Controlling shareholders deserve particular attention in M&A because they may have acute conflicts of interest.
To be sure, notwithstanding the presence of a controlling shareholder, every merger and most other steps in an M&A transaction still need to be reviewed by the full board, whose members may not have the same conflict of interest (in particular, the controlling shareholder may not be a member of the board). Technically, the board may recommend the transaction only if it is good for the corporation as a whole. But even if all directors are technically completely independent, the directors must also be aware that the controlling shareholder could replace them at any moment (under the default rules, DGCL 141(k), 228; but even a staggered board etc. would merely delay the replacement). There is thus always a suspicion that the board may be driven to be partial to the controlling shareholder’s interests.
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|1||Show/Hide More||Squeeze-outs / Going-privates|
In a squeeze-out a/k/a cash-out merger, a controlling shareholder acquires complete ownership of the corporation’s equity, squeezing/cashing out the minority. Technically, the transaction is structured as a merger between the controlled corporation and a corporation wholly-owned by the controlled corporation’s controlling shareholder. The controlling shareholder retains all the equity of the surviving corporation, while the merger consideration for the outside shareholders is cash (or something else that is not stock in the surviving corporation). If the controlled corporation was previously publicly traded on a stock exchange, the transaction is also known as a going private merger because the surviving corporation will no longer be public, i.e., it will be delisted from the stock exchange.
There can be good economic reasons for a squeeze-out. It facilitates subsequent everyday business between the controller and the corporation, among other things because there are no more conflicts of interest to manage (cf. Sinclair). Private corporations do not need to make filings with the SEC and the stock exchange. Finally, the controlling shareholder may be more motivated to develop the corporation's business when owning 100% of it.
At the same time, squeeze-outs pose an enormous conflict of interest. Any dollar less paid to the minority is a dollar more to the controlling shareholder. For this reason, the SEC requires additional disclosure under rule 13e-3, and Delaware courts police squeezeouts under the duty of loyalty. In fact, controlling shareholders' duty of loyalty was developed principally in squeeze-out mergers, in particular the adaptation in Kahn v. MFW below.
Question: Can you think of another, procedural reason why squeeze-outs generate most duty of loyalty cases against controlling shareholders in Delaware courts? Hint: Consider Aronson and its scope of application.
|1.1||Show/Hide More||Weinberger v. UOP, Inc. (Del. 1983)|
This decision introduced the modern standard of review for conflicted transactions involving a controlling shareholder. We could have read it in the general Duty of Loyalty section above, but I wanted you to read it together with the next two cases.
Review questions (answer now or while reading the opinion):
Check your understanding:
|1.2||Show/Hide More||Glassman v. Unocal Exploration Corp. (Del. 2001)|
|1.3||Show/Hide More||Kahn v. MFW (Del 2014)|
1. What standard of review does the court apply? Is it different from the cases we had seen thus far?
2. How does the court want to protect minority shareholders? Does it work? Does it work better than alternatives?
3. Why did this case proceed to summary judgment, whereas the complaint in Aronson was dismissed even before discovery? Hint: under what rule was Aronson decided, and did that rule apply here?
|2||Show/Hide More||Sales of Control|
When the controlling shareholder is not buying but selling, a different problem arises: The controlling shareholder may sell control to a buyer who makes the minority shareholders worse off.1 Concretely, upon assuming control, the buyer might divert more value from the corporation than the seller did, be it through self-dealing transactions or by failing to develop the corporation’s business (e.g., imagine the buyer is a competitor of the acquired corporation or of one of its major clients). Technically, such diversion would violate the buyer’s duty of loyalty, but enforcement is always imperfect.2 Such diversion might even be the business rationale for the sale: the buyer might be able to pay more than the controlling shareholder’s valuation of the control block precisely because the buyer plans to divert more value. To guard against this possibility, many jurisdictions around the world, such as the UK, require the buyer of a control block to offer to buy out all minority shareholders at the same price. The U.S., however, does not have such a mandatory bid rule – control blocks in U.S. corporations can be bought and sold freely without having to deal with the minority stockholders at all, short of selling to a “known looter.”3
One reason not to have a mandatory bid rule is that it creates problems of its own when the buyer is benign, i.e., when the buyer does not divert value, or at least not more than the seller. If the buyer has to offer the same price to everyone, it has to pay everyone as much as it pays the selling controlling shareholder. But the controlling shareholder owns more than the minority shareholder: it has control, which it may value either because it allows diversion of pecuniary benefits, and/or simply because it (or now I should say: he or she) enjoys being in charge. And the controlling shareholder will refuse to sell unless it/he/she is fully compensated for giving up control. So paying the same to the controlling shareholder and to the minority on a per share basis probably means overpaying the minority – and possibly means overpaying for the firm as a whole. Since buyers cannot be expected to overpay, the deal may simply fall through. As a result, insisting on equal treatment may end up hurting everyone, including the minority shareholders.
