My colleague Eric Talley at Columbia Law School has proposed an ingenious modification of SB 21 – scheduled for a vote today in the Delaware legislature – that highlights the contractarian traditions of Delaware law and builds off the experience with fiduciary duty contractarianism in Section 102(b)(7).
I want to suggest an additional framing and a minor modification to Talley’s proposal, a friendly amendment. The additional framing is this. In the corporate law and governance debate, the controlling shareholder is offered as the solution to managerial agency costs, the tendency of management to pursue its own goals rather than shareholder goals. Controllers have incentives to monitor managers closely and the capacity to bring this monitoring into the operation of the firm. This can produce gains for all concerned. The concern is the flip side: “controller shareholder agency costs,” the capacity of the controller to extract the “private benefits of control,” including an excess share of corporate cash flows through various diversionary transactions.
The efficiency of controlling-shareholder governance depends upon appropriate control of its potential misuse. We see this in a cross-national comparison. In the U.S., a selling controller can retain its control premium. Elsewhere, the “mandatory bid” rule generally prevails, meaning that a selling controller must share its premium with other shareholders. What accounts for the difference is trust in U.S. courts, most particularly Delaware courts, to maintain a system of fiduciary litigation that will minimize add-on private benefit extraction by a new controller.
The control of controlling-shareholder conduct is particularly important in the case of dual-class common stock because the dual-class structure creates a wedge between cash flow rights and control rights that is a constant temptation. Control creates the capacity to divert cash flow to the controller, and the wedge heightens the temptation. An example: For each $100 diverted by a controller with 55 percent of the control rights (and thus the power to select directors) but only 40 percent of the cash flow rights, the controller nets out $60; with 20 percent of the cash flow rights, the controller nets out $80. Over time, as the controller wants greater liquidity and diversification, the wedge will grow.
Thus this crucial insight: Incorporating in Delaware is a commitment strategy by a controller to assure investors in an IPO and purchasers on a secondary market that the controller will not extract impermissible private benefits of control, namely a material non-pro rata benefit for the controller and a detriment to the other shareholders.[1] The controller’s commitment is to subject itself to Delaware’s rigorous fiduciary-duty regime, including courts, for transactions with the controller where serious fiduciary questions might be raised.
Capital market developments, including changes in stock-listing rules that have opened the way to dual-class structures, have resulted in many more controller fiduciary-duty cases in Delaware over the past decade. Some think that the current Delaware standards are too intrusive and demanding. But here is the ingenuity of Talley’s opt-in proposal: It preserves the availability of a demanding fiduciary-duty regime for some controllers but permits others to opt out. The optionality lets controlled companies choose on the basis of anticipated pricing in an IPO and subsequent capital market considerations as between two regimes.
My addition is minor. For companies with a dual-class structure, approval of the opt-out by a majority of the outstanding shares of each class is conclusive. If challenged, the opt-out would be evaluated under a waste standard. If the two classes vote as a single class on the opt-out, and a majority of the low-voting shares do not vote in favor, then the opt-out, if challenged, should be evaluated under the TripAdvisor structure.
For companies with a single class, approval of the opt-out by a majority of the disinterested shareholders is conclusive. Otherwise the opt-out, if challenged, would also be evaluated under the TripAdvisor structure.
As a final point, I think a controller choosing to opt into the alternative regime should be able to lower the threshold for a “facts and circumstances” determination of control. For example, the present standard is 33 percent. A party that holds only 20 percent, say, and wants to commit to the new Delaware regime for single-sided controller transactions, should be able to adopt a 20 percent threshold in the opt-in.
Here is the proposed language for a new Section 102(b)(8):
A provision adopting the safe harbor rule as reflected in Delaware General Corporation Law Section 144A, provided that the provision (i) is in the initial charter of a corporation organized in Delaware, (ii) in the case of an existing corporation with more than one class of common stock, is approved by a majority of the outstanding shares of each class; and (iii) in the case of an existing corporation with a single class of common stock, is approved by a majority vote of the outstanding stock and by a majority vote of the shares not owned or otherwise controlled by a party owning 50 percent of the outstanding stock (a “disinterested majority”). In the case of (ii) or (iii), if the provision has been approved by a majority of the voting power entitled to cast votes for the board of directors, or for a majority of the board, but in the case of (ii) not bv a majority of the outstanding stock for all classes, and in the case of (iii) not by the disinterested majority, any litigation that challenges the controller’s fiduciary duty in adopting the charter amendment shall be evaluated under the standard set forth by the Delaware Supreme Court in Maffei et al. v Palkon et al (TripAdvisor). The provision may modify the safe harbor rule of Section 144A to the extent of reducing the minimum percentage required for the determination of a “controlling stockholder.”
ENDNOTE
[1] Sinclair Oil. V. Levien, 280 A.2d 717 (1971).
This post comes to us from Jeffrey N. Gordon, the Richard Paul Richman Professor of Law at Columbia Law School.