Asking a judge—particularly a bankruptcy judge—to say a few words about the needs and opportunities for pro bono representation in our courts, particularly in the context of Chapter 13 bankruptcy cases, is a high-risk enterprise, for a couple of reasons.[1] To be honest, there is just so much to say. But I will do my best to be brief—even though we judges are not known for this. I have three things to say: we need your help, we appreciate your help, and we thank you for your help.
First, we need your help. Chapter 13 bankruptcy cases occupy a very particular place in the bankruptcy world, and in the federal justice system. I can’t think of another area of law that more directly and consistently affects a family’s fundamental desire to keep their home, or if that is too much to manage, a family’s hope to find a path forward that is as dignified and decent as possible under the circumstances. And of course, every time a family succeeds in this way, the lender succeeds too—because a non-performing asset (a mortgage in default) is resolved, one way or another. If a Chapter 13 plan is confirmed, the arrears will be repaid; if loss mitigation leads to a modified mortgage or some other resolution, that’s good too; and if the case does not succeed, at least there is closure.
But a successful Chapter 13 case is not easy. In bankruptcy court, we live at the messy crossroads of debtors and their creditors, mortgagors and mortgagees, homeowners and banks. Things can happen quickly, and a misstep at the outset of a case can be devastating to its prospects. The advice of counsel—even the most basic guidance—can make the difference between a case that is dismissed in 45 days and a case that leads to a successful outcome for debtors and creditors.
Most—indeed, nearly all—lenders are represented in these proceedings, and experienced lenders’ counsel is absolutely invaluable in this process. These lawyers have vast experience in understanding and working with a situation to get the best result for their clients, and they are an indispensable part of the process. The Chapter 13 trustee is likewise highly skilled at guiding a process that can be successful for the homeowner and the lender alike. And the bankruptcy court has resources for all of the parties, including regular case conferences on the confirmation of a Chapter 13 plan, a highly successful loss mitigation program, a pro se law clerk, and more.
But many Chapter 13 debtors are not represented by counsel. Their situation may be urgent, and their bankruptcy case may be incomplete, filed in haste to stop a foreclosure sale or an eviction. They may lack even the most basic understanding of whether bankruptcy makes sense for them or how to get the benefits of a bankruptcy case in their particular circumstance. When this happens, the prospects for a successful outcome, one way or another, can be diminished or even lost. That’s an unfortunate result for the debtor and their family, for the mortgage lender and other creditors who might have been paid through a bankruptcy case, and for the bankruptcy system itself.
That doesn’t have to happen. In many of these cases, the debtor may be able to retain counsel. Unrepresented debtors are regularly encouraged to contact the lawyer referral services of local bar associations to obtain referrals to attorneys who are qualified to assist them in evaluating their bankruptcy options and to represent them in a Chapter 13 case. Sometimes family or household members can assist in paying the fee, whether up-front or over time, including through the Chapter 13 plan. But other times, no matter how hard the debtor and the debtor’s family try, the funds to pay an attorney just aren’t there.
Here’s where the need for pro bono counsel comes in. Not for every pro se debtor—that’s not at all what I’m suggesting. But in those situations where the debtor is unable to pay a fee, even with help from contributors, even over time, and still meet their basic needs, then every participant in the process, from the debtor to the secured creditor and all of the other creditors, to the Chapter 13 trustee, and the court, benefit from the service of pro bono counsel.
Second, we appreciate your help. Bankruptcy courts have many tools. We have broad jurisdiction, the Bankruptcy Code and Rules, our extraordinary colleagues, a highly professional, sophisticated, and creative bar, and some of the most interesting cases in the federal system. All of us in the bankruptcy practice have the opportunity to make a difference, every single day. We help companies reorganize, we give families the opportunity to get back on their feet with a fresh start, and we get creditors paid.
But sometimes, it takes a lawyer to get these good results. And in Chapter 13, that “sometimes” is actually most of the time. A missed opportunity to get to a good result is a loss for the debtor, the creditors, and the court. And a saved opportunity to get to that good result, through the service of pro bono counsel, is a win.
It’s hard adequately to describe how satisfying it is to see a pro bono attorney succeed in a case—no matter what the definition of “succeed” proves to be in the particular situation—or how much this representation is appreciated. Bankruptcy court is often where individuals and families land at a moment of crisis in their economic lives, and as hard as we try to make it a user-friendly and accessible place, it can be intimidating. There are countless ways to make a mistake early in a case, and the cost of such a mistake can be high indeed. The costs of a failed case are borne by the debtor and their family, of course. But they are also borne by creditors, who lose the chance to get paid through the orderly administration of a bankruptcy case. This may well be avoided when pro bono counsel steps in early in the case.
Even more fundamentally, every party—whether represented or not—deserves to understand what is expected of them, what is happening to them, and why. We can conduct hearings in person, telephonically, and on video, and we have access to interpretation in countless languages—but courts cannot “interpret” the law for a pro se party or provide legal advice. Here too, it’s hard adequately to describe how satisfying it is to see that a party who would otherwise risk being lost in a maze of legal proceeding is now represented by their own counsel, or how much this work is appreciated.
Third, we thank you for your help. Sometimes it’s worth remembering that “pro bono” means so much more than “for free.” It is derived from “pro bono publico,” and means “for the public good.” According to the Oxford Reference, it was first used in this sense in England in the late seventeenth century, and now is commonly used to mean “work undertaken for the public good without charge, especially legal work for a client on a low income.” According to Wikipedia, it means “professional work undertaken voluntarily and without payment.” When I was in private practice, I liked to think that a characteristic of my pro bono work was that all of the income that it generated—in the form of professional satisfaction—was non-taxable.
It should also generate this: thanks. We don’t say it nearly often enough, and it could never be said too much. Thanks for considering pro bono work, thanks for every hour you have ever spent on pro bono work, and thanks for every hour that you are spending now and that you will invest in the future in pro bono work. Thanks for keeping that family in their home, or for helping them to understand that they need to move on. Thanks for helping your pro bono client get through one of the hardest times they will face, knowing that there is someone in their corner—and thanks for being that “someone” for them. And thanks for providing the secured creditor’s lawyer and the Chapter 13 trustee with a lawyer with whom they can speak in addressing the situations presented by the case.
Finally, thanks for appearing in court on behalf of your client, and helping the court to have the best possible hearing in a difficult situation. And when I have to make a hard decision in a Chapter 13 case, and because of your service the debtor has an advocate, thanks for helping me sleep well that night.
***
Does any of this make it easier to step forward and take on a Chapter 13 bankruptcy case, maybe for the first time? Does it begin to answer the question why someone who owns a home could somehow need a pro bono lawyer to help save that home? Hopefully, it does, at least a little bit. The need for this help is there. We may not see it from the bench every day, but we surely see it often—too often.
Pro bono assistance also fills a critical gap between what the pro se debtor needs and what the court, the Chapter 13 trustee, and counsel for other parties can provide. Closing that gap can make the difference between success and failure of a case.
And finally, pro bono assistance is not just legal work “for free.” It is foundational to the profession, and serves the public good. And it deserves our recognition, and our thanks.
In a keynote panel at September’s Virtual Section Annual Meeting, leaders in the American Bar Association’s Business Law Section shared thought-provoking and informative reflections on the impacts of the past year on the profession and expectations for the year ahead.
During the meeting’s Welcome Reception, Citigroup General Counsel Rohan Weerasinghe and Teresa Wilton Harmon, Managing Partner of Sidley Austin LLP’s Chicago office, discussed the future of legal practice for business lawyers. Jeannie Frey, 2020–2021 chair of the Business Law Section, moderated the panel, whose wide-ranging discussion touched on changing expectations for attorney work-life balance; diversity, equity, and inclusion; and business and professional development.
Work-Life Issues
Harmon highlighted that the COVID-19 pandemic has left the legal profession at a “pivotal moment” in changing work environments. “We have a new economy starting up all around us, we have new ways of working together,” she said. “Firms are recognizing that we’re in a talent business—that health and wellbeing, and satisfaction of our team members, are really important to getting the results that we need.”
The panelists praised the increased flexibility that has come with remote work and expressed hope it will continue; Frey described the remote work world as giving attorneys “permission to be human… to be able to acknowledge that you have other parts of your life and have that be respected.”
But they noted new challenges, too.
“There’s a blurring of when you’re at work and when you’re at home,” Weerasinghe said. “We have to figure out how to deal with that in a post-COVID Zoom environment. I think it’s important to protect people’s personal time just as much as giving them the flexibility.”
Diversity, Equity, and Inclusion Issues
Frey pointed out that in the past year and a half, the “need to acknowledge real systemic social and racial justice issues in the legal profession as well as society at large” has been as significant a focus as the pandemic. She asked Harmon and Weerasinghe whether we can expect to see “real progress in the near future in law firms being more likely to hire, support and promote lawyers of color, women, and other diverse and underrepresented groups.”
The panelists agreed the profession is improving on these issues but has much further to go: “We’ve got to keep fighting,” Weerasinghe said. Harmon discussed some bright spots, noting that she’s seeing stronger buy-in for DEI initiatives, as well as more efforts like the Sidley Prelaw Scholars program that aim to address systemic barriers to a diverse array of talent entering the legal profession.
“Our job is to ensure a just world,” Harmon said. “Racial justice has to be part of our bread and butter every day.”
The conversation turned to how in-house lawyers can work on increasing diversity and inclusion. Weerasinghe highlighted the importance of thoughtful hiring, ensuring that not only candidate pools but also the set of individuals who interview them are diverse. “It’s a key part of making sure we get the right perspective, and we try to minimize—I’d like to say eliminate, but I’m practical—minimize any kind of unconscious bias,” he said. He also pointed out that greater openness to remote work is enabling employers to draw on a larger and more diverse talent pool.
Business Development
As with many aspects of attorneys’ work that have changed during the pandemic, business development has been no exception. The panelists argued those changes presented new chances for success, particularly for young lawyers.
“We’re seeing entire areas, including areas that are focused on technology, and health and life sciences, and fintech, that really weren’t that strong before the pandemic where there’s incredible growth now,” Harmon said. “For newer lawyers… I think it’s actually a neat business development opportunity.”
The panel also discussed the need for young and mid-career lawyers to work with more experienced colleagues, and for those colleagues to actively support them.
“You’re going to have to figure out, as the COVID situation improves, how you can get more visibility on a face-to-face with some potential clients but also work with more senior partners at law firms to get them to introduce you,” Weerasinghe said.
Frey argued that reaching out to connect with up-and-coming attorneys is crucial. “I look around at my team, and I have team members who will be practicing here, I hope, long after I’m gone. I want them to be developing those peer relationships now… so that that relationship with the firm and the individuals can grow, and we can support the professional growth of those more junior lawyers.”
No matter what other opportunities arise in the future, Harmon argued, professional organizations like the ABA should stay part of attorneys’ business development mix.
