Bringing Controlling Shareholders to Court : Standard-Based Strategies and Controlling Shareholder Opportunism 9789460949357, 9789462361072

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BJU CRBS Bringing Controlling Shareholders to Court_vDEF:BJU 01-11-13 13:05 Pagina 1

c r b s - d i s s e r t a t i e r e e k s

C h u n ya n Fa n

Bringing Controlling Shareholders to Court Standard-Based Strategies and Controlling Shareholder Opportunism

C h u n ya n Fa n

The book identifies three sub-issues that need to be addressed properly by law makers for a standard-based strategy to function in an efficient way: (1) What is the substantive standard of controlling shareholder conduct?; (2) How should the standard be enforced by court?; and (3) How to choose between standard-based strategies and other regulatory strategies? The book tries to answer these three questions through studies of three individual jurisdictions: the US, the UK and China.

c r b s - d i s s e r t a t i e r e e k s

Controlling shareholders have largely unbalanced power in the governance structure of corporations, which leaves the minority shareholders vulnerable of being exploited. One way to deal with thefproblem is to allow minority shareholders to sue a controlling shareholder when they think they have been treated unfairly by the said controlling shareholder, and the challenged conduct will be reviewed by court under certain standard pre-set by law. Law and economist call this kind of solution a standard-based strategy. This book is a research on how to use these standard-based strategies most efficiently when dealing with conflicts between controlling and minority shareholders.

c r b s - d i s s e r t a t i e r e e k s Bringing Controlling Shareholders to Court

Bringing Controlling Shareholders to Court

Bringing Controlling Shareholders to Court STANDARD-BASED STRATEGIES AND CONTROLLING SHAREHOLDER OPPORTUNISM

Chunyan Fan Tsinghua University School of Law

Published, sold and distributed by Eleven International Publishing P.O. Box 85576 2508 CG The Hague The Netherlands Tel.: +31 70 33 070 33 Fax: +31 70 33 070 30 e-mail: [email protected] www.elevenpub.com Sold and distributed in USA and Canada International Specialized Book Services 920 NE 58th Avenue, Suite 300 Portland, OR 97213-3786, USA Tel: 1-800-944-6190 (toll-free) Fax: +1-503-280-8832 [email protected] www.isbs.com Eleven International Publishing is an imprint of Boom uitgevers Den Haag. ISBN 978-94-6236-1072 ISBN 978-94-6094-9357 (E-book) © 2013 Chunyan Fan | Eleven International Publishing This is the publication of the doctoral thesis defended on 4 July 2013 at the University of Groningen. Promotors: Prof. Jan Berend Wezeman and Prof. Oscar Couwenberg. This publication is protected by international copyright law. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publisher. Printed in The Netherlands

Acknowledgement In many ways, writing a Ph.D thesis is not unlike raising a child: it takes a huge investment of time, energy, enthusiasm, and persistence. It is such a demanding journey that it is hardly possible for one to reach the destination if travels alone. Fortunately, throughout the years of working on this book, I have been supported by friends and family each and every step of my way. The foremost thankfulness goes to my promoters: Prof. Jan Berend Wezeman and Prof. Oscar Couwenberg. Their intelligence and kindness have not only provided me guidance for the academic research, but also been a great inspiration for me to become a better person. A heartfelt “thank you” to all my friends who have accompanied me through this journey. The memories and friendship we share are no less valuable to me than any other achievements I accomplished along the way. Sorry I could not mention every one of you, here are but a few names that will always ring a sweet note in my heart: Loes, Xiaoning, Qiuju, Ella, Simone, Joop, Bo, Xiaoyan, Miner, Hui, and Weiwen. Last but not least, special thanks to my family. Without your constant encouragement, this book will never be able to see the day of its finish. I dedicate this book to you as a small token for my great appreciation for having you in my life.

Contents Chapter I Introduction §1.1 Controlling Shareholder Opportunism §1.2 Standard-Based Strategies §1.3 The Research Issue and Sub-Issues §1.4 Individual Jurisdiction Study §1.5 Structure of the Book

1 1 3 5 6 8

Chapter II Shareholder Dynamics and Agency Problem §2.1 Shareholders’ Control Rights 2.1.1 Shareholder as Risk Capital Provider 2.1.2 Legal Nature of the Company 2.1.3 Shareholder Control 2.1.3.1 Matters Subject to Shareholder Voting 2.1.3.2 Implications of Shareholder Voting Rights 2.1.4 Conflict of Interests within Shareholder Group §2.2 The Agency Theory 2.2.1 Agency Relationship 2.2.2 Agency Problem 2.2.2.1 An Utility Maximizing Agent 2.2.2.2 Agency Cost 2.2.3 The Strategies: An Overview §2.3 Dealing with the Controlling v. Minority shareholders Conflict 2.3.1 Affiliation Rights 2.3.2 Reward Strategy 2.3.3 Decision Rights Strategies 2.3.4 Rules and Standards

11 12 12 13 16 17 20 22 24 24 26 26 28 30 32 32 35 36 38

Chapter III Fiduciary Duty: The Standard-based Strategy §3.1 Director’s Fiduciary Duty 3.1.1 The Fiduciary Relationship 3.1.2 Director as a Fiduciary 3.1.3 The Standard-Based Strategy in Evolution: Director-Related

43 43 43 45

V

Transaction Regulation as an Example §3.2 Enforcing Fiduciary Duty 3.2.1 Courts and Enforcing Directors’ Duties 3.2.1.1Duty of Loyalty and the Entire Fairness Standard 3.2.1.2Duty of Care and Business Judgment Rule 3.2.1.3 To Review or Not to Review? 3.2.2 Derivative Action §3.3 Reflecting on the Strategy Chapter IV The United States §4.1 Introduction §4.2 Controlling Shareholders and Their Role as Fiduciaries 4.2.1 Definition of “Controlling Shareholder” 4.2.1.1 De jure Controlling Shareholder 4.2.1.2 De facto Controlling Shareholder 4.2.2 Controlling Shareholders as Fiduciaries §4.3 The Standard of Entire Fairness: Fair Price and Fair Dealing 4.3.1 Fair Price 4.3.2 Fair Dealing 4.3.2.1 Arm’s Length Bargain 4.3.2.2 Duty of Full Disclosure 4.3.2.3 Fair Dealing and the Burden of Proof in Judicial Review 4.3.3 Entire Fairness: A Non-bifurcated Test 4.3.4 Substantive vs. Procedural Fairness: Some Reflection 4.3.4.1 Rosenblatt 4.3.4.2 Procedure as Safeguard §4.4 Applicability of the Entire Fairness Review 4.4.1 Introduction 4.4.2 The Sinclair Advantage/Disadvantage Test 4.4.2.1 The Case and the Test 4.4.2.2 Applying the Test in Sinclair 4.4.3 Weinberger and other Post-Sinclair Cases 4.4.4 Sinclair Revisited 4.4.5 Judicial Review of Transactions Bargained at Arm’s Length or Approved by Minority Shareholders 4.4.5.1 A Safe Harbor under the Entire Fairness Review? VI

48 50 51 51 52 56 58 61 65 65 66 66 67 68 75 78 79 82 83 86 94 95 99 99 103 105 105 107 107 109 110 114 117 117

4.4.5.2 Double-Checking the Controlling Power: Over-regulation or Not? §4.5 Controlling Shareholders’ Conducts under Review 4.5.1 Controlling Shareholder Voting in Self-Interest 4.5.2 Corporate Opportunity 4.5.3 Sale of Control 4.5.3.1 Sale at Premium 4.5.3.2 Limitations on Right to Sell 4.5.4 Dividend Declaration 4.5.5 Allocation of Tax Savings 4.5.6Tender Offer 4.5.6.1 Nature of the Conduct 4.5.6.2 Glassman and its Impacts 4.5.6.3 CNX Gas: towards a Unified Standard §4.6 Conclusion Chapter V The United Kingdom §5.1 Introduction §5.2 Directors’ Duty and Derivative Actions 5.2.1 Regulating Directors’ Conduct under Fiduciary Duty 5.2.1.1 Directors’ Duty 5.2.1.2 Breach of the Duty and Ratification of the Breach 5.2.1.3 Enforcing Director’s Duty through Derivative Actions 5.2.1.4 Impacts Controlling Shareholders’ Conducts 5.2.2 Controlling Shareholder as Shadow Director §5.3 Regulating Majority’s Voting Power 5.3.1 Alteration of Articles 5.3.2 General Constraints on Voting Power 5.3.2.1 Estmanco 5.3.2.2 A General Equitable Principle? §5.4 Unfair Prejudice Remedy 5.4.1 The Statutory Provision 5.4.2 Elements of Unfair Prejudice 5.4.2.1 Meaning of “the Company’s Affairs” 5.4.2.2 Interests qua Member 5.4.2.3 Prejudice VII

119 122 123 127 130 130 131 134 137 140 140 142 143 146 153 153 155 156 156 157 159 162 163 165 166 169 169 171 173 173 174 174 177 178

5.4.2.4 Unfairness §5.5 The Substantive Standard of Fairness in the UK §5.6 Regulating Controlling Shareholder Opportunism in Listed Companies: Other strategies 5.6.1 A Less-Trodden Path 5.6.2 The Strategies in the Self-Regulation System 5.6.3 Choice of Strategies §5.7 Conclusion

180 181

Chapter VI China §6.1 Introduction §6.2 Standard-Based Strategy: The Substantive Standards 6.2.1 Defining Controlling Shareholder 6.2.2 Art. 20: Prohibition of Abuse of Shareholder Rights 6.2.3 Art. 21: Prohibition of Unfair Related Transactions 6.2.4 The Substantive Standard §6.3 Enforcing the Standard through Judicial Review 6.3.1 Shareholder Litigation under 05 Company Law 6.3.2 Applicability of Judicial Review: Balancing the Cost and Benefit of Review §6.4 Specific Situations in China 6.4.1 The Players 6.4.2 Alternative Strategy: Decision Right Strategy §6.5 Evaluation and Recommendation §6.6 Conclusion

193 193 195 195 197 205 209 211 211 213 218 218 221 223 227

Chapter VII Conclusion §7.1 An Economic Analysis of Standard-Based Strategies §7.2 Defining the Standard 7.2.1 US and UK 7.2.2 What China Has and What China Can Learn §7.3 Enforcing the Standard 7.3.1 US and UK 7.3.2 What China Has and What China Can Learn

229 229 230 230 232 234 235 237

Bibliography

241

VIII

184 184 185 188 190

Table of Cases

255

Abbreviations

261

IX

Chapter I Introduction §1.1

Controlling Shareholder Opportunism

An 800-Pound Gorilla In almost all jurisdictions, companies are said to be owned by shareholders but run by the board of directors.1 Shareholders as owners of the company can decide who will sit in the boardroom. They also can make final decisions on a bunch of vital matters for the company, such as to be merged into another company.2 Beyond that, however, they are not allowed to interfere with the day-to-day management of the company. This function is vested in the hands of the directors, who are bound by their “fiduciary duty” to perform their function for the interest of the whole company.3 When the shareholding of a company is dispersed, this governance structure ensures that shareholders as a group reach a balance with the board of directors concerning the powers governing the corporation. As Fama and Jensen put it, the function of decision management is vested in the board of directors, while the function of decision control is within the authority of the shareholders, and the separation guarantees the efficient functioning of the corporate decision making system.4 However, the presence of a controlling shareholder will significantly change the above image of power structure in a company. When a shareholder—or a small group of closely connected shareholders—holds enough shares to dominate the shareholder meeting, directors actually are accountable to him rather than the entire shareholder group simply because they owe their seats to him. As a result, the said separation of decision management and decision

1

Kraakman et al. (2009), pp. 12-15. Id., p. 14. 3 Rotman (2005), p. 412. 4 Fama & Jensen (1983), at *4. Decision management includes two functions: initiation and implementation; decision control includes ratification and monitoring. See also Kraakman et al. (2009), p.14 (board serves as a check on shareholders’ power). 2

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BRINGING CONTROLLING SHAREHOLDERS TO COURT

control no longer exists; both functions are under the dominance of the controlling shareholder. Given their largely unbalanced power over company affairs, in Re Pure Resource,5 Vice Chancellor Strine, the American judge who presided the case, sees controlling shareholders as an “800-pound gorilla whose urgent hunger for the rest of the bananas is likely to frighten less powerful primates.”6 The judge observes that, “the powers and influence possessed by controlling stockholders were so formidable and daunting to [other company participants] that protective devices like special committees and majority of the minority conditions (even when used in combination with the statutory appraisal remedy) were not trustworthy enough [to protect the interest of minority shareholders].”7

Tunneling Despite of the well-accepted image of modern companies being widely held corporations,8 companies with controlling shareholders are actually common around the world. 9 Unfortunately, together with controlling shareholders comes the almost equally common phenomenon of controlling shareholder opportunism, i.e., expropriation of minority shareholders by their controlling shareholders, which is sometimes also called “tunneling”.10 Tunneling can be done in many ways, and some often seen forms of tunneling include transfer-pricing-contracts advantageous to the controlling shareholder, loan guarantees, expropriation of corporate opportunities, and so 5

808 A.2d 421 Id., at 436. Id. (Because the independent directors owe their seats to the controlling shareholder and the minority shareholders might fear for some retaliation from the controlling shareholder, such as to stop dividend payments.) 8 In 1932, Adolph Berle and Gardiner Means first drew people’s attention to this type of corporations in their classic work “The Modern Corporation and Private Property”(New York, Macmillan publishing Co.). Later studies on corporate theories have largely developed around this “Berle and Means widely held corporation image”. See La Porta et al. (1998a), at *1. 9 Id., at *34. (The empirical study shows that other than in common law countries, the Berle and Means image is more likely to be inaccurate rather than accurate. That is to say, a large percentage of companies’ equity is not held in a widely dispersed way. On the contrary, they are usually controlled—often by the state or a family.) 10 Johnson et al., (2000), at *1. 6 7

2

INTRODUCTION

on.11 Through tunneling, company resources are transferred to the controlling shareholders and the minorities are excluded from sharing those resources. Economists call these benefits received by the controlling shareholders “private benefits of control (“PBC”).”12 If the level of PBC extraction is too high,13 investors will be less willing to invest in a controlled company. This, in turn, will lead to the lowering of company value, rise of capital cost and, in the end, underdevelopment of the capital market.14 Tunneling is one of the major forms of value-reducing opportunism among different corporate constituencies,15 and it is the most prominent challenge faced by corporate law regarding controlled companies.16

§1.2 Standard-Based Strategies What is a Standard-Based Strategy? There are many ways to deal with the problem of controlling shareholder opportunism, among which some have been mentioned in the above-cited paragraph from Re Pure Resource: using independent directors and requiring approval of minority shareholders. These two methods will both take away the decision-making power from the controlling shareholder and thus are called “decision right strategies”. 17 The focus of this book, however, is another often-seen type of strategy called “standard-based strategies”, that is, to impose a certain standard of conduct on the controlling shareholders to constrain their discretion in the exercise of the controlling power.

11

Id., at *3. Gilson & Gordon (2003), at *2. 13 Some private benefits of control is justifiable and will be tolerated by the minority shareholders, because controlling shareholders bear a higher risk and minority shareholders save cost in the monitoring of directors when there is a controlling shareholder. 14 La Porta et al. (1999), at *27. Dyke & Zingales (2004), at *36-37. See also Wu (2004), pp. 77-78 (when the confidence of the investors is totally destructed by controlling shareholders’ exploitation, the whole securities market turns into a casino rather than a place to allocate resources efficiently.) 15 Kraakman et al. (2009), p. 2. There are three principal sources of opportunism in company context; besides the conflicts among shareholders, the other two are conflicts between managers and shareholders, and conflicts between shareholders and other corporate constituencies. 16 La Porta et al. (1998a), at *5. 17 For an overview of the strategies, see Sec.2.2.3. 12

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BRINGING CONTROLLING SHAREHOLDERS TO COURT

The core characteristics of a standard-based strategy include a pre-set standard and an ex post adjudication process.18 That is to say, if the minority shareholders think the controlling shareholder’s act violates the standard, they can go to court for redress; and if the court agrees with the minority, liability will be imposed on the controlling shareholder. Efficiency of a Standard-Based Strategy As Vice Chancellor Strine has correctly pointed out, the formidable power of a controlling shareholder undermines the trustworthiness of other possible decision makers in the company, including independent directors and minority shareholders.19 Therefore, allowing the disgruntled minority shareholders to resort to the courts seems to be a natural and necessary choice. However, to have a day in court does not in itself guarantee an efficient solution for the conflict between controlling shareholders and minority shareholders. For one thing, controlling shareholders’ controlling power comes from the majority rule, which is a proven efficient solution for shareholder decision making. 20 Any interference of this system bears the risk of lowering the corporate decision making efficiency. Therefore, the need of holding controlling shareholders—as decision makers— accountable for their decisions needs to be balanced against their decision making authority.21 For the other, litigation has always been expensive. It not only is time and resource demanding, but also may bring damage to the company’s reputation and, in turn, profitability. Both will potentially further harm the interest of the minority shareholders. Indeed, whether all these costs generated from the use of a standard-based strategy are worthy of incurring is not a self-evident question, and it is the very task of this book to find out how to make sure those costs are spent well.

18 19 20 21

4

Kraakman et al. (2009), p. 40. Supra n.7. Cheffins (1997), pp. 68-69. Bainbridge (2002), p. 242.

INTRODUCTION

§1.3 The Research Issue and Sub-Issues The Issues The central issue of this book is how to use standard-based strategies efficiently in the “controlling v. minority shareholder” context. As said, a standard-based strategy has two core elements—a preset standard and ex post adjudication. To reach an optimal efficiency, both elements need to balance between costs and benefits carefully. Firstly, a properly set substantive standard should be high enough to protect the minority shareholders’ interest, yet not too high to discourage people from becoming controlling shareholders at all. It is obvious that if the standard is too low, the strategy would not be of much help to the small shareholders. However, it is not that the higher the standard is the better either. To become a controlling shareholder, the investor has to forego the benefit of diversified investment and thus bears a higher risk than the minority shareholders. Too harsh a standard might make the investor feel unworthy of bearing the extra risk and defeat his intention to become a controlling shareholder, which also will end up in under-investment.22 How should the standard be defined is the first question that needs to be answered whenever a standard-based strategy is to be deployed. As for the enforcing process, the key factor is the accessibility of court. If the bar for initiating a lawsuit is too high, few cases have the chance to be reviewed by the court and the constraining effect of setting a standard becomes too weak. However, if the bar is too low and corporate decisions are constantly reviewed by the court, the corporate decision making system is unlikely to function smoothly and properly. Moreover, there is the additional damage to the reputation of the company. In the end, excessive judicial review might harm, instead of help, the minority shareholders. Therefore, for a specific dispute between a controlling shareholder and the minority shareholders, it is not necessarily efficient to have it reviewed by a judge. When and how the standard

22

This is especially bad for start-up businesses.

5

BRINGING CONTROLLING SHAREHOLDERS TO COURT

should be enforced by court is the second question that is critical to the efficacy of a standard-based strategy. Last but not least, in practice, there are always multiple strategies co-functioning with each other.

23

When assessing the efficiency of

standard-based strategies, the effect of co-existing strategies should not be neglected, because the efficiency of the co-functioning system is the ultimate goal of regulation. For this purpose, the relationship between standard-based strategies and other strategies is the third sub-issue to be examined in the book. Limit of the Research The conflicts between controlling and minority shareholders are common in big as well as small companies. However, this book only considers public companies. The situation in a close company might be very different because the relationship between the shareholders, the interests of the parties, the balance of power between them and the resorts available to them are all different. Therefore, although many basic ideas apply to both types of companies, such as the fiduciary duty or “unfair prejudice”, the practical effect may differ to a fair extent in the two types of companies. Close companies’ problems are not covered in this book. Besides, as a book on the efficacy of judicial review, one important aspect of the issue has not been touched due to the time limits of the project, namely, remedy. Without doubt, remedy is surely relevant—even critical—with the effectiveness and efficiency of judicial review. However, it is beyond the coverage of this book and has to be left for future study.

§1.4

Individual Jurisdiction Study

This book tries to explore into these above-listed issues through individual jurisdiction studies, namely, the US, the UK and China. Standard-based strategies can be seen in the regulation of controlling shareholder opportunism in many jurisdictions. They usually use general civil 23

Such as a decision right strategy which requires the approval of minority shareholders for controlling shareholder-related transaction.

6

INTRODUCTION

law principles such as “good faith” or comparable rules as the basic standard.24 However, from a practical perspective, not many jurisdictions are actively pursuing this approach through judicial review.25 Actually, there is only one jurisdiction—the US—that is heavily relying on judicial review.26 Having a generally pro-litigation culture, the Americans have sufficient experience in using judicial review to deal with pretty much all kinds of problems. It is hardly surprising that it is also the jurisdiction that most actively uses judicial review to protect minority shareholders and it has developed the most sophisticated standard-based strategy in the regulation of controlling shareholder opportunism. A study of the US law will be especially enlightening as for how a standard-based strategy “actually” works. The UK, compared to the US, is less litigation-oriented despite of the fact that they both belong to the common law family. Judicial review is not a much-followed path in the UK. Interestingly, empirical studies show that the level of PBC extraction in the UK is nonetheless close to the US. 27 A comparison between the two jurisdictions will reveal the relationships between different regulatory strategies and help to answer how the balancing should be done in the enforcement of a standard-based strategy. Similarity of the legal tradition as well as the company structure between the two jurisdictions makes the UK an ideal sample for comparative study against the US. The third jurisdiction studied in this book is China, which is a jurisdiction from the civil law family. As a newly developed market economy with an even younger capital market, China is in particular need for effective controlling shareholder regulations. Although the Chinese company law also provides for standard-based strategies in the regulation of controlling shareholder opportunism, it is still in a preliminary stage. Therefore, the study of China actually serves two purposes: one is to see whether standard-based strategies will be significantly different in jurisdictions from a different legal family; the

24

Kraakman et al. (2004), p. 126. Id., p. 127. 26 Id., pp. 127-28. 27 Which is generally lower than jurisdictions from the civil law family (with the exception of Scandinavian countires). See Dyke & Zingales (2004), at *36; Nenova (2003), at *4. 25

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BRINGING CONTROLLING SHAREHOLDERS TO COURT

other is to draw lessons from the other two jurisdictions and to refine the strategies used in China.

§1.5 Structure of the Book The first two chapters of the book are devoted to a theoretical analysis of the problem. Chapter Two is about the nature of the relationship between controlling shareholders and minority shareholders, possible strategies to deal with the problem of controlling shareholder opportunism and the factors to be considered when making a choice of a strategy. Specifically, the chapter will introduce the agency theory, which is used by economists to approach the conflicts between controlling and minority shareholders. The relationship between controlling shareholders and minority shareholders is seen as one of the agency relationships in companies. Opportunistic behaviors from the agent, i.e., the controlling shareholders, lower the efficiency of the relationship, and the loss of efficiency is called “agency cost”. The purpose of regulation is to lower the cost and to improve the efficiency of the relationship. The strategies to deal with the problem will be categorized and the benefits and costs generated from the regulatory strategies will be explored in this chapter. Chapter Three examines a standard strategy widely used in the company context, namely, directors’ fiduciary duty. The study will show how the costs and benefits of a standard-based strategy are balanced at the director v. shareholder level—the conflict between the two groups has been seen as the prototypical agency problem in companies.28 The chapter will look into the rules developed around directors’ fiduciary duty, including the fairness standard, the business judgment rule and the demand rule in the US, to learn how the balance has been found in the director setting. The experience of dealing with director opportunism will indicate the important factors to be considered in the use of a standard-based strategy and provide valuable lessons for the regulation of controlling shareholder opportunism. 28

8

Kraakman et al. (2004), p. 33.

INTRODUCTION

Chapter Four focuses on the law of the US. Given that fact that the US is the jurisdiction that most heavily relies on judicial review, its practice is examined closely, with detailed study in various aspects of the whole system of judicial review on controlling shareholder conduct. The chapter will look into the standard as set by Delaware law, which include both a substantive and a procedural aspect, the threshold test for judicial review and see how the court has applied the test in various situations. Chapter Five, the UK chapter, first examines how the standard is defined for controlling shareholders in the UK; then the chapter will try to explain why judicial review is far less used in the UK by exploring other regulatory mechanisms in the UK. Comparative analysis between the US and the UK will be done regarding both the substantive standards in the two jurisdictions and the choice of strategies by the two jurisdictions. Chapter Six is a study of China’s new company law, which for the first time in China’s history applies standard-based strategies in the regulation of controlling shareholder opportunism. The chapter looks into the definition of the standards given by law, as well as their enforcement mechanism. It also analyses the places that the Chinese system falls short and tries to make suggestions on improvement according to the experiences of the US and the UK. Chapter Seven revisits the research issues and concludes the comparative study.

9

Chapter II Shareholder Dynamics and Agency Problem The conflict between controlling shareholders and minority shareholders is rooted in the governance structure of a company. As equity capital providers of the company, shareholders have the rights to vote on the company’s vital affairs, including director selection and substantial company transactions. When a shareholder holds a controlling block of shares, he can out-vote minority shareholders and make his will dominant in the company. While he deserves to be in control, the possibility of abuse of his controlling position poses a threat to the interests of minority shareholders. Opportunistic conducts of a controlling shareholder may not only lower the value of the company, but also lead to the destruction of the minority shareholders’ confidence in the market and ultimately discourage them from investing. The relationship between controlling shareholders and minority shareholders is one of the agency relationships found in companies,29 and the problem faced by minority shareholders is an “agency problem”. This chapter will conduct a general discussion of the nature of the problem and its possible solutions. The chapter starts with a discussion of the relationship between shareholders and the company, as well as the intra-group relationship of shareholders, in Sec 2.1. The section explains where the controlling shareholders’ controlling power comes from and why that controlling power might be a threat to minority shareholders’ interests. Sec 2.2 is a theoretical analysis of the problem, yet from a much broader perspective, i.e. the agency problem and its possible solutions in general. Sec 2.3 comes back to the specific “controlling vs. minority shareholder” setting and provides an overview of the strategies used when dealing with controlling shareholder opportunism.

29

Kraakman et al. (2009), p. 35.

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BRINGING CONTROLLING SHAREHOLDERS TO COURT

§2.1

Shareholders’ Control Rights

2.1.1 Shareholder as Risk Capital Provider There are many tags for the role played by shareholders in a company, among which the most often seen ones are “owners” or “members” of the company. The idea of shareholders as “members” of the company can be traced back to Victorian days. As explained by Davies,30 the reason behind the idea is that the initial group of shareholders were the first “members” of the organization as subscribers to the memorandum: it was they who brought the company into existence. Subsequent shareholders also become members according to law.31 As for shareholders’ being “owners” of the company, it is in fact a misleading statement. Shareholders own their shares, which bring them certain rights and interests, but they do not own the company.32 The “ownership” enjoyed by shareholders, as will be explained later,33 is actually quite different from its usual meaning in property law. 34 As far as revealing the nature of the relationship between shareholders and the company is concerned, neither of the two popular tags is very helpful. By comparison, some other titles held by shareholders seem to be more enlightening—that they are “residual claimants” or “risk capital providers” of the company. Shareholders provide equity capital to the company, which means that their investment differs from those of the other participants of the company not only because of its open-ended duration,35 but also its largely unfixed return. 36 Shareholders’ relationship with the company does not have a prescribed duration because a company has “continuity of life.”37 While an individual shareholder may sell his shares and no longer be related to the company, it only means the shares are transferred to other people’s hands; the relationship 30

Davies (2002), p. 7. Id. 32 Davies (2002), p. 257. 33 See Sec 2.1.3. 34 Bainbridge (2002), p. 64. 35 Cheffins (1997), p. 49. 36 Cheffins (1997), p. 59. By contrast, debt contracts usually provide for a specific term which can expire, and the amount that a creditor can get generally only varies in case of default or renegotiation. 37 Hamilton (2000), p. 2. 31

12

SHAREHOLDER DYNAMICS AND AGENCY PROBLEM

between the company and its shareholders as a group is not changed. Such a relationship only comes to an end when the company winds up, then the shareholders will receive whatever is left after the company has paid all its creditors.38 Since “on a winding-up, the shareholders go first as far as losses are concerned and go last as far as surplus is concerned,”39 they are the ultimate risk bearers of the company and the equity capital provided by them is called “risk capital”. Risk capital is a crucial form of financing for companies, especially for those large ones. As Davies points out, “[t]o be successful without long-term risk capital a large company needs either to be able to generate internally all the resources it needs for its operation and expansion or to have a predictable income stream against which bond-holders will lend money.”40 In any case, it will not be easily feasible for most big companies.41 Given the importance of the risk capital and the risk faced by shareholders, it is reasonable to expect that shareholders would want to have some control over the company. Indeed, along with their shares, a bundle of control rights are vested in the hands of shareholders. These control rights will be discussed later in the section—it makes better sense to understand the nature of the company first, and to ask what shareholders can do with their control rights thereafter.

2.1.2 Legal Nature of the Company From a law and economic point of view, a company serves as the nexus of a set of contractual relationships among different groups of company participants, including shareholders, managers, and creditors.42 Understanding the nature of company means to understand these contractual arrangements surrounding it. Incorporated companies have five core features: distinct legal personality, limited liability for investors, transferable shares, centralized management and 38

Davies (2002), p. 255. Davies (2002), p. 256. 40 Davies (2002), p. 262. 41 Davies (2002), p. 262. 42 Cheffins (1997), p. 36. The economists are using the term “contract” here in a much broader way than a lawyer would use: basically, any “voluntary arrangements” are seen as contracts. See Easterbrook & Fischel (1989), p. 1428. 39

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BRINGING CONTROLLING SHAREHOLDERS TO COURT

shareholder control.43 Each of these core features illustrates a facet of the contractual arrangements among the company participants.

Legal Personality Companies are given by law an “artificial personality”, which allows them to act very much like a real person, including not only to own assets, but also to enter into contracts, incur liability, enforce its rights by bringing a lawsuit, and so forth.44 Since a company is considered by law as a distinct player in the market, company law usually does not establish legal relations directly between different groups of company participants, “but instead may, and typically does, mediate them through another legal person, the company.”45 Hansmann and Kraakman argue that giving business firms a distinct personality is “the first and most important contribution of corporate law”46 because it allows “affirmative asset partitioning,” which means “the shielding of the assets of the entity from claims of the creditors of the entity’s owners or managers.”47 In their “The Essential Role of Organization Law”, the authors observe that affirmative asset partitioning is beneficial to firms because it “reduces the cost of credit for legal entities and enhances the value of these entities by protecting against premature liquidation of their assets.”48

43

Kraakman et al. (2009), p. 5. Hamilton (2000), p. 1. 45 Davies (2002), p. 10. For instance, directors owe their duty to the company, not to the shareholders. 46 Kraakman et al. (2009), p. 6. For a more comprehensive discussion of the issue, see Hansmann & Kraakman (2000), in which the authors argue that while limited liability has been considered by many scholars as being the most important feature of corporate law, it is affirmative asset partitioning that is the most essential function of organization law. 47 Hansmann & Kraakman (2000), p. 390. 48 Hansmann & Kraakman (2000), pp. 398-405. For a shorter version of the discussion see Kraakman et al. (2009), pp. 6-8. (The authors identify two rules of affirmative asset partitioning: the “priority for creditors” rule gives the creditors of a firm a claim on the firm’s assets that is prior to the claims of the personal creditors of the firm’s owners; the “liquidation protection” rule prevents the owners of the firm from withdrawing their share of firm assets at will, and the personal creditor of the owners from foreclosing on the owner’s share of firm assets. The authors call the first rule as a “ ‘weak form’ legal personality,” which can be seen in partnership; and the combination of the two rules provides a “ ‘strong form’ legal personality,” which is a core characteristic of business corporations.) 44

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Limited Liability Like two sides of a coin, when the company’s assets are insulated from the reach of its shareholders or their personal creditors, a shareholder’s personal assets cannot be reached by the creditors of the company either. The principle is often referred to as “limited liability” for investors.49 This is a somewhat misleading term since shareholders actually have no personal liability towards company debts; rather, it is their possible loss that is limited—to the extent that they invested in the company. 50 Scholars have thoroughly discussed the various advantages of having limited liability,

51

(or, “defensive asset

partitioning,” as termed by Hansmann and Kraakman,) among which the most prominent one is to lower the cost of equity capital by limiting the risk faced by shareholders.52 Furthermore, the combination of limited liability with legal personality not only reduces the overall cost of capital for the firm, but also isolates “the value of the firm from the personal financial affairs of the firm’s owners”, which facilitates tradability of the firms’ shares.53 Transferable Shares Because of the combination effect of legal personality and limited liability, the transfer of shares from one person to another will have no influence either on the value of the share or the identity of the company.54 In other words, it has no positive or negative externalities on other shareholders or the company. Therefore, a shareholder can transfer his shares to a third party without the approval or consent of the company or his fellow shareholders. 55 As transferability of shares allow shareholders to dispose of their holdings if they

49

Kraakman et al. (2009), pp. 9-10. Kraakman et al. (2009), pp. 9-10. 51 See Easterbrook & Fischel (1996), pp. 41-44; Hansmann & Kraakman (2000), pp. 423-28. 52 Kraakman et al. (2009), p. 10. As said above, risk capital is a crucial form of finance for the company. Individuals, however, are generally assumed to be risk-averse. Therefore, unless there is someway to moderate the risk, shares will not be attractive to investors. Limited liability allows shareholders to limit their risk by diversification. ( Cheffins (1997), p. 59) 53 Kraakman et al. (2009), p. 10. 54 Kraakman et al. (2009), p. 12. 55 In the UK, free transferability of shares is the default rule for incorporated companies. Closely held companies may limit the transferability of their shares by provisions in the company constitution. See Davies (2002), p. 24. 50

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wish to do so, it increases shareholders’ willingness to invest in the company, which means the company can more easily get the capital it needs.56 Centralized Management Once shareholders have injected their money into the company, they no longer have direct control over the disposition of the money; instead, the power goes to the hands of the board of directors, which is a body distinct from the shareholders.57 Entrusting the management of the company to its board of directors saves the cost of company decision-making by avoiding the involvement of the shareholders, who are usually large in number, in the decision-making process.58 Furthermore, running the company with centralized management and hierarchical decision-making also improves specialization, which, in turn, promotes the company’s productivity.59 Centralized management is not a feature exclusively for companies: all large firms share this characteristic. 60 The specialty in companies is that the managers are selected by the company’s equity capital providers,61 which is closely related to the last core feature of companies’, namely, shareholder control. Because of its importance to the main topic of this book, this feature is discussed in more detail in the next part of the section.

2.1.3 Shareholder Control Shareholders, like other participants of a company, have a contractual relationship with the company. However, compared to other participants, shareholders’ interests receive the least protection from contracts.62 As the ultimate risk bearers of the company, the return for their investment may vary

56

Davies(2002), p. 22. Kraakman et al. (2009), pp. 13-14. 58 Kraakman et al. (2009), p. 14. 59 Cheffins (1997), pp. 33-35. Directors not only have more expertise, but also are more motivated in making good decisions for the company because their investment is usually more firm-specific. Shareholders, by contrast, are less motivated because of their small shareholding and the free-riding problem. See also Davies (2002), p. 13. 60 Kraakman et al. (2009), p. 13, n. 35. 61 Kraakman et al. (2009), p. 14. 62 Id. 57

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to a considerable degree depending upon the performance of the company.63 Since the company is run by the board of directors, the shareholders’ fortune is largely not in their own hands. For an individual shareholder, although he can expect to share the company’s earnings in the form of dividends throughout the company’s life,64 it is seldom a legally enforceable right against the company.65 To counterbalance the insecurity of shareholders’ pecuniary interest, they are given a bundle of rights, which allow them to make certain critical decisions for the company. The matters subject to shareholder voting might differ to some degree in different jurisdictions, but is in large measure the same.66 Among the matters that require shareholder voting, the most significant is the selection of directors. It is also a general rule in most jurisdictions that shareholder approval is needed for the “major transactions” of the company.67 2.1.3.1  Matters Subject to Shareholder Voting

Appointment of Directors In most jurisdictions around the world, directors are periodically elected by shareholders.68 The general rule is that the selection is done by a simple majority of the votes cast at the shareholder meeting.69 Compared to the rules for director appointment, the rules for director removal are even more important for holding directors accountable to shareholders. jurisdictions.

70

71

The removal rules differ to a greater degree across The UK has the toughest mandatory rule: shareholders may, by

an ordinary resolution, remove a director before the expiration of his period of 63

Cheffins (1997), p. 59. Cheffins (1997), p. 54. 65 Davies (2002), p. 21. (“[C]ompanies tend to be extremely cautious in granting legally enforceable entitlements to dividends to shareholders.”) This is especially true for public companies; close companies might be different. 66 Kraakman et al. (2009), p. 56. 67 Kraakman et al. (2009), p. 72, 82. 68 The UK does not have a mandatory term requirement. (See Kraakman et al. (2009), p. 61.) 69 See, for example, MBCA, Sec. 7.28(a). In the UK, a resolution adopted by a simple majority is called an “ordinary resolution”, as in contrast with “special resolutions”, which require super-majority vote. (CA 2006, s. 282, 283.) Whether a quorum is required for the shareholder meeting to elect directors depends on the specific jurisdiction or the constitution of the company. 70 Davies (2002), p. 102. 71 For a general comparison among the jurisdictions, see Kraakman et al. (2009), pp. 60-62. 64

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office, notwithstanding anything in any agreement between the company and the director.72 There is no need for the shareholders to give a reason for the removal.73 The power to remove a director mid-term in the US, however, is weaker. For instance, in Delaware, mid-term removal is only possible when the shareholders are explicitly authorized by the charter of the company to call a special shareholder meeting on such a matter.74 It is observed that “corporate boards in almost all jurisdictions are characterized by high responsiveness to the current majority.”75 This is the natural consequence of giving shareholders the power to appoint and remove directors: since the shareholders do not have their interests sufficiently protected by contracts, they need to make sure that the ones who are running the company are accountable to them and will run the company in a way that promotes their interests. Significant Transactions It is difficult to draw a clear line for the “significant transactions” that need shareholder approval. Scholars have observed that transactions with the following characteristics are more likely to be subject to shareholder voting: (1) they are large relative to the value of the company; (2) they require broad-gauge, investment-like judgment; and (3) they create a possible conflict of interests for directors.76 Generally speaking, these transactions fall into two categories: those bringing “organic changes” to the company, and those bringing changes related to the company’s equity capital structure.77 A company’s charter has long been seen as a contract between shareholders and the company, as well as among the shareholders themselves.78 Amendment of the charter, and the transactions that will result in material changes of the 72

CA2006, s.168(1). Davies (2002), p. 129. 74 Kraakman et al. (2009), p. 61. 75 Kraakman et al. (2004), p. 34. 76 Kraakman et al. (2004), p. 131. The conflict here is not necessary to be on the level of self-dealing. See also Kraakman et al. (2009), p. 72. 77 There is no sharp line between the two categories; the division is more for the convenience of the discussion. Davies observes that the decisions that need shareholder approval in general are the ones that are “likely to have an impact upon the shareholders’ legal or contractual rights.” (Davies (2008), p. 375.) 78 Hamilton (2000), p. 5. 73

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charter, such as mergers, consolidations, or voluntary dissolutions, are all “organic changes” to the company and will fundamentally change the shareholders’ relationship with the company. These changes require shareholder approval—usually by supermajority—almost everywhere around the world.79 Furthermore, in many, but not all, of the jurisdictions, the sale of all or substantially all of the corporate assets is also a major transaction that requires shareholder voting, because it is “comparable to the acquisition of a target company in a merger transaction”.80 Although it is general practice to require shareholder approval for organic changes of the company, shareholders’ right to initiate such changes differs in different jurisdictions. In the US, shareholders’ rights are more limited compared to those in other jurisdictions, and they are powerless to initiate transactions such as charter amendments or mergers.81 By contrast, a minority shareholder in the UK can place a resolution to amend the articles of association of the company on the agenda of the general meeting, and such a resolution can be approved over the opposition of the board.82 Besides organic changes of the company, a change in the company’s equity capital structure also has a direct impact on shareholders’ interests. Some of the changes, such as an increase in the amount of authorized capital of a US company, may require an amendment of the charter as well. 83 Therefore, actions that “bear on the flow of equity capital into and out of the corporation” are often subjected to shareholder approval.84 Some common forms of this type of actions include decisions to increase or reduce legal capital, new issues of shares, distributions of capital by means of share repurchase, and so forth.85 Of course, whether a specific type of action needs to be approved by shareholders depends on the provisions of each individual jurisdiction, and the

79 80 81 82 83 84 85

Kraakman et al. (2009), p. 73. Kraakman et al. (2004), p. 145. See also Kraakman et al. (2009), p. 74. Kraakman et al. (2009), p. 186. Id. Kraakman et al. (2004), p .146. See also Kraakman et al. (2009), pp. 186-221. Kraakman et al. (2004), p. 145. Id. Decrease of capital does not need shareholder approval in the US.

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similarity across jurisdictions may be less as in contrast with the provisions on mergers or charter amendments.86 Other Matters Subject to Shareholder Voting Besides the appointment of directors and significant transactions, some other important decisions may also be subjected to shareholder voting. However, individual jurisdictions differ to a large extent in this regard. For instance, shareholders of a public company in the UK have the right to appoint the company’s auditors, whose duty is to verify the financial statements which the company presents annually to the shareholders.87 Transactions involving a strong conflict of interests, such as substantial property transactions with a director, or excusing directors from breaching of their duties, also need to be approved by shareholders.88 By contrast, the US law gives much less authority to shareholders on the decision-making of the company’s affairs.89 Even for conflict-of-interests transactions, shareholder approval is not compulsory in the US.90 2.1.3.2  Implications of Shareholder Voting Rights

Equality of Shares A basic presumption of law is that all shareholders should be treated equally,91 which means without an explicit contractual arrangement between the shareholders which says otherwise, all shares are attached with equal rights and also subject to equal limitations. This principle has two implications: regarding shareholders’ pecuniary interest, all distributions—whether it is in form of

86

For instance, neither reducing the legal capital nor new issuance within the authorization limits specified in the charter requires shareholder approval in the US. Kraakman et al. (2004), p. 146. 87 CA2006, s. 489(4). All EU Member states have given shareholders of listed and larger non-listed companies the right to appoint and to dismiss auditors. French and German law also requires shareholder approval on the distribution or reinvestment of the company’s earnings. (See Kraakman et al. (2004), pp. 47-48.) 88 CA2006, s.190(1), s.239(2). For a comprehensive discussion of the matters require shareholder voting under CA2006, see Mayson, French & Ryan (2008), pp. 367-68. 89 Kraakman et al. (2004), p. 47. It is observed that while the US is the most friendly jurisdiction towards minority shareholders, it is the least friendly towards the shareholders as a group. 90 Further discussion on the issue see Chapter 3 and 4. 91 Davies (2008), p. 819.

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dividends, return of capital, or sharing the surplus assets on a winding up—should be proportional; as for shareholders’ control rights, each share should represent equal voting power in the shareholder meeting, that is, the “one-share-one-vote” rule. If shareholders want to deviate from this principle, they should do it through explicit contractual arrangement, usually by creating different classes of shares, so that in each class, all shares are still equal.92 This equality of shares is a cornerstone of the contract among the shareholders and between the shareholders and the company. Voting Rights as Proprietary Rights As a general rule, shareholders’ voting rights are considered as proprietary rights, and shareholders can exercise their voting rights for their own interest, regardless whether that interest is against the company’s and the other shareholders’ interest. 93 In other words, when voting on a shareholder resolution, a shareholder has no duty to sacrifice his own best interest so as to take care of his fellow shareholders’ interests. However, there is no right without limitation. Indeed, giving shareholders unlimited discretion for casting their votes can cause problems in many regards, and one of the central concerns of this book is to find the proper boundary for a controlling shareholder’s voting rights to prevent him from expropriating the minority shareholders.94 Shareholder Democracy Based on the one-share-one-vote rule, when shareholders exercise their control rights by voting in the shareholder meeting, resolutions are passed either by a simple majority or a super majority. Acting by a majority rule is an efficient choice, especially for companies with a large number of shareholders, because requiring unanimous approval will make it very difficult for the shareholders to reach any decision for the company.95 92

Id. Davies (2003), p. 707. 94 Limitations on voting rights are not just to protect minority shareholders. For instance, it is also prohibited that shareholders as a group acting unanimously to cheat creditors. 95 Cheffins (1997), p. 68. 93

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So long as each shareholder has equal opportunity to be on the side of majority, denying the minority shareholders’ say will not be a problem.96 The equality of shares still stands. 97 However, if a controlling shareholder is present, a potential tension within the shareholder group arises since the controlling shareholder will be able to constantly outvote the other shareholders. If the controlling shareholder’s will always prevails over the minority shareholders’, the equality of shares is destroyed and the minority shareholders’ voting rights are no longer a meaningful safeguard for their interests. Having a controlling shareholder has further impact on the minority shareholders: being selected by the majority, i.e. the controlling shareholder, the directors very likely will be dominated by the controlling shareholder as well.98 Therefore, for the controlling shareholder, his control can be materialized either through a direct exercise of his voting rights, or through his dominance of the board of directors. The minority shareholders, by contrast, will not only face a disadvantageous position in a voting that has a direct impact on their interests, but also lose the accountability of the directors towards them. Apparently, the majority rule together with the general principle of voting rights as proprietary rights put the minority shareholders in a very vulnerable situation. The next section will look into this unbalanced relationship between a controlling shareholder and the minority shareholders and try to identify the special scenarios where the presence of a controlling shareholder poses a real threat to the minority shareholders’ interests.

2.1.4 Conflict of Interests within Shareholder Group As said in the previous section, the equality of shares implies equalities both as to voting power and to pecuniary interests, which means all pecuniary interests are distributed proportionally among shareholders. For this reason, shareholders are generally considered a homogeneous group, that is, the interests of all group 96

Easterbrook & Fischel (1996), p. 70. Because each shareholder has the equal opportunity to be on the “winning side” (i.e., the majority), their interests are equally protected by their voting rights. 98 Kraakman et al. (2004), p. 34. 97

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members are aligned and there is no intra-group conflict of interests.99 For instance, if the company is about to sell a part of its business and the transaction requires shareholder voting, no matter how each shareholder votes, everybody gains if the final resolution is a winning deal for the company and vice versa. However, the situation changes when “a single individual or a cohesive coalition of shareholders own a controlling percentage of a company’s shares.”100 Consider a very simple hypothetical case: if a 80% shareholder is selling a piece of property to the company and the fair price is $100, by setting the price at $120 he will gain $20 extra profit as the seller; for the $20 loss suffered by the company, he only needs to bear $16 as a shareholder. Since his gain as a creditor of the company is more than enough to cover his loss as a shareholder of the company, it is very likely that he might choose to over-price the property and use his controlling power to force the company to accept the transaction. Controlling shareholder-related transactions is a typical scenario where the interests of the controlling shareholder and the minority shareholders are not aligned,101 yet this is not the only type of scenario. Other transactions that will have a direct impact on shareholders’ legal rights and interests may also see a split of interests between the controlling shareholder and the minority shareholders. Shareholders’ rights are contractual; an organic change of the company means the contract between shareholders and the company, or among the shareholders, is to be modified. When the shareholders need to renegotiate the contract, it often causes a redistribution of the interests or the powers among the shareholders, which leads to an intra-group competition among shareholders. An exemplary case of this type of transaction is the so-called

99

Easterbrook & Fischel (1996), p. 70. Cheffins (1997), pp. 64-65, 101 Of course, it is always true that in all shareholder-related transactions, the interest of the related shareholder is not aligned with the interest of the other shareholders. However, only when the related shareholder is in the controlling position, can he force through an unfair transaction and cause harm to other shareholders’ interests. Therefore, the conflict of interests among the shareholder group only needs special attention when the transaction is controlling shareholder-related. 100

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“freeze-out” or “going private” transaction, in which the controlling shareholder, who will be the only shareholder after the freeze-out, will have his interest in direct conflict with the minority: the lower the price he pays to the minority, the more he gains for himself. If the shareholder resolution for the going private decision sets the price lower than the fair value of the minority shareholders’ shares, the controlling shareholder will gain at the loss of the minority shareholders by voting for the resolution. Although the cause of the conflict of interests in organic changes is different from the related transactions, they share an important common characteristic. That is, the controlling shareholder can gain something in the transaction that is not proportionally available to the minority shareholders. The very possibility of unproportional gain for the controlling shareholder defeats the homogeneity of the shareholder group. As said above, if the shareholder group is a homogeneous group, it does not matter how shareholders use their voting power, and the minority shareholders have no need to feel uncomfortable because of the presence of a controlling shareholder.102 Only if there is a possibility of unproportional gain for the controlling shareholder, the minority shareholders should really have to worry about the abuse of controlling power by a controlling shareholder. If the controlling shareholder is allowed to use his controlling position to force through a transaction from which he gets an unproportional gain, the minority shareholders’ interests can easily be expropriated.

§2.2 The Agency Theory 2.2.1 Agency Relationship The relationship between a controlling shareholder and the minority shareholders is seen by law and economics scholars as an “agency relationship”, 102

Actually, in such circumstances, the presence of a controlling shareholder is beneficial to the minority shareholders because the controlling shareholder can easily hold the directors accountable to the shareholder group and his large stake holding will make him more motivated to make the company profitable.

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which means one party’s welfare is dependent on how the other party exercises his discretion.103 In an agency relationship, the party that has his interests dependent on the other party is called the “principal,” and his counter party, who has the discretionary decision-making authority, is called the “agent.”104 Obviously, the term “agent” or “agency” is given a much broader definition here than when it is used by lawyers.105 While legal agency relationships surely fall in the definition,106 many other relationships that do not meet the legal definition of agency are also considered by economists as agency relationships. As explained by Jensen and Meckling in their “Theory of the Firm”, any relationship that involves co-operational efforts has an agency feature. 107 Besides the relationship between controlling and minority shareholders, another classic agency relationship that is to be found in the company setting is the relationship between directors and shareholders as a group. Since it is the directors who are in charge of the day-to-day management of the company’s affairs, shareholders’ welfare largely depends on how the directors perform their duties.108 The directors, who have the discretionary power, are thus agents for the shareholders. It is not difficult to see why people would want to enter into agency relationships because co-operation usually means making a better use of both sides’ resources. For instance, in the case of directors and shareholders, by entrusting the management of the company to the hands of directors, who are usually better specialized in making business judgments, the shareholders’ money can generate more profits than holding it in shareholders’ own hands.109 103

Jensen (2000), pp. 85-86. Jensen (2000), p. 86. Davies (2002), p. 118. 106 As defined in Restatement (3rd) of Agency, “the common law of agency, encompasses the legal consequences of consensual relationships in which one person (the ‘principal’) manifests assent that another person (the ‘agent’) shall, subject to the principal’s right of control, have power to affect the principal’s legal relations through the agent’s acts and on the principal’s behalf.” (REST 3d AGEN INTRO.) 107 Jensen & Meckling (1976), p.6. 108 Kraakman et al. (2009), p.362. A third agency problem can be seen in companies, that is, the company as the agent and other contracting parties as the principals. The problem, however, is beyond the topic of the book. Relevant discussion see Kraakman et al. (2009), pp. 115-152. 109 Davies (2002), p. 117. Strictly speaking, it is not always necessary for the agent to have more expertise in the entrusted affair than the principal. For instance, a shareholder can be very good in 104 105

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However, whenever one party is relying on the other, there is always a question to be asked, that is, is the other party reliable? Indeed, there is an inherent risk in any agency relationship that the agent will abuse the entrusted power and harm the interest of the principal. The possibility of abuse is often called the “agency problem”.

2.2.2 Agency Problem 2.2.2.1 An Utility Maximizing Agent

A basic assumption of economics is that rational market players are utility maximizers. 110 Transactions between these utility maximizers are efficient because by voluntarily entering into exchanges, each party improves his own welfare, and the overall allocative efficiency is reached as the result of the transactions.111 However, from the perspective of a principal, the fact that his agent always prefers maximizing his own utility is not good news. The following hypothetical case helps to illustrate the problem faced by a principal. Assume A wants to sell his old car. Since he is not familiar with the second-hand car market and has no time to find or bargain with potential buyers, he decides to ask a second-hand car dealer B to sell the car for him and pays B a commission of $100. Assume B spends one day, which costs him $30, and finds a buyer who will pay $1000 for the car. If B works harder, that is, to spend another day, he could find a new buyer who is willing to pay $1100. However, since B will have to spend another $30 for the second day’s work and does not get more commission for it, he will not keep working after the first day, which means A cannot get the highest price for his car. Of course, A can think of some measure to encourage B to work harder. For instance, the commission will not be a fixed $100, but $100 plus 50% of the part of the price that exceeds $1000. Then if B works for a second day and finds the buyer who pays $1100, B will get $50 extra commission for the higher price he finds for A. After managing his own money, nevertheless, he might think it is better to let others take care of it because he can make better use of his time and energy. To the last analysis, the general principle is not changed, that is, people enter into agency relationship to maximize their own utility. 110 Cheffins (1997), p. 4. 111 Cheffins (1997), pp. 5-6.

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deducting the cost, he will still be $20 better off than working one day, so the rational choice for B is to work the second day.112 While a bonus commission arrangement seems to be able to help A get a higher gain for selling the car—$950, as compared to the $900 under the fixed commission arrangement113—it is no guarantee that A will get the optimal deal. Assume that on the second day, B finds a buyer at noon who is willing to pay $1080 for the car. From B’s point of view, to keep working for the rest of the day will only raise the price to $1100, which means a $10 extra commission for him, while at the cost of a half day’s work, that is, $15. Naturally, B will stop work at 12 o’clock, which leaves A’s gain from the sale at $940 instead of $950. In other words, the best choice for the agent deprives the principal the chance of getting the best deal. For A, the principal, B’s diligence is not the only factor that he needs to be concerned about. There is yet the problem of honesty. Assume on the second day, B finds the buyer who offers $1100 for the car, and he proceeds with the transaction in the following way: first he sells the car to himself at $1000 and then re-sells it at $1100. As a result, B appropriates the extra $100 profit all to himself, and A receives only $900 from the sale. It is often suggested that the problem caused by an agent not working hard enough—often termed as “shirking”—is very different from the problem of “stealing”, that is, an agent diverting the principal’s assets to his own pocket.114 While the dichotomy is a useful approach for dealing with the problems,115 if looking to the underlying cause and the ultimate outcome of the problems, “stealing” and “shirking” are far less different. Actually, whether it is because of sloth or dishonesty, the agent is driven by the motivation of maximizing his own utility and acts “opportunistically” towards the principal.116 Since the 112

Assuming there is no opportunity cost for the second day, that is, B is only working for A for the moment. 113 A’s ultimate gain from the sale is the car price minus the commission. So under a fixed commission arrangement, it is 1000−100˙$900; and under the bonus commission arrangement, it is 1100−(100ˇ (1100−1000)×50%)˙$950. 114 Easterbrook & Fischel (1996), p. 103. 115 See further discussion in the next section as well as Chapter three. Some strategies, such as rewards, are more effective for solving the shirking problem than the stealing problem, while others ( e.g. a standard-based strategy) are just the other way around. 116 The term “opportunism” is often used to indicate some element of dishonesty. (see Kraakman et al.

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agent’s utility is not completely aligned with the principal’s utility, the principal ends up with a second best deal in both cases. 2.2.2.2  Agency Cost

The difference between a principal’s gain from the actual transaction and the gain from an optimal transaction is called the “residual loss”.117 Residual loss lowers the value of the agent’s service to the principal and decreases the principal’s willingness to enter into the agency relationship. In the dishonest car-dealer case, if the car was worth more than $900 to A, A will actually suffer a loss by entering the agency relationship with B. Moreover, because A has no knowledge—or very little knowledge—as to B’s preference function, there is no way for him to make a reliable estimation for the risk he is facing in the relationship. People are generally considered to be risk-averse. A might very likely decide not to enter into the agency relationship in the first place because of the unpredictable risk he will be facing, which means an all-lose outcome for both the agent and the principal.118 Since an agency relationship is mutually beneficial, both the agent and the principal will be willing to seek ways to control the level of residual loss in order to maintain the relationship’s value. Many measures—such as facilitating monitoring by the principal, creating an incentive for the agent, and so forth—can be used, and have been used, to achieve that goal. None of the measures, however, can reduce the loss caused by the agent’s opportunistic conduct in a cost-free way. 119 For instance, by providing the principal sufficient information, he can better monitor the performance of the agent and thus lower the risk of opportunistic conduct of the agent. However, neither providing the information nor processing the information is free of cost: the former generates cost for the agent, and the latter for the principal.

