WARNING – Don’t Frustrate your Shareholders!! –James U. Jensen

Boards that Work – How CEO’s Find Them and Flourish Provided

by: Jim Jensen – CEO, ClearWater Group

NACD, UTC and MWCN meeting on January 21, 2010 in Salt Lake City, Utah

WARNING – Don’t Frustrate your Shareholders!!
— The Evolving Legal Consideration of the Duty to Avoid Frustration of Purpose

These three recent legal cases from three separate jurisdictions each address the concept of frustration of purpose. Consider:

McLaughlin v. Schenk; Utah Sup Ct., Oct. 2, 2009. (2009 WL 3151201 (Utah), 640 Utah Adv. Rep. 27, 2009 UT 64.)

In this Utah Supreme Court case, announced in October 2009, Utah joined a majority of states in holding that shareholders in closely held corporations owe each other enhanced, or more stringent fiduciary duties, than the standard for publicly traded corporations. Relying on Massachusetts precedent, the Court relied on the resemblance between close corporations and partnerships in requiring a standard of utmost good faith and loyalty to ALL shareholders of the corporation. The court based this decision on several unique and potentially oppressive aspects of closely held corporations. First, shareholders in closely held corporations have no liquidity in their shares. Thus, minority shareholders who disagree with the direction of the company often face impractical or nonexistent remedies for abuses created by a small number of shareholders (due in part to the familial and personal relationships that dominate close corporations).

Breaches of the fiduciary duty owed by close corporation shareholders were identified as 1) unequal treatment, 2) frustration of reasonable expectations of involvement [emphasis added], and 3) a freeze-out or squeeze-out. However such activity is conduct by majority shareholders, it is not oppressive, the Court said, simply by virtue of a minority shareholders unfulfilled desire to join the venture—“disappointment alone should not necessarily be equated with oppression.” As a side note, Delaware, unsurprisingly narrowly construes the duties of shareholders in closely held corporations and imposes the same fiduciary duties imposed on public corporations. [Local Boards might consider the potential for different expectations for a local corporation incorporated in Delaware or in Utah].

ENZON (Delaware)

Activist shareholders (represented by artful counsel) can force improved governance standards such as the separation of Chairman and CEO roles. But managements and Boards don’t like meddlesome advice from shareholders and often close ranks even in the face of threatened or actual litigation. BOARDS THAT WORK will want to respond to feedback much sooner than shown here by the Enzon Board and will want to support their CEO in a manner that does not “frustrate” [emphasis added] the shareholders legitimate interest in clear lines of duty between management and the directors.

Upset by the drastic decline of the value of shares a minority group of shareholders of Enzon Pharmaceuticals, a Delaware Corporation, filed a preliminary consent solicitation statement with the SEC seeking to amend the bylaws to allow shareholders to remove the CEO. The statement cited a section of Delaware Corporate Code requiring that officers hold office for terms prescribed by the bylaws until resignation or removal. And remarkably there was no prescribed period in the extant bylaws. The filing of this statement exerted enough pressure on the board and the CEO that the CEO gave up his position as chairman of the company, but kept his role as CEO and the change was made a mere three months after the statement was filed.

1) As of 2004, in 66% of companies, the roles of CEO and Chairman were occupied by the same person.

2) The proposed Act: “Restoring American Financial Stability Act of 2009” (the “RAFSA-2009 Act”) proposed the following amendment to Section 14 of the Exchange Act:

SEC. 973. DISCLOSURES REGARDING CHAIRMAN AND CEO STRUCTURES. Section 14A of the Securities Exchange Act of 1934, as added by section 971, is amended by adding at the end the following:

(b) DISCLOSURES REGARDING CHAIRMAN AND CEO STRUCTURES.— Not later than 180 days after the date of enactment of this subsection, the Commission shall issue rules that require an issuer to disclose in the annual proxy sent to investors the reasons why the issuer has chosen—

(1) the same person to serve as chairman of the board of directors and chief executive officer (or in equivalent positions); or (2) different individuals to serve as chairman of the board of directors and chief executive officer (or in equivalent positions of the issuer).”

3) Interestingly, note that North Dakota has taken this step and under the Publicly Traded Corporations Act, required that CEO and Chairman be separated. No such requirement is found in Utah law and will likely never be found in Delaware law.

HUDBAY (Ontario-Canada)

In the Matter of HudBay Minerals Inc. was decided by the Ontario Securities Commission (“OSC”) on appeal from the Toronto Stock Exchange. Announced on January 23, 2009, this case stands for the proposition that a Board’s decision may be overturned by regulators when approving a Management proposal to complete a major transaction without shareholder approval. Steps to avoid such owner participation may be said to adversely affect the “quality of the marketplace” [Canadian language] by “frustrating the legitimate exercise by shareholders of their right to require a shareholders’ meeting . . .” [Canadian language-emphasis added]. Here the OSC found that the importance of “deal certainty” was inadequate reason to prevent a shareholder meeting where completion of the transaction without such approval “could significantly and adversely affect the quality of the marketplace.” A BOARD THAT WORKS might have insisted on shareholder oversight of a 50% merger even where regulatory framework might be manipulated to avoid it. And a Board that Doesn’t Work can be completely unseated as in the HudBay case.

NOTE: The RMBCA-2009 Act provides that in a merger situation, approval by shareholders of the surviving corporation is not required if: 1) the articles of incorporation will not differ from the articles before the merger, 2) each shareholder of the survivor whose shares were outstanding immediately prior to the effective date of the merger will hold the same number of shares, with identical preferences, limitations and rights; and 3) the voting power of the shares issued as a result of the merger will comprise of no more than 20% of the voting power of the shares of the surviving corporation that were outstanding immediately prior to the merger. RMBCA §§11.04(g); 6.21(f). Consider similar provisions already in effect for Nasdaq companies.

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