Saturday, October 9, 2021
Guest Post by Itai Fiegenbaum: How Overturning Gentile Widens the Controlling Shareholder Enforcement Gap
The following is a guest post by Itai Fiegenbaum, Visiting Assistant Professor of Law at Willamette University College of Law:
Minority expropriation by a controlling shareholder manifests in a variety of forms. Controllers can cause the corporation to sell them an asset at a steep discount. Or purchase from them an asset for an inflated price. These self-dealing transactions share a common thread: Unfair pricing transfers value away from the corporation, and, by extension, from its minority shareholders, to the controller. An additional complication arises when the corporation’s stock is issued to the controller. In this case, a sweetheart deal dilutes the value of their relative voting and dividend rights.
Shareholder litigation is designed to keep transaction planners honest. Not all manner of minority expropriation, however, is subject to the same enforcement procedure. Long-standing corporate law principles distinguish between transactions that harm shareholders directly and transactions that harm them derivatively, through a reduction in their share price. Challenges against the former can proceed directly; challenges against the latter, by contrast, must overcome several procedural hurdles before a court will adjudicate a claim on its merits.
An unmodified application of the bifurcation framework would filter most self-dealing transactions between the corporation and its controller to the derivative enforcement procedure. Until two weeks ago, the rule had one noticeable exception. Under Gentile v. Rossette, equity issuances to a controlling shareholder were deemed to engender both a direct and a derivative cause of action, thus allowing shareholder challenges to circumvent the cumbersome derivative mechanism. This exception was emphatically wiped out in Brookfield Asset Management v. Rosson.
The Delaware Supreme Court provided two justifications for this shift. First, a single streamlined approach through which to evaluate shareholder claims restores doctrinal certainty. Second, even without the Gentile carve-out, other legal theories provide shareholders with a direct claim in change of control scenarios. A closer look finds both explanations unpersuasive.
An outsized emphasis on doctrinal certainty gives short thrift to the underlying concerns that likely prompted the Gentile exception in the first place. Self-dealing transactions are not required to undergo internal approval procedures as a condition to their validity. While corporate fiduciaries are expected to faithfully bargain on behalf of the shareholders, external factors influence their willingness to steadfastly confront the controller. The benefits of continued incumbency and the allure of additional posts are weighed against the harm of potential personal liability and the embarrassment of a public airing of their shortcomings. The result of this assessment hinges on the prospect of a shareholder lawsuit.
The two enforcement procedures are hardly equivalent in that regard. A direct claim affords plaintiffs an unobstructed path to the courthouse. Plaintiffs that wish to vindicate a derivative harm, by contrast, are required to first navigate a procedural gauntlet. These differences impact the likelihood that a plaintiff steps forward and, consequently, the bargaining agents’ cost-benefits analysis in their negotiations with the controller. Effective independent director committees and attendant best practices were forged in the crucible of near-ubiquitous litigation based on a direct shareholder claim. An unaltered application of their teachings in the derivative context ignores the factors that encourage directors’ unflinching loyalty. Gentile provided a pathway around the cumbersome derivative procedure and made it more likely that a plaintiff step forward. Its elimination widens the enforcement gap for a large segment of self-dealing transactions.
The context-specific direct claims alluded to in Brookfield are incapable of satisfactorily covering this gap. Revlon grants plaintiffs a direct claim for equity issuances that transfer control. Ann Lipton has astutely observed the malleability of the control threshold and its impact on the parties’ incentives. My contribution is in highlighting Revlon’s gradual diminishment in the corporate governance ecosystem. Moreover, current doctrine allows a positive shareholder vote to extinguish Revlon claims. Shareholders’ near-certain approval of these transaction call into question the vote’s effectiveness at promoting accountability. In sum, eliminating the Gentile exception reduces the likelihood of a shareholder lawsuit, without ensuring that an alternative accountability mechanism picks up the slack.