Marcel Kahan & Edward Rock, How to Prevent Hard Cases from Making Bad Law: Bear Stearns, Delaware, and the Strategic Use of Comity

• Publication year: 2009

HOW TO PREVENT HARD CASES FROM MAKING BAD LAW: BEAR STEARNS, DELAWARE, AND THE STRATEGIC USE OF COMITY

Marcel Kahan^*

Edward Rock^**

ABSTRACT

The Bear Stearns-J.P. Morgan Chase merger placed Delaware between a rock and a hard place. On the one hand, the deal's unprecedented deal protection measures-especially the 39.5% share exchange agreement-were probably invalid under current Delaware doctrine because the measures rendered the Bear Stearns shareholders' approval rights entirely illusory. On the other hand, were a Delaware court to enjoin a deal brokered by the Federal Reserve and the Treasury Department, and arguably necessary to prevent a collapse of the international financial system, it would invite just the sort of federal intervention that would undermine Delaware's role as the de facto provider of U.S. corporate law.

Faced with a choice between undermining the delicate and subtle balance struck between managers and shareholders and standing in the way of the imperatives of national and international economic policy, Delaware found a third way that avoided both horns of the dilemma: it took advantage of a pending New York action to stay the Delaware action and avoid making a decision. In this Essay, we tell this story, analyzing the doctrinal issues under Delaware corporate and procedural law, and discussing the implications of this episode for our understanding of the landscape of U.S. corporate lawmaking.

INTRODUCTION

Over half of the publicly traded corporations in the United States are incorporated in Delaware. No other state even comes close.¹Under the "internal affairs" rule, the law of the state of incorporation governs the internal affairs of the corporation-the rules of corporate decision making; the allocation of power between shareholders, directors, and management; and fiduciary duties²-and other states often look to Delaware law in fashioning their own rules.³Delaware, one of the smallest states in the nation, has thus become the de facto national lawmaker for corporate law.⁴

Yet, Delaware's dominant position in corporate law could be eroded. The

Securities and Exchange Commission encroaches from a variety of directions.⁵

Congress could enact a national corporate law. Other states could displace

Delaware, just as Delaware displaced New Jersey nearly 100 years ago.⁶

Delaware has so far been successful in fending off these potential threats. To be sure, our colleague Mark Roe has expounded the view that Delaware enjoys little autonomy in devising its corporate law because it must constantly respond to the threat of federal preemption.⁷We have argued that the relationship is far more complementary than Roe suggests.⁸But, regardless of whether Roe or we are right about the extent of Delaware's legal autonomy, it is clear that, from a business perspective, Delaware is a stunning success:

Delaware earns more than $550 million per year in franchise taxes;⁹these fees amount to more than 20% of its annual tax revenues;¹⁰Delaware's market share of public corporations has increased from 30% for firms that went public between 1960 and 1964, to 56% for firms that went public between 1980 and

1984, to 77% for firms that went public between 1995 and 1998;¹¹and no other state attracts more than a nominal percentage of public corporations that are not headquartered in the state.¹²Until now, at least, any federal encroachment on Delaware's autonomy may have hurt its pride, but not its pocketbook.

Yet it remains true that there is no assurance that the goose that lays Delaware's golden eggs will live forever. As we have argued elsewhere, the biggest threat facing Delaware is the emergence of some major crisis that focuses public attention on the peculiar mode of U.S. corporate lawmaking-in which the elected officials and judges of one of the smallest states set the rules governing most publicly traded corporations-and undermines the public faith in Delaware's ability to handle the job.¹³

The recent events leading to the demise of Bear Stearns thus presented a problem for Delaware. The shareholder litigation challenging J.P. Morgan Chase's (J.P. Morgan) acquisition of Bear Stearns caught Delaware between a rock and a hard place. How does Delaware respond when it finds itself with a choice between picking a fight it cannot win and maintaining the integrity of the fabric of Delaware corporate law?

Delaware came up with a wonderful answer: let New York decide! As we describe in this Essay, when faced with a set of deal protection measures that raised serious problems under Delaware law, Delaware managed what one might have thought impossible-it avoided a fight and also avoided undermining its nuanced jurisprudence-by the simple expedient of deferring to a court of a sister state (never mind that it was not the state of incorporation!).

