Delaware Chancery Court Research Articles

Post-Siliconix Freeze-Outs: Theory, Evidence & Policy

At approximately the same time that the Sarbanes-Oxley Act increased the costs associated with being a public company, important Delaware case law created a difference in the standard of judicial review for the two basic methods of freezing out minority shareholders. While a freeze-out executed as a statutory merger is subject to stringent entire fairness review, the Delaware Chancery Court held in In re Siliconix Shareholders' Litigation that a freeze-out executed as a tender offer is not. This paper presents the first systematic empirical evidence on post-Siliconix freeze-outs. Using a new database of all freeze-outs executed during the current doctrinal regime, I find that a controlling shareholder pays less to the minority shareholders, on average, when it uses a tender offer compared to a merger. This difference between tender offers and mergers seems to increase with the size of the controller's pre-deal stake. These findings introduce a puzzle as to why more than two-thirds of post-Siliconix freeze-outs still proceed through the traditional merger route. I present some evidence that controllers are more likely to choose a merger when they hold a relatively small controlling stake, in order to avoid supermajority approval from the minority that would be required in a tender offer. I also present some evidence that a freeze-out is more likely to be executed as a tender offer when the controller's outside counsel has substantial M&A experience. These findings bolster arguments for convergence in judicial standards of review between tender offer and merger freeze-outs, and provide guidance on how such convergence might best be achieved.

The Firm and the Nature of Control: Toward a Theory of Takeover Law

Like much of life, corporate governance is about control. One of the most interesting and controversial subjects in corporate law concerns the market for corporate control - the buying and selling of companies. Should boards have the authority to fend off hostile takeover attempts, including the right to just say no, or should target shareholders have the right to decide whether or not to sell the company to a willing buyer, overriding the board's objections? After nearly twenty years of doctrinal developments since the landmark Unocal case, the Delaware Supreme Court and the Delaware Chancery Court continue to struggle with the proper role of directors and shareholders in responding to a bid for the company. Lawyers, investment bankers, corporate executives, directors, shareholders, and legal scholars also remain unclear about the extent to which directors can impede the decision of shareholders to sell to a bidder. The Delaware Supreme Court's most recent takeover decision, Omnicare, Inc. v. NCS Healthcare, Inc., seems to confuse things only more. This Article offers a model of Delaware takeover law that explains how the leading Delaware Supreme Court takeover cases fit together. Instead of looking at takeover law through the lens of fiduciary duty, this Article's control-based approach to Delaware takeover law relies on the theory of the firm, as well as positive corporate law, to understand how control is allocated between the board and shareholders. At bottom, there are separate spheres of board (managerial) control and shareholder (residual) control. The takeover decision occurs at the intersection where board and shareholder control meet and in fact overlaps both spheres. One might think that shareholders have an absolute right to sell to a bidder, since alienability is a characteristic feature of ownership. However, the fact that a shareholder quite literally owns her shares is not enough to resolve the debate over defensive tactics, because the sale of the company can significantly impact the target's corporate strategy, over which the board exercises authority. According to the control-based model of takeover law, the extent to which target directors can adopt defensive tactics depends on whether the takeover attempt primarily implicates board control or shareholder control - in other words, on whether the bid raises matters of corporate policy and strategy sufficient to justify the board in blocking shareholders from selling. This general framework is then applied to explain how the leading Delaware takeover cases fit together and sheds light on two particularly important questions: first, what triggers Revlon; and second, can target boards just say no? The paper concludes with a blueprint for the future development of Delaware takeover law in a way that would ultimately lead to more shareholder choice and limits on defensive tactics.

Controlling Controlling Shareholders

The rules governing controlling shareholders sit at the intersection of the two facets of the agency problem at the core of 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, a large shareholder may better police management than the standard panoply of market-oriented techniques. The second is the agency problem that arises between controlling and non-controlling shareholders, which produces the potential for private benefits of control. 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 point of view of public shareholders, 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 benefits from reduction in managerial agency costs are greater than the costs of private benefits of control. 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. 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 symmetrical 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 non-controlling 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 efficiency gains are greater from sale of control than from freeze outs, so that a shift that favors freeze outs as opposed to sales of control is a move in the wrong direction. 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 offer without a special committee approval.

