In one of his annual posts disparaging Delaware corporate law decisions of the past year, Jay Brown attacks en passant one of my favorite Delaware cases; namely, Sinclair Oil v. Levien. As I explain in my book Corporation Law and Economics
Sinclair Oil owned 97 percent of the stock of a subsidiary, the Sinclair Venezuelan Oil Company (Sinven), with the remaining 3 percent being held by minority shareholders. A minority shareholder challenged three transactions between Sinclair Oil and Sinven: (1) Payment of large cash dividends by Sinven; (2) Sinclair Oil’s use of other (wholly-owned) subsidiaries to develop oil fields located outside of Venezuela; and (3) Sinclair Oil’s actions with respect to a contract between Sinven and another Sinclair Oil subsidiary.
What standard of review should a court apply to such disputes? The Delaware supreme court identified two standards potentially applicable in such situations: the business judgment rule and the intrinsic fairness rule. Under the business judgment rule, the directors of Sinven get the benefit of a rebuttable presumption of good faith. Under the intrinsic fairness test, the burden of proof is on the directors to show, subject to close scrutiny, that the transactions were objectively fair to Sinven. In this case, as in most, it mattered quite a lot which standard applied. As is often the case, the party bearing the burden of proof on a given dispute lost.
Under Sinclair Oil, a court will apply the intrinsic fairness standard, as opposed to the business judgment rule, when the parent has received a benefit “to the exclusion and at the expense of the subsidiary.” In other words, the fiduciary obligations owed by a parent corporation are limited to self-dealing. The more exacting intrinsic fairness standard comes into play only when the parent is on both sides of the transaction and, moreover, used its position to extract nonpro rata benefits from a transaction to the minority shareholders’ detriment.
The Sinclair Oil opinion began with a summary of the court’s prior decision in Getty Oil Co. v. Skelly Oil Co. In that case, a regulatory agency overseeing oil imports concluded that Skelly was controlled by Getty. As a result, the agency further determined that Skelly was no longer entitled to a separate allocation of imported crude oil. Skelly sued Getty, contending that it was entitled to a share of Getty’s allocation. The court upheld Getty’s refusal to share its allocation with Skelly, applying the business judgment rule. Intrinsic fairness was inapplicable, because Getty had not received a benefit at the expense of Skelly. Getty gained nothing to which it was not already entitled. Accordingly, no self-dealing, no intrinsic fairness review, and no liability.
The Sinclair Oil opinion then turned to whether Sinven’s dividend payment policy violated Sinclair’s fiduciary duties. Sinven had paid out large amounts of dividends during the applicable period—dividends that in fact exceeded its earnings. Plaintiff contended that the dividends resulted from an improper motive; namely, Sinclair’s need for cash. The court applied the business judgment rule to this dispute. Because the minority shareholders had received a pro rata share of the dividends, Sinclair did not receive a nonpro rata benefit at their expense. The dividends were within the limits proscribed by the relevant legal capital statute and were not so large as to amount to a waste of corporate assets. Accordingly, plaintiff was unable to rebut the business judgment rule’s presumption of good faith. In dicta, the court suggested that the intrinsic fairness test would be applied to dividend decisions in which there are two classes of stock and dividends are paid on the class owned by the parent but not on the class owned by the minority. This example implicates the conflict of classes discussed in the next section.
The court next took up plaintiff’s claim that Sinclair Oil had prevented Sinven from expanding. The Chancellor had applied the intrinsic fairness standard to this issue, concluding that Sinclair had improperly and unfairly denied Sinven opportunities to expand its operations outside of Venezuela. On appeal, the Delaware supreme court reversed, identifying the business judgment rule as the proper standard of review. Plaintiff could point to no opportunities that Sinclair had usurped from Sinven. Absent the taking of a corporate opportunity properly belonging to Sinven, the decision of which subsidiary would be allowed to act outside of Venezuela was a business judgment for Sinclair Oil to make. Again, the key consideration was that Sinclair Oil did not take anything away from Sinven that belonged to Sinven.
