One distinctive feature of the U.S. economy over recent decades has been the rise of the entrepreneur-dominated public company.  This development has  derived largely from the growth of private funding available through venture capital, so that initial public offerings have commonly served as a “harvesting” moment for the venture capital investors rather than a fund-raising vehicle that would dilute the entrepreneur’s control position. Moreover, the success of the Google IPO in 2004 provided market validation for the entrepreneur’s use of dual class common stock as a way of retaining control while retaining considerably less than 50 percent of the cash flow rights of the public company.   The entrepreneur’s “idiosyncratic vision” has also received its celebration in the academic world.[1]

We commonly think of corporate law and governance as focused on managerial agency costs, given management’s self-interest and the monitoring challenges faced by diffuse public shareholders. These concerns feature most prominently in the fiduciary duty doctrines that address defensive measures against an unsolicited takeover offer or a control contest through the proxy system.  Controlling entrepreneurs present a quite different set of challenges for corporate law and governance. Controllers may limit managerial agency costs, but their self-interest produces so-called controlling shareholder agency costs.[2]

Alongside the rise of a new class of controllers has been a fundamental change in capital markets: the rise of portfolio investing, whether through asset managers or self-help portfolio construction, that captures the insight that investors can achieve higher risk-adjusted returns through a strategy of diversification that smooths out firm-specific risk.[3]   A specialized financial intermediary, the asset manager, has exploded in significance.[4]

These capital market developments came to the Delaware courts this year in a way that produced a series of unusually important cases:  In re Match Group, Inc. Derivative. Litig.[5] arguably expanded the range of controller-driven transactions that require heightened procedural measures to achieve business judgment rule protection;  Tornetta v. Musk[6]  looked beyond a bright-line test of equity ownership percentage in deciding whether a CEO had “control;” and  W. Palm Beach Fire Fighter’ Pension Fund v. Moelis & Co.[7] held that control-shifting shareholder agreements were inconsistent with board-centric provisions of Delaware law.  Moelis was subsequently overruled by legislative amendment.[8]

Finally there was McRitchie v. Zuckerberg,[9] holding that a company’s board and officers are not obligated as a matter of fiduciary duty to pursue a strategy that would accommodate the purported  interests of the company’s shareholder majority of fully diversified investors (“portfolio investors”) in reducing externalities but rather should pursue a “single firm” or “firm-specific”  strategy. This outcome is hardly a surprise, but the broad phrasing of the opinion casts some unwonted shade on the also axiomatic obverse proposition – that a board may, shielded by the business judgment rule, take account of the interests and desires of the dominant portfolio investors in pursuing a business strategy.  It is directors’ discretion shielded by the business judgment rule but subject to the legitimating acquiescence of shareholders that is Delaware’s gift to the current debate over corporate behavior.  As a bonus, although rejecting compulsion by judicial fiat, the court sketches explicit private-ordering routes under Delaware law to compel management of the firm, as a fiduciary duty matter,  in light of the interests of fully diversified investors.  The opinion includes a cautionary reflection on the limits of corporate law, at least the law of a single small state, as a lever for the pursuit of pro-social objectives.  This is the recent case that I think offers the deepest dive into the possibilities and limits of Delaware corporate law.

Compliments must be paid to the cleverness of the McRitchie complaint in two respects.  First, it argues that the traditional framing of the directors’ duties in terms of “the corporation and its shareholders” means that at least in cases where the shareholder majority is fully diversified portfolio investors, the directors and officers need to manage by taking account of those shareholders’ portfolio interests. Second, because the directors and officers and controlling shareholder have concentrated investments in the specific firm – here Meta—their interests conflict with the interests of the portfolio investors, and thus they bear the burden of showing “entire fairness” in their chosen strategy.

The court rejects plaintiff’s first move as a kind of a pun.  “The corporation and its shareholders” necessarily refer to shareholders in the single firm model, and no one would think otherwise, much as a fish has no concept of an environment other than “water.”[10] The court handles plaintiff’s second move with a jujitsu sidestep, arguing that the equity interests held by Zuckerberg, the officers and the directors actually align their interests with their fiduciary duties as seen from the firm-specific perspective.