Controlling Controlling Shareholders

The rules governing controlling shareholders sit at the intersection of the two facets of the agency problem at the core of 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, a large shareholder may better police management than the standard panoply of market-oriented techniques. The second is the agency problem that arises between controlling and non-controlling shareholders, which produces the potential for private benefits of control. 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 point of view of public shareholders, 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 benefits from reduction in managerial agency costs are greater than the costs of private benefits of control. 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. 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 symmetrical 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 non-controlling 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 efficiency gains are greater from sale of control than from freeze outs, so that a shift that favors freeze outs as opposed to sales of control is a move in the wrong direction. 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 offer without a special committee approval.

The “Unhappy Lot”: Limits on preferred stock protective provisions

“The lot of a holder of junior preferred stock is not always a happy one,” observed the Delaware Chancery Court in Benchmark Capital Partners IV, L.P. v. Vague. It certainly wasn’t for Benchmark Capital Partners. Benchmark’s fate holds important lessons for institutions and funds that invest in preferred stock. Preferred stock investors typically seek voting rights or veto rights over certain significant corporate actions and against direct economic impairment of the preferred stock investment. The Benchmark case illustrates some limitations of such traditional preferred stock protective provisions. Examining these limitations illustrates several ways that investors may help limit impairment of their preferred stock investments.

Securities Fraud as Corporate Governance: Reflections Upon Federalism

Federal securities law and enforcement via securities fraud class actions today has become the most visible presence in regulating corporate governance. State law, long at center stage in discussions of corporate governance, continues to provide the legal skeleton for the corporate form and state fiduciary duty litigation continues as a frequent means to monitor managers. Yet, in today's world, state law does so almost entirely in the specific contexts of decisions about acquisitions or in self-dealing transactions. The empirical evidence in this Article illustrates that corporate governance outside of these areas has passed to federal law and in particular to shareholder litigation under Rule 10b-5. The Sarbanes-Oxley Act of 2002, passed by Congress in the wake of the current corporate accountability scandals, provides new evidence of the expanded role of federal law. But, the move to federal corporate governance is broader than that law and has a longer history than the current scandals. The ascendancy of federal law in corporate governance reflects at least three factors. First, disclosure has become the most important method to regulate corporate managers and disclosure has been predominantly a federal, not a state, methodology. Second, state law has focused largely on the duties and liabilities of directors, and not officers, and federal law has increasingly occupied the space defining the duties and liabilities of officers. Officers have become the fulcrum of governance in today's corporations. Third, federal shareholder litigation based on securities fraud has several practical advantages over state shareholder litigation based on fiduciary duty that have contributed to the greater use of the federal forum. As a result of these trends, federal law now occupies the largest part of the legal corporate governance infrastructure in the 21st century. The outpouring of suggested reforms that have followed in the wake of Enron and WorldCom have focused on federal law and on the conduct of officers and directors, rather than state law, which in practice, focuses mainly on directors. Indeed, the discussions about reforms have excluded state law almost entirely. In this article, we develop the idea of federal law as corporate governance in three parts organized around history, empirical data, and analysis. In Part I, we begin with the traditional legal template. State corporate law is the focus and federal securities law plays a supporting role. In Part II, we present empirical data on the use of both federal and state litigation to regulate corporate governance. We begin with a data set we have developed of securities fraud class action complaints filed in 1999. Our analysis of those complaints shows that securities fraud class action litigation is being used mostly in areas that relate to the managers' operation of the business. Not surprisingly, for example, many of the complaints raise concerns about the ways in which managers have recognized revenues or engaged in some form of accounting manipulation. From that base, we expand the story using data developed by others on securities fraud class actions more generally. Then, we compare transactions that give rise to securities fraud claims to another data set that covers all corporate cases filed in the Delaware Chancery Court for that same year. The result is a surprisingly narrow focus for state litigation and a much broader one for federal suits, revealing a gap in the standard learning about corporate governance. In Part III, we address how the federal securities fraud picture we provide might fit with state shareholder litigation in a current theory of corporate governance.