“That’s always been a huge part of my business plan, of my business development, since I went to my first ABA Section of Business Law meeting as an associate,” Harmon said. “It’s been great to see the ABA stay strong, reach out to more people, and find new ways for people to build connections across their professional lives… It’s a really important part of our fabric as lawyers.”
The Task Force on Residual Interests of the American Bar Association Committee on Securitization and Structured Finance[1] was organized in response to a series of ongoing litigation proceedings described by one writer as a “multicourt, multistate legal war,”[2] that involves 15 special purpose Delaware statutory trusts known as the “National Collegiate Student Loan Trusts” (the “Trusts” or “NCSLTs”). These proceedings have raised serious concerns among securitization industry participants—in particular, as to whether securitization documents properly address the role of residual interest holders in special purpose vehicles.
The issues being litigated in the NCSLT proceedings focus on whether certain actions of the residual interest holder in the Trusts were properly authorized. At this point, the legal consequences of such actions largely remain unresolved. Accordingly, the goal of the Task Force in writing this article is to raise awareness of these concerns and the possible ramifications when such concerns aren’t fully considered.
We start by summarizing the background, history and current status of these cases. We then examine issues relating to trust agreements under Delaware law, as well as more generally under securitization indenture documents. Finally, we recommend several principles to consider in drafting securitization documents in light of these cases.
Background
Between 2001 and 2007, the Trusts acquired and provided financing for over 800,000 private student loans in aggregate principal amount exceeding $15 billion through the issuance of over $12 billion in aggregate principal amount of investor notes. Until 2009 the Trusts were owned jointly by an affiliate of First Marblehead Corporation and The Education Resources Institute, Inc. (“TERI”). In 2008 TERI went bankrupt; thereafter Vantage Capital Group (“VCG”), a Florida-based private investor, acquired (through its affiliates) the majority of the beneficial ownership interests (a /k /a, residual equity interests) in the Trusts.
Once it acquired the beneficial interests, VCG took a number of actions in its capacity as beneficial owner. In November 2015 VCG directed the Owner Trustee for the Trusts to engage counsel chosen by VCG, and to enter into a Servicing Agreement (the “Odyssey Servicing Agreement”) with Odyssey Education Resources, LLC, a VCG affiliate (“Odyssey”), to service non-performing loans for certain of the Trusts. That direction was given notwithstanding that the Trusts had pre-existing agreements with other servicers to collect defaulted loans. The Odyssey Servicing Agreement, among other things, allowed Odyssey to purchase such loans from the Trusts at a discount from market price. Then, during the course of 2015 and early 2016, Odyssey incurred more than $1.24 million in legal fees and costs allegedly conducting diligence on the Trusts’ portfolios and submitted those invoices for payment from the Trusts’ assets.
In response to the demand for payment of Odyssey’s invoices, the Indenture Trustee commenced a Trust Instruction Proceeding in Minnesota (later removed and transferred to Delaware Federal District Court) seeking judicial direction. Additional counsel were subsequently engaged at VCG’s direction for other matters, resulting in invoices for millions of dollars of additional legal fee costs, costs that were also submitted for payment from the Trusts’ assets.
These and other actions by VCG seeking to control the Trusts resulted in multiple legal proceedings spanning several states, including four lawsuits in the Delaware Chancery Court. Three of those lawsuits involve various claims and causes of action by VCG, or by the Trusts at VCG’s direction, against the Trusts’ primary and special servicers, administrator, indenture trustee, owner trustee, noteholders and note insurer, and the fourth an action by noteholders against VCG, which proceedings, not surprisingly, have now been consolidated by the Chancery Court.
Finally, independent of those actions, another perhaps even more noteworthy proceeding relating to the Trusts was commenced in 2017 by the Consumer Financial Protection Bureau (the “CFPB”). In that year, the CFPB filed suit against the Trusts in Delaware Federal District Court based on alleged conduct of the Trusts’ servicers. The CFPB also filed a proposed consent judgment, negotiated with counsel retained at VCG’s direction, that would have resulted in a broad transfer of control to VCG over the Trusts’ assets.
Description and Current Status of Relevant Litigation Proceedings
The litigation stemming from VCG’s attempts to act on behalf of the Trusts has now been pending for several years, and the litigation landscape relating to these issues remains in flux. It is therefore unclear whether any of VCG’s attempts to bind the Trusts will succeed, or whether VCG will ultimately face legal consequences for its attempts to control the Trusts without authorization from other trust parties. However, 2020 and 2021 saw material developments in several of these cases.
The Trust Instruction Proceeding pending in Delaware Federal District Court[3] initially sought instructions as to whether Odyssey was properly appointed as special servicer. Intervening investors also asserted that (x) the new Odyssey Servicing Agreement violated the clauses granting liens to the Indenture Trustee (the “Granting Clauses”) and requiring consent of the Indenture Trustee or noteholders (the “Consent Clauses”) in the Trusts’ Indentures and (y) the Trusts (acting through VCG) were engaged in self-dealing. In September 2018, the District Court ruled that the actions taken on behalf of the Trusts did not violate the Granting Clauses and Consent Clauses in the Trusts’ Indentures and that the related invoices should be paid from the Trusts’ assets.
In August 2020, the Third Circuit reversed in part,[4] holding that:
The Trusts (here, acting through VCG) may appoint a new servicer so long as the appointment does not violate any terms of the Trusts’ governing agreements, including those agreements’ prohibitions on improper self-dealing.
The Odyssey Servicing Agreement did violate the Granting and Consent Clauses because it impermissibly reserved for the Trusts (again, acting through VCG) several rights conveyed by the Granting Clause to the Indenture Trustee, including the right to replace any servicer for cause, and violated the Indenture Trustee’s right to consent to modifications to any servicing agreement and the Trust governing agreements.
The Court did not reach the issue of whether the Odyssey Servicing Agreement also constituted improper self-dealing prohibited by the Indenture, but noted that VCG “stands on both sides” of the Agreement, and that “[i]t is hard to see how such a transaction could be considered as conducted at arm’s length.”
The case was remanded to consider whether invoices submitted for payment from the Trusts’ assets are payable even if the Odyssey Servicing Agreement was invalid and thus void. The case remains pending before the Delaware Federal District Court as of the date of publication of this article.
The CFPB action in Delaware Federal District Court[5] sought, among other things, to hold the Trusts liable under the Consumer Financial Protection Act of 2010 (the “CFPA”) for alleged servicing violations and to approve a CFPB Consent Judgment entered into by VCG’s counsel purportedly on behalf of the Trusts. The Consent Judgment would have (w) placed servicing control of the entire 800,000-loan portfolio in the hands of VCG, (x) required proceeds of collections to be turned over to an account under VCG’s control, (y) authorized VCG to audit all 800,000 loans held by the Trusts, at the Trusts’ expense, and (z) required payment of almost $20 million by the Trusts in restitution, disgorgement, and civil money penalties.
The court issued two important rulings in this case in the last twelve months:
In May 2020,[6] the court refused to enter the proposed CFPB Consent Judgment based upon the court’s holding that VCG’s counsel had not been authorized to enter into the CFPB Consent Judgment on behalf of the Trusts.
In March 2021,[7] the court dismissed the CFPB’s complaint based upon findings that the CFPB initially filed the case in September 2017 when the bureau’s structure violated the U.S. Constitution’s separation of powers,[8] that the CFPB’s attempted ratification was untimely, and that the CFPB was not entitled to equitable tolling of the statute of limitations given an absence of pleaded facts showing that the bureau diligently pursued its rights.
The court’s March 2021 ruling on the motion to dismiss was notable for what it did not address. First, it did not respond to the Trusts’ important substantive arguments that the Trusts are not “covered persons” under the CFPA (although the court noted that it “harbors some doubt that the Trusts are ‘covered persons’ under the plain language of the statute”). In addition, the ruling did not address the assertion that the CFPB did not state claims against the Trusts based on alleged servicing violations, because those claims could only lie against the servicers themselves. Those arguments, therefore, remain open legal questions on which a court has not yet ruled.
The court order allowed the CFPB to replead its case by filing an amended complaint, noting, however, that it was “hardly clear” that the bureau could “cure the deficiencies noted in the memorandum opinion.” The CFPB filed an amended complaint on April 30, 2021. On October 1, 2021, after the motion to dismiss the amended complaint was fully briefed, Judge Noreika, the presiding judge, was replaced (possibly due to a backlog of jury trials) by Judge Stephanos Bibas, a 2017 appointee to the Third Circuit. Judge Bibas has indicated that he will hear oral argument before deciding the motion.
It is of course unknown at this point whether or how the change in presiding judge will affect the progress, timing and result of the CFPB proceeding.
Actions taken by or at the behest of VCG are also at the core of a series of four lawsuits involving the Trusts that have been consolidated in the Delaware Chancery Court for the purpose of resolving proposed declarations regarding certain common contract interpretation issues:[9] (1) a March 2016 action filed in the name of the Trusts (at VCG’s direction) seeking emergency authorization to compel the Pennsylvania Higher Education Assistance Agency, the primary servicer for performing loans, to provide its books and records for an audit by Boston Portfolio Advisors, a former member (along with VCG) of Odyssey; (2) a March 2018 action filed in the name of the Trusts (at VCG’s direction) against the Indenture Trustee, the Administrator, and certain special servicers alleging their failure to supervise servicing; (3) a November 2018 action filed by noteholder investors against VCG for breach of contract, civil conspiracy, and breach of fiduciary duty; and (4) a November 2019 action filed by VCG against the Trusts’ Owner Trustee, Indenture Trustee, Administrator, Note Insurer, and Noteholders seeking declaratory relief regarding various Trust constituents’ rights and certain contract interpretation issues under the Trusts’ governing agreements.
In August 2020, the Court issued a lengthy memorandum opinion containing rulings on the following subjects:
Ownership of Collateral and Rights to Act on Behalf of Trusts. The court ruled that the Granting Clauses of the Trusts’ Indentures convey all the beneficial interest in and the right to control the collateral to the Indenture Trustee for the benefit of the Note Insurer and the Noteholders, even pre-Event of Default. The Trusts retain legal title to the collateral and the right to exercise authority over such collateral to the extent of fulfilling the Trusts’ obligations. Until the Indenture is discharged, the Trusts cannot take any action that “derogates from the Granting Clause or otherwise violates a Basic Document.”
Fiduciary Duties. The court ruled that the residual interest holders owe the Note Insurer and the noteholders fiduciary duties when acting on behalf of the Trusts, or when directing Trust parties to act on behalf of the Trusts or their assets. This duty arises because of the Note Insurer’s and the noteholders’ relationship to the collateral, not because of their relationships to the Trusts. The Trusts must “regulate their conduct” and act in the best interests of the collateral’s beneficial owners, and the residual interest holders’ duty “surely entails” an obligation not to use control of the collateral to advantage themselves at the expense of the Note Insurer and noteholders.
