Controlling Controlling Shareholders: New Limits on the Operate, Sale of Control, and Freeze Out Alternatives
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January 01, 2003
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"University of Pennsylvania Law Review" article coauthored by Professor Ronald Gilson, is among the "Top 10 Corporate and Securities Articles of 2004" according to "The Corporate Practice Commentator"
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DOCTRINES AND MARKETS
CONTROLLING CONTROLLING SHAREHOLDERS
RONALD J. GILSON† & JEFFREY N. GORDON††
INTRODUCTION
The rules governing controlling shareholders sit at the intersection
of the two facets of the core agency problem in United States
public corporations law. The first is the familiar principal-agency
problem that arises from the separation of ownership and control.
With only this facet in mind, the presence of a large shareholder may
better police management than the standard panoply of marketoriented
techniques. The second is the agency problem that arises
between controlling and non-controlling shareholders, which produces
the potential for private benefits of control—benefits to the
controlling shareholder not provided to the non-controlling shareholders.
There is, however, a point of tangency between these facets.
Because there are costs associated with holding a concentrated position
and with exercising the monitoring function, some private benefits
of control may be necessary to induce a party to play that role.
Thus, from the public shareholders’ point of view, the two facets of
the agency problem present a tradeoff. The presence of a controlling
shareholder reduces the managerial agency problem, but at the cost
of the private benefits agency problem. Non-controlling shareholders
will prefer the presence of a controlling shareholder so long as the
† Charles J. Meyers Professor of Law and Business, Stanford Law School, and Marc
and Eva Stern Professor of Law and Business, Columbia Law School. Contact at rgilson@
stanford.edu.
†† Alfred W. Bressler Professor of Law, Columbia Law School. Contact at jgordon@
law.columbia.edu.
We are grateful to Frank Balotti, Bernard Black, Steven Fraidin, Michael Klausner,
Ted Mirvis, Victor Lewkow, Charles Nathan, Adam Pritchard, Mark Roe, Kenneth Scott,
Vice Chancellor Leo Strine, and participants at the Symposium on Control Transactions
cosponsored by the University of Pennsylvania’s Institute of Law and Economics
and the Law Review and at faculty presentations at Stanford and Harvard Law Schools
and to the University of Pennsylvania Law Review for helpful comments on an earlier
draft of this Article. We are also grateful to Scott Ashton for research assistance.
786 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 152: 785
benefits from reduction in managerial agency costs are greater than
the costs of private benefits of control.1
The terms of this tradeoff are determined by the origami of judicial
doctrines that describe the fiduciary obligations of a controlling
shareholder. In this Article, we examine the doctrinal limits on the
private benefits of control from a particular orientation. As we will
show, a controlling shareholder may extract private benefits of control
in one of three ways: by taking a disproportionate amount of the corporation’s
ongoing earnings, by freezing out the minority, or by selling
control. Our thesis is that the limits on these three methods of extraction
must be determined simultaneously, or at least consistently,
because they are in substantial respects substitutes. We then consider
a series of recent Delaware Chancery Court decisions that we argue
point in inconsistent directions—on the one hand, reducing the extent
to which a controlling shareholder can extract private benefits
through selling control and, on the other, increasing the extent to
which private benefits can be extracted through freezing out noncontrolling
shareholders. While judicial doctrine is too coarse a tool
to specify the perfect level of private benefits, we believe these cases
get it backwards. The potential for overreaching by controlling shareholders
is greater from freeze-outs than from sales of control, so a
shift that favors freeze-outs as opposed to sales of control is a move in
the wrong direction.
In Part I, we develop the simultaneity framework for controlling
private benefits of control and describe briefly the general doctrinal
structure. In Part II, we review and evaluate recent Delaware case law
regarding sale of control and minority freeze-outs. In particular, we
argue that the Delaware law of freeze-outs can be best reunified by giving
“business judgment rule” protection to a transaction that is approved
by a genuinely independent special committee that has the
power to say “no” to a freeze-out merger, while also preserving what
amounts to a class-based appraisal remedy for transactions that proceed
by freeze-out tender offers without special committee approval.
Part III concludes that, although some may disagree with our views
concerning the appropriate levels of restriction governing techniques
for extracting the private benefits of control, the terms of the debate
will be more sharply focused if the rules governing these techniques
are evaluated simultaneously.
1 RONALD J. GILSON & BERNARD S. BLACK, THE LAW AND FINANCE OF CORPORATE
ACQUISITIONS 1229-31 (2d ed. 1995).
2003] CONTROLLING CONTROLLING SHAREHOLDERS 787
I. PRIVATE BENEFITS OF CONTROL: THE LINK BETWEEN EXTRACTING
PRIVATE BENEFITS FROM OPERATING, SELLING
CONTROL, OR FREEZE-OUTS
Imagine that a controlling shareholder can extract benefits from
its ongoing operation of the company. For example, the controlling
shareholder can take out significant benefits through cost-sharing arrangements
that overpay the controlling shareholder for providing
central services such as pension, accounting, or the like. Alternatively,
the controlling shareholder can benefit through “tunneling”—that is,
through contractual dealings with the company, like transfer pricing,
that favor the controlling shareholder.2 In either event, the controlling
shareholder secures value from its control position that is not received
by the non-controlling shareholders.
In turn, the controlling shareholder can extract the same value
from control by selling it at a premium to the value of the noncontrolling
shares. The existence of an ongoing stream of private
benefits increases the value of the controlling shares compared to the
non-controlling shares by the present value of the future private benefits.
A sale of control simply capitalizes the cash flow associated with
private benefits of control.
The same private benefits can also be secured by freezing out the
minority shareholders. In a public corporation, the trading price of
shares in a corporation with a controlling shareholder reflects the
value of a non-controlling share.3 The price of a non-controlling
share will have been discounted by the capitalized value of the controlling
shareholder’s private benefits. A freeze-out at the discounted
price allows the controlling shareholder to capture the capitalized
value of future private benefits.
The critical point is that, without more, we should expect doctrinal
regimes of equivalent rigor to cover each of the three methods
of extracting private benefits. While which technique a controlling
shareholder resorts to will depend on the particular circumstances, as
yet there is no reason to favor one method over another. In fact, the
legal rules that govern the three methods are quite different. One set
of legal rules specifies the boundaries for private benefits in the ongoing
operation of the corporation.4 A second addresses efforts by a
2 For one description of this strategy, see Simon Johnson et al., Tunneling, AM.
ECON. REV., May 2000, at 22, 22.
3 GILSON & BLACK, supra note 1, at 1234.
4 See infra text accompanying notes 7-19 (discussing this particular set of rules).
788 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 152: 785
controlling shareholder to sell control at a premium not shared with
others. A third polices freeze-outs of non-controlling shareholders. As
we will see, the rules controlling the level of private benefits from operations
are the central determinant of the judicial doctrine that controls
controlling shareholders; these rules set the level of private benefits
that can be appropriately capitalized through sale of control or a
freeze-out.
