Robert K. Clagg Jr., an "easily Side-stepped" and "largely Hortatory" Gesture?: Examining the 2005 Amendment to Section 271 of the Dgcl

• Publication year: 2009

AN "EASILY SIDE-STEPPED" AND "LARGELY HORTATORY" GESTURE?: EXAMINING THE 2005

AMENDMENT TO SECTION 271 OF THE DGCL

INTRODUCTION

Section 271 of the Delaware General Corporation Law ("DGCL") grants stockholders final approval on transactions that will sell all or substantially all of a corporation's assets via a vote. In 2004, the Delaware Court of Chancery, in Hollinger Inc. v. Hollinger International, Inc.,¹addressed in dicta whether the stockholders possessed the right to vote on a transaction that sold all or substantially all of the assets of a subsidiary of the corporation.²In 2005, Delaware amended section 271 of the DGCL to address the interpretive issues brought to light by Hollinger. This Comment examines the nature of the 2005 amendment and argues against an expansive reading of the amendment that would stretch its implications beyond the scope of section 271 into other sections of the DGCL. Such an expansive reading would be contrary to both Delaware jurisprudence and the Delaware corporate model;³additionally, an expansive reading is unnecessary because Delaware's existing standards of review provide adequate stockholder protections.

Corporate law statutes are state laws that serve as default rules governing the relationship between two primary corporate players: the board of directors and the principal owners of the corporation-the stockholders.⁴For better or worse,⁵the DGCL is the basis of the preeminent body of law regulating corporate governance in America.⁶In conjunction with the corporate jurisprudence shaped by the Delaware Supreme Court and the Delaware Court of Chancery,⁷the DGCL governs the relationship between the board and stockholders for more than 615,000 business entities.⁸Among these entities are nearly 60% of the companies on the Fortune 500 and the New York Stock Exchange.⁹

The DGCL charges the board of directors with the primary responsibility of running the business affairs of the corporation.¹⁰While the board of directors is empowered with broad discretion over the management of the business, stockholders still possess important powers, such as the right to elect directors, the right to vote on mergers, the right of appraisal, and the right to vote on the sale of all or substantially all of the assets of the corporation.¹¹The last of these rights is codified in section 271 of the DGCL.¹²

At its core, section 271 is a measure enacted to protect the interests of shareholders.¹³The need for such protections arose in the nineteenth century, when legal thinkers viewed the merging of two independent corporations with deep suspicion.¹⁴The jurisprudence of the early nineteenth century did not view the sale of all of a corporation's assets as a special or unique transaction requiring additional stockholder protections.¹⁵Over time, however, the sale of all of a corporation's assets began to be viewed differently from a pure economic operation, and these transactions "took on some color of being fundamental"¹⁶as courts began viewing sales of all assets as a fundamental change requiring stockholder consent, much like a merger.¹⁷This development occurred because an asset sale could be structured to bring about identical economic results as a merger.¹⁸Consequently, the provisions of section 271 were necessary to maintain consistency in the law and to protect substantive stockholder rights from being infringed upon by lawyers structuring mergers as asset sales.¹⁹

While mergers or sales of corporate assets are no longer viewed as the equivalent of legal "murder,"²⁰stockholders still possess voting rights to protect them from transactions such as mergers and asset sales.²¹Since the inception of these corporate protections, corporate law has become increasingly complex and technical.²²Section 271 was recently amended in

2005 to address what may, to casual observers, appear to be a minor and technical issue: the nature of the protections afforded to stockholders when a corporation undertakes a subsidiary asset sale. ²³This seemingly narrow issue is extremely important, however, because most public companies no longer directly hold their valuable operating assets.²⁴Indeed, ultimate ownership of business assets is usually two or more times removed from the parent corporation.²⁵

Corporations place their assets in subsidiaries for a variety of perfectly legitimate business reasons, such as a desire to limit liabilities to third parties for certain business operations or to minimize tax liabilities.²⁶The ever- increasing complexity of corporate structures has a profound impact on the efficacy of stockholder protection provisions such as section 271.²⁷Legally, the right to vote on the subsidiary's stock inheres in the parent. Consequently, the board of directors of the parent could complete transactions, such as mergers of subsidiaries, without triggering a vote by the parent corporation's stockholders, which would be required by the DGCL if the assets were held directly by the parent.²⁸

The importance of this issue is underscored by the following hypothetical: Suppose that there are two publicly held American corporations specializing in the production of high-end toys.²⁹These two companies, DreamTown Toys, Inc. (DreamTown) and White-Picket Fence Toy Co. (WPF), share a similar corporate background and history. They also each control large percentages of the high-end toy market. The two companies, mindful of an upcoming election and a possible change in antitrust enforcement, are eager to merge as quickly as possible. Furthermore, the companies want to merge at the lowest possible cost and to avoid unnecessary stockholder votes.