But of course there is a conflict, as there is with virtually every situation of a controller, who directly or indirectly will extract some private benefits of control.  A permissible level of private benefit extraction is explicitly and implicitly allowed in the cases.  Explicit private benefit extraction is at the core of the seminal case of Sinclair Oil Corp. v. Levien,[11] in which the Sinclair parent used its control over its partially owned Venezuelan subsidiary Sinven to produce a dividend payout of virtually all Sinven’s profits, which had the effect of denying Sinven the freedom to pursue energy opportunities outside of Venezuela.  Because the dividends were paid out pro rata – one share, one dollar – the Delaware Supreme Court held that the dividend payout decision was not “self-dealing” and was subject to permissive business judgment review.  By contrast, the cancelling of a contractual obligation owed by Sinclair to Sinven – which would have resulted in disparate pecuniary treatment – was self-dealing and thus triggered “entire fairness” review.  It is of course plain that in resolving the conflict of interest between the controller and the public minority shareholders, the court rejected the “firm specific” test.  The dividend payout did not maximize Sinven’s value as a public company.  Nor as a normative matter should this necessarily trouble us.  As Gilson and Gordon (2003) argue, this deviation in favor of the controller reflects an allowable level of private benefits that would compensate the (undiversified) controller for extra risk-bearing while providing a benefit to the public (diversified) shareholders in the control of managerial agency costs.[12]

Implicit private benefit extraction is at the core of Mendel v. Carroll.[13]  The controlling Carroll family made a take-private proposal for Katy Industries at a price negotiated with the special committee of $25.75 per share, thus presumably triggering the board’s Revlon duty to obtain the highest value for shareholders. Overbidders arrived. The Pensler-Steinhardt group offered $27.80 per share for all shares and asked for an option exercisable at the deal price that would enable it to prevail over the expected opposition of the Carroll family.  The Carroll family withdrew its proposal, and the court refused to order the board to grant the dilutive option.

Chancellor Allen decided against granting the injunction on the ground that the Carroll family simply valued its control block at more than $25.75 a share.  Perhaps the family had private information about the value of the firm, but this presumably would have been elicited in the special committee’s scrutiny of the initial take-private offer. Instead, the family valued the pecuniary and non-pecuniary private benefits of control by more than the offered price.[14]

In short, we are far from assuming there is no conflict between controllers and public shareholders just because the controller owns shares.  Moreover, validating the controller’s utility function would not necessarily produce the highest value from a firm-specific perspective. [15]

Maybe we can put aside the controller cases on the ground that the conflicting shareholder interests in these cases are still about allocation of the pecuniary and non-pecuniary elements flowing from the specific firm and not about increasing the value of other investments of the controller.   But this doesn’t do justice to the objection.  Sinclair wanted the dividends from Sinven precisely because it wanted to make investments elsewhere in its portfolio of opportunities. Controllers commonly control dividend payouts (or stock repurchases) with the rest of their portfolio in mind.

Thus the controller cases show us that the court is incorrect about the incentive alignment of the controller’s stock ownership and also about the demands of a single-firm approach. But those cases show that the plaintiff is wrong too. The corporate world is filled with cases in which controllers bring a multi-dimensional objective function to the operation of the firm, but those decisions are routinely thought of as presenting business-judgment-rule questions only, assuming no blatant skewing of pecuniary payouts.[16]

The court cites many cases of different scenarios that employ specific-firm rhetoric, more obviously prioritizing the interests of shareholders over stakeholders (as in Revlon) but implicitly seeming to rule out consideration of the shareholders’ other investments. As a doctrinal matter, this may be mechanically accurate but functionally wrong.

Let’s take the easiest case, the forms of corporate governance.  Firms typically adopt governance attributes (e.g., single class board; annual say-on-pay; various board committees and leadership structure) because these are regarded as “best practices” by fully diversified shareholders looking to maximize performance across a portfolio of firms without the costly work that would be required for firm-specific tailoring.[17]  Boards commonly acquiesce to such shareholder preferences even when they subjectively believe that alternative arrangements would be superior on a single-firm basis.

More fundamentally, firms pick their business strategies to accommodate the interests of shareholders who they know are diversified portfolio investors.

This is how I have developed the point previously:

We have also accepted without question allowing the risk preferences of diversified investors to shape our theory of optimal firm structure in a way that has firm-specific consequences.[18] Diversification at the portfolio level means that such shareholders disfavor diversification at the firm level, biasing the firm against conglomeration and other diversification measures that may reduce the financial distress risk at the own-firm level and may thus increase costs for the undiversified shareholders.  Diversified investors encourage risk taking at the firm level to maximize own-firm expected returns, despite the greater own-firm solvency risks, on the view that this strategy will increase expected returns across the portfolio. As part of this approach to risk, diversified investors push for cash distributions despite the increased own-firm risks. Portfolio investors are not mere kibitzers with talking points; their support is a crucial factor in the success of hedge fund activists who commonly push these strategies on target firms.[19] The say-on-pay mechanism is another vehicle by which portfolio investors promote the pursuit of a particular strategy of maximization.

