The Controlling Shareholder Enforcement Gap

• Date: 01 September 2019
• DOI: http://doi.org/10.1111/ablj.12147
• Author: Itai Fiegenbaum
• Published date: 01 September 2019

American Business Law Journal

Volume 56, Issue 3, 583–644, Fall 2019

The Controlling Shareholder

Enforcement Gap

Itai Fiegenbaum

†

The regulation of controlling shareholder related-party transactions is one of cor-

porate law’s animating concerns. A recent Chancery Court decision extends the

double approval framework endorsed by the Delaware Supreme Court—

independent director committees and a majority of the minority shareholders—to

non-freezeout transactions. This article explains why the Chancery Court’s innova-

tion does not decrease the risk faced by minority shareholders. Subjecting a trans-

action to the double approval framework is a voluntary decision. Transaction

planners will willingly traverse this path if the benefits outweigh the loss in deal

certainty and attendant costs. When almost every freezeout is challenged in court,

the voluntary application of this framework is the logical outcome. The calculus in

the non-freezeout context leads to a different result. Non-freezeouts must be chal-

lenged by a derivative lawsuit. The procedural hurdles inherent in the derivative

mechanism affect both the demand for the ratification framework and the incentive

to comply. Without a tangible threat of a lawsuit to coax voluntary compliance in

the non-freezeout setting, transaction planners have nothing to gain by subjecting

the deal to the double approval gauntlet. This article’s analysis reveals a large gap

in the enforcement of self-dealing transactions. Recent high-profile litigation

exposes questionable adherence to the double approval framework for obviously

conflicted non-freezeout transactions. The paucity of derivative lawsuits foretells a

troubling fate for similar transactions at less enticing litigation targets. Worse yet,

the superficial step toward improved minority shareholder protection stifles the dis-

cussion on additional reform.

†

Fellow, Harvard Law School Program on Corporate Governance. An earlier draft of this

article was presented at the Fifth Annual Corporate & Securities Litigation Workshop and

the Harvard Law School Corporate Fellows Workshop. For additional insights I would like

to thank Lucian Bebchuk, Tami Groswald Ozery, Jesse Fried, Lawrence Hamermesh,

Sharon Hannes, Scott Hirst, Kobi Kastiel, Travis Laster, Amir Licht, Susan Park, and Barak

Yarkoni. All errors and inaccuracies are my own.

©2019 The Author

American Business Law Journal ©2019 Academy of Legal Studies in Business

583

INTRODUCTION

The pathologies of influential corporate insiders with a significant equity

stake were on full display during Oracle’s 2016 acquisition of industry

rival NetSuite.

1

Larry Ellison, Oracle’s long-time CEO and dominant fig-

ure, played a major role in choosing the acquisition target. Under nor-

mal circumstances, Ellison’s involvement should have eased any worries

Oracle’s shareholders might have had about the deal’s wisdom. His

industry savvy had helped grow the company from a tiny Silicon Valley

start-up to a $200 billion juggernaut, and his thirty percent ownership

stake created an enormous incentive for him to maximize shareholder

value.

2

Yet Oracle’s minority shareholders were right to be wary: at the time

the deal was proposed, Ellison owned forty-five percent of NetSuite’s

stock. The conflicting ownership stake raised questions about Ellison’s

singular devotion to maximizing Oracle’s profit from the transaction.

Although Ellison’s Oracle stock would depreciate if the deal was skewed

in NetSuite’s favor, the concurrent rise of value in his NetSuite stock

1

In re Oracle Derivative Litig., No. 2017-0337-SG, 2018 WL 1381331, at *1 (Del. Ch. Mar.

19, 2018).

