Inversions and Phantom Fiduciary Duties | Practical Law

Inversions and Phantom Fiduciary Duties | Practical Law

A discussion of Delaware law on the absence of a fiduciary duty to minimize corporate taxes.

Inversions and Phantom Fiduciary Duties

Practical Law Legal Update 7-576-5485 (Approx. 6 pages)

Inversions and Phantom Fiduciary Duties

by Practical Law Corporate & Securities
Published on 31 Jul 2014 • Delaware
A discussion of Delaware law on the absence of a fiduciary duty to minimize corporate taxes.
One of the top trends in public M&A in 2014, particularly among large-cap companies and particularly in the healthcare sector, is the ongoing wave of inversion deals. In an inversion, a US corporate group re-domiciles its top holding company in a new jurisdiction, typically for the purpose of accessing a lower tax rate in a European jurisdiction and avoiding US taxes on the repatriation of foreign-held cash. Although self-inversions are permissible under certain circumstances, in most cases the inversion is performed as a consequence of a merger, known as a deal-related inversion. For more on the rationale and structuring of inversions, see Article, Inversions to Ireland.
According to data provided by Thomson Reuters, cross-border M&A volume accounted for 39% of total global activity in the first half of 2014, more than double the level in the first half of 2013. Much of this activity was spurred by inversion deals, many of which were valued at several billion dollars. Some examples of inversions summarized in the What's Market public merger agreements database include:
In the past month, the inversions trend has only gained steam. Announced inversion deals have included:
  • Medtronic Inc.'s acquisition of Covidien plc in a $42.9 billion cash-and-stock deal. The combined company would be incorporated in Ireland.
  • Salix Pharmaceuticals Ltd.'s merger with Cosmo Technologies, the Irish unit of Cosmo Pharmaceuticals SpA of Italy, in a deal valued at $2.7 billion in stock.
  • Mylan Inc.'s purchase of Abbott Laboratories' generic drug business for $5.3 billion in stock, to be followed by reincorporation in the Netherlands. Like the Nabors/C&J deal, the acquisition is being preceded by a spin-off of the target business that will allow for the inversion.
  • AbbVie Inc.'s $53.6 billion takeover of Shire plc, to be followed by reincorporation in Ireland. AbbVie is itself a product of a spin-off from Abbott Laboratories.
In an attempt to stem this tide, the President and several members of Congress have made proposals for legislation to either (retroactively) change the 80%-shareholder continuity test, which would result in the foreign acquiring corporation being treated as domestic for US federal tax purposes, or withhold government contracts from companies that invert.
In response, various observers have defended the inversions trend on several grounds, including by claiming that boards of directors are obligated by their fiduciary duties to examine the possibility of pursuing and, if feasible, then in fact doing an inversion. This claim has been made by a CEO considering an inversion deal, by legal commentators and by media commentators alike. The contention apparently goes beyond the well-worn argument that directors have a duty to maximize profits or shareholder wealth (itself a highly dubious claim) and asserts that directors have a specific duty to minimize corporate taxes.
As discussed below, the Delaware judiciary has rejected this claim.

