Deconstructing Duff and Phelps

University of Chicago Law Review

Volumn 74, Issue SPEC. ISS., 2007, Pages 1739-1759

  Henderson, M Todd ^a  

^a UNIVERSITY OF CHICAGO LAW SCHOOL   (United States)

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EID: 38049023079     PISSN: 00419494     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (65)

1. 815 F2d 429, 444-52 (7th Cir 1987) (Posner dissenting). The case is featured in the leading casebook on corporate law, see William A. Klein, J. Mark Ramseyer, and Stephen M. Bainbridge, Business Associations: Agency, Partnerships, and Corporations 651 (Foundation 6th ed 2006) (presenting Duff and Phelps as a key case on abuse of control), has been cited in well over one hundred subsequent cases and in over 150 law review articles, and is a staple of legal education. Westlaw search, Feb 2007.
2. See Duff and Phelps, 815 F2d at 443 (Cudahy concurring).
3. All searches in this paper used the Westlaw database for the particular circuit court and were conducted on February 7, 2007; all search queries were "PANEL(name)" and "DISSENT (name)," unless otherwise indicated, and required some culling of cases where the judge in question did not author or join the dissent.
4. Among Judge Posner's peers are judges Cardamone (1.3 percent) and Winter (1.5 percent) of the Second Circuit; Garwood (2.1 percent) and Higginbotham (0.7 percent) of the Fifth Circuit; Reinhardt (5.2 percent) and Pregerson (3.7 percent) of the Ninth Circuit; and Seymour (1.4 percent) of the Tenth Circuit.
5. This figure represents the average number of dissents for active judges.
6. Compiled from search queries "PANEL(Easterbrook) & DISSENT(Posner /s dissenting) % DISSENT(Easterbrook /s dissenting)" and "PANEL(Posner) & DISSENT(Easterbrook /s dissenting) % DISSENT(Posner /s dissenting)."
7. Compiled from search queries "JUDGE(Easterbrook) & PANEL(Posner) & DISSENT (Posner /s dissenting) % DISSENT(Easterbrook /s dissenting) % CONCURRENCE(Easterbrook /s concurring)" and "JUDGE(Posner) & PANEL(Easterbrook) & DISSENT(Easterbrook /s dissenting) % DISSENT(Posner /s dissenting) % CONCURRENCE(Posner /s concurring)."
8. The year before Duff and Phelps was decided, Easterbrook coauthored the leading law review article to this day on close corporations. See generally Frank H. Easterbrook and Daniel R. Fischel, Close Corporations and Agency Costs, 38 Stan L Rev 271 (1986).
9. Posner's most famous contribution to academic law is his theory of negligence and his contribution to the law and economics of torts and other common law subjects. See generally Richard A. Posner, Economic Analysis of Law (Aspen 6th ed 2003).
10. Easterbrook is the coauthor of the most famous corporate law text, see generally Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law (Harvard 1991), and teaches corporate law and advanced regulation of securities.
11. Courts give firms wide latitude in crafting these agreements, even when extreme, since they serve several functions essential to firm formation and survival. See Easterbrook and Fischel, The Economic Structure of Corporate Law at 228-29, 233 (cited in note 9) ("Because the firm's principal investors also manage, it is often necessary to restrict the investors' ability to alienate their shares.").
12. This interpretation of the stock purchase is in accord with D&P's policy according to people familiar with the firm.
13. See Duff and Phelps, 815 F2d at 432.
14. 15 USC § 78j(b) (2000) ("It shall be unlawful . . . [t]o use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe.").
15. 17 CFR § 240.10b-5(b) (2006) ("It shall be unlawful . . . [t]o make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made . . . not misleading . . . in connection with the purchase or sale of any security.").
16. See Flamm v Eberstadt, 814 F2d 1169, 1175-78 (7th Cir 1987) (adopting the price-and-structure rule for public companies because of its certainty benefits and the possible negative effects of premature disclosure).
17. See Duff and Phelps, 815 F2d at 447 (Posner dissenting).
18. Id at 438-39 (majority).
19. Wakefield v Northern Telecom, Inc, 769 F2d 109, 112-13 (2d Cir 1985) (holding that a firm cannot fire an employee to avoid paying him his commission).
20. See, for example, Harrison v NetCentric Corp, 433 Mass 465, 744 NE2d 622, 630 (2001) ("[U]nvested shares are not earned compensation for past services, but compensation contingent on [ ] continued employment.").
21. See, for example, Gallagher v Lambert, 74 NY2d 562, 549 NE2d 136, 137 (1989) ("Plaintiff got what he bargained for - book value for his minority shares . . . . There [is] no basis presented . . . to interfere with the operation and consequences of this agreement between the parties."). See also text accompanying notes 33-36.
22. There was, after all, some chance that the market value of the firm's shares might be less than book value when Jordan left the firm. Although unlikely, this buyout formula would protect Jordan from losing his capital contribution in the event the firm fell on very hard times.
23. See Duff and Phelps, 815 F2d at 448 (Posner dissenting) ("Jordan gambled that he was and would continue to be such a good employee that he would be encouraged to stay long enough to profit from the firm's growth.").
24. See id at 448 ("The relationship that the parties created aligned their respective self-interests better than the legal protections that the court devises today.").
25. 370 Mass 842, 353 NE2d 657 (1976).