(2009), p. 35, n. 2) However, as explained in the main text, there is no essential difference in the nature between the two types of problems. (See Easterbrook & Fischel (1996), p. 103.) Therefore, the word will be used to include both shirking and stealing. See also Kraakman et al. (2009), p.35 (Agent acting opportunistically might “skimping on the quality of his performance, or even diverting to himself some of what was promised to the principal.”); Jensen & Meckling (1976), p. 13. 117 Jensen & Meckling (1976), p. 6. 118 B loses the gain from commission, A loses the chance of selling his car at a price higher than $1000. 119 Jensen & Meckling (1976).

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In “Theory of the Firm”, Jensen and Meckling describe the cost that generated from dealing with the agency opportunism as the “monitoring cost” incurred by the principal and the “bonding cost” incurred by the agent. These costs plus the residual loss are the overall cost generated by the agency relationship, i.e., the “agency cost”. 120 Theoretically, the principal, with a correct anticipation of the effect of the agency problem, should be able to deduct the monitoring cost from his payment to the agent, so that ultimately it will be the agent who bears the costs.121 In reality, however, full-deduction is barely possible because there is always an asymmetry of information between the agent and the principal,122 which puts the principal in a disadvantageous position and can hardly calculate the exact deduction. As a result, the principal still needs to bear at least a part of the agency cost. In the end, no matter how the agency cost is allocated between the agent and the principal, the overall cost decreases the benefits of the agency relationship. In this regard, it can be argued that it is the co-operative project of the agent and the principal that bears the agency cost. As Jensen & Meckling acknowledge in a footnote, if the project is “not sufficiently profitable to cover all the costs (including the agency costs), it will not be taken.”123 After all, it is the agency relationship that improves allocative efficiency. Dealing with the agency problem is not just a need for the protection of the interests of principals, but more importantly a call for fostering those efficiency-optimizing relationships.124 Taking this relationship-oriented approach, the following discussion will proceed from a perspective of the overall costs generated by the relationship rather than trying to group them into the principal’s “monitoring cost” or the agent’s “bonding cost”. For the same reason, it is important to be aware that an 120

Id. As the authors have illustrated with an “owner/manager vs. outside shareholder” model, as long as the equity market anticipates correctly the problem, “[p]rospective minority shareholders will realize that the owner-manager’s interests will diverge somewhat from theirs; hence the price which they will pay for shares will reflect the monitoring costs and the effect of the divergence between the manager’s interest and theirs.” Jensen & Meckling (1976). 122 Kraakman et al. (2009), p. 35. 123 Jensen & Meckling (1976), p. 54, n. 57. 124 See Rotman (2005), p. 18 ( it is the fiduciary relationship that is valuable to the society and needs to be protected.) 121

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efficient regulatory system of the agency problem should aim at lowering the overall costs, which include not only the residual loss caused by the opportunistic conduct of the agent, but also the cost of regulation. It is not that more regulation is always better for the relationship. On the contrary, if the cost of using a regulatory strategy is higher than the benefit that could be achieved, the parties will actually be better off by not using the strategy: the cure would make matters even worse.125

2.2.3 The Strategies: An Overview Over the years, many strategies have been developed to deal with the agency problem. In his “Introduction to Company Law”, Davies gives a systematic overview of these strategies and categorizes them as shown in the following table:126 Enhancing the principal’s control

Structuring

the

agent’s

decisions Affiliation

Appointment

Decision

Setting agent Constraining

rights

rights

rights

incentives

agent decisions

Entry

Selection

Initiation

Trusteeship

Rules

Exit

Removal

Veto

Rewards

Standards

Davies first divides all strategies into two large categories: those aiming at enhancing the principal’s control and those aiming at structuring the agent’s decisions. The latter category includes two sub-sets: setting agent incentives 125

There were cases that the litigation fee was way above the actual loss suffered. (In Re Elgindata Ltd. [1991] BCLC 959, the legal cost was £320, 000 while the parties’ dispute was over shares whose value was only £24,600. See Law Commission CP142 (1996), p. 3, n. 16.) From the economic point of view, it is not a wise decision to bring such a lawsuit. 126 Davies (2002), pp. 118-22. Besides the strategies categorized in the table, Davies takes disclosure as a special type of strategy, which is “such an important strategy that it is needed in the application of all other strategies.” Without sufficient information, the principal cannot evaluate the agent’s performance, let alone make a sensible decision as to how to use those strategies to protect his own interests. Davies comments that disclosure is actually a way of implementing other strategies, and it serves an “over-arching role.” Since it is an all-time necessity, disclosure is not treated as an independent strategy. (Davies (2002), p. 122.)

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and constraining agent decisions. As Davies explains, constraining strategies use rules or standards to directly constrain the exercise of the agent’s discretion. The difference between the two approaches is that rules specifically define as to what conducts are permissible or impermissible, while standards only provide a general guide. For instance, a rule would require “drive below 70km/h;” by contrast, a standard would say “drive safely”. As to whether a particular speed is “safe”, it needs to be answered by ex post adjudication.127 Incentive strategies can take the form of trusteeship or rewards, which aim at moderating the conflict of interests between the agent and the principal. A rewards strategy tries to align the interests of the two parties by connecting the compensation of the agent with his performance. The bonus commission arrangement in the car dealer case is a typical reward strategy. By comparison, a trusteeship strategy moves the decision right to a new agent (namely, a “trustee”) when the original agent has a conflict-of-interest with the principal. Enhancing principal’s control can be achieved in three ways. Decision right strategies aim at giving principals more power in the decision-making process, either in the form of an initiation right or a veto right. That is to say, some kinds of transactions can only be initiated by the principal while some can be vetoed by the principal. Appointment rights and affiliation rights both focus on the establishment and the dissolution of the agency relationship: the appointment right concerns the principal’s control over the agent’s position in the relationship (the rights of appointment and removal), while affiliation rights focus on the principal’s control over his own position (the rights of entry and exit). Apparently, although all the strategies listed above aim at lowering the damage of agent opportunism, they work in very different ways. As a matter of fact, a practical regulatory system of the agency problem always involves a combination of strategies because each type of strategy has its own strong as well as weak points. The choice of strategies and the design of the regulatory

127

Davies (2002), p. 121.

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system require a careful balance of the benefits and the costs of a regulatory strategy, which can only be done context-specifically.128 In the next section, a brief illustration will be given as to how the strategies can be used in the “controlling vs. minority shareholder” context.

§2.3

Dealing with the Controlling v. Minority shareholders Conflict

Although the central concern of this book is about using standard-based strategies to regulate controlling shareholder opportunism, it is important to be aware that multiple strategies, as given in the previous section, can be used to deal with the problem. To use standard-based strategies most efficiently, it is necessary to find the appropriate position for the strategy in the regulatory system, which warrants an exploration of the system. This section provides an overview of the various strategies used in the regulation of controlling shareholder opportunism. It is only with this overall perspective that the first question posed at the end of the introductory chapter, i.e. when should a standard strategy be deployed, can be answered properly. To suit the specific “controlling vs. minority shareholder” setting and the purpose of the following discussion, the strategies will be examined in a way somewhat different to Davies’ method of categorization: the reward strategy will be discussed separately and the trusteeship strategy, for reasons illustrated below, will be grouped together with decision right strategies.

2.3.1 Affiliation Rights According to Davies, there are three types of strategies to enhance the principal’s control over the agency relationship, namely, affiliation rights, appointment rights and decision rights.

128

Whether a certain strategy is a proper choice is a context-specific question: the answer depends not only upon the characteristics of the strategy, but also related to the specific acts to be regulated and the quality of players involved. The issue will be further discussed in the next section and following chapters.

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In agency relationships, appointment rights, i.e. the powers to select the right agent and to dismiss the ones that under-perform their duties are usually the very fundamental safeguards of the principal’s interest. 129 However, it is apparent that controlling shareholders are not appointed and cannot be removed by the minority. That is to say, the appointment rights strategy has no room to play in the “controlling vs. minority shareholder” context at all.130 As for affiliation rights and decision rights, while they are both useful in the “controlling vs. minority shareholder” context, they work very differently: affiliation rights deal with how a principal enters or exits the agency relationship and the decision rights strategy concerns with how to allocate the decision-making power on a transactional basis. Because of the difference, the decision rights strategy will be discussed together with the “trusteeship” strategy (which is similar to the decision rights strategy) later and this section deals only with the affiliation rights strategy. Affiliation rights have two aspects: the right of a principal to enter the relationship and the right to exit. Since there are few problems if someone wants to become a shareholder of public companies,131 the only meaningful affiliation strategy for minority shareholders is actually the right to exit the relationship. It should be noted that selling in the market is not an exercise of the exit right, because it gives no meaningful protection to minority shareholders.132 A real exit right means to have either the majority or the company buy out the minority with full compensation. However, because allowing minority shareholders to exit the company goes against the general principle of “no withdraw of share capital,” and majority shareholders are 129

For instance, in the company setting, the right of appointing and removing the directors is the most important way for the shareholders as a group to hold the directors accountable. The right is widely available around the world ( Kraakman et al. (2009), p. 42). 130 Some scholars see cumulative voting as an appointment strategy for protecting minority against majority. However, the appointment right, as defined, means the principal’s right to appoint the agent. In minority shareholders’ case, it should be the controlling shareholder as the agent, not a director. Cumulative voting is actually more like a trusteeship strategy. Anyhow, it is observed that cumulative voting does not play an important role in minority protection. Kraakman et al. (2009), pp. 90-91. 131 Hansmann and Kraakman take the disclosure rules in securities law as a part of the affiliation strategy, because those rules ensure that shareholders enter the agency relationship on an informed basis (Kraakman et al. (2009), p. 49). 132 Davies (2002), p. 228. Because the minority shareholders as a group cannot “exit” the company simply by selling out in the market.

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unlikely to be willing to give the minority a unilateral right of contract dissolution,133 such a right is available to the minority shareholders only in limited circumstances. These circumstances often include “egregious abuse of power by a controlling shareholder or upon the occurrence of major transactions that threaten to transform the enterprise.”134 In the UK, under the statutory “unfair prejudice remedy,”135 an exit right can be granted to minority shareholders as a remedy upon a finding of “unfair prejudice” by the majority.136 The minority shareholders in the US receive protection via an exit right in a somewhat different way: the appraisal remedy allows dissatisfied shareholders to sell their shares to the company at a “reasonable price” in case the majority approved organic changes, including mergers, sale of substantial corporate assets, or charter amendments that materially affect the right of dissenting shareholders.137 The exit right138 is a means to protect minority shareholders’ interests in the way that when there is an abuse, or a possibility of abuse, of controlling power, 139 minority shareholders can get a fair compensation of their investment.140 However, being an “end-game” solution, the applicability of the exit right is apparently limited to extreme situations.

133

Id. Kraakman et al. (2004), p. 60. 135 The unfair prejudice remedy is in essence a standard-based strategy, and the exit right is one type of remedy under the statutory jurisdiction. See further discussion in Chapter 5. 136 Davies (2002), pp. 228-229. 137 The scope of the appraisal remedy may vary widely among jurisdictions. See Kraakman et al. (2009), pp. 200-2. 138 Another type of situation that gives the minority an exit right is when the mandatory bid rule applies. In the UK, the rule will be triggered by the acquisition of de facto control, and requires the acquirer to make a general offer once it has acquired sufficient shares by private contract to obtain control of the target at the highest price paid for controlling shares. This rule is seen as based on the equal share principle, and the purpose is to protect minority shareholders from the acquirer’s making a market raid resulting in a possible controlling vs. minority shareholders conflict after control is transferred.. While the mandatory bid rule is widely used in other jurisdictions than the UK, it is disfavored by the Americans, because it significantly raises the cost to the acquirer. This seriously increases the risk of reducing the number of would-be-efficient control transactions. Whether the mandatory bid rule is efficient is beyond this book. It is enough to say that the rule deters people becoming a controlling shareholder rather than that it is a regulatory scheme against the abuse of controlling power ( Kraakman et al. (2009), pp. 252-54). 139 The exit right as a remedy for unfair prejudice is rewarded on the actual finding of abuse of controlling power, while the appraisal right does not depend on such a finding. 140 In practice, the exit right is not as helpful as it may appear due to many reasons. See Kraakman et al. (2009),p p. 201-2. 134

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2.3.2 Reward Strategy As long as the principal and the agent are two distinct parties, the divergence of their interests can never be eliminated. The bigger the divergence between the parties’ interests, the more the agent’s incentive to use his best efforts to promote the principal’s interests fails, and the tendency arises to appropriate the entrusted resource to benefit himself.141 In the extreme situation of self-dealing, that is, the agent is transacting with himself on behalf of the principal, the agent’s interests is in direct conflict with the principal’s: every cent one party gains, the other loses. In such situations, it will be an uphill task to hold the agent to the promise to put the principal’s interests over his own. The idea behind a reward strategy is rather straightforward: the more money the agents make for the principals, the more they gain for themselves, so to align the agents’ interests with the principals as much as possible.142 One important advantage of such a strategy is, once it is adopted, it is self-enforcing, that is, the parties do not need to take extra actions to make it work. However, reward strategies have apparent limitations too. Effective as they can be, such arrangements only lower the degree of divergence between the interests of the principals and the agents, but never eliminate it. Therefore, if the parties are facing extreme situations, such as self-dealing, reward strategies are not likely to be very helpful. In other words, reward strategies work better in solving the agents’ diligence problems, but not as well in dealing with honesty problems. In the case of “controlling vs. minority shareholder”, the basic protection device for the minority shareholders’ interests is a reward strategy, that is, the principle of equality of shares.143 The principle requires all distribution to the shareholders should be proportional, so that the interests of the majority shareholders and the minority shareholders are completely aligned. Of course, as shown above, the equality of shares is at danger whenever there is some non-proportional interest available to the controlling shareholders. In such 141

Jensen (2000), pp. 90-91. Easterbrook & Fischel (1996), p. 91. In practice, this kind of arrangement—sometimes called a “reward plan” or “performance-based compensation”—is widely used to create incentives for the directors, so that their interests will be more aligned with the shareholders’. (Kraakman et al. (2009), p. 75.) 143 Kraakman et al. (2009), p. 43. 142

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circumstances, a conflict of interest between shareholders arises, and the problem cannot be solved by any reward strategy.

2.3.3 Decision Rights Strategies As said above, the idea underlying a trusteeship strategy is to hand over the decision-making power to a third agent—a “trustee”, as Davies calls it—in case of a high risk of agent opportunism. Similarly, the “decision right strategy” under Davies’ system is also about changing the allocation of the decision-making power. The difference is that the power is moved to the hands of the principal. In practice, as will be shown by discussions in later chapters, the two strategies often have similar legal effects and can be used as an alternative for each other.144 Because both strategies focus on the allocation of the decision-making power, for the convenience of the following discussion, the two will be grouped together as the “decision right strategies”, and when the power is given to the principal, the strategy will be called the “principal approval” strategy. Principal Approval Strategy The most often-seen application of the principal approval strategy in company context is in director-related transactions. The UK law requiring shareholder approval for substantial director-related transaction is a typical example.145 However, in the “controlling vs. minority shareholder” setting, a principal approval strategy is more problematic. Unlike directors, controlling shareholders are also investors and are entitled to exercise their voting rights for their own interests. Depriving the controlling shareholders of their decision making power just because the existence of a conflict of interests among shareholders significantly limits control rights and goes directly against the general principle that voting rights are proprietary rights, which makes the strategy difficult to justify.146 Meanwhile, once the 144

For instance, in the US, both independent director approval and disinterested shareholder approval reinstate business judgment rule for reviewing a director-related transaction. See Chapter 3. 145 CA2006, s. 190. 146 Kraakman et al. (2009), p. 167.

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decision-making power is given to the minority, the minority shareholders actually become the agent for the controlling shareholder, which inevitably creates the risk of minority opportunism. Thirdly, in public companies, minority approval can be very expensive since a large number of shareholders need to be involved. Last but not the least, because of the small fractional shareholding of minority shareholders and the collective action problem, the minority shareholders usually do not have sufficient incentive to spend energy and resources to reach “good” decisions for the company.147 Because of these obvious downsides, minority approval is rarely a mandatory requirement,148 and the high cost associated with the strategy can only be justified in exceptional situations where a substantial large interest is at stake. In the UK, substantial director-related transactions need to be approved by shareholders, and the CA2006 prohibits the interested director to vote as a shareholder. Therefore, if the director is also a controlling shareholder, it is equivalent to minority approval. If no approval is obtained, the director will be in breach of his fiduciary duty.149 In the US, if minority approval has been given to controlling shareholder-related transactions, it will give the controlling shareholder strong protection if he is challenged by a minority shareholder in court, albeit not absolute protection.150 Trusteeship Strategy As an alternative to minority approval, the minority shareholders may also choose to entrust the power to a less-conflicted third party, such as independent directors.151 Independent directors are given a more important role especially in public companies. The UK self-regulation rules require the majority of the board of listed companies to consist of independent directors.152 In the US,

147

Easterbrook & Fischel (1996), p. 101. Kraakman et al. (2009), p. 167. 149 However, that does not automatically render the transaction invalid or make the minority entitled to any compensation. Further discussion in Chapter 5. 150 See Chapter 4. 151 Kraakman et al. (2009), p.43. 152 Other independent third parties, such as an independent accountant can also work as a trustee and the listing rules require an opinion to related transactions from such an independent third party. See Chapter 5. 148

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approval of independent directors has the same effect as approval by disinterested shareholders.153 Besides independent directors, other trustees may also be used in conflict of interests transactions. For instance, the UK listing rules require an independent advisor to give an opinion on related transactions.154 Compared to minority approval, a trusteeship strategy generates lower cost,155 and has the advantage of allowing the company to enjoy the benefit of the trustee’s expertise. However, there is always the question whether or not the “independent” trustee is really free from the influence of the controlling shareholder. It has been argued that not only the independent directors are subject to the controlling shareholder’s influence, 156 but also that the independent advisors are likely to be biased towards the people who hire them, who most likely is the controller of the company.157 These problems inevitably compromise the credibility of a trusteeship strategy.158

2.3.4 Rules and Standards The agent’s discretionary power is a necessity for an agency relationship for it to achieve its efficiency advantage. It is impossible to regulate the agent’s conduct by a complete contract—the cost of such a contract will defeat the whole purpose of entering the relationship,159 let alone the simple truth that no contract can be complete.160 The discretion given to the agent, however, is a double edged sword: it brings the principal the benefit of the agent’s expertise, but at the cost of possible abuse. Constraining strategies aim at regulating the exercise of the agent’s discretionary power by setting norms for the 153

See Chapter 4. See discussion in Chapter 5. 155 Retaining a trustee and providing him with adequate information to make the decision generate costs, but most likely a lower cost than mobilizing the minority shareholders who can be very large in number. 156 For a discussion on a controlling shareholder’s influence on the independent directors, see Haas (2004). 157 See Posner (1999), p. 93. 158 Kraakman et al. (2009), pp. 95-96. 159 Parties cannot negotiate cost-freely; the more comprehensive the contract is, the more cost are incurred. Cheffins (1997), p. 8. 160 Prof. Posner once mentioned in his article that he had presided a case in which the contract was 2,000 pages long, but did not cover the issue that the parties were litigating (see Posner (2005), p. 1606). 154

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decision-making process, that is, using either specific rules or general standards to constrain the agent’s options. Rules or Standards? Rules and standards are both transaction-based strategies, i.e. they will be applied every time the agent makes a decision about a transaction. The difference is that rules draw a clear-cut line between what can be done and what cannot, while standards only give a general guide and leave room for the agent to exercise his discretion. Whether a rule has been violated can often be told once the decision is made; by contrast, whether a decision has met the standard often needs an ex post adjudication. In other words, unlike rules, the content of a standard is actually given by the adjudicators in the enforcement stage.161 Making rules means the parties need to be specific as to the future situations in which the rules will apply, as well as to give specific content as to how the rules should be formulated. This apparently requires more bargaining effort than just setting general standards. Therefore, if the act to be regulated happens repeatedly, the high bargaining cost may be more justified than when the act happens only occasionally.162 By contrast, setting standards generally does not involve a high bargaining cost because the content of the standard is to be given afterwards. The costs associated with a standard-based strategy usually arise in the enforcement stage of the strategy.163 As a result, the enforcement cost will have a direct impact on the constraining effect of a standard-based strategy: if litigation is cheap, the threat of litigation will be enough to let the agent behave with caution; vice versa, if the compensation a principal may get from litigation will not cover the litigation cost, the agent should not be too worried about being sued.

161

Davies observes that if the law is standard-based, it in effect means that the legislature is sharing the law-making power with the judiciary. (“[T]he standard is a grant of power by the legislature to the courts to be exercised on a case-by-case basis.”) (Davies (2002), p/ 121.) 162 For an indepth comparison between rules and standards, see Kaplow (1992). 163 A standard-based strategy may also generate ex ante cost. For example, to find out the exact meaning of a standard, such as “fair price”, the parties might need to pay consultancy fees to a lawyer. However, compared to other strategies, such as a decision right strategy, the ex ante cost of a standard-based strategy is usually lower.

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Besides bargaining cost and enforcement cost, interference with an agent’s decision-making process via a constraining strategy always generates another type of cost, i.e., a loss of efficiency in the agent’s decision-making. Because of the rigidity of rules, such a sacrifice is often more severe with rule-based strategies. Consider again the hypothetical car dealer case: A, the car owner, can bargain for a rule to prohibit B, the car dealer, from selling the car to anybody related to him, so to lower the residual cost of possible self-dealing. However, the adoption of such a rule also prohibits B from selling the car to his cousin, who, because of his special fondness of the model, is willing to pay $1200 for the car. Therefore, the regulatory strategy itself costs A the best deal he can get. By comparison, if A asks B to look for a “good deal,” then A might get the chance to sell the car for $1200 to B’s cousin, but also bears the risk of B selling it at $900 to his uncle. This trade-off relationship between the constraining effect of a regulatory strategy and the loss of decision-making efficiency is an important factor that should be taken into consideration when making the choice between rules and standards. Rules Because of a lack of flexibility and the complexity of commercial activities, rules only have a relatively limited application in the company context. They are of most use to protect creditors and public investors when they transact in the capital market.164 The protection of public investors in the capital market is said to be a “close cousin of consumer protection law in other markets.”165 Regulatory authorities and stock exchanges use rules to protect the quality of securities in the public market, 166 among which the most important is mandatory disclosure.167 It is observed that systematic disclosure rules are “particularly important in screening out opportunistic agents in the public capital markets.”168

164 165 166 167 168

40

Kraakman et al. (2009), p. 39. Kraakman et al. (2004), p. 193. Kraakman et al. (2009), p. 39. Kraakman et al. (2009), p. 280. Kraakman et al. (2009), p. 40.

SHAREHOLDER DYNAMICS AND AGENCY PROBLEM

Other rule-based strategies can also be found. For instance, prohibition of insider trading—including prophylactic restrictions on short-term trading and direct bans on trades informed by material inside information—is another example of a rule-based strategy that is widely used in securities laws.169 In the US and the UK, the gains of short-term “round trip” transactions170 will be allocated to the corporate treasury on the theory that these gains reflect corporate value. 171 Similarly, those trading on the basis of non-public information will also be held accountable for the profit.172 Many of the self-regulation rules on corporate governance aim to protect the “quality” of the securities involved—such as the use of independent directors, or requiring a certain voting structure173—the outcome of which can be seen as a hybrid of strategies. For instance, the requirement of independent directors has a constraining feature in the sense that it limits the discretion of the majority’s appointment rights. However, it is also more like a trusteeship strategy than a rule strategy. Standards Standard-based

strategies

are 174

intra-corporation relationships,

a

major

instrument

for

regulating

both in the “director vs. shareholder” context

and the “controlling vs. minority shareholder” context.175 The fiduciary duty, which requires the directors to act “bona fide” in the best interest of the shareholders as a group,176 is the most important standard-based strategy in the regulation of directors’ conducts and has a key role in controlling shareholder conduct as well. It will be discussed thoroughly in the next chapter. Many jurisdictions impose a general standard such as fairness or good faith upon the controllers of companies, albeit with a large degree of divergence

169

Kraakman et al. (2009), p. 170-72. “Round-trip transactions ” means purchase-and-sale or sale-and-purchase in less than six months. See Kraakman et al. (2009), p. 170. 171 Kraakman et al. (2009), p. 170. 172 Kraakman et al. (2009), p. 171. 173 Kraakman et al. (2009), p. 289. 174 Kraakman et al. (2009), p. 40, 173. 175 Kraakman et al. (2009), p. 173. 176 Davies (2002), p. 159. 170

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concerning the strength of enforcement.177 The US is the jurisdiction that most heavily relies on standard-based strategies and most fiercely enforces these standards through judicial review.178 Controlling shareholders in the US owe a fiduciary duty to the minority and the related transactions between a controlling shareholder and the company should meet the standard of “entire fairness”. In the UK, the majority power is required to be exercised “bona fide” for the interests of the company in certain circumstances.179 The UK law also grants minority shareholders who have been “unfairly prejudiced” by the controller of the company a statutory remedy. This remedy has a very wide coverage. However, as a practical matter, judicial-enforced standards play a far less significant role in the governance of public companies in UK than in the US.180 With the sketch on the regulation of controlling shareholder opportunism given above, it is clear that multiple strategies can be used to deal with the problem and standard-based strategies are just one of them. Each type of strategy has its own specific way in lowering the damage of agent opportunism, yet each has its own limit. With this background, in the next chapter the discussion will be focused on standard-based strategies. It will be examined more closely how the benefits and the costs of a standard-based strategy are balanced in the company context, and how the strategy co-functions with other regulatory strategies.

177

Kraakman et al. (2009), pp. 173-74. Kraakman et al. (2009), pp. 173-74, 178. Except for the US, other jurisdictions often approach the “controlling vs. minority shareholders” conflict through holding the directors to their duties. (See Kraakman et al. (2009), p. 176.) 179 See further discussion in Chapter 5. 180 Kraakman et al. (2009), p. 178. Further discussion on the unfair prejudice remedy see Chapter 5. 178

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Chapter III Fiduciary Duty: The Standard-based Strategy Due to their flexibility, standard-based strategies have special advantages in dealing with complex business activities and have long been used in the company context. This chapter is devoted to directors’ fiduciary duty, which is essentially the standard-based strategy in the regulation of director opportunism. While the focus of this book is on the agency problem at the “controlling vs. minority shareholders” level, to understand how a standard-based strategy is used at the “director vs. shareholder” level is nonetheless necessary for several reasons: firstly, in many cases, a controlling shareholder has to exercise his control through the directors, therefore, regulating the conduct of directors can, at least indirectly, help to reduce the chance of misuse of controlling position by the controlling shareholder;181 secondly, looking into the agency problem in the director setting will help to reveal the factors that influence the benefits and costs of the standard strategy; and lastly, since in some jurisdictions, most notably the US, the fiduciary duty is applicable to controlling shareholders directly,182 it is vital to understand the basic principles of the fiduciary law which have been developed in the director setting. Discussions in this chapter will be limited to general principles; relevant technical details will be left to later chapters.

§3.1 Director’s Fiduciary Duty 3.1.1 The Fiduciary Relationship The concept of “fiduciary” is a “peculiar creature of English equity.”183 Its basic principles originated from the law of trust,184 which regulates a special 181

See Bainbridge (2002), p. 513. (Because of the separation of ownership and control mandated by the US corporate law, actually “it is the shareholder’s ability to affect the election of directors that determines the degree of influence it will hold over the corporation.”) See also Kraakman et al. (2009), p. 14. (An independent board can work as a check on controlling shareholders opportunism.) 182 See discussions in the following chapter. 183 Rotman (2005), p. 1. The division between “common law” and “equity” is more or less a historical

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type of relationship, in which one party is obliged to deal with certain property for the benefit of another person.185 Later on, the fiduciary principles were applied by analogy to situations which did not meet the definition of “trust”, but in which a person was nonetheless obliged to act like a trustee,186 that is, to act with good faith for the best interest of his counter party. Such situations can be found in the relationships between guardian-ward, agent-principal, partner-fellow, director-corporation, lawyer-client, and so forth.

187

The

analogical approach of applying the fiduciary concept allows the fiduciary law to extend its jurisdiction considerably; however, it also makes it very difficult to give a clear-cut answer as to which relationships are fiduciary in nature.188 Despite the difficulty of strictly defining a fiduciary relationship, 189 similarities in all the above-mentioned relationships can easily be found, and a few common elements can be identified in all these relationships. A fiduciary relationship always involves two parties: on the one end sits the fiduciary and on the other, the beneficiary. The fiduciary has discretionary power over certain property that belongs to the latter,190 which makes the beneficiary vulnerable since his welfare is dependent on how the fiduciary exercises his discretion. It is not difficult to see that a fiduciary relationship is just a classic setting that will give rise to an agency problem. In response to the need of mitigating labeling caused by the division of the courts which went back to the 15 th century. For an interesting discussion on the “common law vs. equity” issue, see Burrows (2002). 184 Brudney (1997), p. 595. 185 Trust, as defined in the Restatement of Trust, describes a special type of “relationship with respect to property, subjecting the person by whom the title to the property is held to equitable duties to deal with the property for the benefit of another person, which arises as a result of a manifestation of an intention to create it.” (Restatement (Second) of Trust §2 (1959).) 186 Sealy (1962), pp. 69-70. 187 DeMott (1988), p. 909. 188 Rotman (2005), p. 74. The fiduciary law is notorious for being “elusive and indefinite”. As put by Rotman, the fiduciary concept has “innate resistance to definition”. Rotman finds this to be well justified because: “[a]s a vehicle through which law imposes its standard of ethics on a potentially infinite variety of actors involved in an indefinite number of circumstances, the fiduciary concept cannot be defined with the explicitness generally desired by legal actors.” (Id., pp. 1-2.) 189 Legal scholars have made constant efforts in giving a satisfactory definition to the fiduciary concept. See discussion in Rotman (2005). See also Smith (2002) and Frankel (1983). 190 Smith (2002), at p. 1402, pp. 1439-40. Scholars have observed that the term “property” does not refer to a “thing”, but rather a “bundle of rights” with respect to a thing. Feeling unsatisfied with the observation, Smith replaces “property” with “critical resource” in his own definition to cover a broader range of relationships. (Id., at p. 1402, pp. 1441-44.) See also Rotman (2005), p. 86. (“One of the oldest fiduciary concept found existence of fiduciary obligation when one party posses the ability to control property belong to another.”)

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the problem, the fiduciary duty is imposed on fiduciaries, which is a typical standard-based strategy and is the very heart of the fiduciary law. 191 The general standard of the duty is always the same in all kinds of fiduciary relationships, that is, every fiduciary should act with the utmost good faith in the interest of his beneficiary. The specific content of the fiduciary duty, however, is always factual-dependent, and the fiduciary duty may work with a greater or lesser degree of stringency in different circumstances.192 Calling somebody a fiduciary, therefore, as Justice Frankfurter has pointed out, “only begins analysis; it gives direction to further inquiry. To whom is he a fiduciary? What obligations does he owe as a fiduciary? In what respect has he failed to discharge these obligations? And what are the consequences of his deviation from duty?”193 The discussion hereunder will briefly look into this “further inquiry” in the corporate director context.

3.1.2 Director as a Fiduciary Director’s Beneficiary The idea that directors are fiduciaries can be traced back at least to the 19th century. 194 The basic corporate governance structure obviously bears the fundamental characteristics of a fiduciary relationship: on the one side, shareholders inject their money into the company and leave the management of the company in the hands of the directors; on the other side, directors are accountable to shareholders and must use their power with a goal to maximize shareholder wealth.195 It should be pointed out that while law and economics scholars sometimes see shareholders as the directors’ principals, lawyers consider the company as the directors’ beneficiary. That is to say, generally speaking, directors owe their 191

Rotman (2005), p. 18. (Fiduciary duty is imposed on the fiduciary to protect the valuable relationship.) 192 DeMott (1988), at p. 879. See also Rotman (2005), p. 13. (“The elasticity of the fiduciary concept, inevitably, means that the fiduciary principles will govern the judicial decision-making process with greater dependency on the facts than the common law principles do.”) 193 SEC v. Chernery Corp., 318 U.S. 80, 85-86. 194 Rotman (2005), p. 412. 195 See Ch2 (2.1.2 and 2.1.3 on centralized management and shareholder control). See also n. 199 hereunder on “shareholder supremacy vs. stakeholderism”.

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fiduciary duties shareholders;

196

towards

the

corporation

rather than

to

individual

they only owe an indirect (or “secondary”) duty to the

individual shareholders. 197 However, the difference between seeing the company or the shareholders as the beneficiary is—at least as far as the directors’ duty is concerned—not so fundamental as it first appears to be,198 because the company’s interest, in turn, is defined as the interests of the shareholders’ as a group.199 The most significant consequence of inserting an extra entity, i.e. the company, between the directors and shareholders lies in the enforcement aspect of the directors’ duty,200 which will be addressed in the next section. There are special situations in which a direct duty towards individual shareholders may arise. A classic example of those circumstances is a duty recognized by the US law in hostile takeovers, often referred to as the “Revlon duty”. The duty requires the directors to get the highest possible price for the shareholders when the sale of the business is inevitable.201 In practice, whether such kind of special circumstance exists or not, depends on the specific facts, thus requires a case-by-case analysis.202

196

Rotman (2005), p. 420. See also Farrar et al. (1991), p380. Directors may also have a duty to consider creditors’ interests when there is a risk of the company being or becoming insolvent, (see Hollington (2004), p. 43,) but that is beyond the scope of this book. 197 Rotman (2005), p. 420. 198 Davies comments that it is “meaningless” to just say the duty is owed to the company, unless to identify the groups of persons that constitute the company. (Davies (2002), p. 153.) 199 There has long been a contention between the shareholder supremacy (which means shareholder wealth maximization is the only ultimate goal of directors’ fiduciary duty) and the stakeholderism (which means directors also owe a fiduciary duty to other company constituencies), and it is not likely that the contention will see a quick end in the near future. However, at least in the common law family, the shareholder supremacy is still the dominant view. CA 2006 can be seen as clear evidence of the victory of shareholder supremacy in the UK, in which directors are required to act “in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole.” (CA 2006, s. 172(1)) See Davies (2008), pp. 479-83, 506-25. (Davies specifically emphasizes that there is a difference between a direct duty owed to the stakeholder group (which has been squarely denied by CA 2006) and the duty owed to the company which requires directors to take into account the interests of stakeholder groups. P482.) More discussion on the issue see also Bainbridge (2002), pp. 408-38; Rotman (2005), pp. 415-62. 200 Davies (2008), p479. 201 Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del., 1986) 202 Rotman (2005), p. 486. Farrar cites a decision of the New Zealand Court of Appeal to illustrate the relevant factors to be considered, which include “the closely held nature of the company, the dependence of the shareholders upon information and advice from the directors, the existence of a relationship of confidence, the significance of the transaction for the parties and the extent of any positive action taken by or on behalf of the director or directors to promote it.”(Farrar et al. (1991), p. 381.)

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Director’s Duties The keystone of the director’s fiduciary duty is the same as in all fiduciary relationships: directors must act with utmost good faith in the best interest of the beneficiary. In the US, jurists routinely say the fiduciary duty includes a duty of loyalty and a duty of care.203 By loyalty, it means directors should use the entrusted power to promote the company’s interest and its interest only, which equals with saying that directors should not promote their own interests.204 By care, it means the directors should act with the care that “a person in a like position would reasonably believe appropriate under similar circumstances”.205 In the UK, by comparison, while the law does recognize a duty of care owed by the directors,206 the fiduciary duty only refers to the duty of loyalty, 207 which is further divided into several facets, including acting within powers and with proper purpose, to exercise independent judgment, and avoiding conflicts of interests.208 Actually, whether or not the duty of care is considered as a part of the fiduciary duty, the focus of the fiduciary law has always been on the issue of “loyalty”.209 The reasons for the different treatment of the two kinds of duties are multi-layered, among which at least one has been shown in the previous chapter: the risk of agent opportunism increases as the degree of the conflict of interest between the agent and the principal increases. Indeed, without relying on agency theory, people have been long aware of the fact that a conflict of interest poses a special threat to a fiduciary relationship. As commented by

203

To divide the fiduciary duty into a duty of loyalty and a duty of care is an approach widely adopted by US jurists. (See, e.g., Black et al. (2006), at p. 1091, n. 124. Another example is, in O’Kelly and Thompson’s textbook on corporate law, Corporations and Other Business Associations (4th Ed., ASPEN Publishers, 2003), the directors duty is also discussed under the title “The Fiduciary Duty of Care” and “the Fiduciary Duty of Loyalty” respectively.) 204 Frankel (1983), at p. 808. 205 See MBCA, Sec. 8.30(b); Hamilton (2000), p. 381. 206 See CA 2006, s.174. 207 Hollington (2004), p. 38. See also Rotman (2005), p. 322 (The fiduciary duty is in essence a high standard duty of “undivided loyalty”). Even some US scholars acknowledge that the duty of care is “not distinctively fiduciary”, for it’s not distinguishable from the common law duty of care. (DeMott (1988), at p. 915.) 208 Davies (2008), pp. 495-97. Avoiding a conflict of interest includes avoiding self-dealing, no exploitation of company property and no receipt from a third party of a benefit for exercising their directorial functions. Further discussion see Chapter 5. 209 Smith (2002), at p. 1409.

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Block, it is just a human characteristic that when one’s own interest is involved, his judgment will be influenced.210 Therefore, regulating an agent’s conduct in case of a conflict of interest has always been the focus of the fiduciary law. The emphasis on the loyalty aspect is more evident in the enforcement stage of the fiduciary duty, which will be discussed in the next section, and the reason for the different treatment of the two duties will be revisited therein.

3.1.3 The Standard-Based Strategy in Evolution: Director-Related Transaction Regulation as an Example The fiduciary jurisdiction is not a static realm. With its content being fleshed out by the judiciary with more and more precedents,211 the fiduciary duty is in a constant process of development. Although the duty is in essence a standard-based strategy, it has grown from a simple and general standard into a system which encompasses a whole set of regulatory mechanisms, including other types of strategies. The regulation of director-related transactions is an exemplary case in this regard.212 As said above, regulating agent conduct in case of a conflict of interest has always been the focus of the fiduciary law. At its earliest stage, the fiduciary duty requires a fiduciary to totally refrain from placing himself in a position where his duty to the beneficiary conflicts with his personal interests and from profiting from his position as a fiduciary.213 The so-called “no-conflict” and “no-profit” rules used to constitute a per se prohibition of director-related transactions.214 Later on, however, people found that a per se prohibition might 210

Block et al. (1993), at p. 72. As commented by Davies, using a standards strategy means the legislature is sharing some of its power with the courts. (Davies (2002), p. 121) From a contractarian’s point of view, the fiduciary duty is just a replacement of detailed contractual terms, and courts should “flesh out” the content of the fiduciary duty by “prescribing the actions the parties themselves would have preferred if bargaining were cheap and all promises fully enforced.” (Easterbrook & Fischel (1993), at p. 427.) 212 Other facets of the duty are also not static, landmark cases such as Smith v. Van Gorkom (488 A.2d 858, directors’ duty of care), or Revlon (506 A.2d 173, directors’ duty in the context of a sale of the company) bring new content or standards into the duty. 213 Farrar et al. (1991), p. 380; Hollington (2004), p. 43. 214 Kraakman et al. (2004), p101. This means that any contract involving a breach of the “no conflict” rule was voidable at the instance of the company, no matter whether the transaction was fair or not. The company could call upon the director to account for the gains he had made. (See also Farrar et al. (1991), p. 403.) 211

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FIDUCIARY DUTY: THE STANDARD-BASED STRATEGY

harm the interest of the corporation rather than protect it, because many transactions which could have been profitable for the corporation would be banned by the per se rules. 215 To give more flexibility to the rule, most common law jurisdictions now allow related-party transactions that have received the approval from the shareholders216 after full disclosure by the director of the nature and the extent of the conflicts.217 The underlying idea is that the beneficiary has the right to excuse the fiduciary who has breached his duty by entering into a conflict-of-interest transaction. However, for the beneficiaries to be able to fully enforce their legal and practical interests, the fiduciary must disclose all the material information to allow them to make an informed decision.218 In CA 2006, it is explicitly provided that the “no-conflict” rule does not apply to director-related transactions. In such transactions, the duty of no-conflict will be substituted by a duty to declare interest,219 and substantial transactions need to be approved by shareholders.220 Using a decision right strategy, i.e. shareholder approval, to replace the per se prohibitive rule leaves a pathway for those would-be efficient related-transactions. However, since shareholders are usually large in number, shareholder approval might be costly. In comparison with CA 2006, the US approach gives directors even more discretion: while shareholder approval will give directors strong protection in related transactions,221 it is not compulsory in the US. Instead, all director-related transactions are allowed to stand so long as the transaction meets the standard of entire fairness.222 From a per se prohibitory rule, to shareholder approval, then to a fairness standard, the fiduciary duty has developed through three stages in the 215 Kraakman et al. (2009), pp. 154-55. (Related-party transactions may be more profitable to the firm than transacting with a less informed outsider. Such transactions are especially important for small businesses.) 216 Or disinterested directors, like in the US. (See, e.g., Delaware General Corporation Law section 144(a)) 217 Kraakman et al. (2009), pp. 155-56. 218 Rotman (2005), p. 325 219 CA 2006, s.175, 177. 220 CA 2006, s.190. The UK law used to not prohibit the director from voting as a shareholder when the approval is sought, the new Act no longer allows the related persons’ vote to be counted. 221 It reinstates business judgment rule, see 3.2.1.3. 222 See Block et al. (1993), at pp. 76-77; ALI-CORPGOV §5.02(a). If only consider the substantive law, the UK law has not taken this last step; from the perspective of practice, however, it is almost the same in the UK, fair transactions will not be voided by the court. See discussions in Chapter 5.

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regulation of director-related transactions.223 This trilogy illustrates how the lawmakers have balanced the costs and benefits of regulation and shaped the regulatory system accordingly. Such balancing will keep playing a critical role when it comes to the design of the enforcement mechanism of the fiduciary duty. Both the above mentioned provisions in the UK CA2006 and the US’s standard of entire fairness play important roles in the regulation of controlling shareholders and will be further examined in the respective individual jurisdiction chapters.

§3.2

Enforcing Fiduciary Duty

Standard-based strategies are often considered as ex post strategies because they can only take full effect with ex post adjudication. By contrast, rules are ex ante strategies because they take effect before the decision is made by the agent.224 While the distinction between ex ante and ex post strategies is not an absolute one since standards also have ex ante constraining effects,225 it is true that for any standard-based strategy, the ex post adjudication is the decisive stage for the effectiveness of the strategy. This is not only because that ex post adjudication gives content to the standard through precedents, but also because the adjudication process generates most of the costs of the strategy. 226 Therefore, for a standard-based strategy such as the fiduciary duty, how the duty is enforced is as crucial—if not even more crucial—a question as how the duty is defined. Reaching a balance between the overall costs and benefits of the ex post review is vital for the success of the strategy. As a matter of fact, whether the intervention of a court will ultimately result in the shareholders being better off is a question far from definitively settled yet.

223

Block et al. (1993). Kraakman et al. (2009), p. 44. 225 For instance, the agent will act more honestly because of the fear of a possible ex post litigation. 226 Generally speaking, a standard-based strategy does not require high ex ante performance cost, but this is not always the case. Actually, as will be shown in following discussions, high ex ante cost is nonetheless possible under a standard-based strategy. See discussion in Chapter 4 on arms-length bargaining. 224

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FIDUCIARY DUTY: THE STANDARD-BASED STRATEGY

When a decision of the directors is reviewed by a court, it means there are two parties intruding into the company’s decision-making system: the court as the reviewer, and the plaintiff as the initiator of the review. The costs of the standard-based strategy are closely related to how these two parties act in the enforcement process. The US law deals with the role played by these two parties with the business judgment rule and the demand rule, which will be discussed in the following sections respectively.227

3.2.1 Courts and Enforcing Directors’ Duties Since directors in the US, being fiduciaries, owe a duty of loyalty as well as a duty of care, it seems to be a fair assumption that their performances towards the fulfillment of the two duties are equally reviewable by the judiciary. In practice, however, the judiciary’s attitude towards loyalty claims and care claims are far from equal. 3.2.1.1Duty of Loyalty and the Entire Fairness Standard

The duty of loyalty requires a director to serve the company’s interest and the company’s interest only. As Hollington has observed, “[t]he greater the interest of the director and the more apparent the conflict [between the interest of the director and the company], the more ‘jealously’…the court should look at the transaction.”228 Indeed, the US judges are very much willing to look into the substance of a conflict-of-interest transaction to see whether or not it meets the “entire fairness” standard. The classic definition of the standard is given by Justice Moore: “The concept of fairness has two basic aspects: fair dealing and fair price. The former embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained. The latter aspect of fairness relates to the economic and financial considerations of 227 228

The two rules are actually related, see 3.2.2. Relevant UK rules will be covered in Chapter 5. Hollington (2004), p. 47.

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the proposed merger, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affected the intrinsic or inherent value of a company’s stock.”229

In short, when it concerns the duty of loyalty, the substantive merits of the transaction will be scrutinized by the court and the court will make its own judgment as to whether the transaction is fair or not. Because the entire fairness standard is equally applicable to controlling shareholder-related transactions, a detailed examination of judicial review under the standard will be left for the next chapter. 3.2.1.2 Duty of Care and Business Judgment Rule

Although courts always recognize that directors owe a duty of care, they are very much deferential to the directors’ decision when facing negligence claims. They repeatedly emphasize that while the fiduciary duty requires directors to act with good faith for the best interest of the company, it is what the directors believe—with good faith—to be the “best interest” of the company that matters, not what the court considers.230 In other word, the court will not “second guess” the substantial merit of the directors’ decision.

231

The judiciary’s

self-restraining policy when enforcing the director’s duty of care is best known as the business judgment rule. Business Judgment Rule Business judgment rule is a presumption that the directors or officers of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interest of the company.232 Under the business judgment rule, courts will abstain from reviewing board decisions unless one or more of the presumptions of the rule are rebutted and so that the

229

Onti, Inc. v. Integra Bank, 751 A.2d 904, 930 (Del. Ch. 1999). See Davies (2002), p. 159. 231 Bainbridge (2002), p. 243. 232 Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985); Aronson v. Lewis, 473 A.2d805, 812 (Del. 1984). 230

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rule does not apply.233 As long as the business judgment rule applies, the court will defer to the directors’ decision as to what they believe to be in the “best interest” of the company and will not second guess that decision.234 Business judgment rule will be rebutted when any of its presumptions fails. 235 First, the rule assumes that there was “an exercise of judgment”. Therefore, when the directors failed to make any decision at all, business judgment rule does not apply. Instead, the inaction will be subjected to a review under the duty of care. Second, the rule presupposes that the directors have no conflict of interest.236 So self-dealing will rebut the rule’s presumption. Third, the assumption that directors have acted “in good faith, and in the honest belief that the action taken was in the best interest of the company” requires that the decision is not tainted by fraud or illegality. The business judgment rule will not insulate directors from liability for illegal acts even though committed to benefit the corporation.237 Fourth, to be protected by the rule, the decision has to be a “business judgment”, i.e., it can be attributed to some “rational business purpose”. It is noteworthy that this requirement does not contemplate substantive review of the decision’s merits.238 As the Delaware Supreme Court has held, the presumptive validity of a business judgment will only be rebutted in those rare cases where the decision under attack is “so far beyond the bounds of reasonable judgment that it essentially inexplicable on any ground other than bad faith.” 239 It has been said that these rare exceptions only exist theoretically,240 and inquiry into the rationality of a decision is often a proxy for and inquiry for whether the decision was tainted by self-interest.241 Last, the rule presumes that the decision was made on an informed basis. This requisite precondition, as Bainbridge points out, can be better stated as a 233

Smith v. Van Gorkom, 488 A.2d 858, 872-73 (Del. 1985); Aronson v. Lewis, 473 A.2d805, 812 (Del. 1984); Sinclair Oil v. Levien, 280 A.2d 717, 720 (Del. 1971). 234 See Davies (2002), p. 159. 235 Bainbridge (2002), p. 270. 236 The director is interested if he will receive benefit or detriment in a way not shared by the company and the shareholders from the decision. If the director is beholden to, or under influence of an interested party, his lack of independence will also rebut the presumption. (Bainbridge (2002), pp. 270-71) 237 Miller v. At&T Co., 507 F.2d 759, 762 (3d Cir. 1974). 238 Bainbridge (2002), p. 274. 239 Parnes v. Bally Entertainment Corp., 722 A.2d 1243, 1246 (Del. 1999). 240 Bainbridge (2002), p. 275, n. 41. 241 Bainbridge (2002), p. 274.

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rational and good faith decision-making process.242 Therefore, the protection of the rule is not available to the directors if, as happened in the landmark case Smith v. Van Gorkom, 243 they fail to inform themselves of all material information reasonable available to them.244 Scholars and judges have contended over two different conceptions of the business judgment rule for years. 245 Some treat the rule as an abstention doctrine that creates a presumption against judicial review of duty of care claims,246 while others see the rule as establishing a standard of review,247 i.e., the rule raises the liability bar from negligence to gross negligence.248 Either way, it is widely agreed that the business judgment rule insulate directors from liability for mere negligence, and it is extremely rare that directors are held liable for breaching the duty of care in absence of a concurrent breach of the duty of loyalty or a conflict of interest.249 Justifying Judicial Deference An often-seen explanation that courts give to justify their abstention of reviewing duty of care claims, is that they are not experts in making business decisions. 250 However, as many people have argued, courts are no more experts in medical decisions, yet they do not refuse to look into the substance

242

Bainbridge (2002), p. 276. Smith v. Van Gorkom, 488 A.2d 858 Smith v. Van Gorkom, 488 A.2d 858, 872. Bainbridge argues that the standard given by Van Gorkom is too high and the question “how much information is reasonable” is also a business judgment. “[I]f the decisionmaking process is adequate, the court will continue to defer to the decision that emerges from that process.” (Bainbridge (2002), pp. 279-81) 245 Bainbridge (2002), p. 243. Practice shows that “Delaware corporate decisional law cycles between [the two] competing doctrinal approaches”, and the contention has not yet seen its end. (Bainbridge (2002), pp. 250-51.) 246 An exemplary case of this proposition is Shlensky v. Wrigley, 237 N.E.2d 776 (Ill.App. 1968). Bainbridge (2002), pp. 243-46. 247 As Eisenberg has explained, “[a] standard of conduct states how an actor should conduct a given activity or play a given role. A standard of review states the test a court should apply when it reviews an actor’s conduct to determine whether to impose liability or grant injunctive relief.” (Eisenberg (1993), at p. 437.) 248 An example case of this proposition is Cede & Co. v. Technicolor, Inc., 634 A.2d 345 (Del. 1993). Bainbridge, p. 243, pp. 246-49. The duty of care requires directors to act with “reasonable” care, for which the corresponding liability bar should be negligence. (Bainbridge (2002), pp. 242-43) 249 Bainbridge (2002), p. 243, 286. 250 Easterbrook (1996), p. 94. See also Bainbridge (2002), p. 254. 243 244

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of medical cases in negligence claims. It appears that lack of expertise is not enough to explain the judicial deference to directors’ business decisions.251 A more plausible justification for the courts’ deferential attitude is that judicial review is often hindsight-biased, thus may cause a stifling effect to the board decision-making process. 252 Because of the complexity of business activities, it is very normal for some business decisions, which could be quite reasonable when looking ex ante, to turn out wrong. Risky plans, which bring potential higher gains, may also have a higher chance of failure. Should these decisions be reviewed afterwards, people who already know the result of the decision and the reasons that led to the failure of the decision are likely to blame the directors for not giving those reasons enough consideration in advance. The risk of liability that follows will lead the directors to consider it better not to make the risky decision at the beginning. Shareholders are generally risk-neutral since their interests are protected by limited liability and they can lower the risk by diversifying their investment.253 By contrast, a director’s investment in the company is much more firm-specific,254 which will make him more risk-averse than the shareholders. The risk of legal liability brought by stringent ex post judicial review may only further decrease his willingness towards risk-taking from the level that the shareholders would prefer. Surely the shareholders would not like to see that the effort trying to cure one bad decision ultimately results in them getting a bunch of poor decisions in the future.255 To encourage optimal managerial risk-taking, therefore, it is necessary for the shareholders to take the risk of “bad” business decisions, and not litigate on the substantive merits of a decision made by directors in good faith. The business judgment rule is just a default rule provided by law to achieve that end.256

251

Bainbridge (2002), p. 254. Bainbridge (2002), pp. 260-61. 253 Easterbrook (1996), pp. 99-100. 254 Easterbrook (1996), p. 97. 255 See Easterbrook (1996), p. 93. (“Behind the business judgment rule lies recognition that investors’ wealth would be lower if managers’ decisions were routinely subjected to strict judicial review.”) 256 Bainbridge (2002), pp. 261-62. 252

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3.2.1.3 To Review or Not to Review?

Care vs. Loyalty The “dichotomous treatment” by the courts for the duty of care cases and the duty of loyalty cases sometimes leads to an argument that there is some fundamental difference as to the nature of these two types of duties. 257 However, as Easterbrook and Fischel point out, a breach of the duty of care is no different from a breach of the duty of loyalty in the sense that they both are agency costs,258 which is caused by the directors’ aiming to maximize their own utilities and results in the shareholders’ loss. The fact that courts only closely scrutinize loyalty cases does not suggest that the duty of care is not important for the shareholders. It simply reflects the judiciary’s understanding that judicial review is not the most appropriate tool for solving duty-of-care problems. As discussed above, judicial review for duty of care cases may have a stifling effect on business decision-making. Bainbridge also points out that when the court sets a high standard of care, it may lead the directors to “over-process” board decisions.259 Both effects result in a loss of corporate decision-making efficiency. Together with the litigation cost, which is usually expensive, the costs of reviewing duty-of-care cases could be rather high. However, when it is the director’s diligence that is at issue, the conflict of interests between the agent and the principal is at a relatively low level, which means the risk of agent opportunism is also low and may not be worthy of the high costs of judicial review. Furthermore, it should always be kept in mind that there are other strategies available. Appointment rights or the reward strategy often work better in solving the diligence problem.260 By contrast, when the problem concerns the director’s loyalty, the risk of agent opportunism is much higher due to the conflict of interest, which justifies 257

See Easterbrook (1996), p. 103. Many scholars consider the duty of care not a fiduciary duty in nature but a common law duty. See supra n. 207. 258 Easterbrook (1996), p. 103. 259 Bainbridge (2002), p. 282. 260 See Easterbrook (1996), pp.95-100, 103-105 for more discussions on why market scheme is more likely to success with the duty of care but not the duty of loyalty problems.

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the expenditure on litigation. As for the loss of decision-making efficiency, since the director’s judgment is doomed to be influenced by the conflict of interest, the decision-making process can hardly be expected to be as efficient as in other situations, so there is not much to sacrifice even if it is disrupted by court review. Meanwhile, many conflict-of-interests transactions are one-shot appropriations, (the so-called “take the money and run,”) for which market mechanisms have little constraining effect. 261 As Easterbrook and Fischel commented, “[l]iability rules are most helpful when other mechanisms fail.”262 Bainbridge points out that enforcing directors’ duty is a matter of balancing between authority and accountability.263 Any ex post review is a disturbance of the decision-making system of the company, and compromises the directors’ authority in managing the company affairs. Since centralized management by the board of directors has been proved by the market to be an efficient mechanism,264 courts are justified to be cautious when interfering with the system. The business judgment rule shows that the US courts have carefully positioned themselves in the enforcement of the directors’ fiduciary duty by balancing the cost and benefit of judicial review of different types of cases. Decision Right vs. Judicial Review: Reinstatement of Business Judgment Rule Even for duty-of-loyalty issues, it should be noticed that relying on judicial review is not the only choice. Recall that the regulation of conflict-of-interest transactions has developed through three stages and the second stage is a decision right strategy 265 . As mentioned above, the UK CA2006 requires shareholder approval for substantial director related transactions.266 In the US, shareholder approval is not compulsory. However, under Delaware General Corporation Law section 144(a), decisions involving a transaction in which a

261

Easterbrook (1996), p. 103. Easterbrook (1996), p. 103. 263 Bainbridge calls it a balance between “authority” and “accountability.” Authority represents the efficient decision-making process under directors’ discretionary power; accountability represents the power being used for the purpose that it was given, that is, to improve shareholders’ interests, and no deviation from that purpose. Bainbridge (2002), p. 242. 264 Bainbridge (2002), p. 252. 265 See Sec. 3.1.3. 266 CA 2006, s.190. 262

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director has an interest may still enjoy the benefit of the business judgment rule if the material facts concerning this interest and the transaction are disclosed to the board of directors and the decision is approved by a majority of the disinterested directors; or disclosed to shareholders and approved by a majority of the shareholders. 267 Therefore, a disinterested approval will give the directors strong protection against breach of duty of loyalty claims. The “reinstatement” of business judgment rule by the adoption of a decision right strategy shows that there is a trade-off relationship between an ex ante approval and an ex post review. That is, once a decision right strategy has been used, judicial review is hardly available. A similar relationship can be found in the UK law as well. According to the CA2006, it is an absolute bar to judicial review in the UK if the challenged transaction has been approved or ratified.268 Even in cases where ratification is not allowed by law because the transaction constitutes a fraud on the minority, the disinterested members’ decision as to whether to pursue the suit will be given “special weight” by the court.269 The

trade-off

relationship

between

decision

right

strategies

and

standard-based strategies will be revisited in the discussions in Chapter 4 and 5.