Part I of this Essay briefly describes the final days of Bear Stearns and the two deals it struck with J.P. Morgan. Part II provides a legal analysis of the deal protection measures in the Bear Stearns-J.P. Morgan merger agreement, with particular attention to the Share Exchange Agreement (SEA), and explains why the SEA was probably invalid under current Delaware doctrine. Part III discusses the dilemma Delaware faced when asked to adjudicate a transaction that, on the one hand, was arguably needed to prevent the collapse of the financial system but that, on the other hand, was hard to reconcile with existing Delaware law. Delaware escaped this dilemma by staying the Delaware action in favor of a contemporaneous action filed in New York state court. Delaware's decision to stay the action did not accord with its usual practice in resolving stay motions in significant corporate law cases and is best understood as a strategic decision to abstain from adjudicating a case that potentially threatened Delaware's place in the corporate lawmaking landscape. Part IV examines the implications for corporate federalism.

I. BACKGROUND

The spectacular failure of Bear Stearns was front-page news. Now that the dust has settled, the outlines of what happened are reasonably clear, although there is much that remains mysterious. What follows is a sketch of the chain of events that led to J.P. Morgan's acquisition of Bear Stearns.¹⁴

During the week of March 10, 2008, rumors began to circulate on Wall Street that Bear Stearns was in trouble, and customers began leaving in droves.¹⁵By the end of the day on Thursday, March 13, it was clear that Bear Stearns faced a crisis.¹⁶So many customers had removed their assets that Bear

Stearns had exhausted $15 billion in cash reserves.¹⁷Lenders who financed

Bear Stearns's operations refused to replenish the financing.¹⁸Clients of other banks were pushing to get out of trades with Bear Stearns.¹⁹By the evening of March 13, Bear Stearns was considering all options: it turned to J.P. Morgan to see if J.P. Morgan would buy it; it considered filing for bankruptcy; and it spoke constantly with representatives of the Federal Reserve Bank of New York camped out in its offices.²⁰

By early morning on Friday, March 14, time had run out. The Federal Reserve and the Department of the Treasury (Treasury) were concerned that a Bear Stearns collapse would have far-reaching effects.²¹A Federal Reserve official was quoted as saying: "For the first time in history the entire world was looking at the failure of a major financial institution that could lead to a run on the entire world financial system . . . . It was clear we couldn't let that happen."²²To prevent this from happening, J.P. Morgan, with nonrecourse financing from the Federal Reserve, agreed to provide financing to Bear Stearns for "up to 28 days."²³

With the J.P. Morgan and Federal Reserve commitments, Bear Stearns was able to open for business on Friday, but customers continued to flee and trading partners continued to disappear.²⁴Throughout the day, Bear Stearns's stock price continued to drop, closing at $32 per share.²⁵Teams from J.P. Morgan, private equity firms J.C. Flowers (Flowers) and Kohlberg Kravis Roberts & Co., and major banks poured over Bear Stearns's financials.²⁶

Friday evening, Treasury Secretary Henry Paulson and Federal Reserve Bank of New York President Timothy Geithner made it clear that a deal to sell Bear Stearns had to be announced by early Sunday evening when the Asian markets opened.²⁷The twenty-eight-day window had suddenly closed.

By the end of the day on Saturday, March 15, Flowers made an offer contingent on lining up financing to continue Bear Stearns's operations.²⁸

Later, J.P. Morgan indicated that it might be willing to buy Bear Stearns for $8 to $12 per share.²⁹

On Sunday morning, J.P. Morgan presented a draft merger agreement with the price left blank.³⁰It became clear that Flowers would not be able to go forward. At about 10 a.m., J.P. Morgan withdrew its offer, but soon returned with a $4 per share offer, with the Federal Reserve taking responsibility for

$30 billion of illiquid securities.³¹Bear Stearns's managers, irate with the low

$4 per share price, seriously contemplated filing for bankruptcy.³²Paulson spoke with J.P. Morgan CEO Jamie Dimon and pushed for a price even lower than $4 per share.³³Paulson wanted to avoid the impression that the government was bailing out the shareholders of an investment bank that had engaged in speculation, while offering no help to the little guy who had defaulted on his sub-prime mortgage.³⁴

By mid-afternoon on Sunday, March 16, J.P. Morgan made a firm offer of

$2 per share.³⁵Faced with a choice of filing for bankruptcy or accepting $2 per share, the Bear Stearns board accepted.³⁶

The March 16 merger agreement contained a variety of fairly standard "deal protection" measures. J.P. Morgan received an option to buy Bear Stearns's corporate headquarters building for $1.1 billion (Asset Option), and an option to buy just under 20% of Bear Stearns stock at $2 per share.³⁷The

Bear Stearns board also provided the necessary approvals to waive the...