Founders and early investors increasingly maintain control of companies while holding small economic stakes in them – raising fundamental questions about how Delaware courts can enforce  accountability in corporate governance. In a new working paper, I challenge the courts’ current approach. While readily acknowledging that a director’s desire to remain on a board can influence decisions, Delaware courts haven’t developed a coherent rule for when this self-interest warrants judicial intervention, and specifically when control is maintained through devices such as dual-class shares.

I propose that we look beyond directors’ interest in staying on boards. Shareholders can always vote to remove directors – indeed, the Delaware Supreme Court has called the “temptation for directors to seek to remain at the corporate helm in order to protect their own powers and perquisites” an “omnipresent specter.” The critical question isn’t whether this interest exists – it always does – but rather who holds the power to remove directors and whether their interests align with shareholders generally.

When a board of a widely held company weighs its options then acts, we should not be too concerned because the affected shareholders are the same as those voting in the next corporate election. The courts, likewise unconcerned, defer under the business judgment rule and don’t scrutinize non-conflicted actions when a controller’s economic interest proportionally matches their voting power. The controller shares the minority’s economic interest in maximizing shareholder value.

When those with the votes to remove a director have incentives contrary to the interests of shareholders generally, Delaware courts closely  scrutinize a transaction. This is the case for transactions in which a controller takes a benefit at the expense of the minority shareholders. Because the interests of the controller and minority shareholders are adverse, the courts are suspicious of who the directors serve. As a result, unless the company neutralizes the controller’s interest, full-fledged equitable review by the judiciary is necessary.

This logic should compel enhanced review of decisions – even seemingly non-conflicted ones – in companies where small-minority controllers hold the power to remove directors. When control greatly exceeds economic investment, the controller’s incentive to maximize shareholder value weakens considerably. In extreme cases, with super-high vote shares, an individual could theoretically purchase control for a penny, bearing almost none of the economic consequences of her decisions. As with conflicted transactions, Delaware courts should be suspicious about whether director action had a proper purpose.

The solution I propose maintains balance: enhanced scrutiny in these circumstances, which need not be burdensome, requiring a minimal showing, at the threshold, that directors or controllers acted for a proper purpose. Upon this showing, business judgment-rule protection will be justified. This approach provides necessary safeguards that are consistent with the doctrines of corporate law without unduly burdening corporate decision-making.

Unconstrained Controllers—Representative Transactions

My proposed reform targets various forms of controller misconduct that have so far escaped judicial scrutiny. A few examples illustrate the gap in corporate accountability.

Consider Block, Inc., where Jack Dorsey and Jim McKelvey control the company through special B-shares carrying 10 times the voting power of ordinary shares, despite owning less than 11 percent of the equity. Dorsey was summering in the Hamptons with his friend Shawn Carter, a rapper, producer and entrepreneur otherwise known as Jay-Z, and thought to acquire TIDAL, a music streaming company associated with Carter. “From his Hamptons retreat,” the Delaware Chancery Court wrote, “Dorsey joined a videoconference meeting of Block’s board and proposed that Block acquire TIDAL.” Block formed a transaction committee, which later learned that TIDAL was a financial failure, could not retain its major contracts, and was under criminal investigation. “It seemed, by all accounts, a terrible business decision.” The committee approved the acquisition for $306 million. Carter joined the board.

In another example, Travis Kalanick, Garrett Camp, and Ryan Graves controlled Uber by holding 10-to-one voting shares. Kalanick orchestrated the hiring of key employees from Google’s autonomous vehicle program in a brazen effort the court characterized as “high risk from the start.” Uber’s directors failed to investigate pre-closing diligence relating to the theft of Google’s intellectual property and “the transaction ended in embarrassment. Uber fired its key hire from Google after it came to light Google’s proprietary information had been misused. It also ended up settling Google’s misappropriation claims by issuing additional Uber stock to Google valued at $245 million.”

There are many examples of wasteful decisions by dual-class controllers that are unaddressed by directors. Yet courts rarely impose accountability. Instead, small-minority controllers and directors are usually protected by the disinterestedness and independence of the board. Under Delaware law, the Chancery Court has noted, “a board comprised of a majority of disinterested and independent directors is free to make a terrible business decision without any meaningful threat of liability, so long as the directors approve the action in good faith.”

By appearances, these directors are often yielding to the controllers, serving as pet directors. As the Delaware courts have held, the “obvious” truth is that “even putatively independent directors may owe or feel a more-than wholesome allegiance to the interests of the controller, rather than to the corporation and its public stockholders.” Even so, to this point it has seemed that no theory of liability can bring accountability.