Finally, the court turned to a contract between another Sinclair Oil subsidiary and Sinven. Sinclair Oil had used its power to cause Sinven to enter into a contract to exclusively sell oil to a wholly-owned Sinclair Oil subsidiary. When that subsidiary breached the contract, Sinclair Oil prevented Sinven from suing to enforce its contract rights. According to the court, this issue properly was reviewed under the intrinsic fairness standard. Forcing Sinven to contract with a Sinclair Oil entity was itself self-dealing. Because the contract was breached and not enforced, moreover, Sinclair Oil had gotten a nonpro rata benefit from the contract at the expense of the minority. Accordingly, Sinclair Oil had to show that its failure to enforce the contract was intrinsically fair to Sinven, which it could not do.
With that background in mind, let's turn to Jay's complaint:
An example [of how Delaware courts supposedly "limit the application of the duty of loyalty through arbitrary standards"] occurred in Sinclair Oil Corp. v. Levien, 280 A.2d 717, 721-22 (Del. 1972). The Court concluded that a dividend approved by the board of a subsidiary entirely dominated by the parent did not implicate the duty of loyalty since the parent did not receive a disproportionate benefit. Why? Because a dividend is paid proportionately to all shareholders. As the Court noted: "[A] proportionate share of this money was received by the minority shareholders of [the Subsidiary]. [The parent] received nothing from [the Subsidiary] to the exclusion of its minority stockholders. As such, these dividends were not self-dealing."
In other words, a controlling shareholder can bleed off the cash and assets held by a subsidiary, do great damage to the subsidiary's business, and have as a primary motivation its own need for cash, without implicating the duty of loyalty. The analysis ignored the Parent's control of the board, the impact on the Subsidiary, or the fact that most of the cash went to the controlling shareholder. The Supreme Court, in reaching the legal conclusion, cited no authority for the proposition.
In contrast, I think the court got it exactly right. As even the pro-minority shareholder courts of Massachusetts concede: "The majority,concededly, have certain rights to what has been termed ‘selfish ownership’ in the corporation which should be balanced against the concept of their fiduciary obligation to the minority." Wilkes v. Springside Nursing Home, Inc. In striking that balance, as I explain in my article, There is No Affirmative Action for Minorities, Shareholder and Otherwise, in Corporate Law, "corporate law ensures that the majority may not benefit itself at the expense and to the exclusion of the minority, [but] corporate law does not require the majority affirmatively to benefit the minority at its own expense. There simply is no corporate law version of affirmative action." Put another way, Corporate law exhibits both solicitude for minority shareholders and tolerance of majority shareholder hegemony.
Why this balance? As I explain in Corporation Law and Economics
According to Wilkes, there must be a balance between the fiduciary duty of the majority and its right to selfish ownership, which gives the controlling group “some room to maneuver” in setting policy. In most cases, the majority will have made a larger investment, by which it effectively purchased the right to control. Hence, the majority should have a greater voice in setting corporate policy. In addition, the minority shareholders presumably knew a controlling block existed when they bought into the firm. The minority shareholders therefore assumed the risk that some decisions would be adverse to their interests.
As far as the standard set out in Sinclair Oil, one must begin where i think the Delaware supreme court did; namely, by recognizing that characterizing the claim as a question of care or of loyalty has vital—indeed, potentially outcome determinative—consequences. If the court treated all cases involving a controlling shareholder as posing a loyalty question, with its accompanying intrinsic fairness standard, the majority's rights of selfish ownership would be sharply constrained because their actions would rarely pass muster. The defendant would be required, subject to close and exacting judicial scrutiny, to establish that the transaction was objectively fair to the corporation. Because this burden is a difficult one to bear, a duty of loyalty analysis makes sense only if we think all controlling shareholder transactions are suspect.
On the other hand, if the court treated all controlling shareholder transactions as posing a care question, virtually all such transactions would survive judicial review. Before the target’s directors could be called to account for their actions, plaintiff would have to rebut the business judgment rule’s presumptions by showing that the decision was tainted by fraud, illegality, self-dealing, or some other exception to the rule. Absent the proverbial smoking gun, plaintiff is unlikely to prevail under this standard.
