Private v. Public Corps, Delaware, IPOs, and Controlling S/Hs

Exam 2

Duties of Majority or Controlling Shareholders

• Shareholders do NOT typically owe fiduciary duties. A shareholder may own shares of Coke and Pepsi.

• But, a shareholder may owe fiduciary duties to minority owners if the s/h owns a majority of a closely held corporation

• The logic is that the majority (or ”controlling”) shareholder can wield such power over the corporation that the dominant S/H may operate the corporation to their own self-interest while harming minority owners.

• Typically, the condition of a private corporation is added because S/Hs of a public corporation can simply sell their shares

  • And practically, it’s rare for a public corporation to be run by a majority or controlling S/H.

In re Sears - Facts

• Facts

  • A corporation ran a profitable and non-profitable business. Its committee of independent directors decided to liquidate and terminate the nonprofitable wing. The controlling s/h (Mr. Lampert) rejected the committee’s plan and then, used his power to enact bylaws making the liquidation plan impossible. He then used his voting power to remove all but one member of the independent committee. The liquidation was blocked.

  • A second transaction was consummated where the majority shareholder negotiated with the remaining committee member to buy out minority shareholders at a premium of 76%, allowing to sell the bad business’s assets.

  • The second transaction was NOT conditioned on a majority of minority S/Hs’ vote.

• Minority S/Hs sued that the controlling S/H breached his fiduciary duties on both transactions (1. defeating the liquidation plan and then 2) buying out the minority shareholders).

In re Sears - Court’s Initial Finding

The Court’s initial finding on blocking the Committee’s plan:

• “In response to a perceived threat, the controller took action that invaded the space typically reserved for the board of directors. The controller faced a subtle conflict, because while the actions he took affected all stockholders equally, he had business agreements with the corp that could have skewed his judgment.”

• I find that the controller did not intend to harm the corporation and its stockholders. He believed in good faith—and I find correctly—that the liquidation plan could not achieve the committee's lofty expectations...

• He also had the most to lose as a stockholder. When the controller exercised his stockholder-level voting power, he acted consistently with his fiduciary duties.

• If the story ended there, judgment would be entered in favor of the defendants

In re Sears - Court’s Second Finding

The court’s second finding on the buyout of shareholders/sale of assets:

• The sole remaining committee member decided that a deal with the controller was the only realistic option. He negotiated with the controller, and they agreed on an end-stage transaction that eliminated the minority s/h’ interests in the company. The controller bore the burden of proving that the end-stage transaction was entirely fair.

• evidence indicates that the controller paid a price for the bad business's inventory that was below the range of fairness; the same is true for the transaction as a whole.

• The fair dealing dimension also falls short… the two sides failed to bargain over the value of the bad business, and the special committee was unable to extract a fair price for the company as a whole. The Controller Intervention had tilted the playing field, and the fallout from that game-changing action was too great.

In re Sears - Ruling

Ruling: “When a conflict transaction is not entirely fair, a self-dealing fiduciary is liable without regard to the fiduciary's mental state. Here, the controller seems to have believed sincerely that the transaction was fair. He nonetheless must face liability. That is the risk that a fiduciary takes in a self-dealing transaction.”

• 1) Defeating the liquidation of bad business seemed fair. Although the controlling shareholder acted in his own best interest, it seems like he also acted in the best interest of minority shareholders. Thus, he did not breach his duty of care of loyalty.

• 2) HOWEVER, his buyout of the minority shareholder was not entirely fair-–even though he intended it to be fair. He bought their shares and sold the bad business’s assets at a below market value.

  • “The fair price analysis shows that Lampert paid a price that was below the range of fairness. Lampert also did not show fair dealing. The Transaction as a whole was therefore unfair..”

  • “This decision has found that a fair price would have been $4.99 per share. The minority stockholders received $3.21 per share. The difference is $1.78 per share. With the minority owning 10,267,611 shares, the aggregate liability is $18,314,800.24.”

