Could Share Buyback Authorizations Prove Demand Futility?
Posted on Nov 2, 2020Luke Ross
An unprecedented expansion in corporate share buybacks has led to a robust discourse over the economic and ethical merits of the practice and its associated corporate governance models.[1] In particular, the continuation of buybacks during pandemic-fueled economic distress into question a corporate governance model based solely on shareholder primacy.[2] For one, share repurchases can come at the expense of investments in innovation and day-to-day operations that are more likely to benefit employees.[3] For another, they can stretch corporate cash and credit reserves such that companies are unable to bear the costs of economic shocks without injections of taxpayer money.[4] Even so, current law is agnostic as to the authorization of buybacks.[5] Thus, absent new legislation, legal efforts to rein in share repurchasing directly will fall short.[6]
This fatalistic viewpoint, however, overlooks a legal avenue with some potential to restrain buyback activity: the shareholder derivative suit. This brief analysis of Delaware law suggests that authorizing buybacks may leave corporate directors without an important procedural shield against derivative suits. If so, corporate directors of underperforming companies would be wise to weigh the short- and medium-term benefits of buyback programs against the risks of costly litigation. Though these risks may exist only for a subset of companies engaged in share repurchasing, the fact they exist at all might surprise and concern corporate decision-makers.
Shareholder Derivative Suits & Demand Futility
In a shareholder derivative suit, the shareholders of a corporation, acting on behalf of the corporation, sue the corporation’s officers and directors.[7] Generally, these suits center on allegations that officers and directors are liable to the company for breaching their fiduciary duties to shareholders or wasting corporate resources.[8] As such, any relief granted at the suit’s conclusion runs to the corporation, rather than the shareholders themselves.[9]
Unsurprisingly, shareholder derivative suits are expensive and time-consuming.[10] Not only do they require protracted discovery but they also involve issues that make for complex and lengthy trials.[11] The non-legal costs are also significant. A derivative suit diverts officer and director attention from day-to-day management to legal conflict and acts as a negative signal to investors of corporate health.[12]
Given these costs, corporate officers have a strong interest in retaining legal procedural obstacles to the initiation of derivative suits. The most robust of these is the legal requirement that shareholders make a demand of corporate leadership to remedy alleged failures prior to bringing suit.[13] Put simply, this is a powerful shield against derivative suits. For one, the requirement increases the cost of litigation by substantially extending the duration of the legal conflict.[14] In fact, corporate leadership can fail to respond directly to a shareholder demand for over a year without waiving their right to a demand.[15] Moreover, Delaware courts are deferential to the efforts of corporate leadership to remedy conduct alleged in the demand.[16] As such, the viability of shareholder action rests, in large part, on the ability to evade the demand requirement.
Delaware law offers shareholders a difficult but manageable path to suing without a prior demand.[17] Shareholders must prove demand futility by raising a reasonable doubt that “(1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.”[18] In applying this standard, known as the Aronson test, Delaware courts have excused shareholder demands as futile when a majority of the board “was not independent” or not disinterested with regards to the alleged conduct.[19] In short, shareholders must do more than allege that corporate directors made a “poor decision” but must demonstrate that a majority of the board has engaged in self-interested conduct.[20]
Can Buyback Authorization Excuse Demand?
With that review of derivative suits in mind, it is plausible that board authorization of buybacks could undergird a shareholder showing of demand futility. At first blush this might seem strange. For one, buybacks tend to raise a company’s stock price, and thus benefit shareholders, as well as corporate directors.[21] For another, Delaware courts accept share repurchases as a valid exercise of business judgment.[22]
Nonetheless, these observations do not eliminate the potential risk to corporate directors and officers. To begin, it is quite possible to conceive of a buyback program that benefits a majority of corporate directors and officers yet harms, or at least confers no benefit onto, shareholders. First, many corporate officers work under board-approved, incentive-based compensation plans based, in part, on earnings-per-share,[23] which naturally rises with buybacks.[24] These officers, unlike common shareholders, thus stand to benefit from buyback programs regardless of the subsequent movement in the stock price. Second, board members often receive compensation in the form of stock grants and the right to purchase shares at discounted prices.[25] As a result, they may realize substantial short-term gains from selling stock following buybacks that produced merely a steadying or even small decline in stock price.
This disentanglement of director compensation from company value may harm shareholders in a variety of ways. For example, board members’ short-term incentives might lead to the authorization and implementation of a buyback program that drains corporate cash reserves months before an external economic shock, like a global pandemic, greatly reduces the company’s value.[26] Alternatively, board members might fail to perceive or ignore opportunities for growth via innovation or acquisition that would have, in hindsight, produced greater value for shareholders.[27] Lastly, board members might implement buybacks simply as a Band-Aid to obscure systemic problems in day-to-day operations rather than take steps to resolve them.[28]
At bottom, however, whether or not shareholders prevail on their claims is far less meaningful than whether they simply reach the courthouse. As noted above, the legal and non-legal costs associated with losing the shield of the demand requirement should not be understated.[29] With that said, however, considering the current historic levels of buyback activity,[30] corporate directors and officers may not yet perceive this risk of losing the demand requirement shield. This may be of little surprise given historic levels of repurchasing have coincided with historic growth in equity prices.[31] Nonetheless, it would be a mistake to assume conduct that has gone unchallenged today may nonetheless remain unscathed tomorrow. The economic uncertainties related to the pandemic as well as the growing debate over the welfare effects of buybacks may well compel litigation for which the authorization of buybacks may be a plaintiffs’ sword.