Delegation of Owner Trustee’s Duties. The court held that the Owner Trustee cannot delegate its authority to agents answerable only to residual interest holders without those directions flowing through the Owner Trustee. Specifically, the Owner Trustee could not fully delegate to VCG’s counsel the Owner Trustee’s rights to approve the proposed CFPB Consent Order.
Other Rulings. The court’s ruling also (1) defined the Administrator’s and the Owner Trustee’s rights and obligations; (2) held that the Trusts’ governing agreements must be read as a whole, including incorporating provisions from other documents; (3) declined to issue requested declarations regarding certain parties’ rights to direct the Trusts’ activities at issue in the case; (4) issued a declaration that amendments to the governing documents require Indenture Trustee, Note Insurer, and noteholder consent; and (5) held that, to be paid by the Trusts, Owner Trustee expenses must relate to the Owner Trustee’s limited contractual duties, but that certain Administrator expenses may include Trust expenses reimbursable by the Trusts’ assets.
As of the date of publication of this article, discovery is proceeding on the remaining common contract interpretation issues. Trial on these issues is expected to commence next year.
We note that, in addition to the proceedings described above, there are or have been cases or proceedings involving the Trusts in other jurisdictions, including New York, Illinois and Florida, mostly seeking reimbursement for fees and expenses incurred by various professionals at VCG’s direction. We have, in the interest of brevity, focused on the proceedings with the greatest relevance to the concerns that the Task Force seeks to highlight.
Effect of the Delaware Statutory Trust Act
The rulings of the Delaware Chancery Court described above have highlighted some significant statutory principles under Delaware law that relate to the scope of rights of beneficial owners of trust interests. Accordingly, those rulings as well as the Delaware Statutory Trust Act need to be carefully considered by transaction participants in determining the appropriate rights of residual owners.
A stated policy of the Delaware Statutory Trust Act, 12 Del. C. § 3801, et seq. (the “Act”), is to give maximum effect to the principle of freedom of contract and to the enforceability of governing instruments (collectively referred to as the “Trust Agreement”). Although the default rule under the Act is that the business and affairs of a statutory trust are managed by or under the direction of its trustees, in practice that default rule is frequently altered by the provisions of the Trust Agreement. For example, to the extent provided in the Trust Agreement, any person (including a beneficial owner) may be given rights to direct the trustees or other persons in the management of the statutory trust. In addition, pursuant to Section 3806(b)(7) of the Act, a Trust Agreement “may provide for the appointment, election or engagement, either as agents or independent contractors of the statutory trust or as delegates of the trustees, of officers, employees, managers or other persons who may manage the business and affairs of the statutory trust and may have such titles and such relative rights, powers and duties as the governing instrument shall provide.”
In practice, the trustee of a statutory trust used in a securitization transaction retains limited discretion with respect to the statutory trust and its assets. Subject to its rights under the Trust Agreement, the trustee will act upon proper direction by the person with the authority to direct the trustee as provided by, and in accordance with, the Trust Agreement. Such direction can also require additional persons, such as investors or an indenture trustee, to provide consent to the giving of such direction. Trust agreements are often drafted so as to require such consents for non-ministerial actions, such as material changes to transaction documents adversely affecting holders; replacing an indenture trustee, administrator or servicer; selling or assigning the trust estate; and such other significant actions as the parties deem necessary. When drafting and negotiating the Trust Agreement, the parties should carefully consider what actions might require additional consents and what actions may be taken unilaterally by the person authorized to direct the trustee in the management of the statutory trust.
Section 3809 of the Act incorporates the laws of the State of Delaware pertaining to trusts and makes such laws applicable to statutory trusts, except to the extent otherwise provided in the Trust Agreement or the Act. Consequently, although trustees of a statutory trust may have duties similar to those of a common-law trustee (such as care, loyalty, good faith, candor and safekeeping of trust assets), contractual provisions in the Trust Agreement often alter those duties. These duties may not apply to those persons who have the right to direct the trustee or otherwise control the management of the statutory trust or the trust estate. However, under current Delaware case law, it is likely that such persons would have, at a minimum, a duty not to use their control of the statutory trust or control over the trust estate to their advantage at the expense of others who might have a beneficial interest in the statutory trust or the trust estate.[10]
The full scope of the duties of a directing party has not been completely fleshed out under Delaware law, but fortunately the Act provides for a method to manage such duties. The Act permits the expansion, restriction or elimination of duties in the Trust Agreement “to the extent that, at law or in equity, a trustee or beneficial owner or other person has duties (including fiduciary duties) to a statutory trust or to another trustee or beneficial owner or to another person that is a party to or is otherwise bound by the” Trust Agreement. However, the Trust Agreement cannot eliminate the implied contractual covenant of good faith and fair dealing. A provision to restrict or eliminate fiduciary duties must be clear and unambiguous in the Trust Agreement in order to be enforceable.
It should be noted that a beneficial owner’s beneficial interest in a statutory trust is freely transferable. As such, if one of the rights of a beneficial owner in the trust is the right to direct the trustee, the parties to the transaction should consider whether restrictions on transfer of that beneficial interest are needed in order to have some limits on who might exercise the direction right. Any such restrictions should be set forth in the Trust Agreement.
Transaction Documents and Other Considerations
The non-recourse, senior/subordinate structure typical in securitizations contemplates that senior security holders will have prioritized control of collateral proceeds, but that they will also benefit from other control provisions, such as the Consent Clauses referenced above. It is not surprising that the Third Circuit relied heavily on the Granting Clauses and Consent Clauses of the NCSLT indentures—provisions typical of indenture documents with this structure—in holding that the beneficial holders exceeded their authority. The potential disconnect between Granting and Consent Clauses, on the one hand, and the trust agreement provisions in the NCSLT’s transaction documents, on the other hand, was clearly a gap the residual interest holders tried to exploit.
The lessons learned in these cases are clear. Securitization documents that are not clearly drafted may inadvertently permit residual holders to claim that they should receive collateral proceeds that would otherwise be used to pay amounts owed on senior classes of notes. Any attempt by a residual holder to rely upon unclear provisions in transaction documents to settle or compromise, either directly or indirectly, claims related to trust assets could have unanticipated, adverse consequences on senior holders and trustees.
Although the marketplace has many examples of providing “first loss” holders with some level of control over asset dispositions, drafters should consider addressing the risk of a residual holder gaining control over, and title to, trust assets. For example, drafters may wish to include express restrictions on who may appoint additional servicers and the terms of such appointments, as well as conditions to payment of fees and reimbursement of expenses of such additional servicers. In an effort to avoid potential conflicts, parties should also consider whether and under what circumstances affiliation between a servicer and holders of residual interests should be permitted.
Attention should also be given to the level of disclosure provided to investors in respect of asset dispositions and the expected level of indenture trustee involvement in such dispositions. As a result of the NCSLT cases, parties should take a fresh look at existing forms with a view towards clearly and unambiguously defining the role of the indenture trustee, while reducing the possibility of conflicting instructions from different investor groups.
One notable aspect of the NCSLT litigation decisions is court reliance on the conveyance language of the “Granting” Clause. As indicated by the name of that clause, practitioners may think of the conveyance language in this clause as merely a precautionary supplement to the security interest grant. But the NCSLT courts found the reverse: that, when considered in the context of the complete trust agreements and the commercial context, the “Granting” Clause is a conveyance supplemented by a precautionary security interest. Although there are certainly structures, particularly in the consumer area, that contemplate a trustee holding record title to assets, it will be interesting to see whether the marketplace starts to re-evaluate granting clauses containing conveyance language with respect to other asset types, useful as it may have been for the NCSLT noteholders.
Finally, substantive consolidation is another important area to consider when granting residual holders any degree of control over a special purpose vehicle. Although not raised as an issue in the NCSLT cases, control over an entity of the type asserted by the NCSLT residual interest holders could be a negative fact in a substantive consolidation analysis (a discussion of which is beyond the scope of this article).
Task Force Recommendations
The series of unfortunate circumstances giving rise to the NCSLT disputes has made it apparent to many in the securitization industry, including investors and trustees as well as originators and sponsors, that:
Unclear provisions in securitization documents could present unforeseen problems, inasmuch as residual owners may seek to exploit such provisions to gain control of a securitization trust in ways not anticipated by other participants.
As evidenced by the NCSLT litigation, residual owner rights could involve control over trust assets and therefore raise substantive consolidation concerns.
Residual owners might engage in self-dealing or have conflicts of interest.
The securitization industry needs to be aware of and consider these risks in its documentation.
In all circumstances, unless specifically negotiated and agreed upon by the relevant transaction parties, transaction parties must seriously consider whether the rights of residual owners should be subject and subordinate to provisions to the contrary in any other relevant transaction documents. True to their name, residual owners are entitled to residual cash flows, but securitization documents need to be clear on the other rights of residual owners and provide adequate protection to other parties should those rights extend beyond mere receipt of cash flows. Accordingly, the Task Force recommends the following in drafting securitization documents:
If residual owners are entitled to rights beyond mere receipt of residual cash flow, those rights should be expressly and explicitly addressed in the relevant transaction documents.
If residual owners are given greater rights (and notwithstanding that such rights may give rise to obligations as a matter of law), consideration should be given as to whether to pair those rights with explicit contractual obligations, so that such rights are exercised in a manner consistent with, and not contrary to, the interests of other transaction parties.
Consideration should also be given as to whether the rights of transferee holders of residual interests should be more limited than those made available to the originator/sponsor.
[1] Although this is a Task Force effort, special thanks go to Richard Facciolo, Elizabeth Frohlich, Jim Gadsden, Barbara Goodstein (Chair), Ori Lev, Doug Rutherford, Andrew Silverstein, and Craig Wolson for their contributions.
[3]In re Nat’l Collegiate Student Loan Trusts 2003-1, et al., Case No. 1:16-cv-341 (D. Del) (notice of removal filed Mar. 25, 2016).
[4]In re Nat’l Collegiate Student Loan Trusts 2003-1, et al., 971 F.3d 433 (3d Cir. 2020).
[5]Consumer Fin. Prot. Bureau v. National Collegiate Master Student Loan Trust, et al., Case No. 1:17-cv-01323 (D. Del) (filed Sept. 18, 2017), and related actions.
[6]Consumer Fin. Prot. Bureau v. Nat’l Collegiate Master Student Tr., C.A. No. 17-1323 (MN), 2020 WL 2915759 (D. Del. May 31, 2020).
[7]Consumer Fin. Prot. Bureau v. Nat’l Collegiate Master Student Tr., C.A. No. 17-1323 (MN), 2021 WL 1169029 (D. Del. Mar. 26, 2021).