To illustrate, consider the following numerical example. Imagine a firm with 100 shares outstanding that is worth $125 in total under the current governance arrangements. It has a controlling shareholder who holds 10 shares (= 10% of the equity) but enough votes for control (e.g., through a dual class arrangement). The controlling shareholder diverts 20% of the firm's value ($25) to herself in private benefits.4 In addition, the controlling shareholder gets 10% of the remaining value by virtue of her equity stake. Her total stake is thus worth $25 + 10% × ($125-$25) = $35 to her. Minority shareholders get the rest: $125 – $35 = $90, or $1 per share (there are 100 shares total, and the controlling shareholder owns 10 of them). Now imagine a sale under a mandatory bid rule. The controlling shareholder will accept an offer only if the per share price P gives her more than what she gets without the deal: 10 × P > $35, or P > $3.50. At P > $3.50, the minority shareholders will obviously accept the offer, since the status quo value of their shares is only $1. Consequently, all shares will be tendered, and the acquirer will have to pay 100 × P > 100 × $3.50 = $350 for the firm. This will only be worthwhile for the acquirer if the firm is worth more than $350 to the acquirer, i.e., more than 2.8 times the status quo value. Such buyers will be rare. By contrast, without the mandatory bid rule, any buyer to whom the firm is worth more than $125 could make an offer that makes everyone better off: for example, a buyer valuing the firm at $125.03 could pay $35.01 to the controller (= $3.501 per controller share), $90.01/90 for each minority share (= $1.0001 per minority share), and still make a $0.01 profit. In short, even the minority shareholders might be better off if the controlling shareholder is allowed to get a control premium.
1 By definition, the controlling shareholder owns and can thus sell enough shares to convey full control to a buyer. Absent special rules, the controlling shareholder can therefore transfer control without the minority’s consent.
2 In particular, the controlling shareholder may find a majority of nominally independent but servile directors to approve self-dealing transactions other than mergers. Review question: Why will this be enough to isolate the transactions from judicial review?
3 See Harris v. Carter, 582 A.2d 222, 235 (Del. Ch. 1990, per Allen Ch.): “while a person who transfers corporate control to another is surely not a surety for his buyer, when the circumstances would alert a reasonably prudent person to a risk that his buyer is dishonest or in some material respect not truthful, a duty devolves upon the seller to make such inquiry as a reasonably prudent person would make, and generally to exercise care so that others who will be affected by his actions should not be injured by wrongful conduct.”
4 This could be $25 in cash through a transfer pricing scheme etc., or simply a psychic benefit of being in control that the controlling shareholder values at $25 – that, too, is value. In the latter case, you should think of the firm as generating $100 in financial value plus $25 in psychic value.
|2.1||Show/Hide More||In re Delphi Financial Group Shareholder Litigation (Del. Ch. 2012)|
This decision involves a target with a controlling stockholder, Rosenkranz. The decision revolves around Rosenkranz’s attempt to obtain a higher price for his shares than for the minority shares.
As you read the decision, consider the following questions:
1. Ex ante, what did Rosenkranz promise to do in a future sale, according to the court? Why do you think he would have made this promise?
2. Ex post, was this promise economically enforceable? In particular, could Rosenkranz be forced to agree to a sale in the first place? How did the court deal with this here?
3. What rule would have governed in the absence of an explicit charter provision?
4. Did Rosenkranz in fact promise what the court says he promised?
5. Bonus question: Could Rosenkranz have amended the charter provision in question without the approval of the minority shareholders? Cf. DGCL 242(b)(2).
December 12, 2017
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