Saturday, August 1, 2020
Gabriel Rauterberg has just posted a fascinating new paper, The Separation of Voting and Control: The Role of Contract in Corporate Governance. It’s about shareholder agreements, and in particular, the fact that they are surprisingly common not only in private companies, but also in public companies. These agreements typically involve a founder and/or institutional investors like private equity funds, and contain various provisions related to corporate control, such as promises to support certain director nominees, and veto power over various types of corporate actions. As Rauterberg explains, shareholder agreements grant the parties far more freedom to order their arrangements than do bylaws and charter provisions; corporate constitutive documents, for example, could not guarantee board seats for specific nominees.
Rauterberg points out that these raise interesting questions under Delaware law, especially with respect to whether these agreements improperly end-run around mandatory corporate governance provisions. This is particularly so when the corporation itself is a party to the agreement, and the board is bound to take certain actions, like recommend a particular board nominee to shareholders or include a nominee on a particular committee. As he puts it:
The tapestry of corporate law draws fundamental contrasts – between control rights and contractual rights, between the types of rights held by creditors (generally, promissory and fixed) and by equity (generally, residual and discretionary), between internal and external, and ultimately, turning on all of the above, between those who do and do not owe fiduciary duties and those who do and do not receive fiduciary protection. It is simple to state why shareholder agreements challenge this picture: They grant significant corporate power to the paradigmatic “internal” patron – shareholders – but in a way that is fixed, external, and contractual, rather than routed through the board.
On this, I have to point out that preferred stock raises similar challenges. As William Bratton and Michael Wachter have explained, “Preferred stock sits on a fault line between two great private law paradigms, corporate law and contract law.” That fish-or-fowl problem has made Delaware courts quite uncomfortable with preferred shareholder rights; Bratton and Wachter go on to note that cases involving the rights of preferreds follow a simple maxim: “The preferred always lose.”; see also Victor Brudney (“For more than half a century the courts have systematically, if not uniformly, upheld the commons’ view of the scope of its discretion to act opportunistically toward the preferred stockholders under the preferreds' investment contract or the statutes that the contract is said to incorporate.”)
The other interesting point that Rauterberg makes has to do with who counts as a controlling shareholder. That’s a topic I’ve revisited a lot in this space – most recently here – and it’s an issue for Rauterberg as well. Most companies with shareholder agreements also identify as controlled companies, but a significant minority do not, which is ultimately going to be a challenge that lands in Delaware’s lap. Indeed, a couple of weeks ago I posted about Lemonade, which went public as a benefit corporation under Delaware law. Lemonade’s two founding shareholders each hold just under 30% of Lemonade’s votes, and they have a shareholder agreement with Softbank – which has another 21% – that the three together will decide on the disposition of Softbank’s votes. But Lemonade does not at this time identify itself as a controlled company. So that’s going to be something to watch if litigation arises.