[8] Relying upon Seila Law LLC v. Consumer Fin. Prot. Bureau, 591 U.S. ____ , 140 S. Ct. 2183, 207 L. Ed. 2d 494 (2020).
[9]In re National Collegiate Student Loan Trusts Litigation, Docket No. 12111-VCS (Del. Ch.) (filed Mar. 16, 2016), and consolidated actions.
[10] See, e.g., Cargill, Inc. v. JWH Special Circumstance LLC, 959 A.2d 1096 (Del. Ch. 2008) (citing In re USACafes L.P. Litig., 600 A.2d 43 (Del. Ch. 1991)).
They call it the “Great Resignation.” It seems that 18 months of remote work has changed value priorities for many employees, a term that here includes both lawyers and administrative personnel. Few people want to go back to the office full time. A Prudential survey found that 87 percent of people working from home wanted to continue remote work post-COVID, and 42 percent of remote workers said they would find a new job if told to work in an office full time. Members of Gen Z (ages 9–24) are more likely to want to remain remote some of the time.
Interest in time flexibility, work-life balance, and corporate values began long before COVID-19 arrived. As Adam Grant recently wrote in the Wall Street Journal,
The Great Resignation is the “culmination of a long march towards freedom. More than a generation ago, psychologists documented a generational shift in the centrality of work in our lives. Millennials were more interested in jobs that provided leisure time and vacation time. . . . They were less concerned about net worth than net freedom.”[1]
Today’s employees are similarly less attached to the 2019 concept of traditional work.
Yet employers desperately need employees. Employees are in the catbird’s seat. This power inversion is totally at odds with the traditional top-down, hierarchical law firm universe. In most law firms, equity partners make decisions without asking for input from anyone else. Yet new employee requirements offer an opportunity to rethink traditional law firm structure.
The first crack in tradition appeared when law firm leaders realized that work continued and productivity even increased while everyone worked remotely. There seems to be universal agreement that technology-augmented remote work will continue post-pandemic. The second crack is acceptance of hybrid office arrangements as a compromise.
Hybrid offices offer many management challenges. Issues range from tangible changes such as scheduling to intangibles such as cultural biases that can impact the careers of remote workers and delay progress toward an inclusive, gender-equal, diverse workplace. “Woke” leadership is essential if firms are to move successfully into the new reality.
Responding to Employees
“Coming out of the pandemic, employees are looking to get more out of their work and their companies,” Shannon Hardy, LinkedIn’s vice president of flexible work, told CNBC. “If employers do not communicate about what the future of work looks like for their company, they risk their employees losing trust in the organization. [They] may risk losing their employees altogether.”[2]
Leadership begins with leaders’ openness to listen carefully to what their employees want— what they say and, more importantly, what they mean but leave unsaid. Personally, leaders need to employ active listening skills and empathy. Leaders interested in using this inflection point to create a less stressful, more effective workplace need to court opportunities for conversations with as many employees as possible, especially informal employee leaders, to get a sense of what their workforce wants. Institutionally they can garner employee opinions through anonymous surveys and focus groups.
To begin the dialogue, leaders need to address employees’ fears, stress triggers, and uncertainties with transparency. Take the firm response to the Delta variant. Decisions to open offices or wait a bit longer change from day to day as CDC prognosticators offer ever-evolving advice. When leaders share plans for reopening and offer time for parents and caregivers to prepare for their return to the office, employees can feel that their concerns are being heard. “It’s all about communication. Even sharing where you are in the planning process or what criteria is being used to determine plans will help employees feel seen and prioritized.” [3]
Near-Term Issues
Currently, the most important issues are plans to address workforce safety and the need to design effective work processes and procedures for a hybrid environment.
What COVID-19 requirements should the firm enforce? What are the guidelines for outside visitors? Client meetings?
How will office space be reconfigured for personal safety?
What will offices be used for—traditional individual work spaces or communal spaces that encourage personal interaction and collaboration? Can and should office space be reduced?
Who will need to be in the office full time and why? How will time flexibility be created for these workers?
What will flexibility mean? Can employees choose their remote work days or will patterns with set days be established? If the latter, on what basis?
How will performance be measured?
“Most employers appear to be attuned to the fact that prioritizing the wellbeing of their workforce is a key determiner of job satisfaction, productivity and retaining top talent. . . . [A] renewed focus on employees’ needs could be what defines the post-pandemic experience of work.”[4]
Some suggestions:
Consider “core hours” as a way to reduce employee burnout and meetings overload by setting time periods when everyone has to be available for collaborative activities balanced by other meeting-free time periods. Establish quiet hours when people know they can work uninterrupted.
Help employees set boundaries between work and life. Mandate vacations and days off. Moderate the intensity of 24/7 communication by banning work emails and texts between certain hours.
Calendar schedules around the work to be accomplished. Should team members all take the same remote work days? Or should certain days, say Tuesday and Thursday, be available for those who want the flexibility to choose when they work remotely?
Long-Term Issues
Norms, policies, and practices will change as firms create a new culture for the new normal. Firms will have to experiment and learn from their mistakes. Key questions remain:
What should the role of the office be?
What work is more effectively done in the office than remotely and vice versa?
How should work be organized? Do teams need to be physically together to work productively on projects? If yes, then how should team schedules be arranged in a hybrid office?
How can you avoid a two-tier system in which people working remotely are less valued and rewarded than those working in the office in close physical proximity to their bosses?
How can meeting leaders ensure equal participation opportunities for remote workers?
What changes should be implemented to address expectations of 24/7 availability, lessen employee burnout and address work-life balance issues?
Can leaders recognize and control innate biases that waylay plans to create an equal, inclusive workplace?
The pandemic gave people a chance to see work in a new way—as another segment of their lives rather than separate from their life. And they liked it. Tuned-in, modern thinking leaders will use the new thinking about work as a jumping-off point for firm modernization. “Work isn’t just a livelihood. It can be a source of structure, belonging and meaning in our lives. . . For several generations, we’ve organized our lives around our work. . . It might be time to start planning our work around our lives.”[5]
In my next article I will discuss suggestions for long-term changes in law firms.
At the Virtual Section Annual Meeting in September 2021, Jeannie Frey, chair of the Business Law Section, awarded Wilson Chu, immediate past chair of the Section’s Mergers & Acquisitions (M&A) Committee, the prestigious “Section’s Chair Award,” which honors members who have made exceptional contributions to the Section and the legal profession.
In her presentation remarks, Frey identified Chu’s leadership skills and his ability to remain “cool and unflappable” under any situation as key components in selecting him for this award. His stewardship as chair of the M&A Committee, noted Frey, demonstrated his commitment to the Section, its members, and the practice of law.
“Wilson brought enthusiasm and creativity to his role as chair of the Mergers & Acquisitions Committee,” said Joel I. Greenberg, partner at Arnold & Porter and a former chair of the M&A Committee. “He was constantly looking for ways to promote the Committee and bring increased value to its members, despite having the bad fortune of serving nearly half of his term during a worldwide pandemic.”
According to Frey, Chu’s accomplishments were impressive—and numerous. He paved the way for M&A to host a major conference; oversaw another Deal Points Study; produced more video content for the M&A Market Check Series; and continued to strengthen the Section’s largest substantive committee.
“Wilson has been a major contributor to the success of the M&A Committee for many years,” said Scott T. Whittaker, partner at Stone Pigman Walther Wittman L.L.C. “It was fortuitous for the M&A Committee that the pandemic coincided with Wilson’s tenure as Chair, because the Committee was able to thrive, despite the lack of in-person meetings, in large part due to his creativity and enthusiasm.”
Whittaker, who also served as chair of the M&A Committee, believes that the key to the long-term success of the Committee is the continuing contributions of its long-term members, combined with a culture that welcomes new members. “Wilson has continued to build on that tradition, which has not only kept the Committee in the forefront of thought leadership in the field of M&A, yet allows for many of our newer Committee members to enhance their personal profiles through Committee involvement.”
M&A Energized and Thriving
Leigh Walton, partner at Bass, Berry & Sims, characterized Chu as one of the most energetic chairs of the M&A Committee since its founding. Chu was also the force behind the debut of new programs, such as M&A Market Check Series in collaboration with Hotshot, and Walton predicts that this new member offering will have a profound impact on the Committee and the Section in years to come. “His emphasis on new, younger and diverse members will serve us well,” said Walton. “I cannot imagine we could have chosen a more capable leader for the last three years.”
If innovation and leadership are hallmarks of Wilson Chu’s tenure as chair, his uncanny ability to “make things happen” must also be added as an underlining theme for all his years in serving the Section. Chu was one of the founding members of the Market Trends Subcommittee that led to the creation of the Deal Points Study—one of the crown jewels of content at the ABA.
Michael O’Bryan, who succeeded Chu as chair of the M&A Committee in September, credits him with a long history of bringing energy and ideas to the M&A Committee and to the M&A profession. “It will be a challenge keeping up with Wilson,” he noted. “Wilson brought our Committee through a difficult transition and got us to a great place.”
Chu’s work has not only been confined to M&A. He also has a liaison role to the Section’s Sponsor Board; and he has helped the Section in identifying the value of Section/Committee membership and increasing the profile of events. In fact, at the Section’s Spring meeting in April 2021, Chu was able to finesse an interview with entrepreneur Mark Cuban that centered on issues relevant to our members.
Section Involvement Leads to Engagement
“As a former chair of the M&A Committee (back when it was called the Committee on Negotiated Acquisitions), I appreciate how much time and effort Wilson’s role has taken up,” said Richard Climan, partner at Hogan Lovells. “His creative thinking and seemingly boundless energy have made him a standout in this role, and his ability to navigate the stresses of the COVID pandemic has made his tenure as chair particularly memorable. He is widely admired and respected among active Committee members.”
As he accepted the award, Chu remarked that he was often asked why he would devote his limited free time to Section and Committee activities and projects. “The answer is simple,” said Chu. “It gives me the opportunity to meet people and to learn from them.”
The Section and its members, especially young lawyers, have indeed learned from Wilson, and will continue to benefit from his skills as a dealmaker.
“Wilson is steadfastly loyal to the idea of making things better than he finds them,” said Chauncey M. Lane, partner at ReedSmith LLP in Dallas. “This is the impact he has had as leader within the Business Law Section and the Mergers and Acquisitions Committee.”
In this unanimous en Banc opinion, the Delaware Supreme Court overturned its oft-criticized decision in Gentile v. Rosette, 906 A.2d 91 (Del. 2006) (“Gentile”). Gentile held that a stockholder who allegedly suffers dilution as a result of a controlling stockholder increasing its holdings had standing to pursue a direct claim because a corporate dilution/overpayment claim was “dual-natured” (i.e., direct and derivative). Gentile, however, stood in tension with the Court’s earlier decision in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004) (“Tooley”), in which the Court articulated a two-part test for determining whether a stockholder’s claim is direct or derivative. The Brookfield Court put to rest the Gentile dual-natured exception in favor of Tooley and thereby made clear that stockholder plaintiffs will now need to contend with the demand requirement under Court of Chancery Rule 23.1 in controller dilution cases.
