Megasubsidiaries and asset sales under section 271: which shareholders must approve subsidiary asset sales.

• Author: Shukairy, Yaman
• Position: Delaware

INTRODUCTION I. EXAMINING DIFFERENT CORPORATE LAW REGIMES AND THEIR APPROACHES TO SUBSIDIARY ASSET SALES A. A Literal and Technical Approach to Statutory Interpretation B. Without Explicit Language, Requiring a Vote by Parent Shareholders Is Contrary to Corporate Law Objectives C. Explicit Statutory Language Allows for a Parent Shareholder Vote While Still Fostering an Environment of Certainty and Definiteness II. CONSIDERING SUBSIDIARY ASSET SALES UNDER DELAWARE LAW A. Upholding the Doctrine of Separate Corporate Existence B. Form-over-Substance Transactions: Two Illustrative Examples C. Fiduciary Duties: Protection for Shareholders of Parent Corporations Engaging in Subsidiary Asset Sales CONCLUSION INTRODUCTION

Corporate law statutes determine the nature of the relationship between shareholders, the principal owners of the corporation, and the board of directors, those who run and operate the corporation. (1) Under the Delaware General Corporation Law ("DGCL"), (2) many of the powers are delegated to the board of directors. More specifically, under section 141, "the business and affairs of every corporation ... [are] managed by or under the direction of a board of directors...." (3) The Delaware courts have interpreted this pro vision by deferring to decisions by directors and their designated management under the business judgment rule, which presumes that in making a business decision, the directors acted on an informed basis with a good faith, an honest belief that the action taken was in the best interests of the company. (4) As many have noted, "[t]he effect of this presumption when applied by a court is that the court will not substitute its judgment for that of the board, unless it is shown by a preponderance of the evidence that the directors' decision involved a breach of fiduciary' duty." (5)

Despite the enormous delegation of power from shareholders to directors, shareholders still retain certain essential powers such as the right to vote on mergers (6) and to elect directors. (7) Among these is the right to vote on the sale of all or substantially all of the assets of the corporation. Section 271 of the DGCL provides that:

Every corporation may at any meeting of its board of directors or governing body sell, lease or exchange all or substantially all of its property and assets ... as its board of directors or governing body deems expedient and for the best interests of the corporation, when and as authorized by a resolution adopted by the holders of a majority of the outstanding stock of the corporation entitled to vote.... (8) In Gimbel v. The Signal Cos., Chancellor Quillen, writing for the Delaware Court of Chancery, articulated the now often-cited Gimbel test, which considers both the quantitative and qualitative nature of the proposed asset sale in determining whether an asset sale constituted substantially all of the assets of a corporation. (9) Chancellor Quillen explained that "[i]f the sale is of assets quantitatively vital to the operation of the corporation and is out of the ordinary and substantially affects the existence and purpose of the corporation, then it is beyond the power of the Board of Directors." (10)

Because the Gimbel test is not a mathematical, bright-line test, many of the issues litigated under section 271 relate to whether a proposed sale of assets unilaterally undertaken by the board is a sale of "substantially all of the assets" of the corporation and therefore requires a shareholder vote. (11) Delaware courts have repeatedly dealt with this issue on a case-by-case basis. (12) There is, however, one technical issue the Delaware courts have yet to completely resolve: whether a sale of substantially all of the assets of a subsidiary which constitutes substantially all of the assets of the parent implicates a parent shareholder vote. Such an issue would arise if a parent corporation decided to sell its assets, which were placed within a subsidiary. The proposed assets to be sold, for the purposes of this Note, represent substantially all of the assets of the parent corporation. If the sale is conducted at the subsidiary level, does the sale only require a shareholder vote by the parent corporation, the record holder of the subsidiary's shares, or also a vote by the shareholders of the parent corporation who ultimately are the beneficiaries of the parent corporation? (13) Put another way, does a section 271 transaction effectuated at the subsidiary level require a shareholder vote by the shareholders of the parent corporation or only the shareholders of the subsidiary?

