In my article, A Course Correction for Controlling Shareholder Transactions, available at SSRN: https://ssrn.com/abstract=5022685, I argue that Delaware courts increasingly exhibit a reflexive suspicion of transactions involving a controlling shareholder. The court has operationalized that skepticism by notably broadening the definition of who qualifies as a controlling shareholder. In particular, the courts are increasingly willing to hold that shareholders who own less than a majority of the corporation’s voting power nevertheless possess control. Taken to its logical extreme, this trend easily could result in someone being deemed a controller even in the absence of stock ownership.
The court’s growing skepticism of controlling shareholders is further reflected in its tightening of the standards governing the conduct of controlling shareholders. In doing so, the court has expanded the range of conflicted transactions necessitating cleansing and heightened the rigor with which cleansing standards are applied, particularly regarding the criteria for independent directors.
My article contends that Delaware courts need a course correction. They have pushed the law governing controlling shareholders far beyond legitimate policing into unnecessary and unwise overregulation. This has prompted a backlash in which controllers threaten to reincorporate outside of Delaware, following Elon Musk’s example of moving Tesla to Texas.
I propose four course corrections, pursuant to which the courts: (1) should narrow the definition of controller; (2) should not attempt to sort out in which cases controllers owe fiduciary duties to the minority from those in which they do not, but instead hold that a controller always owes fiduciary duties to the minority; (3) narrow the class of cases under which entire fairness is the standard of review by adopting a reinvigorated Sinclair Oil threshold test under which entire fairness is triggered only when the controller receives a benefit at the expense of and to the exclusion of the minority; and (4) improve the regime for cleansing transactions in which entire fairness applies. These changes will reduce costs and encourage beneficial investment, while also enhancing Delaware’s position as the state of choice for incorporation. Accordingly, if the courts fail to adopt them, the Delaware legislature should consider doing so by statute.
The Delaware legislature has now undertaken just such a reform effort. Newly introduced SB 21 is largely consistent with the proposals I make in my article. In this post, I highlight the key changes:
SB 21 creates new DGCL § 144(e)(2), which defines controlling shareholder as:
[A]ny person that, together with such person’s affiliates and associates: Owns or controls a majority in voting power of the outstanding stock of the corporation entitled to vote generally in the election of directors; or
Has the power functionally equivalent to that of a stockholder that owns or controls a majority in voting power of the outstanding stock of the corporation entitled to vote generally in the election of directors by virtue of ownership or control of at least one-third in voting power of the outstanding stock of the corporation entitled to vote generally in the election of directors or for the election of directors who have a majority in voting power of the votes of all directors on the board of directors and power to exercise managerial authority over the business and affairs of the corporation.[1]
Like my proposal, SB 21 creates a presumption of control for holders of a majority of the corporation’s voting power. As for minority shareholders, SB 21’s functional equivalence language likely would lead to the same results as my practical certainty proposal. Finally, also like my proposal, SB 21 requires stock ownership, but goes further by supplementing the functional equivalence standard by creating a brightline rule by requiring a controller to own at least one-third of the company’s voting power.
We come now to a couple of provisions that are inconsistent with my proposals and, as matter of good policy, need to be revised. SB 21 defines a controlling shareholder transaction as “an act or transaction between the corporation or 1 or more of its subsidiaries, on the one hand, and a controlling stockholder or a control group, on the other hand, or an act or transaction from which a controlling stockholder or a control group receives a financial or other benefit not shared with the corporation’s stockholders generally.”[2] As such, it is likely to capture a much wider set of cases than the foregoing proposal. First, it captures all transactions between a controller and the controlled entity. Like current law it thus will treat many ordinary controller—controlled entity transactions as being conflicted even though they are common commercial transactions. Sinclair Oil’s threshold test was specifically designed to prevent just that result. My article argues that the Sinclair Oil court was correct to do so. Second, and more importantly, SB 21 treats any controller transaction in which the controller receives a benefit to the exclusion of the minority as conflicted. Under Sinclair Oil, however, a transaction is only deemed conflicted if the controller’s benefit comes both to the exclusion of and at the expense of the minority. As we shall see below, both elements are essential to an optimal standard.