These theoretical understandings do not obligate the directors or officers as a matter of fiduciary duty to follow (or avoid) particular business strategies in their management of the firm, but the observed pattern of M&A activity (including divestitures) shows how directors and officers have chosen to accommodate the objectives of portfolio investors. Inevitably there will be a conflict between the interests of diversified and undiversified investors on this dimension.

It turns out that a portfolio approach is embedded at the core of ‘shareholder wealth maximization,” as it is commonly understood, in light of how portfolio theory is critically involved in stock price formation.[20]Modern Portfolio Theory holds that investors are compensated for bearing risk, but only for risk that cannot be diversified away.[21]  This is operationalized through specific pricing models like the well-known “Capital Asset Pricing Model” (“CAPM”). Thus market prices of specific securities are set on the assumption that investors are holding such shares in a well-diversified portfolio.  Firms trying to “maximize shareholder value” will avoid unrelated diversification, the effect of which may be to reduce own-firm risk but at cost of local inefficiencies in managing a conglomerate enterprise, resulting in a stock price penalty.  This follows from a price formation process that assumes idiosyncratic risk can be substantially eliminated through portfolio diversification.  More generally, when managers are trying to “maximize shareholder value” for a widely held public company they cannot escape the portfolio structure of share ownership and will almost invariably be acting at the behest of portfolio investors.

In short, what may serve the interests of portfolio investors will often disserve the interests of the undiversified. In this important respect, there is no such thing as a “single firm focus.”[22] Rather, at most it is what could be described as a “single firm focus constrained by awareness that the majoritarian shareholders are portfolio investors and their interests are best served by a firm strategy that in significant respects takes that fact into account.

But perhaps there is less conflict than one might think between maximizing on a firm-specific basis and taking account of the objective function of portfolio investors.  If pricing of the firm’s stock is embedded in Modern Portfolio Theory, then running the firm in accord with the preferences of portfolio investors may well produce the highest stock price. But note, while this might produce the best risk-adjusted returns for the portfolio investor, it will not for the undiversified investor, who may have a substantial investment in the specific firm.

So this conclusion follows: The doctrinal framing of the board’s role in terms of a single-firm model casts a veil over how board decisions are commonly made, which takes account of the desires and interests of the firm’s dominant, sometimes controlling but sometimes fully diversified, shareholders.

The McRitchie court is plainly correct that a board cannot be compelled, as a matter of Delaware fiduciary law, to take account of the   interests of diversified investors in the management of the firm, particularly as regards externalities and even patently obvious systemic externalities such as climate change.  But the court’s rhetoric goes too far in its insistence on an exclusively firm-specific focus.  Surely the firm can seek to avoid externalities, including the systemic externalities that diversified investors will be keenest to avoid. Delaware fiduciary law does not require profit maximization at the cost of what the board determines are externalities that it wants to avoid.  More generally the board has freedom under the umbrella of the business judgment rule, certainly if framed as in consideration of the long term as well as the short term, to take into account the pecuniary and non-pecuniary interests of the actual shareholders of the company.

So if the board can consider the interests of the shareholders who are controllers, it ought to be able to consider the interests of the shareholders who are diversified portfolio investors.  As noted above, this already occurs.  The key question is preserving the legitimacy of directors in taking these actions.  This is why the integrity of shareholder voting is critical and must be protected. This has been acknowledged in Delaware, most recently in the striking down of anti-activist pills[23] but also more broadly.[24]

At the end of McRitchie v. Zuckerberg, Vice Chancellor Laster plays a trump card in turning down plaintiff’s request for an injunction that would impose affirmative duties on a board and management to reduce externalities. Such a mandatory approach is not sustainable, he says. Objecting corporations and shareholders would simply leave.  Delaware corporate law does not provide the lever to force corporations to take what at least some shareholders regard as a more pro-social approach.