This case arose from a June 2018 private placement in which Brookfield Asset Management, Inc. (“Brookfield”) acquired $650 million shares of TerraForm Power, Inc. (“TerraForm” or the “Company”) increasing Brookfield’s interest in TerraForm from 51% to 65.3% (the “Private Placement”). Stockholder plaintiffs sued, alleging that TerraForm issued stock for insufficient value in the Private Placement, diluting the minority stockholders’ economic and voting interests. Plaintiffs asserted their claims both directly and derivatively, but in July 2020, Brookfield affiliates acquired all outstanding stock of the Company not already owned by Brookfield, and plaintiffs lost standing to pursue the derivative claims.
Defendants moved to dismiss the plaintiffs’ remaining direct claims, arguing they are exclusively derivative under Tooley.In October 2020, the Court of Chancery found that plaintiffs’ overpayment claims were derivative under Tooley and were also direct under Gentile’s dilution claim exception to Tooley. Defendants moved for interlocutory appeal of that decision, which application was granted in light of earlier criticism from the Delaware Supreme Court questioning the continued validity of Gentile.
In this decision, the Delaware Supreme Court identified doctrinal, practical, and policy reasons for overturning Gentile. The Court acknowledged three ways in which Gentile was in tension with Tooley.
First, the Court found tension in Gentile’s conclusion that economic and voting dilution was an injury to stockholders independent of the corporation. The Court stated that the basis for plaintiffs’ claims was that the Private Placement allegedly harmed the Company by issuing shares to Brookfield for an unfairly low price, resulting in the plaintiffs suffering harm through the reduction in economic and voting power in proportion to their shareholdings, and the harm was therefore indirect.
Second, the Court found that Gentile’s explicit reliance on In re Tri-Star Pictures, Inc. Litig., 643 A.2d 319 (Del. 1993) (“Tri-Star”) created tension with Tooley because Tri-Star relied on opinions applying the “special injury” test that Tooley expressly rejected. Gentile stated that it was applying both Tooley and Tri-Star, which the Court found inconsistent with Tooley’s clear rejection of the “special injury” test.
Third, the Court noted that Gentile’s reliance on the presence of a controlling stockholder conflicted with the Tooley test, which solely focuses on who suffered harm and who would recover rather than the nature of the wrongdoer.
The Court then identified practical concerns with Gentile. First, the carve-out for dual-natured claims in Gentile was unnecessary because there are other avenues through which stockholders may assert fiduciary duty claims in change-of-control transactions or challenge the fairness of a merger. Second, because both the corporation and stockholders could recover for harm under Gentile, there was a risk of double recovery.
Next, the Court explained why stare decisis did not prevent overturning Gentile. The opinion held that fifteen years grappling with Gentile was sufficient to determine that the difficulties that it created were unworkable and that Gentile was a substantial departure from Tooley. The Court also found that the Supreme Court’s statements casting doubt on the continued viability of Gentile in El Paso Pipeline GP Co. v. Brinckerhoff, 152 A.3d 1248, 1256 (Del. 2016), meant that parties could anticipate that Gentile’s status was in jeopardy.
While Gentile was limited to dilution claims, the decision to overturn it is a continued endorsement of the simplified direct versus derivative analysis established by Tooley. This decision provides more certainty for litigants and the courts regarding the applicable pleading standards to assert a dilution claim (i.e., it must meet the Rule 23.1 pleading standard for derivative claims) and the standing of stockholders to bring a dilution claim (i.e., they must be continuous owners of the nominal defendant corporation’s stock).
In this en Banc opinion, the Delaware Supreme Court unanimously eschewed the long-standing test for determining demand futility set forth in Aronson v. Lewis, 473 A.2d 805 (Del. 1984) (“Aronson”) in favor of a “universal” three-part test that incorporates principles from both Aronson and Rales v. Blasband, 634 A.2d 927 (Del. 1993) (“Rales”). The universal demand futility test adopted in this decision focuses primarily on whether directors are disinterested and independent with respect to the litigation demand rather than the decisions or actions being challenged in the litigation. The Court also held that claims exculpated by a corporation’s Section 102(b)(7) charter provision do not expose a director to a “substantial likelihood of liability” for purposes of the demand futility analysis.
Prior to Zuckerberg, the Delaware Supreme Court had established two tests—in Aronson and Rales—to determine whether directors can exercise independent and disinterested judgment regarding a pre-suit demand. Aronson applied when the directors who made the challenged decision also constituted a majority of the directors who would consider a pre-suit litigation demand and focused on the substance of the challenged transaction. The Rales test applied when no specific board decision was challenged (e.g., failure of oversight claims) or when a majority of the directors on the board that would be considering the litigation demand did not participate in the challenged decision. The Rales test focused on the independence of the decision regarding a litigation demand rather than the underlying business decision being challenged.
Zuckerberg involved a proposed reclassification of the shares of Facebook, Inc. (“Facebook”) that would have allowed Mark Zuckerberg to donate a majority of his Facebook stock to charity while still maintaining control of the company (the “Reclassification”). The Reclassification was challenged by Facebook stockholders and, shortly before trial, Facebook withdrew the Reclassification, rendering the lawsuit moot. Facebook spent more than $20 million defending the litigation and paid plaintiffs’ counsel more than $68 million in attorneys’ fees under the corporate benefit doctrine in a class action settlement.
After the Reclassification litigation concluded, another Facebook stockholder filed a derivative complaint seeking compensation for the money Facebook spent in connection with the prior action. The stockholder plaintiff argued that demand was futile, and defendants moved to dismiss the complaint under Court of Chancery Rule 23.1 for failure to make demand on Facebook’s board of directors or adequately plead demand futility. Although the Court of Chancery acknowledged—and the parties agreed—that the Aronson test applied because a majority of the board members who would have considered a demand also made the challenged decision to pursue the Reclassification, Vice Chancellor Laster determined that Aronson’s“analytical framework [was] not up to the task,” and instead chose to apply the Rales test while also “draw[ing] upon Aronson-like principles.” In applying this hybrid test, the Court of Chancery concluded that a majority of the Facebook board was capable of considering a demand and dismissed the claim under Rule 23.1.
In Zuckerberg, the Delaware Supreme Court endorsed the demand futility analysis applied by the Court of Chancery as the “universal test” for assessing demand futility. Therefore, it is no longer necessary to determine whether the Aronson test or the Rales test governs the demand futility inquiry. Under the refined test, courts will focus on the following three questions, applied on a director-by-director basis:
whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;
whether the director faces a substantial likelihood of liability on any of the claims that would be the subject of the litigation demand; and
whether the director lacks independence from someone who received a material personal benefit from the alleged misconduct that would be the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand.
If the answer to any of these questions is “yes” for at least half of the members of a demand board, then demand is excused as futile.
In affirming the Court of Chancery’s decision and adopting this approach to demand futility, the Court explained, “The purpose of the demand-futility analysis is to assess whether the board should be deprived of its decision-making authority because there is reason to doubt that the directors would be able to bring their impartial business judgment to bear on a litigation demand.” The Court’s opinion thus provides more clarity for determining demand futility, by blending the previous tests from Aronson and Rales and appropriately “refocus[ing] the inquiry on the decision regarding the litigation demand, rather than the decision being challenged,” while remaining consistent with Aronson, Rales, and their progeny. The refined test is especially helpful in situations where Aronson would have proved difficult to apply, such as when there has been turnover on a corporation’s board or director abstention.
Companies are subject to various types of regulatory and statutory compliance requirements, whether they are publicly traded, privately held, or even nonprofits. The requirements may vary by industry and location, the latter referring to both the company’s state of incorporation and where it does business. Publicly traded companies have a further overlay of Securities and Exchange Commission (SEC) and stock exchange regulation. This article provides a broad overview of how board members should address these compliance requirements as part of their oversight duties to forestall future issues, and how preparation is key when an issue does arise.
The fiduciary duties of board members include far more than just oversight of compliance, and so it is important to note at the outset that compliance is not the same as governance. However, a central duty of corporate board members is the oversight of the company’s compliance with all laws and regulations to which the company is subject. This includes staying aware of any new regulations that may arise, as well as changes in existing regulations, particularly as both the regulatory landscape and a company’s activities are constantly changing.
For example, as companies expand vertically, whether upstream into activities like production and raw material sourcing or downstream into activities like distribution and retail sales, the company may become subject to regulatory schemes that are new and unfamiliar to the company and its board. A company’s merger and acquisition activity may introduce new businesses and/or business jurisdictions, which may also be new and unfamiliar. Even the regulatory frameworks with which the company may be experienced are likely changing constantly, whether in small ways or large, and of course how those regulations are applied and interpreted by tribunals affects the requirements for compliance. The board’s oversight of compliance should therefore be a regular part of the board’s agenda, and optimally a board committee such as audit—or a risk committee, if there is one—should be assigned to monitor compliance closely, including watching out for new areas of compliance and changes in preexisting ones.
Inevitably, breakdowns in a company’s compliance policies and procedures may occur. Noncompliance can cause severe disruptions in a company’s business activities, and it can create material costs in terms of investigations—both internal and by regulatory agencies and/or law enforcement—and penalties. These failures can also seriously damage a company’s reputation and brand, impacting relationships with customers and vendors, and they can depress employee morale and hinder a company’s ability to attract new employees. And of course, noncompliance can potentially result in liability for individual directors.
Board members should also be aware that whistleblowers have become a regular part of the governance landscape, and their revelations are typically related to some area of alleged noncompliance. Many companies have programs that ostensibly are designed to encourage whistleblowers to report actual or suspected noncompliance, and to provide boards with direct visibility into such reports. However, there are significant variations in the effectiveness of whistleblower programs, as well as in the quality of the board responses. Ideally, on a “clear day,” boards should regularly review their company’s whistleblower program, looking for opportunities to strengthen and improve it, and of course to prepare extensively and in advance for their own response if/when the need arises.
When evidence of noncompliance arises—whether through an effective compliance program, whistleblower report, management discovery, or regulatory or law enforcement action—boards must decide whether to launch an internal investigation. If a regulatory agency or law enforcement is not already involved, the board must determine with the assistance of counsel whether the company is required to report the noncompliance, and then cooperate fully with any ensuing investigation. There may also be a requirement—or at least an opportunity—to communicate with stakeholders, such as customers, vendors, employees and/or local communities.