3.2.2 Derivative Action Rise of the Issue Enforcing directors’ fiduciary duty through litigation necessarily requires somebody to initiate the litigation in the first place. It is a very basic legal principle that only the person whose right has been infringed can bring a lawsuit against the wrongdoer.270 Also it is a basic principle that the directors’ fiduciary duty is owed to the corporation instead of to individual shareholders.271 Thus it follows that when the duty is breached, very often it is the corporation who should initiate the procedure.

267 268 269 270 271

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Del. Code. Ann. tit. 8 § 144(a) (2005) CA 2006, s.263(2)(b), (c). CA 2006, s.263(4). Hollington (2004), pp. 98-99. See discussion above in Sec. 3.1.2 on directors’ beneficiaries.

FIDUCIARY DUTY: THE STANDARD-BASED STRATEGY

A legal claim is part of the company’s assets, although pursuing it is not cost-free for the company. When the would-be defendant is a party not related to the directors, whether company resources should be dedicated in pursuing the litigation, is just another business decision that falls within the directors’ realm of authority. However, when the would-be defendants are the director themselves, they seem to be less than trustworthy to make the decision to sue or not. Actually, unless a different set of directors is in place and enforce the company’s right against their predecessors, it is simply unreasonable to expect the breaching directors to sue themselves. The other organ that can act for the company in such situations is the shareholders general meeting.272 However, as a practical matter, unless a controlling shareholder273 is present, it is not quite feasible for the shareholders to pass a resolution without the support of the board.274 Given the difficulty of having the shareholders to act collectively, the natural follow-on question would be: should they be allowed to act individually? Should they have the right to bring a “derivative action” against the breaching directors in the name of the company? Shareholder Apathy Disrupting a company’s decision-making system and engaging its resources in a lawsuit just based on an individual shareholder’s decision is very problematic. The apparent shortcoming is that the shareholder may simply not be qualified to make such a decision because of their lack of relevant information or expertise in business matters. More importantly, individual shareholders, who usually hold only a small fraction of the company’s stocks, are not motivated to make the necessary investment to make their decision a “good decision” for the interest of the company.275 The “rational apathy” theory claims that individual shareholders, who hold only small stakes, will not be interested in influencing the management of the 272

When the directors are the wrong-doers, the proper organ is the general meeting of shareholders. See Davis (2002), p. 193. 273 Or a small group of shareholders together having control. 274 See Davies (2002), pp. 194-95. 275 Davies (2002), p. 225, Easterbrook (1996), p. 101. (“Holders of small stakes have little incentive to consider the effect of the action on other shareholders, the supposed beneficiaries, who ultimately bear the cost.”)

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company, and it is a totally rational choice for them to stay passive.276 Their risk is limited by limited liability and diversified investments. If the company takes a downturn, then to simply walk-away has a much better cost/benefit ratio for an individual shareholder than to seek a cure for the company. 277 Meanwhile, the free-riding issue will further lower a shareholder’s incentive to take action.278 If a shareholder is not interested in influencing the company’s management generally, there is not much reason to suppose that he would change his position when it comes to lawsuits, especially given the fact that any compensation from a derivative action goes to the company, not the individual shareholder.279 Indeed, as Bainbridge observes, many derivative actions are motivated by the plaintiff’s lawyers, because they are the ones who profit the most from the suits. 280 Lawyer-driven cases might either be wrongfully brought when the claim has no merit; or be wrongfully settled, when the claim has merit but was settled for less-than-sufficient compensation.281 Both cause harm to the company’s interest rather than promoting it. Regulating Derivative Action While individual shareholders are not ideal candidates for enforcing the company’s rights against the directors, the directors themselves are hardly more reliable than the shareholders as the decision-maker. The law has to make a choice between two imperfect solutions.282 As a result, derivative actions are possible, but always subject to strict limitations. There are many procedural rules, such as a shareholding requirement or requiring a plaintiff to give

276

Cheffins (1997), p. 62. Id. 278 The situation might be a little different if there are institutional investors, but not much. For one thing, even institutional shareholders are not that enthusiastic about looking into the company’s affairs; for the other, if the institutional investors are unsatisfied with the directors, they would probably deal with the problem behind closed doors instead of going to court, because of the concerns for a negative impact on the company’s image if a lawsuit starts. See Cheffins (1997), pp. 63-64. 279 Davies (2008), p. 609. 280 Bainbridge (2002), pp. 365-68. There is a general concern as to whether the plaintiff-shareholder is ill-motivated. See Davies (2008), p. 609. 281 Bainbridge (2002), pp. 365-68. 282 Easterbrook (1996), p. 106. 277

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FIDUCIARY DUTY: THE STANDARD-BASED STRATEGY

security for the expenses of the lawsuit,283 which are aimed at providing some assurance of the plaintiff’s motivation. However, the most critical issue is actually not “when an individual shareholder’s judgment is reliable;” instead, it is “when the directors’ judgment is so unreliable that it is worth the risk of trusting an individual shareholder.” In short, the general approach of US law to the issue is that the shareholder must first demand the board of directors to bring suit on the alleged cause of action, unless demand is excused because it will be futile.284 The Delaware standard of demand futility is that, based upon the particularized facts alleged, the shareholder has a “reasonable belief” that the majority of the board was interested or lacked independence, or the transaction challenged was not protected by the business judgment rule. 285 That is to say, the courts are deferential to the boards as the final business decision makers—including the decision on litigation—unless they are disqualified because of being self-interested or a failure to follow a proper decision-making procedure.286 It is not difficult to see that the demand rule is just an application of the business judgment rule in derivative action context, 287 and the courts obviously considers that individual shareholders, like themselves, should only intervene into the corporate decision-making system when there is reasonable belief that the system has failed.

§3.3 Reflecting on the Strategy For any standard-based strategy, naturally the first question is “what is the standard?” Then, being an ex post strategy, there is always a critical follow-on 283

See Easterbrook (1996), pp. 105-06. Bainbridge (2002), p. 386. For a more comprehensive discussion of the issue, see Li (2007), pp. 160-74. 285 Bainbridge (2002), pp. 388-90. Demand futility is decided at the pleading stage. (Id., p. 393. Relevant facts must be pleaded with particularity. “[C]onclusory allegations will not cut it.” The plaintiffs at this stage are not entitled to discovery, thus must rely on “the tools at hand”, i.e., external sources of information.) 286 The test of demand futility has a second prong of “the transaction otherwise not protected by business judgment rule.” This mostly concerns with the directors’ decision-making process measured by concept of gross negligence. Bainbridge (2002), p. 392. 287 Bainbridge (2002), pp. 394-95. Also, when demand is not excused, i.e., the case does not meet the standard of demand futility, the board’s decision as to whether to accept or refuse the demand is protected by the business judgment rule. 284

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question of how to enforce the standard. This chapter gives a brief study of directors’ fiduciary duty, which is the most important standard-based strategy in the company context, concerning those two questions. The discussion shows that efficient use of a standard-based strategy requires proper balance of the benefits and costs of regulation in both regards. On the substantive standard aspect, the most exemplary case is the rule concerning conflict-of-interest transactions. The fiduciary duty requires directors to be loyal to the company’s interest and conflict-of-interest transactions corrode this loyalty severely. To protect the beneficiary’s interest in case of a conflict-of-interest transaction, the fiduciary duty used to be a per se prohibition rule of such transactions. However, the rule was later substituted by a decision right strategy, and then a standard-based strategy, in order to give flexibility to the would-be efficient transactions.288 As for the enforcement of directors’ fiduciary duty, both the business judgment rule and the rules on derivative actions have the same central concern, i.e., as Bainbridge puts it, reaching an optimal balance between authority and accountability. Since judicial review is not the only choice to fight the problem of agent opportunism and even not necessarily the preferable choice, to use the judicial review in the most efficient way requires the court to focus on the cases that are most proper to be dealt with in court.289 The above discussion shows that these cases usually involve a serious conflict of interests. Balancing the costs and benefits of a standard-based strategy also means to have a full vision of the regulatory framework and to make a proper choice among various regulatory strategies. Courts usually refrain from reviewing duty-of-care cases because those issues might be more efficiently solved by strategies such as appointment rights or reward strategies. Even for loyalty issues, decision right strategies can work as a substitute for judicial review. In fact, among all the major jurisdictions around the world, the US—which is known for its litigation-oriented culture—is the only one that heavily relies on

288 289

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See Sec. 3.1.3. As will be shown in Chapter 5, the law in the UK has essentially the same policy.

FIDUCIARY DUTY: THE STANDARD-BASED STRATEGY

judicial review to deal with the problem of director opportunism.290 In the UK, which shares the same legal tradition and substantially the same principles of fiduciary law with the US, litigation is a much less trodden path. Governance strategies and decision right strategies are more preferred by British lawmakers.291 How to weave the standard-based strategy into the appropriate position of the whole regulatory system is a question to be answered by each individual jurisdiction according to its own characteristics. Being the most important and sophisticated standard-based strategy in the company setting, directors’ fiduciary duty gives a valuable illustration of how to use standard-based strategies efficiently, including the main principles as well as the factors to be considered. When it comes to the “controlling vs. minority shareholder” level, the dynamics between the parties will be different from the “director vs. shareholder” level. How to adapt standard-based strategies to this situation is the question to be answered through the study of individual jurisdictions.

290

Kraakman et al. (2009), p. 178; Davies (2002), p. 171 (“[J]udicial assessment of the fairness of self-dealing transactions has not been a significant part of British law.”) 291 Further discussion see Chapter 5.

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Chapter IV The United States §4.1

Introduction

Standard-based strategies are often seen across jurisdictions for the regulation of controlling shareholder opportunism. 292 From a practical perspective, however, the US is the only jurisdiction that relies heavily on judicial review to deal with the agency problem between controlling shareholders and minority shareholders.293 In most US state jurisdictions, controlling shareholders owe a fiduciary duty towards their corporations and the minority shareholders,294 and the American judges have been fairly aggressive in enforcing the duty against the controlling shareholders, which results in a rich collection of case law and their world-known expertise in using the standard-based strategy in the “controlling vs. minority shareholder” setting.295 This chapter is a study of the American law concerning using a standard-based strategy to regulate controlling shareholder opportunism. The ultimate question is the same as in the previous chapter, i.e., how to balance the costs and the benefits of a standard-based strategy; and it will also be the same in that the cost/benefit balancing needs to be done both in defining the standard and in enforcing it. The difference with the previous chapter is that the discussion has moved from “directors vs. shareholders” to “controlling vs. minority shareholders”. Due to the widely recognized importance of Delaware law in the area of corporate law, 296 the discussion in this chapter will be mainly based on Delaware case law, with at times reference and comparison to American Law 292

Kraakman et al. (2009), pp. 175-76. Kraakman, et al. (2009), p. 178. 294 Sinclair Oil Corporation v. Levien, 280 A.2d 717, 719 (Del. 1971); Jones v. H. F. Ahmanson & Co., 1 Cal.3d 93, 108 (Cal. 1969). Block et al. (1993), at p. 91, n.124. 295 Kraakman, et al. (2009), p. 175, 178. 296 Delaware court has long been known as the “mother court of corporate law”. See, e.g., Kamen v. Kemper Fin. Serv., Inc., 908 F.2d 1338, 1343 (7th Cir. 1990) (describing Delaware as “the Mother Court of corporate law”), reversed on other grounds, 500 U.S. 90 (1991); see also Gordon (1991), at p. 1969 (arguing that “the Delaware Supreme Court remains the national supreme court on corporate law”). 293

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Institute’s Principles of Corporate Governance (“ALI’s Principles”). Some influential or distinctive cases from other jurisdictions will be covered as well. As for federal law, although there are some federal securities transaction rules that have some relevance on the topic,297 the federal regulations do not impose on the controlling shareholders a different standard of conduct concerning their dealings with the minority shareholders.298 Therefore, the details of federal rules are not within the scope of the research. Section 4.2 starts with the definition of “controlling shareholder” and gives a general description of the fiduciary relationship between a controlling shareholder and his beneficiaries; Section 4.3 examines the substantive standard of controlling shareholders’ conduct as fiduciaries, namely, the “entire fairness” standard; Section 4.4 deals with the applicability of judicial review under the “entire fairness” standard; Section 4.5 discusses judicial review of various controlling shareholder conducts, and Section 4.6 concludes.

§4.2

Controlling Shareholders and Their Role as Fiduciaries

4.2.1 Definition of “Controlling Shareholder” Unlike directors, who have a distinctive role in the company compared to shareholders’ and whose agency relationship with the shareholders is apparent by the provisions in law, controlling shareholders are not a naturally distinguishable group among shareholders. The easier case is when one has only one majority shareholder. The simple fact that his voting is decisive for any shareholder meeting resolution is enough to make the other shareholders’ interest dependent upon how he exercises his discretionary power and thus makes that he meets the definition of an agent. Without a majority shareholding, however, the existence of an agency relationship among shareholders is less than self-evident, and identifying the right agent, (namely, the “controlling

297

E.g., SEC’s Rule 10b-5 (17 C.F.R. § 240.10b-5, which is a general anti-fraud provision). Federal courts have found that the federal securities laws are violated only upon breach of state common-law duties. Bainbridge (2002), at p. 557. 298

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shareholder”,) necessarily becomes the first step in solving the agency problem between controlling shareholders and minority shareholders. Delaware law regards the notion of “controlling shareholder” as including two types of control, namely, de jure control and de facto control.299 The rule was set by the Delaware Supreme Court in Ivanhoe Partners v. Newmont Mining Corp. 300 (“Ivanhoe Partners”), which held that a shareholder is deemed to have control “only if [he] owns a majority interest in or exercises control over the business affairs of the corporation (emphasis added).”301 4.2.1.1 De jure Controlling Shareholder

Traditionally, shareholders are not considered to be fiduciaries of the corporation and their fellow shareholders merely because of their share ownership.302 Even a majority ownership does not create a fiduciary relation between the shareholders.303 A shareholder becomes a fiduciary only if he has usurped the functions of the directors in the management and the conduct of the business of the corporation.304 The early cases that established the principle that controlling shareholders are fiduciaries often emphasized the connection between the actual exercise of control by the majority shareholders and the imposition of a fiduciary duty upon them.305 After Ivanhoe Partner, however, it is clear that such a traditional rule is no longer good law in Delaware. According to Ivanhoe Partners, a majority shareholder306 who owns more than 50% of the outstanding shares, becomes a controlling shareholder as a matter of law. As Delaware Vice Chancellor Jack Jacobs has observed, when the challenged transaction is related to a majority shareholder who holds more

299

Solomon v. Armstrong, 747 A.2d 1098, 1116, n.53 (Del. Ch. 1999). 535 A.2d 1334 (Del. 1987). 301 535 A.2d. at 1344. 302 William Meade Fletcher, “Fletcher Cyclopedia of the Law of Private Corporations”, 12B Fletcher Cyclopedia of Private Corp. §5811, n.1. See also “American Jurisprudence, 2d Edition, Corporations”, 18A Am. Jur. 2d Corporations §613, n.4. 303 12B Fletcher Cyclopedia of Private Corp. §5811. 304 Bell v. Fred T. Ley & Co., Inc., 278 Mass 60, 72 (Mass., 1932). 305 E.g., Southern Pac. Co. v. Bogert (250 U.S. 483); Allied Chemical & Dye Corporation v. Steel & Tube Co. of America et al. (120 A. 486) 306 “Majority shareholder” is not limited to an individual shareholder, but also includes a group of shareholders who “join hands” with each other. See Allied Chemical & Dye Corporation v. Steel & Tube Co. of America et al., 120 A. 486, 491. 300

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than 50% of the corporation’s stock, what alerts the court is his “ability”, or the “potential” to control or manipulate corporate affairs.307 A majority shareholder’s ability to control the corporation is apparent: without cumulative voting, he can elect the entire board of directors.308 While directors are not deemed to lack independence merely because they are nominated by a certain shareholder,309 the power to nominate board members nonetheless allows the majority shareholder to exercise far more influence over corporate affairs than anyone else. 310 Indeed, the potential influence of a majority shareholder is so great that even the so-called independent directors cannot neglect his presence and be completely free from his influence.311 Furthermore, because the influence of a majority shareholder can work in a subtle way, it is difficult to entirely negate the possibility that the corporate affair has been controlled or manipulated by the majority shareholder. Delaware law, therefore, will not ask whether or not the majority shareholder has actually exercised his control over corporate affairs before imposing a fiduciary duty upon him. The ALI’s Principles adopts basically the same proposition as of Delaware law. Under its definition of controlling shareholder in § 1.10(a), either the ownership of, or the power to vote more than 50% of the corporation’s equity securities is enough to make a shareholder to become a controlling shareholder.312 4.2.1.2  De facto Controlling Shareholder

De facto control sometimes is also called practical or working control.313 It refers to the situation that a shareholder has a less-than-majority block of shares, but nonetheless controls the corporation.

307 308 309 310 311 312 313

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In re Wheelabrator Technologies, Inc. Shareholders Litigation, 663 A.2d 1194, 1205 (Del.Ch.1995). Bainbridge (2002), p. 336. Aronson v. Lewis, 473 A.2d 805, 815 (Del., 1984), reversed on other grounds. Kraakman, et al. (2004), p. 118. Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110, 1116 (Del. 1994). See infra 4.4.2.1. ALI-CORPGOV § 1.10(a) Gottesman v. General Motors Corp., 279 F.Supp. 361 (S.D.N.Y. 1967)

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4.2.1.2.1 Plaintiff’s Burden of Proof It is firmly established in Delaware law that “a shareholder who owns less than 50% of a corporation’s outstanding stocks does not, without more, become a controlling shareholder of that corporation, with a concomitant fiduciary status.”314 For a dominating relationship to exist in the absence of majority stock ownership, a mere potential of control is not enough,315 there must be actual control of corporate conduct for a minority shareholder to be held as a controlling shareholder.316 A similar rule can be found in the ALI’s Principles, which provides that a person who “exercises a controlling influence over the management or policies of the corporation or the transaction or conduct in question by virtue of the person's position as a shareholder” becomes a controlling shareholder.317 There is no sharp line for the percentage of stock ownership for establishing working control. It varies with the size and type of the corporation, the number of shareholders and the degree of ownership concentration.318 Sec 1.10(b) of the ALI’s Principles provides for a rebuttable presumption that a person who “owns or has the power to vote more than 25 percent of the outstanding voting equity securities of a corporation is presumed to exercise a controlling influence over the management or policies of the business”, and thus presumptively is a controlling shareholder.319 This proposition, however, is not widely accepted and Delaware courts have never adopted such kind of presumption: 320 when a defendant shareholder holds less than 50% of outstanding stocks, the plaintiff always bears the burden of showing actual

314

Gilbert v. El Paso Company, 490 A.2d 1050, 1055 (Del.Ch., 1984). Citron v. Steego Corp., 1988 WL 94738, at *6 (Del. Ch.). 316 Kaplan v. Centex Corporation, 284 A.2d 119, 122-23 (Del.Ch., 1971). As to whether such domination exists, it is a matter of fact. (Citron v. Steego Corp., 1988 WL 94738, at *6.) 317 ALI-CORPGOV § 1.10(a) 318 18 A Am. Jur. 2d Corporations §655, n.11. For instance, in Traub v. Barber, 452 N.Y.S.2d 575 (N.Y.A.D.,1982), the court holds that a shareholder’s 20.6% ownership of the outstanding shares of the corporation was a "controlling" interest because no other shareholder had more than 5% of the outstanding shares. 319 ALI-CORPGOV § 1.10(b). The presumption does not apply if “some other person, either alone or pursuant to an arrangement or understanding with one or more other persons, owns or has the power to vote a greater percentage of the voting equity securities.” Id. 320 Bainbridge (2002), p. 337, n.9. 315

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exercise of control before an imposition of a fiduciary duty upon the defendant is possible.321 4.2.1.2.2 Establishing Working Control Control is interpreted by Delaware courts as “a direction of corporate conduct in such a way as to comport with the wishes or interests of [those] doing the controlling.” 322 Although inexact, the concept certainly carries with it the power to direct corporate policy and implies “considerable patronage” from the directors.323 Control may be exercised directly or through nominees.324 Nomination of directors alone, however, is not sufficient to establish control. In Aronson v. Lewis,325 a 47 percent stockholder personally selected all the directors of the corporation. Justice Moore held that such fact alone is not enough to establish control of the board by that stockholder, because the law requires showing of such “facts as would demonstrate that through personal or other relationships the directors are beholden to the controlling person.” 326 For instance, the beholden nature of a director may be demonstrated by showing the existence of “specific business or professional relationship” between the director and the controlling person.327 In the final analysis, a judge will reach his conclusion as to the independence of the board basing “not merely on the manner in which the various director relationships were created but on the cumulative effect of the trial record.”328 Kahn v. Lynch Communication Systems, Inc.329 (“Lynch I”) In Lynch I, Alcatel U.S.A. Corporation ("Alcatel") was a 43.3% shareholder of Lynch Communication Systems, Inc. ("Lynch"). Alcatel nominated five of the eleven members of Lynch's board of directors; two of three members of the 321 322 323 324 325 326 327 328 329

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Siegel (1999), at p. 35. Kaplan v. Centex Corp., 284 A.2d 119, 123. 18A Am. Jur. 2d Corporations §655, n.6. Kaplan v. Centex Corp., 284 A.2d 119, 123. 473 A.2d 805, 815 (Del., 1984), overruled on other grounds. 473 A.2d 805, 815 (Citation omitted.) Mayer v. Adams, 167 A.2d 729, 732 (Del. Ch. 1961). Greene v. Allen, 114 A.2d 916, 920 (Del. Ch. 1955). 638 A.2d 1110 (Del. 1994).

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executive committee; and two of four members of the compensation committee. The threshold question faced by the chancery court was whether Alcatel was a controlling shareholder of Lynch.330 Since the court’s finding is essentially based upon the testimony and the minutes of the August 1, 1986 Lynch board meeting, it is worthy of citing in detail. In this specific board meeting, two issues were discussed, one was the renewal of the management contract, and the other was a proposed acquisition of a target company, Telco Systems, Inc. 331 Directors from Alcatel were opposed to both. And they told the other board members “[y]ou must listen to us. We are a 43 percent owner. You have to do what we tell you”. They also declared that “you are pushing us very much to take control of the company”. The Alcatel directors opposed the acquisition, because “Alcatel, with its 44% equity position, would not approve such an acquisition as … it does not wish to be diluted from being the main shareholder in Lynch.” Both proposals were finally voted down.332 Based on the evidence, Justice Holland agreed with the Vice Chancellor’s factual finding: “Alcatel did control the Lynch board, at least with respect to the matters under consideration at its August 1, 1986 board meeting. […] The management and independent directors disagreed with Alcatel on several issues. However, when Alcatel made its position clear, and reminded the other directors of its significant stockholdings, Alcatel prevailed. […] I conclude that the non-Alcatel directors deferred to Alcatel because of its position as a significant stockholder and not because they decided in the

330

The challenged transaction in Lynch I is a cash-out merger, i.e., the controlling shareholder was offering cash to buy out the minority shareholders’ shares. The substantive issue of the case will be discussed later. 331 In the spring of 1986, Lynch determined that in order to remain competitive in the rapidly changing telecommunications field, it would need to obtain fiber optics technology to complement its existing digital electronic capabilities. Lynch's management identified a target company, Telco Systems, Inc. ("Telco"), which possessed both fiber optics and other valuable technological assets. The record shows that Telco expressed interest in being acquired by Lynch. (638 A.2d at 1114.) 332 638 A.2d at 1114.

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exercise of their own business judgment that Alcatel’s position was correct.”333

The Chancellor’s finding that the Lynch directors had not exercised their own business judgment in making their decision was critical for holding Alcatel as a controlling shareholder. As Bainbridge observes, when a majority of the board lacks independence, it is justified to hold the shareholder in control as a controlling shareholder, with a concomitant imposition of the fiduciary duty.334 Besides a showing of direct control over the challenged transaction at issue, control may also be established by showing a general controlling influence over the management or policies of the business. Feldheim v. Sims, is an exemplary case in this regard. Feldheim v. Sims335 This is an Illinois case in which Delaware law was applied. The challenged transaction in this case is the restructuring of the Chicago Board of Trade (CBOT), the largest futures and options exchange in the United States. In the restructuring, all assets of CBOT would be allocated among its members. An independent Allocation Committee (“Allocation Committee”), comprised of five CBOT “outside directors”,336 was appointed to develop a recommendation to the Board of CBOT regarding an appropriate and fair allocation of value among CBOT members in connection with the restructuring. The CBOT membership comprised five different classes, including full memberships (FMs) (1402 seats, collectively, “the majority”); and associate memberships (AMs) (789 seats), Government Instruments Market (GIMs) (156 seats), Community Options Market (COMs) (643 seats) and Index, Debt and Energy Market (IDEMs) (642 seats) (collectively, “the minority”). The 333

638 A.2d at 1114. An independent director, who had the “watershed vote”, testified that he voted against the renewal of the contract because he wanted to keep the management and didn’t want the management to “win the battle but lose the war”. 334 Bainbridge (2002), p. 337. 335 800 N.E.2d 410 (Ill. App. 1 Dist., 2003). 336 The members of the Allocation Committee owned no membership interests in the existing CBOT.

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plaintiff-minority sought declaratory and injunctive relief against the FMs on the ground that the FMs, as controlling shareholders, would breach their fiduciary duty by voting for the allocation plan which was unfair to the minority. Finding that no shareholders took part in the allocation process and FMs were not in control of CBOT, the trial court granted summary judgment in favor of defendants. Plaintiff appealed. According to the CBOT’s certificate of incorporation, FMs were entitled to one vote on all matters that were subject to a vote of the general membership, while AMs were entitled to one-sixth of one vote. Holders of GIM, COM and IDEM membership interests did not have any voting rights. As a result, FMs could outvote the minority by a margin of 1402 to 131 with respect to any matter that was put to a membership vote.337 Plaintiffs claimed that the FM majority consistently had used its “overwhelming voting power” to dominate and control the corporation. The plaintiffs made a lengthy list of facts to support its argument, such as, (1) only FMs had been elected as chairman and vice chairman of the CBOT Board, the CBOT’s highest elected offices, because CBOT rules required that the chairman and vice chairman be FMs;338 (2) the minority members were prevented from amending CBOT rules without the support of FMs as CBOT rules provided that no rule or amendment could be enacted without at least 300 votes cast and a majority of those votes approve the rule or amendment, while minority members had only 131 votes in total; (3) the rights to trade silver was allocated only to FMs; (4) CBOT adopted rules to require certain products to be cleared by FMs and not by AMs; and (5) CBOT Board adopted a resolution to require the CBOT to fully indemnify the FMs from all costs and expenses associated with this current litigation, etc.339 Based on these records, the appellate court found that “when [the FMs] exercise their votes with respect to issues affecting trading practices which impinge upon access to certain markets and procedures, those votes principally benefit themselves and substantially exclude the other four member classes […]. 337

800 N.E.2d at 417, n.13. Plaintiffs claimed that this was critical because the CBOT’s policies were generated almost exclusively by the chairman. 339 800 N.E.2d at 419. 338

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The FMs collectively act to control the outcome to their own financial advantages.” Therefore, although the circuit court found that there was no evidence in the record of direct involvement by voting members other than the outside directors in the allocation process, and the Allocation Committee was not controlled or directed by any CBOT member,340 the appellate court held that the FMs “clearly constitute[d] a controlling majority” and thus owed a fiduciary duty to the minority.341 The discussion above of the Delaware definition of “controlling shareholder” shows that Delaware law has clearly premised its regulation of conducts from a shareholder with substantial shareholding on the actual existence of an agency relationship between the shareholder and his fellow shareholders. When a majority shareholder meets the definition of “agent” by the simple fact of his majority voting power; the law will ask no more and hold him as a de jure controlling shareholder. In the case of a less-than-majority shareholder, however, the plaintiff first needs to establish “working control” by the defendant shareholder. In other words, the defendant shareholder must have actually assumed a position which makes the other shareholders’ interest dependent upon his conduct before he can be subjected to the regulation of law. Be it de jure or de facto controlling shareholders, Delaware courts have been fully aware of their substantial power over corporate affairs. The courts are especially concerned with the board’s potential lack of independence when a controlling shareholder is present. This concern is not only reflected by their willingness to impose a fiduciary duty upon the controlling shareholder when they think the board is not independent, but also by their attitudes towards setting up (or rather, not setting up) a safe harbor for controlling shareholders, which will be discussed later in this chapter.

340 341

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800 N.E.2d at 420. 800 N.E.2d at 422.

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4.2.2 Controlling Shareholders as Fiduciaries The rule that stated the fiduciary duty for controlling shareholders’, was first articulated in the U.S. Supreme Court’s decision of Southern Pac. Co. v. Bogert342 in 1919. Justice Brandeis opined for the Court that “the majority has the right to control; but when it does so, it occupies a fiduciary relation toward the minority, as much so as […] directors.”343
Shortly afterwards, the state of Delaware accepted a comparable proposition in Allied Chemical & Dye Corporation v. Steel & Tube Co. of America et al. (“Allied Chemical”):344 “When, in the conduct of the corporate business, a majority of the voting power in the corporation join hands in imposing its policy upon all, …… they are to be regarded as having placed upon themselves the same sort of fiduciary character which the law impresses upon the directors in their relation to all the stockholders.”345

In 1939, Justice Douglas wrote in his opinion for Pepper v. Litton346: “A director is a fiduciary. So is a dominant or controlling shareholder.”347 To date, this remains to be the standard citation for the proposition.348 Controlling Shareholders’ Beneficiaries The previous chapter has explained that, as a general rule, a director’s fiduciary duty is owed to the corporation instead of to individual shareholders; the directors only owe a direct duty towards the shareholders in special circumstances. 349 Since controlling shareholders have been analogized to directors by the early cases cited above, they naturally owe a fiduciary duty towards the corporation. However, their duty does not stop there: in the

342 343 344 345 346 347 348 349

250 U.S. 483 (U.S. 1919). 250 U.S. at 487-88. 120 A. 486 (Del. Ch. 1923). 120 A. at 491. 308 U.S. 295 (U.S. 1939). 308 U.S. at 306. (Citation omitted.) Bainbridge (2002), p. 336, n.4. See 3.1.2. See also Carter (1988), at 844-45.

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controlling shareholder context, it was quite apparent that from the very beginning that the ultimate purpose of imposing the duty has been to protect minority shareholders against the possible harm inflicted upon them by the controlling shareholders. In Allied Chemical, the case that established the rule of controlling shareholders being fiduciaries under Delaware law, the court explicitly asserted that in order to protect the minority from the danger of wrongful exercise of control power, the majority “are to be regarded as owing a duty to the minority”.350 Indeed, the general proposition is that controlling shareholders owe their fiduciary duty to both the corporation and the minority shareholders.351 Controlling Shareholders’ Fiduciary Duty Controlling shareholder’s fiduciary duty is largely derived from the fiduciary duty of the directors:352 when the duty was first imposed upon controlling shareholders, both the US Supreme Court and the Delaware court drew the analogy between controlling shareholders and directors.353 However, unlike directors, controlling shareholders have the same rights and interests as other shareholders, and they are entitled to exercise those rights in their own interests.354 Therefore, requiring controlling shareholders to act like a fiduciary, which means they must act unselfishly and can use their power only to promote their beneficiaries’ best interest, seems to be problematic.355

350

120 A.at 491. Emphasis added. Dalley (2004), at p. 183. Controlling shareholder’s fiduciary duty may also extend to creditors, see 12B Fletcher Cyclopedia of Private Corp. §5811, n.32; but such duty is beyond the scope of this research. See Corpus Juris Secundum Corporations § 378, n.1 and n.2 for cases holding that controlling shareholders owe a fiduciary duty to their corporations and to minority shareholders respectively. Saying that a direct fiduciary duty is owed by controlling shareholders towards the minority shareholders should not be interpreted as giving the minority shareholders a direct cause of action against the controlling shareholders whenever they suffer damages because of controlling shareholders’ wrongdoings. Whether or not the minority shareholders have to sue derivatively depends on whether or not their losses are a reflection to the losses of the corporation’s. (Li (2007), pp. 125-27.) See Li (2007), p. 127, for a summary of actions that are generally regarded as giving individual shareholders a direct cause to sue. 352 Seiler et al. (1995), at p. 459. 353 See supra n. 343-45 and accompany text. 354 See 2.1.3.2. 355 Siegel (2008), at p. 447 (“Imposing fiduciary duties on controlling shareholders may seem counter-intuitive, given that they do not buy their stock in order to act in anyone's best interest but their own.”) 351

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The theoretical flaw of holding controlling shareholders’ as fiduciaries, however, does not concern the US judges much. As commented by DeMott, the fiduciary duty is always context-specific, and the judges have always treated it as such.356 Therefore, the particular duty owed by a controlling shareholder is not necessarily the same as that of a director. While many cases have suggested that, in a general sense, both the duty of care and the duty of loyalty apply to controlling shareholders,357 the duty in the controlling shareholder context is different from the one imposed upon a director. 358 In other words, the substantive standard of conduct for controlling shareholders is different from the one of directors. To begin with, it is unclear what exactly the requirement is of the controlling shareholders’ general duty of care—if such a general duty exists at all.359 To date, the only situation in which a controlling shareholder has been found to be in breach of his duty of care is the sale of control.360 Indeed, given the large stake a controlling shareholder holds in the corporation, the lack of a definition of a controlling shareholder’s general duty of care in case law is very much understandable. It is not that controlling shareholders do not need to act with care; rather, it is just not necessary to hold controlling shareholders to a judicially enforced standard. In most cases, controlling shareholders have a strong incentive to exercise their power with care; otherwise they themselves suffer the severest loss. However, when a controlling shareholder sells off his controlling position, his interest is no longer aligned with the interest of the corporation and the minority shareholders. It is only in such a situation that the protection via a duty of care is needed by the minority shareholders.361 As for the duty of loyalty, because a controlling shareholder, as an investor, has a right to act in his own interests,362 it is by definition impossible that he can simultaneously be “undividedly” loyal to his beneficiary, something that is 356

DeMott (1988), at p. 879. Seiler et al. (1995), at p. 461. See also Varallo & Herring (1999), at 47; Summa Corp. v. TWA, 540 A.2d 403, 406 (Del., 1988) (controlling shareholders also have duty of care). 358 Seiler et al. (1995), at p. 459. 359 Seiler et al. (1995), at p. 461. 360 Seiler et al. (1995), at p. 463. 361 Id. 362 See 2.1.3.2. 357

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expected from a director.363 The judges have always been clear that controlling shareholders are not asked to “sacrifice” their own interests. 364 Therefore, unlike directors, who should refrain from pursuing personal interests, controlling shareholders do not have to put the interests of minority shareholders above their own. Instead, all that is required by law from controlling shareholders is that they “use their ability to control the corporation in a fair, just, and equitable manner.”365 Like every standard-based strategy, it does not cost much to formulate a general standard such as “fair” or “just”; the difficulty lies in the interpretation and application of the standard.

§4.3

The Standard of Entire Fairness: Fair Price and Fair Dealing

A standard such as “fairness” is only an empty shell unless it is given content through courts’ precedents. This section examines how the Delaware courts have defined the controlling shareholders’ fiduciary duty and set a standard of fairness for them. In other words, what does it mean “to act entirely fair” towards their beneficiaries as interpreted by courts in the controlling shareholder setting.366 The best-known definition of “entire fairness” has been given by the Supreme Court of Delaware in Weinberger v. UOP Inc. (“Weinberger”).367 It has been so widely acknowledged that it almost has become black letter law. In this parent-subsidiary cash-out merger case, Justice Moore opined for the Court: “The concept of fairness has two basic aspects: fair dealing and fair price. The former embraces questions of when the transaction was timed, how it 363

See Sec. 3.1.2. Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584, 598 (Del.Ch.1986); Thorpe v. CERBCO, 1993 WL 443406, at *7 (Del.Ch.1993). 365 18 A Am. Jur. 2d Corporations §645, n.1. Jones v. H. F. Ahmanson & Co., 1 Cal. 3d. 93, 108. 366 U.S. courts sometimes use “inherently fair” to mean the same thing as “entirely fair”. Pepper v. Litton , 308 U.S. 295, 306. 367 457 A.2d 701 (Del., 1983). 364

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was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained. The latter aspect of fairness relates to the economic and financial considerations of the proposed merger, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affected the intrinsic or inherent value of a company’s stock. […] However, 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. However, in a non-fraudulent transaction we recognize that price may be the preponderant consideration outweighing other features of the merger.”368

The two prongs of fairness — fair price and fair dealing — are also referred to as “the substantive fairness” and “the procedural fairness”.369

4.3.1 Fair Price What is Fair Price? In essence, fair price requires that when dealing with their beneficiaries, controlling shareholders should give the corporation, or, as in the merger case, the minority shareholders a fair compensation which is substantially equivalent in value as compared to what they take from the corporation or the minority shareholders.370 Fair price points to a range rather than to a specific figure. As explained in the comments of ALI’s Principles §5.10: “The test of fairness […] permits the transaction to be sustained if the controlling shareholder shows that it falls within a range of reasonableness. Where the transaction involves a purchase or sale of goods or services that are of comparable quality and are sold at the same price and upon the same terms as those in transactions with third parties in contemporaneous 368 369 370

Weinberger, 457 A.2d at 711. Onti, Inc. v. Integra Bank, 751 A.2d 904, 930 (Del. Ch. 1999). Sterling v. Mayflower Hotel Corp., 93 A.2d 107, 114 (Del., 1952).

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transactions at arm's length, the controlling shareholder will have satisfied the burden of proving fairness.”371

When deciding the fair price for a transaction, all relevant factors—including elements of future value—must be considered.372 For instance, in determining a fair price in a stock-for-stock merger, important factors usually include, but are not limited to, the corporations’ net assets value, past earnings, dividend declarations, and book value and market value of the companies’ stock.373 Besides the past performance, future prospects of both companies, including the nature of the enterprise, which are “known or susceptible of proof as of the date of the merger and not the product of speculation”, may also be considered.374 The requirement that consideration should be given to all relevant factors “does not mean that any one factor is in every case important or that it must be given a definite weight in the evaluation.” 375 In fact, there is no specific valuation method favored by the court.376 The court will adopt a “liberal approach that must include proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court.”377 The relative importance of the several tests of value depends upon the circumstances of each case.378

371

ALI-CORPGOV § 5.10, comment e. The Delaware Court of Chancery has also accepted market price or comparable bid from third party as evidence of fair price. See In re Fort Howard Corp. Shareholders Litigation, 1988 WL 83147, at *15-23 (Del. Ch.); In re MAXXAM, Inc., 659 A.2d 760, 772 (Del. Ch. 1995). 372 Weinberger, 457 A.2d at 711. 373 Sterling v. Mayflower Hotel Corp., 93 A.2d 107, 114. 374 Weinberger, 457 A.2d at 713. 375 Sterling v. Mayflower Hotel Corp., 93 A.2d at 115. 376 See further discussion in Sec. 4.3.4 on the Rosenblatt case. 377 Weinberger, 457 A.2d at 713. 378 Sterling v. Mayflower Hotel Corp., 93 A.2d at 115-16.

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Balancing the Constraining Effect on Opportunism against the Chilling Effect on Efficient Transactions The first and foremost function of a substantive standard is to limit the agent’s discretion, and so to lower the residual loss of the principal.379 However, adopting a constraining strategy also may sacrifice some efficiency in the agent’s decision-making. 380 The two effects need to be carefully balanced when setting the standard. Consider the following hypothetical case: a controlling shareholder is buying from the corporation a certain product, which is worth $1,000 to the corporation and $1,200 to the controlling shareholder. If there is no constraint on the controlling shareholder’s power, he can make the corporation sell the product to himself for $800, and the corporation will suffer a loss of $400. Under the standard of fair price, by contrast, any transaction at a price lower than $1,000 would be barred, because fair price requires the controlling shareholder to pay the corporation “the substantial equivalent in value to what they had before.”381 The loss is thus limited to $200. The next question is: does fair price requires the controlling shareholder to pay $1,200 because that would minimize the loss?382 The answer, as given by Chancellor Allen in his memorandum opinion for Kahn v. Tremont Corp.,383 is “No”: “[C]orporation law does not impose upon officers, directors or controlling shareholders the obligation in a conflict of interest transaction to pay a price that no reasonable counter-party could decline. That standard would too thoroughly chill a class of transactions that can be jointly productive. Nor is it the burden of such a party to pay the highest price that it is economic for him or her to pay. That too would effectively preclude transactions that may

379 380 381 382 383

See Sec. 2.3.4. Id. Sterling v. Mayflower Hotel Corp., 93 A.2d 107, 114 (Del., 1952). Or, rather, to maximize the corporation’s profit. 1996 WL 145452 (Del. Ch.), reversed on other grounds.

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be efficient. A fair price is a price that is within a range that reasonable men and women with access to relevant information might accept.”384

In this paragraph, Chancellor Allen sharply pointed out that the need to lower the loss caused by an opportunistic controlling shareholder should be balanced against the possible chilling effect on the “transactions that can be jointly productive”. 385 In the above hypothetical case, a transaction at any price between $1,000 and $1,200 would be beneficial to both sides. If fair price requires the controlling shareholder to pay $1,200 with the only aim of minimizing the corporation’s loss, then the controlling shareholder most likely would drop the transaction and both sides would suffer a loss.386

To avoid

such a chilling effect, therefore, the fair price standard will uphold a price as long as it falls within a reasonable range that might be accepted by disinterested parties dealing at arm’s length.387 Apparently, the determination of “fair price” is a fact-intensive issue. More importantly, as Weinberger has asserted, because the test of “entire fairness” is not a bifurcated one as between “fair price” and “fair dealing,” very often the question of whether a particular price falls within that “reasonable range” needs to be answered in the light of the transaction process. The relationship between “fair price” and “fair dealing” will be examined after the discussion of the procedural prong of the “entire fairness” test.

4.3.2 Fair Dealing Weinberger’s definition of fair dealing “embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to 384

1996 WL 145452, at *1. Kahn v. Tremont Corp., 1996 WL 145452, at *1. 386 The controlling shareholder may turn to some third party for an equivalent product. However, since the third party—if present at all—is not the controlling shareholder’s first choice, the product must be worth more than $1,000 to this third party, and a transaction between them is less efficient than the one between the controlling shareholder and the corporation. So, inevitably, there is loss of efficiency. 387 The fairness of the price is often judged using what “disinterested parties dealing at arm’s length might have agreed” as a reference. See supra n. 371-74 and accompanying text. See also Bainbridge (2002), at p. 315. 385

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the directors, and how the approvals of the directors and the stockholders were obtained.”388 The first four elements, i.e., the timing, initiation, structuring and negotiation of the transaction, all relate to the bargaining process; and the last two elements relate to the controlling shareholders’ duty of disclosure when seeking approval from the directors or the minority stockholders. 4.3.2.1  Arm’s Length Bargain

Whether an arm’s length bargain has been reached between the parties is very often the most decisive factor for the issue of entire fairness. In Weinberger, Justice Moore wrote in a widely cited footnote: “Although perfection is not possible, or expected, the result here could have been entirely different if [defendant] had appointed an independent negotiating committee of its outside directors to deal with [the subsidiary] 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.” 389

A transaction between a controlling shareholder and the corporation must meet three requirement to be “an arm’s length bargain”: first, the bargain is conducted by independent negotiators;390 secondly, the controlling shareholder must not dictate the terms of the transaction; and lastly, the independent committee must have real bargaining power that it can exercise with regard to

388

Weinberger, 457 A.2d at 711. 457 A.2d at 709, n.7. 390 Delaware court “has defined ‘disinterested directors’ as those directors that ‘neither appear on both sides of a transaction nor expect to derive any personal financial benefit from it in the sense of self-dealing, as opposed to a benefit which devolves upon the corporation or all stockholders generally.’ …Likewise, ‘independent’ means that a ‘director's decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences.’” See Williams v. Geier, 671 A.2d 1368, 1377, n.19. (Citation omitted.) 389

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the controlling shareholder on an arm’s length basis, 391 including, most significantly, the power to say “no”.392 As shown by the following case, Lynch I, if the independent committee has no power to reject a term which they think is unfair, the bargain will not be deemed an arm’s length bargain. Kahn v. Lynch Communication Systems, Inc.393 (“Lynch I”) Alcatel, the parent corporation, made an offer to acquire the entire equity interest in its subsidiary, Lynch, at $14 cash per share. An independent committee was mandated by the Lynch board to negotiate the cash merger offer with Alcatel.394 The Independent Committee found that the $14 per share offer was inadequate and then made a counteroffer to sell at $17 per share. Alcatel’s next two offers, at $15 and $15.25 per share respectively, were also rejected by the Independent Committee. Alcatel then made its final offer of $15.50 per share.395 According to an Independent Committee member’s testimony, Alcatel let them know that if the $15.50 offer was rejected, they would proceed with a hostile tender offer at a lower price. This was perceived as a threat by another committee member, who ultimately decided to accept the offer because “although the $15.50 was not fair, a tender offer and merger at that price would be better for Lynch’s stockholders than an unfriendly tender offer at a significantly lower price.”396 Based on these facts, the court found that in this case, “the coercion was extant and directed to a specific price offer which was, in effect, presented in the form of a ‘take it or leave it’ ultimatum by a controlling shareholder with 391

Rabkin v. Olin Corp., 1990 WL 47648, at *6 (Del. Ch.). In Rabkin v. Olin, because the special committee had been given “the narrow mandate of determining the monetary fairness of a non-negotiable offer”, and because the majority dictated the terms, the court concluded that there was no arm’s-length bargain. 392 Lynch I, 638 A.2d at 1119. 393 638 A.2d 1110. Background facts see supra Sec. 4.2.1.2.2. 394 The same independent committee was first appointed to negotiate the merger with another company Celwave Systems, Inc., which was proposed by Alcatel. After the Independent Committee found the merger ratio was not fair, instead of pursuing further negotiation, Alcatel dropped the plan and made the offer to buy Lynch. Besides, Alcatel has already shown its intension to dominate Lynch on the August 1, 1986 Lynch board meeting. (See previous discussion in Sec. 4.2.1.2.2). Because the Independent Committee was fully aware of all these situations, its ability to bargain with Alcatel at arm’s length was found by the court suspect from the outset. 638 A.2d at 1118. 395 638 A.2d at 1113. 396 638 A.2d at 1118-19.

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the capacity of following through on its threat of a hostile takeover.”397 The court cited its holding in Rabkin v. Philip A. Hunt Chem. Corp., that the requirement of fair dealing had not been met where the negotiation process “could be considered a quick surrender” to the dictated terms of the controlling shareholder.398 The Delaware Supreme Court held that the Court of Chancery’s determination that the Independent Committee “appropriately simulated a third-party transaction, where negotiations are conducted at arm’s-length and there is no compulsion to reach an agreement,” is not supported by the record.399 In other words, despite of the fact that an independent committee was used in the negotiation of the transaction, there was no real “arm’s length bargain” due to the lack of real bargaining power of the committee. It is not difficult to notice that, although fair dealing is considered a procedural fairness standard, requiring an arm’s length bargain actually means that an ex ante decision right strategy has been incorporated into the standard strategy. That is to say, the independent negotiators are acting as trustees for the corporation and the minority shareholders’ interest. Since the decision right is not in the hands of the controlling shareholder when a trusteeship strategy is adopted, the risk of agent opportunism will be much lower. To put in the words of Justice Moore, a real arm’s length bargain is often “strong evidence” of fairness of the transaction.400 Once the controlling shareholder shows that an independent committee has bargained at arm’s length for the corporation, the plaintiff-minority shareholders will face an up-hill struggle to prove the unfairness of the transaction.401 The importance of an arm’s length bargaining process does not imply that the lack of it automatically leads to the conclusion that the transaction is unfair. Again, it should be kept in mind that “the question is one of entire fairness” and 397

638 A.2d at 1120. 498 A.2d 1099, 1106, n.7 (Del.Supr., 1985), in which the court concluded, “[t]he majority stockholder’s ‘attitude toward the minority,’ coupled with the ‘apparent absence of any meaningful negotiations as to price,’ did not manifest the exercise of arm’s length bargaining by the independent committee.” 399 638 A.2d at 1121. 400 Weinberger, 457 A.2d at 709, n.7. 401 638 A. 2d at 1117. 398

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not a bifurcated test.402 As held by the Delaware Supreme Court in Lynch I, the controlling shareholder still has a chance to prove the overall fairness of the transaction even if he fails to show an arm’s length bargain has been approximated. 403 Indeed, Alcatel, the controlling shareholder in Lynch I, succeeded in Lynch II,404 which will be discussed later in this section, in proving the transaction was “entirely fair” to the minority shareholders. 4.3.2.2  Duty of Full Disclosure

As Davies observes, disclosure is an auxiliary strategy that is always needed in dealing with agency problems.405 It is a general principle of the fiduciary law that a fiduciary owes a duty of full disclosure, which requires the fiduciary to disclose all the material information that is relevant to the beneficiary’s ability to enforce his legal and practical interests.406 The disclosure must be in such detail and to such extent that the beneficiary can make an informed decision.407 According to Weinberger, how the transaction is “disclosed to the directors and how the approvals of the directors and the stockholders were obtained” are essential aspects of fair dealing.408 Therefore, disclosure is an integral part of the test of “entire fairness” that the courts use in reviewing controlling shareholder’s conduct. 4.3.2.2.1 “Completeness” in the Disclosure of Material Information To meet the requirement of fair dealing, “all the material facts and circumstances surrounding the transaction” must be disclosed by the controlling shareholder.409 Information will be deemed material if “there is substantial likelihood that a reasonable shareholder would consider it important in deciding how to [act].” 410 Or, to put it another way, if a reasonable shareholder considers the additional information as having “significantly 402 403 404 405 406 407 408 409 410

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Weinberger, 457 A. 2d at 711. 638 A.2d at 1121. Kahn v. Lynch Communication Systems, Inc. (“Lynch II”), 669 A.2d 79 (Del. 1995). Davies (2002), p. 122. Rotman (2005), p. 325. Rotman (2005), .p 334. 457 A.2d at 711. Lynch II, 669 A.2d at 88. 669 A.2d at 88.

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altered the total mix of information made available”, then the information is material.411 Besides “material”, Delaware judges sometimes also use “germane” to describe the extent of disclosure. While literally the two words are not quite the same thing, they are used by the judges, at least in the context of controlling shareholder related transactions, as synonyms.412 Lynch v. Vickers Energy Corp. (“Lynch v. Vickers”) In this tender offer case, the parent offered to buy all the subsidiary’s outstanding shares at $12 per share. In the Tender Offer Circular, the subsidiary’s net asset value was estimated to be “not less than $200,000,000 … and could be substantially greater”. What had never been disclosed to the minority shareholders was that the parent received another valuation (“the Harrell Report”) from the subsidiary’s vice-president who concluded the value could be as high as $300 million.413 The trial court held that the phrase used by the Tender Offer Circular, that is, “not less than $200,000,000 … and could be substantially greater”, had already given the subsidiary minority shareholders “adequate facts on which to make an educated choice”. Therefore, the non-disclosure of the Harrell Report was not fatal.414 In reversing this holding, Justice Duffy wrote for the Supreme Court: “[The trial court’s] approach to the controversy was, in our view, mistaken in two respects: First, to reach such a conclusion it was necessary for the Court to weigh the merits of the Harrell report and, in the context of this case, that was error. The Court's function was not to go through Harrell's estimates of oil reserves and recoveries, for example, and make its own judgment about whether these should be ‘substantially discounted’ […].

411

669 A.2d at 89. Lynch v. Vickers Energy Corp., 383 A.2d 278, 281 (Del., 1977); Rosenblatt, 493 A.2d 929, 944.(“[W]e noted that “germane” means “material” facts.”) 413 383 A.2d 278, 280. 414 Lynch v. Vickers Energy Corp., 351 A.2d 570, 575 (Del. Ch., 1976). 412

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The stockholders and not the Court should have been permitted to make such qualitative judgments. The Court's duty was to examine what information defendants had and to measure it against what they gave to the minority stockholders, in a context in which ‘complete candor’ is required. In other words, the limited function of the Court was to determine whether defendants had disclosed all information in their possession germane to the transaction in issue. And by ‘germane’ we mean, for present purposes, information such as a reasonable shareholder would consider important in deciding whether to sell or retain stock. […] A second reason why we think that the Court of Chancery was mistaken in applying the law was that it incorrectly substituted a ‘disclosure of adequate facts’ standard for the correct standard, which requires disclosure of all germane facts. Completeness, not adequacy, is both the norm and the mandate under present circumstances.”415

The court held that Harrell’s estimate, which contained information pertaining to the net value of the subsidiary’s assets and the per share value of its stock, was germane to the tender offer in that it included the type of information which a reasonable shareholder would consider important in deciding whether to sell or retain stock. Besides the Harrell Report, plaintiffs also claimed that the parent should have disclosed that, immediately before making the offer, the parent management had authorized open market purchase of subsidiary shares for bids up to $15 per share. The parent corporation claimed that the $15 price was just a procedural convenience on board authorization and not an accurate reflection of the true value of the stock. The trial court thus held the nondisclosure was not fatal. The Supreme Court, again, held that “the [trial court] incorrectly weighed the quality of the information before it ruled on the claim of

415

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383 A.2d at 280-81. Citation omitted.

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nondisclosure.”416 The justice went on to hold that whether the price was a real reflection of true value or was just a convenience tool “is not relevant in a context involving the fiduciary obligation of full disclosure. What is important is the fact that the authorization price was germane to the terms of the tender offer, and as such it should have been disclosed to the minority shareholders.”417 As illustrated by Lynch v. Vickers, the extent of the disclosure has no relevance to issues such as whether the minority shareholders would have changed their decision had they known the additional information, or whether the information they already had was enough for them to make the right choice, or whether the additional information itself has merit, etc. All that matters is the “completeness” of the disclosure, that is, the controlling shareholder must disclose all material information in their possession related to the transaction”.418 4.3.2.2.2 Limitation as to Materiality: Examples from Rosenblatt and Lynch II Not every omission of relevant information will lead to a breach of the duty of fair dealing. Only material information needs to be disclosed. A better understanding of materiality can be achieved from the cases that held certain information is immaterial. In Rosenblatt v. Getty Oil Co.,419 (“Rosenblatt”) which is a parent-subsidiary merger case, an independent third party, DeGolyer and Macnaughton (“D&M”), was retained to evaluate the respective oil, gas and mineral reserves of the parent corporation and the subsidiary. It was agreed by the negotiators from both corporations that the method of evaluation was to be kept secret to both sides. The plaintiffs, who were minority shareholders of the subsidiary, claimed that this agreement between the negotiators was not disclosed in the proxy statement, and because of the omission, the proxy was misleading the

416 417 418 419

383 A.2d at 282. 383 A.2d at 282. 380 A.2d at 281. 493 A.2d 929 (Del. 1985). Further discussion of the case see 4.3.4.

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subsidiary minority shareholders to think that the negotiators of the subsidiary knew the valuation method. Citing TSC Industries Inc. v Northway Inc.,420 a U.S. Supreme Court case, the Delaware Supreme Court held that to meet the standard of materiality, “there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” The Court found that from the disclosure made in the proxy, a reasonable shareholder would know D&M alone estimated the reserves. The Court “seriously doubt[ed]” that, had the agreement between the negotiators to keep the valuation method secret been disclosed in the proxy, a reasonable shareholder would consider that extra piece of information have significantly altered the “total mix of information.”421 Because the omission was immaterial, the Court concluded that the parent had met its duty of full disclosure.422 Comparably, in Kahn v. Lynch Communication Systems, Inc. (“Lynch II”), the plaintiff-minority shareholder claimed that the proxy statement did not disclose that the controlling shareholder (“Alcatel”) would consider a tender offer at a substantially lower price if the negotiation broke down.423 Plaintiff argues that the proxy is an incomplete description of Alcatel’s negotiation options and thus was misleading. The Court found that the proxy did disclose that Alcatel would consider “making an offer directly to the stockholders” if the negotiation broke down, and “[t]he narrow question thus becomes whether a reasonable shareholder would have considered the additional language [about the tender offer price might be far lower than the merger price] ‘as having significantly altered the total mix of information made available.’” The Court held that, because a reasonable shareholder should know that a controlling shareholder has the

420 421 422 423

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426 U.S. 438 493 A.2d at 945. 493 A.2d at 945. 669 A.2d at 89. Background facts see Lynch I, supra Sec. 4.3.2.1.

