Corporate Governance

Delaware's Top Five Worst Shareholder Decisions for 2009 (#4): San Antonio Fire & Policy v. Amylin

By J. Robert Brown

Delaware courts assert that boards have a duty to be informed, something that often goes under the label of a duty to monitor.  The duty was first discussed in a meaningful way in Caremark, although it took the Delaware Supreme Court 15 years to acknowledge that in fact boards had a duty to monitor.  In Caremark, Chancellor Allen placed the duty squarely in the realm of good faith.  Directors had a good faith obligation to ensure an adequate system for reporting information to the board.

Recognizing the obvious harm to shareholders, the Chancery Court admonished outside counsel to make it a practice to report these types of matters to the board.

• Thus, I am of the view that a director's obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards.

In other words, there was no obligation of the board to require that counsel do so.  There was no fiduciary obligation to be informed of provisions in contracts that could have a materially detrimental effect on voting rights.  Instead, matters would be left to the professionalism of outside counsel.

The rationale was an example of the Ostrich approach to management. 

What did the reporting system have to include?

• But it is important that the board exercise a good faith judgment that the corporation's information and reporting system is in concept and design adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations, so that it may satisfy its responsibility.

Caremark, therefore, required as a matter of good faith that boards put in place reporting systems designed to alert them to important developments inside the company.  The court also indicated that the system had to be sufficient to ensure timely revelation of appropriate information.

In fact, as is often the case in Delaware, the potential of Caremark was quickly abandoned.  While the Delaware courts have often repeated the adage about the need for a reporting system, they have resolutely declined to give the reporting system any significant content.  Thus, as long as a reporting system is in place, boards have no obligation to ensure that the system actually provides them with the information needed to adequately oversee the activities of the corporation.

This unwillingness can be seen from the strained rational in San Antonio v. Amylin.  The case involved poison puts.  Amyln issued debt that contained default covenants triggered whenever the board no longer contained a majority of "continuing directors."  This could occur, for example, when shareholders elected a majority of non-management nominated directors.  In those circumstances, debt holders could put their notes back to the company at face value, a decided advantage since the Amylin debt was trading on a deeply discounted basis.

Shareholders challenged the puts, noting that they interfered with the corporate franchise by discouraging shareholders from voting for dissident directors.   The board's defense, however, was that it had been unaware of the put.  The case turned, therefore, on whether the board had a duty to be aware of contractual provisions in the change of control context that severely restricted the voting rights of shareholders.  It being Delaware, the resolution was predictable.

• The answer must be no. The board retained highly-qualified counsel. It sought advice from Amylin's management and investment bankers as to the terms of the agreement. It asked its counsel if there was anything 'unusual or not customary' in the terms of the Notes, and it was told there was not. Only then did the board approve the issuance of the Notes under the Indenture. This is not the sort of conduct generally imagined when considering the concept of gross negligence, typically defined as a substantial deviation from the standard of care.

In short, the corporation could implement contractual provisions that severely restricted the shareholder franchise and that provided the corporation with little apparent benefit.  As long as counsel and others kept the board in the dark, the decisions were unreviewable.  

• This case does highlight the troubling reality that corporations and their counsel routinely negotiate contract terms that may, in some circumstances, impinge on the free exercise of the stockholder franchise. . . . Outside counsel advising a board in such circumstances should be especially mindful of the board's continuing duties to the stockholders to protect their interests. Specifically, terms which may affect the stockholders' range of discretion in exercising the franchise should, even if considered customary, be highlighted to the board. In this way, the board will be able to exercise its fully informed business judgment.

The last sentence was the most telling.  The board had no obligation to ask for the information.  The board's fiduciary duties and the obligation to act on an informed basis did not require them to insist on the information.  Instead, acting in a "fully informed" matter was something that depended upon the voluntary cooperation of outside counsel.   In other words, the duty of care and the business judgment rule requires nothing affirmative. 

As for the Supreme Court's view?  On appeal, the Court affirmed the lower court but in an entirely disingenous fashion.  The Court acted as if the board had considered the poison put and determined that it was appropriate.  

• The Court of Chancery determined, inter alia, that Amylin Pharmaceuticals' board of directors did not breach its duty of care in authorizing the corporation to enter into the Indenture Agreement, with its 'proxy put' provision. That determination was correct, not only for the reasons made explicit in the Court's opinion, but also for one that is implicit: no showing was made that approving the 'proxy put' at that point in time would involve any reasonably foreseeable material risk to the corporation or its stockholders. That risk materialized only months later, and was aggravated by the unexpected, cataclysmic decline in the nation's financial system and capital markets beginning in the Spring of 2008.

It was, in the end, the best example of the ostrich approach to governance yet to come out of Delaware.  Companies can use contracts to substantially restrict shareholder governance as long as the board is told about it. 

It is the type of decision that justifies federal intervention and the requirement that reports be made to the board of directors.  SOX took that approach; so do other reform efforts.  If the Delaware courts will permit know nothing boards, federal legislation will need to insist otherwise.  

The primary materials in this case can be found at the DU Corporate Governance web site.  

Full post as published by The Race to the Bottom on January 04, 2010 (boomark / email).