The rules governing a sale of control and those governing a
freeze-out of non-controlling shareholders are quite different from
one another. There is quite limited judicial intervention in the case
of sales of control and quite intensive judicial intervention in the case
of minority freeze-outs. In this Part, we argue that this pattern of judicial
intervention represents the right relationship: more intense judicial
review is appropriate in a freeze-out than in a sale of control. The
objective of the legal rules in both the sale of control and freeze-out
cases should be identical: to protect the controller’s continuing claim
to the permissible level of private benefits while limiting the controller’s
take to that level plus an appropriate share of the synergy gains.
This is much easier to achieve in a sale of control, where continuing
shareholders participate pro rata in synergy gains, than in a freezeout,
where the synergy gains must be priced and allocated as part of
the freeze-out price. In the next Part, we argue that recent Delaware
case law is moving in the wrong direction.
Getting it right is not a matter of indifference. A significant body
of scholarship links capital market development and public shareholder
protection.5 As we will see, legal rules and the enforcement
mechanisms for those rules affect the “minority discount”—that is, the
value difference between the shares of equivalent cash flow rights held
by public shareholders and by controlling shareholders.6 The minority
discount in turn affects the feasibility of “equity carve-outs,” transactions
in which a parent sells a minority interest in a subsidiary via an
5 The literature is summarized in Rafael La Porta et al., Investor Protection and Corporate
Governance, 58 J. FIN. ECON. 3 (2000). See also Rafael La Porta et al., Law and Finance,
106 J. POL. ECON. 1113 (1998) (examining the legal rules protecting corporate
shareholders in common law and civil law countries and hypothesizing that small, diversified
shareholders are not likely to hold much influence in countries that do not
protect their rights); Rafael La Porta et al., Legal Determinants of External Finance, 52 J.
FIN. 1131, 1131 (1997) (postulating that countries with poorer investor protections
have smaller and narrower capital markets).
6 See Alexander Dyck & Luigi Zingales, Private Benefits of Control: An International
Comparison, 59 J. FIN. (forthcoming 2004) (documenting cross-country differences in
private benefits); Tatiana Nenova, The Value of Corporate Voting Rights and Control: A
Cross-Country Analysis, 68 J. FIN. ECON. 325, 342 (2003) (same).
2003] CONTROLLING CONTROLLING SHAREHOLDERS 789
initial public offering (IPO), and also affects, generally, the value of
control transactions where some shares remain in public hands.
A. Private Benefits of Control in Operating the Company:
The Sinclair Standard
The legal rules governing private benefits of control in operating
a company set the limits on the price of monitoring by a controlling
shareholder. If these limits are effective, the presence of a controlling
shareholder benefits the non-controlling shareholders because the
reduction in managerial agency costs will exceed the level of private
benefits.
Two basic legal rules police the level of private benefits that result
from ongoing operations. First, if the controlling shareholder is a
director, then any contract between the controlling shareholder and
the corporation is an interested transaction and must meet the standards
of statutes like Delaware General Corporation Law section 144,7
which requires that the transaction be sanitized through either procedural
techniques or substantive judicial review.8 If the controlling
7 DEL. CODE ANN. tit. 8, § 144 (2001).
8 Delaware General Corporation Law section 144 provides in pertinent part:
(a) No contract or transaction between a corporation and 1 or more of its directors
or officers, or between a corporation and any other corporation, partnership,
association, or other organization in which 1 or more of its directors
or officers, are directors or officers, or have a financial interest, shall be void
or voidable solely for this reason, or solely because the director or officer is
present at or participates in the meeting of the board or committee which
authorizes the contract or transaction, or solely because any such director’s or
officer’s votes are counted for such purpose, if:
(1) The material facts as to the director’s or officer’s relationship or interest
and as to the contract or transaction are disclosed or are known to
the board of directors or the committee, and the board or committee in
good faith authorizes the contract or transaction by the affirmative votes
of a majority of the disinterested directors, even though the disinterested
directors be less than a quorum; or
(2) The material facts as to the director’s or officer’s relationship or interest
and as to the contract or transaction are disclosed or are known to
the shareholders entitled to vote thereon, and the contract or transaction
is specifically approved in good faith by vote of the shareholders; or
(3) The contract or transaction is fair as to the corporation as of the time
it is authorized, approved or ratified, by the board of directors, a committee
or the shareholders.
Id.; see also Oberly v. Kirby, 592 A.2d 445, 466 (Del. 1991) (“[W]here an independent
committee is not available [to approve an interested transaction under § 144], the
stockholders may either ratify the transaction or challenge its fairness in a judicial forum
. . . .”).
790 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 152: 785
shareholder is not a director, then Sinclair Oil Corp. v. Levien9 applies,
which sets out the general standards for the conduct of controlled
corporations.10 For this purpose, the Delaware Supreme Court essentially
divides sources of private benefits into two categories.
The first category concerns the business and strategic decisions of
the corporation. In Sinclair, for example, a minority shareholder of
Sinven Venezuelan Oil Company, a controlled corporation that operated
primarily in Venezuela, claimed that Sinven’s dividend policy favored
the controlling shareholder, Sinclair Oil Corporation.11 By paying
out as dividends a large percentage of Sinven’s profits, Sinven was
alleged to favor the controlling shareholder, which apparently had attractive
investment opportunities outside of the controlled corporation,
and to disadvantage the non-controlling shareholders, who received
equal dividends but lost the opportunity for the controlled
corporation to reinvest its earnings.12
The second category concerns the core aspect of private benefits—
the controlling shareholder’s direct dealings with the controlled
corporation. Here we are in the realm of true self-dealing—unfair
transfer pricing, the transfer of assets from the controlled corporation
to the controlling shareholder, and the use of the controlled corporation’s
assets as collateral for a controlling shareholder’s debt.
The standards established for the two categories of private benefits
are radically different. In general, courts treat business and strategic
decisions that even-handedly affect the controlling and noncontrolling
shareholders essentially as business judgments. Thus, the
Delaware Supreme Court handled the dividend decision in Sinclair, as
well as the related claim that the controlled corporation’s business was
limited to the development of oil opportunities in Venezuela (presumably
why the controlled subsidiary was in a position to pay such
9 280 A.2d 717 (Del. 1971).
10 See id. at 720 (invoking the intrinsic fairness standard when the fiduciary duty a
parent owes its subsidiary “is accompanied by self-dealing—the situation when a parent
is on both sides of a transaction with its subsidiary”).
11 Id. at 719-21.
12 The dividend may also have had a differential tax impact on minority shareholders.
Depending on whether the subsidiary was part of an affiliated group, at least
eighty percent and as much as one hundred percent of the dividends received by the
parent would not be taxed. See GILSON & BLACK, supra note 1, at 1239-41 (explaining
the impact of dividend-received deductions on the decision to employ a minority freezeout).
