Saturday, November 6, 2021

New essay by me: The Three Faces of Control. And, also, a new paper by Hamermesh, Jacobs, and Strine that is really required reading.

As the followers of this blog well know, I've written a lot about controlling shareholders.  There have been blog posts here, here, here, here, here, here, here, here, here, here, and here, and an essay, After Corwin: Down the Controlling Shareholder Rabbit Hole.  So, I finally posted a whole new essay to SSRN on the subject, called The Three Faces of Control.  It's very short; it's kind of a follow-up/sequel/coda/friendly amendment to After Corwin. Here is the abstract:

Controlling shareholders are subject to distinct legal obligations under Delaware law, and thus Delaware courts are routinely called upon to distinguish “controlling shareholders” from other corporate actors.  That is an easy enough task when a person or entity has more than 50% of the corporate vote, but when a putative controller has less than 50% of the vote – and is nonetheless alleged to exercise control over corporate operations via other means – the law is shot through with inconsistency.

What is needed is a contextual approach that recognizes that the meaning of control may vary depending on the purpose of the inquiry.  Under Delaware doctrine, the controlling shareholder label subjects that entity to unique legal treatment along three distinct dimensions.  First, controlling shareholders – unlike minority shareholders – have fiduciary duties to the corporation.   Second, interested transactions with controlling shareholders – unlike interested transactions with other fiduciaries – are subject to a unique cleansing regime in order to win business judgment deference from reviewing courts.   Third, when certain transactions involving sales of control are challenged in court, they may be treated as direct rather than derivative actions, even when similar transactions that do not involve control sales would be treated as purely derivative.

By teasing out these three aspects of the legal framework and analyzing them separately, courts can more closely attend to the reasons why control carries special significance, and ultimately develop a more rational and consistent set of definitions.  Most critically, courts may properly designate someone a controlling shareholder for some purposes, but not others. 

Frankly, if you've been following my posts on controlling shareholders, a lot of it will seem familiar.  I wrote the essay because I wanted to formalize my thinking rather than leave it all in the blog, and also to articulate an overall framework that is a little different from how I approached things in the After Corwin essay. 

But then, right after I drafted this here post announcing my paper, I discovered that Lawrence Hamermesh, Jack B. Jacobs, and Leo Strine posted their own general assessment of current trends in Delaware law, including controlling shareholder transactions.  They, ahem, cover a lot of the same ground that I do (and, I will admit, do so far more extensively), and their recommendations are the opposite of mine (which makes the whole thing more than a little awkward for me personally but here we are). 

Anyhoo, while my proposals would likely result in more scrutiny of interested transactions, they want less.  They think that Chancery erred by extending the MFW framework to all conflicted-controller transactions,  and instead would jettison the entire line of cases holding that interested transactions with controllers are inherently coercive.  They would allow all such transactions to be cleansed either by the disinterested directors or the disinterested shareholders (just like other interested transactions), with MFW reserved for cases where a shareholder vote is statutorily required.  They agree with the point I made in After Corwin that the MFW framework has created pressure to overdefine the category of controlling shareholders, but their solution is to limit MFW to a small group of cases, so that the controlling shareholder label does less work.  That's a possibility I raised in the conclusion of After Corwin, but I can't say it's what I recommend: they are very afraid of frivolous litigation, and very trusting of institutional shareholders and independent directors to defy controllers, but it seems to me that a lot of the problem here is that courts are looking at cases that are technically "cleansed" but just don't pass the smell test, and they want to let plaintiffs get a shot at discovery.  If there's injustice that courts feel they can't reach, I don't think the solution is to make it even harder for courts to get there. 