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leverage of making a hostile tender offer at a lower price, the omission was permissible.424 4.3.2.2.3 “Privileged Information” in an Arm’s Length Bargain? In Kahn v. Tremont Corp. (“Tremont”), 425 the Delaware Supreme Court rejected Chancellor Allen’s holding that for an arm’s length bargaining process to make sense, some material information is “privileged” thus does not need to be disclosed. Kahn v. Tremont Corp. The controlling shareholder in Tremont simultaneously controlled two companies. He sold part of his shares in one company to the other company. The buyer company mandated a special committee comprising of three independent directors to negotiate the terms of the transaction. A minority shareholder of the buyer company brought the suit challenging the fairness of the transaction. The plaintiff claimed that, among others, the controlling shareholder breached his duty of disclosure by failing to disclose an informal opinion issued by an investment banker (“the Salomon’s opinion”), which opined that a 20% or greater illiquidity discount from market price of the defendant’s shares would be required in order to conclude the transaction.426 At the trial stage, Chancellor Allen examined the rule concerning disclosure in a controlling shareholder related transaction negotiated by a special committee through an arm’s length bargain: “In my opinion appreciation of the interests to be protected and the mutual gains to be achieved by the special committee process require the conclusion that there are some categories of information that while possibly material to the decision must be regarded as privileged from disclosure in order for a negotiation to occur at all. The clearest example would involve information disclosing the top price that a proposed buyer would be willing 424 425 426

669 A.2d at 89. 694 A.2d 422 (Del. 1997) 694 A.2d at 431.

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or able to pay, or the lowest price that a proposed seller would accept. If the law required such information to be disclosed it would (insofar as it would not simply create additional incentives for deception) simply mean that a committee could not approve a transaction at other than the highest price that the counter party could pay. Obviously such a rule would grossly impede, if it would not eliminate, such transactions because it would destroy the incentive for a parent corporation to offer a transaction that was beneficial to both itself and the subsidiary. […] Thus, I take it as clear that there is a category of information that is material but that a fiduciary has no duty to disclose.”427

Based on this reasoning, Chancellor Allen concluded that the Salomon’s opinion fell into such a category of “privileged” information thus needed not to be disclosed. 428 To Chancellor Allen, “to require the disclosure of such information in this context would be to take a large step towards abandonment of the special committee structure as a useful technique to try to deal with the potentials and the risks of self-dealing transactions.”429 On appeal, the Supreme Court of Delaware disagreed with Chancellor Allen that the Salomon’s opinion was privileged information.430 The Court found that Allen’s “carv[ing] out a ‘privilege’ exception” to the general standard of materiality had no basis in Delaware law.431 Nonetheless, the Court held that the Salomon’s opinion needed not to be disclosed. Justice Walsh opined for the Court: “[the defendant] had no duty to disclose information which might be adverse to its interests because the normal standards of arms-length bargaining do not mandate a disclosure of weaknesses. The significance of 427

Kahn v. Tremont Corp., 1996 WL 145452 (Del. Ch.), at *15. In Rosenblatt, the Supreme Court also stated that controlling shareholders do not under all circumstances owe a duty to disclose their highest bid. However, the Court did not explain when such a duty will arise. 493 A.2d at 939. 428 1996 WL 145452, at *17. 429 1996 WL 145452, at *17. 430 The Supreme Court also disagreed with Chancellor Allen regarding whether or not the special committee had negotiated at arm’s length. The significance of this factual finding, though not relevant here, will be discussed in Sec. 4.3.3. 431 694 A.2d at 432.

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the illiquidity discount to this transaction lies not in whether [defendant] had a duty to disclose it but whether an informed independent committee had a duty to discover it.”432

While Justice Walsh did not agree with Chancellor Allen’s reasoning, he did agree with Chancellor Allen that in an arm’s length bargain, some information does not need to be disclosed, notwithstanding that the information might be material. The Justice’s rationale was that “the normal standards [of disclosure] of arms-length bargaining” did not require it to be disclosed. Disclosure in arm’s length bargain is only required when a non-disclosure is equivalent to an assertion that the fact does not exist.433 As summarized in CJS Fraud §20, the general principle of disclosure in arm’s length bargain is: “Where the parties deal at arm’s length, there is no duty of disclosure where the facts are equally within the means of knowledge of both parties […] or peculiarly within the knowledge of one party and of such a nature that the other has no right to expect information. If the fact concealed is peculiarly within the knowledge of one party and of such a nature that the other party is justified in assuming its nonexistence, there is a duty of disclosure, and deliberate suppression of such fact is fraud.” 434

Therefore, in an arm’s length bargain, whether certain information needs to be disclosed depends on whether the corporation and the minority shareholders have a right to expect information, or, in case of non-disclosure, to assume the non-existence of the information. In Lynch v. Vickers, the Harrell report was prepared by the vice-president of the subsidiary (thus owned by the subsidiary), and the parent got access to the information by virtue of its controlling position in the subsidiary. Therefore, not only should the parent not benefit itself from the information due to the fiduciary duty it owed to the subsidiary and the minority shareholders, but also was the minority justified in assuming the 432 433 434

694 A.2d at 432. Restatement (2d) of Contracts 7, 1 IN NT and § 161 (1981). Corpus Juris Secundum, Fraud §20. Citation omitted.

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non-existence of the information in case of non-disclosure. Moreover, the Court’s seemingly far-reaching holding of requiring disclosing the $15 price set at the controlling company’s board meeting was also well founded, because the $15 price was set based on the information in the Harrell report. By contrast, in Tremont, the information at issue was not about the buyer company, of which the plaintiff was a minority shareholder, but another subsidiary controlled by the controlling shareholder. In other words, the controlling shareholder’s possession of the information had nothing to do with his controlling position in the buyer company. To require the controlling shareholder to share the information would grant the minority of the buyer company some benefit that they were not entitled to. As the Court held, in such a case, there is no duty for the controlling shareholder to disclose and it is the buyer company’s duty to find out that information. 4.3.2.3  Fair Dealing and the Burden of Proof in Judicial Review

When a court scrutinizes a challenged controlling shareholder conduct under the standard of entire fairness, the initial burden of proof is always on the defendant-controlling shareholder. 435 That is to say, a plaintiff-minority shareholder only needs to establish a prima facie case of breach of fiduciary duty by the controlling shareholder by alleging facts from which, if taken to be true, one can reasonably conclude that a breach of the fiduciary duty has occurred.436 It is the controlling shareholder who has the burden to show that the challenged transaction is fair to the corporation and the minority shareholders. However, if the challenged transaction has been conducted through an arm’s length bargain, or the transaction has received approval from the minority shareholders after full disclosure by the controlling shareholder, the burden of proof will be shifted to the plaintiff-minority shareholder, that is to show the transaction is unfair.437 Nevertheless, the controlling shareholder will not be 435

Weinberger, 457 A.2d at 710; Lynch I, 638 A.2d at 1117. See Palm & Kearney (1995), at 1359. See also Monroe County Employees' Retire. Sys. v. Carlson, 2010 WL2376890, at *2, (Del. Ch. 2010). (Plaintiff needs to allege facts, which, if taken to be true, would prove unfair price.) 437 Rosenblatt, 493 A.2d at 937; Lynch I, 638 A.2d at 1116-17. 436

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burden-free: if the controlling shareholder counts on an arm’s length bargain to shift the burden of proof, he must first “demonstrate that [he] has not only formed an independent committee but also replicated a process ‘as though each of the contending parties had in fact exerted its bargaining power at arm’s length.’” 438 Similarly, if the controlling shareholder relies on minority shareholder approval, he must first show a full disclosure of all material facts around the transaction, which would enable the minority shareholders to make an informed decision as to how to cast their votes.439 Because the burden-shifting effect of fair dealing takes place in the enforcement process of controlling shareholders’ fiduciary duty, its implication will be further examined in the later section discussing the enforcement process. At this point, it is enough to say that shifting the burden of proof will considerably lower the risk of liability and the overall cost of litigation for the controlling shareholder.440

4.3.3 Entire Fairness: A Non-bifurcated Test The analysis of entire fairness is not a bifurcated test as between fair dealing and price, but rather, as Justice Moore wrote in Weinberger, “[a]ll aspects of the issue must be examined as a whole since the question is one of entire fairness.”441 In Lynch II, discussed hereunder, the Delaware Supreme Court has made it clear that the absence of certain elements of fair dealing does not automatically defeat the fairness of the transaction. Kahn v. Lynch Communication Systems, Inc. (“Lynch II”)442 In Lynch I, the cash out merger transaction between Alcatel and Lynch was found by the Delaware Supreme Court to be coercive, and thus there was no 438

Lynch I, 638 A.2d at 1121, citing Weinberger, 457 A.2d at 709-10, n.7. Rosenblatt, 493 A.2d at 937. The ultimate purpose of disclosure is to enable the beneficiary to make informed decisions. (Rotman (2005), at p. 325.) See also Steinberg (2002), at 494; McMullin v. Beran, 765 A.2d 910, 920 (Del.2000) (minority shareholders must be able to make an informed decision whether to accept the tender offer price or seek an appraisal of their shares.) 440 Latham & Watkins (2010), at p. 3. 441 457 A.2d at 711. 442 669 A.2d 79. For background facts see previous sections. 439

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true arm’s length bargain notwithstanding the use of an independent committee.443 However, the Court moved on to say that such a finding did not automatically lead to the conclusion that the transaction was unfair. Instead, the case was remanded to the trial court for a “redetermination” of the entire fairness of the transaction with the burden of proof on the defendant.444 On remand, the Court of Chancery held that the transaction met the standard of entire fairness.445 Affirming the trial court’s decision, the Delaware Supreme Court ruled in Lynch II that “the absence of certain elements of fair dealing does not mandate a decision that the transaction was not entirely fair.”446 The Court first held that although the transaction was coercive, the influence of the coercion on the transaction was not material; therefore, the presence of coercion would not prevent a finding of entire fairness.447 The Court agreed with the lower court’s finding that Alcatel had treated Lynch not worse than when it had not adopted a bargain process at all, which it had sufficient power to do.448 Secondly, the Court found the merger price of $15.50 per share was fair based on the fairness opinions of experts.449 And lastly, the Court upheld the trial court’s finding that Alcatel had not violated its duty of disclosure owed to the minority shareholders.450 Such a finding, as said by the Court, “though not determinative of entire fairness, [was] of ‘persuasive substantive significance’”, because it “place[d] this case in the category of ‘nonfraudulent transactions’ in which price may be the preponderant consideration.”451 Based on the foregoing analysis, the Court concluded that the non-bifurcated standard of Weinberger was satisfied, the transaction was entirely fair to the minority shareholders of Lynch.452 443

See 4.3.2.1. Lynch I, 638 A.2d at 1122. Kahn v. Lynch Communication Systems, Inc., 1995 WL 301403, at *3. 446 669 A.2d at 83. 447 669 A.2d at 86. (The Court found that it was more likely that other economic forces had led to the minority shareholders’ decision to sell.) 448 669 A.2d at 85. 449 Both the advisor retained by Alcatel and those retained by the Independent Committee agreed the final merger price was fair. Meanwhile, the court upheld the Chancery Court’s finding that the valuation method of the analyst retained by the plaintiff, who concluded that the fair value for Lynch was $18.25 per share, was flawed and thus should be rejected by the court. 669 A.2d at 86-88. 450 669 A.2d at 89. 451 669 A.2d at 89. Citation omitted. 452 669 A.2d at 90. 444 445

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Lynch II rules that in a nonfraudulent transaction, price may be the “preponderant consideration” for evaluating the fairness of the transaction. However, the fairness of a price is not a context-free question; instead, it often needs to be evaluated together with the backdrop of the bargaining process. Kahn v. Tremont Corp. Because the challenged transaction in Tremont was negotiated by a special committee composed of three independent directors, at the trial stage, Chancellor Allen held that the burden of proof is on the plaintiff.453 Basing on this premise, the Chancellor made a lengthy analysis as to the issue of fair price and concluded that the price was fair.454 On appeal, the Supreme Court reversed. The Court found that the special committee had not functioned independently, thus the defendant was not entitled to a shift of the burden of proof.455 Further, in an opinion for the purpose of providing guidance for the parties and the Court of Chancery, the Supreme Court agreed with Chancellor Allen’s conclusion as to the issue of disclosure, that is, the defendant had not breached his duty of disclosure.456 As to Chancellor Allen’s finding of fair price, the Supreme Court held that although the price fell arguably in a broad range of fairness, this alone was not enough to satisfy the test of entire fairness as defined in Weinberger.457 Citing Weinberger, the Court pointed out that “[a]lthough often applied as a bifurcated or disjunctive test, the concept of entire fairness requires the court to examine all aspects of the transaction in an effort to determine whether the deal was entirely fair.”458 Following Lynch I, the Court found it appropriate to remand the case to the trial court, because “[w]hether the defendants, shouldering the burden of proof, will be able to demonstrate entire fairness is, in the first instance, a task committed to the Chancellor.”459 453

1996 WL 145452, at *8. 1996 WL 145452, at *9-14. 455 694 A.2d at 429-30. 456 694 A.2d at 432. Although the Supreme Court reached the conclusion on a different basis. See supra discussion on disclosure, Sec. 4.3.2.2.3. 457 694 A.2d at 432. 458 694 A.2d at 432 459 694 A.2d at 433. 454

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At the first glance, Tremont’s conclusion may be confusing. In Lynch II, the Court held that in a non-fraudulent transaction the price may be the preponderant consideration outweighing other factors. The Tremont plaintiff had never claimed the transaction to be fraudulent, and the transaction should have been qualified as non-fraudulent since there was no breach of the duty of disclosure. Why is it that the finding of fair price by Chancellor Allen could not lead to a conclusion that the transaction was entirely fair? The Supreme Court has not given a direct explanation. However, they did point out that the conclusion of Chancellor Allen had been reached “in a procedural construct which required [the plaintiff] to prove unfairness of price.”460 The implication of this assertion will be clearer if read together with Vice Chancellor Lamb’s opinion after the case was remanded. In interpreting the Supreme Court’s opinion on the issue of fair price, the Vice Chancellor wrote: “I do not understand this part of the Supreme Court’s decision to preclude a finding that the $11.75 per share price paid in the transaction was adequate to support a finding of entire fairness. Rather, I understand it to mean that Chancellor Allen’s conclusion in this regard must be revisited in light of the Supreme Court’s assignment of the burden of proof to the defendants and its finding that the Special Committee process was fundamentally flawed. Thus, the question to be addressed is whether the $11.75 price is sufficient to support a conclusion of entire fairness where it is found to be the product of a negotiating process lacking in independence.” 461

In short, the issue here is not whether a fair price can be “the preponderant consideration” in a non-fraudulent transaction, but is how to evaluate the fairness of the price. The answer, as given by the Vice Chancellor, is that the fairness of the price must be reviewed “in light of” the transaction process. As observed by the Supreme Court, in most cases, the issues of fair price and fair dealing are addressed by the courts respectively, yet these two factors are 460 461

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694 A.2d at 432. Kahn v. Tremont Corp., 1997 WL 689488 (Del. Ch.), at *2.

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actually intertwined with each other.462 While the weight given to them by the courts in the analysis of entire fairness may vary with different sets of facts, it is always based on the “cumulative effect” of the manner in which a controlling shareholder discharges his fiduciary duty.

4.3.4 Substantive vs. Procedural Fairness: Some Reflection A next question to be asked at this point is, why require fair dealing at all? An arm’s length bargain is obviously more expensive than a controlling shareholder-dictated transaction as regard to transaction cost. If the court can hold the controlling shareholder on fair price, would it not be a more efficient solution for both parties to save the bargaining cost and just pay the fair price? After all, Delaware courts have recognized that fair price is the preponderant element for the determination of fairness in a non-fraudulent transaction; and as shown by Lynch II, arm’s length bargaining is not a “must-have” for a controlling shareholder to win his case.463 This section will first look into a benchmark case concerning the entire fairness standard, then come back to reflect on the relationship between the substantive and procedural prong of the standard. 4.3.4.1 Rosenblatt

The Delaware Supreme Court case Rosenblatt v. Getty Oil Co.464 is a model case illustrating the relationship between “fair price” and “fair dealing”. The case is intriguing because it gives a perfect example as to how a seemingly simple and straightforward term as “fair price” can cause great difficulty for the fact reviewers, as well as what a real “arm’s length bargain” can bring (or cost) the parties. These are all critical factors to be taken into consideration when making a choice of strategies to regulate controlling shareholder opportunism. To appreciate the issue, the case is discussed in detail below.

462

694 A.2d at 432. See also Delaware Open MRI Radiology Assoc’s, PA. v. Kessler, 898 A.2d 290, 311 (Del. Ch. 2006) (“[T]he overriding consideration [for the court to determine entire fairness] is whether the substantive terms of the transaction were fair.”) 464 493 A.2d 929. (Del. 1985) 463

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Rosenblatt v. Getty Oil Co. Rosenblatt is a class action brought by minority shareholders of Skelly Oil Company ( “Skelly”) challenging the stock-for-stock merger of Skelly and Mission Corporation (“Mission”) into Getty Oil Company (“Getty”). Before the merger, Getty owned 7.42% of Skelly’s outstanding shares and 89.73% of Mission, which in turn held 72.6% of Skelly’s stock. Both Getty and Skelly were integrated oil companies. In July, 1976, a high-level conference which was attended by the principal officers of both Getty and Skelly was held in Dallas. On this conference, the two parties reached consensus that a stock-for-stock merger would be desirable for both parties. They also agreed that DeGolyer and Macnaughton (D&M), a petroleum engineering firm, would assist the parties in evaluating their respective oil, gas, and mineral reserves. Besides its worldwide reputation, D&M had worked periodically with both Getty and Skelly since 1939, and had prepared annual estimates of oil and gas reserves for both companies for many years.465 After the Dallas meeting, both parties devoted substantial resources in evaluating their own surface and subsurface assets and preparing to negotiate the exchange ratio, including hiring reputable investment banks in assisting the valuation. In negotiating the exchange ratio, Getty recommended the Delaware Block method, which was by then the exclusive technique used in appraisal and other stock valuation proceedings, be used to value the companies’ stock.466 In utilizing the method, Skelly attempted to maximize the weight of the elements in which they had a comparative advantage over Getty and minimize the weight of those elements in which Getty had an advantage. To get a higher exchange ratio, Skelly also used different valuation methods for different items of its property, totally disregarding consistency. In contrast, Getty adopted a more consistent and conservative method in valuing its assets.467 465

493 A.2d at 933. 493 A.2d at 934. Using the so called Delaware Block method, elements of value, including assets, earnings, and market price will be given a dollar figure, assigned percentage weights, and then summed to yield a weighted average value per share 467 493 A.2d at 934 466

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Concerning the valuation of reserves by D&M, while both parties concurred to D&M’s reserve estimates, they disagreed on D&M’s projection of future price in valuing the reserves. To overcome the obstacle, the parties agreed that each side delegate to D&M the task of calculating the present fair market value of their respective reserves, and D&M’s methods would not be revealed to the parties. The parties also agreed that D&M’s valuation would be final and binding upon them.468 When the parties began to negotiate about the stock exchange ratio, Getty anticipated a ratio of between .46 to .55 shares of its common stock for one share of Skelly common share. On the other side, Skelly proposed .7, a figure which angered Getty as being absurdly high. The negotiation almost broke down when Getty raised to .57 and Skelly persisted on .61.469 Finally, after Getty informed Skelly that the Getty board had concluded .58 was the highest acceptable ratio, agreement was reached at .5875. The merger consummated after shareholder approval in January 1977.470 The plaintiffs challenged both the fair price and fair dealing prong of the merger. With regards to the merger price, plaintiffs claimed that the exclusive use of the Delaware Block method yielded a value of $110 per share, considerably less than Skelly’s appraised asset value of $195 per share.471 The court found that the plaintiffs’ valuation was done on the assumption that Skelly’s minority shareholders should have received Getty stock equal to the liquidation value of Skelly.472 The court held that this contention of the plaintiffs was not supported by Delaware law, because “[i]n Delaware a company is valued as a going concern [for purposes of determining fairness of merger exchange ratio], not on what can be obtained by its liquidation.”473 The court also pointed out that the Delaware Block method, which was challenged by the plaintiffs, “was the only valuation technique permitted at that time. In

468

493 A.2d at 935. A press release announcing the end of merger negotiations had already been drafted by Getty. 493 A.2d at 936. 470 493 A.2d at 936. 471 493 A.2d at 936 472 493 A.2d at 942. 473 493 A.2d at 942. 469

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any event, Weinberger did not abolish the block formula, only its exclusivity as a tool of valuation.”474 As to the components of the .5875 ratio, the court found that Skelly succeeded in obtaining an equal weighting of earnings and assets, despite that under Delaware law assets are often given the greatest weight.475 Skelly also succeeded in belittling the market price of the companies’ stocks, notwithstanding that Getty shares were selling at a much higher price. Lastly, the court found that the record showed “that the merger would result in a more competitive, efficient company, thereby benefiting the Skelly stockholders who would maintain a continued ownership interest in the surviving company.”476 Based on all these finding, the court concluded that the price received by the Skelly shareholders was fair.477 When it came to the issue of fair dealing, the court found that because of a litigation threat from a Skelly minority shareholder, Getty had sought to structure the transaction to meet the standards imposed by Delaware law. To avoid the potential conflict of interests because of the interlocking management of both companies, two Getty personnel who used to sit on the Skelly board resigned from their position. As to the negotiation process, the court was also satisfied that Getty had dealt fairly with Skelly throughout the transaction. The court especially noted that because of Skelly’s aggressiveness, the negotiation nearly broke down on at least two occasions.478 Justice Moore wrote: “There is no credible evidence indicating that Getty, as the majority shareholder, dictated the terms of this merger. If anything, the facts are to the contrary. Thus, what we have here is more than the theoretical concept of what an independent board might do under like circumstances. Instead, it

474

493 A.2d at 940. 493 A.2d at 941. Plaintiffs did not challenge the asset value eventually agreed upon by Getty and Skelly. 476 493 A.2d at 942. 477 493 A.2d at 942. 478 493 A.2d at 938. 475

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is clear that these contending parties to the merger in fact exerted their bargaining power against one another at arm’s length.” 479

After careful scrutiny of the entire transaction, the justice concluded that Getty had dealt fairly with the Skelly minority shareholders in the merger. 4.3.4.2 Procedure as Safeguard

Procedure as Safeguard Rosenblatt is exemplary as to “fair dealing”. As the court noticed, both parties spent large amount of resources in the bargaining process. The outcome of the case suggests that, while the saving on bargaining cost might be attractive, incurring such cost is not without good reason — at least from the minority shareholders’ perspective. As pointed out by Chancellor Allen, a “fair” price may vary in a considerably wide range. 480 Without a bargaining process, therefore, even when the controlling shareholder is acting in good faith, the minority shareholders may end up at the lower end of the price-range. The controlling shareholder in Rosenblatt, who deliberately acted “fairly” in order to avoid litigation, only anticipated .55 as the upper-limit of the price it would pay, while the ultimate result of the bargain gave the minority .5875. Apparently, a “fair” behaving controlling shareholder might not be good enough for the minority shareholders to get the best deal. Similarly, relying on an independent third party provides not much more assurance to the minority shareholders’ interest either. It has been observed that the range of fairness can be “so large that even expert financial opinions can fail to aid the outside shareholder in determining what constitutes a fair deal.”481 Therefore, to push it to the limit, the minority can only rely on an expensive — yet might well be worthy — arm’s length 479

493 A.2d at 937-38. For instance, in Rosenblatt, Getty’s original estimation was a ratio between .46 to .55, which means a twenty percent difference between the high end and low end price. 481 Schwartz (1986), at p. 531. (The author gives an example in which the price of the shares is valued from $55 to $77 per share by different buyers. See n.245 and accompanying text.) Meanwhile, the independent advisors are likely to be biased towards the people who hire them, who most likely are the controller of the company. (See Posner (1999), at p. 93.) 480

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bargaining process. In other words, the procedural fairness works as a safeguard of the substantive fairness for the minority shareholders. Enhancing Enforceability of the Substantive Standard Besides helping the minority shareholders to get a better deal, procedural fairness also enhances the enforceability of the substantive fairness, especially in those complicated transactions such as the one in Rosenblatt. While it is conceivable that sometimes there is a widely accepted market price which can be used as a reference by the parties, Rosenblatt suggests that, more often than not, the price is the outcome of the bargaining process, and there is no readily available yardstick to judge its fairness for an outsider adjudicator. Under such circumstances, as elaborated by Vice Chancellor Lamb in the Tremont case, the fairness of the price can only be assessed in the light of the transaction process. Chancellor Chandler has put it more concisely in Monroe County Employees' Retire. Sys. v. Carlson: “a fair price is more likely to follow fair dealing.”482 In this sense, fair dealing actually defines the fair price,483 especially in the complicated transactions for which there may be a wide range for “fair price.” Without an observable bargaining process, a court would have great difficulty in evaluating the fairness of a given price; in other words, without procedural fairness, the substantive fairness would be much less enforceable. Flexibility under the Non-bifurcated Test With the importance of fair dealing settled, it should not be forgotten that the ultimate purpose of regulating agent opportunism is not to maximize the interest of the principal, but to optimize the efficiency of the agency relationship.484 Rosenblatt shows that an arm’s length bargaining process can 482

2010 WL2376890, at *2. Or to put it another way, an arm’s length bargain is “strong proof” of fairness. (Weinberger, 457 A.2d at 709, n.7.) 484 Especially given that in parent-subsidiary transactions, some public shareholders might be shareholders for both corporations. Spending as much as possible to raise the price for the subsidiary is not necessarily in the minority shareholders’ best interest. (See In re Cox Communications, Inc. Shareholders Litigation, (“Cox Communications”) 879 A.2d 604, 632-33.) 483

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be very expensive. How to make sure that the benefits of fair dealing can cover its costs is not a question that can be fully answered at this point: it has to be examined together with the enforcement process and will be discussed later in this chapter.485 Nevertheless, one point should be briefly made here. That is, because the test of entire fairness is a “non-bifurcated” test, and in a non-fraudulent transaction, price is the preponderant consideration, a controlling shareholder may choose to skip the procedural safeguard if he does not think it is worth the cost.486 This typically happens when a controlling shareholder can easily prove the fairness of the price — say, because there is a generally accepted market price for a certain product, or a comparable price at which the company has transacted with a third party,487 then it would be a more rational choice for the controlling shareholder to save the bargaining cost and bear the risk of litigation.488 The non-bifurcated entire fairness standard has the flexibility of allowing a controlling shareholder to structure the transaction in a more efficient way according to its specific circumstances.

§4.4 Applicability of the Entire Fairness Review 4.4.1 Introduction In Chapter 3, it has been shown that judicial review of the directors’ fiduciary duty is a matter of balancing the directors’ authority against their accountability.489 The threshold question that needs to be answered is whether a court or an individual shareholder should be allowed to intervene with the corporate decision-making system. The fundamental idea underlying both the 485

See infra Sec. 4.4.5.2. Of course, unlike the minority shareholders, who are balancing the cost of the arm’s length bargain against the increase in transaction price, a controlling shareholder is balancing the bargaining cost, plus the increase in the transaction price, against the possible litigation cost. The issue will be revisited in Sec. 4.4.5.2. 487 See supra n. 371. 488 As said, fair price is a fact-intensive question. If the fact pattern of the case makes it a simple question to evaluate the fairness of the price, litigation cost will drop. See, Lee & Willging (2010), at p. 5, 7. (Empirical study shows that factual complexity is associated with higher litigation cost.) Because the issue is related with litigation cost, it will be further discussed in Sec. 4.4.5.2. 489 See Sec. 3.3. 486

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business judgment rule and the demand rule490 is that the board’s authority as the corporation’s decision-maker should not be disturbed unless there is reasonable belief that the corporate decision-making system has failed.491 The specialty about the enforcement of controlling shareholders’ fiduciary duty, as contrasted to the enforcement of directors’ duty, is that, by definition, when a shareholder has control over corporate affairs, it is a logical inference that the directors lack independence.492 As a result, demand is usually excused when a controlling shareholder is a named defendant in a derivative action.493 Nevertheless, a court still needs to decide whether or not it should interfere with the controlling shareholder’s decision-making itself, and it is well accepted that the business judgment rule, though originally designed to protect directors, applies to controlling shareholders as well. 494 As stated by Chancellor Duffy in David J. Greene & Co. v. Dunhill Intern., Inc., “[i]n the absence of divided interests, the judgment of the majority stockholders and/or the board of directors […] is presumed made in good faith and inspired by a bona fides of purpose.”495 Therefore, a controlling shareholder’s conduct will be reviewed by the court under the standard of “entire fairness” only if the plaintiff-minority shareholder can overcome the business judgment rule. In the “canonical parent-subsidiary case” Sinclair Oil v. Levien, 496 the Delaware Supreme Court created a threshold test for invoking the entire fairness review in the controlling shareholder context.

490

See discussion below. See Sec. 3.2.2 492 Lerach (1990), at p. 568. (Where the directors are all dominated by a controlling shareholder who participated in the wrongdoing, demand would be excused as there is reasonable doubt as to the directors’ independence and impartiality as to the institution or prosecuting a suit to remedy such misconduct.) See Louisiana Mun. Police Employees' Retirement System v. Fertitta (2009 WL 2263406) for an example in which from a same set of fact the court held a 39% shareholder as a controlling shareholder and found demand futility. (Id. at *7, n.25.) 493 Wilder (1985), at p. 644. 494 Lashbrooke (1995), at p. 460. 495 249 A.2d 427, 430 (Del. Ch. 1968) 496 280 A.2d 717 (Del. 1971). Bainbridge calls the Delaware Supreme Court’s decision of Sinclair Oil v. Levien as “the canonical parent-subsidiary case” (Bainbridge (2005), p. 238.) Although Siegel has commented that Sinclair has been largely undermined by later cases, (Siegel (1999), at p. 31,) its importance is still undeniable and it is impossible to bypass Sinclair in the discussion of what standard of review should apply to a given controlling shareholder’s conduct. 491

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4.4.2 The Sinclair Advantage/Disadvantage Test 4.4.2.1 The Case and the Test

In Sinclair Oil v. Levien (“Sinclair”), the parent company, Sinclair Oil, owned 97% of the outstanding stock of its subsidiary, Sinclair Venezuelan Oil Company (“Sinven”). A minority shareholder of Sinven brought a derivative action alleging the parent company had breached its fiduciary duty on three aspects: (1) by causing the subsidiary to pay excessive dividends to satisfy the parent’s need for cash; (2) by diverting corporate opportunities to other wholly owned subsidiaries; and (3) by causing the subsidiary not to enforce a contract under which Sinven was entitled to sell a fixed, minimum amount of products to another wholly owned subsidiary of the parent.497 Plaintiff demanded for a fairness review of these conducts, while defendant-parent company claimed business judgment rule should apply. In determining which standard of review should govern, Chief Justice Wolcott, who opined for the Delaware Supreme Court, first accredited the rule established by precedents: “[w]hen the situation involves a parent and a subsidiary, with the parent controlling the transaction and fixing its terms, the terms of intrinsic fairness, with its resulting shifting of the burden of proof, is applied.”498 Therefore, two elements are required to apply the entire fairness review: a transaction between a parent and a subsidiary, and the parent fixing the term of the transaction. However, the justice did not stop by the traditional statement; instead, he re-stated the rule on the issue of when entire fairness review should be invoked in controlling shareholder context as in the following paragraph, which has been widely cited: “A parent does indeed owe a fiduciary duty to its subsidiary when there are parent-subsidiary dealing. However, this alone will not evoke the intrinsic fairness standard. This standard will be applied only when the fiduciary duty is accompanied by self-dealing—the situation when a parent is on both sides of a transaction with its subsidiary. Self-dealing occurs when the 497 498

280 A.2d at 719. 280 A.2d at 720. (Citation omitted.)

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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 to the detriment to, the minority stockholders of the subsidiary.”499

This paragraph is so important that it is worthy of some careful scrutiny: at the beginning, the court claimed that not all parent-subsidiary “dealing” will be subject to fairness review, notwithstanding the fiduciary duty owed by the parent. Instead, only “self-dealing” will invoke a fairness review. As to what constitutes “self-dealing”, the court first gave a general description — the situation in which a parent is on both sides of a transaction with its subsidiary — then explained in more detail on how to identify self-dealing in the sentence that immediately followed. According to the court’s definition, four elements must be present to constitute self-dealing: (1) the parent has domination over the subsidiary; (2) the parent has gained some advantage from the subsidiary; (3) the minority shareholders of the subsidiary were excluded from sharing the advantage (the “exclusion” prong); and (4) such benefit gained by the parent was to the detriment of the subsidiary’s minority shareholders (the “detriment” prong). Most commentators read the last sentence of the paragraph as adding a “qualification” to the description of self-dealing in the third sentence, and thus negating the sufficiency of “standing on both sides of a transaction” to constitute self-dealing. 500 Commentators and later cases often refer to the holding as the “Sinclair ‘advantage/disadvantage’ threshold test” for the applicability of the fairness review of parent-subsidiary dealings.501

499 500 501

280 A.2d at 720. McGovern (2002), at p. 205. Siegel (1999), at p. 29.

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4.4.2.2  Applying the Test in Sinclair

When the Justice applied this advantage/disadvantage test to the plaintiff’s three claims respectively, he found that: (1) for the dividend claim, proportional benefit had been given to the minority, there was no self-dealing, so business judgment rule should apply;502 (2) for the corporate opportunity claim, the minority failed to show that any opportunity that belonged to the subsidiary had been taken away by the parent company.503 Since no advantage was gained by the parent, the court would not interfere with parent corporation’s policy of allocating opportunities among its subsidiaries; and (3) as to the non-enforcement of the breached contract,504 the parent company did receive benefit to the exclusion and detriment of minority, therefore the parent must show intrinsic fairness of its conduct.505 Given the importance of the case, the Justice’s reasoning—especially with regard to the third claim—is worth some further pondering. The first and the second claim were relatively straightforward: they failed the second (benefit received from subsidiary) and the third element (“exclusion” of minority) of the test respectively, thus no self-dealing, so no fairness review. The Justice held that the transaction in the third claim met all the elements of self-dealing; however, as to how the test was met, the explanation given by the Justice was in itself inconsistent: “Clearly, Sinclair’s act of contracting with its dominated subsidiary was self-dealing. Under the contract Sinclair received the products produced by Sinven, and of course the minority shareholders of Sinven were not able to share in the receipt of these products. If the contract was breached, then

502

See infra Sec. 4.5.4. See infra Sec. 4.5.2. 504 The contract was between Sinven and a wholly-owned subsidiary of Sinclair, Sinclair International. Under the contract, Sinclair International agreed to buy certain amount of Sinven’s crude oil and refined products at specified prices. However, Sinclair International did not meet the quantity requirement set in the contract; neither did it meet the payment requirement. The court found that Sinclair had used its dominant power not only to cause Sinven to enter into the contract, but also to prevent Sinven from enforcing the contract when it was breached by Sinclair International. (280 A.2d at 722-23.) 505 280 A.2d at 723. 503

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Sinclair received these products to the detriment of Sinven’s minority shareholders.”506

In this paragraph, the Justice first acknowledged that the “act of contracting with its dominated subsidiary” was “clearly” self-dealing. As said, most commentators read the paragraph that defined “self-dealing,” which has been cited above, as that the advantage/disadvantage test was meant to negate the sufficiency of “standing on both sides of a transaction” to constitute self-dealing. If this understanding were correct, entering the contract with its subsidiary alone would not be enough to constitute self-dealing, and by claiming that Sinclair’s contracting with its subsidiary was self-dealing, the Justice misused the term he himself had just defined. If, however, the commentators’ understanding were not correct and the Justice had used the term “self-dealing” consistently, then his finding of the “detriment” prong being met by the breach of the contract would be wrong, because the “detriment” was assumed to happen because of the conduct of “contracting”. Either way, Sinclair was, and still is, confusing and lacking in consistency, which caused difficulty for later cases in applying the advantage/disadvantage test.

4.4.3 Weinberger and other Post-Sinclair Cases Despite of Sinclair’s widely acknowledged importance, its application by later Delaware cases was inconsistent and confusing.507 The source of the confusion lies partly in Sinclair’s lack of consistency and partly in the Delaware Supreme Court’s holding in Weinberger v. UOP, Inc. (“Weinberger”),508 which is another landmark case concerning controlling shareholders’ fiduciary duty. Weinberger was a parent-subsidiary cash-out merger case.509 The Supreme Court did not even mention Sinclair when it discussed the issue of the 506

280 A.2d at 723. Feirstein (2006), at p. 487. 508 Id. Even before Weinberger, Delaware courts had not used the Sinclair test in parent/subsidiary merger transactions. (See Siegel (1999), at p. 55.) 509 457 A.2d 701. The detailed facts of the case are irrelevant here; the court approached the threshold issue on a non-factual-specific basis. Weinberger came out in 1983, 12 years after Sinclair. 507

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appropriate standard of review. It simply held that “[t]he requirement of fairness is unflinching in its demand that 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 court.”510 Since the Court, without going through a Sinclair advantage/disadvantage analysis, directly invoked the heightened scrutiny based on the fact that the parent was “on both sides of the transaction”, such a proposition was considered by many commentators as being in direct conflict with Sinclair.511 After Weinberger, the cases dealing with the issue of parent corporations’ fiduciary duties can be divided into two categories: those following (or, at least alleged to follow 512 ) Sinclair and engaging an advantage/disadvantage threshold analysis before invoking fairness review; and those ignoring Sinclair and, following Weinberger, imposing fairness review solely upon a finding of the parent’s standing on both sides of the transaction.513 In the cases that ignored Sinclair, the courts never gave any explanation for their disregard of the Sinclair test, thus were totally unhelpful for the understanding of the relationship between Sinclair and Weinberger. This not only left the commentators very much frustrated in their efforts to reconcile Sinclair and Weinberger, but also brought doubt as to the vitality of the Sinclair test.514 Even

in

the

cases

that

allegedly

followed

Sinclair,

the

advantage/disadvantage test was sometimes applied in a compromised way. Jedwab v. MGM,515 which involved a cash-out merger with third party, was a typical example. Jedwab v. MGM (“Jedwab”) In Jedwab, the defendant-controlling shareholder owned 69% of the outstanding common stock and 74% of the preferred stock of the corporation 510

457 A.2d at 710. Citation omitted. See, e.g., Feirstein (2006), at p. 495 and Siegel (1999), at pp. 55-56, both arguing that Weinberger and Sinclair are mutually exclusive. 512 Some cases alleged to follow Sinclair but only in a mechanical or compromised way. See Siegel (1999), at p. 31 and discussion hereunder. 513 Feirstein (2006), at 487. The cases following Weinberger were not limited to merger cases. 514 Siegel (1999), at pp. 65-66. 515 509 A.2d 584 (Del. Ch. 1986). 511

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(“MGM”).516 Another corporation, Bally, was contemplating a merger with MGM. Neither the controlling shareholder nor any of the directors of MGM was associated with Bally. The plaintiff owned MGM’s preferred stock. The defendant took an active part in the negotiation of the merger. Bally offered to buy all the shares of MGM at $440 million without indicating how the money should be divided between common and preferred shares. The defendant, with the assistant of his lawyer, determined that the fair price of the common and the preferred shares would be $18 and $14 per share respectively, and the $440 million total price offered by Bally then was insufficient.517 To solve the problem, the defendant proposed that he was willing to accept a lower per share value for his common shares -- $12.24 per share -- in exchange for some non-cash assets,518 so that the remainder of the $440 million would be sufficient to allow each of the other shareholders of MGM to receive the fair price for their shares as evaluated by the defendant. 519 An independent financial advisor, Bear Stearns & Co., conducted an appraisal of the non-cash assets and opined that the total value that the defendant would receive for his common shares would be lower than $18 per share.520 An agreement with Bally was reached as the controlling shareholder suggested.521 The plaintiff claims that the proposed merger constituted a breach of the controlling shareholder’s duty of distributing the merger consideration fairly among all classes of shareholders.522 In deciding which standard of review should apply, Chancellor Allen explicitly adopted the proposition of Sinclair that fairness review will only be invoked when self-dealing is present.523 When he applied the advantage/disadvantage test to the case, however, he simply emphasized the fact that all the non-cash assets were apportioned to the controlling shareholder. He then held that “in apportioning that element of 516

509 A.2d at 587. Before the negotiation with Bally, another company has proposed to buy all the common shares at $18 per share. The price was set with the assistance of independent financial advisors. (509 A.2d at 589.) 518 The non-cash assets included transfer of the exclusive rights to the name MGM Grand Hotels and certain contingent rights in litigation proceeds. (509 A.2d at 590) 519 Which means $18 and $14 per share for common and preferred shares respectively. 520 The advisor also opined that the $14 price for preferred stocks was fair. 521 509 A.2d at 590-91. 522 509 A.2d at 591. 523 509 A.2d at 595. 517

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consideration wholly to his own shares to the exclusion of others [the defendant] was exercising power of a kind and in circumstances justifying invocation of the heightened standard of judicial review.”524 The noteworthiness of Chancellor Allen’s reasoning is that, in reaching his conclusion, the judge totally neglected the fact that the controlling shareholder received a lower per share value for his common shares, and the total effect, as shown in the opinion of the financial expert retained by the company, might well be that the controlling shareholder still received a lower per share price compared to other shareholders.525 Based on the facts then before the court, therefore, one could hardly conclude that the controlling shareholder’s apportioning of all non-cash assets to himself was to the detriment of the minorities. Actually, it might well be just the opposite: the minority shareholders benefitted because of the controlling shareholder’s arrangement. Nevertheless, the Chancellor found the Sinclair threshold test for invoking entire fairness review was met. As observed by Siegel, it seemed that the “detriment” prong of the test had been just “unintentionally” omitted by the Chancellor.526 After a thorough examination of the parent-subsidiary dealing cases after Sinclair, Siegel claims that Sinclair had been so much undermined that it “currently does little more than relegate pure pro rata transactions to the business judgment rule,”527 and to date the dominant standard of review for parent-subsidiary dealings is entire fairness.528 While she was surely correct in the sense that Weinberger has been more consistently followed by later cases, as the following discussion will show, she understates the importance of Sinclair.

524 525 526 527 528

509 A.2d at 595. 509 A.2d at 590-91. Siegel (1999), at p. 70. Siegel (1999), at p. 31. Id.

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4.4.4 Sinclair Revisited Chief Justice Veasey stated in Nixon v. Blackwell, “[i]n a case where the court is scrutinizing the fairness of a self-interested corporate transaction the court should articulate the standards which it is applying in its scrutiny of the transactions. These standards are not carved in stone for all cases because a court of equity must necessarily have the flexibility to deal with varying circumstances and issues.”529 While he was talking about substantive standards, the logic should be equally applicable if a threshold test was to be given by the court. Indeed, when judges articulate a rule, most of the times they are giving it in the light of the particular case before them, even if they are speaking in general terms and do not explicitly give the limitations of the rule. Both the holding of Sinclair and Weinberger should be read as such. The difference between the propositions of the Sinclair court and the Weinberger court will be much more understandable if read in their respective factual settings. When the facts of the two cases are compared, the first thing to be noticed is that the Sinclair court was facing three claims, which involved three different types of transactions: a dividend distribution, a corporate opportunity appropriation and a breach of a controlling shareholder-related contract. By contrast, the Weinberger court only directed its mind to one transaction: a parent-subsidiary cash-out merger. That was why, unlike Weinberger, Sinclair could not simply say that a parent standing “on both sides of the transaction” would be enough to invoke entire fairness review. Instead, the Sinclair court needed to formulate a rule that would be able to exclude the claims that it thought should not be subjected to judicial review. A follow-on question would be, whether Sinclair was correct in excluding the first two claims from entire fairness review? The previous chapter has argued that the judicial deference in directors’ duty of care claims is very much justified, because absent a conflict of interest, the risk of agent opportunism is negligible and will not justify the high cost of judicial review. The rationale applies equally in the controlling shareholder 529

626 A.2d 1366, 1378.

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context: without a “divided interests” between the controlling shareholder and the minority shareholders, the court should be deferential to the controlling shareholders’ decision.530 Chapter 2 has explained that because of the principle of equality of shares, usually the interests of all shareholders are aligned with each other; intra-shareholder conflicts only arise when there is a chance for the controlling shareholder to extract some non-proportional benefit from the company, either through a related transaction, or some significant changes of the company that will result in a re-distribution of the interests among the shareholders. 531 In other words, if, and only if, there is a possibility of non-proportional distribution of corporate assets, a conflict of interests between the controlling shareholder and the minority shareholders might arise.532 In Sinclair, neither the dividend claim nor the corporate opportunity claim involved non-proportional distribution of corporate assets — in the former the distribution was proportional, and in the latter no distribution of corporate assets at all. Therefore, the court’s decision of excluding them from entire fairness review was well founded. As a threshold test, the Sinclair advantage/disadvantage test should not only be able to exclude all the transactions that do not involve a conflict of interests between controlling shareholders and minority shareholders, but also be able to identify those cases that do involve a conflict of interests. It was on this point that the Sinclair test failed to reach perfection, partly due to the particular facts that the court was facing. The Justice did say that the parent contracting with the subsidiary was self-dealing at first. However, he was then distracted by the fact that the contract was breached, and took that fact as meeting the “detriment” prong of the test. Had it been a different case, such as Weinberger or Jedwab, to 530

See David J. Greene & Co. v. Dunhill Intern., Inc., 249 A.2d 427, 430 (Del. Ch. 1968) Sec. 2.1.4. The “conflict of interests” between a controlling shareholder and the minority shareholders should be differentiated from the “conflict of preference” of the controlling shareholder and the minority shareholders. For instance, in Sinclair, the parent made the subsidiary declare a large dividend, which was excessive as in the eyes of the minority and was to meet the parent’s own need of cash. Obviously, the preference of the parent and the minority shareholders of the subsidiary were different here: the parent wanted cash, and the minority wanted the subsidiary to expand. However, the way in which the parent sufficed its own need of cash, namely, by a declaration of dividend, did not created conflict of interests. The point is, the legitimate interest of minority shareholders did not extend to the expansion of the subsidiary, which by the principle of equal shares, was within the discretion of the majority. 531 532

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follow Sinclair,533 the court would have to go all the way down to review the merit of the transaction to see whether or not it was to the “detriment” of the minority. 534 It would be rather ironic that the court needs to review the “fairness” of the transaction to decide whether fairness review is applicable. No wonder that Sinclair has been criticized as outcome-determinative:535 when actual detriment already happens, it is hardly possible that the transaction is nonetheless fair.536 In other words, Sinclair will turn into a substantive fairness standard rather than a threshold test if it is applied strictly.537 By contrast, both Weinberger and Jedwab were right to impose a fairness review directly without a search for the “detriment” suffered by the minority, because in both cases there was clearly a conflict of interests. Although the conflict need not necessarily result in an actual detriment to the minority, it indicated a non-negligible chance of such detriment, which should be enough to invoke the entire fairness review. As for Sinclair, the court reached the correct conclusion; however, due to the specific fact it was facing, it required—at least when read literally—a showing of actual “detriment” to pass its threshold test, which would make the test awkward when faced in a different situation. To suit the function of a threshold test, therefore, if the court in Sinclair would have lowered the bar from “detriment” to “a possibility of detriment,” then this “weaker form” would be completely consistent with Weinberger and Jedwab.538

533

While Jedwab did claim to have followed Sinclair, but only in a “diluted way”, see discussion above. 534 Feirstein argues that since the benefit received was part of the corporate assets which the minority shareholders were proportionally entitled, in such circumstance, exclusion is detriment. (Feirstein (2006), at p. 494). However, in a fair transaction, while the controlling shareholder receives the consideration from the corporation to the exclusion of the minority, the minority is not worse off because of the transaction; therefore it can hardly be said that the exclusion is to their detriment. 535 McGovern (2002), at p. 206. (The Sinclair threshold test seemingly requires “a plaintiff to establish that a transaction was unfair, and if the plaintiff meets the burden, the court will examine the transaction whether it was fair. Not surprisingly, […] if a plaintiff satisfies the threshold test, the Delaware courts typically find the challenged transaction was unfair.”) 536 Summa Corp. v. Trans World Airlines, Inc., 540 A.2d 403, 407. Siegel observed that most cases that passed the Sinclair test were settled “presumably” because once the test is met, it is very difficult for the defendant to show fairness of the transaction. (Siegel (1999), at p. 78, n.259.) 537 There are cases using Sinclair as a substantive standard. See Siegel (1999), at p. 51. 538 Siegel has commented that the test of Jedwab is actually a compromised Sinclair test, that is, the detriment prong is neglected. (Siegel (1999), at p. 70.) As will be shown in the next section, the detriment prong is critical and cannot be simply neglected. As for the cases that seemingly neglect the detriment prong, it is just because the “possibility of detriment” was apparent and thus was left unmentioned by the judges. See further discussion in Sec. 4.5.

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Notwithstanding that it is short of perfection, the Sinclair test does more than “regulating pure pro rata” transactions as Siegel comments. It did correctly point out the factor that indicates a strong conflict of interest between the controlling

shareholder

and

the

minority

shareholders,

namely,

non-proportional distribution of corporate assets to the controlling shareholder. Thus it has a broader application than Weinberger. As will be shown later, the Sinclair test also helps to screen cases from fairness review other than pro rata transactions.

4.4.5 Judicial Review of Transactions Bargained at Arm’s Length or Approved by Minority Shareholders 4.4.5.1

A Safe Harbor under the Entire Fairness Review?

The difference between Sinclair and Weinberger has another element, which has been less noticed but is nonetheless important. Vice-Chancellor Jacobs wrote in the footnote of his opinion for Citron v. E.I. Du Pont de Nemours & Co.:539 “The precise circumstances that will trigger the ‘entire fairness’ standard of review have not been consistently articulated in the Delaware cases. Sinclair Oil Corp. v. Levien, […] holds that the plaintiff must demonstrate that the parent corporation stood on both sides of the transaction and have dictated its terms. […] However […] Weinberger v. UOP, Inc., […] indicate that to invoke that exacting review standard, all that is required is that the parent corporation have [sic] stood on both sides of the transaction. Being the most recent pronouncements of the Supreme Court in the parent-subsidiary merger context, Weinberger [and other accordant cases] are authoritative.”540

In short, the question is, whether actual control of the transaction by the controlling shareholder is required to invoke the fairness review. To put it 539 540

584 A.2d 490 (Del.Ch.,1990). 584 A.2d at 500, n.13.

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another way, if the controlling shareholder had not actually exercised his controlling power to dominate the transaction, and had used an arm’s length bargaining structure, as required by his duty of fair dealing, whether or not there should be a safe harbor for him when challenged in court, like the one provided by DGCL s.144(a) for directors.541 .

At the beginning, courts have been split as to the effect of the use of an independent committee and an arm’s length bargain structure. Some Delaware cases held that such a process shifts the burden of proof from the defendant-controlling shareholder to the plaintiff, while others held that it re-instates the business judgment rule and thus provides controlling shareholders a safe harbor.542 The question was finally answered by Lynch I, in which the Delaware Supreme Court holds that the “exclusive standard of judicial review” in a controlling shareholder-interested cash-out merger transaction is entire fairness.543 The Court asserted in Lynch I that, because the controlling shareholder will continue to dominate the corporation regardless of the outcome of the transaction, board members and minority shareholders might perceive that their disapproval may lead to retaliation later by the controlling shareholder. Consequently, even if the transaction was negotiated by disinterested, independent directors, no court could be certain whether the transaction terms fully approximated what truly independent parties would have achieved in an arm's length negotiation. 544 The Court thus concluded that the use of an independent committee approximating arm’s length bargain cannot re-instate the business judgment rule, but only shifts the burden of proof to the plaintiff.545 Similarly, the Court does not consider minority shareholders’ approval as a reliable check of the fairness of controlling shareholder-related transactions either: 541

See Sec. 3.2.1.3 Veasey & Guglielmo (2005), at pp. 1481-1482. See also, Haas (2004), at pp. 2260-65. 543 Lynch I, 638 A. 2d at 1117. 544 638 A.2d at 1116. 545 638 A.2d at 1117. Though this decision was made under a cash-out merger context, later Delaware cases extended it to other corporate transactions as well. (See Haas (2004), at p. 2270.) 542

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“The controlling stockholder relationship has the 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. Even where no coercion is intended, shareholders voting on a parent subsidiary merger might perceive that their disapproval could risk retaliation of some kind by the controlling stockholder. For example, the controlling stockholder might decide to stop dividend payments or to effect a subsequent cash out merger at a less favorable price, for which the remedy would be time consuming and costly litigation. At the very least, the potential for that perception, and its possible impact upon a shareholder vote, could never be fully eliminated.”546

Therefore, approval by disinterested shareholders also only shifts the burden of proof to the plaintiff, instead of providing the defendant a safe harbor.547 4.4.5.2  Double-Checking the Controlling Power: Over-regulation or Not?

The previous chapter has argued that DGCL s.144(a), which allows directors to enjoy the benefit of the business judgment rule if the director-related transaction has been properly disclosed and has received disinterested approval, suggests that there is a trade-off between ex ante decision right strategies and ex post judicial review. 548 By comparison, in the regulation of controlling shareholder conduct, because the Delaware courts have denied controlling shareholders a safe harbor for transactions bargained at arm’s length and/or approved by minority shareholders, controlling shareholder-related transactions are subject to a double-check by both ex ante strategies549 and ex post judicial review.550 While the courts’ concern of controlling shareholders’ formidable 546

Lynch I, 638 A. 2d at 1116. See also Weinberger, 457 A.2d at 703. 638 A. 2d at 1117. See section 3.2.1 549 Arm’s length bargaining implies trusteeship strategy and minority approval is a principal decision right strategy. Plus there is disclosure requirement, which is also an ex ante strategy. 550 Albeit a less plaintiff-friendly review (because of the shift of the burden of proof) if ex ante strategies have been adopted. By comparison, ALI’s Principles adopt a different position. §5.10(a)(2) provides that it is enough if the transaction has been approved by disinterested shareholders and “does not constitute a waste of corporate assets”. Waste of corporate assets, as defined in §1.42, means “an expenditure of corporate funds or a disposition of corporate assets for which no consideration is received in exchange and for 547 548

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influence is understandable,551 a question nonetheless needs to be asked is, and that is whether this double-check is a form of over-regulation? After all, the aim of regulation is to lower the over-all agency cost, and regulation cost is part of it. Judicial review is expensive and should only be used in the cases that involve a high risk of agent opportunism. When ex ante strategies have been adopted — as required by the duty of fair dealing, the risk can be lowered considerably, which may then not be worth the cost of judicial review anymore. That is why directors are given a safe harbor by DCGL s.144(a). Furthermore, from the controlling shareholders’ perspective, the very motivation for them to use an expensive arm’s length bargain or to seek minority approval is to avoid ex post litigation.552 If all the expenses to meet the fair dealing requirement cannot save them the cost of going to court, why spend them at the beginning? It seems to be a reasonable choice for controlling shareholders—at least when the estimated bargaining cost exceeds the litigation costs—to just pay the price and take their chance of proving its fairness in court if the transaction is ever challenged. In the end, ex post judicial review might discourage, rather than encourage, the controlling shareholders’ compliance with procedural fairness. Admittedly, under the current Delaware law, the use of an arm’s length bargain or minority approval has a burden-shifting effect, which, to a fair extent, will mitigate the problem. Shifting the burden of proof to the plaintiffs will elevate their risks significantly when go to trial, and often lead to a favorable settlement or trial outcome for the controlling shareholder. 553 Therefore, seeking the burden-shifting effect by following a fair transaction procedure will which there is no rational business purpose, or, if consideration is received in exchange, the consideration the corporation receives is so inadequate in value that no person of ordinary sound business judgment would deem it worth that which the corporation has paid.” Successful waste claims are very rare. (Bainbridge (2005), p. 315.) 551 Controlling shareholders have been described by the courts as “an 800-pound gorilla who wants the rest of the bananas all for himself,” and “chimpanzees like independent directors and disinterested stockholders could not be expected to make sure that the gorilla paid a fair price.” Cox Communications, 879 A.2d 604, 617. 552 Rosenblatt is a perfect illustration. 553 Gerstein (2010), at 283 (“Indeed, the authors are not aware of any reported decision where the burden was effectively shifted as a result of a special committee process in which a Delaware court subsequently determined the transaction was not entirely fair.”)