Until recently, the Delaware courts had summarily concluded that the only vote required was the vote of "the record holder of all of the shares," obviating the need to attain shareholder approval from shareholders of a parent corporation. (14) In J.P. Griffin Holding Corp. v. Mediatrics, Inc., the Delaware Court of Chancery concluded that because the defendant corporation was the record holder of all of the shares of its subsidiary and voted all of its shares in favor of the proposed sale, the requirements of section 271 were met. (15) By implication, the court refused to construe section 271 to require shareholders of the parent corporation vote on the proposed asset sale. In the court's view, the section 271 subsidiary asset sale did not require shareholder approval by the shareholders of the parent corporation. A later case, Leslie v. Telephonics Office Technologies, Inc., avoided deciding a similar issue but noted that "more often than not, Delaware courts have upheld the legal significance of corporate form, in a corporate-subsidiary complex...." (16)

A more recent case, however, cast doubt on this technical statutory interpretation by the Delaware courts. In Hollinger Inc. v. Hollinger International, Inc., Vice Chancellor Strine viewed the defendant corporation's argument that the section 271 subsidiary asset sale did not implicate a vote by its shareholders with a healthy amount of skepticism. (17) He cautioned against a strict, technical statutory construction of section 271, because of the widespread phenomenon of public companies indirectly holding all of their operating assets through subsidiaries. (18) Vice Chancellor Strine worried that such a reading of section 271 "would, as a practical matter, render [section] 271 an illusory check on unilateral board power at most public companies." (19) Ultimately, he decided to leave the section 271 subsidiary asset sale issue unresolved, (20) but his brief discussion raises concerns and leaves open the possibility that a court could enjoin a section 271 subsidiary asset sale without approval from shareholders at the parent level.

On its face, this section 271 subsidiary asset sale issue may seem a narrow, technical issue, but its relevance is becoming increasingly important. As noted by Professor Melvin Eisenberg, "a significant portion of the country's business assets is now held, not only by corporations, but by massive subsidiary corporations--megasubsidiaries. As a result, ultimate ownership of business assets is often not only once but twice or more removed from the assets themselves." (21) The growing and widespread practice of corporations placing their assets under subsidiaries supports the need for resolution of the section 271 subsidiary asset sale issue discussed in the hypothetical above. Without certainty on what votes are required to authorize such transactions, certain corporations are less likely to pursue asset sales through their subsidiaries--despite their potentially beneficial, value-creating nature--and instead sell through the parent. Moreover, when corporations do choose to effectuate asset sales through their subsidiaries, litigation is likely to arise between parent shareholders and the parent corporation. These potential adverse effects could create significant costs that ultimately harm shareholders of corporations in Delaware. As such, determination of which shareholders are entitled to a vote to authorize a sale of substantially all of the parent corporation's assets held under a subsidiary is critical. This Note aims to address and resolve this issue.

This Note argues that a parent shareholder vote is not implicated under section 271 when a parent corporation effectuates a sale of substantially all of its assets held under a subsidiary. Part I examines a number of different corporate law legal regimes, including Delaware's, and concludes that without clear legislative direction, a parent shareholder vote in the context of the hypothetical transaction is not necessary and contrary to a number of principles integral to corporate law and its application. Part II then specifically addresses the non-statutory interpretation aspects of Delaware corporate law as they relate to this issue. Section II.A reviews the separate corporate existence doctrine and its applicability to this particular issue. The doctrine strongly supports the conclusion that a shareholder vote at the parent level is unnecessary. Section II.B considers other form-over-substance transactions, such as triangular mergers and de facto mergers, which Delaware courts have condoned despite their indirect, adverse effects on shareholder rights. Finally, Section II.C engages in a brief fiduciary duty analysis establishing that the fiduciary duties owed by directors to shareholders provide adequate protection to shareholders in the context of a section 271 subsidiary asset sale. Section II.C then concludes that a section 271 transaction effectuated by a subsidiary and voted on by the parent corporation and not the parent's shareholders is entitled to the presumptive protection of the business judgment rule.

1. EXAMINING DIFFERENT CORPORATE LAW REGIMES AND THEIR APPROACHES TO SUBSIDIARY ASSET SALES

   In considering the section 271 subsidiary asset sale issue, Part I provides an overview of a number of significant state corporate law regimes and how...