Minority shareholders would be taxed on dividends received unless they were
otherwise exempt.
2003] CONTROLLING CONTROLLING SHAREHOLDERS 791
large dividends), as business judgments, and thereby outside the realm
of intrusive judicial review.13
In contrast, core self-dealing is held to a dramatically different
standard. If the controlling shareholder appears to benefit at the expense
of the controlled corporation (for example, when the controller
disparately gains from contract terms or the enforcement of those
terms where the two parties are on opposite sides), the intrinsic fairness
standard—the most rigorous in corporate law jurisprudence—
applies. In that situation, the controlling shareholder bears the
burden of proving that the terms of the transaction were intrinsically
fair, with the court making a de novo determination.14
These two standards thus allow some range of private benefits of
control but, consistent with the minority shareholders’ calculus, at a
level that still may make the non-controlling shareholders better off.15
What kind of private benefits remain? At the most benign, maintaining
a publicly traded, majority-owned subsidiary may benefit the controlling
shareholder by more effectively opening the controlled
company’s performance to public scrutiny, thereby assuring more accurate
pricing of the controlled corporation’s business than if it was
bundled with that of the controlling shareholder. Reciprocally, the
controlling shareholder may then make use of market signals to help
assess its own and the controlled corporation’s business prospects as
well as the performance of the controlled corporation’s management.
Additionally, controlling shareholders may use market signals to devise
more accurate incentive compensation for the management
and employees of both corporations.16 In these circumstances, the
13 280 A.2d at 722.
14 Id. at 720.
15 The efficacy of these standards is offered by Johnson et al., supra note 2, at 26,
as an explanation for the absence of pyramidal structures in the United States: “Perhaps
the reason that pyramidal group structures are relatively rare in the United States
and the United Kingdom [yet ubiquitous elsewhere in Europe] is that many transactions
inside a group would be challenged on fairness grounds by minority shareholders
of subsidiaries, who would get a receptive hearing in court.”
16 These reasons are commonly offered as explanations for the efficiency of equity
carve-outs. See Katherine Schipper & Abbie Smith, A Comparison of Equity Carve-outs and
Seasoned Equity Offerings: Share Price Effects and Corporate Restructuring, 15 J. FIN. ECON.
153, 182 (1986) (“[T]he equity carve-out may improve public understanding of the
subsidiary’s growth opportunities.”); see also Anand M. Vijh, The Positive Announcement-
Period Returns of Equity Carveouts: Asymmetric Information or Divestiture Gains?, 75 J. BUS.
153, 189 (2002) (“[T]he market reacts positively to the announcement of carveouts
because it thinks that carveouts create value by divesting unrelated businesses, enabling
a complete spinoff or a third-party acquisition, providing new financing, undertaking
new investments, and reducing stock complexity.”). Announcement of such
792 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 152: 785
non-controlling shareholders get more focused monitoring at a relatively
low cost.17
Other conduct involving private benefits that does not involve
core self-dealing may be more costly. Here we have in mind a variety
of business decisions that, while not rising to the level of business opportunities,
may provide the controlling shareholder a benefit that
would not otherwise be available to it, even if the controlled corporation
does not directly bear an offsetting cost. These decisions seem to
us to have the character of real options: for example, where the activities
of the controlled corporation may keep open a strategy for the
controlling corporation.18 Nonetheless, this source of private benefit
remains limited, certainly when compared to core self-dealing.19
transactions results in a slightly less than two percent positive abnormal return in the
parent company’s stock. See Schipper & Smith, supra, at 153 (“These gains are in contrast
to the average abnormal loss associated with announcements of seasoned equity
offerings.”); see also Heather M. Hulburt et al., Value Creation from Equity Carve-Outs, 31
FIN. MGMT. 83, 99 (2002) (finding that empirical tests support the divestiture gains
hypothesis because “rivals of parent firms exhibit negative stock price reactions to equity
carve-out announcements”). Additional explanations for this gain include the
signal that the parent company’s stock is undervalued (otherwise the offering would
have been of parent stock), see Vikram Nanda, On the Good News in Equity Carve-Outs, 46
J. FIN. 1717, 1733 (1991) (“[T]he choice of financing decision may provide information
not just about the subsidiary’s assets in place but also about the value of the assets
in place of the rest of the corporation.”), and the increased analyst coverage of both
companies’ stock, see Stuart C. Gilson et al., Information Effects of Spin-offs, Equity
Carve-outs, and Targeted Stock Offerings 18 (June 1998) (unpublished manuscript)
(“Investment bankers . . . often argue that the level and quality of analyst coverage significantly
improves following these transactions.”), available at http://papers.ssrn.com/
sol3/papers.cfm?abstract_id=42904. In the end, some controversy remains about the
source of abnormal returns. See David Haushalter & Wayne Mikkelson, An Investigation
of the Gains from Specialized Equity: Tracking Stock and Minority Carve-Outs 24
(May 29, 2001) (unpublished manuscript) (conjecturing that “the stock price effects
do not reflect real benefits of specialized equity arrangements”), available at http://
papers.ssrn.com/sol3/papers.cfm?abstract_id=271691. For a more skeptical view of
valuation creation by carve-outs and carve-out stability, see André Annema et al., When
Carve-outs Make Sense, MCKINSEY Q. No. 2, at 13, 15 (2002) (finding that, two years after
the carve-out, most carve-outs “destroy[ed] shareholder value” and warning that
“[c]arving out even small stakes in subsidiaries will likely lead to complete and irreversible
separation”).
17 This statement is consistent with empirical evidence indicating that carve-out
subsidiary stocks do not underperform stock portfolio benchmarks, contrary to the
usual findings of underperformance for IPOs or seasoned equity offerings. Anand M.
Vijh, Long-Term Returns from Equity Carveouts, 51 J. FIN. ECON. 273, 275 (1999).
18 For this purpose it is useful to consider two different kinds of controlling shareholders:
One group has a unidimensional relation to their portfolio company—that is,
the controlling shareholder’s only connection with the company is its shareholdings.
A second group, in contrast, has a multidimensional relation to their
2003] CONTROLLING CONTROLLING SHAREHOLDERS 793
Finally, there is a level of private benefits extraction that arises
from non-actionable self-dealing. For example, a contract with a controlling
shareholder at market prices will still impound market-level
rents and will not reflect savings from reduced information asymmetries.
The relationship may also entail “micro” self-dealing that in
each instance is small but in the aggregate is significant.
What’s important is that judicial doctrine effectively puts a ceiling
on the private benefits of control associated with operating the corporation.
Behavior that has the potential to transfer large amounts of
value is subjected to intense judicial scrutiny, which is consistent with
our hypothesis that controlling shareholders do not take markedly
more from non-controlling shareholders than they provide.20 Thus,
the level of private benefits from operations provides a benchmark for
assessing the standards governing alternative methods of securing private
benefits.