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still have its appeal to controlling shareholders.554 This is especially true for complicated transactions, such as mergers, in which proving fairness is a factual-intensive issue and carries with it a higher risk of liability and a higher cost of litigation.555 However, burden shifting rarely leads to pre-trial dismissal,556 which means the plaintiff will have more bargaining leverage compared to the situation in which the controlling shareholder is protected by the business judgment rule,557 and thus undoubtedly will diminish the value of fair dealing to the controlling shareholder.558 The previous section argued that procedural fairness works as a valuable safe guard for substantive fairness for minority shareholders.559 It is hardly in the minority shareholders’ best interest to erode the controlling shareholders’ incentive of following a fair transaction process by double checking it with ex post judicial review.560 Indeed, there has been strong suggestion, from both scholars and judges, that a safe harbor should be provided for controlling shareholders.561 In 2005, Vice Chancellor Strine, talking in a freeze-out merger scenario, suggested in his dicta of Cox Communications that controlling shareholders should be given the protection of business judgment rule if the merger has been both negotiated and recommended by a special committee, and approved by a majority of the minority shareholders.562 However, until the law is changed by the Delaware Supreme Court, Cox Communications’ authority is rather limited.563 Moreover, 554

Cox Communications, 879 A.2d at 617. (Burden shifting was a modest protection provided to encourage controlling shareholders to adopt a fair procedure.) 555 Because the complexity of the case usually means the need to hire better lawyers and expert witness, as well as a prolonged litigation process, which all generate more cost. (Lee & Willging (2010), pp. 6-7. 556 Latham & Watkins (2010), p. 3. 557 Latham & Watkins (2010), p. 3. (Business judgment rule “not only makes defense on the merits simpler, but also significantly increases the opportunity for a pre-trial dismissal, both of which contribute to optimize an inexpensive settlement.”) See also Cox Communications, 879 A.2d at 613 (the current law creates inefficient incentives for the plaintiff lawyer to pursue frivolous lawsuits.) 558 879 A.2d at 620. 559 See also Cox Communications, 879 A.2d at 645 (“most commentators believe [the negotiating power of special committees] is responsible for the bulk of the premiums paid in the going privates.”) 560 According to Vice Chancellor Strine, there is no empirical evidence to support the argument that, for a merger negotiated by an independent committee, litigation further increases the value received by the minority shareholders. 879 A.2d at 624-30. 561 See Haas (2004), at pp. 2275-83. To be fair, there are also strong supporters to the judicial review. See Subramanian (2005); see also Cox communications, 879 A.2d at 632-33. 562 879 A.2d at 643-44. 563 Gerstein (2010), at p. 284.

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Cox Communications, which was decided in a merger context, requires both a special committee negotiation and approval of minority shareholders to reinstate the business judgment rule; whether other types of controlling shareholder-related transactions should be subject to the same requirement is yet an unanswered question.

§4.5

Controlling Shareholders’ Conducts under Review

This section discusses six types of situations in which a controlling shareholder’s conduct might be challenged in court as being unfair towards the minority shareholders, namely, (1) controlling shareholders’ voting in their own interests; (2) appropriation of corporate opportunity; (3) sale of control; (4) dividend distribution; (5) allocation of tax benefit; and, (6) tender offer. The list is not meant to be inclusive, but chosen to highlight the key issues that come up when applying the Sinclair threshold test.564 The Sinclair test requires the controlling shareholder to (1) receive some benefit from the corporation (2) to the exclusion and (3) detriment of the minority shareholders to invoke the entire fairness review. The discussion begins with the voting cases, in which the controlling shareholders use their voting power to promote their own interest rather than the minority shareholders’ interest. The courts need to balance the general principle of a shareholder’s right to vote in self-interest and a controlling shareholder’s fiduciary duty. Next, the corporate opportunity cases and the sale of control cases both concern with situations in which a controlling shareholder has received some benefit to the exclusion of the minority, yet the sticking point of the case is whether or not that benefit was received “from the corporation”. The dividend cases help to illustrate the application of the Sinclair test to pro-rata distributions (or non-distributions). The tax benefit cases are examples of the situations in which all elements of the Sinclair tests are seemingly met, but the

564

The discussion in this section only focuses on the threshold question, because if the test is not passed, then business judgment rule applies, which basically means “end of story;” and once the test is passed, the case will be reviewed under the standard of entire fairness, of which the topic has been covered by Sec. 4.3.

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court refuses to step in. And lastly, in tender offer cases, the controlling shareholders are dealing directly with individual minority shareholders on a voluntary basis, and thus arguably do not hold a “controlling position”.

4.5.1 Controlling Shareholder Voting in Self-Interest Voting is one of the fundamental rights of shareholders.565 There are numerous cases holding that a shareholder can vote in his self-interests, even when his interests is not in line with other shareholders.566 In Williams v. Geier, the Delaware Supreme Court held that “[s]tockholders (even a controlling stockholder bloc) may properly vote in their own economic interest, and majority stockholders are not to be disenfranchised because they may reap a benefit from corporate action which is regular on its face.”567 This right to vote, however, is limited by the controlling shareholders’ duty owed to other shareholders.568 A controlling shareholder, as a fiduciary, cannot exercise his voting power to secure an undue advantage to himself over the minority.569 As the Delaware Court of Chancery held in Heil v. Standard Gas & Electric Co.: "[S]tockholders have the right to exercise wide liberality of judgment in the matter of voting and may admit personal profit or even whims and caprice into the motives which determine their choice, so long as no advantage is obtained at the expense of their fellow stockholders."

570

The line to be drawn between a rightful “voting their strength” and an impermissible misuse of a controlling position, therefore, is just whether they have gained some advantage “at the expense of minority shareholders”. Given 565

See Sec. 2.1.3. See, e.g., Norton v. Union Traction Co., 110 N.E. 113, 120 (Ind. 1915); Williams v. Geier, 671 A.2d 1368, 1380-81 (Del. 1996); 567 671 A.2d at 1380-81. 568 Bershad v. Curtiss-Wright Corp., 535 A.2d 840, 845 (Del. 1987); Tanzer v. International Gen. Indus., Inc., 379 A.2d 1121, 1124 (Del. 1977) 569 William Meade Fletcher, “Fletcher Cyclopedia of the Law of Corporations”, 5 Fletcher Cyc. Corp. § 2031. 570 151 A. 303, 304 (1930) 566

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that, as argued in the last section, the Sinclair test is a substantive standard if applied strictly, the apparent similarity between the Heil holding and the Sinclair test should not be a surprise: they are just describing the same fiduciary duty owed by controlling shareholders. As will be shown by the following cases, the threshold test for courts to review voting cases is the Sinclair test, or, to be more exact, the “weaker form” of the Sinclair test.571 If the test is passed, the vote will be reviewed under the entire fairness standard; otherwise, the controlling shareholders are free to vote as they see fit. Feldheim v. Sims572 In Feldheim v. Sims, a not-for-profit Delaware corporation, Chicago Board of Trade (“CBOT”), was to be restructured to a for-profit corporation, in the process of which the corporation’s equity had to be reallocated among all of its five classes of members. In the restructuring process, an independent Allocation Committee, comprised of five CBOT outside directors, was appointed to develop a recommendation to the board regarding an appropriate and fair allocation of value among CBOT members and allocation of shares in the new for-profit corporation. The Committee, after receiving an allocation proposal developed by the investment banking firm it retained, recommended a five-to-one ratio between rights allocated to majority full-members (“FMs”) and other minority members respectively. The plaintiff-minorities claimed that the proposed allocation would unfairly benefit the FMs to the detriment of the minority, and “[a]s such, it would be a breach of fiduciary duty for the [FMs], or any of them, to vote in favor of the proposed allocation in connection with the next phase of the CBOT restructuring.” Plaintiffs sought an injunction to prohibit the FMs from voting in favor of any allocation based on that methodology and a declaration as to a fair and equitable methodology and allocation of shares.

571

I.e., a possibility of detriment would suffice the test. Note in the following case, while the court holds that Sinclair applies, it does not say that the allocation ratio was unfair. 572 For more facts of the case, see discussion in Sec. 4.2.1.2.2.

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The court first found that the FMs collectively were controlling shareholder of CBOT and thus owed a fiduciary duty to the other minority members.573 In delineating the scope of controlling shareholder’s fiduciary duty under the given circumstance, the court relied principally on Sinclair. The court cited the definition of self-dealing in Sinclair, i.e., “the majority shareholders cause the dominated corporation to act in such a way that the majority shareholders receive something from the corporation to the exclusion and detriment of the minority shareholders,” then followed with a finding that controlling shareholder had engaged in self-dealing,574 and they would be breaching their fiduciary duty by voting for the allocation plan if the allocation ratio was not entirely fair.575 The court pointed out that nothing in the record showed exactly how the five-to-one allocation rate had been reached, while the record showed that the market value of majority seats was only 1.87 times greater than minority seats during the relevant time period. The court held that the minority shareholders were entitled to an entire fairness hearing. Mendel v. Carroll576 In Mendel v. Carroll, a third party offered to buy all the company’s stock at $27.80 per share. Meanwhile, the controlling shareholders577 offered to buy all the outstanding stock of the company that they did not own at $25.75 per share, and made it very clear that they would not sell their shares in the company. As the controlling shareholders’ 50.6% stock ownership made no merger transaction feasible without their vote, the board turned down the third party’s offer. In the suit that followed, plaintiffs complained that because the minority shareholders could get more cash for their stock in the third party’s deal than they would have received in the proposed controlling shareholder’s deal, by turning down the third party’s offer, the controlling shareholders were using

573 574 575 576 577

800 N.E.2d at 422-23. 800 N.E.2d at 422. 800 N.E.2d at 422, citing Kahn v. Tremont Corp., 694 A.2d 422, 428 (Del. 1997). 651 A.2d 297. The controlling block was held by a family.

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their voting power to exploit the minority shareholders and thus breached their fiduciary duty.578 Chancellor Allen first pointed out that although the third party’s $27.80 price was higher than the controlling shareholder’s offer on its face, the price was offered for all the shares, which means it actually included an evenly distributed control premium. 579 Therefore, the chancellor held that $27.80 cannot be deemed as the fair price of minority’s shares, and the controlling shareholder’ $25.75 offer was not necessarily unfair.580 More importantly, the Chancellor ruled that, since no part of the controlling shareholder’s fiduciary duty requires them to sell their shares, they had no obligation to support the third party transaction just for the benefit of the minority shareholders. Consequently, turning the offer down was not a breach of their fiduciary duty.581 It is often said that, whatever controlling shareholders’ fiduciary duty might be, it does not require them to sacrifice their own interests for the interests of the corporation or the minority.582 Therefore, controlling shareholders have the right to veto the transaction that they do not desire, 583 even if such a transaction may on its face benefit the minority shareholders. In Mendel v. Carroll, the controlling shareholders used their voting power to turn down the competing offer. Had they voted the other way, the minority shareholders 578

651 A.2d at 304. Discussion in the main text is a simplified version of the original case. Because the controlling shareholders did not actually cast their vote, (their clear attitude had made it meaningless to hold a shareholder meeting,) the plaintiff was not suing them for breach of their fiduciary duty or sought an injunction to prevent them from casting their votes, but instead sought a court order to require the board to grant an option to the third party to buy 20% of the company’s stock for the primary purpose of diluting the voting power of the controlling block. Chancellor Allen admitted that “the possibility that a situation might arise in which a board could, consistently with its fiduciary duties, issue a dilutive option in order to protect the corporation or its minority shareholders from exploitation by a controlling shareholder who was in the process or threatening to violate his fiduciary duties to the corporation.” However, after analyzing (as in the main text) the facts of the case, the Chancellor found that “such a situation does not at all appear to have been faced by [the board of directors in this case].” (Id. at 306.) And thus the plaintiff’s application was denied. 579 For discussion of control premium, see Sec. 4.5.3.1. 580 651 A.2d at 305. 581 651 A.2d at 306. Controlling shareholder has no duty to sell, see also Bershad v. Curtiss-Wright Corp., 535 A.2d 840, 841, 845 (Del. 1987) (the Delaware Supreme Court held that a controlling stockholder has no duty to sell its stock in a subsidiary to the highest bidder). 582 Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584, 598 (Del. Ch. 1986). 583 Thorpe v. CERBCO, Inc., 676 A.2d 436, 444 (Del. 1996).

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would have benefitted from the transaction. However, the loss of the opportunity to profit is not considered by the court as being an “expense” for the minority shareholders. The plaintiff failed to prove that the $27.80 price was something that they were originally entitled to, but deprived by the controlling shareholders. When minority shareholders had no entitlement in the benefit, it is not problematic that the controlling shareholders use their voting strength to deny the minority shareholders receiving such a benefit and instead, to pursue a more favorable transaction for themselves. By contrast, if the situation is such as in Feldheim v. Sims,584 the minority shareholders have a right to the benefit, namely, a fair portion of the corporation’s equity, then the controlling shareholder cannot use their voting power to deny the minority of their equitable share. In other words, they must vote their share in an entirely fair way.

4.5.2 Corporate Opportunity The focal question posed by a corporate opportunity case, as the Delaware Supreme Court said in Equity Corp. v. Milton, is always “whether or not the [fiduciary] has appropriated something for himself that, in all fairness, should belong to his corporation.” 585 The Sinclair test requires the controlling shareholder to receive some benefit “from the corporation” to constitute self-dealing, which, in turn, triggers the entire fairness review. Delaware has developed its corporate opportunity doctrine under the director-related context known as the “line of business” test. The rule has been articulated by the Supreme Court as: “[I]f there is presented to a corporate officer or director a business opportunity which the corporation is financially able to undertake, is, from its nature, in the line of the corporation's business and is of practical advantage to it, is one in which the corporation has an interest or a reasonable expectancy, and, by embracing the opportunity, the self-interest 584 585

800 N.E.2d at 410. 221 A.2d 494, 497 (Del. 1966).

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of the officer or director will be brought into conflict with that of his corporation, the law will not permit him to seize the opportunity for himself.”586

No explicit adjustment has been made by Delaware courts when the issue comes into the controlling shareholder context. However, this “line of business” test could be problematic when considering parent-subsidiary relations. Unlike directors, controlling shareholders are not subjected to a fiduciary duty not to compete with the corporation.587 As a matter of fact, it is very often so that a parent corporation is in the same “line of business” as its subsidiary, or a parent corporation has more than one subsidiary operating in the same line of business.588 There is a need to balance the interest of the subsidiary and the parent (and its shareholders) or the interest between different subsidiaries. The court, therefore, needs more evidence than in the director context to be persuaded that a particular opportunity in its nature belongs to the allegedly suffering subsidiary, which the parent wrongfully diverts to elsewhere. Although the Delaware Supreme Court has not articulated a systematic answer, their decision of Sinclair sheds some light on the issue. Sinclair Oil v. Levien

589

When the plaintiff in Sinclair claimed that Sinclair had usurped Sinven’s opportunity by purchasing or developing oil fields in Alaska, Canada, Paraguay, and other places around the world through Sinclair’s other subsidiaries, the Court found this argument unsound. The Court pointed out that basically all of Sinven’s operations had been conducted in Venezuela, and Sinclair had a policy of exploiting its oil properties located in different countries by subsidiaries located in the particular countries. “The plaintiff proved no business opportunities which came to Sinven independently.” Meanwhile, “[n]o evidence indicates a unique need or ability of Sinven to develop these

586 587 588 589

Guth v. Loft, Inc., 5 A.2d 503, 511 (Del. 1939). ALI-CORPGOV§5.12, Comment c. E.g.. Sinclair, Rosenblatt, etc. Relevant facts see previous discussion in Sec. 4.4.2.1.

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opportunities.”590 Because nothing had been taken from Sinven by Sinclair, there was no self-dealing by the parent, “[t]herefore, business judgment is the proper standard by which to evaluate Sinclair's expansion policies.”591 The ALI’s Principles’ definition of “corporate opportunity” provides more insight in understanding the issue in the controlling shareholder context. §5.12(b)(1) of the ALI’s Principles states a test for identifying corporate opportunities based on how the controlling shareholder has gained access to the opportunity: if the opportunity has been developed or received by the corporation, then it is an asset of the corporation; or, if the opportunity was first received by the controlling shareholder, but “the controlling shareholder is not engaged in the particular activity, and the corporation is actively engaged in the activity,” then a fair inference is that the controlling shareholder received the opportunity only because of his relation with the corporation. Under either circumstance, the opportunity will be considered as belonging to the corporation.592 As explained in the comment of this section, this definition is narrower than the definition of corporate opportunity in director-related context, “in order to balance the right of the controlling shareholder to engage in business, possibly in competition with the corporation, against the need to ensure that the controlling shareholder does not seize opportunities that could fairly be said to belong to the corporation.”593 If the opportunity taken by the controlling shareholder is shown to be a corporate opportunity, then the court will review the controlling shareholder’s conduct under the standard of entire fairness. Fairness of the controlling

590

280 A.2d at 722. 280 A.2d at 722. ALI-CORPGOV § 5.12, Comment d. For example, in David J. Greene & Co. v. Dunhill Intern., Inc. ( 249 A.2d 427), the controlling shareholder, “Dunhill”, was a diversified operating company and did not make or sell toys of any kind. Dunhill had solicited proposals for the acquisition of businesses for itself as well as for one of its subsidiaries, Spalding, which had a toy division. Dunhill asked that all proposals be submitted to Dunhill. After receiving a proposal for the acquisition of a toy company, Dunhill assigned the opportunity to one of its book publishing divisions, instead of to Spalding. Plaintiff claimed that Dunhill appropriated a corporate opportunity that belonged to Spalding and the court found that the evidence was in favor of the plaintiff. 593 ALI-CORPGOV § 5.12, Comment d. 591 592

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shareholder’s taking of the opportunity might be shown through factors such as a lack of interest by the corporation in the opportunity, the corporation’s financial inability to acquire the opportunity, legal restrictions on the corporation’s ability to accept the opportunity, or unwillingness of a third party to deal with the corporation.594 In short, it will not be deemed unfair to the minority shareholders if they suffered no actual detriment because of the controlling shareholders’ taking of the corporate opportunity.

4.5.3 Sale of Control Shares of stock in a corporation are not essentially different from other kinds of property in that the owner has the right to dispose of his stock to anyone and for any price.595 When a controlling block is for sale, however, this right needs to be balanced with his duty owed to the corporation and the minority shareholders. 4.5.3.1 Sale at Premium

In Mendel v. Caroll,596 Chancellor Allen pointed out that the third party’s $27.80 price offered for all the shares was higher than the controlling shareholder’s $25.75 price offered for minority’s shares, because the former included an evenly distributed control premium. The Chancellor then explains the nature of the control premium as follows: “Financial markets in widely traded corporate stock accord a premium to a block of stock that can assure corporate control. Analysts differ as to the source of any such premium but not on its existence. Optimists see the control premium as a reflection of the efficiency enhancing changes that the buyer of control is planning on making to the organization. Others tend to see it, at least sometimes, as the price that a prospective wrongdoer is willing to pay in order to put himself in the position to exploit vulnerable 594

ALI-CORPGOV § 5.05, Comment to §5.05(a). In some jurisdictions, factors such as financial or legal inability will be taken as to negate the existence of corporate opportunity as a matter of law. See Miller v. Miller, 222 N.W.2d 71, 81 (Minn, 1974). 595 9 Am. Jur. Proof of Facts 2d 261, §1. See also Harris v. Carter, 582 A.2d 222, 234 (Del. Ch. 1990). 596 651 A.2d 297. Factual background see Sec. 4.5.1

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others, or simply as a function of a downward sloping demand curve demonstrating investors' heterogeneous beliefs about the subject stock's value. In all events, it is widely understood that buyers of corporate control will be required to pay a premium above the market price for the company's traded securities.”597

Bottom line is that a control premium is not regarded as a corporate asset and need not to be shared with other shareholders when the controlling shareholder sells his controlling block.598 In the leading case Zeitlin v. Hanson Holdings, Inc., the court holds that “absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, a controlling stockholder is free to sell … at a premium price.”599 This ruling is concordant with the Sinclair test: although the controlling shareholder has received some benefit (i.e. the control premium) to the exclusion of the minority shareholders, the benefit is not received from the corporation; therefore, it is not unfair for the controlling shareholder to keep it. 4.5.3.2  Limitations on Right to Sell

4.5.3.2.1 Sale to Looter: Duty of Care As mentioned in Section 4.2, the only circumstance under which a controlling shareholder has been held liable for breach of the duty of care is in a sale of control. It has been held that “when the circumstances would alert a reasonably prudent person to a risk that his buyer is dishonest or in some material respect not truthful, a duty devolves upon the seller to make such inquiry as a reasonably prudent person would make, and generally to exercise care so that others who will be affected by his actions should not be injured by wrongful conduct.”600

597

651 A.2d at 305. (Footnotes omitted.) See also Citron v. Steego Corp., 1988 WL 94738, at *8. By contrast, in other jurisdictions, such as the UK, control premium may be considered as corporate assets and be shared by the minority shareholders. (See Kraakman et al. (2004), at 184-85.) 599 397 N.E.2d, 387, 388-89 (N.Y. 1979). 600 Harris v. Carter, 582 A.2d 222, 235. 598

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Although the duty of care is seen as an element of the controlling shareholder’s fiduciary duty, as Chancellor Allen correctly has pointed out, the origin of the duty is actually tort law.601 What is imposed upon the controlling shareholder by this duty of care is no more than the general rule that “each person owes a duty to those who may foreseeably be harmed by her action to take such steps as a reasonably prudent person would take in similar circumstances to avoid such harm to others.”602 Indeed, Chancellor Allen saw no difference between this duty and the duty owed by a motor vehicle driver on a highway.603 Subjecting a controlling shareholder to a duty of care and review the sale of control, therefore, does not contradict with the Sinclair test: it is just a different set of rules targeting a different kind of misbehavior, which runs parallel with the regulation of agent opportunism. In practice, various factors have been identified by courts that would put a seller on notice of some fraudulent intent of the buyer. Among others, such factors may well include: the resignation of directors, the occurrence of other fraudulent acts by the same purchaser, the purchaser's financial condition, permitting the purchaser to obtain immediate access to the corporation’s assets, and insistence by the seller and the purchaser on secrecy in concluding the sale, etc.604 If a reasonable person would have been alerted that the potential buyer of his shares may loot the corporation, then the controlling shareholder has a duty to investigate the intention and motive of the purchaser before selling his stocks.605 4.5.3.2.2 Sale of Corporate Opportunity Under certain circumstances, a sale of control will be seen by the court as a sale of a corporate opportunity, and the control premium paid to the controlling shareholder is actually a compensation for the sale of the corporate opportunity.

601

Harris v. Carter, 582 A.2d at 234-35. Harris v. Carter, 582 A.2d at 234-35. 603 Harris v. Carter, 582 A.2d at 235. 604 9 Am. Jur. Proof of Facts 2d 261, §4. 605 For a comprehensive compilation of cases on controlling shareholders’ duty to investigate, see 77 A.L.R. 3d. 1005 (‘Controlling stockholder's duty to investigate intent and motive of purchaser before selling stock’). 602

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Unlike a control premium, a corporate opportunity belongs to the corporation, and minority shareholders are entitled to a proportional benefit derived from the opportunity. Therefore, a controlling shareholder who sells the opportunity and keeps the compensation to himself will be subject to judicial review. In Perlman v. Feldmann,606 a controlling stockholder and principal officer of a steel corporation, at the time of a steel shortage, sold his controlling shares to an end user of steel, which consequently gave the end user the right to control the distribution of steel. Plaintiffs claimed that the consideration paid for the stock included compensation for the sale of a corporate asset, i.e., the ability to control the allocation of the corporate product in a time of short supply. The court noted that the corporation had derived two potential benefits from the steel shortage, namely, the ability to obtain interest free loans from prospective purchasers607 and the ability to build up patronage in geographical areas. Both were opportunities that belonged to the corporation and should be used to the corporation’s advantage only.608 The court held that “fiduciaries always have the burden of proof in establishing the fairness of their dealings with trust property”, thus unless defendant could “negate completely any possibility of gain” by the corporation from these opportunities, otherwise he was accountable to the minority shareholders for the premium he had received.609 To sum up, a controlling shareholder’s right to sell his shares, just like his right to vote, is a proprietary right in nature and can be exercised for his own interest. However, such a right should be balanced against his fiduciary duty owed to the minority shareholders. As illustrated by the Perlman case, if the sale of the controlling block deprived of the minority shareholders something they were originally entitled to, i.e., a proportional benefit from the corporate opportunity, then it is not permissible for the controlling shareholder to keep the premium to himself.

606

219 F.2d 173 (C.A.2, 1955). Because of the government imposed price control, the corporation developed a mechanism to take advantage of the short supply by requiring steel purchasers to provide interest-free loans to the corporation. This was a “legal – but somewhat shady – way of getting around the price control”. See Bainbridge (2002), p. 346. 608 219 F.2d 177. 609 219 F.2d at 177-78. 607

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4.5.4 Dividend Declaration It is settled law that the declaration and payment of a dividend rests in the discretion of a corporation’s board of directors and enjoys a presumption of business judgment, therefore, “fraud or gross abuse of discretion” must be shown before the courts will interfere with the judgment of the board of directors in such matters.610 Sinclair Oil Corp. v. Levien611 In Sinclair, the subsidiary, Sinven, paid out $108 million in dividends during the year 1960 to 1966, $38 million in excess of its earnings during the period. Plaintiff alleged that because of the payment of this excessive dividend, the industrial development of Sinven was effectively prevented. Plaintiff further argued that the dividend payment was the result of the parent using its dominant power to demand such dividends as it was in need of cash, and was in breach of the parent’s fiduciary duty. After setting out its famous assertion as to the prerequisites for invoking a fairness review, the Supreme Court first pointed out that the payment was made in compliance with Delaware statutory provision regarding dividend declarations, therefore the excessiveness alone would not state a cause of action.612 The Court then cited various authorities and summed that even a declaration made by a wholly dominated board will not automatically be subjected to a fairness review.613 Nevertheless, the Court admits that entire fairness review can be applied to a dividend declaration by a dominated board under certain circumstances, i.e., when there is self-dealing by the controlling shareholder. The Court explained its rationale by using a hypothetical case: if a corporation has two classes of stocks, one class owned by the controlling shareholder and the other by the minority shareholders, yet the dividend is only given to the first class of stock holders. In such a scenario, the controlling shareholder will be engaging in 610 611 612 613

Gabelli & Co., Inc. v. Liggett Group Inc., 479 A.2d 276, 280 (Del. 1984). 280 A.2d at 717. 280 A.2d at 721. 280 A.2d at 721.

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self-dealing, because the controlling shareholder receives something from the corporation to the exclusion and detriment of the minority. Therefore, the entire fairness standard will apply.614 What happened in Sinclair, however, is different from the hypothetical case. The Court found that all the shareholders of Sinven received a proportional benefit. Since the minority shareholders are not “excluded” from the benefit and the threshold test thus not met, the Court concluded that the fairness review could not be invoked.615 Because “[i]n the arena of corporation decision making, a decision not to act is as much a decision as an affirmative decision to enter into a specific transaction”,616 a decision not to declare dividend, such as the one challenged by the minority shareholders in the following case, will be reviewed by the court under the same standard as the decision to declare a dividend. Gabelli & Co., Inc. v. Liggett Group Inc.617 This case, as summarized by the Supreme Court, is “an action to compel the declaration and payment of a dividend by the Board of Directors of Liggett for the benefit of about 13% of its stockholders who were then in the final stages of being cashed-out in a merger transaction for a price conceded to be fair for the acquisition of all of the assets of Liggett.” The controlling shareholder of Liggett owned 87.4% of Liggett’s outstanding stock, which was acquired through a tender offer at $69 per share. In June 1980, immediately following the consummation of the tender offer, preparations for a cash-out merger at the same price were commenced. 618 The stockholders’ meeting approving the merger was held on August 7, and the merger became effective on that date.619 614

280 A.2d at 721. 280 A.2d at 722. 616 Gabelli & Co., Inc. Profit Sharing Plan v. Liggett Group Inc., 444 A.2d 261, 265 (Del. Ch. 1982). 617 479 A.2d 276 (Del. 1984). 618 The plan for the follow-up merger and the merger price had been set out and sent to the shareholder in the Offer to Purchase. 619 The $69 price was recommended by the board as being fair, no shareholder attempted to block the merger. The appraisal proceeding arising from the merger was voluntarily dismissed. 479 A.2d 276, at 615

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For sixteen years, Liggett had a history of declaring its third quarter dividend in late July, with a mid-August record date and payment in September. No third-quarter dividend had yet been declared for the year 1980. Plaintiff brought the action seeking a compellation of declaration.620 Plaintiff claimed that the controlling shareholder had breached its fiduciary duty to Liggett’s minority shareholders by stopping the Liggett board to declare the regular dividend. As alleged by the plaintiff, the non-declaration was to enable the controlling shareholder to obtain the dividend funds for itself after the merger.621 The plaintiff argued that under the law and the facts of this case, the third-quarter dividend was “usurped,” or “misappropriated” by the controlling shareholder, which constituted “self-dealing” by the controlling shareholder as defined in Sinclair. The court, in responding to the plaintiff’s argument, pointed out that to meet the “detriment” prong of the Sinclair test, the plaintiff must first establish his entitlement to the third-quarter dividend.622 However, since the $69 per share price was conceded to be fair, it already included full compensation to minority shareholders for their shares, including any right to receive any additional dividends. 623 The court held that plaintiff had no right to a third quarter dividend in the absence of a declaration; therefore, the plaintiff failed to show the non-declaration was to his “detriment”. Since the Sinclair test is not met, the entire fairness review is not applicable to the non-declaration of dividend.624 Cases concerning the declaration of dividends usually fall into Siegel’s category of “pure pro rata” cases.625 Sinclair has made it a clear rule that, as long as the distribution is made proportionally to all shareholders, the motive of 278. 620 The action was brought before consummation of the merger, but plaintiff did not seek to enjoin the consummation of the merger or attack the fairness of the price offered. 621 The court found that the merger transaction involved approximately $300 million, while the dividends claimed on behalf of the minority stockholders involved approximately $677,000. 622 479 A.2d at 281. 623 479 A.2d at 281. The court found the plaintiff had no valid reason “to expect extra compensation for its stock, by dividend or otherwise, over and above that paid to [his] fellow stockholders” who tendered their shares before the merger process; and if a declaration was to be compelled, it would be unfair to those shareholders. 624 479 A.2d at 281. 625 Siegel (1999), at p. 31.

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the controlling shareholder is irrelevant, and the decision is protected by the business judgment rule. In case of non-declaration, a plaintiff-minority shareholder will face the uphill struggle to show his entitlement to a declaration. As mentioned in Chapter 2,626 it is indeed rare that a shareholder is granted a legally enforceable right against the corporation for a declaration of dividend. Absent such an entitlement to the dividend, a non-declaration does not constitute a “detriment” to the minority shareholders and will not invoke the entire fairness review.

4.5.5 Allocation of Tax Savings Generally, corporations have to file their income tax as separate taxable entities. The federal income tax law, however, permits certain corporations that are members of an “affiliated group” to file a consolidated tax return,627 which will allow the tax liability of a member in the group to be reduced by another member’s tax attributes. This may have significant value.

628

When

consolidated returns are filed, the extent to which the subsidiary should share in the tax savings or refunds resulting from the application of one corporation’ profits against another corporations losses, is an issue that involves the controlling parent’s fiduciary duty towards the subsidiary and its minority shareholders.629 Case v. New York Central Railroad Company (“New York Central”)630 Mahoning Coal Railroad Company (“Mahoning”) is a subsidiary of New York Central Railroad Company (“Central”). The subsidiary owned railroad lines 626

See Sec. 2.1.3, n. 35. “Affiliated group” is defined in Section 1504(a) of the Internal Revenue Code. In general, an affiliated group consists of a parent corporation, at least one subsidiary in which the parent holds at least 80% of the stock, and any other subsidiaries that over 80% of its stock are hold in aggregate by the parent and/or other group members. Once consolidated returns are filed, the members of the group are required to continue filing consolidated returns. 628 McGovern (2002), at p. 174. The author gives an example of a hypothetical case: for a parent who is subject to tax at a 34% rate and has $100 profit to file income tax on its own, it would have a tax liability of $34; if it has a subsidiary who runs at a loss of $100 and they file a consolidated tax return, then the parent will save $34 of tax. 629 The I.R.C. did not address the issue. The entity that is ultimately entitled to the benefit of a consolidated tax return, is a matter of state law. 630 15 N.Y.2d 150 (1965) 627

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and leased them to the parent. The rental fee was paid from the revenues of operating the lines. The subsidiary itself had no operating expenses and thus was sure to make a profit as long as the parent remained its lessee. Central and its other subsidiaries entered into an agreement for the allocation of tax savings among the affiliated group members in 1955. Mahoning joined the agreement in 1956. In substance, the agreement provided that corporations showing losses were to be reimbursed for a portion of their losses measured by a substantial part of the tax reductions obtained by profiting companies, and the profiting companies would gain the benefit of a proportion of the tax savings resulting from this utilization of the losses of others. During the tax years 1957-60, by filing consolidated tax return, Mahoning was relieved of more than $3.8 million income taxes. Under the provisions of the allocation agreement, Central received more than $3.5 million from Mahoning and Mahoning was left with the difference, which was approximately $0.27 million. Minority shareholders of Mahoning brought action to rescind the agreement alleging the agreement was unfair to Mahoning.631 The New York Court of Appeals first acknowledged that, as the majority shareholder, Central was required to follow a course of fair dealing towards the minority, and could not use its power to gain undue advantage to itself at the expense of the minority.632 Then, it asserted “[a] basic ground for judicial interference with corporate decisions on complaint of minority interests is an advantage obtained by the dominant group to the disadvantage of the corporation or its minority owners.”633 Applying this test, the court found that although the arrangement made by the parent had greater advantage to itself than to the subsidiary, but there was no loss or disadvantage to the subsidiary.634 Because of the small portion of the tax return that was retained by the subsidiary, it was actually better off than if it had filed a separate income tax.

631 632 633 634

15 N.Y.2d at 153-55. 15 N.Y.2d at 156. 15 N.Y.2d at 156. 15 N.Y.2d at 157-58.

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Since the subsidiary lost nothing, the court refused to interfere with the corporate decision.635 The New York Court of Appeals refused to review the allocation agreement in New York Central because in the court’s eyes, the subsidiary and its minority shareholders suffered no detriment. However, one may argue that, had the subsidiary been bargaining at arm’s length with the parent, they might have gained a bigger portion of the tax return; therefore, the subsidiary did suffer a disadvantage because of the parent-dictated arrangement.636 Surprisingly, the New York Court of Appeals seemed to have never thought of the adoption of an arm’s length bargain test in New York Central. Notwithstanding their acknowledgment of the importance of “a course of fair dealing”,637 the court simply asserted that it was difficult for the court to say how large a portion of the tax benefit is fair for the subsidiary.638 The US courts’ position of disfavoring an arm’s length bargaining test in tax benefit allocation cases has been fairly consistent.639 In Meyerson v. El Paso Natural Gas Co.,640 a Delaware case concerning allocation of tax benefits, Vice Chancellor Short opined for the court that “the arms length measure [is] unacceptable in the parent-subsidiary relationship.” He found that it was impossible to set a fair standard for an allocation agreement between a parent and its subsidiary, because “in such a situation the terms of agreement would depend almost entirely on the bargaining ability and the personal characteristics of the parties. Such factors defy the making of an estimate of the result that would be reached.”641 The Vice Chancellor’s reasoning in Meyerson is helpful to understand the deferential position of the judiciary in tax benefit allocation cases. The reason that leads to the courts’ unwillingness to interfere is not that an arm’s length

635 636 637 638 639 640 641

15 N.Y.2d at 158-59. McGovern (2002), pp. 253-54. 15 N.Y. 2d at 156. 15 N.Y.2d at 158. See also Western Pac. R. Corp. v. Western Pac. R. Co., 206 F.2d 495, 499-500 (C.A.9 1953). 246 A.2d 789 (Del. Ch., 1967). 246 A.2d at 792, citing New York Central.

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bargaining process is unworkable in these cases, but rather, is that the fairness of the outcome of the bargaining is not measurable by a court. Because of the provisions in the federal tax law, the subsidiary cannot transact with any party other than the parent. There is no market value, or whatsoever means, to estimate the fair portion of the tax benefit to which the subsidiary is entitled. Similar to Gabelli v. Liggett, 642 the dividend case discussed above, if the plaintiff cannot establish his entitlement to a certain benefit, then not receiving it is not to his detriment. Consequently, a court will not subject the allocation agreement under the entire fairness review.643

4.5.6 Tender Offer 4.5.6.1 Nature of the Conduct

In short, a tender offer is a public invitation to a corporation’s shareholders to purchase their stock for a specified consideration. 644 A tender offer by a controlling shareholder for all the shares he does not already own may achieve exactly the same result as a cash-out merger, i.e., the elimination of the minority shareholders. However, courts have distinguished them from each other in that in tender offers, minority shareholders tender their shares on a voluntary basis.645 In Lynch v. Vickers, the Delaware Court of Chancery held that in a tender offer transaction, neither Delaware Corporation Law, nor equitable principles require the controlling shareholder to pay for the “intrinsic value” of the tendered stocks.646 This position was later affirmed by the Delaware Supreme Court in Solomon v. Pathe Communications Corp (“Solomon”). The Supreme Court emphasized the voluntary characteristic of a tender offer, and ruled that,

642

479 A.2d 276. McGovern (2002), at p. 263. 644 CJS SECURITIES §122. 645 Solomon v. Pathe Communications Corp., 672 A.2d 35, 39 (Del., 1996). 646 351 A.2d at 576. However, the court does recognize a duty of complete candor in a tender offer. (Fiduciary duty required them “to exercise complete candor in its approach to the minority stockholders, … namely a duty to make a full disclosure of all of the facts and circumstances surrounding the offer for tender.” Id. at 573.) On appeal, the Delaware Supreme Court affirmed the lower court’s statement of law regarding the duty of disclosure without reaching the issue of fair price. (383 A.2d 278, 279 (Del. 1977).) 643

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in such a voluntary transaction, minority shareholders have no right to receive a particular price and entire fairness is not required by law.647 The Court further explained that “the determinative factor as to voluntariness is whether coercion is present, or whether there is ‘materially false or misleading disclosures made to shareholders in connection with the offer.’”648 Five years later, the Court of Chancery supplemented this “voluntary action” theory with a “non corporate action” theory in its decision for In re Siliconix Inc. Shareholders Litigation (“Siliconix”).649 In refusing to apply an entire fairness review to the tender offer, the court stated that “tender offers essentially represent the sale of shareholders’ separate property and such sales—even

when

aggregated

into

a

single

change

in

control

transaction—require no ‘corporate’ action and do not involve distinctively ‘corporate’ interests.”650 The decision as to whether to accept or reject the tender offer is a decision to be made by individual shareholders; the board of the target corporation has not been asked to make any corporate decision.651 The court found that in a tender context, the controlling shareholder is only standing on one side of the transaction, with minority shareholders on the other. Therefore, as long as the tender offer is pursued properly—this is to say, absent evidence that material information about the offer has been withheld or misrepresented or that the offer is coercive in some significant way—the free choice of the minority shareholder to reject the offer provides sufficient protection.652 Relying on either the “voluntary action” or the “non-corporate action” theory, the result is the same: there is no self-dealing by the controlling shareholder because the controlling shareholder is not standing on both sides of the transaction. The shares that the controlling shareholder acquires are from the 647

672 A.2d 35, 39 (Del. 1996), citing Lynch v. Vickers. 672 A.2d at 39. 649 2001 WL 716787 (Del. Ch., 2001). In Siliconix, the parent owned 80.4% of the subsidiary’s stock and sought to freeze out the other 19.6% minority shareholders by making a tender offer. The plaintiff, among others, claimed that the price offered was unfair. 650 2001 WL 716787, at *7. 651 2001 WL 716787, at *7. 652 2001 WL 716787, at *6. As to whether “free choice” of minority shareholders can provide them sufficient protection; for an opposite view, see Eisenberg (2000), at 1130-31. 648

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minority shareholders, instead of the corporation. Consequently, the entire fairness review should not be applicable to such cases. As logical as this conclusion might sound, it becomes problematic when the ruling in Siliconix is examined together with Glassman v. Unocal Exploration Corp. (“Glassman”),653 a case which was handed down only one month after Siliconix. 4.5.6.2  Glassman and its Impacts

Glassman involves a judicial review of a short-form merger. A short-form merger is based on title 8, §253 of the Delaware Code,654 which provides that when a parent owns 90% of the subsidiary’s stock, a merger can be effected without any action by either the board or the shareholders of the subsidiary. A dissatisfied minority can ask for an appraisal as remedy. In Glassman, the Delaware Supreme Court held that the parent corporation does not have to establish entire fairness in a short-form merger, and “absent fraud or illegality, appraisal is the exclusive remedy available to a minority shareholder who objects to a short-form merger.”655 The Court reasoned that section 253 was intended to provide a streamlined process for accomplishing a merger, which is squarely at odds with the procedural apparatus that the fair process prong of entire fairness requires: “[i]f . . . the corporate fiduciary sets up negotiating committees, hires independent financial and legal experts, etc., then it will have lost the very benefit provided by the statute—a simple, fast and inexpensive process for accomplishing a merger.”656 As commentators have quickly noted, the combined effect of Siliconix and Glassman will provide controlling shareholders a roadmap to freeze-out minority shareholders while avoiding the burdensome entire fairness review.657 A controlling shareholder can take a two-step freeze-out: first, make a tender offer, through which to increase ownership above the 90% level, and then take a back-end short-form merger. Siliconix and Glassman will exempt the two 653 654 655 656 657

777 A.2d 242 (Del. 2001). Del. Code Ann. Tit 8, § 253 (2002). 777 A.2d at 248. 777 A.2d at 247-48. See Subramanian (2005), at pp. 20-21.

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steps from fairness review. This result creates a clear disparity in the review standards between a tender offer freeze-out and a negotiated merger freeze-out, notwithstanding that the two types of transactions have substantially the same function.658 Numerous concerns have been raised by the possibility that the protection provided by judicial review for minority interests in a freeze-out context will be undermined because of this combined effect of Siliconix and Glassman.659 Later in In re Pure Resources Shareholder Litigation (“Pure Resource”),660 Vice-Chancellor Strine noted the disparity created in Delaware corporate law, namely, treating “economically similar transactions as categorically different simply because the method by which controlling stockholder proceeds varies.”661 Despite of the incoherence, however, the Vice-Chancellor chose to stick with the Solomon/Siliconix line of cases and held that as long as the tender offer is non-coercive, entire fairness is not applicable.662 The court reasoned that it is the coercive nature of a tender that distorts the shareholders’ free choice, which would otherwise be sufficient protection of minority shareholder interests.663 The court then went on to identify three conditions that must be met in order for a tender offer to be non-coercive: (1) the offer must be subject to a non-waivable majority of minority condition; (2) the controller must guarantee to consummate a prompt short-form merger at the same price if it obtains 90% or more of the shares; and (3) the controller must make no “retributive threats”.664 Because these conditions are first defined in Siliconix, they are sometimes also referred to as a Siliconix structured tender offer.665 4.5.6.3  CNX Gas: towards a Unified Standard

Although Vice Chancellor Strine decided to follow the authority of Solomon in Pure Resourse, his concern of the disparity in law did not fade away. Three

658 659 660 661 662 663 664 665

Subramanian (2005), p. 21. See, for instance, Subramanian (2005); Pritchard (2004); Resnick (2003). 808 A.2d 421 (Del. Ch. 2002). 808 A.2d at 435. 808 A.2d at 443-444. 808 A.2d at 442. 808 A.2d at 445. See Gerstein (2010), p. 283.

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years later, the Vice Chancellor took the chance to revisit the issue in Cox Communications, which is a merger case. 666 After a lengthy and in-depth analysis, he strongly recommended in the dicta that a unified standard of review should be applied to both types of transactions, that is, if the freeze-out has been (1) negotiated and recommended by a special committee, and (2) approved by a majority of the minority shareholders, then the case will be reviewed under the business judgment rule.667 In May 2010, the Delaware Court of Chancery issued its decision in In re CNX Gas Corporation Shareholders Litigation (“CNX Gas”).668 In this tender offer case, Vice Chancellor Laster, who opined for the court, explicitly accepted the unified standard recommended by Vice Chancellor Strine in Cox Communications.669 In CNX Gas, a special committee was appointed by the target board to make a recommendation as to the fairness of the tender price offered by the controlling shareholder. The court noticed that the special committee not only did not have full authority to negotiate the terms of the tender offer, but also eventually decided not to recommend the tender offer to the minority shareholders.670 The court also found that the minority approval was tainted by an interested vote which should not have been counted.671 Since neither prong of the test was met, the court held that the controlling shareholder did need to show fairness of the tender price.672 Commentators have observed that CNX Gas may be an important step in the evolution of Delaware’s fiduciary duties law; however, they also noticed that CNX Gas is not yet settled law.673 Until the Delaware Supreme Court has 666

879 A.2d 604. In Vice Chancellor Strine's view, a Siliconix-style tender offer that is not approved by a special committee should be subject to entire fairness review. 668 In re CNX Gas Corp. S'holders Litig., 2010 WL 2291842, (Del. Ch. May 25, 2010) 669 2010 WL 2291842, at *1. This is the first time a Delaware court applied a “unified standard” for reviewing controlling shareholder freeze-out transactions. (Gerstein (2010), p. 286.) 670 2010 WL 2291842, at *16. 671 2010 WL 2291842, at *16-17. 672 2010 WL 2291842, at *19. 673 Gerstein (2010), at pp. 287-88. (“Indeed, when faced with the familiar standard-of-review question just weeks before CNX Gas was decided, Vice Chancellor Parsons did not even mention the unified standard in [Cox Communications]. Instead, Vice Chancellor Parsons applied the prerequisites for business judgment review developed in an earlier case, Pure Resources.”) 667

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adopted or refused to adopt the unified standard, uncertainty regarding this unified standard of review will prevail.674 If the unified standard is actually accepted by the Delaware Supreme Court, an inevitable question will be: does that mean tender offer cases will be exempted from the Sinclair test? So far the Sinclair test seems to be working in all five types of transactions discussed in this section. To invoke entire fairness review, the plaintiff always need to establish that the controlling shareholder has received some benefit from the corporation, and the minority shareholders are denied their proportional share to which they originally entitled. A tender offer transaction, however, does not fit into this picture. In a tender offer, it can hardly be said that the controlling shareholder is an agent of the minority shareholders. Controlling shareholders control the corporation, (through which the minority shareholders’ interest is influenced) not individual minority shareholders. Whether or not an individual shareholder will tender his shares is not a matter subjected to the controlling shareholder’s power. Strictly speaking, there is no danger of agent opportunism here, given that the decision right has never been vested in the “agent”. Indeed, regulation of tender offers is mostly justifiable not because controlling shareholders are “agents” of the minority shareholders in these transactions, but rather because of the information asymmetry and the collective action problem. Courts have long been aware that the informational advantage of the controlling shareholder is gained due to his controlling position in the corporation, and thus have imposed a duty of full disclosure in tender offer cases on the controlling shareholders.675 As to whether or not a duty of fair price should also apply, while up to date the answer has been “no,” at least some judges have switched position. This is not a surprise given that mergers, which lead to substantially the same economic effect as tender offers, have always been subject to the fair price standard. It seems only fair that tender offers should receive equal treatment. More importantly, minority 674 675

Gerstein (2010), at p. 284. Lynch v. Vickers, 351 A.2d at 573.

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shareholders are hardly arm’s length negotiators to encounter a controlling shareholder in a tender offer.676 Given the apparent inequality of bargaining power between the controlling shareholder and the minority shareholders, to protect the weaker side in the transaction, Vice Chancellor Strine’s proposition seems to be plausible: either the controlling shareholder follows a procedure to allow a real bargain, or bears the burden of proving the fairness of the price. As for the “absence” of the Sinclair test in tender offer cases, since these cases are of a different nature, it is understandable that they do not square with the formula which is tailored for agent opportunism cases in Sinclair, and Sinclair has no room to play here.677 Therefore, even though tender offers are subject to entire fairness review without a Sinclair analysis, it does not impair the validity of the Sinclair test as a threshold test for judicial review of controlling shareholder opportunism.

§4.6

Conclusion

In the US, minority shareholders’ major weapon against controlling shareholder opportunism is a standard-based strategy, namely, the controlling shareholders’ fiduciary duty.678 As mentioned in the introductory chapter, the effectiveness of the strategy has been proven by multiple empirical studies.679 The American judiciary provides the world with rich lessons both on how to appropriately define the standard and on how to enforce the standard efficiently in the “controlling v. minority shareholders” context. Identify the existence of an agency relationship The source of controlling shareholder opportunism is an agent abusing his discretionary power to the detriment of his principal. The Delaware law defines 676

Empirical study shows that mergers negotiated by a special committee give minority shareholder a higher premium than tender offers. See Cox Communications, 879 A.2d at 625 677 It is comparable to the duty of care cases in sale of control, they are targeting a different type of problem than Sinclair. See 4.5.3.2.1. 678 Kraakman et al. (2004), p. 141 (Suing controlling shareholders for breach of the fairness duty is “arguably the most effective remedy available to minority shareholders harmed by conflicted transactions.”) 679 See Sec. 1.3.2.

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“controlling shareholders” to mean shareholders with a majority shareholding, or, in case of minority shareholding, a shareholder that has exercised actual control over the corporate affairs.680 Beyond this group, a shareholder, even if he owns a substantial block of shares, is not an agent of the minority shareholders, and will not be subjected to the rules regulating agent opportunism. Define the standard: The Entire Fairness Standard Being a fiduciary, a controlling shareholder needs to meet the standard of “entire fairness” when dealing with the corporation and the minority shareholders. The entire fairness, as defined by Delaware courts, means fair price and fair dealing.681 Fair price represents the substantive fairness, which guarantees that everything the controlling shareholder takes from the corporation has been adequately paid. To balance the need of limiting the residual loss of the minority shareholders and the chilling effect on the efficient transactions, fair price does not require the controlling shareholder to pay the highest price possible, but just a price that might be accepted by reasonable people dealing at arm’s length. Fair dealing, which is also referred to as the procedural fairness, requires an uncontrolled bargaining process (both the bargainer and the terms of the transaction need to be uncontrolled) and a duty of full disclosure. Although requiring procedural fairness will increase transaction cost, it is a necessary price to pay: the procedural fairness not only works as a safeguard of substantive fairness, but also proves and defines the fair price, which enhances the enforceability of the entire fairness standard. The test of entire fairness is not a bifurcated one, and the court needs to evaluate the fairness of the price in the light of the bargaining process; however, in a non-fraudulent transaction, price is the preponderant element.

680 681

Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d at 1344. Weinberger, 457 A.2d at 711.

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As for the other element of the fiduciary duty, namely, the duty of care, the law is basically silent. This is mostly due to the controlling shareholders’ substantial stake which is usually enough to motivate them to act with caution and thus there is no need for the law to interfere. The only exception is the case of a sale of control, when the interest of a controlling shareholder is not aligned with other shareholders as usual, the law requires them to act with care and not to cause harm to the minority shareholders.682 This duty, however, is more properly to be seen as a duty arising from tort law, rather than from an agent’s fiduciary duty. Applicability of Judicial Review: Enforcing the Standard Due to the high cost of judicial review, interference of the court into the corporate decision making system is only justifiable when there is a high risk of controlling shareholder opportunism. The threshold test created by the Delaware Supreme Court in Sinclair holds that only self-dealing by a controlling shareholder, that is, the controlling shareholder receives something from the corporation to the exclusion and detriment of the minority shareholders, will be reviewed under the standard of entire fairness.683 Reading literally, the Sinclair test requires an actual detriment to the minority shareholders to invoke the entire fairness review. As a matter of fact, it is a “weaker form” of the test that is followed by later cases, namely, a possibility of detriment would be enough to invoke judicial review.684 As shown in Chapter 2, if and only if a disproportional distribution is available to the controlling shareholder, a conflict of interest between the controlling shareholder and the minority shareholders will arise, which will substantially increase the risk of agent opportunism.685 Therefore, the Sinclair test can effectively filter out the “suspicious” transactions to be examined under the lens of the court and at the same time screen those low-risk ones from judicial review. 682 683 684 685

Harris v. Carter, 582 A.2d at 235. Sinclair, 280 A.2d at 720. Siegel (1999), p. 70. See Sec. 2.1.4.

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Because the possibility of detriment to the minority shareholders is always present in controlling shareholder-related transactions, Weinberger correctly subjects all such transactions to fairness review.686 For other cases that do not directly involve a controlling shareholder-related transaction, the key issue is often to determine whether the benefit received by the controlling shareholder is something that minority shareholders are entitled to participate, which in turn, is determined by two factors: firstly, the asset is a corporate asset, and secondly, the minority has a legal right to the benefit.687 Once the threshold test is met, the transaction will be subject to judicial review under the standard of entire fairness, even if the transaction has been negotiated at arm’s length by independent negotiators, or has received approval from the minority shareholders. Following a fair dealing procedure, however, can shift the burden of proof from the controlling shareholder to the plaintiff-minority shareholders.688 Some conducts of controlling shareholders have been reviewed by the courts without going through a Sinclair analysis, including sale of control to looters and tender offers. 689 However, the relationship between the controlling shareholder and the minority shareholders are not exactly fiduciary in nature in these transactions. It is not that they are “exempted” from the Sinclair test, but rather, the Sinclair test is irrelevant to the regulation of these transactions. Relation with Other Strategies The procedural aspect of the entire fairness standard actually has incorporated other ex ante strategies (namely, trusteeship strategy, principal approval strategy and disclosure,) into the standard-based strategy. This has several implications.

686 687 688 689

Weinberger, 457 A.2d at 710. Mendel v. Carroll, 651 A.2d 304, 306; Equity Corp. v. Milton, 221 A.2d at 497. Lynch I, 638 A. 2d at 1117. Harris v. Carter, 582 A.2d 222; CNX Gas, 2010 WL 2291842.

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Firstly, it suggests that a substantive standard is difficult to enforce, especially in complicated business transactions. Very often other strategies need to be introduced to help define the standard.690 Secondly, as Chapter 3 has explained, in the “director vs. shareholder” setting, there is a trade-off relationship between ex ante and ex post strategies. When it comes to the controlling shareholder context, the trade-off effect only exists in a much more limited sense: adoption of ex ante strategies shifts the burden of proof, but cannot totally shield the controlling shareholder from judicial review. The justification behind the system is that the substantial power owned by a controlling shareholder overshadows the effectiveness of the ex ante strategies.691 Thirdly, although the importance of a fair dealing procedure has been repeatedly emphasized by the courts, ex ante strategies are not compulsory. In other words, if a controlling shareholder wants to bear the risk of litigation, he can proceed with a controlled transaction and try to prove the fairness of the price when challenged;692 if not, he can choose the protection of a fair dealing procedure and create an up-hill situation for the plaintiff-minority shareholders. The flexibility allows the controlling shareholder to choose the more efficient path.693 Last but not least, even with the burden-shifting rule, subjecting an independently negotiated or a minority shareholder approved transaction under entire fairness review not only increases the total cost of regulation, but also diminishes the incentive for the controlling shareholders to follow the fair dealing procedure. The co-existence of ex ante and ex post strategies constitutes a double-check on the controlling shareholder.694 It is arguable that there might be a problem of over-regulation in Delaware’s approach. There have been suggestions, both from scholars and judges, that a safe harbor should be created

690

Kahn v. Tremont Corp., 1997 WL 689488 (Del. Ch.), at *2. Lynch I, 638 A. 2d at 1116-17. 692 For instance, when the fairness of the price is easy to prove because there is a generally established market price, which makes the cost of litigation lower than in an arm’s length bargaining process. 693 Latham & Watkins (2010), pp. 3-4. 694 The US has been observed as the jurisdiction that is most friendly towards minority shareholders. See Kraakman (2004), p. 154. 691

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for controlling shareholders, i.e., if they have followed a fair dealing procedure, they should be protected by the business judgment rule when challenged in court.695 The law, however, is not set yet in this regard.

695

Cox Communications, 879 A.2d 604; Haas (2004), at pp. 2275-83.

