The Delaware Court of Chancery recently decided In re eBay, Inc. S’holders Litig., No. 19988-NC, 2004 Del. Ch. LEXIS 4 (Del. Ch. Jan. 23, 2004) on the alleged practice of "spinning" IPO shares. The case is notable both because of its strong language regarding the practice and because it lowers the barriers for plaintiffs to show that plaintiffs are not required to make a "demand" on the Board of Directors before filing suit.

Factual Background

A major investment bank was retained by eBay as the lead underwriter for eBay’s initial public offering in 1998. The bank then served as the lead underwriter for a second offering a year later (by which time, eBay stock had risen from $18 to $175 per share). In 2001, it also served as eBay’s principal financial advisor in connection with eBay’s acquisition of PayPal, Inc. eBay paid the bank over $8 million for these services.

The complaint, a derivative action on behalf of eBay, alleged that the bank rewarded certain directors and executives at eBay for steering this (and perhaps future) business to the bank by allocating to them thousands of shares in the IPOs of other companies taken public by the bank. Because of the heated securities market at the time, investors who got shares at the initial offering price were supposedly able to "flip" the shares at a substantial profit, sometimes only hours after the offering. The individual defendants, eBay officers and directors, allegedly resold the shares for millions of dollars in profit. The complaint alleged that the bank used allocations of IPO shares to eBay insiders to show its appreciation for past business and to enhance its chances of getting future business.

The Decision

Chancellor Chandler first asked whether plaintiffs were excused from making a pre-suit demand on the Board. Chancellor Chandler concluded that a pre-suit demand would have been futile because a majority of the Board was unable to evaluate the suit impartially.

eBay had seven directors, three of whom were named defendants. While the Court recognized that the other four were not involved in the "spinning," it found that non-defendant directors were not able to evaluate the suit impartially because the defendants owned sufficient stock to control the election of directors and thus might force the non-defendant directors off the Board, causing them to lose valuable unvested options for substantial amounts of eBay stock. Hence, the Court concluded it would be futile to make a demand on the non-defendant directors to authorize suit against the other three. Here, the Court placed great reliance on its conclusion that the individual defendants owned sufficient stock (about 50% at one point, but less when the lawsuit was filed) to control the company and the election of directors. The Chancellor concluded that under those circumstances, a non-defendant director would not be able to "objectively and impartially consider a demand to bring litigation against those to whom he is beholden for his current position and future position on eBay’s board."

The Chancellor then turned to the question of whether "spinning" violates the law. He concluded that the defendants had usurped eBay’s corporate opportunity to receive the allocated IPO shares, stressing that investing in marketable securities was a "line of business" for eBay because its financial statements showed millions of dollars invested in equity and debt securities. He brushed aside the argument that these IPO allocations were risky or even losing investments unsuitable for eBay because eBay was never given the chance to turn them down.

The Court also rejected the argument that allowing the suit to proceed would open the floodgates and make every adventurous investment that is offered to an officer or director a corporate opportunity because he concluded these shares were "unique below-market" shares offered as "financial inducements to maintain and secure corporate business." That seems to make the test turn on the bank’s intent. What if the directors were told the shares were offered to them to get their personal not corporate business? Should the investment be judged on what a reasonable person would conclude, regardless of the parties’ actual intent?

Lastly, the Court held that "spinning" shares put the insiders’ interest in conflict with that of the corporation, even if they were not corporate opportunities because "an agent is under a duty to account for profits obtained personally in connection with transactions related to his or her company" and there was a reasonable inference that the directors accepted a gratuity that rightfully belonged to eBay.

The Chancellor also rejected the bank’s argument that plaintiffs had failed to adequately allege that the bank aided and abetted the alleged breach of the directors’ fiduciary duty. He concluded the bank could have "knowingly participated" because it knew that the insiders owed a duty to eBay, knew that eBay was in the business of investing in securities and should have known of SEC interpretations which the Chancellor concluded would prohibit allocating "hot issue" securities to insiders who could steer business to the bank at a later time.

What May Follow

The eBay decision has, not surprisingly, attracted the interest of plaintiffs’ lawyers. At least one new "spinning" case has already been filed in Delaware and others may follow. Whether there will be a large number of such cases may turn on the assessment of plaintiffs’ lawyers as to what profits the insiders made or what fees the investment banks received. It remains to be seen whether such cases can be defended on the grounds that insiders were told, or the investment banks believed, the allocations were in response to their personal wealth rather then their corporate positions.

Equally troubling is the Chancellor’s conclusion that a director loses his independence simply because he or she might lose money if removed from office by individual defendants. A similar argument has been made in connection with the boards of mutual funds who were supposedly chosen at the pleasure of the investment advisor. See Strougo v Scudder, Stevens & Clark, Inc., 964 F.Supp. 783, 795 (S.D.N.Y. 1997). Many directors, particularly of technology companies, have options in companies where they have invested time, money or both, but would be surprised indeed to learn they are not independent of management. In eBay, the Court placed great emphasis on the individual defendants’ ownership of the majority of the shares and their supposed ability to elect directors. Plaintiffs can be expected to try to expand this concept to the limits of "control" in arguing that demands on virtually any Board would be futile.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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