What Do Stockholders Own? The Rise of the Trading Price Paradigm in Corporate Law

In a spate of recent decisions, the Delaware Supreme Court has embraced a shift in its approach to stockholder appraisal rights, a development that has attracted considerable comment. The greatest impact of these decisions, however, may lie beyond appraisal and still be to come.  The decisions present a new conception of how trading prices relate to the stockholder’s entitlement, one that would alter basic ideas surrounding mergers, stock ownership, and the nature of the corporation as a vehicle for co-ownership. Delaware corporate law appears to be on the verge of a paradigm shift.

At the heart of the shift is a confounding question: How should a stockholder’s interest in a corporation be measured, in dollars and cents? Where stock is publicly traded, the answer may seem simple: The value of the bundle of entitlements held by the stockholder should be the trading price of the stock. Outside of the corporate domain, this answer is, in fact, the law. When tax authorities, for example, must determine the value of a share of stock received by gift, the market price supplies a ready answer.

Delaware, however, has famously rejected this answer when the question involves an internal corporate dispute. At some level, this rejection is unavoidable. The trading price of a share of stock is simply the market’s estimate of the value of the legal entitlements belonging to the owner of the share. In many contexts, the judicial inquiry can take the content of these entitlements for granted. But in an intracorporate dispute, the court is engaged in defining the entitlements of the stockholder. It would be circular to attempt to set the content of the stockholder’s legal entitlements by reference to a market price that itself depends entirely on the content of those legal entitlements.

The merger context puts these issues in sharpest relief. For a century, Delaware courts have determined a stockholder’s entitlement by looking at their proportional share of the value of the corporate enterprise as a whole, rather than at the value of the individual fractionalized share of stock. As such, the courts largely disregarded trading prices, drawing a distinction between the trading price of a marginal share and the hypothetical value of the entire corporation. As the Delaware Supreme Court confirmed in Cavalier Oil, quoting the decision below, in an intracorporate dispute at merger, the court’s job is “to value the corporation itself, as distinguished from a specific fraction of its shares as they may exist in the hands of a particular shareholder.”

This proposition has served as the Atlas of Delaware’s corporate law, supplying the theoretical underpinnings of its entire doctrinal universe. In the landmark Unocal case, the Delaware Supreme Court endorsed a corporate board’s conclusion that a pending $54 offer for the corporation was “wholly inadequate,” even though the stock had never traded higher than $44. A board is not only empowered to reject a bid that exceeds the prevailing trading price, but it may also be compelled by its Revlon duties to seek better alternatives, even where an above-market offer is already in hand. In Smith v. Van Gorkom, directors who assessed the adequacy of a bid by comparing it with the “current and historical stock price” were famously held to have committed an error so basic that it exposed them to personal liability.

The past few years, however, have seen the emergence of a new paradigm. In a series of important decisions – DFC Global, Dell, Aruba, and Jarden – the Delaware Supreme Court has thoroughly refashioned the appraisal remedy, elevating the role of trading prices in delineating the stockholder’s entitlement. In Dell, for example, the court claimed that it was difficult to conceive of a difference “between Dell’s stock price and the Company’s intrinsic value.” Jarden is the culmination of this line of reasoning, where the court proclaimed, “[t]here is no ‘long-recognized principle’ that a corporation’s unaffected stock price cannot equate to fair value.”

In a forthcoming article, we argue that these appraisal cases represent the beginnings of a foundational shift in Delaware’s corporate law. The Delaware Supreme Court has done nothing less than alter its conception of the public corporation as a form of property.

What a stockholder is entitled to receive in a merger depends on what claims the stockholder has as an owner of property in the first place. In the old paradigm, the stockholder’s entitlement is to a pro rata equitable claim on the value of the entire corporate estate. In the new paradigm, the stockholder’s interest in a share of stock is no different than a property interest in ordinary chattel, like a gold nugget or a toaster, where the trading price is perfectly appropriate as the beginning and the end of any inquiry into value. Where the “chattel” trades in a liquid market, then, what grounds could there be for a stockholder to make a claim on the corporation that exceeds the value given by the trading price?

This paradigm shift augurs dramatic change not simply in appraisal, but in all of merger law. Most obviously, the shift will necessarily affect the basic measure of damages in other contexts. Indeed, the Court of Chancery has already confronted this scenario in PLX Technology: a merger involving a breach of fiduciary duty that gave rise to no damages simply because the transaction was at a premium to the market price. But perhaps the most notable doctrinal reckoning involves Unocal and its progeny, which afford directors the power to defend against the threat of acquisitions where the price is “too low.” That power reached is fullest expression in the 2011 Air Products v. Airgas decision, where the Court of Chancery held that an allegedly “inadequate price” justified the board of Airgas in blocking a $70 acquisition offer from Air Products, even though Airgas stock had previously been trading between $40 and $50 per share.

The continuing force of the reasoning behind Airgas is now in serious doubt. If, as the Delaware Supreme Court held in Aruba, the best evidence of the value of the shareholder’s entitlement is the market price, and if, as the Delaware Supreme Court held in DFC Global, the absence of higher bidders demonstrates the attractiveness of the bid, and if, as the Delaware Supreme Court held in Dell, the opinion of informed insiders is insufficient to call into question the fairness of a market-tested price, then on what ground can Airgas still stand?

At first glance, it may appear that the recent decisions are simply a tempest in the appraisal-rights teapot, not reflective of a broader paradigm shift in Delaware’s law. It’s unlikely, however, that the Delaware Supreme Court either (1) did not understand the broader implications of its holdings; or (2) understood those implications but intended to restrict them to appraisal, thus injecting a new and deep inconsistency into Delaware’s merger law. The same critics who have long urged fundamental changes in Delaware’s broader merger law also advocated for precisely what the Delaware Supreme Court did in the appraisal cases, and on the same grounds as their broader objections. Furthermore, the appraisal opinions deliberately echoed critics of Delaware’s traditional rejection of market price, declaring the identity of market prices and fair value as “economic fact.” Moreover, appraisal law is a natural area for initiating such a change. Just as a century ago it was in the crucible of appraisal that Delaware forged its original conception of the stockholder’s entitlement, it is altogether natural that appraisal would be the vehicle for the Delaware Supreme Court to articulate its replacement.

We argue that the new paradigm is, on the whole, a negative development for Delaware’s corporate law and for American capital markets more generally. The new approach renders appraisal essentially nugatory, functionally eliminating a remedy with beneficial corporate governance effects. More broadly, however, it puts the public Delaware corporation at a systematic disadvantage to other forms of property as a vehicle for organizing an enterprise. If the stockholder’s entitlement is based on the trading price of a marginal share, rather than the value to an owner of the unified equity interests, would-be entrepreneurs will be forced to take a discount when they raise capital through a public corporation, with consequences for the market for corporate control and for the continued vitality of public equity markets in the United States. Delaware should recommit to its historic approach that afforded a stockholder a pro rata claim on the same basket of rights in a corporation as a sole owner. In the context of the corporate form, as in most others, “[i]t would be astounding if weakening well-defined property rights increased welfare.”[1]

ENDNOTE

[1] Haddock, Macey, and McChesney, Property Rights in Assets, 73 Va. L. Rev. at 740.

This post comes to us from professors Charles Korsmo at Case Western Reserve University School of Law and Minor Myers at the University of Connecticut School of Law. It is based on their recent article, “What Do Stockholders Own? The Rise of the Trading Price Paradigm in Corporate Law,” available here.

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