Separating Voting and Control: Shareholder Agreements and Corporate Governance

In corporate democracy, the default system for electing directors is voting, but shareholders are free to commit their votes by contract. In private companies, shareholders routinely do so, using shareholder agreements – contracts among the owners of a firm – to bargain directly over directorships and other rights of control. In recent years, disputes involving these agreements have increasingly appeared before Delaware’s courts. In late 2019, the Delaware Supreme Court issued a controversial decision addressing whether the parties to a shareholder agreement together formed a controlling shareholder and holding that, in this case, they did not. Economists and legal scholars, however, have tended to overlook the distinctive questions raised by shareholder agreements. In a new paper, I explore shareholder agreements conceptually, empirically, and doctrinally, and show how they raise deep questions about the architecture of corporate law.

First, I explain the distinctive legal role of shareholder agreements. Statutory corporate law confers authority over corporate affairs on the board of directors and justifies that authority through the board’s election by shareholders. That statutory system makes the election of the board a function of shareholder voting power. Even statutory law’s most flexible default rules, such as class voting rights, tether directorships to shareholders’ voting power. Yet shareholders can and do contract over their votes and other control rights. Why? Why use a contract to shape control rather than corporate law’s more familiar instruments – the charter and bylaws?

I explain how shareholder agreements’ role in corporate governance arises both because of contracts’ distinctive attributes as a legal mechanism, in comparison with charters, and because corporate law empowers shareholders to personally waive rights by contract that the charter and bylaws cannot eliminate. Statutory rules that are mandatory for the charter and bylaws do not bind shareholder agreements. As a result, while corporate law’s statutory rules tie control to voting power, shareholder agreements allow the separation of voting and control. As I show, shareholders in fact use these contracts to extensively reallocate all manner of control rights.

Shareholder agreements can do this for reasons that lie in governing case law. The limits on parties’ freedom to design the corporate charter and bylaws are the capacious, but ultimately limited statutory scheme contemplated by the Delaware General Corporation Law (“DGCL”). Shareholder agreements need not be so limited; instead, they sometimes impose only the generic boundaries of freedom of contract – the public policy of the state, here Delaware. Why this difference in treatment? As contracts, shareholder agreements are a creature of parties’ actual consent and can only be changed with their consent (as a default). The charter and bylaws, in contrast, can be altered by collective decision-making that subordinates a specific shareholder’s rights without consent. The Delaware courts take the difference seriously: There are rights that cannot be taken from a shareholder but which he or she can personally waive.

The second contribution of the article is empirical. To the extent that one exists, the conventional wisdom about shareholder agreements is that they are common in private companies, but private companies are the dark matter of the corporate universe – important but challenging to study empirically. In public companies, on the other hand, shareholder agreements are thought to play a trivial or nonexistent role.

This view, it turns out, is false. I show that about 15 percent of companies that went public over the last six years did so subject to a shareholder agreement. Shareholders use these agreements to broadly transform their rights. They are used, pervasively, to contract over the composition of the board of directors. The vast majority of the agreements grant specific shareholders board nomination rights, and more than half of them include a contract to vote in specific ways among some or all of an agreement’s parties. The agreements are also used to form contracts between shareholders and the corporation itself. In a substantial minority of agreements, the corporation grants specific shareholders veto rights over major corporate decisions, such as mergers, terminating the CEO, or changing lines of business. Other agreements waive the corporate opportunity doctrine, restrict the transferability of shares in any number of ways, or mandate arbitration of claims. Most troubling, in a majority of agreements, the corporation commits to supporting specific shareholders’ board nominees for indefinite duration by including the nominees in the corporate proxy slate and using its best efforts to ensure the nominees’ election. The contents of these agreements thus diverge in several respects from what we know of private company shareholder agreements as well.

The third contribution is to map out the conceptual features of post-IPO shareholder agreements and the novel legal issues they raise. These agreements involve commitments along what you could call both horizontal and vertical dimensions, where horizontal commitments are among shareholders and vertical commitments between one or more shareholders and the corporation. The commitments by shareholders to vote for each other’s nominees are horizontal commitments, while promises by the corporation to support those nominees, corporate grants of veto rights to shareholders, or commitments by shareholders to the corporation to waive rights they could otherwise exercise (like director removal rights) are all vertical commitments. These kinds of commitments raise distinct legal issues, and the vertical commitments by corporations raise enforceability issues under existing law that horizontal provisions do not.

This explanatory and empirical account has normative implications for some of corporate law’s most foundational debates. For instance, understanding shareholder agreements challenges two central distinctions in corporate law: that control over the board should be accompanied by fiduciary duties, while the mere exercise of contractual rights should not, and that shareholders bargain for discretionary “residual rights of control,” while other stakeholders, like creditors, protect themselves by contract. Shareholders’ extensive use of contractual rights forces us to revisit the nature of control along both fronts. It also raises the fundamental normative question of whether it is desirable for shareholders to be able to contractually reallocate control rights that are otherwise tied to the ownership of shares and the corporate charter.

This post comes to us from Professor Gabriel V. Rauterberg at the University of Michigan Law School. It is based on his recent article, “The Separation of Voting and Control: The Role of Contract in Corporate Governance,” available here.