Bloomberg reports:
Delaware’s top court is weighing a potentially groundbreaking ruling that could streamline corporate dealmaking while scaling back protections for minority investors in many transactions that favor insiders.
A case involving dating site Match.com is giving the leading US forum for M&A disputes a chance to reaffirm or rein in enhanced scrutiny of deals involving a potential conflict of interest between a company and its controlling stockholder. ...
The legal framework getting a hard look from the Delaware’s high court is known as the “MFW” doctrine. Named after the court’s seminal 2014 ruling in Kahn v. M&F Worldwide Corp. , it was developed for “squeeze-out” or “freeze-out” transactions that forcibly cash out investors at a price unilaterally set by a controlling stockholder.
But judges on Delaware’s Chancery Court are now applying the standard to a wider range of deals.
Bloomberg further explains that:
The legal standard facing an unexpected challenge requires corporate leaders to defend a transaction as “entirely fair” unless the board sets up an independent special committee and seeks “majority of the minority” approval from unaffiliated investors, onerous steps that can derail a deal.
IAC is asking the state high court to reject that “belt and suspenders” approach and instead require only one or the other.
But IAC didn't go far enough. Independent board committees and votes of the disinterested shareholders are what we call cleansing devices. They supposedly "cleanse" the conflicting shareholders' conflict of interest in transactions with the company.
My own view is that not all controlling shareholder transactions need cleansing. I start with the Delaware Supreme Court's decision in Sinclair Oil. v. Levien, 280 A.2d (Del. 1971). Under Sinclair Oil, as I explain 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)
Accordingly, the initial question is whether the controlling shareholder “has received a benefit to the exclusion and at the expense of the subsidiary.” Only if that is the case does thee transaction require cleansing. Controlling shareholder transactions that do not involve such a benefit are reviewed under the business judgment rule without the need for cleansing by an independent board committee of disinterested shareholder vote. (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 to trigger ckeansing. 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.
Moreover, the need for cleansing is not triggered even if the controlling shareholder get a benefit or even if 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.
I will grant you that some recent Chancery Court cases appear 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 requirement that the controller receive a benefit “to the exclusion and at the expense of the" minority 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.
The rule thus is not: Controlling shareholder > was controlling shareholder connected to transaction > fairness unless cleansing.
The rule is: Controlling shareholder > did controlling shareholder benefited at the expense of and to the exclusion of minority shareholders > if yes, fairness unless cleansed; if no, business judgment rule.
In other words, If the plaintiff can't carry the burden of proof of showing that the controlling shareholder benefited itself at the expense and exclusion of the minority, then no cleansing--whether ordinary Kahn v. Lynch or MFW--is required.
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 either Kahn v. Lynch or MFW.
In Corporate Law (Concepts and Insights) I go on 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)
To be sure, the Sinclair Oil approach does not explain the law in freeze-out mergers. As a policy matter, I think that it makes sense to go immediately into an entire fairness review--and thus to require cleansing--in this context. tThe 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 freeze out merger, the transaction takes on even greater significance than in the ordinary case because the controlling shareholder is buying the company and thus has a strong incentive to minimize the price at the expense of the minority. Freeze out mergers thus have long been the subject of especially close review.
