Corporate Control and the Limits of Judicial Review

Zohar Goshen is the Jerome L. Greene Professor of Transactional Law at Columbia Law School and Assaf Hamdani is Professor of Law at Tel Aviv University. This post is based on their 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 The Untenable Case for Perpetual Dual-Class Stock (discussed on the Forum here) and The Perils of Small-Minority Controllers (discussed on the Forum here), both by Lucian Bebchuk and Kobi Kastiel.

In 2012, Google’s board approved a proposal amending Google’s charter to authorize the issuance of a new class of nonvoting Class C stock. Prior to this proposed recapitalization, Google’s capital structure was comprised of one-vote-per-share Class A shares, primarily held by public shareholders, and ten-votes-per-share Class B shares, primarily held by Google’s founders, Larry Page and Sergei Brin. Under this dual-class structure, Google had the ability to raise capital, incentivize employees, and acquire other corporations, by issuing Class A shares, while preserving control over the company in the hands of Class B shareholders. However, this strategy faced an upper limit–––if enough Class A shares were issued, eventually the voting power of Class B shares would be diluted to the point of the founders losing control. The recapitalization allowed Google to issue as many Class C nonvoting shares as it deemed necessary, without ever threatening to dilute the founders’ control. This move, therefore, reallocated control rights from the public shareholders to the company founders, and enabled the founders to keep their control over the company even as it continues to issue new shares.

Class A shareholders challenged the recapitalization by filing lawsuit in Delaware, arguing that the recapitalization amounted to “self-dealing” that should be reviewed under Delaware’s long-standing regime of entire fairness. The Google defendants, however, claimed that the decision ought to receive the deferential business judgment protection. The parties settled, and the Google litigation left unanswered the key doctrinal question as to whether entire fairness, business judgment, or some intermediate level of scrutiny is the appropriate standard of review for “midstream” reallocations of control rights. Other firms announced midstream recapitalizations from dual-class to triple-class structures after the Google settlement. Facebook and InterActiveCorp (IAC) announced plans to create a new class of nonvoting stock. Both companies, however, withdrew their recapitalization plans after they were sued by shareholders who argued that these recapitalizations amounted to unfair self-dealing.

These cases raise a fundamental question at the heart of corporate law: What is the appropriate standard of review for conflicts over the reallocation of control rights at controlled companies? While a long line of Delaware case law has addressed disputes over various forms of midstream reallocations of control rights, the Delaware courts have not yet adopted a clear approach concerning the standard of review that applies to these reallocations of control rights.

This paper argues that the legal framework that governs controlling shareholders’ self-dealing—the entire fairness analysis—cannot and should not be applied to conflicts over the reallocation of control rights. Entire fairness review explicitly requires courts to make an objective determination of the “fair price” of the transaction at issue. Economists have developed valuation models for many types of cash-flow rights, like specific assets and entire companies, that aid courts in determining fair price. However, similar economic models for valuing the reallocation of control rights simply do not exist. Moreover, this Article posits that developing an economic model that objectively values the reallocation of corporate control rights is an inherently futile task because the value of control rights is firm-specific and individual-specific. Economic theory is capable of abstracting away from specific attributes of an asset (such as a factory) in order to approximate the value of that asset. Yet economic theory could not abstract away from the specific firm and the specific personality of a controller (such as Mark Zuckerberg or Sergei Brin) without excluding from the valuation analysis the very specific characteristics that make control valuable in that particular controller’s hands.

Without a reliable valuation model, Delaware’s entire fairness framework breaks down: Not only will ex post judicial determinations of “fair price” be impeded by the impossibility of reliably pricing corporate control rights, but also ex ante attempts to secure minority shareholder approval will be thwarted by the lack of a reliable valuation backstop.

In light of the impossibility of valuing control rights–––and consequent courts’ inability to apply entire fairness review–––how should courts regulate conflicts over reallocation of control rights? The allocation of control rights raises an inevitable tradeoff between investors’ protection from agency costs and the controller’s ability to pursue its idiosyncratic vision, thus making the value of different allocations of control rights both firm-specific and individual-specific. The parties—controlling shareholders and minority shareholders—are best left to agree ex ante on the voting rule that will govern midstream reallocations of control rights. Therefore, courts’ principal task should be to determine whether the controller can reallocate control rights without receiving the approval of the minority shareholders. Delaware courts should then defer to the arrangements on which the parties had initially agreed, and forego any attempt to evaluate the fairness of reallocation of control rights. As long as the charter grants the controller the power to reallocate control rights, courts should apply the business judgment rule to a controller’s choice to recapitalize. All other methods will fail in the absence of objective valuations.

In defending this view, this paper argues that the approach not only avoids costly litigation and the valuation issues implicated by control rights, but also encourages clear drafting of the initial allocation of control rights in the corporate charter. And where the charter does not provide an answer, courts should craft a default rule that balances the potential loss of idiosyncratic vision (which results from giving the minority reallocation authority) with the potential increase in agency costs (which results from giving the controller reallocation authority). The inherent tradeoff between agency costs and idiosyncratic vision cannot be resolved as a matter of theory or empirics. Yet, Delaware’s longstanding pre-Google precedents preferred the protection of idiosyncratic vision by granting controllers business judgment rule protection in midstream reallocations of control rights. Studies of market performance and changing market realities all weigh against changing the prevailing default rule.

The complete paper is available here.

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