On the other hand, SB 21’s definition does not capture an important category of cases; namely, those between subsidiaries of a parent corporation. In Sinclair Oil, the transaction between Sinven and International was subjected to entire fairness review.[3] Even though Sinclair Oil was not a party to the contract, it received a benefit from the transaction through its control of International.[4] Because International was a wholly-owned subsidiary of Sinclair Oil, the parent benefited both at the expense of and to the exclusion of the minority.[5] For the reasons explained in my article, Delaware law needs to continue applying entire fairness to such transactions.
Returning to changes with which I concur, SB 21 modifies the MFW cleansing standard in a number of ways. First, it treats going private transactions differently from all other conflicted controller transactions.[6] As for the latter, it allows cleansing via either MFW prong.[7]
In this regard, SB 21 appears to have been heavily influenced by Hamermesh, Jacobs, and Strine’s article. They proposed limiting MFW to the going private context, [8] which SB 21 does. They proposed allowing other conflicted controller transactions to be cleansed using either “of the traditional cleansing techniques”—i.e., approval by disinterested directors or disinterested shareholders[9]—which SB 21 also does. In one respect, however, SB 21 goes beyond what Hamermesh, Jacobs, and Strine proposed. They argued for eliminating what they called the “vestigial waste claim” if a transaction were approved by the disinterested shareholders, while retaining it if a transaction was approved by the disinterested directors.[10] In contrast, as discussed above, my proposal would eliminate the waste claim in either case. SB 21 adopts the latter approach, providing with respect to both types of controller transactions that they “may not be the subject of equitable relief, or give rise to an award of damages or other sanction against a director or officer of the corporation or any controlling stockholder or member of a control group, by reason of a breach of fiduciary duty by a director, officer, controlling stockholder, or member of a control group, if” cleansed as per the statutory requirements.[11]
SB 21 also addresses the Chancery Court’s cramped definition of director independence, providing reforms comparable to those proposed herein. Several provisions work together to accomplish that result. “Disinterested director” is defined by new § 144(e)(4) to mean “a director who is not a party to the act or transaction and does not have a material interest in the act or transaction or a material relationship with a person that has a material interest in the act or transaction.” The reference to material relationship thus expands disinterestedness to encompass independence. “Material interest” is defined by new § 144(e)(8) as “an actual or potential benefit, including the avoidance of a detriment, other than one which would devolve on the corporation or the stockholders generally, that . . . would reasonably be expected to impair the objectivity of the director’s judgment when participating in the authorization or approval of the act or transaction at issue . . ..”[12] “Material relationship” is defined by new § 144(e)(9) as “ a familial, financial, professional, employment, or other relationship that . . . would reasonably be expected to impair the objectivity of the director’s judgment when participating in the authorization or approval of the act or transaction at issue . . ..”[13]
Although § 144(e)(9)’s reference to “other relationship” might seem to create a loophole through which a court could drive the sort of personal relationships that have bedeviled the analysis in recent years, new § 144(d)(2) includes a presumption tracking that suggested above:
Any director of a corporation that has a class of stock listed on a national securities exchange shall be presumed to be a disinterested director with respect to an act or transaction to which such director is not a party if the board of directors shall have determined that such director is an independent director or satisfies the relevant criteria for determining director independence under any rules promulgated by such exchange, which presumption shall be heightened and may only be rebutted by substantial and particularized facts that such director has a material interest in such act or transaction or has a material relationship with a person with a material interest in such act or transaction.[14]
In sum, these new provisions thus are largely consistent with my proposals. They should provide considerably greater certainty and predictability, while expanding the definition of independence beyond the narrow one towards which the Chancery Court has been moving.
