Corporate ostracism: freezing out controlling shareholders.

• Author: Dammann, Jens

1. INTRODUCTION II. THE TRANSACTION-CENTERED APPROACH III. DISTORTING OWNERSHIP STRUCTURES A. Background B. Allocating the Costs and Benefits of Control 1. The Upper Limit for the Extraction of Private Benefits 2. The Lower Limit for the Extraction of Private Benefits C. The Failure of the Transaction-Centered Approach 1. Excessive Private Benefit Extraction a. The Basic Problem i. Indirect Forms of Self-Dealing ii. Direct Forms of Self-Dealing b. Counterpoint: Going-Private Transactions 2. Insufficient Private Benefit Extraction a. The Problem b. Counterpoint: Going-Private Transactions D. Empirics 1. Private Benefits a. Block Trades i. Insufficient Private Benefit Extraction ii. Excessive Private Benefit Extraction b. Dual Class Shares i. Insufficient Private Benefit Extraction ii. Excessive Private Benefit Extraction 2. The Controller's Impact on the Value of the Firm 3. Summary IV. PRODUCING THE WRONG CONTROLLERS A. Favoring Controllers Adept at Extracting Private Benefits B. Deterring the Corporation's Business Partners 1. The Value of Business Partners as Controllers 2. The Self-Dealing Rules as an Obstacle C. Counterpoint: Countervailing Incentives D. Summary V. UNDESIRABLE CONTROL WITHOUT BENEFIT EXTRACTION A. The Problem B. Family-Controlled Firms C. Going-Private Transactions VI. COURT-BASED ALTERNATIVES A. How Would a Court-Based Alternative Function? 1. Insufficient Benefit Extraction 2. Excessive Benefit Extraction B. The Drawback of Court-Based Alternatives VII. THE EQUAL OPPORTUNITY RULE AND RELATED APPROACHES A. The Equal Opportunity Rule B. Mandatory Bid Rules that Do Not Offer an Equal Opportunity VIII. CORPORATE OSTRACISM A. The Basic Structure B. Potential Benefits 1. Excessive Private Benefit Extraction 2. Other Undesirable Controllers C. Potential Costs 1. Uninformed Choices 2. Extortion a. Extortion as a Chicken Game b. Excessive Demands 3. Conflicts of Interest 4. Minimal Shareholdings 5. Summary D. Why Don't Corporations Adopt Corporate Ostracism on Their Own? 1. General Obstacles to Innovative Governance Arrangements 2. Agency Conflicts a. Existing Firms i. Without a Controlling Shareholder ii. With a Controlling Shareholder b. IPO Firms E. Corporate Ostracism as the Appropriate Default Rule 1. IPO Firms a. Ostracism Brings Net Costs b. Ostracism Brings Net Benefits c. The Costs Weigh About as Heavily as the Benefits 2. Publicly Traded Firms 3. Summary IX. TURNING THE TRANSACTION-CENTERED PROTECTIONS INTO DEFAULT RULES A. The Mandatory Nature of Self-Dealing Rules B. The Case Against Mandatory Protections 1. Potential Benefits a. The Lower Limit of Desirable Benefit Extraction b. Favoring the Most Desirable Controller 2. Potential Costs a. Adequate Information b. Looting c. Shareholder Passivity i. Legal Obstacles ii. Damage Caused by Self-Dealing iii. The Costs of a Takeover 3. Letting the Shareholders Decide C. The Transaction-Centered Protections as the Default X. CONCLUSION The ancient city-state of Athens had an ambivalent relationship with its political elite. On the one hand, the city relied on that very elite to bring forth the statesmen it depended on for its survival. On the other, there was always the risk that an overly ambitious politician might abuse his influence to replace democracy with tyranny. One mechanism to curb such ambitions was the institution of ostracism. (1) Once a year, the citizens of Athens were given the opportunity to expel one from among their number for a period of ten years. (2) The procedure consisted of two steps: first, a vote was taken on whether or not an expulsion was necessary. (3) If the outcome was positive, the citizens then proceeded to the second step: a vote on whom to expel. (4) Interestingly, ostracization was not perceived as a penalty for any wrongdoing. (5) Accordingly, the ostracized citizen's property was not confiscated, (6) and once the ten years had passed, he was free to return with all of his citizenship rights restored. (7)