B. Sale of Control at a Premium
The second method by which a controlling shareholder may extract
private benefits of control is by selling its control for a premium
that reflects the capitalized value of the private benefits of control
available from operating the controlled corporation. Although the
holding in Perlman v. Feldmann21—that a controlling shareholder cannot
sell control at a premium that is not shared with non-controlling
shareholders22—continues to amuse corporate law teachers (both because
it provides the basis for an interesting class and because of the
Second Circuit’s Fantasia-like view of Indiana law), by the early 1990s,
portfolio—that is, in addition to the controlling shareholder’s stock position,
it also has an operational relation to the company, for example, as customer
or supplier.
. . . A unidimensional controlling shareholder has few channels by which
to appropriate private benefits [from the controlled corporation].
GILSON & BLACK, supra note 1, at 1233. For the unidimensional controlling shareholder,
real options may be the primary source of private benefits. Id. at 1233-34.
19 Id. at 1233-34.
20 John Coates is more pessimistic with respect to the potential size of private
benefits that controlling shareholders can secure through operations. See John C.
Coates IV, “Fair Value” as an Avoidable Rule of Corporate Law: Minority Discounts in Conflict
Transactions, 147 U. PA. L. REV. 1251, 1314-27 (1999) (contending that controllers can
readily shift value from controlled subsidiaries). However, much of Coates’s focus is
on whether value-reducing operational decisions that affect all shareholders can be
transmuted into private benefits in a freeze-out as a result of valuation standards. Id.
21 219 F.2d 173 (2d Cir. 1955).
22 Id. at 178.
794 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 152: 785
the applicable legal rule was radically different. Whether one looks to
Delaware case law23 or to the American Law Institute’s (ALI) Principles
of Corporate Governance,24 the rule is clear: in general, a controlling
shareholder can sell control at a premium that is not shared with noncontrolling
shareholders.
Given the limits on private benefits of control from ongoing operations,
it seems clear that non-controlling shareholders would prefer
a rule that allows controlling shareholders the right to sell their
shares at a price that reflects the net present value of the flow of private
benefits from operating the company.25 Correspondingly, a buyer
of control presumably would not wish to acquire the controlled corporation
at a price that reflects the capitalized value of private benefits
unless it thought it could increase the value of its purchased interest.
Because the amount of private benefits from operating the controlled
corporation is capped by the legal rule applicable in that situation, the
non-controlling shareholders will share any increase in value resulting
from an increase in the common value of the controlled corporation.
26
23 The court in Harris v. Carter, 582 A.2d 222, 234 (Del. Ch. 1990), stated that,
“[w]hile Delaware law has not addressed this specific question, one is not left without
guidance from our decided cases. . . . [It] is [a] principle [of Delaware law] that a
shareholder has a right to sell his or her stock and in the ordinary case owes no duty in
that connection to other shareholders when acting in good faith.” See also Thorpe v.
CERBCO, Inc., 676 A.2d 436, 442 (Del. 1996) (distinguishing the fiduciary relationship
between directors and the corporation from the relationship between controlling
shareholders and other shareholders); In re Sea-Land Corp. S’holders Litig., No. 8453,
1987 WL 11283, at *5 (Del. Ch. May 22, 1987) (“A controlling stockholder is generally
under no duty to refrain from receiving a premium upon the sale of his controlling
stock.”); cf. Robert W. Hamilton, Private Sale of Control Transactions: Where We Stand Today,
36 CASE W. RES. L. REV. 248, 249 (1985) (“It is unlikely that any American court
today would reject the general proposition that controlling shareholders may obtain a
premium for their shares which they need not share with other shareholders.”).
24 PRINCIPLES OF CORP. GOVERNANCE: ANALYSIS AND RECOMMENDATIONS § 5.16
(1994).
25 This discussion draws on GILSON & BLACK, supra note 1, at 1231-32, which in
turn was informed by Frank H. Easterbrook & Daniel R. Fischel, Corporate Control
Transactions, 91 YALE L.J. 698, 711 (1982) (arguing that minority shareholders want a
rule that increases the market value of shares in the corporation). See also Lucian Arye
Bebchuk, Efficient and Inefficient Sales of Corporate Control, 109 Q.J. ECON. 957, 974-81
(1994) (comparing the market rule with the equal opportunity rule in the context of
corporate control transfers); Marcel Kahan, Sales of Corporate Control, 9 J.L. ECON. &
ORG. 368, 378 (1993) (analyzing the legal rules governing the sale of corporate control).
26 An empirical study of Perlman v. Feldmann showed that the stock of Newport
Steel, the controlled corporation, experienced abnormal returns of thirty-four percent
during negotiations for sale of control and abnormal returns of seventy-seven percent
2003] CONTROLLING CONTROLLING SHAREHOLDERS 795
Next, assume that the new controller realizes certain synergies from
its operation of the controlled corporation. Does this change the legal
rule that non-controlling shareholders would choose? We think
not. So long as the legal rules governing private benefits of control
from operations do not allow all of the synergy to be captured by the
controlling shareholder, the non-controlling shareholders will participate
in the value increase resulting from the sale of control. This is
a plausible assumption given that actually achieving synergy will require
direct interaction between the controlling shareholder and the
controlled corporation, an interaction that will be subject to Sinclair.27
There are exceptions to the permissive general rule, but these
seem to fit well within the present analysis. Section 5.16 of the ALI
Principles of Corporate Governance states these exceptions.28 The general
rule that a controlling shareholder can sell its shares at a premium is
qualified in two circumstances: first, when the controlling shareholder
acquires shares from non-controlling shareholders in anticipation
of the contemplated sale of control without disclosure and, second,
when it is apparent that the purchaser is likely to extract illegal
levels of private benefits from operating the controlled corporation.29
(twenty-nine percent on an industry-adjusted basis) over the entire year during which
control was sold. Michael J. Barclay & Clifford G. Holderness, The Law and Large-Block
Trades, 35 J.L. & ECON. 265, 270-71, 270 n.7 (1992). Because market price measures
the value of the public minority shares, the data suggest that the minority shareholders
benefited from the sale of control. The experience of Newport’s non-controlling
shareholders seems to be a generalizable one.
On the other hand, it is also possible to see Perlman v. Feldmann as correctly decided
on its own peculiar facts, namely the Korean War price controls that produced a
valuation gap between the capped wholesale price of steel and the value of the steel to
end-users, whose products were not price-capped. 219 F.2d at 175. To try to capture
this difference, Newport had insisted that customers provide advances against future
purchases, i.e., interest free loans. Id. at 177. Even if the end-users who acquired control
of Newport continued to make these advances on their purchases, if the present
value of the interest-rate differential was less than the steel-product valuation gap, then
at least part of the control premium can be considered a form of special synergy gain
that, because it was not ratably shared with the minority, was properly subject to recovery.
27 See supra notes 9-14 and accompanying text for a discussion of the standards
imposed by Sinclair.
28 PRINCIPLES OF CORP. GOVERNANCE: ANALYSIS AND RECOMMENDATIONS § 5.16
(1994).
