On September 9, 2010, Chancellor Chandler issued his much-anticipated post-trial decision in eBay Domestic Holdings, Inc. v. Newmark, et al., C.A. No. 3705-CC, which involved a dispute between eBay and craigslist regarding a poison pill, staggered board amendments and a right of first refusal offer. At the end of this 90-page decision, available here, the Court rendered a spilt-decision in this bi-coastal fight, rescinding craigslist’s poison pill and the right of first refusal offer because of the directors’ breach of fiduciary duties to craigslist’s minority shareholder, eBay. The Court did not rescind, however, craigslist’s staggered board amendment finding no breach of fiduciary duties by the two craigslist directors.
This summary was prepared by Kevin F. Brady of Connolly Bove Lodge & Hutz LLP.
The factual story of how the parties got to the Delaware Court of Chancery is long and complicated. Indeed, the Court characterized this as a “unique case with distinct facts and difficult legal issues.” Given that description and over 40 pages of facts in the decision, it would be very difficult to address the factual nuances of this case and the detailed legal discussion in any abbreviated form. As a result, I will attempt to highlight the key facts and salient points of Chancellor Chandler’s reasoned analysis.
Corporate Culture eBay and craigslist — “Oil and Water”
While the real jumping off point for this dispute is when eBay became a minority shareholder of craigslist, the Court started its recitation of the post-trial facts by discussing in great detail the dissimilarities between the corporate cultures. This becomes important in the Court’s discussion of the poison pill. eBay is a publicly-traded NASDAQ company which operates its business with a focus on maximizing revenues and profits. craigslist, which is a private company with no reporting requirements under the federal securities laws (and thus its financial information is not in the public domain), has never had more than three shareholders. In addition, craigslist operated its business as a community service with nearly all of its classified advertisement placed free of charge.
craigslist’s three shareholders were Craig Newmark (“Craig”) and James Buckmaster (“Jim”) and Philip Knowlton (“Philip”) (the Court in its decision used first names for ease of convenience so I will as well). In 2004, Philip wanted to sell his shares and eBay was looking for a way to get a foothold into craigslist to eventually acquire craigslist, so eBay entered into discussions with the three directors about acquiring Philip’s shares. In August 2004, eBay agreed to pay $32 million for Philip’s shares of which $24 million went to Philip and $8 million went to Jim and Craig. After the sale, Craig owned 42.6%, Jim owned 29% and eBay owned 28.4% of craigslist. The terms of eBay’s investment in craigslist were set out in a stock purchase agreement (the “SPA”) and a shareholders’ agreement (the “Shareholders’ Agreement”). Jim and Craig also executed a voting agreement (the “Jim-Craig Voting Agreement”).
The Shareholders’ Agreement set forth: (1) eBay’s agreement, as a craigslist stockholder, to treat confidential craigslist information with the same degree of care eBay afforded its own confidential information; (2) eBay’s right to consent to certain transactions craigslist might enter into including any amendment to the charter that might adversely affect eBay; (3) numerous transfer restrictions on the craigslist shares owned by Craig, Jim, and eBay; (4) eBay’s right to compete with craigslist subject to certain consequences; and, (5) the consequences should eBay decide to compete with craigslist.
The SPA required, among other things, eBay to assist in changing the incorporation of a predecessor to craigslist (and one of the parties to the SPA) from California to Delaware and approving a new charter for craigslist which provided for a three-person board of directors to be elected with cumulative voting. The mechanics of cumulative voting ensured that eBay could use its 28.4% stake in craigslist to unilaterally elect one of the three members to the craigslist board.
