Control and Its Discontents

In Control and its Discontents, forthcoming in the University of Pennsylvania Law Review, we examine the Delaware courts’ growing skepticism toward corporate actions in controlled companies. This skepticim culminated in three recent decisions — Tornetta, Match and Sears Hometown – which have potentially wide-ranging implications. Language in the decisions suggests the possibility that, going forward, the Delaware courts will apply entire fairness to a wide range of transactions and to an arguably increasingly expansive set of controlling shareholders.

These decisions reflect an evolving approach to the role and responsibilities of controlling shareholders. We trace its development from the traditional analysis of controlling shareholder duties which, as we explain focused primarily on majority shareholder freeze-outs and similar transactions. Our concern is not whether this evolution is faithful to the languge of the earlier decisions but whether the curent approach to control theoertically defensible or pragmatically appropriate.

Our theoretical critique is grounded in the fundamental principle that shareholders do not, and we argue should not, owe fiduciary duties to the corporation and their fellow shareholders when they act in their traditional capacity as shareholders. The rationale for this principle is that individual shareholder action is not taken in a fiduciary capacity on behalf of the corporation. Actions taken by shareholders as shareholders are also is subject to the existing structural mechanisms of corporate governance— the actions of the board of directors and the unaffiliated shareholders—which play a critical role in converting “shareholder action” into “corporate action.”

Two components of the Delaware courts’ recent jurisprudence thus warrant particular analysis. The first is the expanded and increasingly flexible definition of what it means to be a controlling shareholder. As the Tornetta court acknowledged, its treatment of Elon Musk as a controlling shareholder was novel. The parameters by which the court reached its conclusion, however, logically extend to a host of other situations involving shareholders with far less than 50% voting power and who exercise control through soft measures such as a position as a super-star CEO or with respect only to a particular transaction. We term these situations “new” control.. Corporations are willing to confer control rights and shareholders are capable of exerting substantial influence on corporate decisions in a growing number of situations that do not involve ownership of a majority economic interest. As a result, cases involving new control will arise with increasingly frequency.

The capaciousness of controlling shareholder status is significant in that it is the trigger for the courts’ imposition of fiduciary duties and the potential application of entire fairness scrutiny. As a result, the second component of the courts’ recent jurisprudence is the prospect that that this trigger will be applied to an increasing range of decisions. The concern is exemplified by the Sears Hometown decision’s application of fiduciary principles (although not entire fairness) to a shareholder acting in his capacity as a shareholder and the Match court’s conclusion that entire fairness analysis applies to any transaction in which a controlling shareholder receives a non-ratable benefit. Together with the broad definition of control, these decisions support significant judicial oversight of controlling shareholder transactions. We challenge this approach and its assumption that all controller transactions are inherently and equally coercive as in tension with the fundamental structure of corporate law, which places legal authority for corporate action in the corporation’s officers and directors and relies on entire fairness as a way of disciplining the use of fiduciary authority.

Our analysis leads to three implications. We highlight the inherent subjectivity in the concept of “new” control and the line-drawing problems that it creates. We agree that shareholders can exercise power through a variety of mechanisms, but we question whether the exercise of that power invariably does or should serve as a trigger for treating that shareholder as a fiduciary and applying entire fairness.

Second, the line-drawing challenges associated with “new” control as exacerbated by the evolving approach to MFW, which has rendered the potential for procedural cleansing uncertain. We explain why the courts’ demanding standard for procedural fairness is in tension with the practicalities of controlled companies. The difficulty in assuring, ex-ante that a process will be sufficiently rigorous to meet the MFW standard undercuts the claim that the impact of control creep is limited. Rather, we predict that a growing number of corporate decisions will be subject not just to litigation challenges, but to merits-based scrutiny under an entire fairness standard.

Third, we consider the pragmatic challenges that stem from the courts’ analysis. Corporate doctrines like the business judgment rule are premised on the principle that courts are poorly situated to evaluate the merits of corporate decisions. As a result, entire fairness scrutiny has traditionally focused on conflict transactions involving traditional corporate fiduciaries: officers and directors. Courts have been more restrained in applying entire fairness to actions involving controlling shareholders, focusing primarily on old control situations and corporate freezeouts — a transactional context where there is both a material, quantifiable, and disproportionate benefit to the controller and a market-based framework for analyzing the fairness of the transaction price. The extension of entire fairness review to all decisions in which a controlling shareholder receives a nonratable benefit undermines that principle. Evaluating fair process in situations in which a substantial shareholder exerts some degree of board influence, and evaluating fair price outside the transactional context—in decisions regarding reincorporation, amendment of the charter, or the setting of CEO pay—potentially bring the courts into treacherous territory.

We therefore call for a reconsideration of the application of fiduciary principles to controlling shareholders. Specifically, we argue that when a shareholder acts in its capacity as a traditional shareholder—even a shareholder with effective voting control—it should be treated as a fiduciary only in freeze-outs and similar transactions in which the controller obtains an economic benefit directly at the expense of the minority shareholders, or in instances of outright fraud. We similarly challenge the application of shareholder-level fiduciary principles in cases of “new” control. While we recognize that a shareholder may use soft power to usurp the role of an officer or director, we argue that liability in such a case stems from, and should be limited to, actions taken in the capacity of a traditional fiduciary.

We also offer three suggestions for addressing accountability in controlled companies.  First, where a plaintiff sufficiently alleges both that a controlling shareholder has dominated a board decision and that the decision results in a quantifiable benefit to the controller to the detriment of the minority shareholders, but the transaction is not akin to a freeze-out, we propose that the board’s decision be subject to the one-step cleansing applicable to director and officer conflicted transactions rather than choosing between the business judgment rule and the MFW approach. Second, where the decision has not been properly cleansed, we argue for the application of the Coster intermediate scrutiny standard. Coster would enable the court to examine the reasonableness of the decision as a substantive matter but involve a less demanding inquiry than entire fairness. Third, we argue that where a director, as a result of controlling shareholder domination, acts other than in good faith, the director does and should face potential liability for a breach of the duty of loyalty (which is not subject to exculpation). We argue that such director liability should receive greater focus from both plaintiffs and courts to increase the incentives both for directors to resist controlling shareholder domination and for controlling shareholders to support directors who are sufficiently independent to withstand allegations of domination.

Download the full paper here.