BEYOND BEHOLDEN.

AuthorLin, Da
  1. INTRODUCTION 516 II. INDEPENDENT DIRECTORS IN CONTROLLED COMPANIES: THE STANDARD 520 ACCOUNT A. Independent Directors as Monitors 521 B. Who is Independent? 523 1. Past and Ongoing Relationships 523 2. The Controller's Power over Director Retention and 525 Termination 3. "Boardroom Atmosphere" and Psychological Factors 527 4. Risk to Reputation 528 III. INDEPENDENT DIRECTOR REALITIES 531 A. Data Sources and Methodology 531 B. Controller-Independent Director Ties 534 C. Creating a Taxonomy of Controlling Shareholders 542 1. Base 543 2. Concentration 546 a. Decisional Allocation 546 b. Spheres of Influence 548 IV. DOCTRINAL AND THEORETICAL IMPLICATIONS 551 A. Enhanced Scrutiny for Powerful Controllers 551 B. A Harder Look at Post-Transaction Relationships 553 C. Understanding Freezeouts as Presenting an Asymmetric 555 Final Period Problem V. CONCLUSION 557 I. INTRODUCTION

    Independent directors have long been a core part of corporate law's answer to the agency problem that arises in controlled companies. The presence of a controlling shareholder produces the potential for private benefits: the controlling shareholder can extract benefits from the corporation at the expense of other shareholders. (1) To contain this risk of opportunism, courts and policymakers have promoted the engagement of independent directors to vet contracts between companies and their controllers. (2) As Guhan Subramanian observes, the move to independent directors is now "standard practice" in controlled firms. (3)

    The conventional notion of independence translates roughly into the absence of substantial prior or ongoing relationships to the controlling shareholder. (4) This definition reflects corporate law's persistent preoccupation with "beholdenness" as the main threat to independence. (5) The paradigmatic concern is that a director with lucrative ties to the controlling shareholder may be subtly pressured by the fact that the controller can cut off those ties or even unseat her from the board. (6) This diagnosis, in turn, has prompted calls to insulate nominally independent directors from the controlling shareholder's ire. (7)

    Corporate governance scholarship focuses extensively on the incentives generated by the controlling shareholder's ability to retaliate against insubordinate directors. What the literature overlooks, however, is that directors may also be influenced by the prospect of reward. What happens when the controlling shareholder is not angered but instead pleased?

    The result, it turns out, is often new opportunities or future benefits from the controlling shareholder to the favored directors. Controlling shareholders can direct their resources or those owned by the controlled company in ways that reward friends. For instance, Charles Dolan, whose family controlled Cablevision Systems until 2016, invested his own money with a fund founded by one of Cablevision's former "independent" directors. (8) Some controllers have substantial influence over other companies as well. When the controlling shareholder of M & F Worldwide, Ronald Perelman, sought to "freeze out" (9) the company's minority shareholders, the company formed a special committee of four "independent" directors to negotiate with Perelman over the terms of his acquisition. (10) Less than a year after the deal closed, two members of the special committee--including the chairman--joined the boards of other firms under Perelman's control. (11)

    This Article is the first to identify controlling shareholder patronage as a systemic phenomenon and to consider how anticipation of future patronage can influence director behavior. I study these issues using an original dataset of nominally independent directors who negotiated with a controlling shareholder over a freezeout transaction between 2000 and 2014. Examining the professional connections--specifically, directorship and employment relationships--between those directors and controllers, I find that some controlling shareholders regularly re-appoint cooperative "independent" directors to executive and board positions at other firms under their control. 36% of the controlling shareholders in my sample have re-appointed at least one nominally independent director in this way. Illustrating this point from a different angle, 20% of the directors in my data have served on the board or as an executive in at least two different companies controlled by the same controlling shareholder. In many cases, the director was independent in the conventional sense when she negotiated the freezeout, meaning that she had no ongoing or prior connections with the controller at that time. But after the freezeout closed, she obtained a job at another company that the controlling shareholder controlled. From a director's perspective, these findings mean that she can obtain future benefits from the controlling shareholder if she acts in the controlling shareholder's interests.

    The likelihood of future patronage from the controlling shareholder is driven by factors that have not been recognized by courts. The current doctrinal regime is based on a generic and stylized idea of the controlling shareholder. But in reality, controlling shareholders come in different forms, hold control through different mechanisms, and acquire control for different reasons. Treating controlling shareholders as monolithic obscures the many moving parts that can affect their power to influence director behavior. As I show, two important determinants of this power are what I call the base of controlled entities and the concentration of decision-making authority.

    Base refers to the size of the network of companies over which a controlling shareholder has control. I find that controllers with a wider base--those that control multiple public companies--are much more likely to have repeat relationships with the nominally independent directors who serve on their boards (54.8% compared with 4.5%). This result makes intuitive sense: controllers with a wider base have greater ability to reward or sanction because they have power over more resources and more boards.

    Concentration refers to the number of actors that share the power to control within the controlling shareholder. I find that controllers who are single natural persons, as opposed to family groups or widely-held corporations, are also more likely to have repeat relationships with the nominally independent directors that they appoint (48.3% compared with 30.4% for widely-held corporations and 25% for family groups). This finding is consistent with classic narratives about power: a single person with consolidated control has greater power to reward or sanction than a group of decision-makers who share control because the single person can act unilaterally and her authority over the controlled company is plenary. (12)

    Together, these two factors provide an analytic framework for assessing which controlling shareholders have greater potential to create conflicts of interest. By disaggregating controllers in this way, courts can move toward a more nuanced doctrine for constraining private benefits of control. Most concretely, courts can tailor the level of scrutiny given to independent directors' decisions, such as approval of a transaction proposed by the controlling shareholder, to the controlling shareholder's ability to influence director behavior.

    Ultimately, my findings illustrate how undertheorized controlling shareholders and the risks they pose to director independence remain. For example, doctrines concerning controlling shareholders do not account for real differences among the people and entities within that broad category; nor do they provide any explanation for why we presume that the bargaining dynamics are the same when nominally independent directors negotiate with controllers who are repeat players--such as venture capital firms that routinely obtain control over the firms they invest in--and when those directors negotiate with one-off controllers. (13) There has also been no serious discussion about how courts might obtain information on a director's expectations about future events, even though basic game theory teaches us that the director's behavior will be shaped by these beliefs. (14) Courts are sometimes presented with evidence that a director received post-negotiation benefits from the controlling shareholder (15) or that a particular controlling shareholder has a reputation for re-appointing friendly directors to other boards, (16) but we have no principled framework for incorporating these insights into doctrine. This Article fills these gaps.

    This Article proceeds in four parts. Part II provides background on controlled companies and independent directors. It briefly describes the conventional marker of independence--that is, the absence of any ongoing or prior relationship with the controller other than as a director. It also summarizes several other factors, such as social norms and reputation, whose impact on director independence has been the subject of some debate. part II shows that, while controlling shareholders can influence nominally independent directors through negative threats or positive incentives, the contemporary discourse has overwhelmingly focused on threats. part III presents my empirical findings on the professional ties between nominally independent directors and controlling shareholders. Building on these findings, part III also presents a taxonomy of controlling shareholders. Part IV provides implications for policymakers and the Delaware courts, and Part V concludes.

    Before I proceed, a caveat is in order. while independent boards have become a mandatory part of good governance in practice, debate about the value of independent directors persists in the scholarly literature. (17) This Article does not enter that debate. My critique of directors' independence-in-fact is not meant to suggest that genuinely independent directors are an unalloyed good...

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