Controlling shareholders function as a dual-edged sword in corporate governance. They can reduce agency costs by monitoring management but also pose risks of self-dealing that can harm minority shareholders. In recent years, Delaware courts have increasingly focused on the latter risk, exhibiting a reflexive suspicion of transactions involving a controlling shareholder.  The courts have operationalized that skepticism by notably broadening the definition of who qualifies as a controlling shareholder. In particular, they are increasingly willing to hold that shareholders who own less than a majority of the corporation’s voting power nevertheless possess control.  Taken to its logical extreme, this trend easily could result in someone being deemed a controller even in the absence of stock ownership.

Delaware courts’ growing skepticism of controlling shareholders is further reflected in their tightening of the standards governing the conduct of controlling shareholders.   In doing so, the courts have expanded the range of conflicted transactions necessitating cleansing and heightened the rigor with which cleansing standards are applied, particularly regarding the criteria for independent directors.

In a new article, I contend that Delaware courts need a course correction. They have pushed the law governing controlling shareholders far beyond legitimate policing into unnecessary and unwise overregulation. This has prompted a backlash in which controllers threaten to reincorporate outside of Delaware, following Elon Musk’s example of moving Tesla to Texas.

Defining Controlling Shareholders

The determination of whether a shareholder owes fiduciary duties hinges on whether the shareholder is deemed to control the corporation. Without evidence of control, shareholders are free to act in their self-interest. If control is established, however, fiduciary obligations toward minority shareholders and the corporation arise.

Historical Approach

Under Delaware law, control traditionally required a majority of voting power. Shareholders with less than 50 percent of stock were not considered controlling unless additional evidence of actual control over corporate conduct was demonstrated. This standard required proof that a minority shareholder exercised significant influence over the corporation, beyond mere stock ownership.

While proving control over day-to-day operations was not necessary, plaintiffs had to demonstrate control over the specific transaction being challenged. Historically, this requirement was stringent, making it challenging to classify minority shareholders as controlling unless their influence was clearly dominant in the relevant context.

Expanding the Definition

Delaware courts have broadened the concept of “control” beyond majority voting power, focusing on other forms of influence, such as managerial authority or contractual leverage. Previously, control required proof of “actual domination” over corporate decisions. Recent cases, however, rely on “inherent coercion” and potential influence, reducing the stock ownership threshold necessary to classify someone as a controller.

Notable shifts include:

1. From Voting Power to Managerial Influence: Cases like Tornetta v. Musk treat “superstar CEOs” as controllers, arguing that their perceived indispensability creates undue deference from boards and shareholders.
2. Soft Control Factors: Cases like Voigt v. Metcalf and W. Palm Beach Firefighters’ Pension Fund v. Moelis & Co.found shareholder control based on contractual rights or economic relationships, a trend that could lead to deeming individuals controllers without stock ownership.

These trends have created ambiguity, with courts emphasizing influence over formal voting control, leading to broader interpretations of who qualifies as a controlling shareholder.

The Case for Recalibration

This trend has created legal uncertainty and escalated litigation and discouraged strategic shareholders and investors. A course correction is necessary to narrow the definition of control so as to reduce ambiguity and foster clearer corporate governance standards.

My proposed reform is based on several foundational guidelines. First, the definition should be based on actual domination and control. Leverage, other forms of bargaining inequalities, the ability to exercise control if one so wishes, and so on should not be factors in the analysis. Second, the definition should not be so all encompassing as to capture those who wield power mainly by virtue of their position as an officer or director. Third, truly substantial stock ownership should be required.  Finally, the standard should provide as much clarity, certainty, and predictability as possible.

The proposal has two legislative pieces: (1) amend DGCL § 122(18) to clarify that authorized contractual provisions do not create fiduciary relationships; and (2) enact a statute stating that positions like officers, directors, or employees alone do not render an individual a controller. This would limit the “superstar CEO” concept and align such CEOs’ accountability under existing director/officer fiduciary laws.

The proposal also encourages courts to use a modified version of the standard from Essex Universal Corp. v. Yates. Under it, shareholders owning the majority of voting power are automatically deemed controllers. Minority shareholders are rebuttably presumed not to have control unless their stockholdings effectively guarantee majority board control. The proposal thus focuses on voting power and actual domination, avoiding subjective factors like relationships or soft control.

The proposal focuses on control over the corporation rather than control with respect to the particular transaction in question. First, a frequently cited justification for imposing fiduciary duties on a controller is the controller’s ability to retaliate against the minority shareholders by using its control over the board of directors to impose “some onerous and oppressive policy.”  Likewise, Delaware courts have argued that a controller should bear fiduciary duties because of the risk that directors may “perceive that disapproval may result in retaliation by the controlling shareholder.”  In either case, a controller who possesses ongoing power over the corporation likely is in a stronger position to retaliate than a shareholder who only exercises control with respect to a particular transaction.

