Cabining MFW

Regular readers know that I’ve spent a lot of time thinking about the problem of controlling shareholders.  I’ve written a bunch of blog posts on the subject (prior posts here, here, here, here, here, here, here, here, here, here, here , and here), and two essays: After Corwin: Down the Controlling Shareholder Rabbit Hole, and The Three Faces of Control. 

To summarize my previous writing on the subject: The label “control” in Delaware carries an enormous amount of legal weight. Controlling shareholders are subject to fiduciary duties; control itself is valuable and subject to special pricing, and interested transactions by controlling shareholders are subject to the MFW cleansing regime rather than ordinary cleansing (“ordinary” meaning by either disinterested shareholders or disinterested/independent directors).  In recent years, the definition of control has become muddled, in part – I’ve argued – because Corwin allows many suspect deals to escape review entirely, encouraging an expansive view.  And once Chancery courts concluded that all conflict transactions by controllers could only be cleansed via MFW review, enterprising plaintiffs became especially creative about identifying interested transactions, including regulatory settlements and reincorporation out of state.

The Delaware Supreme Court may have taken the first tiny steps for dealing with the first problem – how “control” is defined – in its opinion in In re Tesla Motors Stockholder Litigation.  There, both Chancery and the Supreme Court left undecided the question whether Elon Musk – with a 22% stake – could be considered a controlling shareholder of Tesla. In that context, the Delaware Supreme Court said:

The fact that such a stockholder lacks the voting power to elect directors, approve transactions, or perhaps use her voting power to block transactions makes the question [of who counts as a controller] an important one  

Which perhaps provides guidance to Chancery courts in the future, that they should concentrate their inquiry on these factors – the power to elect directors, the power to approve transactions, and the power to block transactions – when determining whether someone qualifies as controlling.  (I note, though, that in Ruprecht v. Third Point, 2014 WL 1922029 (Del. Ch. May 2, 2014), the court believed that a 20% stake might be enough to achieve blocking control. So, you know.  If control is defined narrowly, does that mean poison pills have to be narrow as well?).

But.

Putting aside the question of how control is defined, we still have the issue of how conflict transactions are cleansed.  As I said, Chancery has settled on the proposition that all conflicted controller transactions are cleansed exclusively through MFW.  But in their article, Optimizing the World’s Leading Corporate Law: A 20-Year Retrospective and Look Ahead, Lawrence Hamermesh, Jack Jacobs, and Leo Strine argued that in the modern world of institutional shareholders, independent directors, and robust SEC disclosure requirements, MFW procedures are no longer necessary; in fact, ordinary cleansing is sufficient to protect minority shareholders from a controller’s influence, and should trigger business judgment review for all controller transactions except freezeouts (or, possibly, transactions that require an organic shareholder vote for approval).

And that’s why it’s a very big deal that at the end of May, the Delaware Supreme Court ordered the parties in In re Match Group Derivative Litigation, No. 368, 2022, to brief the issue whether MFW cleansing is required for all interested controller transactions, or whether ordinary cleansing is permissible outside the freezeout context.  The case involved a series of transactions by which the old Match Group reorganized its assets, in a manner that public shareholders claimed benefitted the controller at the expense of the minority.  VC Zurn held that MFW cleansing was satisfied and the public shareholders appealed, arguing that the stringent MFW requirements were not met – leading to the question whether MFW was even necessary to trigger business judgment review.

Significantly, this issue was waived by the Match Group defendants before the Court of Chancery; the Delaware Supreme Court said that notwithstanding that waiver, “the Court finds that resolving the issue raised by the IAC Defendants is in the interests of justice to provide certainty to boards and their advisors who look to Delaware law to manage their business affairs.”

I admit to some trepidation in saying this, but what else is tenure for I can’t help noticing that this is kind of a fraught moment for the Delaware Supreme Court to actually reach out and grab the issue in a case where it was not properly presented.  Elon Musk just loudly moved Twitter from Delaware to Nevada, and the controller of TripAdvisor and Liberty TripAdvisor is now moving his companies out of Delaware and into Nevada, quite explicitly for the purpose of engaging in conflict transactions under a more permissive standard of review.  It’s hard not to recall how Martin Lipton* suggested reincorporation outside of Delaware in the wake of the City Capital Assocs. v. Interco, Inc., 551 A.2d 787 (Del. Ch. 1988) decision, and how the Delaware Supreme Court subsequently rejected Interco.  In so doing, the Delaware Supreme Court may not have been responding specifically to the Lipton memo, but it might have been swayed by a general … mood ... that the memo reflected. 