29 Section 5.16 (a) and (b) restrict a controlling shareholder’s right to sell control
at a premium if:
(a) The controlling shareholder does not make disclosure concerning the
transaction to other shareholders with whom the controlling shareholder
deals in connection with the transaction; or
796 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 152: 785
The first exception operates merely as a form of insider trading regulation.
The second backstops the rule, limiting the level of private
benefits from operations. In circumstances of looting, the controlling
shareholder may be judgment proof. The exceptions provide an alternative
source of recovery when the seller of control should have
known what was coming.
In short, the legal rule governing receipt of private benefits
through sale of control fits nicely with the legal rule governing the
level of private benefits from ongoing operations of the company.
Except when there is reason to believe that the operating rules will be
violated following the sale, there is no reason for a more restrictive
rule. Put differently, if the stream of private benefits from operations
is effectively controlled, there is no need to regulate the transfer of its
capitalized value.30
C. Freeze-out of Minority Shareholders
The third method by which a controlling shareholder can extract
private benefits of control is through freezing out minority shareholders
at a market price that reflects a discount equivalent to the private
benefits of control available from operating the controlled corporation.
In contrast to the simple permissive rules governing the sale of
control at a premium, the rules governing minority freeze-outs are
both complex and restrictive.
The modern law of minority freeze-outs dates to the Delaware
Supreme Court’s decision in Weinberger v. UOP, Inc.31 In that case, the
(b) It is apparent from the circumstances that the purchaser is likely to violate
the duty of fair dealing . . . in such a way as to obtain a significant financial
benefit for the purchaser or an associate.
Id. § 5.16(a)–(b) (citations omitted).
30 Thus, one way to understand “mandatory bid” systems that are common to takeover
practice in the European Union, see infra note 115 (last paragraph), which give
public minority shareholders an exit right upon an acquisition of control, is in terms of
the differential capacity of legal systems to articulate and enforce minority shareholder
rights.
31 457 A.2d 701 (Del. 1983). The present historical account relegates Delaware’s
flirtation with a business purpose test as a precondition to a freeze-out—announced in
Singer v. Magnavox Co., 380 A.2d 969, 975-76 & n.5, 982 (Del. 1977) (apparently in response
to pressure from the federal courts) and overruled in Weinberger, 457 A.2d at
715—to accounts more concerned with the impact of federalist considerations on the
development of corporate law. For one such account, see GILSON & BLACK, supra note
1, at 1254-69. See also Mark J. Roe, Delaware’s Competition, 117 HARV. L. REV. 588, 600
(2003) (asserting that Delaware’s race is not with other states, but with the risk of federal
preemption).
2003] CONTROLLING CONTROLLING SHAREHOLDERS 797
Signal Companies determined to acquire the 49.5% of UOP that it did
not own through a merger in which the UOP shareholders would receive
cash for their UOP stock.32 Although Signal was prepared to pay
up to $24 per share for the stock, the UOP board agreed to accept $21
per share, an approximately fifty percent premium over the market
price of UOP stock.33 The court treated the freeze-out transaction as a
simple manifestation of the core self-dealing conduct that requires intensive
judicial review of the transaction terms for fairness.34 Because
the lower the price Signal paid to UOP shareholders, the better off it
was, and because Signal had benefited by its receipt of a feasibility
study prepared by Signal’s UOP directors to the detriment of the UOP
minority, the transaction simply presented a variation of the typical
scenario that triggers heightened review of operating transactions under
Sinclair.35 Consistent with the general principle that a controlling
shareholder is cut no slack in its dealings with a controlled corporation,
the court stressed that Signal-designated directors of UOP
should be held to the same standard as non-Signal directors; conflicting
loyalties had to be resolved in favor of the controlled corporation.
36
Having established that a freeze-out triggered intensive judicial
review of the transaction’s fairness, the court went on to delineate the
terms of that review. “Fairness,” the court explained, consists of the
process by which the transaction is negotiated: “fair dealing” together
32 Weinberger, 457 A.2d at 705.
33 Id. at 705-06.
34 Id. at 710.
35 “Self-dealing occurs when the parent, by virtue of its domination of the subsidiary,
causes the subsidiary to act in such a way that the parent receives something from
the subsidiary to the exclusion of, and detriment to, the minority stockholders of the
subsidiary.” Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971).
36 See Weinberger, 457 A.2d at 710 (relying on “the long-existing principle of Delaware
law that these Signal designated directors on UOP’s board still owed UOP and its
shareholders an uncompromising duty of loyalty”). In the post-Weinberger evolution of
freeze-outs, the inherent tensions in a transaction proposed by a controller, who either
has the necessary voting power to accomplish the transaction or, if the transaction is
conditioned on a majority of minority approval, will remain in control even if the minority
refuses, have led to the imposition of entire fairness review in all such freezeouts;
no explicit taking advantage of minority shareholders is required. See Kahn v.
Lynch Communications Sys., Inc., 638 A.2d 1110, 1115 (Del. 1994) (requiring entire
fairness review when a controlling or dominating shareholder stands on both sides of
the transaction); Rosenblatt v. Getty Oil Co., 493 A.2d 929, 937 (Del. 1985) (“‘[T]he
requirement of fairness is unflinching . . . where one stands on both sides of a transaction,
he has the burden of establishing its entire fairness, sufficient to pass the test of
careful scrutiny by the courts.’” (quoting Weinberger, 457 A.2d at 710)).
798 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 152: 785
with “fair price.”37 With respect to fair dealing, the court stressed both
the obligation of candor on the part of the parent38 and the importance
of a process that mirrors a real arm’s-length transaction in
which each party has the right to say “no.”39 As to fair price, the court
adopted for this purpose the liberalized appraisal standard previously
adopted by the Delaware legislature.40
Unfortunately, the court provided no real guidance as to how the
two elements of fairness interacted. On the one hand, Weinberger can
be read as suggesting that, if the parent allowed the subsidiary to establish
an independent negotiating committee that had the right to
say “no,” the court could then infer that the price resulting from
arm’s-length bargaining was also fair. Alternatively, however, the
court simultaneously and unhelpfully stressed that “the test for fairness
is not a bifurcated one as between fair dealing and price. All aspects
of the issue must be examined as a whole since the question is
one of entire fairness.”41
The importance of this confusion cannot be overemphasized. For
this purpose, it is important to keep in mind what is at stake. Controlled
corporation shareholders already have a remedy if they believe
the price to be paid in a cash-out merger is too low: an appraisal proceeding
with precisely the same measure of value as that adopted
by the Weinberger court.42 The difference between the two remedies
is technically procedural, but ultimately of enormous substantive consequence.