The court therefore adopted a preliminary filter to separate out suspect cases from permissible exercises of the majority's right of selfish ownership. Majority shareholders thus may behave selfishly, so long as they do not do so at the expense of and to the exclusion of the minority. This rule makes sense to me. Selfish conduct by the majority is is consistent with the reasonable expectations of minority shareholders and promotes efficient changes in control. If controlling shareholders could engage in transactions that not only exclude the minority from participation but also affirmatively injure the minority, however, the latter doubtless would take precautions to prevent such transactions. By providing a coercive backstop preventing such transactions, the Sinclair Oil rule minimizes bargaining and enforcement costs.
An alternative policy rationale for the Sinclair Oil decision is suggested by Frank Easterbrook and Daniel Fischel's classic 1982 Yale L.J. article, Corporate Control Transactions, in which they argue that:
Other value-increasing transactions would also be deterred by a sharing requirement. First, as we have noted above, sometimes a purchase of control is profitable to the purchaser only if he can prevent minority shareholders from sharing in the gains. Freezeouts of minority shareholders after a transfer of control perform precisely this function. Second, if the controlling shareholder in a going-private transaction or merger of a subsidiary into a parent corporation must underwrite the costs of future value-increasing transactions and thereby incur a proportionally greater risk of loss than the minority shareholders in the event expectations are not realized, the deal may become unprofitable to the controlling shareholder if he must share the gains with minority shareholders if all goes well. Thus, a sharing principle in these transactions leads to a reduction in total wealth as people desist from entering into otherwise profitable transactions.
There are other ways in which the gains from corporate control transactions may depend on unequal distribution. Because investors in the firm must cooperate to transfer control, sharing creates incentives to “free ride.” In a tender offer, for example, shareholders must tender rather than hold their shares if the bid is to succeed; in a merger (other than a shortform merger), they must vote favorably rather than abstain. If gains must be shared equally, however, each shareholder may find it worthwhile not to cooperate in the transaction. To illustrate, suppose that all of the gains from a tender offer must be shared equally among the investors in the target corporation and that, if there is a follow-up merger, non-tendering shareholders cannot be eliminated for less than the tender offer price. When a prospective acquiror makes a bid, the investors recognize that the acquiror can profit only to the extent it causes the value of shares to rise. If the bidder is offering $50 per share, the reasoning runs, it cannot profit unless value eventually rises above $50. Under the legal rules assumed above, it may be rational for every shareholder to spurn the $50 offer and hope that enough other shareholders tender to make the offer succeed: If there is a follow-up merger, the “fair” price cannot be less than $50 for the untendered shares. If there is no follow-up merger, the shareholder expects the price to exceed $50. Each shareholder, in other words, may attempt to take a free ride on the efforts of the bidder and other shareholders. To the extent free riding prevails, it reduces the chance that the beneficial transaction will go forward. </P
A final reason why the gains from beneficial transactions may depend on unequal division is that sharing rules may lead to costly attempts to appropriate greater parts of the gains. The appropriation problem arises because most gain-sharing rules do not produce completely predictable results—it is difficult to determine the “fair” price. If all investors are entitled to a “fair” share of the bounty, each will find it advantageous to claim as much as possible and fight for his claim. He would spend as much as a dollar, on the margin, to claim another dollar of the benefits. It is possible for a substantial part of the gain to be frittered away, therefore, as claimants attempt to make the argument that they are entitled to more. Fear for this eventuality may cause otherwise beneficial control transactions to fall through; in any event resources will be wasted in litigation or other skirmishings.
They conclude that:
Investors' welfare is maximized by a legal rule that permits unequal division of gains from corporate control changes, subject to the constraint that no investor be made worse off by the transaction. In essence, this is a straightforward application of the Pareto principle of welfare economics.
It also strikes me as "a straightforward" explanation of why the Delaware court got Sinclair Oil exactly right. The court created precisely such a rule.