26. See Duff and Phelps, 815 F2d at 438 (majority).
27. See Wilkes, 353 NE2d at 663 (requiring that majority stockholders accused of breaching their good faith duty to minority stockholders show a "legitimate business purpose" for their actions).
28. Making corporations look more like partnerships reduces the contracting space of parties and the clarity of choice of business forms. This raises overall transaction costs for promoters.
29. See Nixon v Blackwell, 626 A2d 1366, 1379 (Del 1993) (en banc) ("It would do violence to normal corporate practice and our corporation law to fashion an ad hoc ruling which would result in a court-imposed stockholder buy-out for which the parties had not contracted."). See also Riblet v Nagy, 683 A2d 37, 39 (Del 1996) ("Wilkes has not been adopted as Delaware law.").
30. See Guy v Duff and Phelps, Inc, 672 F Supp 1086, 1088-89 (ND Ill 1987). Other cases involved age discrimination claims and wrongful termination claims morphing into federal securities fraud cases. See, for example, Smith v Duff and Phelps, Inc, 5 F3d 488, 489-90 (11th Cir 1993) (remanding for trial former employee's federal securities fraud claim that he was coerced into retirement); McLaury v Duff and Phelps, Inc, 691 F Supp 1090, 1097, 1099 (ND Ill 1988) (upholding a former employee's allegedly wrongful termination based on federal securities fraud and age discrimination claims).
31. In the typical disclosure case - say, whether a homeowner should disclose something to a buyer - the parties are bargaining at arm's length. In this case, the parties had a preexisting contractual relationship, which militated in favor of requiring the parties to bargain about the obviously foreseeable possibility of the firm's value differing from book value.
32. For a theory on why contracting parties without bargaining power should not be bailed out by courts in gap-filling cases, see Omri Ben-Shahar, A Bargaining Power Theory of Gap-Filling 4, 19-21 (unpublished draft, 2006) (arguing that a "bargain-mimicking" theory to fill gaps in purely distributive contract terms will save transaction costs).
33. See Easterbrook and Fischel, 38 Stan L Rev at 277-79 (cited in note 8) (describing the different monitoring costs of public and closely held corporations as a result of their different distributions of management and risk bearing.
34. 74 NY2d 562, 549 NE2d 136 (1989).
35. See id at 138 ("There being no dispute that the employer had the unfettered discretion to fire plaintiff at any time, we should not redefine the precise measuring device and scope of the agreement.").
36. See id at 137.
37. See id at 138 ("[P]arties contract between themselves in advance so that there may be reliance, predictability and definitiveness between themselves on such matters.").
38. See, for example, Blank v Chelmsford Ob/Gyn, PC, 420 Mass 404, 649 NE2d 1102, 1105 (1995) (finding, where an employee-shareholder with an employment contract that mimicked an at-will regime was bought out at a contract price far below market value, that "questions of good faith and loyalty . . . do not arise when all the stockholders in advance enter into agreements concerning termination of employment and for the purchase of stock of a withdrawing . . . stockholder" despite a fiduciary duty "of the utmost good faith and loyalty" among stockholders in a close corporation).
39. Duff and Phelps, 815 F2d at 447 (Posner dissenting).
40. Id at 436 (majority) ("It is a violation of duty to steal from the corporate treasury; it is not a violation to write oneself a check that the board has approved as a bonus.").
41. Blank, 649 NE2d at 1104 (defining the terms of the employment contract referred to in note 37). See also Riblet, 683 A2d at 37 ("[A]lthough majority stockholders have fiduciary duties to minority stockholders qua stockholders, those duties are not implicated when the issue involves the rights of the minority stockholder qua employee under an employment contract.").
42. Duff and Phelps, 815 F2d at 449 (Posner dissenting).
43. Id at 433 (majority).
44. See Zetlin v Hanson Holdings, Inc, 48 NY2d 684, 397 NE2d 387, 389 (1979) (holding that minority stockholders are not entitled to share in a premium paid for a controlling interest in a corporation).
45. Pub L No 90-439, 82 Stat 454 (1968), codified as amended at 15 USC § 78n(d)(6) (2000 & Supp 2002).
46. Shareholders can allege "oppression" as a ground for remedies in a very limited class of cases. See Hollis v Hill, 232 F3d 460, 465 n 8 (5th Cir 2000) (providing three definitions of "oppression" courts have used in this context: unfair behavior by the majority, violation of fiduciary duty, and disappointment of the minority's reasonable expectations). In addition, under certain deal structures, such as a freeze-out merger, minority shareholders can seek appraisal of the value of their shares, which generally, and even in Delaware, does not include a minority discount reflecting the lack of a control premium. See Cavalier Oil Corp v Harnett, 564 A2d 1137, 1144-45 (Del 1989) (refusing to apply a minority discount to a minority shareholder's admittedly less marketable stock in an appraisal action). This asymmetry - majority sellers can sell for a premium but minority shares are not discounted in an appraisal proceeding - is odd and may not be sensible, but this is a subject for another time.
47. Duff and Phelps, 815 F2d at 445 (Posner dissenting).