Under the Delaware appraisal procedure, a shareholder
must jump through a number of procedural hoops, including not
37 Weinberger, 457 A.2d at 711.
38 Id.
39 In an oft-cited footnote, the court stated that
the result here could have been entirely different if UOP had appointed an
independent negotiating committee of its outside directors to deal with Signal
at arm’s length. Since fairness in this context can be equated to conduct by a
theoretical, wholly independent, board of directors acting upon the matter
before them, it is unfortunate that this course apparently was neither considered
nor pursued. Particularly in a parent-subsidiary context, a showing that
the action taken was as though each of the contending parties had in fact exerted
its bargaining power against the other at arm’s length is strong evidence
that the transaction meets the test of fairness.
Id. at 709 n.7 (citations omitted).
40 Id. at 703-04; see also DEL. CODE ANN. tit. 8, § 262 (Supp. 1982) (current version
at tit. 8, § 262 (2001)).
41 Weinberger, 457 A.2d at 711. The court’s reasoning is unclear. Suppose the price
is entirely fair, but the process is faulty. To what else are shareholders entitled beyond
a fair price?
42 Id. at 703-04.
2003] CONTROLLING CONTROLLING SHAREHOLDERS 799
voting for the transaction and not accepting payment, in order to
retain the right to bring an appraisal action.43 More importantly, the
Delaware corporate statute does not authorize a class appraisal procedure.
44 In contrast, a breach of fiduciary duty claim can be brought
on behalf of all subsidiary shareholders regardless of how they voted
or whether they accepted payment for their shares.45 Thus, the economics
of the litigation process mean that, if a fight about price is limited
to appraisal, the controlling shareholder is exposed as to price
only with respect to the number of shares for which appraisal rights
are perfected, typically a quite small number. Moreover, the controller
can manage its potential risk by conditioning its obligation to close
the merger on a certain level of shareholder approval. In a class action
under the Weinberger standard, however, the price exposure extends
to all shares acquired through the freeze-out merger without the
need for shareholders to take any action at all.46
Finally, if the freeze-out merger consideration is stock in the controller
or stock in any publicly traded corporation, the minority
shareholders have no right to appraisal.47 Thus, without a cause of action
for breach of fiduciary duty, the minority shareholders in such a
transaction may have no remedy at all.
What remained open after Weinberger, then, was the procedural
key. If the parent adopts an arm’s-length negotiating structure, including
an independent negotiating committee with a right to say
“no,” and receives the approval of a majority of the minority shareholders,
does the standard of review shift to business judgment
and therefore relegate shareholders to their appraisal rights as the
43 § 262(a).
44 Id.
45 See Kahn v. Lynch Communication Sys., Inc., 638 A.2d 1110, 1111 (Del. 1994)
(noting that the plaintiff brought a class action on behalf of all shareholders of the acquired
company whose stock had been procured through the merger).
46 See GILSON & BLACK, supra note 1, at 1266-69 (discussing the differences between
appraisal actions and other claims). In Andra v. Blount, 772 A.2d 183, 183-84
(Del. Ch. 2000), Vice Chancellor Strine confronted the critical procedural consequence
of a plaintiff’s successfully invoking entire fairness review of a freeze-out merger in the
context of applying standing as a barrier to entire fairness review. See also Clements v.
Rogers, 790 A.2d 1222, 1225 (Del. Ch. 2001) (confronting a similar procedural consequence
with respect to the acquiescence doctrine).
47 § 262(b)(2). If, however, the controller owns at least ninety percent of the
target’s stock and uses the short-form merger procedure under DEL. CODE ANN. tit. 8,
§ 253 (2001), then the minority shareholders have appraisal rights irrespective of the
consideration. § 262(b)(3).
800 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 152: 785
Weinberger court suggested in footnote 7?48 Alternatively, would the
appraisal measure of value nonetheless be applied on a class basis because,
as the Weinberger court also explained, “the test for fairness is
not a bifurcated one as between fair dealing and price”?49 This and
related issues were more or less clearly worked out in two Delaware
Supreme Court opinions, Kahn v. Lynch Communications Systems, Inc.
(Kahn I )50 and Kahn v. Lynch Communications Systems, Inc. (Kahn II ),51
involving Alcatel U.S.A. Corporation’s freeze-out of non-controlling
shareholders in Lynch Communication Systems, Inc.
Kahn I plainly resolved the issues at stake in structuring the approval
process of a freeze-out merger. The court considered a perfectly
sensible argument that entire fairness review should not apply,
and therefore shareholders would be remitted to an appraisal remedy,
if the negotiating structure plausibly protected their interests52—as,
for example, where the merger terms met the approval of a fully
empowered, independent negotiating committee and the merger
was conditioned upon approval by the majority of the disinterested
minority.53 Where the procedure approximated an arm’s-length negotiation,
no special judicial review would be appropriate, and the
business judgment standard would apply. Furthermore, it would
follow that the frozen-out shareholders would be held to their decision
regarding the pursuit of appraisal. Instead, the Kahn I court held
that adopting such a negotiating structure served only to shift the
burden of proof to the plaintiff on the issue of the freeze-out’s fairness.
54 The court believed that the controlling shareholder retained
the capacity to influence the minority that cannot be procedurally
48 457 A.2d at 709 n.7. See supra note 39 for the footnote quotation.
49 457 A.2d at 711.
50 638 A.2d at 1117.
51 669 A.2d 79, 84 (Del. 1995).
52 See Kahn I, 638 A.2d at 1115 (discussing the possibility that approval of a cashout
merger by a committee of interested directors “renders the business judgment rule
the applicable standard of judicial review”).
53 In re Trans World Airlines, Inc. S’holders Litig., No. 9844, 1988 WL 111271, at
*7 (Del. Ch. Oct. 21, 1988):
Both the device of the special negotiating committee of disinterested directors
and the device of a merger provision requiring approval by a majority of disinterested
shareholders, when properly employed, have the judicial effect of
making the substantive law aspect of the business judgment rule applicable
and, procedurally, of shifting back to plaintiffs the burden of demonstrating
that such a transaction infringes upon rights of minority shareholders.
54 638 A.2d at 1117.
2003] CONTROLLING CONTROLLING SHAREHOLDERS 801
dissipated.55 In effect, the court envisioned an implicit threat that, if
the non-controlling shareholders did not approve the freeze-out, the
controlling shareholder would exercise its operating discretion to
their disadvantage.56 In Kahn I itself, the court found that Alcatel had
coerced the independent negotiating committee set up by Lynch
Communications by threatening to proceed with a tender offer at a
lower price if the committee continued to resist.57 The court remanded
the case to the chancery court to determine the transaction’s
entire fairness.58
Kahn I left open two important issues. First, what happens if the
transaction structure fails this initial fair-dealing inquiry and therefore
does not operate to shift the burden of proof? If a transaction has to
exhibit both fair dealing and fair price to be entirely fair, then how
can the fairness standard ever ultimately be satisfied if, as in
Kahn I, the fair-dealing component is not met? Second, why should a
controlling shareholder allow the creation of a fully empowered negotiating
committee if all it gets in return is a burden shift? Unless the
evaluation of price is somehow different—even without the presumptions
of business judgment review—as a result of procedural protections,
what is in it for the controlling shareholder?59
On remand, the chancery court found that the transaction satisfied
both the fair-dealing and fair-price components of the entire
fairness review.60 As has been suggested, finding that the fair-dealing
component was satisfied, despite the controlling shareholder’s coercion
of the independent negotiating committee, required some fasttalking.