Prior to the 2005 amendment to section 271, their goals arguably could have been achieved by dropping the assets of DreamTown into a subsidiary and then selling those assets to WPF.³⁰This Comment argues that although the 2005 amendment clearly requires a vote on this transaction, neither the amendment nor the case law prevents DreamTown and WPF from completing an economically similar transaction that avoids section 271's stockholder voting requirement. Section 271, in its current form, leaves the directors another means to the same end.

To accomplish this, DreamTown could create a subsidiary and, without stockholder approval, transfer all of its assets into the wholly owned subsidiary, receiving as consideration 100 shares in the new subsidiary. DreamTown could subsequently complete the transaction without triggering a stockholder vote as follows: WPF could merge DreamTown's subsidiary with either WPF itself or a subsidiary of WPF (the "Cash-Out Merger").³¹If WPF were to offer DreamTown cash for its 100 shares in the subsidiary as consideration for the merger, the net effect of the merger would be identical to an asset sale under section 271.³²Despite the similar economic result, under

Delaware jurisprudence the transaction would likely be governed by section

251, not by section 271.³³Thus, despite the statutory precautions meant to protect the stockholders, the merger would bring about the same economic result without triggering any of section 271's protective measures.³⁴

By focusing on the Cash-Out Merger, this Comment argues that the protections provided by section 271 may still be easily side-stepped, despite the 2005 amendment to the statute. Furthermore, despite assertions to the contrary,³⁵this result is not only consistent with the Delaware corporate model,³⁶but also creates the best result for stockholders.³⁷This Comment argues that the Cash-Out Merger designed to evade the voting requirement of section 271 should not be found illegal or inequitable per se, but should be subject to the "Revlon standard" of review,³⁸which is in itself a formidable shareholder protection.

Part I examines the 2005 amendment to section 271 of the DGCL and Hollinger Inc. v. Hollinger International, Inc., the case that precipitated the amendment. Part II explains the principles of Delaware law that enable a board of directors to avoid the voting requirement of section 271. Part III discusses the "Delaware corporate model," which results in a certain degree of uncertainty in predicting whether a Delaware court would allow a board of directors to evade the voting requirement of section 271. Part IV explores the various standards of review that may be applicable to the foregoing hypothetical transaction and endorses the Revlon standard. Part V then argues that this approach is consistent with Delaware jurisprudence.

I. HOLLINGER AND THE 2005 AMENDMENT TO SECTION 271

Given the DGCL's status in the world of corporate transactions, any revisions to it are of great interest to corporate practitioners.³⁹A clear, precise statute provides transactional attorneys with clear guidelines within which they may confidently structure deals in the best interests of their clients.⁴⁰

Conversely, imprecise draftsmanship leaves practitioners on much less certain ground.

One of the benefits of incorporating in Delaware is the general ease and relative promptness with which Delaware may change the DGCL when an issue of interpretation becomes critical.⁴¹While Delaware's constitution sets a high bar for amending the DGCL,⁴²the economic (and thus political) importance to Delaware of maintaining its leadership in the area of corporate law creates a major incentive for state politicians to act when clarity or reform is needed.⁴³Consequently, the state legislature is quick to update or modify laws as necessary to supplement the traditional common law basis of Delaware corporate law.⁴⁴The problem, of course, is that even a well-drafted change to the DGCL can often leave issues unresolved.

One such example of this drafter's dilemma is the recent amendment of section 271 of the DGCL.⁴⁵To address an interpretive issue brought to the fore in Hollinger Inc. v. Hollinger International, Inc.,⁴⁶in 2005 the Delaware legislature amended section 271 to clarify that a sale of all the assets of a wholly owned and controlled...