No Fiduciary Duty to Minimize Corporate Taxes

The potential existence of a fiduciary duty of directors of a Delaware corporation to minimize corporate taxes was first addressed explicitly in Freedman v. Adams, No. 4199–VCN, (Del. Ch. Mar. 30, 2012). In that case, the stockholder-plaintiff brought a derivative claim against XTO Energy Inc. and its board of directors, alleging that the board's decision to pay $130 million of cash bonuses to certain officers without adopting a plan that could have made those payments tax deductible under Section 162(m) of the Internal Revenue Code caused a loss of $40 million in wasted tax savings. In the complaint, the plaintiff argued that the board's failure to approve a Section 162(m) plan was "irrational" under the formulation in Disney for a finding of corporate waste and therefore enough to deprive the board of the presumptions of the business judgment rule (see In re the Walt Disney Co. Deriv. Litig., 906 A.2d 27, 74 (Del. 2006)).
The board had responded that it was aware of the possibility of qualifying for performance-based exemptions under IRC Section 162(m), but that its compensation committee still determined that it should not be constrained by attempts to qualify for as many deductions as possible under that statute. The parties eventually agreed to, and the Delaware Court of Chancery granted, a stipulated order of dismissal, but the plaintiff brought a motion for an award of attorneys' fees and expenses.
The Delaware Court of Chancery denied the motion. In addressing and rejecting the argument of waste, Vice Chancellor Noble concluded explicitly that "there is no general fiduciary duty to minimize taxes" (Freedman, , at *12). The Court went on to explain its rationale, first noting that there was no case law of the Court of Chancery or the Delaware Supreme Court to support the purported fiduciary duty to minimize taxes. On policy grounds, the Court explained that:
"For reasons that are both numerous and obvious, this Court is not convinced that it should endorse this proposed new duty. Tax strategy is a complex, dynamic area of corporate decision-making that affects and is affected by many other aspects of a company. A company's tax policy may be implicated in nearly every decision it makes, including decisions about its capital structure, the legal forms of the various entities that comprise the company, which jurisdictions to form these entities in, when to purchase capital goods, whether to rent or purchase real property, where to locate its operations, and so on. Minimizing taxes can also require large expenditures for legal and accounting services and may entail some level of legal risk. As such, decisions regarding a company's tax policy are not well-suited to after-the-fact review by courts and typify an area of corporate decision-making best left to management's business judgment, so long as it is exercised in an appropriate fashion. This Court rejects the notion that there is a broadly applicable fiduciary duty to minimize taxes, and, therefore, the Plaintiff's argument that the Board failed to act despite a duty to minimize taxes is unavailing." (Id.)
The rationale in Freedman was soon repeated in Seinfeld v. Slager, No. 6462–VCG, (Del. Ch. June 29, 2012). In Seinfeld, the Court similarly addressed an argument that board approval of a supplemental retirement bonus constituted waste for the reason that it was not structured to take advantage of IRC Section 162(m). Vice Chancellor Glasscock cited to the conclusion in Freedman that there is no general fiduciary duty to minimize taxes and added that a decision to pursue or forgo tax savings is generally a business decision for the board of directors. Accordingly, the Court explained, "Delaware law is clear that there is no separate duty to minimize taxes, and a failure to do so is not automatically a waste of corporate assets" (Seinfeld, at *3).
In the beginning of 2013, the Delaware Supreme Court affirmed the decision of the Court of Chancery in Freedman (58 A.3d 414 (Del. 2013)). In its opinion, the Supreme Court agreed that "the decision to sacrifice some tax savings in order to retain flexibility in compensation decisions is a classic exercise of business judgment" (58 A.3d at 417). Therefore, even if the decision to not adopt a Section 162(m) plan may have been a poor one, it was not unconscionable or irrational and the board was still entitled to the presumptions of the business judgment rule.
The Supreme Court's ruling in Freedman is brief and limited on its face to the board's decision to forego adoption of a Section 162(m) plan. It does not specifically cite to the phrase "there is no general fiduciary duty to minimize taxes." But while the Supreme Court did not explicitly endorse the broader finding, its ruling that a board's sacrifice of some tax savings is a "classic exercise of business judgment" essentially produces the same result.
The broader conclusion of the Court of Chancery has also been cited at the federal court level. In Warhanek v. Bidzos, a magistrate judge recommended to the full District Court that it grant a motion to dismiss a derivative action brought against VeriSign, Inc. and its board ( (D. Del. Sept. 18, 2013)). The plaintiff in that action had alleged that the company made false and misleading representations in its proxy statement about the potential tax treatment of compensation awarded under its equity plan. The plaintiff also alleged that certain payments made under the company's incentive compensation plan constituted waste. To that argument, the judge cited to both Freedman and Seinfeld for the principles that the payment of higher taxes does not itself sustain a waste claim and that there is no fiduciary duty to minimize taxes (Warhanek, , at *9).
Whatever the merits of inversion transactions or the legislation being proposed to end them, the argument that fiduciary duties dictate that boards of Delaware corporations must consider pursuing these complex transactions has no place in the debate.