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[1] See, e.g., Jesse M. Fried, Share Repurchases, Equity Issuances, and the Optimal Design of Executive Pay, 89 Texas L. Rev. 1113 (2011); Hearing on “Examining Corporate Priorities: The Impact of Stock Buybacks on Workers, Communities, and Investors,” Before the Subcomm. on Inv. Prot., Entrepreneurship, & Cap. Mkts. of the H. Comm. on Fin. Serv. 116th Cong. (2019) (statement of Lenore Palladino, Professor, University of Massachusetts-Amherst) (hereinafter, “Statement of Lenore Palladino”).
[2] See Cydney Posner, So Long to Shareholder Primacy, Harv. L. Sch. F. on Corp. Governance (Aug. 22, 2019), https://corpgov.law.harvard.edu/2019/08/22/so-long-to-shareholder-primacy/.
[3] Statement of Lenore Palladino, 3.
[4] Emily Flitter & Peter Eavis, Some Companies Seeking Bailouts Had Piles of Cash, Then Spent It, N.Y. Times (Apr. 24, 2020), https://www.nytimes.com/2020/04/24/business/coronavirus-bailouts-buybacks-cash.html. arv L. Sch. F. on Corp. Governance (Feb 22, 2019)tion, 964 A.2d 106, 137 (Del Ch. 2009). It (ck programs -making. porate healt
[5] Statement of Lenore Palladino, 2.
[6] Id.
[7] See Joseph M. McLaughlin, Shareholder Derivative Actions and Demand Futility, Simpson Thatcher & Bartlett (Aug. 13, 2015), http://www.stblaw.com/docs/default-source/default-document-library/corporate-litigation-shareholder-derivative-actions-and-demand-futility-(8-13-2015).pdf?sfvrsn=0&id=772cdc0e-743d-6a02-aaf8-ff0000765f2c.
[8] See D. Scott Carlton, Derivative Suits 101: Tips for Successful Settlements, Am. Bar Ass’N (Jan 17. 2020), https://www.americanbar.org/groups/litigation/committees/class-actions/practice/2020/tips-for-successfulsettlements/#:~:text=A%20shareholder%20derivative%20suit%20seeks,cannot%20seek%20a%20personal%20benefit.
[9] Id.
[10] See Mark J. Loewenstein, Shareholder Derivative Litigation and Corporate Governance, 24 Delaware J. Corp. L. 1, 5-6 (1999).
[11] Id. at 15-16.
[12] See Carlton, supra note 6.
[13] Delaware Court of Chancery Rule 23.1(a).
[14]See Loewenstein, supra note 10.
[15]See Thorpe v. CERBCO, Inc., 611 A.2d 5, 8-10 (Del Ch. 1991).
[16] See Zapata Corp. v. Maldanado, 430 A.2d 779, 784 n.10 (Del. 1981) (explaining that “when stockholders, after making demand and having their suit rejected, attack the board's decision as improper, the board's decision falls under the ‘business judgment’ rule and will be respected if the requirements of the rule are met”).
[17] See Carlton, supra note 6.
[18] Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984).
[19] Id. at 811.
[20] Ash v. McCall, 2000 WL 1370341, at *10 (Del Ch. Sep. 15, 2000).
[21] Cory Janssen, Stock Buybacks: A Breakdown, Investopedia (Mar. 19, 2000), https://www.investopedia.com/articles/02/041702.asp.
[22]See In re Citigroup Inc. Shareholder Derivative Litigation, 964 A.2d 106, 137 (Del Ch. 2009).
[23]See Neil Minow, A Capitalist’s Solution to the Problem of Excessive Buybacks, Harv L. Sch. F. on Corp. Governance (Feb. 22, 2019), https://corpgov.law.harvard.edu/2019/02/22/a-capitalists-solution-to-the-problem-of-excessive-buybacks/.
[24] Caroline Banton, Share Repurchase, Investopedia (Sep. 23, 2020), https://www.investopedia.com/terms/s/sharerepurchase.asp.
[25]See Diane Lerner. Board of Directors Compensation: Past, Present and Future, Harv. L. Sch. F. on Corp. Governance (Mar. 14, 2017), https://corpgov.law.harvard.edu/2017/03/14/board-of-directors-compensation-past-present-and-future/.
[26] See Flitter & Eavis, supra note 4.
[27] Statement of Lenore Palladino, 3.
[28] See Minow, supra note 23.
[29] See Loewenstein, supra note 10.
[30]See Kate Rooney, Share Buybacks Soar to Record $806 Billon — Bigger Than a Facebook or Exxon Mobil, CNBC (Mar. 25, 2019), https://www.cnbc.com/2019/03/25/share-buybacks-soar-to-a-record-topping-800-billion-bigger-than-a-facebook-or-exxon-mobil.html.
[31]See Lucy Harley-McKeown, Why Are U.S. Stock Markets Booming When Everything is so Bleak?, NEWSWEEK (Aug. 5, 2020), https://www.newsweek.com/us-stock-markets-dow-nasdaq-sp500-booming-economic-downturn-1522880.