Tentative Draft No. 1 of the Restatement of the Law of Corporate Governance purports to restate the law governing transactions involving a controlling shareholder.
Section 5.10 states that:
If the corporation enters into a transaction in which a controller [§ 1.10] is interested [§ 1.23], the controller fulfills its duty of loyalty to the corporation and its shareholders with respect to the transaction if:
(1) the transaction is fair to the corporation at the time it is entered into; or
(2) the transaction is conditioned on it being approved in advance, and is so approved, by both disinterested directors [§ 1.15], acting in good faith and on reasonable inquiry with the power to retain their own professional advisers and to negotiate the terms of the transaction, and disinterested shareholders [§ 1.16], in each case following disclosure concerning the conflict of interest [§ 1.14(a)] and the transaction [§ 1.14(b)] to the disinterested directors and disinterested shareholders, respectively.
I have a number of problems with this provision, as drafted. First, by incorporating the definition set forth in section 1.23(b), the drafters have swept far too large a swath of transactions into the operative provisions. They define an interest as:
A shareholder of a corporation is “interested” in a transaction involving the corporation or in conduct by the corporation for purposes of § 1.16 if:
(1) the shareholder is a director, officer, or controller of the corporation, or an affiliate of a director, officer, or controller of the corporation, that is interested in the transaction or conduct or that is not independent of a person that is interested in the transaction or conduct; or
(2) both the corporation and the shareholder are parties to the transaction or conduct; or
(3) the shareholder receives a benefit (or suffers a detriment) in the transaction or conduct which is not generally shared with (or suffered by) the other shareholders of the corporation, and that benefit (or detriment) is of such significance to that particular shareholder that it would reasonably be expected to affect the shareholder’s judgment with respect to the transaction or conduct.
Subsections (a) and (b) basically replicate Delaware General Corporation Law section 144’s definition of when a director or officer has an interest in the transaction. So what, you ask? The Delaware legislature could have adopted a 144-style provision applicable to controlling shareholders. But it has not done so. Neither has the Model Business Corporation Act.
Instead, Delaware law took an entirely different approach in Sinclair Oil. v. Levien, 280 A.2d (Del. 1971). Under Sinclair Oil, the initial question is whether the controlling shareholder “has received a benefit to the exclusion and at the expense of the subsidiary.” (To be sure, Sinclair Oil involved a parent-subsidiary relationship, but the parent by definition is a controlling shareholder and the principles are the same.)
The fact that the controlling shareholder is a party to the transaction is not enough. The controlling shareholder must have gotten a benefit that is both at the expense of and to the exclusion of the minority shareholders.
This is made clear by the court’s treatment of the minority’s objection to the subsidiary’s dividend policy. Sinven (the subsidiary) had adopted at Sinclair Oil’s behest a policy of paying out the maximum lawful dividend. This benefited Sinclair Oil but did not constitute self-dealing by Sinclair Oil because Sinclair received nothing from Sinven to the exclusion of its minority stockholders.” Id. at 772.
Unlike Restatement subsection (3), moreover, it is not enough that the controlling shareholder get a benefit or even that the benefit is not shared. The controlling shareholder must get a benefit not only that excludes the minority but comes at their expense. This is made clear by the court’s treatment of the minority’s complaint that Sinclair Oil had denied Sinven opportunities to develop oil properties outside of Venezuela. “From 1960 to 1966 Sinclair purchased or developed oil fields in Alaska, Canada, Paraguay, and other places around the world. The plaintiff contends that these were all opportunities which could have been taken by Sinven.” Id. But the court rejected that claim: “Sinclair usurped no business opportunity belonging to Sinven. Since Sinclair received nothing from Sinven to the exclusion of and detriment to Sinven's minority stockholders, there was no self-dealing.” Id. Again, you must have both exclusion AND detriment.
Sinclair Oil also suggests that the Restatement gets the substantive law wrong. Section 5.10 seems to assume that any “interested” transaction involving a controller is subject to intrinsic fairness analysis (unless cleansed as per below). But that is not the law, at least in Delaware. Under Sinclair Oil, there are two standards of review. If the plaintiff can carry the burden of proof of showing that the controlling shareholder benefited itself at the expense and exclusion of the minority, then entire fairness is the standard. But if the plaintiff cannot, the business judgment rule is the standard of review.
The rule is not: Controlling shareholder > controlling shareholder connected to transaction > fairness.
The rule is: Controlling shareholder > controlling shareholder benefited at the expense of and to the exclusion of minority shareholders > if yes, fairness; if no, business judgment rule.
In addition, you will note that the drafters have basically grafted the MFW standard for freezeout mergers by a controlling shareholder onto to all cases involving a controlling shareholder. It is debatable whether the MFW rule ought to extend beyond the freezeout merger context. The potential conflict of interest is especially pronounced in this context. After all, “a merger in which it is bought out is the most important event that can occur in a small corporation's life, to wit, its death . . ..” SEC v. Geon Industries, Inc., 531 F.2d 39, 47 (1976). In a freezeout merger, the transaction takes on even greater significance because the controlling shareholder is buying the company and thus has a strong incentive to minimize the prize at the expense of the minority. Freezeout mergers thus have long been the subject of especially close review.