The Jim-Craig Voting Agreement set forth how Jim and Craig were to vote their shares in director elections. It required Jim and Craig to vote their shares so as to elect one director designated by Jim and one designated by Craig. The third director would be filled by eBay, not by contract but rather under a cumulative voting system with a non-staggered board. eBay appointed Omidyar who was eBay’s CEO to the craigslist board. While he was on the board, Omidyar’s plan was to gather inside information as to how craigslist runs it business so that eventually eBay could take over craigslist. At the same time, eBay was independently building up its own portfolio of online classifieds sites.
eBay Starts a Competing Business
On June 29, 2007, eBay launched an online classifieds site at www.Kijiji.com. The new site had the benefit of craigslist’s nonpublic information that eBay had access to as a result of its seat on the craigslist board. When craigslist was notified of the new venture, it sent eBay a Notice of Competitive Activity pursuant to the Shareholder’s Agreement, which gave eBay ninety days to cure before eBay would lose (1) its consent rights, (2) its preemptive rights over the issuance of new shares, and (3) its rights of first refusal over Jim and Craig’s share. If eBay failed or declined to cure (which it did), the craigslist shares eBay owned would become fully transferable. Thereafter, Jim informed eBay that he wanted to unwind the relationship with eBay. eBay responded that it was not interested, so Jim and Craig decided to take measures to ensure that eBay would not get access to any more confidential information of craigslist or purchase any more shares.
The January 2008 Board Action
On January 2, 2008, Jim and Craig, acting in their capacity as directors: (i) adopted a stockholder rights plan (“Rights Plan”) that restricted eBay from purchasing additional craigslist shares and hampered eBay’s ability to freely sell the craigslist shares it owned to third parties; (ii) implemented a staggered board through amendments to the craigslist charter that made it impossible for eBay to unilaterally elect a director to the craigslist board; and (iii) sought to obtain a right of first refusal in favor of craigslist (the “ROFR/Dilutive Issuance”) over the craigslist shares eBay owned by offering to issue one new share of craigslist stock in exchange for every five shares over which any craigslist stockholder granted a right of first refusal in craigslist’s favor. Jim and Craig accepted the right of first refusal offer in their capacity as craigslist stockholders and received new shares; eBay, however, declined the offer, did not receive new shares, and had its ownership in craigslist diluted from 28.4% to 24.9%.
Lawsuit filed in Delaware and California
In April 2008, eBay filed suit in the Delaware Court of Chancery challenging the January 2008 board actions. eBay claimed that in approving and implementing these measures, Jim and Craig, as directors and controlling stockholders, breached the fiduciary duties they owe to eBay as a minority stockholder of the corporation. In response, craigslist filed suit in California claiming, among other things, unfair competition and misappropriation of trade secrets. Interestingly, eBay did not file a claim for breach of contract or breach of an implied covenant of good faith and fair dealing and the Court commented on that:
Throughout this dispute, I have repeatedly read and listened to what look and sound like breach of contract arguments, which eBay uses not to prove Jim and Craig breached a contract, but rather to prove Jim and Craig breached their fiduciary duties. This has been an odd exercise, and I admit I am puzzled by eBay’s decision not to bring a breach of contract claim or, more promising perhaps, a claim for breach of the implied covenant, considering eBay expended significant effort arguing that the 2008 Board Actions violated both the technical provisions and the spirit of the SPA and the Shareholders’ Agreement.
Standard of Review
Chancellor Chandler discussed in great detail which standard applied to reviewing each of the three actions taken by the board in January 2008. In the end, he determined that the Rights Plan was subject to the enhanced scrutiny test under Unocal Corporation v. Mesa Petroleum Company, the staggered board amendments were subject to the business judgment standard and the ROFR/Dilutive Issuance was subject to an entire fairness test.
Rights Plan Does Not Meet Enhanced Scrutiny Test
Under the using the intermediate standard of enhanced scrutiny, the Court stated that the directors must “(1) identify the proper corporate objectives served by their actions; and (2) justify their actions as reasonable in relationship to those objectives.” Chancellor Chandler noted that he faced a unique situation with this case in that this standard is typically applied to a publicly–traded company where stockholders are challenging a rights plan implemented as a defensive measure. Here the Court found that Jim and Craig, who were acting as controlling shareholders of a privately held company, were not using the Rights Plan improperly to preclude craigslist shareholders from considering and opting for a value-maximizing transaction or to protect their board seats. Nevertheless, Chancellor Chandler found that the Unocal test still controlled for the following two questions: (i) did Jim and Craig properly and reasonably perceive a threat to craigslist’s corporate policy and effectiveness; and (ii) if they did, is the Rights Plan a proportional response to that threat?