On appeal, the supreme court’s assessment of fair dealing
took an unacknowledged but major shift. While in Kahn I the inquiry
55 Id. at 1116-17.
56 “‘The controlling stockholder relationship has the [sic] potential to influence,
however subtly, the vote of [ratifying] minority stockholders in a manner that is not
likely to occur in a transaction with a noncontrolling party.’” Id. at 1116 (quoting Citron
v. E.I. DuPont de Nemours & Co., 584 A.2d 490, 502 (Del. Ch. 1990)). In making
this statement, the court appears unaware that this “inherent coercion” can exist only
to the extent that judicial review of the controlling shareholder’s operating decisions
fails to control private benefit extraction.
57 See id. at 1118 (stating that the independent negotiating committee had “full
knowledge of Alcatel’s demonstrated pattern of domination” while considering Alcatel’s
proposal to purchase Lynch Communications).
58 Id. at 1121-22.
59 See In re Cysive, Inc. S’holders Litig., No. 20341, 2003 WL 21961453, at *15-16
(Del. Ch. Aug. 15, 2003) (concluding that burden-shifting, particularly on “fair value,”
is not generally material either at the pleading stage or at trial).
60 Kahn II, 669 A.2d at 83.
802 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 152: 785
was whether the independent negotiating committee had been coerced,
in Kahn II the inquiry shifted to whether the non-controlling
shareholders voting on the freeze-out merger were coerced.61 Despite
the finding that “the specter of coercion” had impaired the functioning
of the independent negotiating committee, the court concluded
that “[w]here other economic forces are at work and more likely produced
the decision to sell,” this coercion still
may not be deemed material with respect to the transaction as a whole,
and will not prevent a finding of entire fairness. In this case, no shareholder
was treated differently . . . nor subjected to a two-tiered or
squeeze-out treatment. . . . Clearly there was no coercion exerted which
was material to this aspect of the transaction . . . .62
Putting Kahn I and Kahn II together, we are left with something
like a two-tiered inquiry concerning the fair-dealing component of the
entire fairness standard. With respect to whether the burden of proof
on entire fairness has shifted to the plaintiff, the appropriate inquiry
assesses the presence and true empowerment of an independent negotiating
committee.63 Fairly read, Kahn I holds that the burden of
proof does not shift unless the independent negotiating committee
has the right to prevent the transaction.64 With respect to the ultimate
determination of whether the transactional procedure satisfies the
fair-dealing component, the inquiry shifts to whether the inherent coercion
and the form of the transaction actually influenced the noncontrolling
shareholders’ votes. Characterized somewhat less than
sympathetically, is fair dealing satisfied despite an unfair, but not
structurally coercive, procedure?65
That leaves the issue of the stakes associated with establishing an
empowered special committee. Will the assessment of fair price be
influenced by the extent to which the transaction structure attempts
61 See id. at 86 (holding that the coercion found by the court in Kahn I did not
have a “material” influence on the shareholders’ decision to sell and, therefore, was
not indicative of unfair dealing).
62 Id. (citation omitted).
63 How to design a fully empowered, independent negotiating committee is itself
an interesting issue. See GILSON & BLACK, supra note 1, at 1303-05 (speculating as to
what negotiating procedures will satisfy the fair-dealing requirement after Kahn I ).
64 See supra text accompanying note 54 (describing the court’s holding that an
arm’s-length negotiating structure shifts the burden of proof).
65 By contrast, a violation of the duty of candor does appear to result in a per se
failure of the entire fairness standard. See Ince & Co. v. Silgan Corp., No. 10941, 1991
WL 17171, at *5 (Del. Ch. Feb. 7, 1991) (stating that “entire fairness includes the obligation
‘to disclose with entire candor all material facts concerning the merger’” (quoting
Sealy Mattress Co. v. Sealy, Inc., 532 A.2d 1324, 1335 (Del. Ch. 1987))).
2003] CONTROLLING CONTROLLING SHAREHOLDERS 803
to dissipate the specter of coercion? The answer to that question remains
opaque, largely because of the court’s continued insistence on
the “non-bifurcated standard of Weinberger.”66 There is, however, a specter
of judicial coercion with respect to the link between procedure
and price. Although Weinberger eliminated the free option that arose
out of Lynch v. Vickers Energy Corp.,67 which held that failing the entire
fairness standard exposed the controlling shareholder to the equitable
remedy of the monetary equivalent of rescission,68 and the court in
the seemingly endless Cede & Co. v. Technicolor, Inc.69 litigation read
the appraisal standard in section 262 to include significant elements
of post-transaction value,70 Weinberger continued to hold out the prospect
of equitable relief beyond the appraisal standard.71 Thus, the
court has left room for a link between procedure and damages, with
an appropriate incentive effect.
D. Summary
The doctrinal origami of the limits on controlling shareholders
presents a clear but complex pattern. The rule governing the extraction
of private benefits of control limits large wealth transfers from
non-controlling to controlling shareholders by imposing rigorous
judicial review of self-dealing transactions between the controlling
shareholder and the controlled company, while still leaving room
for a range of private benefits that may be more beneficial to the controlling
shareholder than costly to the controlled company and that
66 Kahn II, 669 A.2d at 90. The court’s reference to “a disciplined balancing approach”
following its mention of the non-bifurcated standard in Kahn II, id., appears to
contemplate an undisciplined tradeoff between procedure and price that seems to assure
the continued pattern of fully litigating every freeze-out transaction.
67 429 A.2d 497 (Del. 1981) (awarding the plaintiff rescissory damages for the controlling
shareholder’s breach of fiduciary duty in a tender offer, rather than the appraisal
damages typically awarded to minority shareholders injured in sales to controlling
parties); see also GILSON & BLACK, supra note 1, at 1269 (discussing the option-like
effect of differing damage standards in appraisal and entire fairness proceedings).
68 429 A.2d at 501; see also Weinberger, 457 A.2d 701, 703-04, 714 (Del. 1983) (overruling
Lynch by holding that appraisal, and not rescissory damages, is the appropriate
remedy for minority shareholders in freeze-out mergers).
69 684 A.2d 289 (Del. 1996).
70 Id. at 299-300.
71 457 A.2d at 714 (“While a plaintiff’s monetary remedy ordinarily should be confined
to the more liberalized appraisal proceeding herein established, we do not intend
any limitation on the historic powers of the Chancellor to grant such other relief
as the facts of a particular case may dictate.”).
804 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 152: 785
may support the more focused monitoring of the managerial agency
problem available to a controlling shareholder.
