In a recent article, I analyze the function of shareholder ratification in corporate governance and argue that understanding this function is critical to both refining shareholder-based cleansing mechanisms and appreciating their inherent limitations. Although I focus on Corwin cleansing in the third-party M&A context, my work also bears on the ability of shareholders to cleanse conflicted controlling-shareholder transactions.
Shareholder cleansing becomes especially useful when no other impartial non-judicial decisionmaker is readily available to bless a conflicting-interest transaction. If shareholders satisfy the required preconditions, their ratification reinstates the business judgment rule after it has been lost in the first instance as a result of the conflict.
The shareholder ratification doctrine attempts to balance the tension in corporate fiduciary law between (1) dispensing efficiently with non-meritorious litigation and (2) holding directors to their fiduciary duties. I offer a principled account of the shareholder ratification doctrine to help guide its development toward this objective.
I start by considering justifications for shareholder-based cleansing grounded in trust and agency theory, as well as the idea that the shareholders are a neutral decisionmaker. I conclude that the shareholder ratification doctrine is better understood as a mechanism for confirming the fairness of a conflicted board’s decision, on par with the implementation of a special committee or submission to substantive judicial review. By fairness, I mean an outcome that is consistent with arm’s-length bargaining conditions.
The history of interested-director statutes and related corporate fiduciary law treats disinterested boards, judicial fairness scrutiny, and approval by either disinterested directors or disinterested shareholders as equally legitimate arbiters of fairness.
When the business judgment rule applies in the first instance—that is, when it is not called into question—the law presumes a fair outcome on the grounds that the board is an impartial decisionmaker with fiduciary duties that drive it to engage in arm’s-length bargaining. When a court engages in substantive review of a conflicted board’s decision, it is evaluating the fairness of the outcome directly. To be sure, the standard of review changes according to the gravity of the conflict, but, in each case, the court measures the actual outcome against what would have been fair to the shareholders given the circumstances. A well-functioning special committee reinstates the business judgment rule because it serves as a proxy for a disinterested board. That leaves us to explain why ratification by non-controlling shareholders, who don’t owe fiduciary duties to their fellow shareholders, should also give rise to the presumption that a conflicted board achieved a fair outcome.
Former Delaware Chief Justice Strine’s answer to this question in Corwin v. KKR Financial Holdings LLC, and before that in Harbor Finance Partners v. Huizenga, was that impartial shareholders have “an actual economic stake in the outcome,” which will motivate them to reject an unfair deal. Relying on a procedural device to confirm the fairness of a suspect transaction requires confidence that the device will in fact produce its presumed outcome. But it is not accurate to assume that the shareholders will always vote to maximize the value of their firm’s equity. This concern exists even assuming that Corwin’s preconditions of full information, disinterestedness, and no coercion are intact.
There are shortcomings in all the foregoing preconditions: With respect to full information, there is no assurance that shareholders will thoroughly evaluate the merits of a transaction before voting. With respect to disinterestedness, there is no assurance that the definition of “disinterested shareholder” includes only a shareholder whose voting incentives are aligned with the financial interests of the shareholders as a group. And with respect to coercion, giving cleansing power to a statutorily required shareholder vote, such as in a merger, is structurally problematic because it bundles approval of the transaction with its ratification, thereby obscuring the meaning of the vote.
Having flagged some important theoretical considerations that undermine the case for wholesale judicial deference to a conflicted board decision that shareholders have ratified, I go on to review the empirical evidence on whether shareholder ratification is consistent with fair outcomes. Such evidence, I find, is inconclusive. While some empirical studies suggest that substantive judicial scrutiny of mergers is associated with higher merger premia than in instances where shareholder ratification was used, others show no such effect.
My article has two main implications for the shareholder ratification doctrine’s future development. First, on the procedural front, it supports continued efforts to refine the preconditions so that they produce a shareholder voting base for cleansing purposes that is motivated to advance the financial interests of the shareholders as a group. Second, I suggest a modest substantive constraint to mitigate the risk that unfair transactions will elude judicial scrutiny by way of shareholder ratification. Specifically, I argue that wasteful and subjective bad-faith board decisions should be per se unratifiable. Granted, Delaware’s shareholder ratification doctrine, in its current form, already excludes waste, but dicta in cases have planted the seed for making the business judgment rule absolutely irrebuttable in the face of shareholder ratification.
The logic behind protecting waste and subjective bad-faith claims from the application of the shareholder ratification doctrine is that waste and subjective bad faith can never be fair to shareholders, and if a plaintiff can allege well-pleaded facts supporting such claims, the plaintiff should be allowed to conduct discovery.
This post comes to us from Iman Anabtawi, professor of law and a member of the Lowell Milken Institute for Business Law and Policy at the UCLA School of Law. It is based on her recent article, “The Limits of Shareholder Ratification,” published in the Journal of Corporation Law and available here.