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Chapter V The United Kingdom §5.1

Introduction

The Research Issue Both belonging to the common law family, the UK and the US have many similarities which have drawn much attention from scholars in empirical law and economics studies. For instance, they both have an active securities market,696 with generally dispersed shareholding in public companies697 and a low level of private benefits of control extraction. 698 Le Porta and his co-authors conclude in their researches that these similarities should be attributed to the similarity in the legal systems of these two countries: they both offer stronger protections to minority shareholders as compared to jurisdictions from other legal origins.699 However, when examined in a closer range with a focus on the standard-based strategies, differences between the two systems become more prominent. One particularly noticeable phenomenon is, although scholars submit that common law countries generally emphasize more on ex post litigations than civil law countries, 700 UK case law concerning minority shareholders’ interest in public companies is close to non-existent,701 which contrasts sharply with the rich collection on the subject in the US legal system. The lack of case law strongly suggests that, unlike in the US, using judicially enforced standards to protect minority shareholders’ interest in public 696

La Porta et al. (1997) La Porta et al. (1998) Nenova (2003), Dyke & Zingales (2004) 699 La Porta et al. (1998) 700 La Porta et al. (2005) 701 During the 15 years between 1994 and 2008, only three derivative action cases involve public companies, among which one was denied by the court to give permission to proceed, and the other two involve companies that are closely-held. See Keay (2008), at 474. The other major tool for minority protection in the UK, unfair prejudice remedy, is also mostly used by minority shareholders in close companies. See Mayson, French & Ryan (2008), at p. 624; Law Commission CP142 (1996), at p. 3, para. 1.5. 697 698

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companies is a less-trodden path in the UK. Therefore, to understand the role played by standard-based strategies in regulating controlling shareholder opportunism in the UK, this chapter is facing a two-part question: firstly, how are the strategies—if any—designed in the UK law; and secondly, why the standards are not actively enforced through judicial review in practice. The first part of the question will be dealt with through Section 2 to 5, with Sections 2 to 4 discussing three types of actions which are related to the regulation of controlling shareholder opportunism in the UK respectively, and Section 5 reflecting on the substantive standard established for controlling shareholders under the UK law. The second part is left for Section 6, which looks into the reasons that make judicial review unpopular in the UK. Section 7 concludes. Defining Control The notion of “controlling shareholder”, when used by British jurists, is more of a descriptive term rather than a strictly defined legal concept. For instance, in his “Introduction to Company Law”, Davies uses “controlling shareholder” to mean “one or a small, semi-permanent group of shareholders who can command at least half of the votes likely to be cast at a meeting of the shareholders.”702 Comparably, in Prudential Assurance Co Ltd v Newman Industries Ltd

703

, the

Court of Appeal held that control covered “a broad spectrum extending from an overall absolute majority of votes at one end, to a majority of votes at the other end made up of those likely to be cast by the delinquent himself plus those voting with him as a result of influence or apathy.”704 Apparently, “votes likely to be cast” is hardly a well-defined yardstick that can help to draw a clear-cut line to identify controlling shareholders. However, the Court of Appeal’s definition of control clearly suggests that control includes both de jure and de facto control.705 Therefore, in the following discussion of

702 703 704 705

Davies (2002), p. 216. [1982] Ch. 204 [1982] Ch. 204 at 219. Keay & Loughrey (2010), p. 172.

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this Chapter, the term “controlling shareholder” will be used to cover both types of control.

§5.2

Directors’ Duty and Derivative Actions

Unlike their American counterparts, controlling shareholders in the UK are not considered by law as fiduciaries of either the company or the minority shareholders,706 and there is no uniform substantive standard for controlling shareholder conducts. Nevertheless, protecting minority shareholders against majority oppression has long been an important topic of British company law.707 Judicial check of the controlling power can be seen in three types of actions, with each having its own set of procedures and formalities, namely, derivative actions for breach of directors’ duty, 708 common law actions for abuse of majority voting power, and statutory actions for unfair prejudice. This and the following two sections will discuss these three types of actions respectively. It has been explained in Chapter 3 that, imposing fiduciary duty upon directors helps to reduce controlling shareholder opportunism. 709 This is because controlling shareholders’ ability to dominate the company is dependent upon their ability to dominate the board of directors, and when the board of directors is held loyal to the company by their fiduciary duty, the controlling shareholders’ ability to exploit the company decreases.710 In other words, by holding the de jure directors liable for breach of their duties if they defer to the will of the controlling shareholder and further the controlling shareholder’s interest at the cost of the company, it indirectly sets up a boundary for controlling shareholders’ dominant power. 706

Shareholders are not trustees for each other. See Hannigan (2000), p. 494. Law Commission CP142 (1996), at p. 56. 708 The derivative action was originally a common law action, but later was substituted by the Companies Act 2006 (“CA2006”) with a statutory derivative action. See Sec. 5.2.1.3 on derivative actions below. 709 See Ch3, the introduction paragraph. 710 Bainbridge (2002), p. 513. By contrast, while acting qua shareholder, the controlling shareholders, only have limited influence over the companies’ affairs, since the basic governance structure of modern public companies determines that the power to manage the corporation is delegated to the board of directors. (Kraakman et al. (2004), pp. 11-14, 33-34.) 707

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Besides this “indirect” constraining effect, directors’ duty can also have a “direct” effect on controlling shareholders under the UK law. That is, if a controlling shareholder is identified as a shadow director, he may be subjected to certain duties owed by a de jure director. The first part of this section will examine the rules and principles in the UK law concerning directors’ duty and its enforcement mechanism, namely, derivative actions. In particular, notice will be paid to the impacts that these rules have on controlling shareholders’ conduct. The second part will discuss the shadow director rule to see whether any substantive standard is established for controlling shareholders’ conduct under this “direct” approach.

5.2.1 Regulating Directors’ Conduct under Fiduciary Duty 5.2.1.1 Directors’ Duty

As has been elaborated in Chapter 3, fiduciary duty is a standard-based strategy in regulating directors’ opportunistic conducts. Directors are fiduciaries of the company and owe their company both a duty of care and a duty of loyalty.711 The Companies Act 2006 (“CA2006”) has codified their duties as including the following general principles in s.171 to s.177:712

711

a.

duty to act within powers

b.

duty to promote the success of the company713

c.

duty to exercise independent judgment

d.

duty to exercise reasonable care, skill and diligence

e.

duty to avoid conflict of interests;

f.

duty not to accept benefits from third parties

g.

duty to declare interest in proposed transaction or arrangement

See Sec. 3.1.2. CA2006, s.171-77. 713 British case law has defined the interest of the company as “interest of its members as a whole.” (Greenhalgh v. Arderne Cinemas Ltd., [1950] 2 All.E.R. 1120.) CA2006 adopts the same proposition, but also requires the directors to take other elements into account, for instance, external influence and equality among shareholders. ( CA2006, s.172) The proposition has been called “enlightened shareholder value.” (CA2006 Explanatory Notes, at p. 50, para. 325.) 712

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Among all the facets of a director’s duty, avoiding conflict of interests has always been the central concern of fiduciary law. 714 The reason has been explained in Chapter 2: when there is a direct conflict between the interests of an agent and his principal, the risk of agent opportunism is the highest. Under the rule set by case law, directors need to obtain approval from the shareholders to be able to transact with the company, otherwise the transaction will constitute a breach of the director’s duty.715 In practice, this rule is often modified by company articles, which only require a disclosure of the conflict of interest by the director.716 Following this general practice, CA2006 does not make shareholder approval for conflict-of-interest transactions a statutory requirement.717 Instead, directors can transact with the company as long as they have disclosed the conflict interest at a meeting of the board of directors.718 However, shareholder approval is still mandatory for substantial director-related transactions.719 5.2.1.2

Breach of the Duty and Ratification of the Breach

Remedy for Breach of Duty CA2006 s.178(1) provides that “[t]he consequences of breach (or threatened breach) of sections 171 to 177 are the same as would apply if the corresponding common law rule or equitable principle applied.” This means the transaction could be voided by the company; the breaching director will be held liable for any profit he made and any loss the company suffered from the transaction.720 Furthermore, when a third party knowingly receives property transferred in breach of a director’s duty, the law regards the third party as holding the property under a constructive trust,721 and the company will be entitled to a recovery from 714

See Sec. 3.1.2. See Sec. 3.1.3. CA2006 Explanatory Notes, at p. 53, para. 348. 717 CA2006 s.175(3). See CA2006 Explanatory Notes, at p. 53, para. 348. (Shareholders may choose to impose requirements for shareholder approval in the articles if they want to.) 718 CA2006 s.177. 719 CA2006 s.190. S.191(2) gives the definition of “substantial”: “An asset is a substantial asset in relation to a company if its value (a)exceeds 10% of the company's asset value and is more than £5,000, or (b)exceeds £100,000.” 720 Farrar et al. (1991), p. 403. See also Worthington (2000). 721 See Mayson, French & Ryan (2008), p. 590 for the theory of constructive trust. See also Boyle 715 716

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such a third party.722 In Re Montagu’s Settlement Trust723, the judge explained that the “knowledge” which could constitute a third party as constructive trustee range from actual knowledge to “willfully shutting one’s eyes to the obvious” or “willfully and recklessly failing to make such inquiries as an honest and reasonable man would make.” Ratification of Breach While the company may chose to pursue personal liability against a breaching director, it is also a basic principle of the fiduciary law that breach of duty by a fiduciary can be forgiven by the beneficiary.724 Applying this principle in the company context means that shareholders, upon full disclosure, can release a director from the liability of breaching his fiduciary duty by an ordinary resolution of the general meeting.725 Ratification not only releases the director from potential liability, but also makes the transaction binding on the company.726 Following the general rule that shareholders are entitled to vote in their own interest, common law does not prohibit a shareholder from ratifying his own breach of duty as a director notwithstanding the obvious conflict of interest.727 As Hollington commented, this power to “forgive one’s own sins is particularly open to abuse.”728 To deal with the problem, the British courts developed the notion of non-ratifiable wrongs,729 that is to say, when “there is an attempt by shareholders to appropriate to themselves money, property or advantages which belong to the company or, more commonly, self-serving breaches of duty by directors to the same effect, the wrong cannot be ratified”.730 Such a use of majority voting power would amount to “a fraud on the company” or “a fraud (1995). 722 CA2006, s.260(3). See Comp Law Editorial (2007), at p. 226. 723 (1987) 1 Ch. 264 724 Davies (2003), p. 644. 725 Id., p. 645. 726 Id. 727 Id., p. 646. 728 Hollington (2004), p. 95. 729 Hirt (2004), p. 201; Davies (2003), p. 708. This court-developed “non-ratifiable wrongs” should be distinguished from the wrongs that are inherently incapable of being ratified (even with unanimous resolution), such as unlawful return of capital. See Hirt (2004), p. 201. 730 Hannigan (2000), p. 500.

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on the minority,”731 which means the wrongdoing has caused benefits to be accrued to the wrongdoer while damage was done to the company.732 The common law concepts of ratifiability and non-ratifiable wrongs are seen as an important mechanism to enforce directors’ duty as well as to regulate the majority’s voting power.733 This approach requires an objective assessment of the substance of the transaction by the court to decide whether there has been734 a fraud on the minority.735 After CA2006, a new approach is adopted by the statute to deal with the problem of opportunistic use of a shareholder’s ratification power, that is, ratification can only be done by a members’ decision “without reliance on the votes in favour by the director or any connected person.”736 However, it is submitted that this does not substitute the rule about non-ratifiable wrongs: the statute only says that, for a ratifiable wrong, it can only be ratified by disinterested votes, and a non-ratifiable wrong stays non-ratifiable.737 5.2.1.3

Enforcing Director’s Duty through Derivative Actions

Chapter 3 has argued that, because of the high cost of ex post judicial review, the benefits and costs of interfering with the company’s decision making system with a judicial review needs to be carefully balanced, 738 and the balance is achieved in the US through the co-effect of the business judgment rule and the demand rule.739 In the UK, the balancing issue has certainly aroused similar concern from the courts and the legislature.

731

Id., pp. 500-03. Joffe et al. (2004), p. 14; Hannigan (2000), p. 505. See also Law Commission CP142 (1996), at p. 73, para. 485. Typical cases of fraud on the minority include taking business opportunities of the company,( Cook v. Deeks, [1916] 1A.C.554) or selling property to company at over-value (or buying at under-value).( Daniels v. Daniels, [1978] 2 All E.R. 89) 733 Hirt (2004), p. 198. Hannigan (2000), p. 505. Davies comments that the scope of non-ratifiable wrongs are unclear. (Davies (2008), p. 588.) More discussion on majority’s voting power see next section. 734 Or would have been, if the ratification is yet to occur. 735 Hannigan (2000), p. 508. 736 CA2006, s. 239. CA2006 Explanary Notes, at p. 67, para 441. 737 Keay & Loughrey (2010), at p. 163. Yet Davies argues that the statute would narrow the scope of non-ratifiable wrongs. (Davies (2008), . 588) 738 See Sec. 3.2. 739 See Sec. 3.2.2. 732

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The Common Law Rule Before CA2006, the rule governing the applicability of derivative actions by the minority was defined in Foss v. Harbottle740 (together with its exceptions), under which it was established that a derivative action is not allowed unless the plaintiff-minority shareholder can show not only “fraud on the minority”, but also “wrongdoer control”, 741 which requires a showing of the wrongdoer holding the majority voting power.742 It is apparent that if the fraud on the minority requirement is met, there must have been a strong conflict of interest between the breaching director and the company; and the wrongdoer control requirement is just like a British version of the demand rule.743 Indeed, these two requirements are looking at exactly the same things as the business judgment rule and the demand rule, namely, a high risk of agent opportunism caused by strong conflict of interest and an unreliable majority. As Davies observes, the common law rule was effective to exclude derivative actions when the majority shareholders’ decision could be relied upon.744 However, the rule creates difficulty for the courts in the sense that they have to examine the substantive fairness of the challenged transaction at the preliminary stage of the case—so to find out whether there has been a fraud on the minority—to decide whether the plaintiff has the standing to proceed with the case.745 Critics argue that the common law rule has resulted in the derivative actions being underused.746 740

(1843) 2 Hare 461. A modern statement of the rule in Foss v. Harbottle can be found in Prudential v. Newman Industries (No.2)[1982] Ch. 204, 210-11. (The rule used to be said as having four exceptions: ultra vires, infringing personal rights, violating supermajority rule and fraud on minority. The Prudential decision differed the circumstances under which the rule has no room to play and which the rule is excepted. According to the Court of Appeal, only the fraud on the minority is a real exception, the other three are where the rule has no room to operate. See also CA2006 Explanatory Notes, at 73) 742 Law Commission CP142 (1996), para. 4.12. Scholars disagree as to whether de facto control would suffice. For two contradicting views, see Reed (2000), at p. 157; and Keay & Loughrey (2010), at p. 172. (Almost ironically, the authors from both sides are actually relying one the same case, i.e., Prudential v. Newman ([1982] Ch. 204). However, Keay & Loughrey’s proposition seems to be supported by a more recent case, Franbar Holdings Ltd v Patel, [2008] EWHC 1534 (Ch).) 743 See Bradley (1999), p. 297. (“[I]n England, lawyers do not talk about a business judgment rule, and the rule which usually prevents the review of business decisions in the courts is more closely related to a demand requirement than to a business judgment rule.”) 744 Davies (2008), p. 610. 745 Law Commission CP142 (1996), at p.49, para. 6.6. See also, Joffe et al. (2004), at p. 34. 746 See Davies (2008), p. 610. 741

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The Statutory Derivative Action To cure the problem, the UK CA2006 provides for a statutory derivative action, which allows minority shareholders to sue derivatively if they can establish a prima facie case of breach of directors’ duty, regardless whether the breaching director has received any personal benefit or controls a majority of the voting power.747 It is then left in the hands of the courts to decide whether the case may or may not proceed.748 Davies observes that this new approach aims at allocating the litigation decision to someone external to the company, namely, a court.749 Under CA2006, a derivative action will not be permitted if the challenged conduct has been authorized or ratified.750 This is comparable to s.144(a) of DGCL: they both take the proposition that if a decision right strategy has been adopted then judicial review is not applicable. 751 Secondly, the court is required to weigh the costs and benefits of proceeding with the case from the perspective of a person who has a duty to promote the interest of the company: if the court is satisfied that a person acting in accordance with the general duty of directors to promote the success of the company would not seek to continue the claim put forward by the individual shareholder, then permission to proceed will be denied.752 Furthermore, the CA2006 requires that “special weight” should be given by the court to the opinion of disinterested members.753

747

CA2006, s.260. After CA2006, derivative actions can only be brought under CA2006. Davies submits that the common law rule is no longer relevant. (Davies (2008), p. 610.) However, as argued in the main text of Sec. 5.2.1.4, understanding Foss is still helpful to understand the statutory derivative action. 748 CA2006, s.263. 749 Davies (2008), p. 610. 750 However, the court has to consider whether the ratification is an effective one. As commentators point out, allowing ratification to bar a derivative action reintroduces the common law issues about ratifiability and wrongdoer control into the statutory derivative action. (Keay & Loughrey (2010), at p. 163.) 751 See Sec. 3.2.1.3. 752 CA2006, s.263(2)(a). It is submitted that only in exceptional cases that no reasonable person will think the litigation is for the benefit of company, will the court refuse to give permission under the provision of this section. (Keay & Loughrey (2010), at pp. 158-59.) 753 CA2006, s.263(4).

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5.2.1.4

Impacts Controlling Shareholders’ Conducts

Theoretically, rules concerning directors’ duty do not impose any substantive standard of fairness directly upon controlling shareholders. However, the regulation of directors, together with the non-ratifiable wrong theory, does establish some borderline for the exercise of controlling shareholders’ discretionary power. Under the common law rule, when the breaching director and the majority shareholder are identical or connected, and the breach has resulted in the majority being benefited, (which is the most often seen scenario),754 derivative action would be allowed to prevent the majority shareholder from exploiting company property by ratifying the breach. In some exceptional cases, the breaching director is not connected with the majority shareholder and has gained no personal benefit, instead, benefit accrued to the majority shareholder. However, British judges and scholars seldom distinguish this kind of cases from the typical cases where the breaching director and the majority shareholder are identical, and simply consider it as being covered under the non-ratifiable wrong theory.755 As a result, the common law derivative action and the common law rule of non-ratifiable wrongs working together prohibit the controlling shareholders to profit at the cost of the company. By contrast, if the director and the majority are not connected and benefit accrued to the director, then there is no danger of majority opportunism and no reason for the court not to allowing the majority to forgive the breaching director if they so choose;756 in other words, courts will respect the decision of a disinterested majority.757 Because of the lack of case law,758 how the courts would exercise their discretion as the gate-keeper of derivative actions under CA2006 is not yet clear. Commentators have suspected that while the new law does not hold fraud on the minority or wrongdoer control as a prerequisite for a statutory derivative

754

See Hirt (2004), p. 202. For instance, see Hannigan (2000), at pp. 500-02 and cases cited therein. 756 See Davies (2008), p. 588. 757 Hannigan (2000), p. 503. 758 Four years into implementation, only two case are granted permission to proceed under CA2006 by courts, both involving close companies. See Keay & Loughrey (2010), p. 177. See also Arsalidou (2009), p. 207. 755

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action,759 this does not necessarily mean that the proposition of the court will be of any substantial difference as from under the common law rule.760 It has been submitted that under the new statute provision, “[p]resumably where the ratification effects a fraud on the minority the Court will be able to let the derivative action continue. Where the wrong can be effectively ratified presumably the Court will be able to adjourn the case to enable a meeting to be held.”761 Therefore, it is a safe bet to say that, even under the new CA2006, derivative actions are most likely to be allowed when the breaching of a director’s duty has resulted in the controlling shareholder being benefited at the cost of the company.

5.2.2

Controlling Shareholder as Shadow Director

The notion of “shadow director” is a statutory creation of British law.762 The definition of the term, as given in the Companies Act 1985 and later restated in the Companies Act 2006, is “a person in accordance with whose directions or instructions the directors of the company are accustomed to act.”763 While a shadow director may not necessarily be a controlling shareholder,764 it should not be a surprise that in practice, among those who have been found to be shadow directors, many are shareholders holding a controlling block in their companies. Once a person is identified as a shadow director, certain statutory obligations of directors become applicable to him. CA2006 s.170(5) provides that the directors’ duties apply to shadow directors “where, and to the extent that, the corresponding common law rules or equitable principles so apply.” 765 Unfortunately, however, it has long been an open question in common law that to what extent a general fiduciary duty is applicable to shadow directors.766 A 759

CA2006 Explanatory Notes, at p. 74, para. 491. See Arsalidou (2009), at p. 207; see also Keay (2008). 761 Comp Law Editorial (2007), p. 227. See also Lee (2007), p. 388. 762 Penningtong (1987), p. 28. See also Noonan & Watson (2006). 763 CA1985 s.741(2); CA2006 s.251(1). 764 For instance, other major “investors”, such as creditors, are also possible of being identified as shadow directors. 765 CA2006 s.170(5). 766 See Davies (2010), p. 148. (Common law’s answer to the question is unclear; it is left to the court to 760

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strong argument supporting the negation of general fiduciary duty was given by Lewison, J. in Ultraframe (UK) Ltd v Fielding767, which is the latest authority on the issue.768 The judge said that he was not “persuaded that the mere fact that a person falls within the statutory definition of ‘shadow director’ is enough to impose upon him the same fiduciary duties to the relevant company as are owed by a de jure or de facto director,” because “[i]f Parliament had intended to impose all directors’ duties on shadow directors, this would have been easy to achieve by the simple expedient of providing that a shadow director owes the same duties to a company as a director.” The same proposition has been argued by Pennington, who submit that an obligation owed by de jure directors only applies to shadow directors when the statute explicitly says so.769 As provided in CA 2006, two particular types of statutory obligations are applicable to shadow directors: (1) the obligation to disclose personal interest in company transactions to its board of directors;770 and (2) the obligation to acquire member approval of certain transactions with the company, such as substantial property transactions and loans.771 Because these duties are directly applicable to shadow directors, some scholars have suggested that identifying a controlling shareholder to be a shadow director is a convenient way of regulating controlling shareholders’ conduct.772 However, given that, at least up to date, the general fiduciary duty is not applicable to shadow directors and both statutory obligations for shadow directors are procedural in nature, the shadow director approach is actually a decision right strategy rather than a standard-based strategy. Therefore, for the purpose of this book, it is enough to say that the shadow directorship does not establish an independent substantive standard for controlling shareholders.

decide.) See also Lacy (2006), p. 299. (No liability has ever been imposed relying on a general fiduciary duty owed by a shadow director; courts will be faced with the task of determining whether or not the common law does/or did embrace shadow directors with respect to the rule of principles at issue.) 767 [2005] EWHC 1638 768 Davies (2010), p. 148, n.8. 769 Pennington (1987), p. 28. 770 CA2006 s.187. 771 CA2006 s.223. 772 Kraakman et al. (2004), p. 126.

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§5.3

Regulating Majority’s Voting Power

When shareholders exercise their voting rights in the shareholder general meeting, the basic rule is that they are not trustees of the company or the other shareholders.773 The voting right is considered a proprietary right and can be exercised for a shareholder’s own interest, regardless whether that interest is against the company’s and the other shareholders’ interest. 774 There is no general duty of good faith owed by shareholders to each other under UK law.775 Furthermore, as a general rule, a shareholder will not be disqualified from voting just because he has a personal interest in the matter.776 That being said, there are cases subjecting shareholders’ exercise of their voting rights to judicial scrutiny. Under the common law jurisdiction, two types of cases involving majority’s voting power have been repeatedly reviewed by the courts, namely, alteration of Articles and ratification of breach of duty by directors. Ratification is a topic which has already been discussed in the last section. In short, the non-ratifiable wrong theory is aimed at those cases in which allowing the majority shareholders to forgive the wrongdoing director would equal to allowing the majority to use their voting power to appropriate company assets—which all shareholders should be entitled to a proportional share—to themselves.777 As stated by Davies,778 “a majority of the shareholders may not by resolution expropriate to themselves company property, because the property of the company is something in which all the shareholders of the company have a (pro rata)

773

Hannigan (2000), p. 494. See also Hirt (2004), pp. 197-212, n.47 and accompanying text. Davies (2003), p. 707. 775 Hollington (2004), p. 164. 776 Hollington (2004), p. 65. Of course this common law rule is now subject to the limitation provided by CA2006: a director cannot vote as a shareholder to ratify his own wrongs, see following discussions. 777 See Burland v. Earle([1902] A.C. 83), in which the court summarized the essence of these category of cases as the following: “the majority are endeavouring directly or indirectly to appropriate to themselves money, property or advantages which belong to the company, or in which the other shareholders are entitled to participate…” 778 Davies (2003), p. 646. See also Hirt (2004), p. 202; Hannigan (2000), p. 500. 774

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interest. Consequently, a resolution to ratify directors’ breaches of duty which would offend against this principle is ineffective […].”

This section will first examine the rules concerning alteration of articles, and then discuss the issue of whether there is a general constraint on majority voting power in the second subsection. It should be pointed out that abuse of voting power might also give a cause of action under the statutory unfair prejudice remedy; the issue, however, will be left to the next section.779

5.3.1

Alteration of Articles

S. 14(1) of CA1985 provides that the articles of a company is a statutory contract: “Subject to the provisions of this Act, the memorandum and articles of association […] bind the company and its members to the same extent as if they respectively had been signed and sealed by each member, and contained covenants on the part of each member to observe all the provisions of the memorandum and of the articles.”

The section has been replaced by s.33(1) of CA2006. The new Act uses the term “a company’s constitution” instead of “memorandum and articles,” but the essence of the provision is unchanged. 780 S.9 of CA 1985 provides that alteration of articles can be achieved by a special resolution of the general meeting of shareholders, which is restated in CA2006, s.21(1). When voting for an alteration to the articles of the company, majority shareholders should cast their vote bona fide for the interest of the company as a whole. The case that established the rule is Allen v. Gold Reefs of W. Africa,781 in which Lindley M.R. held as follows:

779

See Davies (2010), p. 237. (Actually they are more likely to be pursued under UFPR today than in common law.) 780 See CA2006 Explanatory Notes, at p. 16, para. 108. 781 [1900] 1 Ch. 656, at 671.

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“The power [to alter the articles] must, like all other powers, be exercised subject to those general principles of law and equity which are applicable to all powers conferred on majorities and enabling them to bind minorities. It must be exercised, not only in the manner required by law, but also bona fide for the benefit of the company as a whole, and it must not be exceeded.”

At the first blush, the Allen test782 of “bona fide for the interest of the company as a whole” seems to be a sound and straightforward rule. In practice, however, the courts have been “beguiled and confused” ever since.783 The difficulty has two aspects: the first one concerns with whether the test is a subjective test or an objective test; and the second is how to define the “interest of the company.” In Shuttleworth v. Cox Bros & Co (Maidenhead) Ltd. (“Shuttleworth”),784 the Court of Appeals held that “bona fide” and “the benefit of the company” should not be treated as two distinct issues.785 Therefore, the Allen test is not a purely objective test. The reasoning in Shuttleworth suggests that as long as there are some grounds “on which reasonable men could come to the same decision,” the court will not interfere with the majority’s exercise of its discretion.786 Later, in Greenhalgh v. Arderne Cinemas Ltd. (“Greenhalgh”),787 the Court of Appeals took the chance to look further into these issues. In this case, the majority shareholders sought to add a restriction to the pre-emption provisions in the articles, which exempted transfers of shares to a third party with the sanction of an ordinary resolution. The amendment would allow the majority to sell their shares to a third party as they wish, while still keep the right to block a sale by the minority.788 Evershed M.R., who presided the civil division of the Court of Appeals, explained the Allen test as follows:

782

The test is also referred to as the “Gold Reefs rule” or the “Gold Reefs principle”. See Davies (2010), at 230. 783 See Hannigan (2007), at p. 476. 784 [1927] 2 K.B. 9. 785 Id., at 19. 786 Id., at 23. 787 [1950] 2 All.E.R. 1120. 788 While this is a close company case, the reasoning of the judge did not rely on any special attributes of a close company.

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“[The test] means that the shareholder must proceed on what, in his honest opinion, is for the benefit of the company as a whole…the phrase, ‘the company as a whole’ does not…mean the company as a commercial entity, distinct from the corporators; it means the corporators as a general body. That is to say, the case may be taken of an individual hypothetical member and it may be asked whether what is proposed is, in the honest opinion of those who voted in its favour, for that person’s benefit.”789

Assisting his hypothetical member test, Evershed M.R. gave a further elaboration of the rule: the judge said special resolutions cannot discriminate between the majority and minority so as to give the majority an advantage of which the minority is deprived.790 The judge found that, in this case, the offer was made by an outsider of the company, and the offer was made to all shareholders at the same price. Although the alteration of the article was to realize the transaction between the majority shareholder and the outsider, any other shareholders can sell at the same price. Therefore, there is no discrimination between the majority and minority shareholders. The special resolution is thus held valid by the court.791 The Greenhalgh decision is widely cited, yet it also has attracted much criticism. The “hypothetical member” test has been said to be “impracticable,” “unhelpful”, 792 and almost “meaningless” in case of conflict of interest between majority and minority.793 Furthermore, requiring the majority to vote in the interest of a “hypothetical member” conflicts with the basic principle that shareholders can vote in their own interest.794 Although Evershed M.R.’s “no discrimination between majority and minority” rule seemed to be more workable,795 it has also been challenged by commentators because the court 789

Greenhalgh, at 1126. Id. 791 The Greenhalgh decision has been challenged by commentators, arguing that the resolution does discriminate minority shareholders. See Hannigan (2007), at p. 480; see also Hollington (2004), at pp. 83-85. 792 Davies (2003), p. 714. See also Hannigan (2007), p. 479. 793 Joffe et al.(2004), p. 90. 794 Hannigan (2007), n.48. 795 For a case that the alteration does discriminate minority shareholders and thus was invalidated by the court, see Re Holders Investment Trust Ltd ([1971] 1 WLR 583). See also Davies (2010), p. 232 (the 790

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failed to show the connection between the discrimination test and the Allen test.796 Unsatisfactory as Greenhalgh is, other cases provided no better answer. Indeed, precedents show that the courts have failed to provide a consistent approach to the Allen test.797 As observed by Hannigan, UK courts have been wavering between the “company entity” and the “corporators” propositions in interpreting the meaning of “company as a whole”, as well as between reading the test as a subjective one and an objective one.798 With all the uncertainties in applying the Allen test, however, two rules seem to have received general acceptance. Firstly, if no reasonable man could consider the alteration is for the benefit of the company, then following Shuttleworth, the resolution fails the test.799 It is said that some decisions just cannot be considered as benefiting the company, no matter how honestly the majority believes them to be.800 As suggested by this formula, the Allen test is predominantly a subjective honesty test, but still leaves room for the courts to step in to form their value judgment towards the majority’s conduct. 801 Secondly, as observed by Davies, the Greenhalgh “no discrimination” test will “at least protect minority shareholders when the majority gains some collateral benefit not available to the minority.”802

5.3.2 5.3.2.1

General Constraints on Voting Power Estmanco

Besides in the two established categories of cases, i.e., alteration of articles and ratification of directors’ breaches, whether there are some general equitable constraints on the majority shareholder’s voting power is a controversial issue.803

limitation at least can protect minority shareholders when the majority gain some collateral benefit not available to the minority.) 796 Hannigan (2007), at p.480, n. 51, 52 and accompanying text. See also Hollington (2004), pp. 83-85. 797 Hannigan (2007), p. 471. 798 Id., pp. 480-81. 799 Id., p. 477. 800 Id., p. 479. 801 Id., p. 481. 802 Davies (2010), p. 232. 803 Hollington (2004), p. 88

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Hollington suggests that majority shareholders’ voting power should be generally reviewable by the court: “[i]t is difficult to see why equity’s intervention should be limited to the two majority powers of ratifying breaches of fiduciary duty and altering articles. If the considerations underlying equity’s intervention in those two cases exist in other cases, why should equity not intervene?”804

One approach of establishing a general principle to review majority shareholders’ voting power has been cited above—Lindley M.R. based his holding in Allen on the principle that “all powers conferred on majorities and enabling them to bind minorities” should be exercised bona fide for the interest of the company as a whole. However, Davies commented that the case law does not support such a universal principle.805 Although the British courts have clearly recognized the necessity to limit the majority’s discretion in exceptional cases;806 the judges have always dealt with the issue on a case-by-case base.807 Estmanco v. GLC (“Estmanco”)808 is a widely-cited case in which the court has reviewed majority voting power under situations other than alteration of articles and ratification. In Estmanco, the majority shareholder breached the contract he had with the company and the board brought a lawsuit against him. The majority adopted a resolution in a special shareholder meeting to instruct the directors to drop the suit, which the directors followed. The plaintiff-minority shareholder applied to the court for permission to continue the suit derivatively. Finding the resolution amounted to fraud on the minority, the court held that the case fell into the exception of the Foss rule and allowed the derivative suit to proceed. The Estmanco court asserted that “[n]o right of a shareholder to vote in his own selfish interests or to ignore the interests of the company entitle him with impunity to injure his voteless fellow shareholders by depriving the company of 804 805 806 807 808

Id., pp. 88-89. Davies (2003), p.707. Hollington (2004), p. 74. Id., p. 67. [1982] 1. W.L.R. 2.

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a cause of action and stultifying the purpose for which the company was formed.”809 The judge found the fraud on the minority theory was obviously applicable to the case: “All that I need say is that in my judgment the exception usually known as ‘fraud on a minority’ is wide enough to cover the present case, and that if it is not, it should now be made wide enough. There can be no doubt about the [applicant] being a minority; there can be no doubt about the advantage to the [majority] of having the action discontinued; there can be no doubt about the injury to the applicant and the rest of the minority […] of that discontinuance; and I feel little doubt that the [majority] has used its voting power not in order to promote the best interests of the company but in order to bring advantage to itself and disadvantage to the minority.”810 5.3.2.2

A General Equitable Principle?

The above discussion shows that, in the UK, judicial review of majority voting power under common law has been conducted according to two standards, namely, “bona fide for the interest of the company” and “fraud on the minority”. While the former is often seen in the regulation of alteration of articles and the later is more often used in the regulation of ratification, the two standards are actually closely related to each other. Indeed, they even have been called by Davies as “twin concepts”. 811 In Estmanco, the judge gave a widely-cited explanation to the term “fraud on the minority”: “Apart from the benefit to themselves at the company’s expense, the essence of the matter seems to be an abuse or misuse of power. ‘Fraud’ in the phrase ‘fraud on a minority’ seems to be being used as comprising not only fraud at

809 810 811

Estmanco, at 16. Id., at 15. Davies (2003), p. 716.

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common law but also fraud in the wider equitable sense of that term, as in the equitable concept of a fraud on a power.”812

As this cited paragraph shows, the essence of “fraud on the minority” is an abuse of power, which runs against the principle that a power granted should be used with good faith. The relationship between the two common law principles is better explained by Worthington as follows: “Courts will intervene, and allow a derivative action, where the general meeting vote to commit the company to a particular course of action is (or would be) a ‘fraud on the minority’. What this usually means is that the vote is a ‘fraud on the company’. This, in turn, simply means a use of power inimical to the purposes for which the power was granted. It is judged by whether the power is used to deliver benefits to individual voters which were not contemplated in the grant of voting power: the power must only be used bona fide and in the interests of the company as a whole.”813

From these observations, it is clear that what Davies means by “twin concepts” is not that prohibiting fraud on the minority equals requiring voting bona fide for the interest of company. Rather, it means that bad faith is evidenced by a fraud on the minority. In other words, a fraud on the minority rings the alarm that the action might not be done in good faith.814 Actually, from a practical perspective, given the difficulty of applying the Allen test, the test of “bona fide for the interest of the company” is often reduced to a search for fraud on the minority.815 As Davies commented, the case law does not support the assertion that all majority power must be exercised in good faith. However, if evidence shows that the majority’s voting amounts to a fraud on the minority, as what happened in 812

Estmanco, at 12. Fraud on the power is a rule in equity, originally designed to impose a duty on donees of particular powers of a non-fiduciary nature, which are given for the benefit of others, to exercise them for the purpose for which they were conferred. (See Hollington (2004), at p. 81.) 813 Worthington (2000), pp. 649-50. See also Hannigan (2007), p. 479. (Exercising the voting power exceeding the bona fide principle would be a “fraud on a power” and void.) 814 See Hannigan (2007), p. 478. (Lack of benefit cast doubt on the good faith of the majority.) 815 Even for the cases of alteration of articles, the Allen test has been criticized as “no longer provide any practical guidance as to the limits on the power of alteration”, and should be substituted with a rule based on fraud on a power. ( See Hannigan (2007), at p. 500.)

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Estamanco, it will be very likely the court will interfere and void the resolution so passed.

§5.4

Unfair Prejudice Remedy

5.4.1

The Statutory Provision

The statutory unfair prejudice remedy (“UFPR”) was designed to “strengthen the position of minorities ‘… primarily but not exclusively in private companies…’”816 It was first introduced by S.210 of CA1948, then developed into s.459-461 of the CA1985, and now restated as s.994~998 of CA2006. S.994(1) of CA2006 states as follows: “A member of a company may apply to the court by petition for an order under this Part on the ground—(a) that the company’s affairs are being or have been conducted in a manner that is unfairly prejudicial to the interests of members generally or of some part of its members (including at least himself), or (b) that an actual or proposed act or omission of the company (including an act or omission on its behalf) is or would be so prejudicial.”

As commented by Davies, the statutory provision has a very wide coverage: it catches the activities of “controllers of companies”, no matter they controlled the business of the company through the exercise of their powers as directors or as shareholders.817 Meanwhile, the statutory remedy grants the courts great discretion in giving relief as they think fit for the matters complained of.818 S.996(2) of CA2006 provides that the court’s order may include but is not limited to: (a) regulating the conduct of the company's affairs in the future; (b) requiring the company to take or to refrain from taking certain action;

816

Law Commission CP142 (1996), at 57. UFPR applicable to public company cases as well, see Re Leeds United Holdings Plc [1996] 2 BCLC 545, at 559; Payne (1999), p. 369. 817 Davies (2003), p. 735. As Davies observes, the cases that used to be governed by the Allen test, are more likely to be purposed under UFPR today. (Davies (2010), p. 237.) 818 Hollington (2004), p. 225.

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(c) authorizing civil proceedings to be brought in the name and on behalf of the company; (d) requiring the company not to make any, or any specified, alterations in its articles without the leave of the court; (e) providing for the purchase of the shares of any members of the company by other members or by the company itself.819 To apply to court for relief from unfair prejudice, a petitioner must show the following four elements:820 (1) the actions complained of amounts to “the conduct of the company’s affairs” or an “act or omission of the company”; and (2) the petitioner’s interests as a member (3) is or would be prejudiced (4) unfairly. These elements will be discussed respectively in the next section.

5.4.2 5.4.2.1

Elements of Unfair Prejudice Meaning of “the Company’s Affairs”

Conduct “in” or “outside” the Company

The statutory provision requires that an unfair prejudice petition must be based on either the manner that “the company’s affairs” being conducted or an “act or omission of the company.”821 Although there is no definition given by the Act as to what are “the company’s affairs” or “act or omission of the company,”822 it is clear that

819

Remedies under UFPR can be very flexible. For instance, in Re Little Olympian Each-Ways Ltd (No. 3), ([1995] 1 B.C.L.C. 636, Ch.D.) the company’s assets had been sold by those in de facto control of the company to another company controlled by them. The court held that the other company should buy out the petitioners. For further discussion on remedy, see Hollington (2004), Ch8. 820 Hollington (2004), at p. 143. CA2006, s.994(1). 821 CA2006, s.994(1). See Re Astec (BSR) plc, [1998] 2 BCBC 556, at 570. 822 Law Commission CP142 (1996), at p. 73, para. 9.5 (The comment was made to CA1985, but the statutory provision has not been changed in this regard in CA2006.)

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“[a] petitioner will be unable to succeed if the matters of which he complains amount to merely to acts or omissions of the directors which are neither an exercise of nor a failure to exercise, nor relate to, the powers conferred on them under the company’s constitution as directors, or if they are merely acts or omissions on the part of other members in their capacity as such.” 823

The Law Commission’s Consulting Paper listed a few cases to illustrate the distinction between the conducts “in the company” and “dehors the company”.824 For instance, a director who sets up a competing business and diverts business opportunities to the new company committs “misconduct of the affairs of the company”; in contrast, a director stealing from the company safe is not conducting the company’s affair—under such a situation, the board would be misconducting company affair if they were aware of the damage done to the company but failed to take an action.825 As for shareholders, their personal acts do not amount to conduct of the company’s affairs.826 In Re Astec(BSR) plc.,827 the court held that the parent company’s negative comment on the subsidiary’s financial status is not conduct of the subsidiary’s affairs. For the same reason, a controlling shareholder negotiating with minority shareholders for buying shares is not conducting the company’s affair. 828 Even when exercising their voting right in the general meeting, the voting of a majority shareholder is not conduct of company affairs because voting right is a private right.829 However, passing a resolution by the general meeting is an action of the company and can be the basis of an unfair prejudice petition.830

823

Joffe (2004), at p. 178. Law Commission CP142 (1996), at pp. 73-74. See also Hollington (2004), pp. 146-47. 825 Law Ccommission CP142 (1996), at p. 74. 826 Joffe (2004), pp. 180-81. 827 [1999]B.C.C. 59, at 60. 828 Hollington (2004), p. 148. Re Estate Acquisition and Development Ltd [1995] B.C.C. 338; Re Legal Costs Negotiators Ltd. [1999] B.C.C. 547. 829 Joffe (2004), pp. 181-82. 830 Joffe (2004), p. 181. Law Commission CP142 (1996), at p. 74. Of course, it may be argued that, from a practical perspective, this is more like a distinction without difference. 824

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Parent and Subsidiary Relations The concept of company’s affairs has a special implication in corporate groups: under certain circumstances, it allows a shareholder in a subsidiary to bring an unfair prejudice claim basing on an act of the parent (or vice versa).831 It has been held that when a parent company has assumed detailed control over the affairs of its subsidiary and treats the financial affairs of the two companies as being one company, actions of the parent may be considered conduct of subsidiary’s affairs. 832 In Nicholas v. Soundcraft Electronics Ltd., 833 the minority shareholder of the subsidiary complained that the parent company failed to pay its debts due to the subsidiary and such a failure was conduct of the affairs of the subsidiary. The court found that “[the parent] was, in effect, treating the financial affairs of the two companies as that of a single enterprise over which it had control.”834 Therefore, although the parent’s failure to pay the debt, if taken in isolation, might not be conduct of affairs of the subsidiary, it was as such in the context of the way in which the business of the parent and subsidiary were administered together.835 In Gross v. Rackind,836 the Court of Appeal endorsed the following reading of the term from an Australian court: “The words ‘affairs of the company’ are extremely wide and should be construed liberally: (a) in determining the ambit of the ‘affairs’ of a parent company for the purposes of [the UFPR], the court looks at the business

831

Law Commission CP142 (1996), p. 74. See also Davies (2003), p. 735. Law Commission CP142 (1996), pp. 74-75. In SCWS v. Meyer ([1959] AC 324), the House of Lords held that the parent company had acted towards the minority shareholders of the subsidiary in an oppressive manner and that this conduct, through the nominee directors, amount to conduct of the affairs of the subsidiary because “the affairs of the company can … be conducted oppressively by the directors doing nothing to defend its interests when they ought to do something…” (At 367.) 833 [1993] BCLC 360. 834 Elements of control included key areas such as administration of export sales; personnel recruitment; supervision of the subsidiary by non executive directors appointed by the holding company; negotiating overdraft borrowing limits for the group; and supervision of finances by the holding company’s finance director. (At 363-64) 835 The court held the parent’s decision in delay payment amount to conduct of the subsidiary’s affair, but there was no unfair prejudice suffered by the minority. (At 366) See further discussions below. 836 [2005] 1 W.L.R. 3505, 3513. 832

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realities of a situation and does not confine them to a narrowly legalistic view; (b) ‘affairs’ of a company encompasses all matters which may come before its board for consideration; (c) conduct of the ‘affairs’ of a parent company includes refraining from procuring a subsidiary to do something or condoning by inaction an act of a subsidiary, particularly when the directors of the parent and the subsidiary are the same.” 837

As mentioned before, the UFPR was drafted intentionally to have a wide coverage and it can catch various conducts of the controllers of a company. A controlling shareholder’s power may be subject to this constraining scheme in different ways: it may apply to directors’ conduct, which prevent them from surrendering to the controlling shareholders’ influence; it may apply to a general shareholder meeting resolution, which constitutes a constraint on the controlling shareholder’s voting power; furthermore, it may even reach a parent company’s conduct of its own affair, provided that the parent company has run the parent and the subsidiary in a close enough way. UFPR has been designed to be a more effective weapon for protecting minority interest, and the definition of “company affairs” enables a wide-catch of s.994 to meet the design purpose. 5.4.2.2

Interests qua Member

UFPR protects a petitioner’s interests as a member.838 This requirement has two implications. Firstly, the interests protected are limited to interests qua member and cannot extend to “other interests of persons who happen to be members.”839 For instance, if a shareholder entered into a sales contract with the company which was then breached by the company, the shareholder cannot protect his interests through an unfair prejudice petition, because what has been harmed was his interests as a contracting party, not a shareholder.840 837 838 839 840

See also Mukwiri (2005), at pp. 77. Law Commission CP142 (1996), at pp. 76-77. Id. See also Joffe (2004), p. 191. See Law Commission CP142 (1996), p. 77. In Re JE Cade & Son Ltd., [1992] BCLC 213, the court

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The second implication of the meaning of “interests qua member” is that the UFPR protects not only the strict legal rights, but also a petitioner’s “interests” as a member.841 Emphasize on the importance of “interests” being broader than “rights”,842 however, only makes a meaningful difference in private companies, where a “legitimate expectation” may arise because of some personal relationships. 843 A typical case would be a shareholder having a legitimate expectation to be a director because he bought the shares of the company based on the understanding that he could participate in management of the company.844 Under such a situation, if he was later removed from the position of a director by the majority, he could claim his “interests”-- not only as a director, but also as a shareholder-- has been prejudiced. For public companies, in contrast, no such legitimate expectation can arise, because outside shareholders are entitled to rely on the assumption that the Articles of Association and the Company Act are exhaustive statements of their members’ interests.845 As Hoffmann L.J. asserted in Re Saul D. Harrision & Sons Plc.,846 absent some personal relationship, a shareholder’s interests goes no further than that the board of the company will act in accordance with its fiduciary duties and that the affairs of the company will be conducted on the basis of the articles and any relevant legislation.847 5.4.2.3

Prejudice

The element of prejudice requires a petitioner to show that his position is materially worse off because of the accused conduct by the controller.848 So trivial or “academic cases” where a petitioner cannot show material prejudice is excluded from UFPR.849

struck out an s.459 petition because the petitioner was pursuing his interests as a freeholder of a farm, which had been farmed rent free by the company, not as a shareholder. 841 Davis (2003), p. 737. Law Commission CP142 (1996), at p. 76. 842 Law Commission CP142 (1996), p. 76. 843 Id., p. 77. 844 Id. 845 See Hollington (2004), p. 150, 154. See also Payne (1999), p. 370. 846 [1995] 1 BCLC 14. 847 See Payne (1999), pp. 369-370. 848 Hollington (2004), p. 155. 849 Id., pp. 154-55.

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Prejudice is not limited to direct financial loss; instead, “the nature of the prejudice suffered will depend upon the nature of the interest in question.”850 For instance, delay in holding a general meeting or exclusion from management can all be prejudice.851 Naturally, prejudice will be found when the value of the petitioner’s shareholding is seriously diminished or jeopardized.852 It has been held that conducts financially prejudicial to the company must also be prejudicial to the shareholders,853 so the petitioner can rely on the financial damage the company suffered to establish his own interests as shareholder being prejudiced.854 The element of prejudice is crucial for an unfair prejudice petition; without substantial prejudice, an unfair conduct alone is not enough to support the petitioner’s case. 855 In Rock Nominees v. RCO, 856 the company sold its shareholding in its wholly owned subsidiary to its majority shareholder. Although the directors had breached their fiduciary duty because of conflict of interest—and thus were, prima facie, acting unfairly857--the court held the only issue was whether the sale price was below fair value. If not, the petitioner had no relief under sec. 459.858 Comparably, in Nicholas v. Soundcraft Electronics Ltd,859 the parent company withheld moneys due to the subsidiary—which had been relying on the financial support from the parent— because of its own financial difficulties. The court held that the minority shareholder of the subsidiary was not entitled to a relief under UFPR, because the decision to withhold the money was a reasonable commercial judgment to keep the group afloat, which was necessary for the survival of the company. 860 Actually, as Hollington observed, even if the directors had breached their duty of avoiding conflict of interest, the decisive factor of the case was that there was no real 850 851 852 853 854 855 856 857 858 859 860

Id., p. 155. Id. Id. Re Macro (Ipswich) Ltd, [1994] B.C.C., 781, at 833. See Joffe (2004), p. 196. Joffe (2004), at 196. Re Saul D. Harrison & Sons Plc., [1995]1 BCLC 14, at 31. [2004] 1 B.C.L.C. 439 See Sec.5.4.2.4 hereunder. See Hollington (2004), p.156. [1993] BCLC 360. Id., p. 366.

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prejudice to the minority, because worse harm would have been done to the subsidiary if the directors had decided otherwise, and because of the lack of real prejudice, the case must be dismissed.861 5.4.2.4

Unfairness

Although the term of “unfair prejudice,” as Hoffmann L.J. read it, is left by the legislature deliberately to be vague and broad,862 it does not mean there will be an entirely new standard of “fairness.”863 The open-end statutory provision does grant the court great discretion in defining the meaning of “fairness” on a case-by-case basis. 864 The courts, however, when balancing its discretion against legal certainty, tilted towards the latter. 865 Lord Hoffmann made his widely cited assertion in O’Neill v. Phillips: when the equitable principles are “tolerably well settled […] it would be wrong to abandon them in favour of some wholly indefinite notion of fairness.”866 Lord Hoffmann summarized in the same case that unfairness may be found either in a breach of the rules or in using the rules “in a manner which equity would regard as contrary to good faith.” 867 The test is an objective one. 868 Therefore, the starting point of any case under UFPR is to ask whether the conduct of which the shareholder complains was in accordance with the articles of association (or, in other words, was there any breach of the agreement).869 Since the directors’ fiduciary duty is considered as part of the legal bargain between the shareholders and the company, a breach of the director’s duty is presumably unfair.870 If the challenged conduct does not involve a breach of agreement among the shareholders, then another possible ground of finding 861

Hollington (2004), p. 200. See Re Saul D. Harrison, [1994] BCC 475, at 488. 863 In the early days following the enactment of s.459, there was an opinion that the statutory remedy provided for “an entirely new jurisdiction, untrammeled by previous authority or established principles, and based on a new concept of ‘fairness’.” See Hollington (2004), p. 129. 864 Davis (2003), p. 742. 865 Hollington (2004), p. 130. 866 [1999] 1 WLR 1092, at 1099. 867 See Joffe (2004), p. 197. 868 Davis (2003), p. 747. (No intention to harm is required from the wrongdoer.) See also Joffe (2004), at 209. 869 Hollington (2004), p. 159. 870 Id. Therefore, when “the management procures the company to enter into transactions either with the majority shareholder or a person associated with him, the starting point […] will be whether or not there has been any breach of the fiduciary duty […]” See Id., at p. 196. 862

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unfairness is the majority shareholders’ using their powers in a way contrary to the traditional equitable principles, such as “fraud on the minority.”871 Hollington, after an examination of the modern leading cases concerned with the UFPR—including the above cited assertions by Lord Hoffmann, concluded the following: “In the light of these cases, it is now clear that the ambit of the statutory remedy can only be properly understood in the context of the traditional and established principles of law and equity developed by the courts since the middle of the 19th century, that is so to say the principles of internal management and the legal bargain between shareholders, majority rule, the rule in Foss v. Harbottle and its exception and the doctrine of ‘fraud on a minority’…”872

Therefore, UFPR is NOT, as some scholars once submitted, “an entirely new jurisdiction, untrammeled by previous authority or established principles, and based on a new concept of ‘fairness’”;873 instead, its substantial standard of fairness is not different from the traditional common law remedies.

§5.5

The Substantive Standard of Fairness in the UK

The previous sections show three regulatory institutions which provide different, but sometimes overlapping regulation of controlling power. 874 Derivative actions aim at misconduct of company directors and are useful when extraction of the private benefit of control has been facilitated by the controlling shareholder’s dominance of the board of directors; common law actions set 871

Id., p161, 190. Other equitable constraints, such as good faith in partnership law, might also be grounds of unfair prejudice. Their application, however, often requires personal relationships which can hardly exist in public companies. For further discussion of these equitable principles, see Id., at pp.161-90. 872 Hollington (2004), p. 132. 873 Id., p. 129. The judge was referring to the Foss rule because the case was decided before CA2006. 874 For instance, breach of directors’ duty can be challenged either through a derivative action or an unfair prejudice petition (because the directors’ fiduciary duty is considered as part of the legal bargain between the shareholders and the company, thus a breach of the director’s duty is presumably unfair). The new CA2006 explicitly provides a court can order a derivative action under proper circumstances as a remedy for an unfair prejudice petition. (CA2006 s.996(2)(c))

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limitations on controlling shareholders’ discretion of voting; UFPR provides a more flexible approach for minority shareholders to get relief, but with largely the same substantive standards established in the common law principles. The three types of actions jointly draw the boundary of a controlling shareholder’s controlling power. Although different terminologies have been used by British judges when describing the substantive standards in different types of cases, the following analysis will show that substantive standard established by British law for controlling shareholder conduct is no difference from its American counterpart, that is, no unproportional distribution to the controlling shareholders. In Sinclair, the Delaware landmark case concerning controlling shareholders, the controlling shareholder gaining some advantage at the cost of the minority is the decisive factor for the finding of breaching controlling shareholder’s fiduciary duty.875 In British law, there is a noticeably comparable notion which plays a critical role in all three types of actions, that is, fraud on the minority.876 Similar with Sinclair’s advantage/disadvantage test, fraud on the minority also requires both benefit accrued to the wrongdoer and detriment suffered by the minority. The most typical cases include a director entering into an unfair transaction with the company which favors himself, or a controlling shareholder voting for a resolution which waives a meritorious claim of the company against himself.877 It is not difficult to see that prohibiting fraud on the minority by a controlling shareholder is just another way to say a prohibition to non-proportional distribution to the controlling shareholder. In all three types of actions, a controlling shareholder’s discretion in exercising his controlling influence goes as far as to the point that he tries to extract some non-proportional benefit from the company. The most direct application of the principle is the common law

875

See Sec. 4.4.2.2. Actually, “fraud on the power” might be a more precise term, because a director committing fraud on the minority does not have to be a majority shareholder (otherwise the “wrongdoer control” element of the Foss rule would be redundant). Although fraud on the minority is no longer a prerequisite for bring statutory derivative actions, it is nevertheless a critical issue. See previous discussion Sec. 5.2.1.4. 877 E.g., Estmanco. 876

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limitation on a majority shareholder’s power to ratify a director’s breach of duty. The ratification is ineffective if it amounts to a fraud on the minority. While the limitation on the power to alter the articles of the company is said to be “bona fide for the interests of the company,” as analyzed previously, judicial review is often reduced to a search for a fraud on the minority.878 It also has been argued that fraud on the minority is very likely to be a general limitation on a majority’s voting power.879 Prohibition on non-proportional distribution to controlling shareholders is also evidenced by the common law rule regarding derivative actions. Under the Foss rule, both fraud on minority and wrongdoer control have to be met for a derivative action to proceed. That is to say, when the majority has not gained any non-proportional benefit from the transaction, they will not be deprived of the decision making power for the company. Although the statutory derivative action no longer requires a plaintiff to show fraud on the minority and wrongdoer control before they allow a derivative action to proceed, that does not mean the substantive standard has changed: as suggested by scholars, if the director by negligence entered into an unfair transaction with the controlling shareholder, the court might well likely allow the case to proceed because in such a case, seeking ratification of the breach from the shareholders would give the controlling shareholder a benefit to themselves at the cost of the company and the minority shareholders; by contrast, if the majority is disinterested, the court might very likely to order a shareholder meeting to decide whether the company should pursue the claim. The substantive standard is not of much difference if the minority shareholder had sought for relief under UFPR. It has been shown that the statutory remedy does not establish a new substantive standard of fairness. Plaintiffs have to shown unfairness within the framework of common law principles. For instance, a majority shareholder may decide not to pursue a claim for the company. Whether such a decision is unfair depends on whether the majority

878 879

See Sec. 5.3.2.2. Id.