The proposal thus restores the traditional difficulty in proving minority control. It also reduces confusion by separating conflicts involving directors/officers from those involving controllers. Finally, it enhances predictability by narrowing the inquiry to measurable factors like share ownership.

Identifying Conflicted Controller Transactions

Delaware’s courts have shown a growing inclination to treat even routine transactions involving a controlling shareholder as conflicted, subjecting them to entire fairness review. I propose that the potential outcome-determinative effect of applying entire fairness necessitates a threshold test to determine whether the transaction should be analyzed under the business judgment rule or entire fairness. The proposal is thus analogous to the initial screening tests used in takeover-defense litigation and derivative litigation.

Specifically, I propose reinvigorating the Sinclair Oil test. Sinclair Oil established a key threshold inquiry for determining the appropriate standard of review in controlling shareholder  transactions. Intrinsic fairness was applied only in cases of self-dealing, where the controlling shareholder gains a benefit to the exclusion and detriment of minority shareholders. The business judgment rule was applied when self-dealing was absent, even if the controlling shareholder benefited, provided that the benefit did not come at the exclusion and to the detriment of minority shareholders.

Initially, some cases adhered to the Sinclair Oil threshold test, scrutinizing whether exclusion and detriment were present before applying fairness review. Others bypassed the threshold inquiry entirely, however, particularly in cases involving ownership or enterprise claims. In such cases, a fairness standard of review was applied without prior inquiry.

A third line of cases subsequently emerged, which diluted the Sinclair Oil standard by eliminating the requirement to prove detriment. For instance, In re Tilray, Inc. Reorganization Litigation presumes entire fairness applies whenever a controller extracts a unique, non-ratable benefit, even without evidence of harm to minority shareholders.

Today, the threshold inquiry established in Sinclair Oil has been largely abandoned by Delaware courts, particularly the Chancery Court. Entire fairness now applies whenever the controller stands on both sides of a transaction or gains a non-ratable benefit, regardless of whether minority shareholders are excluded or harmed.

The shift away from the strict Sinclair Oil test has made fairness review more expansive, applying even in situations without clear evidence of exclusion or harm. This evolution raises concerns about over-policing controllers and the potential chilling effect on beneficial transactions.

Cleansing Conflicted Transactions

Delaware courts have developed procedural safeguards to cleanse controller transactions, such as requiring approval by independent directors or majority-of-the-minority shareholders. However, these mechanisms have become overly rigid, particularly in assessing director independence.

The proposed course correction focuses on clarifying the definition of when a director is independent. A legislative component could include aligning with stock-exchange listing standards. The Sarbanes-Oxley and Dodd-Frank laws require stock exchanges to adopt listing standards requiring boards to have independent audit, compensation, and nominating committees. The NYSE standards include clear independence tests, such as limits on employment relationships and compensation thresholds. The Delaware legislature could adopt these guidelines as a statutory definition of director independence. Alternatively, the legislature could establish a presumption that directors meeting NYSE-like criteria are independent.

Alternatively, Delaware courts could incorporate the NYSE definitions, which are well-researched and align with Delaware principles. Alternatively, courts could presume directors chosen by independent nominating committees are independent, consistent with findings that these committees enhance firm performance. If reasonable and informed businesspeople might disagree on independence, courts should not rebut the presumption.

Conclusion

Current Delaware law faces challenges in balancing the rights of controllers and the protections needed for minority shareholders, especially in light of the evolving interpretations of director independence and fiduciary duty. My paper highlights the pressing need for clearer, more predictable guidelines to address conflicts of interest, particularly regarding conflicted controller transactions and the inherent coercion doctrine. Additionally, it calls for a refined standard that better delineates the circumstances warranting entire fairness review, thus mitigating the risk of deterring beneficial transactions.

The suggested adjustments, such as a reinvigorated threshold test for applying entire fairness, aim to foster a governance environment where both controllers and minority shareholders can coexist with reduced litigation risks and a heightened focus on transparency and fairness. The proposed reforms hold promise for enhancing legal certainty, ultimately strengthening Delaware’s position as a leading jurisdiction for corporate law.

This post comes to us from Stephen M. Bainbridge, the William D. Warren Professor of Law at the University of California, Los Angeles (UCLA) School of Law. It is based on his recent article, “A Course Correction for Controlling Shareholder Transactions,” available here.