In Re Sears - Key and Holding

• Key: There’s no business judgment rule for a controlling shareholder who creates a conflict of interest. The deal must be entirely fair, especially since the board and independent committee are properly tasked with the decision.

  • Especially important is whether the majority’s interests are aligned with minority shareholders or not. In the first transaction, aligned interests (i.e., to get top dollar of stock). The second interest, no (the majority was buying minority S/Hs out).

• Holding: Breach of his fiduciary duty as a controlling shareholder.

Delaware Corp Law

• Delaware’s legislature has created a nuanced and sophisticated body of corporate law. The general assembly is very quick to enact new laws meant to correct problems or foresee future issues.

• Delaware’s Court of Chancery is almost exclusively tasked with resolving corporate disputes. They act extremely quickly and with lots of sophistication. Their judges (chancellors) act without juries are wield substantial expertise on business and corp matters

• Many states lack a long history of corporate law disputes, so they just adopt Delaware’s precedents as their own.

• The generations of case law has created foreseeability and comfort, giving investors and corporations confidence.

• A company looking to incorporate will thus typically decide whether to incorporate in its home state or Delaware.

• Delaware profits from franchise taxes that scale up by the company’s size (large corporations can pay over $1,000)

Executive Compensation

• Executive compensation is a function of the duty of loyalty as well as waste

• If a board engage in waste, then it is breaching its duty of loyalty to shareholders by destroying corporate assets.

• A board should form an independent committee to establish compensation based upon reasonable metrics.

  • Further, independent (sub)committees help corps and boards fulfill otherwise conflicted duties

• If compensation is grossly above the market rate, then it’s considered a “gift” and thus advances no corporate purposes. It’s a breach of loyalty.

Richard Tornetta

• When Tornetta sued Musk over his $56 billion compensation package, he owned 9 shares. Nine.

• He’s the guy who prompted Musk to take Tesla to Texas

Fleeing Delaware? And, to where?

• Sparked by Elon Musk’s compensation package, which the DE Court of Chancery struck down.

• Musk sought another state where “shareholders matter.” Should corp law give S/Hs more power?

• Why Nevada? The state has eliminated director liability unless there’s fraud or intentional violations of the law

• Why Texas? Corps can limit S/H lawsuits unless a shareholder owns at least 3% of stock.

  • Proxy advisors must disclose non-economic interests, or “subordinated the financial interest of shareholders,” if focused on ESG (A proxy is a company that seeks to pool votes of shareholders to achieve a common goal)

  • Limits “activist investors” (will discuss later).

Maffei v. Palkon - Facts, Issue, and Ruling

• Facts: TripAdvisor sought to reincorporate in Nevada, abandoning Delaware. Minority shareholders contested the “corporate inversion,” which required a s/h ratification. The shareholders would have defeated the action but for the affirmative vote of the controlling s/h.

• Issue: should the court apply the BJR or assess the deal’s entire fairness?

• Ruling: The DE Supreme Court held that it was too tough to say whether the diminished S/H protections afforded on Nevada law constituted a conflict of interest. And therefore, the court approved the corporate inversion under the BJR.

  • “The court did note, however, that there is much debate about whether upstart corporate regimes like Nevada’s are part of a ‘vibrant competition among laboratories of democracy or a race -to - the -bottom of stockholder protections.”

Moellis

• Facts: The DE Court of Chancery ruled that an agreement was invalid that limited a corporation’s director’s power to act and gave it, via contract, to shareholders —here, a founding shareholder. This type of agreement could, for instance, allow shareholders to select or fire the CEO rather than the board.

• This led the Delaware’s legislature to amend its corporate laws to allow certain types of shareholder agreements, reallocating power to shareholders and away from directors.

  • Still, an agreement may not eliminate duties of loyalty.

• This arrangement is particularly powerful with respect to controlling shareholders who may now exert greater power over their corporations.