Saturday, July 14, 2018
Several months ago, I posted about the Chancery decision finding Elon Musk to be a controlling shareholder of Tesla for the purposes of Corwin v. KKR Financial Holdings, 125 A.3d 304 (2015), despite the fact that he held only a 22% stake. The decision took into account both Musk’s stock holdings and his other mechanisms of influence.
One of the reasons the decision stood out was because, while there is a long history in Delaware of considering both voting power and other factors to determine controlling shareholder status, after a certain point, you have to wonder whether the “stockholder” piece is doing any work, and whether instead the question should just be whether someone has effective control, either of the corporation generally or of a particular business decision.
Well, last week, we took a few steps more toward answering that question in Basho Technologies Holdco B, LLC et al v. Georgetown Basho Investors, LLC et al. There, plaintiffs contended that a minority stockholder was a “controller” for purposes of owing fiduciary duties to the corporation. Vice Chancellor Laster agreed, based on a holistic inquiry that took into account, among other things, the stockholder’s contractual rights via preferred stockholdings, its use of those rights (to block alternative transactions), its control over certain board members, and those members’ conduct.
But that’s not the important part. The important part is that Laster laid out a test for “controller” that appears to depend minimally – if it all – on voting power. As Laster put it:
If a defendant wields control over a corporation, then the defendant takes on fiduciary duties, even if the defendant is a stockholder who otherwise would not owe duties in that capacity. One means of establishing that a defendant wields control sufficient to impose fiduciary duties is for the plaintiff to show that the defendant has the ability to exercise a majority of the corporation’s voting power. A defendant without majority voting power can be found to owe fiduciary duties if the plaintiff proves that the defendant in fact “exercises control over the business and affairs of the corporation.” …
To show that the requisite degree of control exists generally, a plaintiff may establish that a defendant or group of defendants exercised sufficient influence “that they, as a practical matter, are no differently situated than if they had majority voting control.” One means of doing so is to show that the defendant, “as a practical matter, possesses a combination of stock voting power and managerial authority that enables him to control the corporation, if he so wishes.”
It is impossible to identify or foresee all of the possible sources of influence that could contribute to a finding of actual control over a particular decision. Examples include, but are not limited, to: (i) relationships with particular directors that compromise their disinterestedness or independence, (ii) relationships with key managers or advisors who play a critical role in presenting options, providing information, and making recommendations, (iii) the exercise of contractual rights to channel the corporation into a particular outcome by blocking or restricting other paths, and (iv) the existence of commercial relationships that provide the defendant with leverage over the corporation, such as status as a key customer or supplier. Lending relationships can be particularly potent sources of influence, to the point where courts have recognized a claim for lender liability when a lender exercises influence over a company that goes “beyond the domain of the usual money lender” and, while doing so, acts negligently or in bad faith.
Broader indicia of effective control also play a role in evaluating whether a defendant exercised actual control over a decision. Examples of broader indicia include ownership of a significant equity stake (albeit less than a majority), the right to designate directors (albeit less than a majority), decisional rules in governing documents that enhance the power of a minority stockholder or board-level positon, and the ability to exercise outsized influence in the board room, such as through high-status roles like CEO, Chairman, or founder Invariably, the facts and circumstances surrounding the particular transaction will loom large.
All of which begs the question whether stockholder status is necessary at all. Are pure lenders, or pure board members, potential controllers? Or is stockholder status a nominal necessity, so that one share is sufficient to begin the inquiry into controller status? These questions are left unanswered by Laster’s opinion.
Now, to be fair, no one who has ever studied Martin v. Peyton or Gay Jensen Farms v. Cargill in their Business Associations class would be surprised to learn that a lending relationship may ultimately transform into a control relationship, with associated duties. That said, it is still striking that Laster concluded that the particular stockholder in Basho was a “controller” for fiduciary purposes without even mentioning how much voting power the controller had, other to say that it was less than a majority. This nominal controller also did not have more than two appointees to a multi-member board. Nonetheless, its contractual rights were sufficient to trigger, in Laster’s view, fiduciary duties.
And that just raises more questions. For example, does a controlling stockholder – versus a controller by any other means – have any special status in this formulation, on the theory that controlling stockholders are uniquely invulnerable to challenge? Or is control the only relevant inquiry? And if control by any means is all that is necessary, can Laster’s analysis square with Corwin? There, the Delaware Supreme Court refused to find controller status where a nominal stockholder nonetheless had complete contractual control of the corporation’s business.
And how are we going to deal with complex capital structures? Both Tesla and Basho dealt with shareholders who had “blocking” rights – i.e., not enough votes to control the Board and dictate corporate action, but enough to block actions with which they disagreed. In Tesla’s case, this was because of a supermajority charter provision; in Basho, it was because a private company had issued multiple rounds of preferred financing with bespoke characteristics. As more companies stay private longer – and as more issue nonvoting stock, and/or high-vote shares – Delaware is going to have to ask more complex questions regarding controlling status and what it precisely entails. On this point, I note that in Third Point LLC v. Ruprecht, 2014 WL 1922029 (Del. Ch. May 2, 2014), the Chancery court determined that Sotheby’s could properly adopt a low-threshold poison pill in order to prevent a hedge fund from obtaining “negative” control, namely, the power to block corporate action, even if it could not generally control corporate policy. Is that what counts as control now? And does that mean – as recommended by Iman Anabtawi and Lynn Stout – that hedge funds now have fiduciary duties? (h/t Eric Goodwin for suggesting the possibility). As I alluded to in my Tesla post, the questions take on a new urgency in the wake of Corwin and Kahn v. M&F Worldwide, 88 A.3d 635 (Del. 2014).
My final thought is, so much of corporate law these days has a back to the future quality. Complex capital structures with multiple rounds of financing, different classes of stockholders with different rights – many of which are nonvoting – were once the norm. Corporate control was relatively concentrated. For example, when Berle & Means wrote The Modern Corporation, they raised the alarm that one-third of America’s wealth was concentrated among 1800 corporations and 200 men.
That changed. With the federal regulation of the apparatus for securities issuance and trading, control over the Exchanges, and so forth, one-share-one-vote became the norm, as did dispersed share ownership and control.
Today, it feels like the pendulum has swung back the other way. As Jan Fichtner, Eelke M. Heemskerk & Javier Garcia-Bernardo put it, “we witness a concentration of corporate ownership not seen since the days of J.P. Morgan and J.D. Rockefeller.” Hidden Power of the Big Three? Passive Index Funds, Re-Concentration of Corporate Ownership, and New Financial Risk, 19 Bᴜs. & Pᴏʟ. 238 (2017). The statistics are well-known – and I talk about a lot of this in my new article, Shareholder Divorce Court (stealth plug! I am so stealthy!) – but, for example, BlackRock, State Street, and Vanguard together constitute the largest shareholder in 88% of the S&P 500, and 40% of all U.S. listed firms. In 2005 ownership of the S&P 500 was so concentrated that in any hypothetical conflict between two member firms, 15% of the equity on either side would be held by institutions that preferred the other side to win.
Meanwhile, we’ve begun to depart from a one-share-one-vote norm as more companies offer private financing with different terms, and even maintain differential voting rights after going public. Even fiduciary duties are up for debate again; they were a matter of some debate back in the early 1900s, they became standard, and now the fastest growing business form is the LLC, which allows fiduciary waivers. It’s as though in many areas – corporate law being, ahem, but one – we’re going to have to learn the lessons of the 20th Century all over again.