In any event, these ideas will absolutely get a workout pretty soon.  I previously posted about the Tesla trial; whatever the verdict, it will certainly be appealed, and the Delaware Supreme Court has never articulated how far MFW extends, even as Chancery has applied MFW to all conflicted controller transactions. To date, almost all of the MFW cases that the Delaware Supreme Court has addressed involved freeze-outs, and one, Olenik v. Lodzinski, 208 A.3d 704 (Del. 2019) (which I forgot when I talked about this in my Tesla post, whoops), did not involve a freeze-out, but did involve a complex transformative transaction that statutorily required shareholder votes to proceed.  Tesla, by contrast, involves Tesla's acquisition of SolarCity.  There was no statutory requirement of a shareholder vote on the deal, just the NASDAQ requirement that a majority of voting shareholders approve an equity issuance of that size.  (The company voluntarily adopted a disinterested-shareholder-approval requirement.) 

So, one way or another, in Tesla if not sooner, the Delaware Supreme Court will be called upon to decide how far MFW extends, and unless the Court ducks the whole issue by holding that the disclosures were deficient (in my Tesla post, I explain how that would work), it will either lean in and extend the MFW framework to a broader category of cases - all conflicted controller transactions, as Chancery has done, maybe something less categorical - or retrench and possibly even agree with Hamermesh, Jacobs, and Strine that we've moved past the idea that controlling shareholders inherently coerce shareholders by their mere presence.

I mean, I know where I'd place my bets as to which direction the Court will choose, but I guess we shall see.  I suppose it's helpful here that of all defendants in the world who are unlikely to settle anything, it's Elon Musk, so I don't think the Tesla case will be resolved that way.

What's also interesting about the Hamermesh, Jacobs, and Strine paper, by the way, is that they disagree with the Delaware Supreme Court's holding in United Food and Commercial Workers Union v. Zuckerberg, and in fact, they agree with what the plaintiffs in that case were arguing.  The plaintiffs argued that the Aronson test should apply if the demand board was the board that made the challenged decision, and that demand should be excused if the plaintiff was able to plead that the directors breached their duties with respect to the challenged decision, even if they were exculpated for that breach.  The theory here is, say there was an interested transaction that was approved by a majority independent board, but the board breached their duty of care in the process.  Under Zuckerberg, demand is not excused when challenging the underlying transaction; the plaintiffs in Zuckerberg argued it should be, because directors who breach their duties may not face monetary liability but they don't want to expose their flaws publicly and therefore won't consider demand fairly.  Hamermesh, Jacobs, and Strine agree with that position.

I'll also note that they highlight the tension between the assumption that controllers are so very scary we need special procedures to cleanse their interested transactions, and a demand-excusal test that assumes independent directors can fairly decide whether to sue a controller.  (That's something I talk about too, both in The Three Faces of Control at fn. 60, and in After Corwin at 1984-85.)  

There's a lot more in their paper; they're concerned about recent merger cases targeting corporate officers for care violations, and recommend amending 102(b)(7) to cover officers, and they want to reform section 220, among other things.  I don't know that all of their ideas will come to fruition but I rather suspect many will have a lot of influence in Delaware, so anyone interested in these subjects should take a look.

https://lawprofessors.typepad.com/business_law/2021/11/new-essay-by-me-and-also-a-paper-by-hamermesh-jacobs-strine.html

Ann Lipton | Permalink

Comments

I really think they miss the mark about the value of cleansing by disinterested shareholders. It looks like they believe such shareholders, including the investment advisers who do a lot of the voting, are much more informed than they really are. See my article, The Risks and Rewards of Shareholder Voting, https://scholar.smu.edu/smulr/vol73/iss4/5/, where I argue that most institutional investors are just as uninformed as retail investors when it comes to voting. In particular, see pages 884-886 (B. SUBSTITUTING THE BUSINESS JUDGMENT RULE FOR ENTIRE FAIRNESS IN CORPORATE LAW).

One thing I agree with them on is the elimination of "substantive coercion." What a convoluted idea. In my recently published paper with Marc Moore, Liberating the Market for Corporate Control, https://lawcat.berkeley.edu/record/1207307?ln=en, we recommend that it be eliminated. We make our recommendation on pages 44-46.

Posted by: Bernard S. Sharfman | Nov 6, 2021 6:50:53 AM