The Insignificance of NRG Yield

Itai Fiegenbaum is a Fellow at the Harvard Law School Program on Corporate Governance. This post is based on his recent paper, and is part of the Delaware law series; links to other posts in the series are available here.

Related research from the Program on Corporate Governance includes Independent Directors and Controlling Shareholders by Lucian Bebchuk and Assaf Hamdani (discussed on the Forum here).

The pathologies of influential corporate insiders with a significant equity stake were on full display during Oracle’s 2016 acquisition of industry rival NetSuite. Larry Ellison, Oracle’s long-time Chief Executive Officer and dominant figure, played a major role in choosing the acquisition target. Normally, Ellison’s involvement should lay to rest any doubts entertained by Oracle shareholders regarding the deal’s wisdom.

Unfortunately for Oracle’s shareholders, one noteworthy detail portrays the acquisition in a different light. At the time the deal was proposed, Ellison owned 45% of NetSuite’s stock. The conflicting ownership stakes questions Ellison’s singular devotion to maximizing Oracle’s value. Although Ellison’s Oracle stock would depreciate if the transaction was skewered in NetSuite’s favor, the concurrent rise of value in his NetSuite stock would more than make up for it. Oracle’s minority shareholders do not enjoy a similar opportunity to offset their losses.

Delaware’s framework for minimizing the risks posed by controlling shareholder self-dealing transactions is well established. Private litigation initiated by disgruntled shareholders remains the primary avenue used to enforce fiduciary obligations. Partly because of the litigation agency costs that result from irrefutable entire fairness review, and partly because of the increased validity of alternative market forces for policing abuse, Delaware has gradually accepted corporate “self-immunization” measures as an alternative to heightened judicial review. In what has already become a modern classic, the Delaware Supreme Court provided a framework that would allow for a more lenient standard of review for going private transactions orchestrated by controlling shareholders. Under the MFW framework, effective use of both an independent director committee and informed approval by a majority of minority shareholders allows for the application of defendant-friendly business judgement rule review.

This backdrop illuminates an overlooked aspect of the NetSuite acquisition. Providing a framework for avoiding entire fairness review was intended to incentivize transaction planners to subject the deal to MFW’s double approval mechanism. The supercharged rate of voluntary adoption indicates that MFW achieved its goal with regards to going private transactions. And yet, both components of the double approval mechanism were virtually ignored by Oracle. The constitution and composition of Oracle’s Special Committee was inconsistent with the teachings of the MFW framework. Oracle’s shareholders were never presented the opportunity to vote on the transaction.

Contemporary legal proceedings suggest that Oracle’s questionable adherence to the MFW guidelines is indicative of a blind spot in the regulation of a large subset of controlling shareholder self-dealing transactions. The NetSuite acquisition, Tesla’s SolarCity acquisition, and the continued compensation for CBS’ arguably incapacitated controller share the conceptual designation of a going concern related party transaction.

Going concern self-dealing transactions differ from going private transactions by their effect on minority shareholders. A successful going private transaction concludes with the elimination of the minority float. By contrast, going concern transactions have no bearing on minority shareholders’ continued ownership rights. However, since the motivating concern in both types of transaction is ostensibly the same, a recent Chancery Court decision explicitly extends the MFW framework to apply in the going concern context as well.

There is no doubt that the expansion of the MFW framework is informed by the desire to provide effective protection for minority shareholders. Unfortunately, the analysis overlooks the different litigation mechanisms that are unique to each transactional setting. A simple extension of the MFW framework to the going concern context ignores the motivating factors that ensure voluntary adoption for future going private transactions.

My paper, Chronicle of Failure Foretold: Controlling Shareholder Enforcement and the Insignificance of NRG Yield, sounds the alarm on the underenforcement of controlling shareholder going concern transactions. The conclusion stems from the disparate litigation procedures and their impact on the enforcement environment for controlling shareholder related party transactions. Shareholders wishing to pursue a claim for a going private transaction are afforded a clear path to the courthouse. By contrast, challenges against going concern transaction face daunting procedural hurdles.

The plaintiffs’ bar is the unquestioned engine for shareholder representative litigation. The transaction-specific litigation avenue influences the cost-benefit analysis undertaken by contemplating shareholders and counsel. Substantial procedural impediments, coupled with a lack of readily-available information necessary to formulate a claim, discourage initiating litigation against even objectively harmful going concern transactions with a controlling shareholder. A more inviting litigation environment ensures a steady stream of complaints against going private transactions instigated at the behest of the controller. While this stream may have trickled down (or partially migrated elsewhere) following Delaware’s recent crack-down on meritless litigation, institutional features ensure that litigation will continue against blatant over-reaching in going private transactions.

The ebb and flow of private enforcement plays a critical role in the development and continued utility of the MFW doctrine. An over-abundance of lawsuits against going private transactions created the demand for a self-immunization mechanism as a substitute for exacting judicial review. As this mechanism is not codified by statute, transaction planners will continue to comply with the framework only if the aggregate benefits outweigh the loss in transaction costs and deal certainty. The ever-present threat of a lawsuit ensures that voluntary adoption of the MFW framework remain the rational choice for going private transactions.

The procedural obstacles inherent in the litigation of going concern transactions produce a vastly different dynamic. Relaxed private enforcement shields even objectively harmful going concern transactions from judicial oversight. Without a tangible threat of a lawsuit to coax voluntary compliance, transaction planners have nothing to gain by subjecting the deal to the MFW gauntlet. The result is that a large swath of potentially harmful transactions evades both court scrutiny and meaningful corporate self-immunization measures. The troubling transactions depicted in this post foretell a troubling fate for similar transactions at less litigation-enticing targets. Worse yet, the latest superficial step towards improved minority shareholder protection stifles the discussion on additional reform.

The complete paper is available here.

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