A few days ago I mentioned 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. They offer seven proposed reforms of Delaware case law, two of which apply to controlling shareholders:
Extending the inherent coercion theory expressed in Kahn v. Lynch beyond freezeout mergers to all controller transactions, thereby (i) making the procedural requirements specified in MFW applicable to decisions for which they were not designed and do not rationally pertain, and (ii) inappropriately expanding the range of full discovery and judicial review for fairness. We advocate abandoning Lynch‘s inherent coercion rationale and limiting the reach of MFW to transactions in which a controlling stockholder seeks to acquire the minority's shares, or a statute requires the approval of both the board and the stockholders.
What's interesting about their proposal is that they don't quite have the courage of their convictions. They point out, for example, "that (i) independent directors and stockholders can exercise real leverage and make informed choices when faced with a conflict transaction involving a controller, and (ii) Delaware law is vibrant enough to protect minority stockholders from retribution by a controller that did not get its way."
Later in the article they expand on those points:
[When Jacobs and Strine's earlier article] was published, independent directors had already shown themselves capable of standing up to corporate managers, and CEO tenure had been declining as a result. Independent directors increasingly owed their continued access to directorships not to ties to management, but to their willingness to support policies that powerful institutional investors liked. These same institutional investors had shown themselves willing to criticize companies — including those with controlling stockholders — and to dissent at the ballot box. Moreover, Delaware courts had proven vigilant in policing electoral manipulation and coercion of stockholders in the voting process, and would readily address any controller who reacted to a negative vote with retribution. Likewise, even controllers had to be sensitive to the prospect that replacing independent directors who said no to a conflict transaction with ones who would do their bidding would impair their ability to raise debt and other capital. ...
Market activity since then has only strengthened that argument. Institutional investors have a powerful voice, no fear of controlling stockholders or corporate management. Stockholders challenge them &equently, and they have hedge funds and the media to help them. Independent directors are under great scrutiny too, and are expected to act aggressively in M&A situations to make sure that the public investors get a good deal. Proxy advisors and analysts scrutinize deals and help institutional investors decide how to vote.
The logic of their argument is that judicial review of a controlling shareholder transaction should not automatically be subject to entire fairness review. Yet, as we have seen, HJS would retain fairness review in cases in which "a controlling stockholder seeks to acquire the minority's shares, or a statute requires the approval of both the board and the stockholders." Why not go all the way?
Which brings us to the question of when entire fairness should be the standard. As HJS explain, there has been a trend towards expanding the scope of entire fairness to include cases beyond freeze-outs and other events in which the statute requires the approval of both the board and the stockholders. They criticize that trend:
[Delaware law is I]nsufficiently distinguishing between transactions involving classic self-dealing and transactions in which a fiduciary (whether a director or controlling stockholder) receives an additional benefit only because of being differently situated, thereby extending entire fairness review to a context where it does not fit. We advocate restoring that distinction, at the injunctive stage, by applying Unocal and Revlon intermediate judicial review to transactions where a fiduciary merely receives (but does not force) a benefit, such as a post-merger compensation package, not received by other stockholders. In a post-closing damages case, the review standard should require the plaintiff to prove a breach of the duty of loyalty and resulting damages.
Hence, they "acknowledge the many cases stating that any conflicted self-dealing transaction with a controlling stockholder is subject initially to the entire fairness standard." In light of the reality of independent director and institutional investor developments they discussed in the excerpts above, however, they deplore that trend.
Extending Lynch's inherent coercion doctrine after MFW had effectively rejected it, thereby dooming to failure any motion to dismiss unless the controller employs the costly MFW procedures, will not generate systemic value for diversified stockholders. Instead, it is more likely to result in excessive transaction costs, increased D&O insurance costs, and contrived settlements designed only to avoid the costs of discovery and justify the attorneys' fee that motivates most corporate representative suits.
They are particularly critical of cases in which Delaware courts have been "expanding the use of non-ratable benefits as a basis for expanding the scope of the definition of self-dealing transactions."