In turn, the rule governing the extraction of the capitalized value
of the private benefits from operations through the sale of control is
both simple and permissive. Because of the restrictions on the extraction
of private benefits from operations (which continue to allow a
level of private benefits consistent with focused monitoring), an acquirer
of control must ordinarily improve the performance of the
controlled corporation in order to profit from its investment. Achieving
this improvement requires two inputs: the capabilities of the new
controlling shareholder and the existing business of the controlled
corporation. Because the non-controlling shareholders remain participants
in the controlled corporation, the gain that results from this
bilateral monopoly is shared more or less proportionately. Judicial intervention
is limited to those circumstances where either there is an
observable risk that the purchaser of control will exceed the level of
allowed private benefits from operation or there has been fraud in the
interaction between the selling controlling shareholder and noncontrolling
shareholders in anticipation of the control sale.
In contrast, the rules that limit extracting the capitalized value of
the private benefits of control through freezing out the noncontrolling
shareholders are both complex and restrictive. This difference
emerges because, unlike with a sale of control, noncontrolling
shareholders will not automatically participate in any value
increase as a result of the freeze-out. This discrepancy results in an
incentive for controlling shareholders to manipulate the operation of
the controlled corporation and the market price of its stock in anticipation
of the transaction, subject to the limits imposed by the Sinclair
standard.72 It also can leave the non-controlling shareholders with no
benefit from the post-transaction increase in value even though an input
in which they have an interest is necessary to achieve that increase.
Requiring an independent negotiating committee and more rigorous
judicial review serves to ensure that the non-controlling shareholders
receive some portion of the gain that would result from bargaining in
a bilateral monopoly.73
72 Sinclair, 280 A.2d 717, 722 (Del. 1971), would not restrict poor decisions that
reduce value generally. To the extent that the effects of such decisions may not be reversible,
the potential for manipulation is real.
73 There is no obvious reason to believe that giving all the gain to one side
or another in a bilateral monopoly is necessary in order to achieve an efficient level
of transactions. From the perspective of either participant, any value above the
2003] CONTROLLING CONTROLLING SHAREHOLDERS 805
II. DISTURBING THE SYMMETRY: THE DIGEX AND
SILICONIX LINES OF CASES
To this point, we have argued that the Delaware doctrine seeking
to control the level of private benefits enjoyed by controlling shareholders
reflects a sensible symmetry between the three alternative
methods by which these benefits can be extracted: through ongoing
operations, by a sale of control, or by a freeze-out. As our discussion
of the case law reflects, we do not assert that this symmetry is the result
of grand design. Rather, we believe only that, when rules governing
one or another alternative get out of line, transaction planners are
quick to adjust their strategies to compensate, such that the Delaware
Chancery Court sees the implications of its previous decisions quickly
and is promptly given the opportunity to adjust the rules and restore
balance.74 We also do not assert that the pattern necessarily reflects a
fully efficient equilibrium that can be reflected in complex equations.
Rather, we suggest only that the pattern reflects a rough but workable
solution, not necessarily any worse than the results of an effort to
mathematically model the solution to three simultaneous equations
under restrictive assumptions.
Our recognition of the overall structure’s viability should not,
however, imply that we believe the Delaware courts always get it
reservation price is a rent. Lucian Bebchuk and Alan Schwartz discuss this issue as it
pertains to the takeover context in an interesting, albeit lengthy, debate. For examples
of their arguments, see Lucian Arye Bebchuk, The Case for Facilitating Competing Tender
Offers: A Last (?) Reply, 2 J.L. ECON. & ORG. 253, 256 (1986); Lucian Arye Bebchuk, The
Sole Owner Standard for Takeover Policy, 17 J. LEGAL STUD. 197, 228 (1988); Alan
Schwartz, Bebchuk on Minimum Offer Periods, 2 J.L. ECON. & ORG. 271, 271 (1986); Alan
Schwartz, Search Theory and the Tender Offer Auction, 2 J.L. ECON. & ORG. 229, 244
(1986); Alan Schwartz, The Sole Owner Standard Reviewed, 17 J. LEGAL STUD. 231, 234
(1988).
74 Ronald Gilson and Bernard Black describe “[t]his drastic telescoping of the
common law process” with respect to takeovers in the 1980s: “Each new decision was
reflected in the tactics of the next transaction; the Chancery Court often had to confront
the ‘next case’ on a motion for preliminary injunction soon after the initial decision.”
GILSON & BLACK, supra note 1, at 4. We do not intend this analysis as a strong
claim for the efficiency of the common law of corporations. We do, however, think
that the claim for efficiency is likely the strongest here, where the rules concern an ongoing
pattern of transactions and where professionals view their role as involving continual
adjustment of transactional structures to reflect new judicial decisions. This explicit
interaction between case law and transaction structure is plainly visible in the
latter line of cases we discuss in this Part. See also John C. Coates IV & Guhan Subramanian,
A Buy-Side Model of M&A Lockups: Theory and Evidence, 53 STAN. L. REV. 307,
328-37 (2000) (documenting the rapid shift from stock options to breakup fees in
friendly mergers following an adverse Delaware Supreme Court ruling on stock options).
806 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 152: 785
right. These are complicated and difficult matters with, as we have
tried to show, a lot of moving parts. Moreover, the case law does not
acknowledge the simultaneity of the three doctrinal lines, which
makes maintaining their symmetry that much harder. Thus, mistakes
happen. The role of commentary is to identify these glitches and offer
suggestions as to how they can be rectified.75
In this Part, we focus on what we believe to be two such glitches
that go to the center of the symmetry developed in Part I. The first,
the chancery court decision of In re Digex, Inc. Shareholders Litigation,76
deals with the rules governing private benefit extraction through the
sale of control, and the second, the line of cases following In re Siliconix
Inc. Shareholders Litigation,77 deals with the rules governing private
benefit extraction through freeze-outs. Recognition of the relationship
between the three doctrinal areas that control controlling shareholders’
extraction of private benefits suggests that, in each, the chancery
court is moving in the wrong direction. More particularly, Digex
threatens to interfere with the controller’s right to retain a control
premium in the sale of control, and the Siliconix line of cases threatens
to reduce minority protections in freeze-out transactions in a way that
will enhance the controller’s take beyond the permitted level of private
benefits.
A. Digex: New Restrictions on Sale of Control at a Premium
The controversy in Digex now seems terribly dated. The transaction
began with a contest between WorldCom, Inc. and Global Crossing,
Ltd. to acquire Intermedia Communications, Inc., a telecommunications
company, and/or Digex, Inc., Intermedia’s controlled
subsidiary in the web hosting business, said to be “well positioned in
one of the hottest segments of the technology sector . . . .”78 World-
Com won the contest, having made clear “that WorldCom would outbid
anyone for Digex.”79 The legal issues were posed by the conflict
between Intermedia and Digex shareholders over which group would
receive the Wo
Author
- Ronald J. Gilson
- Stanford Law School