It’s usually better to “play offense rather than defense” with regard to publicity after noncompliance is discovered, which gives the company the opportunity to affect the narrative. Again, a board that is prepared in advance for a range of possible needs can be more effective in overseeing management’s response. For example, preparations could include lining up potential outside advisors, determining how company communications will be handled, and assigning a board committee to oversee the responses by management, both internal and external, as well as help coordinate any board action that may be needed. For example, in addition to the possibility of an internal investigation and notification of appropriate authorities as noted above, there may be personnel issues uncovered by the issue, weaknesses in systems and controls, or other management actions called for that should receive board oversight.
Such a board committee may need to be a new one—a “special committee”—composed exclusively of independent and “disinterested” directors, both to provide the necessary board resources to focus on the problem, as well as to insulate the board’s response from any parties that may have been involved, whether by act of omission or commission. Rather than scrambling to add independent directors when the need arises, it’s better to have enough independent directors in place at all times in order to form a special committee, should the need ever arise. Suffice it to say, “The games are won in practice!”
The quickness and thoroughness of the company’s response can favorably influence the severity of whatever regulatory or law enforcement penalties may ultimately be applied, as well as help reduce any damage to the company’s reputation and relationships. However, the potentially beneficial effect provided by the company’s response may vary widely with the type of noncompliance problem, e.g., antitrust, Foreign Corrupt Practices Act, health and safety, etc. Again, boards are well-advised to prepare for all of the above potential needs well in advance. In addition to the potential preparatory actions mentioned above, preparation may include, among other things, refreshing bylaws and strengthening and reinforcing the reporting processes, e.g., through compliance or internal audit.
Board oversight of compliance has undoubtedly been affected by the pandemic. Sources of information have been disrupted with employees not being on-site, and the lack of in-person communication may have had a subtle but nonetheless important effect on decreasing the flow of information. The lack of in-person board meetings, as well as the distraction of exigent issues raised by the pandemic, may contribute to a decrease in attention to overseeing compliance. Remaining compliant requires deliberate allocation of attention and resources, both of which may have been strained during the COVID-19 pandemic.
Boards must take account of this, or risk falling victim to compliance failure. Valuable knowledge can be gained from the cautionary tales of compliance failures of companies that have been made all too public, becoming object lessons for boards in general. In many cases, class actions and other litigation have followed, with courts reviewing the actions and inactions of boards and providing guideposts for the future through their decisions. The Caremark line of case decisions[1] has provided some guidance for boards, the overarching message of which is that boards must be diligent in their oversight of compliance, and properly document in board minutes and elsewhere that they have done so. For example, in the Marchand case,[2] involving a dairy producer and an outbreak of listeria from its products, the Court found that compliance with food safety regulations was central to the company’s business, and therefore should have received greater board oversight.
Regardless of whether a company ultimately prevails in such litigation, much of the damage may have already been done to the company’s reputation, brand and relationships—possibly its most valuable assets but which appear nowhere on its balance sheet. The value of advance preparation cannot be overestimated, since the company’s speed of response may be crucial in limiting the damage from a noncompliance issue. While not a noncompliance example, the historical “gold standard” for crisis response was that of Johnson & Johnson, when, in 1982, bottles of Tylenol were discovered to have been tampered with, leading to several deaths. The company famously took broad action, including the removal of millions of bottles from store shelves. What is less remembered is that response took several days, possibly because the company was unprepared to ever have to take such action. Contrast this with the episode on United Airlines in 2017 when a passenger was forcibly dragged off the plane, with videos circulating via the Internet within seconds. The damage to a company that can follow a crisis can occur within minutes, and companies—and the boards that oversee them—must be prepared in advance.
Oversight of compliance is an important board duty, and it should be high on the list for attorneys advising boards on their governance.
[1] See, e.g., In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).
[2]Marchand v. Barnhill, 2019 WL 2509617 (Del., 2019).
This article is the third in a series on intersections between business law and the rule of law and their importance for business lawyers, created by the American Bar Association Business Law Section’s Rule of Law Working Group. Read more articles in the series.
Introduction
Press reports have referred to Facebook’s Oversight Board using a range of descriptors from the cynical to the ridiculous. Oversight Board has been referred to as “an elaborate structure for a supposedly independent body to review…content decisions”[1] and “a group of [Zuckerberg’s] own making.”[2] It has also been called an “independent body,”[3] an “independent panel,”[4] and a “quasi-independent oversight board.”[5] Some reports have gone so far as calling it Facebook’s “Supreme Court,”[6] “a quasi-judicial organization,”[7] or even an “international human rights tribunal.”[8] These descriptions are neither fitting nor accurate. In stark contrast, Oversight Board uses more narrow terminology to describe itself, using little more than its own highly suggestive name and sharply defined contractual terms.[9] Most recently, placing board members on par with journalists, academics, and other members of civil society, the board characterized its work as a mere “part” of a “collective effort” to steer Facebook towards greater transparency.[10] In the face of conflicting characterizations and persistent controversy surrounding Facebook’s business activities, how do lawyers, particularly business lawyers, understand and evaluate Oversight Board’s novel construction, that claims to incorporate principles of the rule of law and international human rights into the core of its activities?
The Structures of Oversight Board
As one of the world’s largest and most prominent social media platforms,[11] Facebook[12] has responded to increasing demand for the regulation of social media companies in a novel manner, by creating a separate private business entity to advise a narrow band of its content decisions. Facebook first announced such a possibility in November 2018 in a note posted to the platform by its CEO Mark Zuckerberg. There, Zuckerberg envisaged an entity that would prevent concentration of decision-making within Facebook as a business, enhance accountability and oversight of Facebook’s content decisions, and assure that content decisions were being made in the best interests of Facebook as a community, rather than merely for commercial purposes.[13]
Zuckerberg’s announcement was made on the heels of the Cambridge Analytica data scandal that broke in the Spring of 2018 when a whistleblower reported that Facebook had allowed a company that sold psychological profiles of voters to political campaigns to harvest detailed personal information from up to 87 million Facebook profiles.[14] This scandal was in addition to growing concern about the polarizing effects of Facebook’s algorithms on society[15] and Facebook’s algorithm-driven censorship practices.[16]
Many credit Sir Nick Clegg, former British Deputy Prime Minister and Facebook’s current Vice-President of Global Affairs and Communications, for forcing action on the business risk confronting Facebook as a result of its mounting scandals.[17] While transitioning to his current role with Facebook, in Fall of 2018, Clegg described Zuckerberg as being “under no illusions about the reputational squall” of the company he leads.[18] To address this “reputational squall,” Clegg conditioned his joining Facebook on the aggressive insistence that Facebook, as “a company with more than 2 billion users,” start acting like a “global power…and go out and engage with the messiness of the real world.”[19]
Subsequently, in October 2019, Facebook settled the $130 million Oversight Board Trust as its sole Settlor. Through its Trustees, the Trust then created a private entity named Oversight Board LLC,[20] a name both suggestive and misleading since Oversight Board is not a board, per se. Oversight Board is a Delaware limited liability company that holds the Oversight Board Trust as its sole member.[21] Acting through Oversight Board LLC, the Trust funds the hiring, remuneration, and maintenance of a panel of experts, also termed “Oversight Board,” and referred to herein as the “board.”
Currently made up of 20 expert members from a range of countries and backgrounds,[22] Oversight Board’s board was created to:
protect free expression by making principled, independent decisions about important pieces of content and by issuing policy advisory opinions on Facebook’s content policies.[23]
Facebook maintains a heavy hand in the selection of board members. For example, Facebook retained the right to select the board’s first four board members, all of whom automatically became (and currently remain) the first Co-Chairs of Oversight Board.[24]
Rule of Law and Oversight Board
As Kimberly Lowe pointed out in the first article in this series, “The Business Lawyer and the Rule of Law,”[25] the American Bar Association has broken down the broad concept of the rule of law into a helpful “set of principles, or ideals, for ensuring an orderly and just society” where:
no one is above the law, everyone is treated equally under the law, everyone is held accountable to the same laws, there are clear and fair processes for enforcing laws, there is an independent judiciary, and human rights are guaranteed for all.[26]
Oversight Board’s Charter quite legibly references these and other principles of the rule of law when discussing the role of its board. For example, inspired by principles of due process and equal treatment, Oversight Board’s Charter “specifies the board’s authority, scope and procedures, including how Facebook and the people registered to use its services…can access the board.”[27] Additionally, the Charter requires the board to operate transparently, including by ensuring that board decisions are “explained clearly to the public, while respecting user privacy and confidentiality” and provide “an accessible opportunity for people to request [the board’s] review and be heard.”[28] Moreover, in the style of courts and international tribunals, the Charter sets out the expectation that past decisions will establish precedent for future boards.[29]
Along these lines, the board produces written opinions that explain the reasoning behind board decisions. These opinions are freely available, in different languages, on the Oversight Board website. Moreover, opinions are structured for ease of access and include case summaries followed by detailed and structured explanations of board decisions. Mirroring the format of opinions published by courts and tribunals, opinions are divided into standardized sections to enable quick reference to key aspects of each decision.
Perhaps the most striking rule of law feature of these opinions is the inclusion of a section, in each opinion, containing a highly stylized discussion on Facebook’s human rights obligations. [30] It should be noted that from a legal standpoint, the board’s discussion of human rights is grounded in Facebook’s official Corporate Human Rights Policy.[31] This policy voluntarily incorporates the United Nations Guiding Principles on Business and Human Rights,[32] the International Bill of Human Rights, and numerous international human rights treaties.[33] Enforcing compliance with Facebook’s Corporate Human Rights Policy, board decisions include, for example, application of Article 19 of the International Convention on Civil and Political Rights on “Freedom of Expression” to Facebook’s private content decisions.[34]
Notably, in its Charter and published opinions, Oversight Board expressly rejects American-style rights adjudication in favor of European/international approaches. This bias is made legible in two ways. First, according to Oversight Board’s Charter, past opinions do not bind future boards; they retain merely persuasive value.[35] Second, the Charter adopts a balancing approach to the adjudication of human rights, an approach favored by European and international forums.[36] To elaborate, it is generally held that the American common law system tends, as a norm, to treat rights as a sort of property—either individuals have them or they do not. To determine whether an individual is in possession of a right, in addition to reliance on constitutions, statutes, and regulations, a common-law judge turns to precedent (a court decision considered authoritative for deciding subsequent cases involving identical or similar facts).
By contrast and as a general matter, European and international forums treat rights like platonic objects that exist independently of the humans that claim them. This approach permits an adjudicator to weigh and balance individual rights against a larger collection of competing and complimentary rights, with an emphasis on preserving the integrity of the broader system of rights, writ large. Thus, in European and international forums, where past decisions generally have persuasive (as opposed to binding) value, judges look to past decisions for broad guidance on general principles without being obligated to align past decisions with future outcomes. In the American system, for example, parties may press judges, on appeal, to explain and account for differences in the balancing or weighing of rights between different cases. In contrast, European judges (and judges presiding over international forums that have adopted a similar style) enjoy a reasonable degree of play in the joints when it comes to describing the interplay between rights.