If the goal is to limit the situations in which a transaction involving a controlling shareholder is subject to entire fairness review, which seems the right goal for the reasons they so eloquently explain, it is curious to me that they ignore a tool lying close at hand; namely, the Delaware Supreme Court's decision in Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971), which they cite but once and in a string cite for the proposition that "the fact that a controlled company makes a decision benefiting its parent should not invoke the entire fairness standard absent harm to the corporation or the minority stockholders."
In my view, Sinclair Oil should be foundational case for analysis of controlling shareholder cases. I discuss it at length in my book Corporate Law (Concepts and Insights):
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 non-pro rata benefits from a transaction to the minority shareholders’ detriment. (Page 210)
So here's how I think controlling shareholder transactions should be reviewed: Does the corporation have a controlling shareholder? If yes, does the transaction, contract, or other event result in the controller getting a benefit “to the exclusion and at the expense of the" minority? This question is essential because it ensures that courts will only get involved where there is a real conflict in the sense of a detriment to the minority, not just a benefit to the controller.
If there is no benefit to the controller at the expense of and to the exclusion of the minority, the business judgment rule should apply. This should be a full stop with no further judicial review, as I agree with HJS that the "vestigial waste" standard should be retired.
If there is such a benefit, however, then entire fairness should be the standard of review with the burden of proof on the defendant. If the transaction was approved either by a majority of the disinterested directors or a majority of the shareholders, then the burden of proof should be on the plaintiff to show that the transaction was not fair to the corporation. If the transaction complies with the full set of MFW conditions, then again the business judgment rule should be invoked to preclude any further judicial review.
Notice that my proposal goes one step beyond HJS in that I would apply the above formula to all transactions involving a controlling shareholder, including going private transactions and ones in which the board and shareholders must vote. Notice also that I would allow the interested shareholder to vote (but that's a story for another post).
My proposal has two hard stops: If there was no non-ratable benefit gained by the controller, the BJR applies and--unlike current law--judicial review is precluded. The vestigial waste theory dies. There is precedent for this. Under the MBCA, where conflict of interest transactions are properly approved by the board or shareholders, there is no further judicial review. Likewise, if there was a non-ratable benefit, the controller can still get a hard stop--i.e., application of an irrefutable BJR--if it complies with both MFW conditions. In addition, I could be persuaded that complying with either disinterested director or shareholder approval should invoke the BJR.
Having hard stops available is critical; because the problem with a burden shift approach Ii.e., Lynch and MFW insofar as the latter retains the vestigial waste review), is that it does not reduce rent-seeking in a game where the plaintiffs are not real parties in interest, and the game is about attorneys’ fees. If there is no dismissal option, there will be excessive litigation costs.
In any case, I go on in Corporate Law (Concepts and Insights) to explain that you can understand many controlling shareholder doctrines through the Sinclair Oil lens. I argue for example, that sale of control cases like Perlman v. Feldmann can be understood as an application of Sinclair Oil:
Perlman does not stand for the proposition that a controlling shareholder must give all other shareholders an equal opportunity to sell their stock on a pro rata basis. Instead, it simply stands for the proposition that a controlling shareholder may not usurp an opportunity that should be available to all shareholders. One could have reached the very same result under a Sinclair Oil-style analysis. The controlling shareholder received a benefit “to the exclusion and at the expense” of the minority. Not only were the minority excluded from the opportunity to sell at a premium, they were left worse off as a result.
Beyond Perlman’s unique facts, where are corporate opportunity issues most likely to arise? Probably in connection with structuring of acquisitions. Suppose Lorraine Looter approaches Susan Stockholder with an offer to buy Stockholder’s control block at a premium. Should there be liability? Not if we adopt the Sinclair Oil analogy. The majority shareholder can do whatever she wants as long as she does not deprive the minority shareholders of something to which they are entitled. On these facts, there is no corporate opportunity to be usurped. (Pages 218-19)
Later in the book I explain how you could use Sinclair Oil to explain cases involving refusal by a controlling shareholder to allow payment of a dividend.
