Controlling controlling shareholders.

• Author: Gilson, Ronald J.
• Position: Symposium: Corporate Control Transactions

INTRODUCTION

The rules governing controlling shareholders sit at the intersection of the two facets of the core agency problem in United States public corporations law. The first is the familiar principal-agency problem that arises from the separation of ownership and control. With only this facet in mind, the presence of a large shareholder may better police management than the standard panoply of market-oriented techniques. The second is the agency problem that arises between controlling and non-controlling shareholders, which produces the potential for private benefits of control--benefits to the controlling shareholder not provided to the non-controlling shareholders. There is, however, a point of tangency between these facets. Because there are costs associated with holding a concentrated position and with exercising the monitoring function, some private benefits of control may be necessary- to induce a party to play that role. Thus, from the public shareholders' point of view, the two facets of the agency problem present a tradeoff. The presence of a controlling shareholder reduces the managerial agency problem, but at the cost of the private benefits agency problem. Non-controlling shareholders will prefer the presence of a controlling shareholder so long as the benefits from reduction in managerial agency costs are greater than the costs of private benefits of control. (1)

The terms of this tradeoff are determined by the origami of judicial doctrines that describe the fiduciary obligations of a controlling shareholder. In this Article, we examine the doctrinal limits on the private benefits of control from a particular orientation. As we will show, a controlling shareholder may extract private benefits of control in one of three ways: by taking a disproportionate amount of the corporation's ongoing earnings, by freezing out the minority, or by selling control. Our thesis is that the limits on these three methods of extraction must be determined simultaneously, or at least consistently, because they are in substantial respects substitutes. We then consider a series of recent Delaware Chancery Court decisions that we argue point in inconsistent directions--on the one hand, reducing the extent to which a controlling shareholder can extract private benefits through selling control and, on the other, increasing the extent to which private benefits can be extracted through freezing out non-controlling shareholders. While judicial doctrine is too coarse a tool to specify the perfect level of private benefits, we believe these cases get it backwards. The potential for overreaching by controlling shareholders is greater from freeze-outs than from sales of control, so a shift that favors freeze-outs as opposed to sales of control is a move in the wrong direction.

In Part I, we develop the simultaneity framework for controlling private benefits of control and describe briefly the general doctrinal structure. In Part II, we review and evaluate recent Delaware case law regarding sale of control and minority freeze-outs. In particular, we argue that the Delaware law of freeze-outs can be best reunified by giving "business judgment rule" protection to a transaction that is approved by a genuinely independent special committee that has the power to say "no" to a freeze-out merger, while also preserving what amounts to a class-based appraisal remedy for transactions that proceed by freeze-out tender offers without special committee approval. Part III concludes that, although some may disagree with our views concerning the appropriate levels of restriction governing techniques for extracting the private benefits of control, the terms of the debate will be more sharply focused if the rules governing these techniques are evaluated simultaneously.

1. PRIVATE BENEFITS OF CONTROL: THE LINK BETWEEN EXTRACTING PRIVATE BENEFITS FROM OPERATING, SELLING CONTROL, OR FREEZE-OUTS

   Imagine that a controlling shareholder can extract benefits from its ongoing operation of the company. For example, the controlling shareholder can take out significant benefits through cost-sharing arrangements that overpay the controlling shareholder for providing central services such as pension, accounting, or the like. Alternatively, the controlling shareholder can benefit through "tunneling"--that is, through contractual dealings with the company, like transfer pricing, that favor the controlling shareholder. (2) In either event, the controlling shareholder secures value from its control position that is not received by the non-controlling shareholders.

   In turn, the controlling shareholder can extract the same value from control by selling it at a premium to the value of the non-controlling shares. The existence of an ongoing stream of private benefits increases the value of the controlling shares compared to the non-controlling shares by the present value of the future private benefits. A sale of control simply capitalizes the cash flow associated with private benefits of control.

   The same private benefits can also be secured by freezing out the minority shareholders. In a public corporation, the trading price of shares in a corporation with a controlling shareholder reflects the value of a non-controlling share. (3) The price of a non-controlling share will have been discounted by the capitalized value of the controlling shareholder's private benefits. A freeze-out at the discounted price allows the controlling shareholder to capture the capitalized value of future private benefits.

   The critical point is that, without more, we should expect doctrinal regimes of equivalent rigor to cover each of the three methods of extracting private benefits. While which technique a controlling shareholder resorts to will depend on the particular circumstances, as yet there is no reason to favor one method over another. In fact, the legal rules that govern the three methods are quite different. One set of legal rules specifies the boundaries for private benefits in the ongoing operation of the corporation. (4) A second addresses efforts by a controlling shareholder to sell control at a premium not shared with others. A third polices freeze-outs of non-controlling shareholders. As we will see, the rules controlling the level of private benefits from operations are the central determinant of the judicial doctrine that controls controlling shareholders; these rules set the level of private benefits that can be appropriately capitalized through sale of control or a freeze-out.

   The rules governing a sale of control and those governing a freeze-out of non-controlling shareholders are quite different from one another. There is quite limited judicial intervention in the case of sales of control and quite intensive judicial intervention in the case of minority freeze-outs. In this Part, we argue that this pattern of judicial intervention represents the right relationship: more intense judicial review is appropriate in a freeze-out than in a sale of control. The objective of the legal rules in both the sale of control and freeze-out cases should be identical: to protect the controller's continuing claim to the permissible level of private benefits while limiting the controller's take to that level plus an appropriate share of the synergy gains. This is much easier to achieve in a sale of control, where continuing shareholders participate pro rata in synergy gains, than in a freeze-out, where the synergy gains must be priced and allocated as part of the freeze-out price. In the next Part, we argue that recent Delaware case law is moving in the wrong direction.

   Getting it right is not a matter of indifference. A significant body of scholarship links capital market development and public shareholder protection. (5) As we will see, legal rules and the enforcement mechanisms for those rules affect the "minority discount"--that is, the value difference between the shares of equivalent cash flow rights held by public shareholders and by controlling shareholders. (6) The minority discount in turn affects the feasibility of "equity carve-outs," transactions in which a parent sells a minority interest in a subsidiary via an initial public offering (IPO), and also affects, generally, the value of control transactions where some shares remain in public hands.

   1. Private Benefits of Control in Operating the Company: The Sinclair Standard

      The legal rules governing private benefits of control in operating a company set the limits on the price of monitoring by a controlling shareholder. If these limits are effective, the presence of a controlling shareholder benefits the non-controlling shareholders because the reduction in managerial agency costs will exceed the level of private benefits.

      Two basic legal rules police the level of private benefits that result from ongoing operations. First, if the controlling shareholder is a director, then any contract between the controlling shareholder and the corporation is an interested transaction and must meet the standards of statutes like Delaware General Corporation Law section 144, (7) which requires that the transaction be sanitized through either procedural techniques or substantive judicial review. (8) If the controlling shareholder is not a director, then Sinclair Oil Corp. v. Levien (9) applies, which sets out the general standards for the conduct of controlled corporations. (10) For this purpose, the Delaware Supreme Court essentially divides sources of private benefits into two categories.

      The first category concerns the business and strategic decisions of the corporation. In Sinclair, for example, a minority shareholder of Sinven Venezuelan Oil Company, a controlled corporation that operated primarily in Venezuela, claimed that Sinven's dividend policy favored the controlling shareholder, Sinclair Oil Corporation. (11) By paying out as dividends a large percentage of Sinven's profits, Sinven was alleged to favor the...