The Value of Voting in Hostile Takeovers: An Experimental Model

For many years academics have debated whether it is better to permit hostile acquirers to use tender offers to gain control over unwilling target companies, or to force them to use corporate elections of boards of directors in these efforts. The Delaware courts have expressed a strong preference for shareholder voting as a change of control device in hostile acquisitions. To force acquirers to accept their preferences, the Delaware courts have developed a jurisprudence permitting the effective classified board (ECB), a poison pill combined with a classified board, to protect target company management from removal by a hostile tender offer alone, or through a single corporate election. For companies with ECB's, this means that a determined acquirer must engage in two corporate elections over a period of two years to force entrenched managers to give up power. In this paper, we examine whether proxy contests, tender offers or combined proxy contest/tender offers are more likely to result in value maximizing outcomes for shareholders when target companies are able to deploy defensive tactics. We begin by showing that prior work suffers from serious flaws involving the use of voting models that are inappropriate for analyzing proxy contests. To develop a more realistic approach to these questions, we employ a probabilistic version of a standard weighted voting model that explicitly incorporates two critical features of corporate voting: first, that shares are normally voted in large blocks rather than in single shares; and second, that independent third party proxy voting advisors play an important, and often pivotal, role in determining the outcome of corporate elections. In addition, we explicitly incorporate information about the size of different corporate constituencies and their voting preferences. Using our model, we show experimentally how the distribution of shares among various investor constituencies will affect the outcome of different types of voting contests. Using this model, and these different sets of assumptions, we find that neither proxy contests, tender offers, nor combined proxy contests and tender offers will always lead to the desirable outcome for target company shareholders in any scenario. With each type of acquisition technique, bidders succeed in obtaining control of the target company in some value decreasing transactions, and are defeated in their acquisition efforts in some value increasing transactions. These results hold whether we permit existing defensive tactics or eliminate them. We conclude that in order to properly analyze the role of defensive tactics, courts must take into account the underlying shareholder ownership patterns. This requires them to engage in a fact sensitive analysis of whether defensive tactics are impeding or facilitating the maximization of shareholder value. When we examine the Delaware Chancery Court's decisions, the reasonableness analysis that they have employed to decide whether to overturn defensive tactics permits them to do so. We recommend that the courts continue to apply this type of analysis in the future with more direct consideration of the impact of the underlying ownership structure in determining whether the defenses are being used to maximize shareholder value.

One step or two? (Delaware’s going‐private dichotomy)

After a series of recent Delaware Chancery Court and Delaware Supreme Court decisions and the standard of judicial review applied in challenges to “going‐private” transactions, controlling stockholders seeking to privatize their subsidiaries may be induced to do so by means of a two‐step acquisition (i.e., unilateral tender or exchange offer, followed by a short‐form merger) instead of a negotiated, single‐step merger. That said, there are a range of practical considerations for public M&A advisors in the wake of these decisions that may not necessarily make the two‐step method the “be all and end all” approach. In any case, there is an incongruity in Delaware’s common law, which is policy‐driven and, to some degree, formalistic, and which may no longer be as defensible today as it once may have been. Accordingly, a critical review of the applicable Delaware precedents and, ultimately, the reversal or modification thereof, seems appropriate at this time.

Contract Law. Mergers and Acquisitions. Delaware Chancery Court Addresses Default Interpretation of Broadly Written Material Adverse Effect Clauses. In re IBP, Inc. Shareholders Litigation v. Tyson Foods, Inc., No. 18373, 2001 Del. Ch. LEXIS 81 (June 15, 2001)

Contract Law. Mergers and Acquisitions. Delaware Chancery Court Addresses Default Interpretation of Broadly Written Material Adverse Effect Clauses. In re IBP, Inc. Shareholders Litigation v. Tyson Foods, Inc., No. 18373, 2001 Del. Ch. LEXIS 81 (June 15, 2001)

The Powerful Antitakeover Force of Staggered Boards: Theory, Evidence, and Policy

