There is an exciting new paper from Lawrence Hamermesh, Jack B. Jacobs, and Leo E. Strine (hereinafter HJS), Optimizing The World’s Leading Corporate Law: A 20-Year Retrospective and Look Ahead. Here we have two prominent and respected ex-members of the Delaware Chancery and Supreme Courts plus a highly respected academic expert on Delaware corporate law evaluating the state of Delaware corporate law.
Here's the abstract:
In a 2001 article (Function Over Form: A Reassessment of Standards of Review in Delaware Corporation Law) two of us, with important input from the other, argued that in addressing issues like hostile takeovers, assertive institutional investors, leveraged buyouts, and contested ballot questions, the Delaware courts had done exemplary work but on occasion crafted standards of review that unduly encouraged litigation and did not appropriately credit intra-corporate procedures designed to ensure fairness. Function Over Form suggested ways to make those standards more predictable, encourage procedures that better protected stockholders, and discourage meritless litigation, by restoring business judgment rule protection for transactions approved by independent directors, the disinterested stockholders, or both.
This article examines how Delaware law responded to the prior article’s recommendations, concluding that the Delaware judiciary has addressed most of them constructively, thereby creating incentives to use procedures that promote the fair treatment of stockholders and discourage meritless litigation. The continued excellence and diligence of the Delaware judiciary is one of Delaware corporate law’s core strengths.
But some recent cases have articulated standards of review that involve greater than optimal litigation intensity and less than ideal respect for decision-making in which independent directors and disinterested stockholders have potent say. Those standards also impair the integrity of Delaware’s approach to demand excusal in derivative cases and the identification of controlling stockholders. We also propose eliminating concepts like substantive coercion that do not provide a legitimate basis for resolving cases. Finally, we urge action to correct new problems such as the unfair targeting of corporate officers for negligence claims in representative actions and the frustrating state of practice under Delaware’s books and records statute.
There is so much in this article to discuss that I expect to get a number of blog posts out of it. Today, I'm starting with their discussion of controlling shareholders because there is also an important new article out from my Twitter friend Ann Lipton, The Three Faces of Control. Herewith her abstract:
Controlling shareholders are subject to distinct legal obligations under Delaware law, and thus Delaware courts are routinely called upon to distinguish “controlling shareholders” from other corporate actors. That is an easy enough task when a person or entity has more than 50% of the corporate vote, but when a putative controller has less than 50% of the vote – and is nonetheless alleged to exercise control over corporate operations via other means – the law is shot through with inconsistency.
What is needed is a contextual approach that recognizes that the meaning of control may vary depending on the purpose of the inquiry. Under Delaware doctrine, the controlling shareholder label subjects that entity to unique legal treatment along three distinct dimensions. First, controlling shareholders – unlike minority shareholders – have fiduciary duties to the corporation. Second, interested transactions with controlling shareholders – unlike interested transactions with other fiduciaries – are subject to a unique cleansing regime in order to win business judgment deference from reviewing courts. Third, when certain transactions involving sales of control are challenged in court, they may be treated as direct rather than derivative actions, even when similar transactions that do not involve control sales would be treated as purely derivative.
By teasing out these three aspects of the legal framework and analyzing them separately, courts can more closely attend to the reasons why control carries special significance, and ultimately develop a more rational and consistent set of definitions. Most critically, courts may properly designate someone a controlling shareholder for some purposes, but not others.
Herewith HJS' summary of their argument with the controlling person standard:
[They object to the way courts have enlarged] the definition of “controlling stockholders” to include persons having little or no share voting power, and to lump together unaffiliated stockholders into a “control bloc,” so that a different standard of review applies, thereby expanding the range of full discovery and judicial review for fairness. To address this concern, we propose limiting the concept of “controlling stockholder” to the situation where a stockholder’s voting power gives it at least negative power over the company’s future, in the sense of acting as a practical impediment to any change of control.
HJS note that "Under Delaware law, it was historically difficult to establish that a stockholder having less than majority ownership was a controlling stockholder." (35) Yet, as Lipton points out, the definition has evolved to include "so many factors and considerations that it allows for a great variety of actors to be designated as controllers." (3) HJS would agree, attributing that development to "the revival of Lynch’s inherent coercion theory has created pressure to expand the definition of controlling stockholder to reach persons having far less than a voting majority, but are either critically important to the company or associated with other stockholders as a group." (36)
There are some key differences in their analyses. Lipton is much more open to the idea that contract rights can make one a corporate controller, at least for purposes of deciding whether they owe fiduciary duties to the entity and the fellow shareholders:
... if control over another’s assets is the hallmark of a fiduciary – and if it is the controlling shareholder’s dominion over corporate assets that gives rise to fiduciary duties on its part – then it follows that no particular level of stock ownership should be necessary before one can be deemed a controller. Indeed, there is no reason that stock ownership, specifically, should be required at all. This is particularly so because in a world where control rights are often allocated not through equity interests directly, but through shareholder agreements, the distinction between control emanating from stock holdings and control emanating from contractual rights is difficult to parse. (7)
In contrast, HJS argue that:
Another troublesome issue arises where a court accepts the claim (at least for purposes of a motion to dismiss) that a person is a controller, with concomitant fiduciary obligations, despite owning no shares of stock at all. ... Our concern, however, is that the amorphous concept of “soft power” not arising out of stock ownership could be applied to trigger the entire fairness standard and preclude dismissal, where the premise of control involves circumstances that reflect garden variety commercial dealings, such as “the exercise of contractual rights to channel the corporation into a particular outcome by blocking or restricting other paths, ... the existence of commercial relationships that provide the defendant with leverage over the corporation, such as status as a key customer or supplier, [or] [l]ending relationships, [which] can be particularly potent sources of influence.”The courts should heed doctrinal guardrails against overuse of this “soft power” concept: “authority [that] takes the form of a contractual right ... must give the nonstockholder power akin to ‘operating the decision-making machinery of the corporation’ (a ‘classic fiduciary’), rather than ‘an individual who owns a contractual right, and who exploits that right,’ forcing a corporation to 'react' (which does not support a fiduciary status).” (39-40)
It will often be the case that creditors, for example, have contractual rights that, if exercised, sharply limit corporate decision-making freedom but I don't think that should result in them being treated as a controller for any purpose. I'm thinking here of classic Business Association cases like A. Gay Jenson Farms Co. v. Cargill, Inc., 309 N.W.2d 285 (Minn. 1981), or Martin v. Peyton, 158 N.E. 77 (N.Y. 1927). Both involved situations in which contract creditors had certain contractual rights that allegedly resulted in the defendants having sufficient control rights to be deemed a principal of an agent in the former case and a partner in the latter. I think Coppola v. Bear Stearns & Co., Inc., 499 F.3d 144, 150 (2d Cir. 2007),got it right when the court explained that "the dispositive question is whether a creditor is exercising control over the debtor beyond that necessary to recoup some or all of what is owed, and is operating the debtor as the de facto owner of an ongoing business."
There seems to be a consensus, however, that where there is no majority shareholder courts should focus on whether the alleged controller's "degree of entrenchment and ... ability to retaliate against disobedient shareholders" (Lipton at 16) and "the potential to use affirmative voting power to unseat directors and implement transactions that the minority stockholders do not like, and use blocking voting power to impede other transactions." (HJS at 37)
I would love to see HJS and Lipton sit down to hash all this out.
In any case, both of these articles are well worth reading.
