Chapter 10 – Corporate Financial Structure

Inserts & Errata (20 Sep 09)

P252 – Insert text box with last paragraph:

Make the Connection!
A “poison pill” is an antitakeover device that dilutes the financial position of an acquiror that buys a controlling interest in a corporation without first obtaining the permission of the corporation’s board of directors. The device thus compels would-be acquirors to negotiate with the board, before acquiring a controlling interest from shareholders. We will discuss “poison pills” in Chapter 14, Shareholder Voting Rights; Chapter 15, Governance Role of Public Shareholders; and Chapter 27, Antitakeover Devices. You can also find a fuller description of the device at p. 388 [CHECK]

P275 – insert following text box within case:

FYI. During the 1990s and 2000s, many of the most important decisions on corporate law were authored by E. Norman Veasey, who served as Chief Justice of the Delaware Supreme Court from 1992 to 2004. Besides solidifying Delaware’s reputation for “fair, reasonable and efficient” litigation (according to the U.S. Chamber of Commerce), Veasey was a national leader on professionalism reform. He chaired a special ABA committee that proposed ethics rules for lawyers (Ethics 2000) that, among other things, permitted lawyers to violate attorney-client confidences to prevent financial crimes. Since leaving the bench, Veasey has been a practicing corporate lawyer in Delaware, a frequent lecturer and writer on corporate law, and an adjunct professor at two law schools.

P279 – strike third full paragraph, beginning “We start …” and all of Dodge v. Ford Motor Co. case / replace with following:

We start with a garden-variety dispute in a close corporation. The majority shareholder has chosen not to pay dividends. The minority shareholder, who is left without any return on his investment, sues to compel the declaration of dividends. In the second case, we look at dividends in a public corporation, where the board has decided to distribute stock held by the corporation as a special dividend. Two public shareholders seek to block the dividend. In both cases, the critical issue is the standard of review. What should be the standard of review regarding corporate dividend policy – fairness or the business judgment rule?

Litle v. Waters

Ch. LEXIS 25 (Del. Ch. 1992)

William Chandler, Chancellor.

Plaintiff, Thomas J. Litle, instituted this lawsuit against defendants alleging that they had committed, and continue to commit, various breaches of fiduciary duties.

As alleged in the complaint, in 1979 Litle and Waters formed Direct Order Sales Corporation (“DOSCO”), a Delaware corporation which engaged in the catalog sales and merchandise fulfillment business. At the beginning, DOSCO was unprofitable and Waters infused it with capital by lending it money. In 1983, Litle and Waters formed Direct Marketing Guaranty Trust Corporation (“old DMGT”), a New Hampshire corporation which engaged in the credit card processing business for catalog sales transactions. Waters owned 2/3 of the stock of both companies and Litle owned 1/3.

The two men agreed that Waters would provide the capital and Litle the management for the two entities. Although the two elected to treat the corporations as S corporations, with flow-through tax status, they never formally agreed that the corporations would actually pay dividends.

In September 1985, Waters fired Litle as president and CEO of both companies. Waters then merged the two companies into DMGT Corp. (“new DMGT”). Waters became the new corporation=s CEO and board chair, and then used the combined entities’ profits to begin repaying the debt that DOSCO had owed him.

Since the merger, new DMGT has done very well:

Year Reported earnings

1987 $ 739,000

1988$ 909,000

1989$ 3.8 million

1990 $ 3.6 million

These earnings have resulted in a tax liability of $560,000 for Litle, who retained a 33% interest in new DMGT, even though new DMGT has not distributed any dividends to its shareholders. According to Litle, Waters is having new DMGT not pay dividends to make Litle’s shares worthless so that Waters can buy Litle out “on the cheap.” In fact, Waters tried to have his accountants justify this hoarding of cash, but the accountants could not state a need for not paying dividends.

In the complaint, plaintiff alleges that “the Director Defendants breached their fiduciary duties to the stockholders in that the course of action embarked upon was designed to and did favor one group of stockholders to the detriment of another.” Defendants argue that “the declaration and payment of a dividend rests in the discretion of the corporation’s board of directors in the exercise of its business judgment; that, before the courts will interfere with the judgment of the board of directors in such matter, fraud or gross abuse of discretion must be shown.” Gabelli & Co., Inc. v. Liggett Group, Inc., 479 A.2d 276, 280 (Del. 1984). Further, defendants argue, the mere existence of funds from which the entity could pay dividends does not prove fraud or abuse of discretion by a board in its determination not to declare dividends. Defendants argue that the Board’s decision to not to declare dividends is protected, unless the plaintiff can show “oppressive or fraudulent abuse of discretion.” Eshleman v. Keenan, 194 A. 40, 43 (Del. Ch. 1937).

In making their respective arguments, the parties overlook an important issue. That is, what is the proper standard of judicial review or the Board’s actions? Plaintiff merely states in a footnote that an entire fairness standard applies. Defendants, by relying on Eshleman imply that the business judgment standard applies.

An interested director is one that stands on both sides of a transaction or expects to derive personal financial benefit from the transaction in the sense of selfdealing, as opposed to a benefit which devolves upon the corporation or all stockholders generally. The decision as to whether a director is disinterested depends on whether the director … involved had [a] material financial or other interest in the transaction different from the shareholders generally. “Material” in this setting refers to a financial interest that in the circumstances created a reasonable probability that the independence of the judgment of a reasonable person in such circumstances could be affected to the detriment of the shareholders generally.

Waters served his own personal financial interests in making his decision to have DMGT not declare dividends. By not making dividends, he was able to ensure that he would receive a greater share of the cash available for corporate distributions via loan repayments. Further, the decision enabled him to put pressure on Litle to sell his shares to him at a discount since the shares are and were only a liability to Litle who receives no corporate distributions, yet owes taxes on the company’s income. Indeed, the loan repayments continue to enable Waters to keep the pressure on Litle to sell the shares at a discount since the loan repayments provide cash that he can use to pay his tax liability, while Litle has to find sources of cash to pay his tax liability. Therefore, I must consider Waters to be an interested director with respect to the Board’s decision to not declare dividends.

Since plaintiff’s complaint sufficiently alleges facts which justifies the applicability of the entire fairness standard and defendant has not adequately rebutted its applicability by showing the other new DMGT directors are independent, the burden shifts to defendants to demonstrate that the decision to not declare dividends and to repay the company’s debt to Waters was intrinsically fair.

Count I of plaintiff’s complaint states claims for which I can grant relief.

------

Pg. 284: Replace point 1 with the following:

1.Dividend policy in the close corporation.

Why is the court more sympathetic with the complaining shareholder in the first case? Would the court have decided differently if Waters (the majority shareholder) had offered some business reasons for not paying dividends, such as to expand the company’s business? What if Waters had offered Litle a fair price for his shares, but Litle had refused in the hope of getting a better price if the company went public?

Was it relevant that the board in the first case was dominated by the majority shareholder? Would the result have been different in the first case if the board had been composed of a majority of outside directors, as in the case of American Express?

Pg. 284: In point 3 insert the following first paragraph:

Does the difference in the cases turn on the remedy being sought – in one, compelling the payment of dividends and, in the other, the blocking of payment? What about that the first case involved a close corporation, while the second a public corporation?

P284 –replace the first sentence of the next paragraph with the following:

What is the rationale for allowing Litle to go forward with his claim to compel the payment of dividends?