This article argues that effective staggered boards (ESBs) provide a powerful antitakeover defense, more powerful than is commonly recognized. We develop a theoretical account of how ESBs impede hostile bids by forcing bidders both to wait at least one year to gain control and to win two elections far apart in time rather than a one-time referendum on their offer. We then test our theory using a new data set of hostile bids during 1996-2000. We find that in this period:1) Not a single hostile bidder won a ballot box victory against an ESB;2) An ESB nearly doubled the odds of remaining independent for an average target in our data set;3) Shareholders of targets that remained independent were made worse off compared with accepting the bid;4) ESBs did not provide significant countervailing benefits in terms of increased premiums to offset the costs of remaining independent;5) Overall, during 1996-2000, ESBs reduced the returns to shareholders of hostile bid targets on the order of 8-10%; and6) Most ESBs were adopted before the developments in takeover jurisprudence that made ESBs.In view of these findings, we argue that courts should not permit managers of a target with an ESB to continue maintaining a pill after they lose one election conducted over an acquisition offer. This approach, we suggest, would best implement the basic proportionality principles underlying takeover doctrine.The Stanford Law Review is planning to publish a symposium with responses and reactions to this article. Participants will include Steve Bainbridge (UCLA), Mark Gordon (Wachtell, Lipton), Patrick McGurn (Institutional Shareholder Services), Lynn Stout (UCLA), and Leo Strine (Delaware Chancery Court). We are now in the process of writing for the symposium a paper that will respond to these five commentators and will further develop our analysis of staggered boards. Accordingly, comments or reactions on the article would be most welcome.

Shaming in Corporate Law

Along with the burgeoning legal literature on norms has come a renewed interest in the use of shaming sanctions as an alternative to standard forms of punishment. Shaming enthusiasts such as Professor Dan Kahan have argued that shaming sanctions can be used either as an independent sanction, or to supplement sanctions such as fines that might not otherwise convey an adequate amount of moral disapproval. Shaming skeptics worry that shaming sanctions will lead to idiosyncratic or unpredictable enforcement. This Article focuses on the role that shaming can or could play in corporate law. Although this Article is not the first to consider corporate shaming, it seeks to extend the literature in at least two respects. First, the Article provides the most detailed examination to date of what we might call the "anatomy" of corporate shaming - the role and limitations of the enforcer; the enforcement community (or audience); and, most interestingly in corporate law, the target, which can be the firm itself, individual managers, or both. Second, the Article significantly expands the focus of the shaming inquiry. The existing literature, both in the corporate context and elsewhere, has focused almost entirely on the use of shaming sanctions as a penalty for violating a criminal or certain kinds of civil laws (such as non-criminal environmental provisions). From this perspective, the enforcer is always a court. Yet private parties also shame wayward directors and firms. In the corporate law context, shareholder activists and the financial press have made frequent use of shaming techniques. Each time CalPERS publishes a list of underperforming firms, for instance, one of its central goals is to shame the offending firms. To more fully understand corporate shaming, the Article therefore considers both private and judicial enforcers. The Article explores three "case studies" of shaming in particular detail: the use by CalPERS and the financial press of "rosters of shame;" shareholder activist Robert Monks and Nell Minow's more aggressive shaming campaigns, which included a full-page Wall Street Journal advertisement shaming the directors of Sears by name; and the decision of the Delaware chancery court in a case stemming from alleged Medicaid and Medicare violations by Caremark Industries. For private enforcers like CalPERS and other shareholder activists, I suggest that the SEC could facilitate shaming by forcing offending firms to bear some of the costs of shaming efforts. Even in the absence of such changes, these shaming efforts seem likely to continue to prove quite effective as a device for prodding recalcitrant boards into action. For judicial shaming, I consider how shaming could be fit into the kinds of multi-faceted liability schemes that have been proposed in the literature on corporate criminal and tort liability.

Battling on: Warner-Lambert sues Pfizer

has asked a Delaware court to allow it to terminate comarketing agreements with Pfizer and reclaim all rights to the blockbuster cholesterollowering drug Lipitor. At stake for Pfizer is a share in revenues estimated to exceed $3.6 billion in 1999 and nearly $6 billion by 2002. Warner-Lambert's countersuit is the latest step in an ongoing battle over creation of die world's largest drug producer. Early last month, as announced a friendly $67 billion merger with American Home Products (AHP), Pfizer stepped in with a higher offer for Warner-Lambert. When that offer was not accepted, Pfizer, seeking to stop the merger, sued and AHP in Delaware Chancery Court, and separately charged the companies with breaching the comarketing agreements. Pfizer believes that Warner-Lambert has engaged in a series of desperate defensive measures designed to deny its shareholders the opportunity to consider an offer . . . that represents a premium. At recent stock prices, ...

Kodak sues to stop Cetus technology sale

Eastman Kodak has requested an injunction in Delaware Chancery Court to prevent Cetus Corp. from selling its polymerase chain reaction (PCR) technology to Hoffmann-La Roche. If successful in its su...