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shareholder has gained some benefit from the decision so that it constitutes a fraud on the minority.880 To sum up, no matter which kind of action a minority shareholder is pursuing, this central idea of “fraud on the minority” is a line drawn by the UK judiciary for abuse of controlling power. On the one hand, the majority cannot use their position to benefit themselves at the cost of the company and the minority shareholders; on the other hand, if no such an element exists, courts will not hold controlling shareholders liable for exercising their controlling power.881

§5.6

Regulating Controlling Shareholder Opportunism in Listed Companies: Other strategies

5.6.1

A Less-Trodden Path

Previous chapters have shown that, to use standard-based strategies efficiently, defining the substantive standard is only the first step. How to balance the benefits and costs of enforcing the standard through judicial review is an even more critical question. Because judicial interference with the decision making system of a company is not only expensive, but also potentially inefficient,882 to achieve the optimal efficiency of the whole regulatory system, the law needs to make a choice of regulatory strategies carefully and only let those cases which are most appropriate for judicial review to go to court. However, when the spotlight of attention shifts to the enforcement stage in the UK, a phenomenon impossible to overlook appears: there is barely any case law concerning regulating controlling shareholder opportunism in public companies.883 Despite that the rules and principles discussed in the previous sections are equally applicable in theory to both private and public companies, in practice, however, most of the cases available are private company cases.884 880

For instance, majority shareholders may fail to take an action (because of collective action problem) or make a business decision of not to take action, neither case is unfair to the minority. 881 Fraud on creditors is not an issue within the coverage of this book. 882 See Sec. 3.2.1.3. 883 See supra n. 701. 884 To be fair, not only controlling shareholders in public companies are rarely being sued, even cases against directors are rare too. See supra n. 701. See also Charkham (1994), p. 315 (British directors generally not concerned of being sued by shareholders.)

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Apparently, the standards that have been discussed in previous sections are not actively enforced through judicial review in public companies. In Sec.5.2.1.3, it has been submitted that the Foss rule, which only allows derivative action to proceed when there is a strong conflict of interest and an unreliable majority, evidences the British judiciary’ awareness of the balancing the costs and benefits of judicial review.885 However, limiting the type of reviewable cases alone cannot fully explain the rarity of case law: there are similar rules in the US, yet they have plenty of cases made their way to court. The reasons that lead to the underused-status of litigation in the UK, therefore, cannot be found just through the examination of standard-based strategies alone; rather, all the relevant regulatory mechanisms need to be considered as a whole. The following discussion will first give an overview of the different strategies available in the UK which are relevant with the regulation of controlling shareholder opportunism in listed companies, and then discuss their impacts on the role of the standard-based strategies.

5.6.2

The Strategies in the Self-Regulation System

The UK is a country with a tradition of relying on self-regulation.886 Listed hereunder are the major relevant strategies adopted in the UK self-regulation system. It is beyond the purpose of this book to discuss the strength or weakness of self-regulation,887 and it should be enough to say that as general practice, these rules have quasi-legislative status and are binding on publicly quoted companies.888

885

Although the Foss rule has been substituted by the statutory derivative action, as argued in Sec.5.2.1.4, its underlying spirit, that is, the concern of only applying judicial review to cases involve a fraud on the minority, is unchanged. 886 Hopt (2011), pp. 65-66. Self-regulation is a term used as to contrast “statutory-regulation”, referring to “a system of private governance where groups of firms or individual members of a profession co-operate to set and meet standards.” See Bovey (1991), p. 3; Hupkes (2009), p. 427. 887 For a more detailed picture of the British self-regulation system, see Cheffins (1997), pp. 365-78. 888 Cheffins (1997), pp. 365-68.

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Decision Right Strategy Unlike Delaware law, which never makes shareholder approval compulsory, both CA1985 and CA2006 require shareholder approval for substantial related transactions.889 The provisions in the Companies Act have two weak points when regulating controlling shareholders: at the first place, the provisions are aimed at director related transactions and have no direct application to controlling shareholder related transactions; at the second place, the Companies Act does not prevent the related party from voting their shares in the shareholder general meeting.890 Both of the weak points are cured in the Listing Rules of FSA.891 Chapter 11 of the Listing Rules is titled as “Related Party Transactions”, and a “substantial shareholder” 892 falls into the definition of “related party” given in Rule 11.1.4. Rule 11.1.7 requires a related party transaction to be disclosed893 and get approval from the shareholder of the listed company,894 and it also provides that the related party should not vote in the relevant resolution.895 Smaller transactions are exempted from the shareholder approval requirement in Rule 11.1.7; instead, Rule 11.1.10 requires the company to inform the FSA about the details of the transaction in advance, and “provide the FSA with written confirmation from an independent adviser acceptable to the FSA that the terms of the proposed transaction or arrangement with the related party are fair and reasonable as far as the shareholders of the listed company are concerned”. Working as a whole, the Listing Rules can be seen as having adopted a “combined decision right strategy”. That is to say, they use principal approval for substantial transactions and a trusteeship strategy for less-than-substantial transactions.

889

CA1985 s.320; CA2006 s.190. Although voting for an unfair transaction may constitute fraud on the minority and give the minority a cause to sue. 891 The Financial Service Authority. 892 A “substantial shareholder” is defined in Listing Rules, Appendix 1, “Relevant Definitions” as “any person who is entitled to exercise or to control exercise of 10% or more of votes able to be cast … at general meetings of the company”. 893 Rule 11.1.7(1), (2) 894 Rule 11.1.7(3). 895 Rule 11.1.7(4). The rule provides that the company should ensure that the related party abstain from voting, and take “all reasonable steps” to ensure the related party’s associates abstain from voting. 890

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Governance Strategy The Code of Best Practice (often known as “the Combined Code”), which is issued by the Committee of Corporate Governance, is an important component of the whole British self-regulation system.896 The Listing Rules endorse the Code by adopting a “comply or explain” policy, that is, to require listed companies either comply with the Code, or explain to the public why they do not comply.897 The spirit of Combined Code is to establish a better governance structure for the company. One of its principles is that the board should be independent. The Code states the principle as follows under title “A.3 Board balance and independence”: “The board should include a balance of executive and non-executive directors (and in particular independent non-executive directors) such that no no individual or small group of individuals can dominate the board’s decision taking.”898

A.3.2 specifically provides that except for smaller companies, at least half the board, excluding the chairman, 899 should comprise non-executive directors determined by the board to be independent. Therefore, as a general practice, a quoted company will have a board with a majority of independent directors. The Exit Strategy The City Code on Takeovers and Mergers, which is administered by the Takeover Panel, is a set of self-regulating rules applicable to all public company

896

Pettet (2001), p. 208. Rule 9.8.6 (5), (6). See also the Combined Code, Preamble, para.4. 898 The supporting principles under title A.3 further emphasized the important of not giving unbalanced power or too much reliance to one or two individuals. 899 A.2.2 provides that the chairman should be independent on appointment, non-compliance should be disclosed and explained. 897

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takeovers and mergers.900 The Code has gained the support of both the Stock Exchange and the courts, thus has a “practically binding” effect.901 The mandatory bid provision is seen as one of the most important features of the City Code,902 which will be triggered when a person’s shareholding carries 30% of a company’s voting rights.903 The mandatory bid rule is considered as an exit strategy because it allows shareholders to exit the company at an attractive price.904 Despite of the fact that mandatory bids actually seldom happen,905 it clearly works as a strong disincentive of taking control of a company at the first place.906

5.6.3

Choice of Strategies

Impact of Self-Regulation Strategies Even with the very rough depiction of the self-regulatory rules given above, it is not difficult to tell that these rules can considerably lower the possibility of controlling shareholder opportunism in the UK. At the first place, the mandatory bids requirement discourages taking control all together, so that minimizes the source of the agency problem. Next, the Combined Code generally weakens the influence of a major shareholder over company affairs by requiring an independent board. Last but not least, the Listing Rules provides for a transaction-based check by requiring either disinterested shareholder approval, or independent valuation. The impact of these ex ante strategies on the role of judicial review is apparent. For instance, given the importance of an independent body’s opinion in derivative action, it can be imagined that a minority shareholder will face great 900

Pettet (2001), p. 412. Id. Pettet (2001), p. 420. 903 The other situation that will invoke mandatory bid is when one holding above 30% but below 50% voting rights acquires more shares which increases his voting rights. The City Code, Rule9. See also Pettet (2001), p. 421; Davies (2010), p. 254.. 904 Kraakman et al. (2009), p. 252. 905 Pettet (2001), p. 421. (Because people will “take great care to ensure that they do not blunder into a situation where they have to make the rule 9 cash offer for what is usually effectively, the whole company.”) 906 Kraakman et al. (2009), p. 254. (The compulsory bid rule reduces control transactions.) 901 902

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difficulty in challenging an independent board’s decision. Similarly, if a related transaction has been opined by an independent adviser as fair, it is unlikely that a minority shareholder can show “substantial prejudice” in a statutory unfair prejudice action. Furthermore, unlike in the US, which has a double check for controlling shareholders, effective approval will constitute a complete bar to derivative action in the UK. With all these ex ante strategies at work, it is no wonder that the court is not the preferred choice of the UK minority shareholders and the rules and principles of judicial review stay largely backstage in the listed company context. The lack of enforcement inevitably results in the underdevelopment of the standard-based strategies in the UK.907 As compared to the US, there is no equivalent rule in UK like the entire fairness standard (which incorporates different strategies into a standard-based strategy) or the Sinclair threshold test (which clearly defines the applicability of judicial review);908 the substantive standards are less clearly articulated and judicial interpretations of the standards are often inconsistent and confusing.909 However, despite that standard-based strategies are unsatisfactorily defined and rarely enforced in the UK, empirical researches have shown that the UK and the US have a similar level of private benefit of control extraction,910 which means the efficacy of their regulatory system as a whole are about at the same level. The only explanation of this result is that there is a trade-off relationship between the standard-based strategies and other strategies: the more sophisticated ex ante strategies make up for the weakness of the ex post strategy in the UK. Indeed, when there is fair control ex ante, there is less need to go to court ex post.911

907 Because the content of a standard strategy needs to be given by courts through ex post judicial review. See Sec.3.1.3, n.31 and accompanying text. 908 The most-close-to-equivalent rule in the UK is the fraud on the minority theory. 909 See, e.g. the discussion on the Allen test in Sec. 5.3.1. 910 Nenova (2003), Dyke & Zingales (2004). 911 See also Coffee (2007), p. 293 (“it can be argued that the United States expends more on enforcement than the United Kingdom because U.S. corporate law gives shareholders fewer control rights than does that of the United Kingdom--in effect, enforcement might be a substitute for weaker corporate governance.”)

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Why a Different Approach There are multiple reasons that lead to the disfavored status of litigation in the UK. It has been observed that, although both the UK and the US have dispersed ownership structure, about 60% of the outstanding shares of UK listed companies are held by institutional investors. By contrast, the US shares are held more in a “retail” form, which means individual shareholders have a more significant position. Compared to individual shareholders, institutional investors are more capable of protecting their interests ex ante, rather than try to correct the wrongful conduct ex post.912 Business culture is another important factor. The “closeness” in the business society leads people more willing to deal with the problem “behind closed doors” rather than go to court.913 It is also observed that the efficacy of the self-regulatory system is substantially bolstered through the “general proximity and homogeneity of the inhabitants” of London’s financial district. 914 Furthermore, litigation in general is far less popular in the UK than in the US.915 The UK procedural law does not allow contingency fees, and the risk of bearing the cost of the lawsuit if the plaintiff losses the case can be a strong disincentive for potential plaintiffs.916 All in all, the UK’s preference of the non-litigious approach is just the natural outcome of its own economic, social and cultural environments.

§5.7

Conclusion

The standard strategies used by the UK regulatory system of controlling shareholder conduct is a network that has three components: derivative actions based on directors’ fiduciary duty, common law action for abuse of majority power, and statutory actions for unfair prejudice.

912

Coffee (2007), p. 296. Hurst (1987), p. 413 (“the close socio-economic ties within the City financial community and British industry and the absence of a history of litigation in the corporate area are significant, if intangible, factors that contribute to the absence of litigation as well.”) 914 Bruner (2010), p. 626; see also Cheffins (2001), p. 475. 915 See Hopt (2011), pp. 68-69. See also Schizer (2008), p. 1441. 916 Coffee (2007), p. 267. 913

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The Substantive Standard The notion of “fraud on the minority” is central to this network. When a controlling shareholder tries to benefit himself at the cost of the minority, his conduct will constitute a fraud on the minority and his discretion as the company’s decision-maker comes to an end. Therefore, the substantive standard of fairness established by British law is actually akin to in the US, namely, no unproportional distribution to controlling shareholders. Balancing the Cost and Benefit of Review The British law has always been aware of the potential negative effect of judicial review. To balance the cost and benefit of review, courts only look carefully into the transaction when there is a conflict of interest involved. When the controlling shareholders have gained no benefit from the transaction, courts will respect their authority and will not interfere with the company’s decision making process. Meanwhile, the new CA2006 gives great discretion to courts as a gate keeper to keep out inefficient cases. Trade-off between Strategies Due to the UK’s traditional favor of self-regulation, litigation is actually a seldom trodden path in public companies. Decision rights strategies are often compulsory. Disinterested approval can effectively bar derivative action; even in situations that judicial review is available, ex ante strategies make it very difficult for the plaintiff to plead successfully. Since self-regulation plays an important role in the UK market, the role of judicial review is rather limited. The choice of the strategies is more of a product of history and culture than a legal choice. Since research shows the level of private benefit of control extraction in UK is very close to that in the US, it suggests strongly that there is a trade-off relation between ex ante and ex post strategies.

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Chapter VI China §6.1

Introduction

Minority shareholder protection is a rather new topic in Chinese company law. When China adopted its first Company Law in 1993,917 the major concern of the legislators was to use the law to facilitate the then-undergoing corporatization of State-owned enterprises918 and to protect the State’s interest as a shareholder—usually the controlling shareholder.919 As a result, the ’93 Company Law, although very pro-shareholder in defining the shareholder general meeting as the “authoritative organ” of a company,920 barely pays any attention to the protection of minority shareholders.921 It is fair to say that, by that time, minority shareholder protection was not yet an issue to the legislators. The situation began to change in the late 90’s of the last century, a period in which a series of cases involving controlling shareholders exploiting company assets attracted much public attention.922 It was gradually realized by both scholars and regulators that minority shareholder protection is critical to uphold 917

The law was adopted in 1993 and came into force in 1994; the following discussion will refer to it as the “’03 Company law”. (In some scholars’ works, it is sometimes also referred to as the “’94 Company Law”.) 918 See Xu (2000), pp. 158-60, 174-75. See also, Gan (2002). Corporatization of the state-owned enterprises is an essential step of China’s economic reform, which began from the late 70’s of the twentieth century. 919 Wu (2004), p. 39. Due to ideological reasons, when the economic reform took place, almost all the large to medium sized enterprises were wholly state-owned. (See Xu (2000), pp. 158-60.) The controlling position of the state does not change much even after decades into the reform: a research done in 2009 shows that about half of the listed companies in China are still ultimately controlled by the State. See Wang, E. (2009). (See also Liu, S. (2008), an analytical report based on the 2007 annual report of the companies listed in Shanghai Stock Market shows that 65% of listed companies are controlled by central or local government and state-assets management agencies.) 920 ’93 Company Law, Art.37. The article is re-stated in the ’05 Company Law. For general discussion on Chinese company law’s “shareholder centrism” proposition, see Fan, S. (2010), at p. 39; Shi, T. (2006), p. 305. 921 The only tools available to minority shareholders are the basic shareholder rights shared by all shareholders, such as voting and certain information rights, (’93 Company Law, Art. 110) and a very general and vague provision that if the interest of a shareholder is injured by a resolution of the board or the shareholder meeting, he can bring a law suit (Art. 111). See Li, X. (2007), at p. 254, 266-72. 922 See Yuan (2004), Vol. 1, Ch19. See also Wu (2004), at p. 77; Xi (2006), pp. 121-22.

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investors’ faith and maintain the normal order of the capital market.923 When the Company Law was revised in 2005,924 one major difference between the new law and its original version is the enhancement of minority shareholder protection.925 The ’05 Company Law has adopted both decision right strategies and standard-based strategies to fight controlling shareholder opportunism. Among the decision right strategies, both trusteeship strategies 926 and principal approval strategies927 are to be found in the new law. As for the standard-based strategies, the new law not only, for the first time, establishes substantive standards for the controlling shareholder’s conduct, but also introduces the mechanism which allows minority shareholders to enforce these standards via a derivative action. The improvement in the ’05 Company Law being acknowledged, it should also be admitted that, since minority shareholder protection is such a new topic for Chinese jurists, the regulatory system is far from ideal. The decision right strategies in the ’05 Company Law, as will be shown in the discussion below, are provided for in a less-than-systematical way. Concerning the standard for controlling shareholder conduct and its enforcing mechanism, the new law gives some much needed answers, yet also leaves as many important problems either unsolved or only unsatisfactorily solved. As said in the introductory chapter, the purpose of this chapter is two-fold: the first is to see whether the standard-based strategies used for regulating controlling shareholder opportunism will be significantly different in jurisdictions belonging to different legal families, and the second is to draw lessons from the US and the UK experience to improve the standard-based strategies in China. To meet these purposes, this chapter will start with an examination of the substantive standards established by the ’05 Company Law 923

Shi, J.Z. (2006), pp. 45-46. The new law came into force in 2006, the following discussion will refer it as the “’05 Company Law”. 925 Shi, J.Z. (2006), at p. 41. 926 Including cumulative voting, independent directors for listed companies, disinterested approval for director-related transactions in listed companies (Art. 125). Further discussion see below. 927 Including Art.16 for surety transactions and Art. 125 and 149 for director-related transactions. See further discussion below. 924

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in Sec. 6.2. The section ends with a comparative overview of the substantive standards in China, the US and the UK. Next, Sec. 6.3 focuses on the enforcement stage of the standards and Sec. 6.4 examines the specific situations that influence the functioning of the standard-based strategies in China. Sec. 6.4 also conducts a brief discussion on the decision right strategies in the ’05 Company Law since the relationship between judicial review and decision right strategies—as has been shown in previous chapters—is crucial to the overall efficiency of the regulatory system. Sec. 6.5 evaluates the efficiency of the system based on the discussions in the previous sections and give recommendations for improvement according to the lessons drawn from the discussion in previous chapters. Sec. 6.6 Concludes. The following discussion will focus mostly on the ’05 Company Law. Some relevant rules set by China Securities Regulation Commission (“the CSRC”)928 and judicial interpretations by the Supreme People’s Court are included as well.

§6.2

Standard-Based Strategy: The Substantive Standards

The ’93 Company Law is completely silent on the exercise of controlling power by controlling shareholders. The ’05 Company Law takes a big step forward in this regard by specifying two articles—Art. 20 and 21—to set substantive constraint on the controlling power. This section first examines the definition of “controlling shareholder” as under the ’05 Company Law Art. 217(2), then discusses the two articles and lastly reflects on the substantive standards established by the ’05 Company Law.

6.2.1

Defining Controlling Shareholder

Art. 217(2) of the ’05 Company Law defines a controlling shareholder as a person who either owns more than 50% of the outstanding shares of the company, or has significant influence on the resolutions of the shareholder meeting because of his voting power. According to this definition, the new law

928

The CSRC rules apply to listed companies only.

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acknowledges both de jure control and de facto control by shareholders.929 However, as to what would qualify a shareholder as having “significant influence”—which is a rather broad and vague expression—on shareholder meeting resolutions, the ’05 Company Law gives no further explanation. Apart from the concept of “controlling shareholder” as defined in the Company Law, “control” is another often-seen concept that has been defined by several other regulatory documents. In “Accounting Standards for Enterprise No.36: Disclosure of Related Parties” (“Accounting Standards No.36”) issued by the Ministry of Finance, control is defined as “having the power to decide a company’s financial and business policy.”930 In the CSRC’s “Regulation of Take-over of Listed Companies” (“Take-over Regulations”),931 the Commission provides that, besides owning over 50% of the company shares or having significant influence on the shareholder meeting resolutions, either the ability to vote on more than 30% of the company’s shares or the ability to elect more than half of the board of directors, would also qualify an investor as “having control of a listed company”.932 Both provisions from the two agencies have been taken by the Shenzhen Stock Market into its Listing Rules to form its own definition of control.933 In practice, these definitions of control may be used by judges as references when deciding whether or not a given shareholder is a controlling shareholder.934 However, it should be noted that none of the definitions given by the Ministry of Finance, the CSRC and the Shenzhen Stock Market is an authoritative interpretation of the definition of controlling shareholder in the 929

Shi, J.Z. (2006), pp. 483-84. Because Chinese does not differentiate single or plural nouns, the law itself is not clear as to whether joint control is possible. As a practical matter, joint control is recognized, although statistics show that it is very rare that a listed company is under joint control. (In 2007, among the 862 companies listed in the Shanghai Stock market, only 3 are jointly controlled. See Liu (2008).) 930 Art. 3. 931 “Shangshigongsi Shougou Guanli Banfa” (2008) 932 Art. 84. 933 Shenzhen Stock Market Listing Rules 18.1(7): “Control means having the power to decide a company’s financial and business policy, and thus allows the person to profit from the company’s business activities. Meeting one of the following situations will be considered as having control over a listed company: (i) owning over 50% of the company stock; (ii) being able to actually dominate over 30% of the company stock; (iii) being able to decide over half of the board members because of the shares controlled; (iv) having significant influence over shareholder meeting resolutions because of the shares controlled; and, (v) other situations provided by the SEC or this Stock Market.” 934 Shi, J.Z. (2006), p. 485. See also Xi (2006), p. 54.

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Company Law.935 Further, these definitions coming from different regulatory agencies are not exactly consistent with each other, which means while they may give some useful guidance, they also bring inconsistencies into judicial practice. Therefore, a judicial interpretation of de facto control by the Supreme People’s Court is still much needed for the judges to apply the definition of controlling shareholder given in Art.217(2) consistently in practice.

6.2.2

Art. 20: Prohibition of Abuse of Shareholder Rights

Art. 20 of the ’05 Company Law reads as follows: “The shareholders of a company shall exercise their shareholders’ rights in compliance with laws, administrative rules and regulations as well as the articles of association of the company, shall not abuse their shareholders’ rights to injure the interests of the company or other shareholders, or take advantage of the company’s independent status or the limited liability of shareholders to injure the interests of the company’s creditors. Where the abuse of shareholders’ rights causes any loss to the company or other shareholders, such abusive shareholder shall be liable for compensation in accordance with the law.”

The General Principle against Abuse of Rights The duty provided in Art.20, i.e., no abuse of shareholder rights, applies equally to controlling and non-controlling shareholders. It is the application of the basic legal principle that “no right shall be abused” in the company law.936 The prohibition of abuse of right is seen as an implied element of the principle of good faith.937 However, there is no exact definition for “abuse of right” in law. Traditionally, abuse of right was interpreted as an exercise of right 935

These regulations are not only at a lower authoritative rank compared to the Company Law, but also, strictly speaking, only applicable to the specific situations subject to the regulation. Also, the Company Law does not give any of the agencies the power to further interpret its definition. 936 Constitution Art 51; General Principles of Civil Law, Art. 7. 937 Ma (1998), p. 65. The Chinese term for the principle of good faith, when translated literally, is called the principle of “honest and trustworthiness”. See Xu & Liang (2002).

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with subjective bad faith to damage the interest of the other party.938 The theory that receives more recent acceptance among Chinese scholars gives more weight to the objective aspect of the conduct and reads the principle as prohibiting an exercise of a right which runs against the purpose of the right.939 The Theory of Common-Benefit Rights Unfortunately, the company law is silent on what is the purpose of shareholders’ rights. There is neither an explicit requirement in the law that the shareholders’ rights should be exercised for the interest of the company, nor any admission that such rights can be exercised purely for individual shareholders’ own benefit. The answer to the question given by the scholars is that, shareholders’ rights can be divided into private-benefit rights (“ziyi quan”) and common-benefit rights (“gongyi quan”).940 The former are the rights to receive economic benefits, which are purely for the private benefit of the individual shareholders. By contrast, the latter are the rights to manage and control the company,941 among which the most important is the voting right.942 Since common-benefit rights are concerned with protecting the interest of the company and shareholders as a class, they should be exercised “not only for the individual shareholder, but also for the benefit of the company.”943 Moreover, it is generally accepted that when there is a conflict of interest between the shareholder and the company, the company’s interest has priority over the shareholder’s interest.944 938

Liu, J. (2004), p. 516. As Liu Junhai has observed, such an interpretation would only provide very limited protection to minority shareholders, because in most cases, the abusing shareholder is aiming at benefiting himself rather than hurting the company or his fellow shareholders. (Liu, J. (2004), p. 516.) 939 Liu, J. (2004), p. 517. Liu observes that, following this approach, it is actually more appropriate to call it “abuse of power” rather than “abuse of right” (Id., p. 517). 940 Jiang & Kong (1994), pp. 72-73; Shi, T. (2006), pp. 239-40; Liu, J. (2004), pp. 53-54. 941 There is actually no clear-cut division between private-benefit rights and common-benefit rights, because common-benefit rights are necessary means for the realization of private-benefit rights. A typical example is the right to information: it is considered as both a common-benefit right and a private-benefit right. See Pang (2007), p. 52; Pei (2007), p. 85. 942 Other common-benefit rights include the right to information, the right to sue derivatively, etc. Shi, T. (2006), p. 240; Liu, J. (2004), p. 54. While other common-benefit rights might also be abused (see, e.g., Shi, T. (2006), pp. 248-52 for a discussion on abuse of the right to information), voting right is the one that mostly pertinent to controlling shareholder opportunism. The discussion below will focus on voting right. 943 Liu, J. (2004), p. 54, 252. See also, Liang (2005), p. 12. 944 Zhang (2009), p. 177. For instance, Shi Tiantao asserts in his “Corporation Law” that all the

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The theoretical interpretation of the purpose of common-benefit rights provides some useful guidance for identifying abuses of shareholder rights under Art. 20.945 For instance, if a shareholder’s vote has caused the company to drop a meritorious lawsuit against himself, according to this theory, it would go against the purpose of shareholders’ voting rights because it benefits himself while causing injury to the interest of the company, and thus constitutes an abuse of the right. However, as the two cases discussed hereunder will show, some critical questions are yet to be answered by the common-benefit rights theory.946 Yijinyuhui v. Liu Xu (“Yijinyuhui”)947 In Yijinyuhui, the plaintiff is a 31% shareholder of the company, Rising Technology Corp. (“Rising Tech.”), and the four other shareholders who are named as defendants jointly owned the other 69%. Rising Tech. is one of the earliest and most successful companies in the area of developing antivirus software in China. However, dispute arose between the plaintiff and the rest of the shareholders in 2003. The plaintiff resigned from the company and started his own two years later. In 2004, the defendants, as investors, set up Rising International Software, Ltd., and Rising Tech. licensed it the brand-name “Rising”. In 2006, the defendants set up another company named Rising Information Technology, Ltd., to which the brand name “Rising”, together with the domain name of Rising Tech.’s business website, was transferred.948 In 2008, Rising Tech. held a shareholder meeting and adopted a resolution to common-benefit rights should be exercised for the interest of all shareholders and only indirectly for the individual shareholders’ private interest. (Shi, T. (2006), p. 240) Comparably, Ding Maozhong submits that the exercise of voting rights should be beneficial, or at least not detrimental, to the interest of the company. (Ding (2006)) See also, Liu, J. (2004), p. 527 (when deciding how to conduct the company’s business, the controlling shareholder must give the interest of the company the highest priority.) For a minority opinion, see Qian (2006). (Qian argues that under current Chinese company law, interested shareholders can vote for their self-interest.) 945 It should be noticed that the common-benefit rights theory is purely academic and its practical value is still questionable. Chinalawinfo, one of China’s largest legal databases, collects 3,710 cases under the topic “company related cases” up to May 2011, among which only four have mentioned the term “common-benefit right” in their decisions, and none of the four is about abuse of common-benefit rights. 946 The first case involves a public company; the second is a close company case. The reasoning of the judges, however, is not limited to any specific type of company. 947 Beijing Yijinyuhui Technology Investment Corp. v. Liu Xu, (2009) YiZhongMinZhongZi No. 7749. 948 Plaintiff brought a separate litigation for these related transactions against the defendants, of which the result is yet unknown.

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change the name of the company into Yijinyuhui Technology Investment Corp., and change the company’s main business from developing anti-virus software to investment. Plaintiff voted against the resolution and then brought the suit to nullify the shareholder meeting resolution, claiming that the resolution was adopted by an abuse of shareholder rights by the defendants.949 The trial court upheld plaintiff’s claim and pointed out that the resolution both injured the interest of the company and the interest of the plaintiff as a shareholder. The court found that Rising Tech. is profiting in its current business with well known reputation in the market. No evidence could show that changing to investment will bring more profit to the company and giving up a profiting main business is detrimental to the company. Furthermore, the court noticed that the resolution was adopted without any assessment of the market or profitability of the future project, and it will benefit the majority but harm the dissenting minority shareholder. Therefore, the court found it violated the principle of equality of shareholders as well as the principle of good faith and held that the resolution was void. When it went to appeal, the decision of the trial court was overruled by the appellate court. The appellate court emphasized the fact that when the trust among the shareholders has failed, it is a reasonable choice for the company to choose to withdraw from the conflicted business, and it is not for the court to tell which is a more profitable business for the company or whether the interest of the company will be injured by changing its main business. The court also asserted that when the interest of the shareholders are no longer aligned and they disagree as to how the company’s business should be conducted, the majority rule should be followed. The dissenting minority may choose to sell or to have the company buy back his shares as provided in the company law, but has no right to say that he is not bound by the majority rule. Dong Li v. Zhida Ltd. (“Zhida”)950 949

Art.22 of the ’05 Company Law provides that any resolution of the shareholder meeting that violates the law is void. This action was brought under Art. 22 to nullify the resolution (because it violates Art.20). 950 (2008)HuErZhongMinSan(Shang)Zhong No.238. See Fan, L. (2009).

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In Zhida, the plaintiff, Dong Li, and the defendant, Zhida Ltd., were the two original shareholders of Taifu Ltd. Taifu had a registered capital of RMB 21 Million, among which the plaintiff contributed RMB 3.15 Million and held 15% of the shares. In 2005, Taifu held a shareholder meeting and adopted a resolution to increase the capital of the company to RMB 50 Million. According to the resolution, Zhida would re-invest RMB 19 Million into the company, and a third party investor, Chuangli Co., would invest RMB 10 Million.951 The new issue was done proportionally to the registered capital;952 as a result, Zhida held 73.7% of the company’s shares after the additional issue, Chuangli held 20% and the plaintiff’s shareholding dropped to 6.3%. Plaintiff brought a law suit to challenge the resolution, claiming that the new issuance was done in bad faith and diluted his interest in the company.953 The trial court, based on an evaluation of Taifu’s net assets at the time of the new issue, held that Zhida had abused its shareholder rights and had to compensate the plaintiff for his loss.954 While the case was settled on appeal, Fan Lihong, a judge of the appellate court, endorsed the trial court judge’s holding in an article he wrote one year later.955 Judge Fan admitted that when an additional issuance has a justifiable business purpose, it does not necessarily violate the minority shareholder’s right even if it has a concomitant effect of lowering the percentage of the minority shareholder’s shareholding, because of the waiving of his pre-emptive right by the minority shareholder.956 However, he found the new issue in this case to be an abuse of the majority rule because the price of the newly issued shares was unfair.957 Fan explained that, because the additional shares were issued at a price calculated on the basis of the registered capital—or, in other 951

Plaintiff waived his preemptive right. I.e., the company now has a registered capital of RMB 50 Million, of which the plaintiff, Zhida and Chuangli contributed 3.15, 36.85 and 10 Million respectively. 953 Although the challenged resolution was adopted before the ’05 Company Law came into force, according to a judicial interpretation given by the Supreme People’s Court, the new law is applicable. See “Provision on Several Issues in the Application of ‘Company Law of the People’s Republic of China’ (Part one)” (“Guanyu Shiyong ‘Zhonghua Renmin Gongheguo Gongsifa’ Ruogan Wenti de Guiding (1)”), Art. 2. 954 The amount of the compensation was around RMB 9 Million. 955 Fan, L. (2009), pp. 152-53.. 956 Id., p. 154. 957 Id. 952

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words, at the original issue price, it was lower than the net asset value per share at the time of the additional issue. Since the net asset value per share represents the undistributed profit of the company, of which the minority shareholder was entitled to a proportional share, when the majority shareholder and the new investor bought the new shares at the original issue price, the minority’s interest in the company was diluted. 958 The judge found that the new issuance constituted an abuse of shareholder rights because it injured other shareholder’s interest, and the plaintiff was entitled to compensation under Art. 20.959 Questions Unanswered about Art. 20 Although neither of the above two cases have explicitly based their reasoning on the common-benefit rights theory, both considered the issue whether the exercise of the voting right by the defendants was for the benefit of the company. As elaborated above, Art. 20, which is based on the general principle of good faith, prohibits abuses of shareholder rights that runs against the purpose of the rights. The common-benefit rights theory argues that the purpose of all common-benefit rights is to protect the interest of the company. Therefore, according to this theory, whether or not an exercise of a common-benefit right is for the benefit of the company is the key question for finding abuse of shareholder rights under Art.20. The importance of the question is well illustrated by the first case, Yijinyuhui: basically, both the trial court and the appellate court based their holdings on their answers to the question that whether changing the name and the main business of the company was for the company’s interest. The trial court of Yijinyuhui found that giving up a profitable main business is detrimental to the company and thus held for the plaintiff; by contrast, the appellate court asserted that when the antivirus software market became too competitive, it is a reasonable choice for the company to withdraw from it and look for other opportunities, and thus held for the defendant. In Zhida, the second case, although Judge Fan found the new issue to be an abuse of right on the ground 958 959

Id., p. 152. Id., p. 155.

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that it violated the interest of the minority shareholder, he did comment that the additional issue might have been for the benefit of the company.960 A test such as “for the interest of the company” is not something new for the readers of this book. The similarity between the common-benefit rights theory and the Allen test 961 (i.e., the majority power to alter the articles of the company should be exercised “bona fide for the interest of the company as a whole”) in British law is apparent. Recall how the British jurists have been struggling to apply the Allen test ever since the test was first stated in Allen v. Gold Reefs,962 and it is not a surprise that Chinese judges find themselves facing no easy task when trying to answer the question posed by the common-benefit rights theory. Indeed, in the first case, to the same set of facts, the two courts reached two opposite conclusions; and in the second case, Judge Fan never gave a conclusive answer to the question but instead had to rely on the violation of other shareholders’ interest as the basis for his opinion. The British experience shows that the difficulty of applying the Allen test lies in two aspects: how to define the “interest of the company” and whether the test is a subjective test or an objective test.963 These two questions are equally present here, and, unfortunately, no satisfactory answer can be found in Chinese company law or jurisprudence. First of all, the “interest of the company” is a concept that is frequently used by Chinese scholars and judges, yet never clearly defined anywhere in law or in academic research.964 Some scholars have equalized it with the interest of the whole shareholder group. 965 While this interpretation is not in itself inappropriate,966 as have been evidenced by both British case law and the two cases cited above, it does not help much when there is a conflict of interest within the shareholder group.

960

The judge noticed that the company was in no need of cash at the moment, but did not think that was enough to negate the possibility of a justifiable business purpose of the re-issue. 961 See Sec. 5.3.1. 962 [1900] 1 Ch. 656, CA 963 See Sec. 5.3.1 964 Deng (2009), pp. 84-85. 965 Shi, T. (2006), p. 240. See also Lin (2001), p. 48. 966 See Sec. 3.1.2 n.19 and accompanying text.

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Second, the issue of defining the “interest of the company” is actually closely related with the issue whether this “for the interest of the company” test under the common-benefit rights theory is an objective or a subjective test. British case law has interpreted that when applying the Allen test, “bona fide” and “for the benefit of the company” should not be treated as two distinctive issues, which means that the Allen test is a predominantly subjective test.967 By comparison, direct discussion of this issue is yet to be seen in China. According to the appellate court’s holding in Yijinyuhui and Judge Fan’s comment on Zhida, it can be argued that these Chinese judges find it necessary for the majority’s decision to have some reasonable ground to sustain the plaintiff’s challenge, i.e., there are some objective element in the test. However, the agreement only goes as far as to this point. Once some reasonable ground can be found for the majority’s decision, the appellate court of Yijinyuhui asserts that the majority is free to cast its vote, and it is not for the court to decide which business is better for the company. By contrast, Judge Fan commented that the majority shareholder cannot invoke “business judgment rule”

968

to protect himself when the decision discriminates minority

shareholders.969 Fan’s opinion is more consistent with the trial court’s holding in Yijinyuhui: when the resolution benefited the defendant but harmed the dissenting minority, the voting by the defendant was in bad faith.970 This line of reasoning has been adopted by some scholars as well, and has become the majority opinion among Chinese jurists. For instance, Liu Junhai asserts that when the decision is for the benefit of the company but will cause damage to minority shareholders, such detriment cannot be discriminative; in other words, unless the majority also suffers a proportional damage, the decision will be an abuse of right.971 967

See Sec. 5.3.1. Chinese company law does not have a business judgment rule. However, due to the wide-acknowledged importance of the rule, it is not rare for a Chinese jurist to use the term in academic discussions or even in judicial opinions. See, e.g., Shi, T. (2006), pp. 403-08; see also Meng (2006), generally on the business judgment rule and Chinese company law. 969 Fan (2009), p. 154. 970 Strictly speaking, in Yijinyuhui, the trial court found the decision was detrimental both to the company and the minority shareholder, while in Zhida, the damage was done directly to the minority shareholder’s interest. However, in both cases the majority was benefited by the resolution. 971 Liu, J. (2004), p. 528. 968

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Comparably, Qian Yulin lists change of main business of the company to avoid competition with another company controlled by the controlling shareholder as a typical case of abuse of shareholder rights.972 The statute provides a strong support for this “no discrimination” proposition as well. Art. 20 prohibits abuse of shareholder rights which injures the interest of the company “or” other shareholders. As the trial court of Yijinyuhui has correctly pointed out, when the resolution benefits the majority in a way that the minority cannot share, it violates the principle of shareholder equality.973 If the benefit is something the minority was originally entitled to, such as the company’s profitability in the antivirus software market in Yijinyuhui, or the undistributed profit in Zhida, the resolution depriving the minority shareholder of it, violates minority shareholders’ interest, and should constitute abuse of right under Art.20 whether or not the resolution injures the interest of the company. To sum up, although there are no definite answers as to what constitute abuse of shareholder rights under Art. 20, the common-benefit rights theory is widely acknowledged by Chinese scholars. The theory has also been applied by judges in practice, albeit only in a few cases and sometimes only implicitly. It is arguable, from the scholars’ works and the cases available, that up to date the majority opinion in China is that, first, if there is no reasonable ground to believe the exercise of a shareholder’s right is for the benefit of the company—which means the interest of shareholders as a group—then it would be an abuse of the right; and second, even if such a reasonable ground can be found, majority shareholders cannot adopt a resolution which allows themselves to be benefited while discriminating the minority shareholders.

6.2.3 Art. 21: Prohibition of Unfair Related Transactions Art. 21 of the ’05 Company Law provides that: 972

Qian (2005), p. 254. The judge did not explicitly explain the relationship between the principle of shareholder equality and Art. 20. However, it is arguable that, since the common-benefit rights are granted for the management and control of the company and shareholder equality is one of the basic principles of shareholder control, violating shareholder equality goes against the purpose of granting common-benefit rights. 973

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“The controlling shareholders, actual controllers, directors, supervisors or senior officers of a company shall not injure the interests of the company by taking advantage of their affiliation relationship with the company and, where any losses are incurred in violation hereof, shall be liable to compensate the company.”

“Affiliation relationship”, as defined in Art.217(4), means the connection between a company and its controlling shareholders, actual controllers,974 directors, supervisors975 and senior officers in which the company is controlled by them, directly or indirectly, or “any other kinds of relationships that are likely to cause diversion of the company’s interests.”976 A Fairness Standard Art. 21 is designed to regulate related party transactions.977 As Shi Tiantao has submitted, since Art. 21 only prohibits using affiliated relationships to injure the interest of the company, the law does not prohibit related party transactions per se.978 Although the article does not use the term “fair” explicitly, it is generally accepted by Chinese scholars and judges that a related transaction should be fair, otherwise it violates Art. 21. 979 The CSRC’s “Code of Corporate Governance for Listed Companies” requires that the price for related transactions “as a principle, should not deviate from the price when transacting with an independent third party”.980 In practice, comparative market price981 or evaluation from a qualified agency982 may be used as evidence of fairness of 974

Actual controllers are defined in Art. 217(3) as people who are not shareholders but have de facto control over corporate actions because of their investment relationships, agreements or other arrangements with the company. 975 China has a two-tier board system. See Li, X. (2007), p. 245. 976 Art. 217(4) also provides that state controlled companies are not considered as having an affiliation relationship just because they are controlled by the state. 977 Shi & Du (2007), p. 126. See also Shi, J.Z. (2006), pp. 43-46. 978 Id., p. 129. 979 See Dong & Chen (2009), Shi, J. (2009). 980 “Shangshi Gongsi Zhili Zhunze”, Art. 13. 981 See, for instance, in Ningbo Lianying Engineering Plastics and Hardware Ltd. Co. v. Zheng Shude ([2006]YongMinSiChu No.212), the company bought material from another company controlled by the defendant-director, the price offered by a competing supplier was used to show that the price of the related transaction was not fair. 982 See Jiang Wenhong v. Wu Jinhui ([2008]HuErZhongMinWu(Shang)Chu No.21); see Huangshan

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the transaction. It has also been suggested that the concept of “fair value”, which has been used for accounting purpose and refers to the price that two informed and unrelated parties dealing under fair conditions may agree upon, should be introduced as the standard for assessing fairness of related transactions.983 Applying Art. 21 to Indirect Related Transactions Apart from regulating contractual relationships with related parties, Shi Tiantao observes that Art. 21 also catches another type of related transactions, which he terms “indirect related transactions”—such as appropriation of corporate opportunities—as contrasted to “direct related transactions”, i.e., contractual relationships such as sales, loans or surety transactions.984 The ’05 Company Law considers two types of indirect related transactions, namely, appropriation of corporate opportunities and competing with the company,985 in Art.149(5), which provides that directors and senior managers of a company cannot engage in these activities without approval of the shareholder meeting. Controlling shareholders, however, are not subject to this article. Many scholars have commented that it is inappropriate for Art.149(5) to limit its application only to directors and senior managers, and suggest that the prohibition on appropriation of corporate opportunities and competing with the company should be applicable to controlling shareholders as well.986 However, the law neither gives definition of corporate opportunity in the controlling shareholder context,987 nor explains whether or how a controlling shareholder should avoid competition with the company. Therefore, under current law, as Xiyuan Zhiye Ltd. v. Zhu Jianhong ([2008]HangMinErChu No.95) for an example that the evaluation was rejected by the court because the evaluator was not a qualified institute. 983 Shi, J. (2009), p. 390. Fair value can be used as a measurement standard in accounting, see “The Accounting Standards for Enterprise—Basic Standards” (“Qiye Kuaiji Zhunze—Jiben Zhunze”) Art. 42(5). Using fair value as measurement in accounting has to meet certain conditions, see, e.g., “The Accounting Standards for Enterprise No.3—Investment Real Estates” (“Qiye Kuaiji Zhunze di 3 hao—Touzixing Fangdichan”) Art. 10 (“Where any well-established evidence shows that the fair value of an investment real estate can be continuously and reliably obtained, a follow-up measurement may be made to the investment real estate through the fair value method.”) 984 Shi & Du (2007), pp. 127-28. 985 Shi & Du (2007), p. 128. 986 See Feng (2010), p. 106; Li, L. (2009), p. 94; Xi (2005); Jin & Li (2006), p. 84. 987 Actually the law gives no definition to corporate opportunity at all, whether in the director context or the controlling shareholder context.

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Shi Tiantao has observed, if a controlling shareholder takes a certain business opportunity or competes with the company, there is no way to judge whether or not the interest of the company is injured. Shi therefore holds the opinion that the article is “only a declaration of the existence of sickness but fails to give a script”.988 Unfortunately, the academic studies are also less than helpful in this area. Up to date, the discussions on the doctrine of corporate opportunity are all done in the director context,989 and no attention has been paid to the specialty of the issue in a controlling shareholder context. 990 As for competing with the company, the majority opinion of Chinese jurists is that controlling shareholders, like directors, should not compete with the company.991 This proposition has also been accepted by the CSRC, which provides that controlling shareholders of a listed company should not operate in a same or similar business as the listed company.992 However, considering the fact that in group companies, parent and subsidiary companies are often in the same line of business, such a per se prohibition is likely to be both unpractical and inefficient.993 Therefore, although theoretically Art. 21 applies equally to indirect controlling shareholder-related transactions, the law needs more refinements to be in actual use in practice.994 For one thing, a proper definition of ‘corporate opportunity’ in the controlling shareholder context is essential, so that once an opportunities is clearly identified as belonging to the company, taking it without fair compensation would naturally damage the interest of the company and thus liability is incurred under Art. 21. For another, instead of using an 988

Shi & Du (2007), p. 133. see, e.g., Shi, T. (2006), pp. 425-29, “corporate opportunities are business opportunities which related to the interest of the company”. See Feng (2010) for a survey on Chinese thinking on corporate opportunity. 990 Cmp. Sec. 4.5.2. (Delaware courts usually need more evidence in the parent-subsidiary context—as compared to the director context—to be persuaded that a particular opportunity is a corporate opportunity that belongs to the subsidiary.) 991 Xi (2005); Jin & Li (2006), p. 84. 992 “Code on Corporate Governance of Listed Companies”, Art.27. (The prohibition applies to other enterprises controlled by the controlling shareholder as well.) However, since there is no provision as to liability for violating this rule, the CRSC provision is actually not enforceable in practice. 993 See Sec. 4.5.2. 994 So far no case is available in this area at all. 989

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outright ban, the rule on competing with the company should reach a balance between the interest of the company and the controlling shareholder.995 In this regard, what the Delaware Supreme Court has done in Sinclair Oil v. Levien,996 that is, to deal the conflict of interest between the parent and subsidiary caused by running the same line of business under the doctrine of corporate opportunity, seems to be a more efficient solution. 997 Actually, Chinese scholars do recognize that the doctrine of corporate opportunity and the duty of non-competing overlap with each other.998 Xi Longsheng has submitted that relying on the doctrine of corporate opportunity might be a better way to regulate the conflict between controlling shareholders and the company.999 Should this proposition be accepted by the legislator,1000 Art. 21 would form a clearer and more coherent fairness standard for both types of related transactions, i.e., whenever a controlling shareholder takes something that belongs to the company, a fair compensation must be provided.

6.2.4 The Substantive Standard Standard Established in 05 Company Law Whether Art. 20 and 21 together establish a uniform standard for controlling shareholder’s conduct is a question with no readily available answer. As can be seen from the discussion above, the two articles are based on different principles and are targeting different types of conducts. Besides, there are still uncertainties as to how to apply the articles. Art. 21 prohibits appropriation of company assets through related transactions, either directly or indirectly. 1001 When a transfer of company 995

This includes the interest of the controlling shareholder’s shareholders, if the controlling shareholder is a parent company. 996 280 A.2d 717. 997 In Sinclair, the judge held that for the subsidiary to claim that the opportunity belongs to it, the subsidiary has to prove either the opportunity came to the subsidiary independently, or the subsidiary has a unique need or ability to develop the opportunity. See Sec. 4.5.2. 998 See Xi (2005), pp. 128-29; Li, L. (2009), pp. 96-97. 999 Xi (2005), p. 129. 1000 Or by the Supreme People’s Court in the form of judiciary interpretation. 1001 Admittedly, there are uncertainties as to how to apply this article to indirect related transactions, see above. However, in theory, the applicability to indirect transaction is no different from direct transactions.

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assets is done through a related transaction, Art. 21 requires a fair price to be paid. Unlike the US or the UK, Chinese company law has never gone through a stage that bans related transactions per se. Instead, the late-starter’s advantage allows China to directly adopt a more efficient approach to deal with the agency problem in related transactions, i.e., using a standard-based strategy to achieve the balance between allowing efficient transactions to go through and screening out opportunistic agent conduct.1002 By comparison, Art. 20, which prohibits abuse of shareholder rights, is an article that has more uncertainties because of the lack of a clear definition both to the purpose of shareholder rights and the company’s interests in law. However, the common-benefit rights theory, which is generally accepted by scholars and has been applied by some judges in practice, provides some plausible answers to these questions. According to the theory, voting rights should be exercised for the interest of company in good faith, which requires there to be some reasonable ground for the shareholders’ decision. 1003 Meanwhile, although not always being consistent, in practice judges tend to overrule the resolutions that discriminate the dissenting minority shareholders because these violate the principle of shareholder equality.1004 Interesting enough, while Art. 21 sets essentially the same standard as the fair price prong of the entire fairness standard in the US,1005 Art. 20—at least when interpreted according to the majority opinion—bears a fair degree of similarity with the common law rules on alteration of the article of the company by majority shareholders in the UK.1006 As has been analyzed in Chapter 5, the substantive standards for controlling shareholders conduct in the UK law and the US law are essentially the same, that is, no unproportional 1002

See Sec.3.1.3. Again, unlike in the UK, which uses different doctrines to regulate the voting on different matters, this principle applies to all exercises of common-benefit rights equally. 1004 The Zhida case and the trial court’s opinion for the Yijinyuhui case are more aligned in this regard, however, the latter’s proposition did not get the endorsement from the appellate court. See Sec. 6.2.2. 1005 See Sec. 4.3.1. 1006 See Sec. 5.3.1. (The Allen test requires the power to alter the articles of the company should be exercised bona fide for the benefit of the company. The landmark case Shuttleworth holds that if no reasonable man could consider the alteration is for the benefit of the company, the resolution fails the Allen test; while Greenhalgh holds that the resolution cannot discriminate between the majority and minority so as to give the majority an advantage of which the minority is deprived.) 1003

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distribution of company assets to controlling shareholders.1007 Therefore, the seemingly unconnected Art. 20 and 21 in the ’05 Company Law of China may very much achieve the same effect—at least when Art. 20 is applied consistently in accordance with the majority opinion among Chinese scholars. This also suggests that, although due to the difference in legal traditions, jurists rely on different legal principles to establish substantive standards for controlling shareholders’ conduct,1008 such difference does not result in any substantial difference with regard to the substantive standard itself. Nevertheless, it should be admitted that the standards established in the ’05 Company Law are much less clearly defined, especially concerning Art. 20, which has caused—and will keep on doing so—inconsistencies in practice until it is clarified by an authoritative interpretation from the Supreme Court.1009 Further, it should be kept in mind that establishing the substantive standard is only the first step of a standard-based strategy. Saying that China has basically the same substantive standard for controlling shareholders as the US and the UK does not mean that China has “basically the same” standard strategy as the other two jurisdictions: on the contrary, as will be shown by the discussion below, China still has a long way to go before it can say its standard-based strategy is as effective and efficient.

§6.3

Enforcing the Standard through Judicial Review

6.3.1 Shareholder Litigation under 05 Company Law The ’05 Company Law allows minority shareholders to sue controlling shareholders both directly and derivatively. As has been discussed above, Art. 20 prohibits abuse of shareholder rights which causes damage to the interest of the company or other shareholders, and the wrongdoing shareholder is liable to compensate any damage so caused. Therefore, if it is the minority shareholder 1007

See sec 5.5. See also Sec. 5.3.2.2 (“bona fide for the interest of the company” and “fraud on the minority” are actually twin concept.) 1008 E.g., good faith in China and fiduciary duty in the US. 1009 Such as the appellate court’s decision on Yijinyuhui. Art.21 also misses the fair dealing prong. However, the procedural facet does not change the substantive standard.

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who suffered the damage, he can bring a direct law suit based on this provision; if it is the company who suffered damage, however, a minority shareholder can only sue derivatively.1010 Derivative action is a new mechanism for minority shareholder protection introduced by the ’05 Company Law.1011 In Art. 152, it is provided that when directors and senior managers of the company violate laws, administrative regulations, or the articles of the company while discharging their duty and cause damage to the company, a shareholder who holds (or shareholders who jointly hold) 1% of the company’s outstanding shares has the right to initiate a derivative action.1012 In Para. 3 of the article, it gives shareholders the right to sue derivatively any “other party” who has injured the interest of the company. While the law does not define which people fall into these “other parties”, it is generally agreed that the paragraph applies to controlling shareholders.1013 Therefore, if a controlling shareholder abuses his right and causes injury to the interest of the company, a minority shareholder is entitled to sue derivatively. Similarly, Art. 21 prohibits using affiliation relationships to injure the company, and violation of it would also give a cause of action for minority shareholders to sue the wrongdoing controlling shareholders derivatively. In addition, Art. 22 of the ’05 Company Law grants shareholders the right to sue under a special type of situation. Art. 22 para 1 provides that if the content of a resolution of a shareholder meeting or the board of directors violates law or administrative regulations, the resolution is void. Therefore, if a resolution was adopted by the shareholder meeting through an abuse of voting rights by the controlling shareholder, it would be void according to Art.22 since it violates Art. 20; and minority shareholders are entitled to bring a law suit to nullify it. 1014 This is a statutory litigation which goes parallel with direct and

1010

Li, X. (2007), p. 280. (Reflective loss should not be considered as being included by the term “interests of the shareholder” in this article; therefore, should not suffice to grant a shareholder the right to sue directly.) 1011 Shi, J.Z. (2006), p. 340. For a general discussion on the development of derivative actions in China, See Li, X. (2007), pp. 266-72. 1012 Art.152 also provides for a preceding procedure. See Sec. 6.3.2. 1013 Cai (2007), p. 158; Liu, K. (2008), p. 160. 1014 Fan (2009), p. 155; Qian (2007), p. 78.

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derivative actions.1015 However, since the remedy under Art. 22 is limited to nullification of the resolution, if the shareholder wants to get compensation, he still has to bring a derivative action or direct action under Art. 20, 21, or 152.1016

6.3.2 Applicability of Judicial Review: Balancing the Cost and Benefit of Review As elaborated in previous chapters, an efficient enforcement system should carefully balance the benefit and cost of using judicial review to interfere with the company’s decision making system. Such balance can be seen in the type of cases that get their day in court and the relationships between enforcing the standards through judicial review and the use of other strategies.1017 In China, however, the topic has received very little attention and the law is hardly developed in this area. Missing the Importance of Conflict of Interests The experience of both the UK and the US suggest that judicial review should focus on cases that involve a strong conflict of interest between the agent and the principal.1018 Using Delaware law as an example, the emphasis on conflict of interest can be seen in both the business judgment rule and the demand rule.1019 That is to say, unless the decision makers of the company become unreliable because of the conflict of interest—either for a business decision or a decision on the litigation—the court will respect their authority and will not step in to review the substantive merit of their decision.1020 By contrast, as the following analysis will show, conflict of interest is not a factor that has been taken into consideration by either the legislator or the court in China.

1015 1016 1017 1018 1019 1020

Li, X. (2007), p. 279. Li, X. (2007), p. 279. See sec. 3.2.1.3, 3.2.2. See sec. 3.2.1.2; 4.4.4; 5.5. See sec. 3.2.1.2; 3.2.2. Id.