So, to bring this all back to Match Group, I’m not saying that the Delaware Supreme Court ordered the MFW briefing out of concern over an exodus from Delaware, but I’m not not saying it, either.

That said, I tend to agree the current system is not sustainable, but – and I argued this all explicitly in Three Faces – I don’t think expanding ordinary cleansing to non-freezeout transactions is the solution.

First, derivative claims against controllers are already protected by the demand requirement.  Hamermesh, Jacobs, and Strine argued for a much more forgiving standard for demand excusal, but their view of demand excusal was rejected by the Delaware Supreme Court in United Food & Com. Workers Union v. Zuckerberg, 262 A.3d 1034 (Del. 2021).  The concepts are sides of a coin; it’s one thing to easily cleanse conflicted controller transactions when there’s a robust ability to bring derivative claims, and quite another to do so when derivative procedures already provide a strong layer of protection.  See Three Faces at n. 102.

Second, the business judgment standard of review is predicated on the idea that shareholders can simply oust directors who are unfaithful to their interests.  That’s not the case when it comes to controlling shareholders, and it’s particularly not the case when the controlling shareholder – through dual class structures or other means – has a level of control that is not correlated with its economic interest in the company.

Third, recent Delaware decisions have made it clear that entire fairness review is not insurmountable.  Musk prevailed after trial in Tesla, and so did the defendants in In re BGC Partners, Inc. Derivative Litigation (currently on appeal to the Delaware Supreme Court); additionally, in In re Baker Hughes Derivative Litigation, the court accepted a one-member SLC’s conclusion that a conflicted transaction was “entirely fair” to shareholders under Zapata, and dismissed a derivative action.  So it’s not like consigning controller transactions to entire fairness review necessarily means liability will be imposed.

Finally, I believe the current predicament is a direct result of the … distance … created by Corwin between an idealized vision of corporate governance and the reality of how transactions actually unfold.  To put it bluntly, Corwin has not prevented a number of transactions that appear to be exploitative on their face, which has sometimes left Chancery floundering for a path to achieve justice.  If the Delaware Supreme Court were to make it easier for controlling shareholders to cleanse conflicted transactions, I believe that distance would become intolerable.

In SMART Local Unions and Councils Pension Fund v. BridgeBio Pharma, Inc serves as a cautionary tale.  In that case, controlling shareholder BridgeBio Pharma squeezed out the minority shareholders of Eidos Therapeutics despite the fact that a third party had offered to buy the minority shares at a higher price (subject to various governance protections).  Vice Chancellor Fioravanti applied business judgment review because, notwithstanding the price differential, BridgeBio had employed MFW procedures.  All of which provides a rather vivid illustration that even MFW leaves plenty of room for exploitation of the minority; if Delaware weakens minority shareholder protections, what new horror stories will emerge that threaten the legitimacy of its law?

But actually what I suspect will actually happen – and again, I made this argument in Three Faces at 821 – is that Chancery courts will try to find an outlet; if they can’t find it through MFW, they’ll find it through definitions of materiality or coercion or independence, which will create a new explosion of malleable standards that will be difficult for transaction planners to anticipate.

Now, I admit the whole situation is a mess (a beautiful mess, it got me two whole papers), and cries out for some kind of order, but I think in the near term, anyway, a more feasible solution is to place some moderate limits on the types of transactions subject to MFW review, without going as far as to confine MFW solely to freezeouts or transactions that require an organic shareholder vote.  For example, Delaware might decide that transactions in the ordinary course of business – like compensation, and routine legal settlements, and the like – can be cleansed using a single protective device, while more extraordinary transactions with controlling shareholders require both methods.  Cf. Three Faces at 827.

Anyway, I’ll just end with: There’s a particular irony that the Delaware Supreme Court is considering alterations to Delaware common law in light of the number of institutional shareholders, while the Delaware legislature is considering alterations to Delaware statutory law in light of the number of retail shareholders.  

*no relation