Judicial Scrutiny Is Necessary and Consistent with Doctrines of Corporate Law

As Judge Richard A. Posner has observed, “No one likes to be fired, whether he is just a director or also an officer.” We can question whether the independent and disinterested directors at Block, Uber and Google were motivated by a desire to maintain the favor of the controllers or to meet their fiduciary duties to all the shareholders. In turn, it is sensible to be concerned that the controllers disregarded their and the minority’s economic stakes.

Because the courts are attuned to the inherent coercion of directors by the threat of removal, the identification of who can remove them determines the circumstances under which enhanced scrutiny is warranted. In turn, the power of removal depends on ownership structure. With a controlled company, the power of removal shifts. The director’s interest in staying on the board is tied to the controller’s interest, not the interests of the non-controlling shareholders.

If that controller does not use a dual-class structure, instead voting in a one-to-one ratio with her economic interest, the controller is aligned with the minority shareholders, as are  the directors, at least temporarily. But for a dual-class company, the controller’s interest diverges.

With this understanding of the doctrine of inherent coercion, courts cannot presume the directors of a dual-class company acted in the company’s best interests and defer to their judgment. That presumption should be reserved for situations in which the threat of removal and fiduciary duties both lead to the same outcome: where good conduct is a standard that enforces itself without law and judicial power.

Consider an ordinary decision made during an ordinary time by the director of a non-controlled company. This director will avoid being voted out of her position by being careful and pursuing the shareholder interest. Short of removal, the other directors – who likewise want to avoid adverse shareholder votes – may choose not to re-nominate her. Additionally, if the director does well, she may be asked to join other boards. Here, the specter of removal “coerces” the director to the benefit of the corporation and its shareholders. There is no need for enhanced scrutiny of purpose.

For situations where interests conflict and good conduct is not self-enforcing, Delaware courts have already established an appropriate test. In Unocal, the Delaware Supreme Court, confronting a decision by a target’s directors to respond to a tender offer that threatened the directors’ control of the board and company, established “enhanced scrutiny” as an intermediate standard of review. A target board satisfies the test only by, first, disabusing the reviewing court of its suspicion that self-interest was at play. To do so, the board must show that, instead, “[it] had reasonable grounds for believing that a danger to corporate policy and effectiveness existed because of another person’s stock ownership.” In other words, Unocal polices purpose.

The Unocal standard is like a rail-switch of corporate law. It directs cases between Delaware’s “tiers of review for evaluating director decision-making” – the business judgment rule and entire fairness. After satisfying the first test, the board has essentially reached the safety of business judgment review. The target board has only to show that it has satisfied an “element of balance.”

Enhanced Scrutiny Is Appropriate for Actions Involving Small-Minority Controllers

At dual- and multi-class companies, the director is aligned with a controller who is not aligned with other stockholders. Because of this, the logic of inherent coercion calls for subjecting even some ordinary decisions at a dual-class company to enhanced scrutiny.

A judicial solution balances burden and benefit. As the use of dual-class structures can be both useful and harmful, policymakers struggle to assess the desirability of the structure. The courts do not face the problem of setting general prescriptions and can address individual cases to avoid  overly burdening companies.

Indeed, this question of proper purpose stands  at the threshold of deferential review, regardless of company structure. Usually, it is passed by a presumption. But the presumption of informed, good faith, honest action is a rule that, if conditions are satisfied, is justified by the principle that the judiciary need not intervene when the director would not gain by acting otherwise than in the manner presumed. Good faith cannot be presumed when small-minority controllers are involved, and for that reason requires a fact for judicial examination.

The courts need not make it difficult to show proper purpose and a flood of litigation is not inevitable.  Plaintiffs will take note if only inexplicable actions fail to satisfy a purpose test: as might have been the case for the Block and Uber examples.

Conclusion

Companies controlled by small-minority controllers face the same problem of the separation of ownership and control that Adolf Berle and Gardiner Means wrote about in the 1930s and that corporate law and governance reforms have aimed to address. The potential issues are similar: bureaucratic, salaried managers are here risk-averse controllers without an incentive to devote significant effort to searching out and implementing profitable new ventures. The same abuses are possible: the use of private planes, country clubs and personal benefits with the public stockholders bearing an overwhelming portion of the expense. Salaried managers and penny-controllers face the same incentives, those that the modern governance movement sought to eliminate.

The incentives of a small-minority controller-selected board harken back to 1963, when the board in Graham v. Allis-Chalmers Mfg. Co. failed to inform itself as to the company’s compliance with applicable laws, limiting its activity to consideration of general policy. Enterprises with dual-class stock risk bringing us back in time. The least the courts could do is be suspicious and surface facts about small-minority controller bias.

This post comes to us from Craig K. Ferrere, a corporate governance fellow at Harvard Law School. It is based on his recent paper, “Delaware’s Dual-Class Dilemma: Unocal and a Judicial Solution,” available here.