In 2012, Google’s board approved a proposal amending Google’s charter to authorize the issuance of a new class of nonvoting Class C stock.
Prior to this proposed recapitalization, Google’s capital structure was comprised of one-vote-per-share Class A shares, primarily held by public shareholders, and ten-votes-per-share Class B shares, primarily held by Google’s founders, Larry Page and Sergey Brin.
Under this dual-class structure,
Google had the ability to raise capital, incentivize employees, and acquire other corporations by issuing Class A shares, while preserving control over the company in the hands of Class B shareholders. However, this strategy faced an upper limit—if enough Class A shares were issued, eventually the voting power of Class B shares would be diluted to the point of the founders losing control.
Google’s authorization of Class C shares was a strategic response to this unwelcome hiccup: After the recapitalization, Google would be able to issue as many Class C shares as it deemed necessary for business purposes, without ever threatening to dilute the founders’ control.
This move, therefore, reallocated control rights from the public shareholders to the company founders, and enabled them to keep their control over the company even as it continued to issue new shares. Of course, the recapitalization required board approval and a shareholder vote to amend the company’s charter.
But these procedures offered little meaningful protection because Page and Brin held a majority of voting rights. Thus, the charter amendment could be, and in fact was, approved with the two founders’ votes, and against the objection of Class A common shareholders—even though Page and Brin were clearly self-interested.
Class A shareholders swiftly responded to the recapitalization by bringing a breach of fiduciary duty lawsuit in Delaware.
The plaintiffs argued that the recapitalization was a form of “self-dealing” that should be reviewed under Delaware’s long-standing regime of entire fairness.
The Google defendants, however, claimed that the decision ought to receive the deferential business judgment protection.
Ultimately, the parties settled the dispute on the eve of the trial.
The Google litigation thus left unanswered the key doctrinal question as to whether entire fairness, business judgment, or some intermediate level of scrutiny is the appropriate standard of review for “midstream” reallocations of control rights—that is, changes to a company’s existing allocation of control rights.
Subsequent to the Google settlement, several other dual-class firms announced midstream recapitalizations from dual-class to triple-class structures. First, Facebook and InterActiveCorp (IAC) proposed to create a new class of nonvoting stock through a charter amendment.
However, after being targeted with suits by their respective shareholders, who argued that these recapitalizations amounted to unfair self-dealing, both Facebook and IAC withdrew their proposed recapitalization plans.
Another company adopted a more cautious approach, and structured the recapitalization ex ante in a way that complied with the entire fairness review.
Lastly, the board of CBS Corporation (CBS), also a dual-class company, recently proposed to unilaterally reallocate control rights from the controlling shareholder to the public shareholders—rather than, as its predecessors had done, from the public shareholders to the controller.
In the face of what it viewed as a merger proposal that would harm the company, the board announced its plan to dilute the controller by distributing voting shares as a stock dividend to all classes of shares (voting and nonvoting), thereby empowering the minority shareholders to block the merger.
Yet again, the resulting suit ended in settlement.
These cases raise a fundamental question of corporate law: What is the appropriate standard of review for conflicts over the reallocation of control rights at controlled companies?
This question has not been explored,
and it is far from an obscure academic inquiry. Recapitalizations like Google’s are likely to recur as controlled companies that go public continue to employ multiclass share structures, thereby increasing the likelihood of future recapitalizations and other midstream reallocation of control rights.
Yet, while a long line of Delaware case law has addressed disputes over various forms of midstream reallocations of control rights,
the Delaware courts have not yet adopted a clear approach concerning the standard of review that applies to these reallocations of control rights.
The doctrinal confusion, this Article argues, is driven by a fundamental shortcoming of corporate law. Delaware critically relies on fiduciary duties and judicial review under the entire fairness standard to govern self-dealing and other conflicts of interest at both controlled and widely held companies. This Article shows, however, that the legal framework that governs self-dealing
—the entire fairness analysis—cannot and should not be applied to conflicts over the reallocation of control rights. Entire fairness review requires courts to make an objective determination of the “fair price” of the transaction at issue.
Economists have developed valuation models for many types of cash-flow rights, like specific assets and entire companies, that aid courts in determining fair price.
Similar economic models for valuing the reallocation of control rights simply do not exist.
Moreover, this Article posits that developing an economic model that objectively values the reallocation of corporate control rights is an inherently futile task because the value of control rights is firm specific and individual specific. The allocation of control rights raises an inevitable tradeoff between investors’ protection from agency costs and the controller’s ability to pursue its idiosyncratic vision,
thus making the value of different allocations of control rights both firm specific and individual specific. Economic theory is capable of abstracting away from specific attributes of an asset (such as a factory) in order to approximate the value of that asset. Yet economic theory cannot abstract away from the specific firm and the specific personality of a controller (such as Mark Zuckerberg or Sergei Brin) without excluding from the valuation analysis the very specific characteristics that make control valuable in that particular controller’s hands.
Without a reliable valuation model, Delaware’s entire fairness framework breaks down: Not only will ex post judicial determinations of “fair price” be impeded by the impossibility of reliably pricing corporate control rights, but also ex ante attempts to secure minority shareholder approval will be thwarted by the lack of a reliable valuation backstop.
Negotiating in the shadow of the law is impossible when the parties cannot reliably estimate how a court will determine a fair price.
In light of the impossibility of valuing control rights—and consequent courts’ inability to apply entire fairness review—how should courts regulate conflicts over reallocation of control rights? This Article argues that Delaware should resolve control rights conflicts by determining, as a matter of contractual interpretation, which party has the authority to reallocate control rights under the company’s charter.
The parties—controllers and minority shareholders—are best left to agree ex ante on the voting rule that will govern midstream reallocations of control rights. Therefore, courts’ principal task should be to determine whether the controller can reallocate control rights without receiving the approval of the minority shareholders. Delaware courts should then defer to the arrangements on which the parties had initially agreed and forgo any attempt to evaluate the fairness of reallocation of control rights.
As long as the charter grants the controller the power to reallocate control rights, courts should apply the business judgment rule to a controller’s choice to recapitalize. All other methods will fail in the absence of objective valuations.
This approach not only avoids costly litigation and the valuation issues implicated by control rights but also encourages clear drafting of the initial allocation of control rights in the corporate charter. And if the charter is silent, courts should craft a default rule that balances the potential loss of idiosyncratic vision (which results from giving the minority reallocation authority) with the potential increase of agency costs (which results from giving the controller reallocation authority).
More specifically, Delaware’s longstanding pre-Google precedents, studies of market performance, and changing market realities in public companies’ shareholder power all weigh in favor of preserving the traditional default rule that protects against the loss of idiosyncratic vision by granting controllers business judgment rule protection in decisions of midstream reallocations of control.
The remainder of this Article proceeds as follows: Part I discusses the Delaware case law on resolving cash-flow and control rights disputes in controlled companies. While Delaware has developed a clear, sophisticated governing regime to adjudicate cash-flow rights, in the case of control rights conflicts, Delaware has struggled and ultimately been inconsistent in its approach. Part II explains this inconsistency by demonstrating the inevitable tradeoff that underlies the allocation of control rights. Moreover, Part II explains why developing a reliable methodology for valuing reallocations of control rights is a futile task that will make the application of Delaware’s existing corporate law regime impossible. In light of the foregoing insights, Part III considers how courts should approach conflicts over control rights in controlled companies and ultimately proposes that courts resolve these conflicts through interpretation of the company charter.