitled" Warburg to a seat on the board.  In addition, a second Warburg "professional" who was a founding investor of Transkaryotic also sat on the board. 

When the shares of Transkaryotic fell dramatically in 2003, Warburg "lost over $100 million" and in 2004 considered the investment "problematic."  Plaintiffs alleged that the two Warburg directors had divided loyalties, favoring the interests of Warburg over Transkaryotic.  The Court summarily dismissed the argument.   

• Clearly, the mere fact that Leff was affiliated with a large stockholder does not disable the business judgment rule.  On the contrary, in fact, "[a] director who is also a shareholder of his corporation is more likely to have interest that are aligned with the other shareholders of that corporation as it is in his best interest as a shareholder to negotiate a transaction that will result in the largest return for all shareholders."  Warburg owned about fifteen percent of Transkaryotic, and this substantial stake gave Leff "powerful economic (and psychological) incentives to get the best available deal.  Plaintiffs have failed to show that this normal presumption is inapplicable here because they have not and cannot on this record make "a strong factual showing" that Leff and Warburg "were willing to leave a substantial sum of money on the table -- simply to rid themselves of [Transkaryotic]." 

Several thoughts on this.  First, the quote refers to directors who are also shareholders.  While one of the two directors did own shares, the allegations by Plaintiffs had nothing to do with direct ownership by the directors.  It was an allegation of a conflict of interest because the directors represented the company's largest shareholders.  The issue, therefore, is whether directors representing a large shareholder can have interests that differ from other shareholders, particularly where the large shareholder pays the director a salary (or other compensation).  That issue was entirely ignored by the Court.

Representing a large shareholder can easily create a conflict of interest with other investors.  There are two reasons.  First, there are different types of shareholders with different motivations that can easily be at odds with other investors.  VC Strine has more or less said this.  Thus, the Court apparently treated Warburg as a typical shareholder, all but ignoring its status as a private equity fund.  While it is true that any large shareholder would likely want to maximize the price received for its shares, shareholders that routinely redeploy assets like private equity funds have other temporal concerns.  If there is a better use for the funds, they may be willing to forgo the possibility of a higher offer in the future for an acceptable one now.  In other words, it is not only about whether Warburg would be willing to leave a "substantial sum" on the table but also about what Warburg's alternative uses for the funds.  

Second, size matters.  Large shareholders do not necessarily have the same interests as other shareholders.  This is why, for example, that the Combined Code of Corporate Governance for the United Kingdom provides that a director is presumptively not independent if he or she "represents a significant shareholder."  In other words, this Code (and others) recognizes that a representative on the board of a large shareholder may well have interests that differ from other shareholders.

None of this mattered to the Court.  It was enough that the directors represented a shareholder and, apparently, all shareholders have the same goals irrespective of the nature of their investment history and the size of their investment.    

Full post as published by The Race to the Bottom on July 23, 2008 (boomark / email).