2

Oracle’s success is at least partially attributable to Ellison’s substantial equity stake in the

firm. Economies of scale and the benefits of diversification are somewhat negated by the

unavoidable agency costs inherent in the corporate form. While shareholders are expected

to punish managerial slack and underperformance, prohibitive collective action costs

reduce this foundational pillar of corporate theory to an aspirational goal. By contrast,

Ellison’s ownership of roughly thirty percent of Oracle’s stock provides a worthy incentive

to monitor management and, if necessary, initiate corrective measures. See Ronald J. Gilson,

Controlling Shareholders and Corporate Governance: Complicating the Comparative Taxonomy,

119 HARV.L.REV. 1641, 1651 (2006) (“[A] controlling shareholder may police the manage-

ment of public corporations better than the standard panoply of market-oriented tech-

niques employed when shareholdings are widely held…. Because she holds a large equity

stake, a controlling shareholder is more likely to have the incentive either to monitor man-

agers effectively or to manage the company itself and, because of proximity and lower infor-

mation costs, may be able to catch problems earlier.”). In addition, Ellison’s ownership stake

enables him to steer Oracle’s course in accordance with his long-term vision, insulated from

the pressures of a myopic market. See Zohar Goshen & Assaf Hamdani, Corporate Control

and Idiosyncratic Vision, 125 YALE L.J. 560, 565 (2016) (“[C]ontrol allows entrepreneurs to

pursue business strategies that they believe will produce above-market returns by securing

the ability to implement their vision in a manner they see fit. The entrepreneur values con-

trol because it protects her against the possibility of subsequent midstream investor doubt

and objections regarding either the entrepreneur’s vision or her abilities.”) (emphasis in

original).

584 Vol. 56 / American Business Law Journal

would more than make up for it. Oracle’s minority shareholders unfortu-

nately did not enjoy a similar opportunity to offset their losses.

Delaware’s framework for minimizing the risks posed by this kind of

controlling shareholder self-dealing is well established.

3

The Delaware

General Corporation Law (DGCL) does not require such transactions to

be subject to an intracorporate ratification mechanism.

4

Instead, private

shareholder litigation remains the primary avenue used to enforce fidu-

ciary obligations.

5

A complaint containing a credible allegation of controlling shareholder

self-dealing engenders a healthy dose of judicial skepticism about the

transaction.

6

In Delaware, this mistrust manifests by way of the exacting

“entire fairness” standard of review.

7

Corporate defendants facing this

standard are required to prove the transaction’s inherent fairness to

3

Delaware’s outsized share of publicly traded corporations has made it an accepted proxy

for U.S. corporate law. See Zohar Goshen & Sharon Hannes, The Death of Corporate Law,

94 N.Y.U. L. Rev. 263, 264 (2019) (“More than half of publicly traded firms are incorpo-

rated in Delaware, and in many law schools in the United States, Delaware corporate law

has become virtually synonymous with American corporate law.”) (footnotes omitted).

4

Blake Rohrbacher et al., Finding Safe Harbor: Clarifying the Limited Application of Section 144,

33 DEL.J.CORP. L. 719, 719–20 (2008) (“By its own terms, section 144 deals with a specific

sliver of transactions in which the directors and officers of a corporation have an interest.

Its stated purpose is to rescue those transactions from per se voidability if they qualify for

safe-harbor protection under the statute. That is, section 144 does not validate those trans-

actions; it merely prevents them from being invalidated due solely to any director’s or offi-

cer’s interest.”).

5

David H. Webber, Lead Plaintiffs and Lead Counsel in Deal Litigation,RESEARCH HANDBOOK ON

MERGERS AND ACQUISITIONS 319, 319 (Claire A. Hill & Davidoff Solomon eds., 2016) (“The

shareholder lawsuit is the primary vehicle for enforcing corporate law. While closely related

fields like securities regulation rely on private shareholder lawsuits to supplement the

enforcement work of public regulators like the Securities Exchange Commission, corporate

law enforcement depends largely on private rights of action brought by aggrieved investors

and their lawyers.”).

6

Leo E. Strine, Jr., The Delaware Way: How We Do Corporate Law and Some of the New Chal-

lenges We (and Europe) Face,30D

EL.J.CORP. L. 673, 678 (2005) (“Consistent with the nuance

that infuses our common law, Delaware is more suspicious when the fiduciary who is inter-

ested is a controlling stockholder. When that is so, there is an obvious fear that even puta-

tively independent directors may owe or feel a more-than-wholesome allegiance to the

interests of the controller, rather than to the corporation and its public stockholders.”).

7

Ams. Mining Corp. v. Theriault, 51 A.3d 1213, 1239 (Del. 2012) (“When a transaction

involving self-dealing by a controlling shareholder is challenged, the applicable standard of

review is entire fairness, with the defendants having the burden of persuasion.”).

2019 / The Controlling Shareholder Enforcement Gap 585