   Besides being of interest to historians, the practice of ostracism also holds the key to one of the most persistent challenges of modern corporate law, namely the question of how to deal with controlling shareholders in publicly traded corporations. It is well established that, given the right set of circumstances, the presence of a controlling shareholder can yield significant benefits for the corporation as a whole. (8) In particular, large shareholders do not suffer from the same collective action problems as small shareholders and can therefore be more effective at monitoring managers. (9) Moreover, one corporation's ownership of another corporation's stock can reduce the transaction costs that these two firms incur in their contractual dealings. (10) At the same time, of course, the presence of a controlling shareholder is not without risks. There is always the danger that the controller will abuse his power and enrich himself at the expense of the other shareholders. (11) Hence, the law faces a difficult task: It must protect the minority shareholders, but in doing so, it must also try to preserve the benefits associated with the presence of a controller.

   Traditionally, corporate law has attempted to solve this dilemma by monitoring individual transactions that are suspected of benefiting the controller at the expense of the other shareholders. For example, in Delaware, all contracts between the controller and the corporation are subject to a test of entire fairness, even if they have been approved by a committee of independent directors. (12) In the literature, the desirability of this transaction-centered approach has never been questioned. This is particularly true for Delaware's version of the transaction-centered approach, which has been praised profusely for its perceived efficiency. (13) Admittedly, individual aspects of Delaware's version of the transaction-centered approach have met with criticism. Edward Rock has argued that Delaware courts may attach too much importance to hard bargaining in evaluating the fairness of a transaction. (14) Marcel Kahan and Ehud Kamar have suggested that Delaware's rules on self-dealing are particularly vague and therefore highly, and perhaps inefficiently, litigation-intensive. (15) And Mary Siegel has faulted Delaware's judiciary with being too quick to apply the entire fairness test in reviewing transactions involving the controlling shareholder. (16) Yet these criticisms concern the modalities of the transaction-centered approach, rather than its justification in principle, and they can be addressed within the framework of that approach.

   By contrast, this Article argues that the transaction-centered approach is fundamentally flawed. Most importantly, the transaction-centered

   approach strikes the wrong balance between the interests of the controller and those of the other shareholders. As explained in more detail below, the amount of private benefits--i.e. benefits not shared by the other shareholders--that the controller should be able to extract from the corporation depends both on how valuable the controller's presence is to the corporation and on the extent to which the controller shoulders costs of control that are not shared by the other shareholders. The transaction-centered approach fails to take these factors into account. Instead, it focuses on the fairness of individual transactions, and accordingly, the level of private benefit extraction depends on how well the individual controller is positioned to exploit loopholes in that fairness review. As a result, the level of private benefit extraction is bound to be too high in some corporations while being too low in others. Because of this and other shortcomings of the transaction-centered approach, this Article suggests that the existing law should be modified in two ways.

   First, to prevent excessive benefit extraction, the law should give minority shareholders in publicly traded corporations the right to force the controller to sell his shares in the corporation. This mechanism, which I shall refer to as "corporate ostracism," would ensure that minority shareholders can rid the corporation of any controller whose presence harms the corporation. Corporate ostracism should be a mere default rule. However, the ability to opt out via a charter amendment should be conditioned on the approval of the minority shareholders.

   Second, to address the problem of insufficient benefit extraction, the existing transaction-centered protections should be stripped of their mandatory character and turned into default rules. As with corporate ostracism, a charter amendment opting out of the default should require the approval of the minority shareholders.

   At this point, a clarification is in order: The costs and benefits of corporate ostracism are to some extent uncertain. This is unavoidable given that the law has so far followed a different approach. Consequently, it is impossible at the present stage to demonstrate that the right to ostracize the controller is the appropriate solution for most, let alone all, corporations. Against this background, it is all the more important to stress that the case for the default regime that I propose does not depend on any such findings. Rather, the crucial point is a different one: Not all default rules are equally easy to opt out of. (17) That is particularly true in the context at hand. If the applicable default rules fail to provide for a right to expel the controller, various factors make it difficult for corporations to create such a right on their own. By contrast, if corporate ostracism is turned into the legal default, then those corporations for whom corporate ostracism is not suitable will likely opt out. Consequently, designating corporate ostracism as the default rule promises to increase the chance that corporations are governed by the rule that is most appropriate for them. In other words, I argue that corporate ostracism is the preferable...