After analyzing the evidence, the Court found that Jim and Craig did not adopt the Rights Plan in response to a reasonably perceived threat or for a proper purpose. Jim and Craig claimed that they were trying to protect the “corporate culture” (citing Paramount Communications v. Time, Inc.), arguing that “they identified a threat to craigslist and its corporate policies that will materialize after they both die and their craigslist shares are distributed to their heirs.” The Court found instead that Jim and Craig resented eBay’s decision to compete with craigslist and adopted the Rights Plan as a punitive defense. In finding that Jim and Craig had failed to satisfy the first prong of Unocal, the Court noted:
There is nothing about craigslist’s corporate culture that Time or Unocal protects. The existence of a distinctive craigslist “culture” was not proven at trial. It is a fiction, invoked almost talismanically for purposes of this trial in order to find deference under Time’s dicta. The defendants also failed to prove at trial that when adopting the Rights Plan, they concluded in good faith that there was a sufficient connection between the craigslist “culture” (however amorphous and intangible it might be) and the promotion of stockholder value. No evidence at trial suggested that Jim or Craig conducted any informed evaluation of alternative business strategies or tactics when adopting the Rights Plan. Jim and Craig simply disliked the possibility that the Grim Reaper someday will catch up with them and that a company like eBay might, in the future, purchase a controlling interest in craigslist. They considered this possible future state unpalatable, not because of how it affects the value of the entity for its stockholders, but rather because of their own personal preferences.
As a result, the Court found that the defendants failed to prove that they acted to protect or defend a legitimate corporate interest, and because they failed to show that the Rights Plan was a reasonable response to a perceived threat to corporate policy or effectiveness, the Court rescinded the Rights Plan.
Court Approves Staggered Board Amendments
With respect to the appropriate standard of review, the Court noted that the staggered board amendments did not function as a defensive measure, because even if craigslist did not have a staggered board, Jim and Craig would control the majority of the board as a result of the Jim-Craig Voting Agreement. Because there is no “omnipresent specter” that the staggered board amendments are being used for entrenchment purposes,” the Court found that Unocal did not apply and the business judgment rule would be the standard.
“Under the business judgment rule, when a party challenges the decisions of a board of directors, the Court begins with the presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.…” eBay tried to rebut the presumption by arguing that: (1) Jim and Craig, as controlling stockholders and directors, were personally interested in the staggered board amendments because implementing a staggered board inured to their benefit but harmed eBay as the minority stockholder, and (2) that Jim and Craig acted in bad faith, with the intent to harm eBay. The Court rejected those arguments stating that it was not persuaded that the entire fairness review applies here on the grounds that eBay, a minority shareholder, was affected differently than the fiduciaries, Jim and Craig, by the implementation of a staggered board. The Court stated:
First, Jim and Craig did not realize a financial benefit by approving the staggered board amendments so there was no self-dealing on the basis of financial considerations. Second, and more importantly, Delaware law does not require that minority stockholders such as eBay have board representation. Delaware corporations do not have to adopt cumulative voting for the benefit of minority stockholders, and Delaware corporations have the express power to implement staggered boards. If a corporation implements a staggered board, and this renders the corporation’s cumulative voting system ineffective, minority stockholders have not been deprived of anything they are entitled to under the common law or the DGCL, because minority stockholders are not entitled to a cumulative voting system in the first instance.