Cementing its preference for European and international approaches to human rights adjudication, Oversight Board’s Charter explicitly sets up the task of its boards as one of balancing the fundamental human right to free expression against “authenticity, safety, privacy, and dignity.”[37] In a similar nod to European approaches, board decisions are produced with the support of an independent research institute headquartered at the University of Gothenburg. With support from a team of over 50 social scientists on six continents, as well as more than 3,200 country experts from around the world, the institute provides expertise to the board on socio-political and cultural context of board decisions.
This preference in favor of European approaches to human rights adjudication is especially noteworthy when considering Facebook’s long struggle for credibility, as a business, with European authorities, including its difficulties with German and European regulators[38] as well as its difficulties with Norwegian Press.[39] Similarly, a preference for a more international approach is also better appreciated when considering the fact that over 80% of Facebook’s users (and around 95% of the world’s population) are located outside the United States and Canada.[40]
Facebook’s Gains from Engaging with the Rule of Law
In 2018, in the face of seemingly endless scandal and controversy, the very act of Zuckerberg’s publicly imagining[41] and Facebook’s publicly designing and establishing Oversight Board altered, for a time and quite instantly, the public conversation around Facebook.[42] The creation of Oversight Board allowed Facebook to distance itself from the Cambridge Analytica scandal. Further, Oversight Board had given Facebook a basis to speak somewhat credibly on principles of the rule of law and on international human rights, both languages that enjoy considerable legitimacy at the international level, particularly in European and Indian courts (two forums controlling important markets for Facebook). Moreover, through Oversight Board, Facebook has added to “team Facebook” 20 established and respected international scholars, all of whom are charged to critique Facebook with the sole aim of protecting the integrity of Facebook’s most vital business asset, its global community of users.
In providing a transparent government-free procedure for ostensibly independent review of a small selection of its content decisions, Facebook has also deployed the language of human rights to the satisfaction of conservative American sensibilities.[43] For example, Casey Mattox, senior fellow at the Charles Koch Institute, argues that a self-regulatory body such as Oversight Board protects Facebook from politicians “trying to impose their own partisan will on the platforms.”[44] Moreover, Oversight Board currently counts John Samples, Vice-President of Libertarian think tank the CATO Institute, as a board member. Samples sits on the board alongside board members who are well-known progressive stalwarts.[45]
In addition to (and perhaps because of) Oversight Board’s bewildering constellation of voices from across the political spectrum, at a more pragmatic level, passing the proverbial buck on content decisions to Oversight Board has allowed Facebook to alter the nature of the scrutiny it receives, since with respect to any action taken by Oversight Board, criticism of Facebook’s conduct becomes, equally, an indictment of Oversight Board’s diverse, eminent, and expert panel.
The Limitations of Facebook’s Engagement with the Rule of Law
Oversight Board’s detailed attention to the rule of law and international human rights notwithstanding, Oversight Board’s structure enables Facebook to avoid serious questions about its ethical responsibilities to its users and the general public. As critics have pointed out, one challenge is that through Oversight Board, Facebook has subjected only a narrow sliver of its content decisions to the discipline of the rule of law. In its first year of operation, the board culled through more than 500,000 requests from users to examine Facebook’s content moderation decisions, taking on 20 cases and issuing 15 decisions. This means that, in essence, Oversight Board’s board has overturned Facebook’s disputed content decisions 11 out of 500,000 times,[46] based on extended consideration of only 0.004% of appeal requests. Notably, the board has not been transparent about how it determines which decisions to review.
Moreover, Oversight Board’s narrow focus on user-generated content has allowed Facebook to avoid much harder conversations about long-standing problems with Facebook’s back-end operations. For example, by design, Oversight Board is not able to comment on the algorithms that Facebook uses to organize and display user content or the balance that Facebook sets between user engagement and community safety. In other words, Facebook seems to have left its most fundamental speech-related business decisions completely beyond the reach of Oversight Board, leaving those paid experts sheltered in a limited liability shell with only its most downstream, politicized, and public-facing controversies on disputed user-generated content.
Reinforcing Facebook’s dominance over Oversight Board, Facebook has already proved reluctant to cooperate with Oversight Board, even within the narrow field of Oversight Board’s authorized activities. For example, Facebook refused to answer several key questions from a board that it personally curated less than one year ago. In reviewing Facebook’s ban of former US President Donald Trump from the Facebook platform, the board
sought clarification from Facebook about the extent to which the platform’s design decisions, including algorithms, policies, procedures and technical features, amplified Mr. Trump’s posts after the election and whether Facebook had conducted any internal analysis of whether such design decisions may have contributed to the events of January 6.
The board reported that Facebook declined to answer these questions, making “it difficult for the [b]oard to assess whether less severe measures, taken earlier, may have been sufficient to protect the rights of others.”[47] Facebook’s narrow construction of Oversight Board, its continued refusal to acknowledge its obligations to cooperate with the board’s fact-finding, and Facebook’s deliberate refusal to operate transparently with respect to its back-end operations raise significant questions about the sincerity of Facebook’s commitment to truly independent oversight based on principles of the rule of law.
The Facebook Files and the Limitations of Oversight Board
The benefit to Facebook in limiting Oversight Board’s scope and power have come to light through a recent document leak. In September 2021, for the first time since the creation of Oversight Board, Facebook became the subject of significant public controversy once again. This time, a whistleblower and former Facebook employee, Frances Haugen, leaked thousands of internal Facebook documents that revealed a considerable range of Facebook’s most predatory practices (the “Leak”). These predatory practices include Facebook’s practice of exempting high-profile users from its ordinary community standards;[48] Facebook’s concealment of research on Instagram’s uniquely harmful effects on teenage girls;[49] and Facebook’s willingness to prioritize user engagement at the cost of user health and personal well-being.[50]
Less than two weeks after news of this Leak, the board’s current Co-Chairs—Catalina Botero-Marino, Jamal Greene, Michael McConnell, and Helle Thorning-Schmidt—authored a narrowly formulated response, posted to the Oversight Board website.[51] The response focused solely on the content-moderation aspects of the Leak, characterizing these as “new information…on Facebook’s ‘cross-check’ system, which the company uses to review content.”[52] Framing the Leak as evidence of the need for greater transparency at Facebook, the board additionally listed examples of policy recommendations it had made to Facebook in the interests of increased transparency. For example, the board had warned, in its decision concerning Trump’s Facebook accounts, that a lack of clear public information on Facebook’s policies regarding its high-profile users could contribute to perceptions that Facebook is unduly influenced by political and commercial considerations.[53] The board pointed out that it had also warned Facebook about the danger of removing user content with little explanation, also pointing out that it had recommended in three of its first five decisions that Facebook tell users the specific rule that triggered removal of their content.[54]
While the board’s response was prompt and detailed, it was so narrowly formulated that it stood disconnected from the very same events it sought to address. First, the board is limited to speaking about Facebook’s user-generated content and content policy. As such, the board addressed the issues of content moderation raised by the Leak with laser focus, while avoiding even so much as a mention of any related issues that provided context, such as concerns about Facebook’s harmful use of algorithms. Second, and more concerningly, the board’s response subtly reframed the narrative around Facebook. For example, what credible news outlets refer to as Facebook’s problematic and deliberate deference to high-profile users, the board describes as the product of “perceptions” of undue influence created by policies in need of review.[55] As an additional example, what Haugen, an independent whistleblower, describes as a company that has made a practice of magnifying and profiting from the worst in human nature,[56] the board instead characterizes as a company that would benefit from being more transparent about its activities and from taking the advice of the board seriously.[57] Notably, Oversight Board offers no basis, textual or otherwise, for these characterizations of Facebook’s motivations and circumstances. Third, the board makes no direct reference to the Leak (referring to it as a “disclosure”), and makes no commitment to review the more than 1,000 documents that were placed on the public record in the public interest. The board merely commits to seeking further information from Facebook and addressing Facebook’s continued failures to be forthright in its dealings with Oversight Board.
Ultimately, the board’s response to the Leak reflects deliberate limitations placed on the scope of Oversight Board’s work and purpose. These limitations, in turn, stem from Facebook’s long-standing assumptions about how social media companies should be regulated. Before the appointment of a single board member, Facebook had already taken a clear position on what aspects of its social media platform should be subject to external regulation: harmful user-generated content, online activity that threatens the integrity of elections, privacy, and data portability.[58] Simultaneously, Facebook has also worked to shield its algorithms and other aspects of its back-end operations from public scrutiny and regulatory zeal.[59] Oversight Board was structured accordingly, as a $130 million project focused tightly on expert-led self-regulation of a narrow line of Facebook’s content moderation decisions. This tight structure leaves very little room to a board of experts to independently consider what effective oversight might look like.
No Court for Facebook
While even lawyers have been willing to claim that Oversight Board is comparable “to an international human rights tribunal or quasi-judicial monitoring institution,”[60] as a private activity funded and established by a single corporation, Oversight Board cannot fairly be described as (or even as similar to) a court or tribunal, simply because it publishes ordered opinions that reference the principles of rule of law and international human rights. The entity deals with a very narrow slice of appeals to Facebook’s content decisions, operating through a framework narrowly tailored by Facebook to address an even narrower pre-determined set of concerns. Even in its processing of such appeals, the board has struggled to gain information and cooperation from Facebook, an entity that has (as the creator of Oversight Board and the settlor of the Oversight Board Trust) far more power and control over the broader context of the board’s decision-making process than any “party” to a dispute should be granted.
As illustrated by the board’s recent response to Facebook’s latest controversy, the narrow ambit of Oversight Board’s work prevents it from engaging with Facebook on fair and equitable terms. The board relies on Facebook for its corporate fact finding and implementation of its policy decisions. By contrast, given the narrow scope of the board’s work, Facebook relies on the board for very little that the board is not obligated to provide. There is a power inequality between the board and Facebook that could not have existed if Facebook had truly granted Oversight Board anything remotely comparable to the authority of a court or tribunal. Oversight Board’s narrowly tailored scope seems to suggest that board members are simply playing out a role designed for them by Facebook. Even if board members fulfill this role with independence and integrity (as one can only assume that they do), their personal independence and integrity is not sufficient to deem the entire structure truly independent.
In the final analysis, there is little value in thinking of Oversight Board as a court, tribunal, or even an independent body. It is something far more interesting. It is an experiment at the cutting edge of technology and the rule of law—one that Facebook has carefully crafted to replicate a precise model of regulation of social media that the company seeks to advance.