For scholars of corporate law and governance VC Laster’s final paragraphs on the plaintiff’s claim are sobering:

By explicitly rejecting the notion that a board of directors can act loyally when consciously deciding to violate positive law in pursuit of greater profits, Delaware ensures that positive laws and regulations have bite. Through those laws and regulations, governments can impose meaningful restrictions on externalities. Through its corporate law, Delaware supports those efforts.

It is frankly difficult for Delaware to use corporate law to do more. Reformers who look to Delaware law to address externalities must acknowledge the larger political environment.  Delaware is one of fifty states, each of which can offer entities embodying different corporate law packages. Delaware is not California. Among the fifty states, Delaware has one of the smaller human populations (only around one million souls), one of the smallest geographical areas (albeit conveniently located), and a relatively small economy (though mighty in spirit). Delaware does not have the market power to force anyone to use its corporations, its law, or its courts. Delaware must identify niches where it has a comparative advantage—like corporate law—so that entrepreneurs want to use its corporations, legal practitioners want to choose its law, and parties want to litigate in its courts.

Delaware has traditionally filled the corporate law niche by taking a distinctively nonpartisan, technocratic approach.  Delaware seeks to supply corporate practitioners with a flexible legal framework, broadly enabling in character but subject to some mandatory floors, that gives managers (framed broadly) expansive discretion to take risks and pursue profit, while at the same time protecting the legitimate rights and expectations of investors.

Delaware has not used its corporate law to address hot-button social issues or to intervene in societal debates. Depending on an observer’s political leanings, there are any number of salient issues that Delaware might use its corporate law to address. But to the extent the General Assembly sought to intervene on any of them, entrepreneurs who did not like the answer could incorporate their firms elsewhere. Strong externality regulation is just one example. If the General Assembly sought to make Delaware the externality regulatory for the country (or the world), corporations who did not agree could readily opt out.

The lesson is a broader one. State-based corporate law in general, and Delaware law in particular, is a poor vehicle for addressing externalities. Delaware law mandates that its entities and the fiduciaries who manage them comply with positive law. That legal requirement promotes legal compliance in its own right, while also providing a mechanism for holding fiduciaries accountable when they knowingly cause an entity to violate positive law. To ask more from state-based corporate law is to pick the wrong tool for the job.[25]

So: “’Delaware law does not charter law breakers,”’[26] and officers and directors may incur liability in a derivative suit if they intentionally violate the law, and, it seems, if they egregiously fail in their oversight duty with respect to compliance.  In this way Delaware corporate law sails parallel to the democratic process that enacted these laws. In In re Match Group, Inc. Derivative. Litig and in Tornetta v. Musk, we learned that Delaware facilitates shareholder democracy by relying on shareholders to determine the decision rule in a contested fiduciary duty case where, but only where, appropriate disclosure and process have been followed.  In McRitchie v. Zuckerberg we learned that the court will honor shareholder decisions to redraw corporate purposes and the board’s duties in the corporation’s foundation documents but will not “blue pencil” those measures through law-like imposition. While Delaware corporate law is not a tool to compel what some might regard as pro-social behavior (other than compliance with law),Delaware would permit directors broad discretion in deciding which externalities to address and to what extent and would treat this permission as subject not to judicial review but to shareholder acquiescence. That leaves ample space for shareholders to petition, for directors to act, and for shareholders, through the processes of corporate democracy, to have the last word.

ENDNOTES

[1] Zohar Goshen & Assaf Hamdani, Corporate Control and Idiosyncratic Vision, 125 Yale L. J. 560 (2016).

[2] See generally Ronald J. Gilson & Jeffrey N. Gordon, Controlling Controlling Shareholders, 152 U. Pa. L. Rev. 785 (2003).

[3] See Ronald J. Gilson & Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights, 113 Colum. L. Rev. 863, 884-86 (2013); Jeffrey N. Gordon, Systematic Stewardship, 47 J. Corp. L. 627, 628-29 (2022).

[4] See, e.g., Dorothy S. Lund, Asset Managers as Regulators, 171 U. Pa. L. Rev. 77 (2022).

[5]  315 A.3d 446 (Del. 2024) (applying freeze-out merger validation standard to a corporate spin-off).

[6] 310 A.2d 430 (Del. Ch.2024).

[7] 311 A.2d 809 (Del. Ch. 2024).