* * *
eBay’s ability to unilaterally elect a director to the craigslist board was solely based on a cumulative voting system combined with a non-staggered board. Before eBay engaged in Competitive Activity, eBay was able to ensure this voting system and board structure remained in place because it had the contractual right under § 4.6(a)(iii) of the Shareholders’ Agreement to consent to any charter amendment that would “adversely affect[] [eBay].” This consent right, however, was not indefeasible…[and] eBay lost its consent rights over charter amendments by engaging in Competitive Activity…The right to amend the craigslist charter, however, without eBay’s consent if eBay chose to compete with craigslist was a benefit Jim and Craig negotiated for and secured in the Shareholders’ Agreement.
In addition, the Court found that the evidence presented at trial failed to show that Jim and Craig approved the staggered board amendment in bad faith, so eBay was unable to rebut the presumption of the business judgment rule. In applying the business judgment rule, the Court found that “[p]reventing a competitor that is also a minority stockholder from unilaterally placing a director on the board so that confidential corporate information will not be freely shared with that competitor, is a legitimate and rational business purpose”. As a result, the Court found that there was no breach of any fiduciary duty with respect to the staggered board amendment.
The ROFR/Dilutive Issuance
In addressing the issue of which standard applied, the Court noted that if a majority of the directors are not disinterested and independent, then the protection afforded by the business judgment rule would not apply. Here the Court found that Jim and Craig stood on both sides of the transaction, and as a result the burden was on Jim and Craig to prove that the transaction was entirely fair. Under the entire fairness test, Jim and Craig had to demonstrate that the transaction was (1) effectuated at a fair price, and (2) the product of fair dealing. In finding that the price was disproportionate rendering the issuance of the ROFR/Dilutive Issuance void, the Court stated:
The “price” of receiving an additional craigslist share under the ROFR/Dilutive Issuance was the granting of a right of first refusal over five shares. This same deal (a 5:1 ratio) was offered to each craigslist stockholder. Jim and Craig argue that the ROFR/Dilutive Issuance was fair to craigslist stockholders because all stockholders were offered the same deal. Superficially, this appears to be true. Deeper reflection, however, reveals that it actually costs eBay more to grant a right of first refusal over five of its craigslist shares than it costs Jim or Craig to do the same. When eBay engaged in Competitive Activity by launching Kijiji, Jim and Craig had to decide whether to issue a Notice of Competitive Activity. If they chose to do so and if eBay failed to cure within ninety days, eBay would lose its contractual consent rights. But there was an upside for eBay if it failed to cure: the rights of first refusal Jim and Craig held over eBay’s craigslist shares under § 7.2 of the Shareholders’ Agreement would terminate, and eBay’s shares would become freely transferable.
* * *
The price Jim and Craig had to pay for a new share under the ROFR/Dilutive Issuance was their granting a right of refusal to craigslist on five already-encumbered shares. The price eBay had to pay for a new share under the ROFR/Dilutive Issuance was its granting a right of first refusal to craigslist on five freely transferable shares. Although each craigslist stockholder had to grant a right of first refusal over the same number of shares to obtain a newly issued share, eBay had to surrender full transferability of its shares to craigslist, but Jim and Craig only had to substitute craigslist for themselves as the party holding a right of first refusal on their shares. Thus, the price of the ROFR/Dilutive Issuance is not fair because it requires eBay, the minority stockholder, to give up more value per share than either Jim or Craig, the majority stockholders and directors.
In the end, the Court found that the ROFR/Dilutive Issuance did not serve a proper corporate purpose in that “Jim and Craig desired a right of first refusal in craigslist’s favor to protect their personal, sentimental interests in controlling the culture of craigslist, including the composition of its stockholders….[and because] Jim and Craig breached their fiduciary duty of loyalty by using their powers as directors and majority shareholders to implement an interested transaction that was not entirely fair to eBay,” the Court rescinded the ROFR/Dilutive Issuance.
Supplement: Professor Gordon Smith has an initial review of the case here. Professor Davidoff provides commentary on this case here. We also refer you to Maxwell Kennerly’s thoughtful review of the case here, and Bloomberg’s take on the case is available here.