Compare Oversight Board to another experiment in social media regulation. Twitter Chief Executive Jack Dorsey has also been experimenting for solutions for self-regulation of social media platforms. Unlike Facebook, Twitter seeks to give users more “algorithmic choice” to decide what they see. To pursue this strategy, Dorsey set up an employee-funded project called “BlueSky.” Invoking a different set of principles than those relied upon by Oversight Board, BlueSky emphasizes users “governing” themselves rather than being governed by companies (e.g., Facebook or Oversight Board). Using federalism[61] as a point of reference, BlueSky invokes the term “fediverse” to describe a de-centralized network that “hands control back to the user, who can choose the app that best suits their needs and still have the freedom to interact with users on different apps.”[62]
Facebook and Twitter could not be more different as social media platforms. Facebook has approximately 2.8 billion users located across the world, with the bulk of its users located outside of the United States and Canada.[63] Twitter has a few hundred million users, most of whom are highly educated, high-income Americans.[64] Regulation that supports one company is likely to destroy the other. For example, Twitter’s fediverse would allow people to interact with Facebook users without having to join the Facebook platform, a change comparable to how e-mail platforms like Hotmail “freed” users from reliance on email attached to paid platforms like America Online. In contrast, the thought of an unelected 20-member interdisciplinary board reigning over content decisions that impact 2.8 billion people, without any oversight of the back-end decisions organizing that content, would probably have Twitter’s highly active and highly informed customer base up in arms. As such, the threat of regulation presents considerable stakes for all companies involved.
As things stand, the situation remains unpredictable. As Oversight Board continues to engage with Facebook and the public, it could build weight for Facebook that might create a more balanced power dynamic between the two entities in the future. The board’s work thus far presents a display of the long-term potential that Oversight Board might offer Facebook in this regard. First, the board can do what Facebook cannot: it can openly acknowledge and publicly address Facebook’s scandals. Second, in so doing, by consistently addressing issues along the single axis of content moderation, the board can take control of the narrative building around Facebook scandals. For example, in its response to the recent Leak, the board characterized Facebook’s failures as stemming from a lack of transparency, rather than from what the Press had labeled deliberate predatory behavior. Third, the board has shown itself well-positioned and adequately incentivized to work with (rather than against) Facebook to address these problems, as the public perception of the board’s effectiveness depends upon its ability to provoke genuine change in Facebook’s corporate practices. On the basis of these strengths, Facebook might eventually find genuine value in cooperation with its advisory entity and support it to build capacity that more closely resembles that of a true court or tribunal. Alternatively, Facebook might find itself satisfied or frustrated with the experiment and move on to greener pastures.
Fundamentally, Oversight Board is not one thing or the other, certainly not yet. At present, it is a vessel, an experiment with various kinds of potential, potential that is itself yet unknown. What it becomes will depend greatly on how it is received, how it is understood, and how it is explained—and this depends, most centrally, on the work of business lawyers.
[34] International Covenant on Civil and Political Rights Art. 19, Dec. 16, 1966, 999 U.N.T.S. 171 (1978).
[35] Oversight Board Charter, Art. 2, § 2 (“For each decision, any prior board decisions will have precedential value and should be viewed as highly persuasive when the facts, applicable policies, or other factors are substantially similar.”).
[36]See, e.g, Michel Rosenfeld, Constitutional adjudication in Europe and the United States: paradoxes and contrasts, 2 I-CON 633 (2004) (citing Louis Favoreu, Constitutional Review in Europe, in Constitutionalism and Rights: The Influence of the United States Constitution Abroad 38 (Louis Henkin & Albert J. Rosenthal, eds., 1989)).
[47] Case decision 2021-001-FB-FBR, Oversight Board, May 5, 2021, https://oversightboard.com/decision/FB-691QAMHJ/. The board asked Facebook 46 questions. Facebook declined to answer seven entirely, and two partially.
[53] Case decision 2021-001-FB-FBR, Oversight Board, May 5, 2021, https://oversightboard.com/decision/FB-691QAMHJ/. The board asked Facebook 46 questions. Facebook declined to answer seven entirely, and two partially.
The governance bells are tolling for corporate, non-corporate, not-for-profit, governmental and other organizations. Investor and stakeholder demand, regulatory actions, and growing litigation risks are all increasing the focus on management and director responsibilities for effective governance. There is therefore the need to stress test governance structures and examine the viability of the existing checks and balances, to review the increased focus on board governance and oversight responsibilities, and to explore opportunities to create governance structures with a harder edge, while continuing to recognize governance’s often pivotal role in litigation. While exemplary corporate governance practices will never eliminate all occasions for suits, a sound governance structure will enhance the ability to successfully defend those suits to an early resolution through a motion to dismiss or for summary judgment.
The article introduces the importance of effective corporate governance, key points to consider in assessing governance, and resources—including many written by the expert co-authors—for gaining further understanding of these issues.
I. Stress Testing Governance Structures: An Introduction
Plan-Operate-Control Cycle
The diagram below sets out the basic governance structure of an organization. Stress testing determines the effectiveness of the governance structure in addressing the needs of the particular firm at that point in time. Stress testing examines how, and how well, an organization’s management and board are directing current operations and are prepared to react to specific risks and challenges, whether those challenges come from business competition, economic events and conditions, regulatory inquiries, changing shareowner expectations, litigation, or other causes.
This is not a middle market situation. The need for effective stress testing is exemplified by the recent breakdowns in the governance structures of Wells Fargo, Volkswagen, Credit Suisse, and Boeing, among others, with this focus on the governance structure going back to the well-known Walt Disney Shareholder Derivative Litigation involving the hiring and the subsequent termination of Michael Ovitz. In Disney, at that time referred to as “the corporate governance case of the century,” the Court made the board’s governance and oversight responsibilities clear, and examined the manner in which Disney management and its board addressed those responsibilities. The Disney litigation was eye-opening to many in the corporate sector because it was previously presumed that the business judgment rule defense would bring a quick end to the litigation. The Delaware Supreme Court did not quite see it that way and remanded the case to the lower court where the derivative suit would be tried on the merits. Ultimately, the Disney directors prevailed, but only after incurring significant legal defense expense. Our February 2019 Business Law Today article “Board Oversight and Governance: From Tone at the Top to Substantive Checks and Balances” examines the difficulties being experienced by the Wells Fargo board in addressing its responsibilities. We have authored four articles on our work in Disney, the first of which was “An Insider Revisits the ‘Disney Case’” (Directors Monthly, August 2008).
“Tone at the Top” vs. Checks and Balances
The long-revered concept of “tone at the top” as the guiding hand of an organization’s governance structure—where tone at the top took the form of a CEO/Chair essentially governing and managing the organization and the board being relegated to oversight—is still valued but now less emphasized. Today, there is broad-based recognition of the need for the appropriate “Checks and Balances” positioned in an environment characterized by transparency. The 2002 CPA Journal article “From Tone at the Top to Checks and Balances” authored by members of the Grace & Co. Board of Advisors, and the 2004 Wall Street Journal op-ed where Paul Volcker and Arthur Levitt Jr. point to the breakdown in checks and balances as the fundamental cause of major corporate collapses, both contributed to this evolving view of governance.
II. Board Governance: The Fed and Wells Fargo; Credit Suisse, Boeing and Volkswagen
One needs only to examine the 2018 Order to Cease and Desist between the Board of Governors of the Federal Reserve and the Board of Wells Fargo, and recent developments concerning Credit Suisse, Boeing and Volkswagen to gain a perspective on the current state of board, board committee and senior management “business” duties to govern, manage and oversee. Indeed, the troubles of Wells Fargo continue, with Senator Elizabeth Warren sending a letter on September 13, 2021, to Federal Reserve Chairman Jerome H. Powell urging a revocation of the bank’s operating license and forcing a break-up splitting the banking operations from Wells Fargo’s other financial and investment services.
Our 2019 article “Board Oversight and Governance: From Tone at the Top to Substantive Checks and Balances,” and the writings of former Delaware Supreme Court Chief Justice Norman Veasey and former Delaware Court of Chancery Chancellor William Chandler further contribute to that perspective that the board of directors will actually direct and monitor the management of the company, recognizing that Delaware law is clear that the business and affairs of a corporation are managed by or under the direction of its board of directors.
Chief Justice Veasey, in his May 2005 University of Pennsylvania Law Review article, stated “the board of directors will actually direct and monitor the management of the company, including strategic business and fundamental structural changes.” Chancellor Chandler, in his opinion in the Disney Shareholder Derivative Litigation, stated, “Delaware law is clear that the business and affairs of a corporation are managed by or under the direction of its Board of Directors.” The Federal Reserve website describes a board’s responsibility to create and enforce prudent policies and practices with the following statement: “Directors are placed in a position of trust by the bank’s shareholders, and both statutes and common law place responsibility for the affairs of a bank firmly and squarely on the board of directors. The board of directors of a bank should delegate the day-to-day routine of conducting the bank’s business to its officers and employees, but the board cannot delegate its responsibility for the consequences of unsound or imprudent policies and practices.”
A recent Delaware case involving Boeing is illustrative of a board’s oversight responsibilities. See In re The Boeing Company Derivative Litigation, 2021 WL 4059934 (Del. Ch. Sept. 7, 2021). This decision from the Delaware Chancery Court arose from the Boeing board’s conduct after two crashes of its 737 Max aircraft and serves as a cautionary tale for directors with regard to the importance of board and executive board committee level oversight and monitoring of “mission critical” product safety risks. Aircraft safety to a company such as Boeing would certainly be a mission critical area.
III. Governance with a Harder Edge
Governance with a harder edge merits consideration. By harder edge, we mean identifying opportunities to ensure board members are informed, involved and have skin in the game; and that the directors understand their responsibilities, are accountable to the organization—not the CEO, and bring an attitude of service and not entitlement to the position. The July 2020 BLT article “Why a Company Should Consider Using an Executive Committee of its Board of Directors” and January 2018 BLT article “Corporate Governance and Information Gaps: Importance of Internal Reporting for Board Oversight” examine the need to put in place governance structures with a harder edge, structures that ensure the voice of the General Counsel is heard. This improved governance positively impacts a firm’s operations; preparations for institutional investor visitations, activist inquiries, and plaintiff firm filings (often supported by litigation funding entities); and the availability and cost of liability insurance.
The current state of the D&O insurance marketplace is what is commonly called a “hard insurance market.” That means premiums for policies are at a relatively high level compared with earlier “soft market” years, and policy terms and conditions may be more restrictive. Also, and perhaps most important, insurance underwriters may look more critically at a risk’s corporate governance in order to select only the more desirable risks for acceptance. Because D&O insurance is frequently the sole or primary funding source in the settlement of securities class action or shareholder derivative litigation, the board and executive management must remain attuned to D&O insurer concerns.
The harder governance edge that exists in certain general partnerships merits examination, and contrasts with corporate governance. In these general partnerships, representatives of the general partners are informed—they understand the business of the partnership; they are involved in the operation of the partnership, and they have skin in the game. They understand their responsibilities, they are accountable back to the general partner they represent and not to the managing general partner, and they bring an attitude of service.