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First or all, the most noticeable thing is that there is no business judgment rule or any comparable rule in Chinese company law.1021 Art. 152 gives a shareholder the right to sue directors derivatively if they breach their duties. The law does not consider whether the breach is a breach of the duty of loyalty or the duty of care. The same article allows individual shareholders to sue any other party derivatively, including controlling shareholders, if that other party causes damage to the interest of the company. This means that there is no requirement that the controlling shareholder benefited from the challenged conduct or has a possibility to be benefited in order for the case to be reviewable by the court. Consequently, even if the controlling shareholder has made a poor business decision—such as an unsuccessful investment choice or a losing contract with a third party—and suffered loss in the same way as the minority shareholders, he might still be sued since, objectively, the company suffered a loss.1022 This apparently goes against the principle that judicial review should only interfere when there is a high risk of agent opportunism, which, in the context of “controlling v. minority shareholders”, means that there is a possibility for the controlling shareholders to extract an unproportional benefit from the company.1023 The same problem exists with the preceding procedure, i.e., the demand requirement provided in Art. 152.1024 As stipulated in the article, a written 1021

See Li, X. (2007), pp. 286-88. See Huangshan Xiyuan Zhiye Ltd. v. Zhu Jianhong (([2008]HangMinErChu No.95)) for an example in which the minority is suing the controlling shareholder for selling company assets to an unrelated third party for allegedly under-price. The court reviewed the substantive merit of the case and rejected the plaintiff’s claim on the base that the price was fair. 1023 See sec. 2.1.4. 1024 Article 152: “Where a director or senior officer [causes detriment to the company while performing his duties in violation of laws, administrative regulations or the articles of association], the shareholders of a limited liability company or a joint stock limited company that individually or jointly hold one percent (1%) of the total shares for consecutive 180 days may request in writing the board of supervisors or the supervisors of a limited liability company without a board of supervisors to file suit before a people’s court. Where a supervisor is involved in the circumstance [...], aforesaid shareholders may request in writing the board of directors or the executive director of a limited liability company without a board of directors to file suit before a people’s court.   Where the board of supervisors or the supervisors of a limited liability company without a board of supervisors, or the board of directors or the executive director refuses to file suit after receipt of the written request mentioned above, or does not file suit within thirty days of the receipt of the same, or comes across an emergency where, if no immediate actions are taken, the company’ s interests shall be incurably impaired, then the shareholders may, for the interest of the company and on their own behalf, directly file suit before a people’s court.   Where the company’s legal rights and interests are violated by others and in the event of any losses 1022

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request to initiate a legal action against the wrongdoing directors or senior managers should first be submitted to the supervisory board, or, if the wrongdoer is a supervisor, the request should be submitted to the board of directors.1025 Shareholders can sue in their own names if the request is rejected by the organ of the company in charge of the affair, or, the organ failed to take action within 30 days after receiving the request, or, there is an urgent circumstance under which delay of initiation of the litigation will cause irreparable loss to the company. 1026 Requiring the use of internal remedy before bringing a derivative suit certainly shows the legislators’ effort to balance the company decision makers’ authority and accountability. 1027 However, the law allows a derivative litigation to go ahead if the demand was rejected by the organ in charge,1028 and pays no attention as to whether or not it is rejected by an interested organ.1029 Given that even a disinterested organ’s decision then cannot deter a derivative action, as commented by Li Xiaoning, the demand requirement in Art. 152 cannot effectively protect corporate efficiency.1030 Despite the obvious deficiency in the law, the practice in Chinese courts might actually be more promising. The concept of “business judgment” has been accepted not only by scholars, but also by judges.1031 Some judges have even expressed in their judicial opinion that the court should not interfere when facing a business judgment.1032 However, since there is no clearly elaborated rule in law, judges are actually acting on their own understanding as to what is business judgment, which inevitably results in inconsistency. Furthermore, the

incurred, the shareholders defined in the first preceding paragraph may file suit before a people’s court in accordance with the first two preceding paragraphs.” 1025 Art. 152, para.1. 1026 Art. 152, para. 2. 1027 Shi, J.Z. (2006), p. 342. 1028 Or the organ does not take action soon enough. 1029 Liu, K. (2008), p. 161. This also reflects the law neglects different strategies’ co-effects since disinterested directors are actually a trusteeship strategy. Further discussion see below. 1030 Li, X. (2007), p. 294. 1031 See supra n. 968 and accompanying text. 1032 Actually, both the appellate court of Yijinyuhui and Judge Fan concede that court should refrain from reviewing business judgments. (See Yijinyuhui; Fan (2009), at p. 154) See also Shi Pinchao v. Zhejiang Huanyu Construction Group Ltd., (2010)ZheShaoShangZhong No.265, in which the court claims that business judgments should not be reviewed by the court.

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importance of conflict of interest has not been fully appreciated by Chinese judges as well.1033 Judicial Review and Choice of Strategies The ’05 Company Law not only fails to distinguish the cases that involve a strong conflict of interest from those that do not when enforcing the standard-based strategy, but also fails to consider the effect of other co-existing strategies on the enforcement of the standard-based strategy. In particular, the new law does not reflect the trade-off between standard-based strategies and decision right strategies, which, as shown in previous chapters, is an essential element in balancing the cost and benefit of a standard-based strategy.1034 Decision right strategies have been used for various situations in the new company law. For instance, Art. 16 requires disinterested approval from shareholders if the company is to provide surety for its shareholders; Art.149 requires director related transactions to be approved by the shareholder meeting;1035 and Art. 125 requires that, in listed companies, directors cannot vote on related transactions. 1036 However, the provisions on shareholder litigation do not differentiate the situations where disinterested approval has been obtained from those that have not. A typical example is what has been discussed above: the law allows a minority shareholder to sue derivatively whenever his request on the company to bring the suit is rejected by the organ in charge, even if the deciding organ is independent from the wrongdoers.1037 This not only means that courts will interfere with the corporate decision making system even if there is a negligible conflict of interest between the decision maker and the company, but it also means that the use of a decision

1033

For instance, the appellate court of Yijinyuhui asserted that the decision to change the main business of the company was a business judgment despite of the apparent conflict of interest among shareholders. See Yijinyuhui. 1034 See sec. 3.2.1.3; 4.4.5.2; 5.6.3. 1035 Art. 149 (4), (5). 1036 A more detailed and systematic discussion on decision right strategies under ’05 Company Law, see below. 1037 Art. 152, para. 1, 2. (When the wrongdoer is a director or senior manager, the supervisory board is the deciding organ; when the wrongdoer is a supervisor, the board of directors is the deciding organ, See above.)

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right strategy does not deprive the minority shareholder of the right to sue. The result would very likely lead to a double check on the challenged conduct. Double checking controlling shareholders conducts’ is not necessarily an over-use of judicial review. Delaware judges also think that even if an independent committee has negotiated the transaction for the company with the controlling shareholder, the entire fairness review is still applicable. 1038 However, there is an important difference between the provisions in ’05 Company Law and the Delaware approach.1039 That is, when a disinterested approval has been obtained for a controlling shareholder-related transaction, the burden of proof shifts to the plaintiff if the transaction is challenged in court. 1040 Although this is not an absolute safe harbor for controlling shareholders, the rule does limit the use of judicial review when a decision right strategy has been followed and helps to strike a balance between the cost and benefit of judicial review. By contrast, the very general provisions in the ’05 Company Law gives no credit to the use of a decision right strategy, which will make the double check more costly than in the US. Given the total indifference of the ’05 Company Law towards conflict of interests and the effect of co-functioning strategies, an inevitable conclusion is that the Chinese legislature has yet to direct their attention to the problem of striking a balance of judicial review’s costs and benefits. 1041 The Chinese regulators still have much to learn about the mechanisms such as the business judgment rule or the burden shifting rule to cure the problem.

1038

See sec. 4.4.5.2. Actually there are two important differences. The other is that in Delaware directors are not subject to a double check (because a disinterested approval reinstates the business judgment rule), only controlling shareholders are (see sec. 4.4.5.2), while in China the double check is applied not only on the controlling shareholders, but also on the directors, senior managers and supervisors. However, the appropriateness of double checking directors’ conduct is beyond the scope of this book and will not be addressed here. 1040 See sec. 4.4.5.1. (The disinterested approval could be either from disinterested director or disinterested shareholders.) 1041 See Guo (2010), at p. 41 (the interest-balancing mechanism in current law is not well developed). 1039

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§6.4

Specific Situations in China

The efficiency of a regulatory strategy is dependent upon many elements: besides the design of the strategy itself, the general economic, cultural as well as political environments in which the strategy will be applied, and the quality of the parties involved in the process of application of the strategy, are all vital factors that determine the efficacy of the strategy. This section examines the specific situations in China that influence the effectiveness of the standard-based strategies; recommendations for improvement will be given accordingly in the next section. Sec. 6.4.1 will focus on the relevant players and Sec. 6.4.2 examines the most important alternative to standard-based strategies, namely, decision right strategies provided in Chinese law.

6.4.1 The Players Concentration of Share Ownership and Unbalanced Power of the Shareholder Meeting The introductory section mentioned that the company law of China is more pro-shareholders when compared to other jurisdictions.1042 The shareholders general meeting is regarded as the authoritative organ of the company and is given the central position in the corporate governance structure by law.1043 It is the highest authority of corporate power and its resolutions are the ultimate representation of the will of the company;1044 it also has wider authority in China when compared to other jurisdictions. 1045 Other organs of the company—the board of directors and the board of supervisors—are obliged to 1042

Shi, T. (2006), p. 305. ’05 Company Law, Art. 99 1044 The shareholder meeting is also called the highest decision-making organ (“zuigao yisi jueding jiguan”). Therefore, while in the daily businesses the company is represented by the board of directors and the board’s decision is seen as the will of the company, the final decision making power is in the hands of the shareholders at the shareholder meeting. See Li, X. (2007), pp. 244-45. 1045 Cao (2006), pp. 192-93. For comparison purposes, just consider the supervisory board in Germany. The supervisory board in China is different from the one in Germany, despite the similarity in form. The power to select directors lies with the shareholder meeting in China, but with the supervisory board in Germany. Similarly, the decision on significant affairs or conflicted transactions is within the shareholder meeting’s authority in China, and within the supervisory board’s in Germany. (See Cao(2006), p.196.) 1043

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carry out the shareholder meeting’s decisions and cannot run against its resolutions while discharging their duty.1046 As a result, despite that in theory the three organs of a company (i.e., the shareholder meeting, the board of directors and the supervisory board) are supposed to reach a balance of powers, 1047 the shareholder meeting actually has unchecked power in the company. Co-existing with this unchecked power structure is the fact that the shareholding in Chinese public companies is usually highly concentrated.1048 The largest shareholder very often has absolute or de facto control.1049 One direct consequence of such a share ownership structure is that the board of directors and the board of supervisors are often dependent, which further undermines the balance in the corporate governance structure.1050 The directors are often an agent of the controlling shareholders than the shareholders as a group, and their accountability to the company’s interests is doubtful. 1051 Therefore, when it comes to a controlling shareholder’s misconduct, the internal checking system in China is weak: the people who are supposed to protect the interest of the company and the minority shareholders against an opportunistic controlling shareholder1052 are very likely both unwilling and unable to do so.1053 The concentration of shareholding together with an unchecked power of the shareholder meeting implies that the major agency problem in Chinese companies is the conflict between the controlling shareholder and the minority 1046

Jiang (2003), p.167. Jiang (2003), p.140. 1048 Supra n. 919. 1049 Id. 1050 Because of the controlling position of the largest shareholder in most listed companies, both directors and supervisors are selected by the controlling shareholders, ( Cao (2006), p. 87) which damages their independence.( Id., p. 195. Many controlling shareholders are state-asset management institutions, which still have a strong administrative color. The directors and supervisors selected by them often have a quasi-administrative connection with the controlling shareholder, and are more likely to be dependent.) See also Li X. (2007), p. 262 (supervisors are either not independent from the controlling shareholder, or are not willing to criticize because of the fear of losing their job, or the Chinese culture.) 1051 Guo (2010), p. 42. 1052 The board of directors, if functioning properly, can provide a check on opportunistic behavior by controlling shareholders. See Kraakman et al. (2009), p. 14. 1053 Shi, T. (2006), p. 308. (The biggest problem in China’ corporate governance in public companies is the concentration of shareholding and lack of effective internal constraining mechanism.) 1047

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shareholders;1054

and since the internal mechanism of checking controlling

power is weak, an outside check becomes more important when compared to other jurisdictions. The Adjudicator As Davies observes, using a standard-based strategy actually means the legislature is sharing its rule making power with the court.1055 Since the courts need to make adjudication according to specific facts, it demands highly qualified judges. Unfortunately, Chinese judges are not known for their expertise, but rather the lack of it.1056 While the situation has begun to change in the more developed areas and high level courts, the majority is still not promising.1057 The uneven distribution of quality of judges is likely to lead to inconsistent results when a legal rule is not clearly defined and judges have to form their own interpretations of the rule. Furthermore, the Chinese judges are not independent from political influence.

1058

The problem is especially prominent when facing a

state-controlling shareholder-defendant. Political interests and administrative considerations can heavily influence the judges’ discretion,1059 and the more discretion they are given, the greater the chance that related parties will seek to manipulate by imposing pressure on the judges. Some scholars have even submitted that to avoid such undue influence, judges should not be given much discretion.1060 While enforcing a standard-based strategy inevitably means that judges are given discretion as to how to interpret the standard, the analysis above suggests that the more clearly-defined and the less abstract the standard is, the better it suits the condition of Chinese courts.

1054 1055 1056 1057 1058 1059 1060

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See Li, X. (2007), p. 248. Davies (2002), p. 121. Li, X. (2007), p. 276. Liebman (2007), Li, X. (2007), p. 276. Liebman (2007), pp. 19-20. Li, X. (2007), p. 276. Xiao&Yang (2009), p. 126 (Chinese judges should not be given too much discretion).

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6.4.2 Alternative Strategy: Decision Right Strategy Previous chapters have shown that decision right strategies have long been an alternative approach for standard-based strategies in the regulation of agent opportunism.1061 Indeed, in the UK, the widely-used decision right strategy has actually marginalized the role of standard-based strategies.1062 Therefore, if decision right strategies are effective and efficient in China, some deficiencies in the standard-based strategies might be more tolerable;1063 if otherwise, the need to improve the standard-based strategies will definitely be more urgent. As said, decision rights strategies have been taken up in various situations in the ’05 Company Law. The provisions, however, are scattered over different parts of the law and do not form a coherent system. There are three articles concerning a principal-approval strategy.1064 In Chapter I “General Povisions”, Art. 16 requires that when a company provides a guarantee for its shareholders or de facto controller, approval must be obtained from the shareholder meeting, and the resolution should be made by a simple majority of disinterested shares presented at the meeting. Next, in Chapter IV “Establishment and Organizational structure of Joint Stock Companies”, Art. 125 provides that in listed companies, when one or more directors have an affiliation relationship in the matter, the resolution must be approved by a majority of disinterested directors; when the number of disinterested directors is less than three, the matter needs to be approved by the shareholder meeting of the company. The article, however, does not prohibit the interested director to vote as a shareholder in the shareholder meeting. Lastly, in Chapter VI “Qualifications and Obligations of the Directors, Supervisors and Senior Managers of A Company”, Art. 149 provides that directors and senior managers cannot enter into contracts with the company or take corporate opportunities without the

1061

See sec. 2.3.3; 3.2.1.3. See sec. 5.6.3. 1063 Just like in the UK, standard-based strategies are less developed as compared to the US. See sec. 5.6.3. 1064 Decision right strategies can be divided into principal approval strategy and trusteeship strategy. See sec. 2.3.3. 1062

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approval of the shareholder meeting.1065 Again, the law does not prohibit the interested director to vote as a shareholder to approve the transaction. The latter two articles are aimed at opportunistic conduct at the director level, not the controlling shareholder level, and thus will only have a limited indirect effect in the regulation of controlling shareholders. While Art.16 does aim at the controlling shareholder level, it only applies to surety transactions. As a result, controlling shareholder-related transactions are largely unregulated via principal approval strategies in the ’05 Company Law.1066 As for trusteeship strategies, the ’05 Company Law requires listed companies to use independent directors. 1067 However, the law leaves the specific rules for the independent directors to the State Council and the State Council has not yet issued any regulations on independent directors. While the CSRC does have rules—the 2001 “Guidelines on the Establishing of the Independent Director System in Listed Companies” and the 2002 “Code on Corporate Governance of Listed Companies” in particular—on independent directors,1068 these rules are not enforceable in court since they do not specify a sanction for violation of the provision. Therefore, it is difficult to evaluate whether or not the use of independent directors will indirectly influence controlling shareholder opportunism.1069 Apparently, both the principal approval strategies and the trusteeship strategies provided in the ’05 Company Law are seriously flawed: the former is unsystematic

and the latter over-simplified. To make it worse, the ’05

Company Law almost completely neglects the issue of disclosure,1070 which, 1065

Art. 149 (4), (5). The CSRC provides in its “Regulation Opinions on the Shareholder Meeting of Listed Companies” (“Shangshi Gongsi Gudong Dahui Guifan Yijian”) (2000) that interested shareholders should not vote on related transactions (Art.34). However, since the rule does not provide a sanction for violation of it, it is actually not enforceable in court. 1067 Art. 123. 1068 For instance, at least one third of the directors of a listed company should be independent directors (2001 Guideline, para. 1(3)); a major task of independent directors is to protect the interests of minority shareholders (para. 1(2). 2002 Code Art.50); and substantial related transactions must be approved by the independent directors before the transaction can be voted on in a meeting of the board of directors (para. 5(1)). 1069 Generally speaking, the performance of independent directors is less satisfactory than expected, and they are sometimes called as “vase directors”. See Wang, J. (2009), at p. 44. 1070 The only article concerning disclosure is Art. 117, which requires a company to regularly disclose to its shareholders information about remunerations received by the directors, supervisors and senior 1066

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given the informational asymmetry between agents and principals, is a vital premise for a decision right strategy to be effective.1071 Consequently, it can hardly be expected that the decision right strategies specified in the ’05 Company Law will be an effective check on the power of controlling shareholders.

§6.5

Evaluation and Recommendation

The picture that evolves from the analysis in the previous section on the specific situation in China is far from pleasant: first, there is a high risk of controlling shareholder opportunism and the internal checking mechanism is weak; second, the decision right strategies are poorly developed, which leaves the reliance on the standard-based strategies and judicial review an inevitable choice;1072 and last, the quality of Chinese judges is not promising. Given these premises, the standard-based strategies as defined in ’05 Company Law need improvement to be effective and efficient. Refining the Definition of Controlling Shareholder The current definition of de facto control in Art. 217(2), i.e., “having significant influence over shareholder meeting resolutions”, is too broad and vague, which makes it difficult for the judges to apply. The definition of control given by the regulations of the Ministry of Finance, the CSRC and the Shenzhen Stock Market can be borrowed to some extent to improve Art. 217(2).1073 First, the definition of control in “Accounting Standards No.36”, i.e., “having the power to decide a company’s financial and business policy,” can be used to narrow the scope of “significant influence”. Second, the two situations listed in the CSRC’s “Take-over Regulations”—having the ability to vote more than 30% of the company’s shares or having the ability to elect more than half of the board of directors—are strong signs of de facto control. Using these clear-cut

managers from the company. 1071 Davies (2010), pp. 115-16; Rotman (2005), p. 325. 1072 See Shi & Du (2007), at p. 138 (the necessity of judicial review as the last resort.) 1073 See sec. 6.2.1.

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parameters in these two situations will greatly ease the task of the trial judges, which especially suits the current condition of Chinese judges. However, the way that the “Take-over Regulations” puts it makes these two situations sound like de jure rather than de facto control, and if taken up literally into the company law, it will be in conflict with Art. 217(2), which provides that only over 50% shareholding will imply de jure control. Therefore, it is better to treat these two situations as creating a presumption of control, which allows the defendant to rebut with counter evidence.1074 A controlling shareholder, therefore, is better to be defined as a person (1) owning over 50% of the company’s shares; or (2) having such a significant influence over the shareholder meeting because of his shareholding that gives him the power to decide the company’s financial and business policy. Meanwhile, when a shareholder has the ability to either vote more than 30% of the company’s shares or elect more than half of the board of directors, he is presumably a controlling shareholder. Substantive Standard In the ’05 Company Law, two separate articles jointly define the substantive standards for controlling shareholders’ conduct, namely, Art. 20 which prohibits abuse of shareholder rights and Art. 21 which prohibits unfair related transactions. However, the provisions in the ’05 Company Law are far from sophisticated. Both articles suffer from being too general and vague, especially Art. 20, which will greatly increase the difficulty for the judges to apply them in practice and cause inconsistent results. The lack of a clear definition of concepts such as the “purpose of shareholder rights” or the “interest of the company” worsens the situation. Given the Chinese judges’ uneven quality, the law should not have just relied on the very abstract principle of no abuse of rights. It is better for the law to

1074

On this issue, a similar proposition has been adopted by the ALI’s Principles. See sec. 4.2.1.2.1. (Sec 1.10(b) of the ALI’s Principles provides for a rebuttable presumption that a person who “owns or has the power to vote more than 25 percent of the outstanding voting equity securities of a corporation is presumed to exercise a controlling influence over the management or policies of the business”, and thus presumptively be a controlling shareholder.)

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endorse the common benefit rights theory and be explicit that voting rights should be exercised for the interest of the company—which means the interests of the shareholders as a group—in good faith. That is to say, there has to be some reasonable ground to believe that the resolution adopted is for the interest of the company. Meanwhile, if the exercise of the voting rights results in any distribution of company resource to a shareholder majority, the distribution cannot be specified in a way that discriminates the minority shareholders. Such a standard will be much easier for the judges to apply than the over-general concept of abuse of rights. 1075 Considering the high cost of revising the Company Law, it will be more efficient if the suggested improvement comes in the form of judicial interpretation issued by the Supreme People’s Court. Concerning Art.21, only requiring fair price is not enough. As shown in Chapter Four, in complicated business transactions, fairness of a given price could be very difficult for the adjudicators to judge1076 and thus make the standard difficult to enforce, especially given the quality of Chinese judges. Therefore, China should learn from the “fair dealing” requirement in Delaware law, that is, requiring procedural fairness as a safeguard for substantive fairness.1077 A judicial interpretation of Art.21 could be adopted to require that dealings between affiliated parties have to follow a fair procedure and with full disclosure of all material information by the controlling party. This will ease the difficulty of reviewing the case—since the procedure is a more easily observable factor—and suits better with the conditions of China.1078 Enforcing the Standard Compared to the provisions on the substantive standards, the rules on enforcement need even more improvement. Chinese law makers have not 1075

The UK approach in applying the Allen test, i.e., treating “bona fide” and “for the interest of the company” as one instead of two separated issues (see sec. 5.3.1, n.89 and accompanying text), is not recommended for China. Even the British jurists themselves think the test is difficult to apply. (See sec. 5.3.1, n.87 and accompanying text.) A two-step test is more suitable for Chinese judges. Also, unlike the UK approach, Chinese law does not differentiate different situations of voting (such as alteration of articles or ratification). A generally-applicable rule is simpler and fits China better. 1076 See sec. 4.3.4.1. 1077 See sec. 4.3.4.2. 1078 Xiao & Yang (2009), at p. 126 (due to the uneven quality of Chinese judges, the review of procedural fairness should be given more weight.)

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considered the issue of balancing the costs and benefits of judicial review. The enforcement rules fail to identify the situations involving a strong conflict of interest, which justify the high cost of judicial review, and allow the court to interfere whenever a corporate decision is challenged. In the long run, such a proposition is likely to cause chilling effects1079 in corporate decision making and harm the efficiency of the regulatory system. To solve the problem, China should introduce a threshold test which mirrors the Delaware Sinclair test,1080 i.e., only those cases that involve a possibility of non-proportional distribution to controlling shareholders will have their substantive fairness reviewed by the court.1081 From the perspective of the entire regulatory system, the current system fails to adjust the enforcement process of standard-based strategies according to the use of ex ante decision right strategies. Although the decision right strategies provided in the ’05 Company Law are less than satisfactory, they nonetheless provide some check on the controlling shareholders’ conduct. A total neglect of their effects in the process of judicial review results in a double check of the controlling power and leads to over-regulation. The US and the UK have adopted two different approaches when ex ante decision right strategies have been used. In the UK, an effective disinterested approval constitutes a complete bar for derivative actions,1082 while in the US, the case is still reviewable under the entire fairness standard, only the burden of proof is shifted to the plaintiff minority shareholder. 1083 Given the strong position of controlling shareholders and the underdeveloped decision right strategies in China, the US approach is a more appropriate choice for China.1084 1079

Such as over-processing board decisions or being over risk-averse, these are the very effects that the business judgment rule trying to avoid. See sec. 3.2.1.2. 1080 Or, its UK counterpart, the concept of “fraud on minority”. Although, between the two, the Sinclair test is a more clearly articulated rule and thus a more preferable choice for China. 1081 The lack of a business judgment rule is a problem not only exists on the controlling shareholder level, but also the director level. Due to the limit of the subject of the book, however, the recommendation given here is only aimed at the controlling shareholder level. From a broader perspective, business judgment rule should be introduced. Actually, as mentioned in the above discussion, both the Chinese academic society and a fair portion of the practitioners are ready for the introduction of such a rule. See supra. n. 968. 1082 See sec. 5.6.3. 1083 See sec. 4.4.5.1. 1084 Shi & Du (2007), p. 138.

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That is to say, judicial review should be always available as the last safeguard; however, if effective decision right strategies have been adopted, 1085 the plaintiff-minority shareholder should be facing a tougher task if trying to challenge the transaction in court.1086

§6.6

Conclusion

The ’05 Company Law has improved the regulation of controlling shareholder opportunism, but is still lacking in several aspects. Compared to the total silence of the ’93 Company Law on the substantive standard of controlling shareholder conduct, Art. 20 and 21 of the ’05 Company Law jointly draw the boundary for the controlling power. The two articles still have the problem of being vague and general, which may lead to judicial inconsistency in practice. However, if appropriate judicial interpretation—as in accordance with the majority academic opinion—could be given by the Supreme Court, these two articles could have the effect of establishing a substantive standard which prohibits non-proportional distribution to the controlling shareholders, consistent with the substantive standards adopted in the US and the UK. For the enforcement of the standards, the new law introduced derivative action, which is a big step forward. However, the law completely neglected the issue of balancing the cost and benefit of judicial review. The total indifference of the ’05 Company Law towards conflict of interests and the effect of 1085

An effective decision right strategy should at least include appropriate disclosure and a (group of) independent decision maker. While how to refine the decision right strategy in the ’05 Company Law is beyond the scope of this book, given the apparent shortcomings of the current provision in the law, there is no doubt that decision right strategies could be used in a more effective way in the regulation of controlling shareholder opportunism in China. The UK self-regulation system provides much valuable lessons in this regard. (See sec. 5.6.2.) Especially Rule 11.1.7 of the Listing Rules, which requires disinterested shareholder approval for all substantial related party transactions: since the internal checking mechanism for controlling shareholder opportunism in China is rather weak (see sec. 6.4.1), a principal-approval strategy (when coupled with proper disclosure requirement) might be the most reliable ex ante strategy in the regulation of controlling shareholder opportunism. However, even with improved decision right strategy, considering the influence of a controlling shareholder can work in a very subtle way (see sec. 4.4.5.1), the conclusion in the above main text does not change and ex ante strategies in China still should not fully substitute ex post judicial review. 1086 Shifting the burden of proof is only one way to make the case less plaintiff-friendly. There are other options too, such as requiring provision of guarantee before the case be accepted, or allocation of litigation fees, etc. The detailed procedure rules, however, are beyond the topic of the book. For more discussion on the issue, see Li, X. (2007), pp. 294-97.

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co-functioning strategies will likely lower the efficiency of the overall regulatory system. To solve the problem, a threshold test should be adopted to limit the applicability of judicial review only to those cases that involve a high degree of conflict of interest; meanwhile, if a decision right strategy has already been adopted, judicial review, although still applicable, should be less favorable towards the plaintiff by making adjustment in procedure rules, such as shifting the burden of proof. All in all, when compared to the US and the UK law, it is fair to say that, despite of the apparent effort, the Chinese company law is still in a premature stage in using standard-based strategies in fighting controlling shareholder opportunism. The legal provisions are general and difficult to apply; the efficiency problem has been given very little consideration.1087 The Chinese company law can learn a lot from the US and the UK experience and still has a long way to go.

1087

See Li, X. (2007) for a discussion how the current provisions try to balance the cost and benefit of derivative action. However, due to the problems discussed above, these attempts are by far not enough.

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Chapter VII Conclusion §7.1

An Economic Analysis of Standard-Based Strategies

Controlling shareholder opportunism, which is a major type of agency problems in companies, can cause serious damage to the interest of the company and its minority shareholders. Among various strategies that have been used in dealing with the problem, standard-based strategies are one of the major choices and have been widely used across jurisdictions. 1088 The advantage of using a standard-based strategy mostly lies in the flexibility of the strategy and thus is more suitable for complicated business transactions.1089 However, like any other regulatory mechanisms, using standard-based strategies generates is not cost free. The costs include both the loss of decision making efficiency and the performance costs required by the strategy.1090 For a standard-based strategy to function effectively and efficiently, its costs and benefits need to be balanced carefully. The balancing has two facets, one is about defining the standard and the other is about enforcing it. The first facet is to balance the benefit of screening out inefficient transactions and the cost of losing efficient transactions; the second actually concerns two interrelated subjects, namely, to balance the costs and benefits of enforcing the standard-based strategy through judicial review and to improve the overall efficiency of the entire regulatory system by making proper choices among different strategies. This book explores these issues in the “controlling v. minority shareholder” context and tries to draw lessons from the more sophisticated legal systems for the development of the Chinese company law.

1088 1089 1090

Kraakman et al. (2009), p. 40, 173. See sec. 2.3.4. Id.

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§7.2

Defining the Standard

7.2.1 US and UK While both being common law countries, there are notable differences between the US and the UK when it comes to controlling shareholder regulation. To begin with, controlling shareholders are considered fiduciaries of their companies and the minority shareholders in the US,1091 which is not the case in the UK.1092 As a result, the Delaware law1093 imposes a uniform duty of “entire fairness” on controlling shareholders,1094 while the UK law uses a network of regulatory institutions that involves several standard-based strategies.1095 However, in the end, the substantive fairness that is required by both jurisdictions is actually nearly the same, that is, controlling shareholders should not use their controlling position to extract non-proportional benefits from the company.1096 What they have in Common: Prohibition of non-proportional Distribution The basic principle of shareholder equality requires that each share is attached with equal rights, including the right to receive distributions of company assets. Any distribution to a controlling shareholder that is not proportionally available to minority shareholders runs against this basic principle. In both the US and the UK, such a distribution cannot meet the standard set up by law for a controlling shareholder’s exercise of his controlling power. Very similar expressions can be found in both jurisdictions that condemn non-proportional distribution to controlling shareholders. In Delaware, courts typically find the challenged transaction unfair if the plaintiff can meet the Sinclair test, that is, the controlling shareholder has gained some advantage “to the exclusion and detriment of the minority shareholders”.1097 In the UK, abuse 1091 1092 1093 1094 1095 1096 1097

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See sec. 4.2.2. Hannigan (2000), p. 494. Which is created by the Delaware court, the "mother court of [US] corporate law". See sec. 4.1, n.5. Weinberger, 457 A.2d at 711. See sec. 4.3. Such as "fraud on the minority" or "bona fide for the interest of company", see sec. 5.3.2.2. See sec. 5.5. Sec. 4.3.1.4.

CONCLUSION

of majority right is constituted when there is a “fraud on the minority”—which means both benefit accrued to the wrongdoer and loss suffered by the minority.1098 If a controlling shareholder committed fraud on the minority, very likely the court will interfere with the controlling shareholders’ discretion of exercising his power.1099 While the prohibition of non-proportional distribution to controlling shareholders sounds like a rule, in both the US and the UK, it is stated as a standard. The reason that law has to use standard-based strategies to achieve a rule-like result lies in the complexity of commercial activities. Unlike a rule that sets the speed limit at 70 mph, the difficulty of prohibiting non-proportional distribution actually lies in how to find out whether there is such a distribution. If it involves a related-transaction, then the price needs to be fair to avoid non-proportional distribution to the controlling shareholder. Cases like Ronsenblatt shows that, in complicated business transactions, it is often not possible to tell ex ante whether the “fair” standard has been met.1100 Since the major part of the work has to be done ex post by the judiciary, the strategy has to be standard-based rather than rule-based. What Distinctive Feature Delaware Experience Has As Davies observes, using standard-based strategies means the legislature is sharing its law making power with the judiciary.1101 Since the content of the standard is given by precedents, naturally the more it is used, the more developed it is. The US is the jurisdiction that relies most heavily on standard-based strategies to deal with the agency problem between controlling shareholders and minority shareholders. It is not surprising that the “entire fairness” standard developed by Delaware courts is the most clearly and sophistically articulated standard for controlling shareholder conduct when compared to other jurisdictions.

1098 1099 1100 1101

Sec. 5.2.1.2, n.36, 37 and accompanying text. Sec. 5.2.1.4. Sec. 4.3.4.1. Davies (2002), p121.

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To assure that any distribution made to shareholders is proportional, the Delaware law requires that controlling shareholders must deal with the corporation and the minority shareholders with “entire fairness”, which contains both a substantive aspect (“fair price”) and a procedural aspect (“fair dealing”).1102 This definition of entire fairness gives much insight in the use of a standard-based strategy in the controlling shareholder context. Apparently, the substantive prong is meant to limit a controlling shareholder’s ability to extract non-proportional benefits by an “unfair price”. However, the Delaware judges have learnt from practice that without a procedural fairness, substantial fairness is very difficult to enforce.1103 Recognizing the limitation of a pure substantive standard strategy, the judges have refined it with a procedural aspect, which includes the use of decision making strategies. 1104 As a result, the entire fairness standard of Delaware law is actually not just a standard-based strategy, but a combination of multiple strategies.1105 By comparison, British law does not show such incorporation. While they also rely on decision right strategies both in their company law and self regulation system, they work as a parallel system rather than an element of the standard based strategies.1106

7.2.2 What China Has and What China Can Learn Substantive Standard in Chinese Law Even with the great improvement made by the ’05 Company Law, which uses standard-based strategies at the controlling shareholder level, minority protection is still a new and underdeveloped topic in Chinese company law The ’05 Chinese Company Law uses two articles, Art. 20 and 21, to set up a substantial standard for controlling shareholders. Art. 20 prohibits abuse of shareholder rights that infringes upon the company’s and other shareholders’ rights, and Art. 21 prohibits violation of company interests through related 1102

Weinberger, 457 A.2d at 711. Sec. 4.3.4.2. 1104 A trusteeship strategy, to be specific: with independent negotiating committee acting as trustee. 1105 Including disclosure, the special type of strategy, which is “such an important strategy that it is needed in the application of all other strategies.” (Davies (2002), p122.) 1106 Sec. 5.6.2 1103

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CONCLUSION

party transactions.

1107

Although there are still uncertainties as to how the two

articles will actually work due to the lack of authoritative interpretation of the articles, the majority opinion among Chinese jurists is that Art. 20 will nullify any exercise of shareholder right that discriminates minority shareholders and Art. 21 requires a fair price to be paid in all related party transactions. Together the two articles establish essentially the same substantial standard for controlling shareholders as in the US and the UK. 1108 Since China is a jurisdiction that follows the civil law tradition, it shows that there is no significant difference between the substantive standards for controlling shareholders across different legal families. Looking Forward Admittedly, the ’05 Company Law is a great improvement regarding controlling shareholder regulation; however, given the unpromising quality of Chinese judges, the provisions in law are far from satisfactory. The relevant articles not only are stipulated in a very broad and vague manner, which leaves too much discretion to the judges in practice and will inevitably lead to inconsistency; but also completely fail to recognize the importance of procedural fairness.1109 The under-development of a substantive standard in China is understandable. The unsatisfactory quality of Chinese judges is almost common knowledge. The judicial system’s lack of independence further undermines the judiciary’s ability to bear the task of rule-making required by a standard-based strategy. However, since the Chinese society is moving towards a rule of law society, a more sophisticated standard strategy seems necessary because of the development in the economic sector. As far as a substantive standard is concerned, it is not difficult for the Chinese law to incorporate the idea of no non-proportional distribution into its current system. Because non-proportional distribution is against the shareholder

1107 1108 1109

See sec. 6.2.2 and 6.2.3 respectively. Sec. 6.2.4. Sec. 6.3.2.

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equality principle, it is completely compatible with the common-benefit rights theory: because the majority rule is based on the equal share presumption, an exercise of right that violates its basis is against its original purpose. The clarification can be done through a judiciary interpretation by the Supreme Court. Such a line not only is easier for the judges to apply, but also provides a clearer guidance for the parties and thus has better constraining effect. Further, due to the lack of expertise of the Chinese judges as fact-tryers, the fair dealing standard developed by Delaware courts provides a particularly valuable lesson for Chinese law, that is, to turn the trial of abstract substantive fairness into the trial of concrete, observable transaction procedure. Particularly, the disclosure of all material information by controlling shareholders, which is an issue barely noticed by the Chinese lawmakers and a key factor in the procedure fairness, should be emphasized in the Company Law. Incorporating procedural fairness into substantive fairness usually means a combination or choice of strategies, which is an issue closely connected to the enforcement of a standard-based strategy.

§7.3

Enforcing the Standard

Balancing the cost and benefit of enforcing the standard through judicial review can be approached from two perspectives: 1110 "when", namely, "when the standard should be enforced", and "which", i.e., "which strategy is the better choice for the case." The two issues are interrelated.

1110

A third question is who should be the one to decide that the standard should be enforced. Individual minority shareholders are hardly the ideal choice for a company on issues such as whether litigation should be pursued. Both the problem of minority opportunism and the collective action problem impair the quality of minority shareholders as a decision maker. In director setting, this issue is important and the demand rule is designed to achieve the proper balance. (See sec. 3.2.2) In controlling shareholder context, however, due to the unreliable independence of directors, the issue is of less importance. (In the US, demand is often excused in such cases, see Chapter 4, n.201; in the UK judges have the discretion to let case in or out, see sec. 5.2.1.3.)

234

CONCLUSION

7.3.1 US and UK Applicability of Review: When a Case Should Go to Court Judicial review is expensive because not only court resources are expensive, but also the disturbance of the firm’s decision making system generates cost as well, including future cost.1111 Therefore, it is not always in the minority’s best interest to have the case reviewed. This is true even in situations that the minority does suffer damage because of an improper conduct of the controlling shareholder. Judicial review is not the only choice to deal with the problem of agent opportunism; it might not even be the preferable choice.1112 For optimal efficiency, only cases that are most suitable for judicial review should go to court, this means that they have a high risk of opportunism, less loss of decision making efficiency and less effective if other strategies are used. In the US, the famous business judgment rule applies in the controlling shareholder context as well. To be exact, courts will only interfere and review a controlling shareholder’s conduct when it involves “self-dealing” by the controlling shareholder, which, as defined by Sinclair, means that the controlling shareholder received something from the corporation to the exclusion and detriment of the minority.1113 The rule was later supplemented by Weinberger, which held that all controlling shareholder related transactions will be reviewed under the entire fairness standard. Practically speaking, all cases that involve a possibility of non-proportional distribution to controlling shareholders are subject to judicial review.1114 The Sinclair test is not perfect.1115 However, in practice, the outcomes of cases have been fairly consistent.1116 The seemingly inconsistency is mostly due to the fact that judges are usually giving their opinion context-specifically.

1111

Such as damage of company reputation and chilling effects in the decision making process of the company. 1112 When the cost of judicial review is higher than the benefit, it is more reasonable to either drop the case, or try to prevent the misconduct ex ante. 1113 Sinclair, 280 A.2d at 720. 1114 Sec. 4.4.4 1115 Sec. 4.4.2.2. 1116 Sec. 4.4.4.

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The consistency in the outcome shows that the high quality of judges helps to mitigate the deficiency in a standard-based strategy. The British law also has been aware of the potential negative effect of judicial review. Although they do not have an explicit business judgment rule, the British courts actually followed a “working” business judgment rule under the common law rule.1117 The “fraud on the minority” element of the Foss rule is in essence a search for conflict of interests. Although the new CA2006 no longer holds conflict of interests as a decisive element for judicial review, if the majority has no conflict of interests, the court will most likely respect their decision making power.1118 Relation with other Strategies Standard-based strategies are never the only choice when fighting controlling shareholder opportunism; other strategies are always available. Among other possible solutions, the most noticeable is the decision right strategy, because, like a standard-based strategy, it is also a transaction-based strategy.1119 As a matter of fact, in every jurisdiction, there is a network of multiple strategies at work. And ex ante and ex post strategies often have a trade-off relationship with each other. The fair dealing prong of the Delaware “entire fairness” standard is actually a decision right strategy. Arm’s length bargaining requires independent bargainers, which is in essence a trusteeship strategy. Approval of minority shareholders is another often-seen decision right strategy, especially in merger cases. However, it should be noted that these decision right strategies are not compulsory in the US.1120 Meanwhile, adoption of ex ante strategies will not insulate the controlling shareholders from liability, but only give them some more protection if being challenged in court, namely a shift of the burden of 1117

Bradley (1999), at p. 297. Sec. 5.2.1.4. 1119 Which means they are applied to each transaction. 1120 This might sound paradoxical since fair dealing requires fair bargaining procedure. However, the entire fairness standard is not a bifurcated test and fair dealing alone is not a decisive factor. (Weinberger, 457 A.2d at 711.) Controlling shareholders may choose a dominated transaction and face the risk of being challenged in court and bear the burden of proof. (See sec. 4.3.3.) 1118

236

CONCLUSION

proof. 1121 To review an independently negotiated or minority shareholders approved transaction, the controlling shareholders’ conduct is actually double checked in the US. In the UK, by contrast, not only decision rights strategies are compulsory for listed companies as they are required by the Listing Rules,1122 but the adoption of a decision right strategy may constitute a complete bar to judicial review.1123 Even in situations that judicial review is theoretically available, ex ante strategies will make it extremely difficult for the plaintiff to plead successfully. 1124 Actually, for public companies in the UK, judicial review is the least they should worry about. The US and the UK provide two different approaches for using standard-based strategies in the controlling shareholder context. Between decision right strategies and standard-based strategies, the US favors the later, while the UK favors the former. The choice seems a product of history and culture, and it is not necessarily so that one way is better than the other. Since research shows the level of PBC extraction in UK is very close to that in the US,1125 it suggests strongly that there is a trade-off relation between ex ante and ex post strategies.

7.3.2 What China Has and What China Can Learn The Status Quo In short, the Chinese law concerning the enforcement of standard-based strategies is even less developed than the law on the substantive standards. The provisions on both direct and derivative actions in the ’05 Company Law are very general. Most importantly, neither of the two questions—"when" and "which"—has been properly answered by law.

1121 1122 1123 1124 1125

Sec. 4.4.5.1. Sec. 5.6.2. See Chapter 5, n.55 and accompanying text. See Chapter 5, n.58 and accompanying text. Nenova (2003), Dyke & Zingales (2004)

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First, there is no comparative rule in Chinese company law to the business judgment rule. The existence of conflict of interest has no particular influence on the reviewability of a case.1126 Second, although sometimes a decision right strategy is required by law, the law makes no difference in the review process when the decision is challenged in court.1127 Both suggest that the Chinese lawmakers have not yet been aware of the need to balance the cost and benefit of the judicial review. As a result, the law fails to identify those cases that are better to be dealt with via a review by the courts from those that are better to be kept out of court. This will lower the overall efficiency of using the standard-based strategy. Looking forward Chinese company law should be more specific on when a court should step in to review controlling shareholders' conduct. The UK approach of giving judges discretion as to whether a case should proceed is not a good solution for China given the unsatisfactory quality of Chinese judges. Such discretion not only will lead to inconsistence in practice but also opens the door for undue influence on the less-than-independent judges. A clear-cut threshold test, like the Sinclair test, is more suitable for the Chinese situation. The concept of business judgment has been accepted by Chinese scholars and even been cited by some judges in practice,1128 and it is time to formally introduce it into the company law. The law should make it clear that first, without conflict of interest, a decision made by a controlling shareholder is a business judgment, and courts should refrain from reviewing such a decision; second, a conflict of interest between a controlling shareholder and minority shareholders arises whenever there is a possibility for the former to attract non-proportional benefit from the corporation. As for the question of "which", given the fact that controlling shareholders have more dominance over company affairs than their counterparts in the US or

1126 1127 1128

238

Sec. 6.3.2 Id. See Chapter 6, n.116 and accompanying text.

CONCLUSION

the UK, and controlling shareholder opportunism is exceptionally severe in China, it is advisable that a double-check—by both ex ante and ex post strategies—should be used in China. It has already been suggested that the "fair dealing" standard, which is in essence a trusteeship strategy, should be adopted by Chinese company law. Especially for substantial business transactions, given the complexity of the case and the quality of Chinese judges, an independent negotiation process should be mandatory so that to enhance the enforceability of the substantive standard. Disinterested shareholder approval should also be given a bigger role than just regulating surety transactions between the company and its shareholders, although a comprehensive discussion on how disinterested shareholder approval should be used is beyond this book. To balance the high cost of a double-checking system, Chinese company law can draw lessons from the Delaware experience, that is, once some decision right strategy has been adopted, judicial review should be made less plaintiff-friendly by procedure rules. However, due to the time limitation of the project, procedural rules of judicial review, although often critical to the effectiveness of a standard-based strategy, have to be left to future studies.

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Table of Cases Allen v. Gold Reefs of W. Africa, [1900] 1 Ch. 656, CA (5.3.1; 6.2.4) Allied Chemical & Dye Corporation v. Steel & Tube Co. of America et al. (120 A. 486) (4.2.1.1; 4.2.2) Aronson v. Lewis, 473 A.2d 805 (Del., 1984) (4.2.1.1; 4.2.1.2.2) Astec (BSR) plc, Re, [1998] 2 BCBC 556; [1999]B.C.C. 59 (5.4.2.1) Beijing Yijinyuhui Technology Investment Corp. v. Liu Xu, (2009) YiZhongMinZhongZi No. 7749. (6.2.2) Bell v. Fred T. Ley & Co., Inc., 278 Mass 60 (Mass., 1932) (4.2.1.1) Bershad v. Curtiss-Wright Corp., 535 A.2d 840 (Del. 1987) (4.5.1) Burland v. Earle, [1902] A.C. 83 (5.3) Case v. New York Central Railroad Company, 15 N.Y.2d 150 (1965) (4.5.5) Citron v. E.I. Du Pont de Nemours & Co., 584 A.2d 490 (Del.Ch.,1990) (4.4.5.1) Citron v. Steego Corp., 1988 WL 94738 (Del. Ch.) (4.2.1.2.1; 4.5.3.1) CNX Gas Corporation Shareholders Litigation, In re, 2010 WL 2291842, (Del. Ch., 2010) (4.5.6.3; 4.6) Cook v. Deeks, [1916] 1A.C.554 (5.2.1.2) Cox Communications, Inc. Shareholders Litigation, In re, 879 A.2d 604 (2005) (4.3.4.2; 4.4.5.2; 4.5.6.3; 4.6) Daniels v. Daniels, [1978] 2 All E.R. 89 (5.2.1.2) David J. Greene & Co. v. Dunhill Intern., Inc., 249 A.2d 427 (Del. Ch. 1968) (4.4.1; 4.4.4; 4.5.2) Delaware Open MRI Radiology Assoc’s, PA. v. Kessler, 898 A.2d 290 (Del. Ch. 2006) (4.3.4) Dongli v. Zhida Ltd., (2008)HuErZhongMinSan(Shang)Zhong No.238. (6.2.2) Equity Corp. v. Milton, 221 A.2d 494 (Del. 1966) (4.5.2; 4.6) Estate Acquisition and Development Ltd, Re, [1995] B.C.C. 338 (5.4.2.1) Estmanco v. GLC, [1982] 1. W.L.R. 2 (5.3.2.1; 5.3.2.2) Feldheim v. Sims, 800 N.E.2d 410 (Ill. App. 1 Dist., 2003) (4.2.1.2.2; 4.5.1) 255

Fort Howard Corp. Shareholders Litigation, In re, 1988 WL 83147 (Del. Ch.) (4.3.1) Foss v. Harbottle, (1843) 2 Hare 461 (5.2.1.3) Franbar Holdings Ltd v Patel, [2008] EWHC 1534 (Ch) (5.2.1.3) Gabelli & Co., Inc. v. Liggett Group Inc., 479 A.2d 276 (Del. 1984) (4.5.4; 4.5.5) Gilbert v. El Paso Company, 490 A.2d 1050 (Del.Ch., 1984) (4.2.1.2.1) Glassman v. Unocal Exploration Corp., 777 A.2d 242 (Del. 2001) (4.5.6.2) Gottesman v. General Motors Corp., 279 F.Supp. 361 (S.D.N.Y. 1967) (4.2.1.2) Greene v. Allen, 114 A.2d 916 (Del. Ch. 1955) (4.2.1.2.2) Greenhalgh v. Arderne Cinemas Ltd., [1950] 2 All.E.R. 1120 (5.2.1.1; 5.3.1) Gross v. Rackind, [2005] 1 W.L.R. 3505 (5.4.2.1) Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939) (4.5.2) Harris v. Carter, 582 A.2d 222 (Del. Ch. 1990) (4.5.3; 4.5.3.2.1; 4.6) Heil v. Standard Gas & Electric Co., 151 A. 303 (1930) (4.5.1) Holders Investment Trust Ltd, Re, [1971] 1 WLR 583 (5.3.1) Huangshan Xiyuan Zhiye Ltd. v. Zhu Jianhong ([2008]HangMinErChu No.95) (6.2.2.2; 6.3.2) Ivanhoe Partners v. Newmont Mining Corp. 535 A.2d 1334 (Del. 1987) (4.2.1; 4.6) JE Cade & Son Ltd., Re, [1992] BCLC 213 (5.4.2.2) Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584 (Del.Ch.1986) (4.2.2; 4.4.3; 4.4.4; 4.5.1) Jiang Wenhong v. Wu Jinhui ([2008]HuErZhongMinWu(Shang)Chu No.21) (6.2.3) Johnston v. Greene, 121 A.2d 919 (Del., 1956) (4.2.1.2.2) Jones v. H. F. Ahmanson & Co., 1 Cal.3d 93 (Cal. 1969) (4.1; 4.2.2) Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994) (4.2.1.1; 4.2.1.2.2; 4.3.2.1; 4.3.2.3; 4.4.5.1; 4.6) Kahn v. Lynch Communication Systems, Inc., 1995 WL 301403 (Del. Ch. 1995) (4.3.3)

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Kahn v. Lynch Communication Systems, Inc., 669 A.2d 79 (Del. 1995) (4.3.2.1; 4.3.2.2.1; 4.3.2.2.2; 4.3.3; 4.3.4) Kahn v. Tremont Corp., 1996 WL 145452 (Del. Ch.) (4.3.1; 4.3.3) Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997) (4.3.2.2.3; 4.5.1) Kahn v. Tremont Corp., 1997 WL 689488 (Del. Ch.) (4.3.3; 4.3.4.2; 4.6) Kaplan v. Centex Corporation, 284 A.2d 119 (Del.Ch., 1971) (4.2.1.2.1; 4.2.1.2.2) Legal Costs Negotiators Ltd., Re, [1999] B.C.C. 547 (5.4.2.1) Leeds United Holdings Plc., Re, [1996] 2 BCLC 545 (5.4.1) Little Olympian Each-Ways Ltd (No. 3), Re, [1995] 1 B.C.L.C. 636, Ch.D. (5.4.1) Louisiana Mun. Police Employees' Retirement System v. Fertitta, 2009 WL 2263406 (4.4.1) Lynch v. Vickers Energy Corp., 351 A.2d 570 (Del. Ch., 1976) (4.3.2.2.1; 4.3.2.2.3; 4.5.6.1) Lynch v. Vickers Energy Corp., 383 A.2d 278 (Del., 1977) (4.3.2.2.1; 4.5.6.1) Macro (Ipswich) Ltd., Re, [1994] B.C.C., 781 (5.4.2.3) MAXXAM, Inc., In re, 659 A.2d 760 (Del. Ch. 1995) (4.3.1) Mayer v. Adams, 167 A.2d 729 (Del. Ch. 1961) (4.2.1.2.2) McMullin v. Beran, 765 A.2d 910 (Del.2000) (4.3.2.3) Mendel v. Carroll, 651 A.2d 297 (Del. Ch. 1994)(4.5.1; 4.6) Meyerson v. El Paso Natural Gas Co., 246 A.2d 789 (Del. Ch., 1967) (4.5.5) Miller v. Miller, 222 N.W.2d 71 (Minn, 1974) (4.5.2) Monroe County Employees' Retire. Sys. v. Carlson, 2010 WL2376890 (Del. Ch. 2010) (4.3.2.3; 4.3.4.2) Montagu’s Settlement Trust, Re, (1987) 1 Ch. 264 (5.2.1.2) Nicholas v. Soundcraft Electronics Ltd., [1993] BCLC 360 (5.4.2.1; 5.4.2.3) Ningbo Lianying Engineering Plastics and Hardware Ltd. Co. v. Zheng Shude ([2006]YongMinSiChu No.212) (6.2.2.2) Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993) (4.4.4) Norton v. Union Traction Co., 110 N.E. 113 (Ind. 1915) (4.5.1) O’Neill v. Phillips, [1999] 1 WLR 1092 (5.4.2.4) 257

Onti, Inc. v. Integra Bank, 751 A.2d 904 (Del. Ch. 1999) (4.3) Pepper v. Litton, 308 U.S. 295 (U.S. 1939) (4.2.2; 4.3; 4.3.2.1) Perlman v. Feldmann, 219 F.2d 173 (C.A.2, 1955) (4.5.3.2.2) Prudential Assurance Co Ltd v Newman Industries Ltd, [1982] Ch. 204 (5.1; 5.2.1.3) Pure Resources Shareholder Litigation, In re, 808 A.2d 421 (Del. Ch. 2002) (4.5.6.2) Rabkin v. Olin Corp., 1990 WL 47648, (Del. Ch.) (4.3.2.1) Rabkin v. Philip A. Hunt Chem. Corp., 498 A.2d 1099 (Del., 1985) (4.3.2.1) Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del., 1986) (3.1.2) Rock Nominees v. RCO, [2004] 1 B.C.L.C. 439 (5.4.2.3) Rosenblatt v. Getty Oil Co., 493 A.2d 929. (Del. 1985) (4.3.2.2.1; 4.3.2.2.2; 4.3.2.3; 4.3.4.1; 4.3.4.2; 4.4.5.2) Saul D. Harrision & Sons Plc., Re, [1995] 1 BCLC 14; [1994] BCC 475 (5.4.2.2; 5.4.2.4) SCWS v. Meyer, [1959] AC 324 (5.4.2.1) SEC v. Chernery Corp., 318 U.S. 80 (3.1.1) Shi Pinchao v. Zhejiang Huanyu Construction Group Ltd., (2010)ZheShaoShangZhong No.265 (6.3.2) Shuttleworth v. Cox Bros & Co (Maidenhead) Ltd., [1927] 2 K.B. 9 (5.3.1) Sinclair Oil Corporation v. Levien, 280 A.2d 717 (Del. 1971) (4.1; 4.4.1; 4.4.2.1; 4.4.2.2; 4.5.1; 4.5.2; 4.5.4; 4.5.6.3; 4.6) Siliconix Inc. Shareholders Litigation, In re, 2001 WL 716787 (Del. Ch., 2001) (4.5.6.1) Solomon v. Pathe Communications Corp., 672 A.2d 35 (Del., 1996) (4.5.6.1) Southern Pac. Co. v. Bogert, 250 U.S. 483 (4.2.1.1; 4.2.2) Sterling v. Mayflower Hotel Corp., 93 A.2d 107 (Del., 1952) (4.3.1) Summa Corp. v. TWA, 540 A.2d 403 (Del., 1988) (4.2.2; 4.4.4) Tanzer v. International Gen. Indus., Inc., 379 A.2d 1121 (Del. 1977) (4.5.1) Thorpe v. CERBCO, 1993 WL 443406 (Del.Ch.1993) (4.2.2) Thorpe v. CERBCO, Inc., 676 A.2d 436 (Del. 1996) (4.5.1) Traub v. Barber, 452 N.Y.S.2d 575 (N.Y.A.D.,1982) (4.2.1.2.1) 258

TSC Industries Inc. v Northway Inc., 426 U.S. 438 (1976) (4.3.2.2.2) Ultraframe (UK) Ltd v Fielding, [2005] EWHC 1638 (5.2.2) Weinberger v. UOP Inc., 457 A.2d 701 (Del., 1983) (4.3; 4.3.2.2; 4.3.2.3; 4.3.3; 4.3.4.2; 4.4.3; 4.4.4; 4.4.5.1; 4.6) Western Pac. R. Corp. v. Western Pac. R. Co., 206 F.2d 495 (C.A.9 1953) (4.5.5) Wheelabrator Technologies, Inc. Shareholders Litigation, In re, 663 A.2d 1194, (Del.Ch.1995) (4.2.1.1) Williams v. Geier, 671 A.2d 1368 (Del. 1996) (4.5.1) Zeitlin v. Hanson Holdings, Inc., 397 N.E.2d, 387 (N.Y. 1979) (4.5.3.1)

259

Abbreviations ALI’s Principles

American Law Institute’s Principles of Corporate

Governance (ALI-CORPGOV) CA

Companies Act

DGCL

Delaware General Corporation Law

MBCA Model Business Corporation Act (3rd. Ed., revised through 2002) www.abanet.org/buslaw/library/onlinepublications/mbca2002.pdf CL

Company Law of China

261