[1] S.B. 21 § 1. In addition, SB 21 defines a control group as “2 or more persons that are not controlling stockholders that, by virtue of an agreement, arrangement, or understanding between or among such persons, constitute a controlling stockholder.” Id.
[2] S.B. 21 § 1 (creating new DGCL § 144(e)(3).
[3] Sinclair Oil established Sinclair International Oil Company (International) in 1961 as a wholly owned subsidiary to manage its international operations, including all crude oil purchases from its geographically delimited oil-producing subsidiaries such as Sinven. Sinclair Oil Corp. v. Levien, 280 A.2d 717, 722 (Del. 1971). Sinclair then arranged for Sinven to enter into a contract with International, under which Sinven would sell its crude oil and refined products exclusively to International at predetermined prices, with specified quantity requirements. Id. at 722-23. Plaintiff alleged that Sinclair caused two material breaches of this contract. First, International consistently failed to make timely payments, delaying them up to 30 days beyond the contractually required payment-on-receipt terms. Id. Second, International failed to purchase the minimum quantities of crude oil and refined products that it was contractually obligated to buy from Sinven. Id.
[4] See id. at 723 (“If the contract was breached, then Sinclair received these products to the detriment of Sinven's minority shareholders.”).
[5] See id. (“Clearly, Sinclair's act of contracting with its dominated subsidiary was self-dealing.”).
[6] See S.B. 21 § 1. SB 21 defines going private transaction as meaning:
For a corporation with a class of securities registered under § 12(d) or 15(g) of the Securities Exchange Act of 1934 or listed on a national securities exchange, a 13e-3 transaction (as defined in 17 CFR § 240.13e-3(a)(3) or any successor provision); and
For any other corporation not subject to [the preceding paragraph], any controlling stockholder transaction, whether by merger, consolidation, amendment, tender or exchange offer, conversion, transfer, domestication or continuance, pursuant to which all or substantially all of the shares of capital stock held by the disinterested stockholders (but not those of the controlling stockholder or control group) are cancelled or acquired.
Id.
[7] SB 21 provides:
(b) A controlling stockholder transaction (other than any going private transaction) may not be the subject of equitable relief, or give rise to an award of damages or other sanction against a director or officer of the corporation or any controlling stockholder or member of a control group, by reason of a breach of fiduciary duty by a director, officer, controlling stockholder, or member of a control group, if:
(1) The material facts as to such controlling stockholder transaction are disclosed or are known to a committee of the board of directors expressly delegated the authority to negotiate (or oversee the negotiation of) and to reject such controlling stockholder transaction, and such controlling stockholder transaction is approved (or recommended for approval) in good faith by the committee (provided that the committee does not include the controlling stockholder and that a majority of the members of the committee approving such controlling stockholder transaction are disinterested directors); or
(2) The material facts as to such controlling stockholder transaction are disclosed or are known to the stockholders entitled to vote thereon, such controlling stockholder transaction is conditioned on a vote of the disinterested stockholders at or prior to the time it is submitted to stockholders for their approval or ratification, and such controlling stockholder transaction is approved or ratified by the uncoerced, affirmative vote of a majority of the votes cast by the disinterested stockholders; or
(3) Such controlling stockholder transaction is fair as to the corporation.
Id.
[8] See Lawrence A. Hamermesh, Jack B. Jacobs, & Leo E. Strine, Jr., Optimizing the World’s Leading Corporate Law: A Twenty-Year Retrospective and Look Ahead, 77 Bus. Law. 321, 339 (2022) (criticizing MFW creep).
[9] See id. at 339-44 (discussing cleansing of conflicted controller transactions other than going private transactions).
[10] Id. at 361-62.
[11] S.B. 21 § 1.
[12] Id.
[13] Id.
[14] Id. In addition, new § 144(d)(3) essentially tracks current law by providing that “[t]he nomination or election of the director to the board of directors by any person that has a material interest in an act or transaction shall not, of itself, be evidence that a director is not a disinterested director with respect to an act or transaction to which such director is not a party.” Id.