48. See, for example, McCormick v Fund American Companies, Inc, 26 F3d 869, 874-75, 884 (9th Cir 1994) (holding that firms do not have an affirmative obligation to disclose details about merger negotiations to executive shareholders even when pressed).
49. For an argument that it was Jordan who was acting opportunistically by quitting and then later suing for a share of the merger consummated after his departure, see Duff and Phelps, 815 F2d at 450 (Posner dissenting) ("The majority says that 'understandably Duff & Phelps did not want a viper in its nest, a disgruntled employee remaining only in the hope of appreciation of his stock.' I call that 'viper' an opportunist.").
50. Even silence here - "We might merge, which might be good for you" - yields the same result, since Jordan might reasonably assume from silence as to specifics that he would participate in any premium.
51. In the several cases that arose from the buyout(s) of D&P, each plaintiff-employee had acted in a way that showed disloyalty to the firm or that the employee's value to the firm was very low. For an example, see note 29 and accompanying text.
52. Using deal structure to solve the Jordan problem may add unnecessary complexity, may be costly to design and implement, and may be too blunt a tool in that it may harm a larger class of employee-shareholders than necessary to achieve the buyer's aims. To this last point, the buyer may be able to narrowly tailor the structure or to make employees it doesn't mean to harm whole in other ways, but this may raise transaction costs significantly, perhaps even enough to kill a deal that would benefit all shareholders.
53. See Deborah A. DeMott, Beyond Metaphor: An Analysis of Fiduciary Obligation, 1988 Duke L J 879, 887 ("[F]iduciary obligation sometimes operates precisely in opposition to intention as manifest in express agreements."). If it is true that majority shareholders owe minority shareholders "fiduciary duties," as typically understood in the trust context, these are not waivable. See id at 923 ("A provision in a trust instrument cannot relieve a trustee of liability for any profit derived from a breach of trust."). But here corporate law may be simply sloppy, and "fiduciary duties" might just mean something else - an obligation to refrain from self-dealing - that may be waived in certain cases.
54. See Securities Exchange Act of 1934 § 29(a), codified at 15 USC § 78cc(a) (2000) ("Any condition, stipulation, or provision binding any person to waive compliance with any provision of this chapter or of any rule or regulation thereunder, or of any rule of an exchange required thereby shall be void.").
55. 521 US 642, 653-55 (1997) (accepting the misappropriation theory as a basis for insider trading liability under § 10(b) of the Securities Exchange Act).
56. See id at 653-54 ("[I]f the fiduciary discloses to the source that he plans to trade on the nonpublic information, there is no 'deceptive device' and thus no § 10(b) [of the Securities Exchange Act] violation.").
57. 26 F3d 869 (9th Cir 1994).
58. See id at 884 (noting the background knowledge the plaintiff had as a "sophisticated businessman" who was at the time a former CEO of a subsidiary of the defendant and a current member of the defendant's board).
59. See, for example, Harsco Corp v Segui, 91 F3d 337, 339 (2d Cir 1996) (affirming the dismissal of federal securities fraud claims for lack of reasonable reliance where sophisticated parties explicitly delineated the representations that were and were not made); Jensen v Kimble, 1 F3d 1073, 1074 (10th Cir 1993) (holding that the failure to disclose information prior to a stock transaction was not deceptive where the buyer advised the seller that he had information but would not disclose it). But see AES Corp v Dow Chemical Co, 325 F3d 174, 180 (3d Cir 2003) (refusing to hold as a matter of law that nonreliance provisions are sufficient to immunize any Rule 10b-5 claims).
60. The average ratio of market value to book value for the largest 7,700 firms in the United States in 2006 was over 5, with a median of 2; only distressed or bankrupt firms are the exception. The overall ratio for the economy was about 3. See Earnings: Book Value and Sales Multiple Averages by Country, online at http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data. html (visited Sept 29, 2007). For financial services firms, like D&P, the average is about 8, with a median of about 2. See id.
61. Posner recognizes this essential feature. See Duff and Phelps, 815 F2d at 447 (Posner dissenting) ("By signing the stockholder agreement Jordan gave Duff and Phelps in effect an option . . . to buy back his stock at any time at a fixed price.").
62. Many of the most famous insider trading cases involve options trading of this kind. See, for example, O'Hagan, 521 US at 647-48 (describing a defendant's use of options to capitalize on nonpublic knowledge of his firm's client's planned tender offer for the Pillsbury Company).
63. 73 NY2d 183, 535 NE2d 1311 (1989).
64. See id at 1313 ("A minority shareholder in a close corporation . . . who contractually agrees to the repurchase of his shares upon termination . . . acquires no right from the corporation . . . against at-will discharge.").
65. As of the end of 2005, only nine out of the largest 7,000 firms in the United States had a market value to book value ratio of exactly 1 (0.1 percent of firms). See Earnings: Book Value and Sales Multiple Averages by Country (cited in note 59).