[8] See Del. Gen’l Corp Law §122(18) (adopted by S.B. 313, 152d Gen Assembly (Del. 2024). For  a skeptical view, see Marcel Kahan & Edward Rock, Proposed DGCL §122(18), Long-Term Investors, and the hollowing Out of DGCL §141(a), https://corpgov.law.harvard.edu/2024/05/21/proposed-dgcl-%C2%A7-12218-long-term-investors-and-the-hollowing-out-of-dgcl-%C2%A7-141a/ (May 21, 2024).

[9] 315 A.3d 518 (Del Ch. 2024).

[10] The irony in the vice chancellor’s citation to David Foster Wallace’s Kenyon Commencement Address, https://fs.blog/david-foster-wallace-this-is-water/, is that Wallace’s point was to urge his audience to question that which seems so obvious. “[T]he real value of an education … has almost nothing to do with knowledge, and everything to do with simple awareness: awareness of what is so real and essential, so hidden in plain sight all around us, all the time, that we have to keep reminding ourselves over and over: ‘This is water. This is water’.”

[11] 280 A.2d 717 (De. 1971).

[12] See Gilson & Gordon, supra  n. 2.

[13] 651 A.2d 297  (Del. Ch. 1994).

[14] The value of these implicit private benefits means that a controller can conclude a take-private transaction at a lower price than an outside bidder would offer for all shares (assuming appropriate procedural measures).  See In re Books-A-Million, Inc. Shareholder Litigation, 2016 WL 5874974 (Del. Ch. 2016) (Laster, VC), aff’d 164 A.3d 56 (2017) (Table).

[15] A numerical example shows the point. Assume the target has 100 shares outstanding.  Controller owns 50, the public owns 50, the stock trades at $10 per share, based on the company’s expected future cash flows.  The controller deems its private benefits are worth $1.50 per share.  A prospective bidders believe it can improve the company’s operations by 10 percent and so is prepared to bid up to $11 a share for all shares.  The controller refuses, even though the company would, on a cash flow basis, be more valuable after the transaction.

[16] The complaint is oddly framed in terms of externalities without any obvious connection to a portfolio investor’s pecuniary interests. It maybe that Meta’s engagement algorithms produce socially harmful behaviors and may spread misinformation that affects elections or disrupts teenage sociability. The impact on the economy and thus the other stocks in the investor’s portfolio is far from clear. There is nothing about the fact of portfolio investing that would necessarily incline such an investor to be more concerned about such harms than an undiversified Meta investor; the reverse seems more likely since the undiversified investor may feel more responsibility for Meta’s conduct.

[17] I develop this point in some detail in Systematic Stewardship: It’s Up to the Shareholder: A Response to Profs. Kahan and Rock, 48  J. Corp. L. 101, 103-04 (2023).

[18] Id. at 104.

[19]  See Anna L. Christie, The New Hedge Fund Activism: Activist Directors and the Market for Corporate Quasi-Control, 19 J. Corp. L. Stud. 1, 9 (2019) (discussing how institutional investor support – i.e., portfolio investors – are a necessary component to a hedge fund activist’s success).

[20] These next paragraphs track Systematic Stewardship Response, supra note. 17.

[21] See generally Richard A. Brealey et al., Ch 8.1–8.3, Portfolio Theory and the Capital Asset Pricing Model, in Principles of Corporate Finance,  198, 198–213 (13th ed. 2020); Ronald J. Gilson & Bernard S. Black, The Law and Finance of Corporate Acquisitions, 101, 101–134 (2d ed. 1995).

[22] Kahan & Rock, supra note 2, at 500.

[23] In Re Williams Companies Shareholder Litigation, 2021 WL 754593 (Del. Ch. Feb. 26, 2021), aff’d sub nom. Williams Cos. v. Wolosky, 264 A.3d 641 (Del. Nov. 3, 2021) (unpublished table disposition) (mem.).

[24]  Coster v. UIP Cos., 255 A.3d 952 (Del. 2021).

[25] McRitchie,  315 A.3d 518, at 572-73.

[26] Id. at 572, quoting In re Massey Energy Co., 2011 WL 2176479, at *20 (Del. Ch. May 21, 2011) (Strine, J.).

This piece comes to us from Jeffrey N. Gordon, the Richard Paul Richman Professor of Law at Columbia Law School. He appreciates comments from Vice Chancellor Laster and Igor Kirman.  He also appreciates helpful discussion at a roundtable on recent developments in Delaware corporate law organized by Profissor Dorothy Lund and sponsored by the Millstein Center for Global Markets and Corporate Ownership.