Yet, as been ably said by a court otherwise quite protective of minority shareholder rights, “The majority . . . 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., 353 N.E.2d 657, 663 (Mass. 1976). This seems to be the principle animating Sinclair Oil, which allows some controlling shareholder transactions the protection of the business judgment rule even without the sort of cleansing envisioned by MFW. The Restatement seems to have abandoned that principle by conditioning the business judgment rule on cleansing.
As support for extending MFW beyond the freezeout merger context the Reporters’ Note cites a number of Delaware Chancery Court decisions. Many of those decisions are unpublished and several pre-date MFW. Those decisions, moreover, have been criticized for blurring the distinction between going private transactions and transactions involving a going concern:
The Supreme Court decision does not create a universally-applicable safe harbor procedure for all manner of controlling stockholder transactions. Two main arguments form the basis of this contention.
The dual tenets of doctrinal clarity and cohesion underpin the first argument. A careful reading of the MFW decision fails to detect any mention of competing precedent or a general proclamation regarding its applicability to other types of controlling stockholder transactions. MFW is clearly situated on a path of doctrinal evolution of judicial inspection of going private transactions with controlling stockholders. Canons of judicial interpretation counsel against an indirect reversal or modification of established precedent.
Additionally, the theoretical justifications for the MFW decision hold significantly less weight in the going concern context. MFW's doctrinal shift is grounded on the twin pillars representing the competency of independent directors and non-affiliated stockholders. Whatever the validity of these mechanisms in the freeze out context, the legal and financial scholarship does not validate an extension to going concern transactions. Serious flaws hamper the ability of independent directors and non-affiliated stockholders to pass meaningful judgment on going concern transactions. In the final tally, MFW does not produce an all-encompassing framework for all controlling stockholder transactions.
Itai Fiegenbaum, The Geography of MFW-Land, 41 Del. J. Corp. L. 763, 767–68 (2017).
Three leading Delaware commentators, including former Chief Justice Leo Strine and former Justice Jack Jacobs likewise have argued that:
We . . . would not apply MFW to all transactions with controlling stockholders: the MFW solution was tailored specifically to the problem created by the Lynch line of cases, namely that those cases created poor incentives in the going private merger context for transactional planners and encouraged wasteful litigation yielding no benefit for investors or society. The solution MFW embraced credits procedures that, if implemented with fidelity, give minority stockholders in a squeeze-out merger the key protections they would receive in a merger with a third-party acquiror: (i) fiduciaries actively negotiating for their benefit and (ii) the right to determine for themselves as stockholders whether the transaction is in their best interests. This solution addressed concerns unique to the controller going private context: the requirement that the controller concede that the special committee of independent directors could say no responded directly to the concern that the controller could bypass that committee decision by presenting a tender offer directly to the minority stockholders.
The MFW solution was never designed to apply to all transactions between controlling stockholders and companies. MFW repeatedly emphasized that it was addressing only the context of going private mergers: it defined the question presented as “what should be the correct standard of review for mergers between a controlling stockholder and its subsidiary,” and recited that “[o]utside the controlling stockholder merger context, it has long been the law that even when a transaction is an interested one but not requiring a stockholder vote, Delaware law has invoked the protections of the business judgment rule when the transaction was approved by disinterested directors acting with due care.” Thus, the idea that MFW meant, without saying so, to define the treatment of all transactions with controlling stockholders is at odds with MFW's own text.
Lawrence A. Hamermesh et. al., Optimizing the World's Leading Corporate Law: A Twenty-Year Retrospective and Look Ahead, 77 Bus. Law. 321, 339 (2022). But the drafters ignored that guidance.
You may say that the Restatement is not intended to restate Delaware law. That is true. As I have quipped before, we already have an excellent restatement of Delaware corporate law.
As I have argued in my article, Do We Need a Restatement of the Law of Corporate Governance?, the Restatement is unlikely to have much influence. Instead, like its predecessor—the Principles of Corporate Governance—it likely will be mostly ignored.
I have argued that one reason the Principles were so controversial and were ultimately mostly ignored is that the Principles’ drafters consistently tried to expand the scope of liability for directors and officers:
Early drafts focused on the need for management accountability and relied on judicial review as the primary mechanism for accomplishing that goal. The early drafts therefore increased the likelihood of a corporate decision undergoing judicial review and the concomitant risk of liability for directors and officers.
Stephen M. Bainbridge, Independent Directors and the Ali Corporate Governance Project, 61 Geo. Wash. L. Rev. 1034, 1041 (1993).
The more I see of the Restatement, the more concerned I am that the drafters are heading in a similar direction. It seems as though whenever the reporters are unable to locate statutory or case law constraining fiduciary conduct, they opt to adopt the most prescriptive available precedent, even if it is from unpublished trial court opinions not tested on appeal.
As I explained, the Principles' drafters ultimately backed off. The drafters of the Restatement ought to do likewise.
