A Course Correction for Controlling Shareholder Transactions

Abstract

This paper critically examines the evolving legal standards applied by Delaware courts to controlling shareholder transactions, highlighting the increasing constraints faced by controlling shareholders. Delaware courts increasingly exhibit a reflexive suspicion of transactions involving a controlling shareholder.  The court has operationalized that skepticism by notably broadening the definition of who qualifies as a controlling shareholder. In particular, the courts are increasingly willing to hold that shareholders who own less than a majority of the corporation’s voting power nevertheless possess control.  Taken to its logical extreme, this trend easily could result in someone being deemed a controller even in the absence of stock ownership.  

The court’s growing skepticism of controlling shareholders is further reflected in its tightening of the standards governing the conduct of controlling shareholders.   In doing so, the court has expanded the range of conflicted transactions necessitating cleansing and heightened the rigor with which cleansing standards are applied, particularly regarding the criteria for independent directors. 

This article contends that Delaware courts need a course correction. They have pushed the law governing controlling shareholders far beyond legitimate policing into unnecessary and unwise overregulation. This has prompted a backlash in which controllers threaten to reincorporate outside of Delaware, following Elon Musk’s example of moving Tesla to Texas. 

The article proposes four course corrections, pursuant to which the courts: (1) should narrow the definition of controller; (2) should not attempt to sort out in which cases controllers owe fiduciary duties to the minority from those in which they do not, but instead hold that a controller always owes fiduciary duties to the minority;  (3) narrow the class of cases under which entire fairness is the standard of review by adopting a reinvigorated Sinclair Oil threshold test under which entire fairness is triggered only when the controller receives a benefit at the expense of and to the exclusion of the minority; and (4) improve the regime for cleansing transactions in which entire fairness applies. These changes will reduce costs and encourage beneficial investment, while also enhancing Delaware’s position as the state of choice for incorporation. Accordingly, if the courts fail to adopt them, the Delaware legislature should consider doing so by statute.

Keywords: corporate law, corporate governance, corporate control, majority shareholders, controlling shareholders, controllers, fiduciary duty

JEL Classification: G34, K22