How to Control Controller Conflicts

We recently posted on SSRN our article How to Control Controller Conflicts, which will be published later this year in the Journal of Corporation Law’s fiftieth anniversary issue.

Our article provides a unified approach to protecting public investors in controlled companies in an effective and internally consistent manner. The article also provides a strong critique of Delaware’s recent legislation on the subject.

We focus on a question that Delaware law has grappled with for several decades: How should corporate law address agency problems in companies with a controlling shareholder (“controlled companies”)? Specifically, when—and to what extent—should approval by independent directors, without a supplemental majority-of-the-minority (MOM) approval, be sufficient to “cleanse” corporate actions involving a controller conflict? Viewing such actions as “cleansed” means that, despite the presence of a conflict, courts would apply the deferential business judgment standard, which generally governs unconflicted director decisions, and thereby preclude judicial scrutiny of the actions’ merits.

After decades-long swings of the judicial pendulum, a recent legislative amendment to the Delaware General Corporation Law, commonly referred to as SB21, adopted an approach that requires a different treatment for freezeout settings and non-freezeout settings. While a MOM vote alongside an independent director approval is necessary for cleansing freezeout decisions, an independent director approval alone is sufficient for cleansing decisions in non-freezeout settings.

Our analysis explains why SB21’s critical distinction between freezeouts and non-freezeout settings is untenable. Allowing cleansing by independent director approval alone in all non-freezeout transactions, we show, is conceptually inconsistent with SB21’s prescription that such approval can never suffice to cleanse freezeout decisions.

We explain why this conclusion is unavoidable, given the structural incentives that influence the decisions of directors whose appointment and replacement are entirely dependent on the controller. We show that, if independent director approval cannot serve as an effective screening mechanism to protect against (i) freezeouts that serve the controller at the expense of other shareholders, then they also cannot serve as an effective mechanism to protect against (ii) decisions in non-freezeout conflicted settings that would serve the controller at the expense of other shareholders. If anything, independent director approval could well be less effective, and certainly not more effective, with respect to (ii) than with respect to (i).

Recall Leo Strine’s metaphorical description of how chimpanzees can be expected to act when they face an 800-pound gorilla who wants the rest of the bananas all for itself ((Strine, 2002) and the judicial opinion in Pure Resources). Anyone who recognizes that (i) the chimpanzees could not be expected to resist the gorilla who wants certain bananas, should also recognize that in this situation (ii) the chimpanzees could not be expected to resist the gorilla if it wants certain other fruits. The key problem with non-freezeout decisions in controlled companies is that, as in freezeout decisions, independent directors appointed by the controller have significant incentives to go along with the controller and lack sufficient countervailing incentives to resist the controller in order to protect other shareholders.

We further argue that the incentives of independent directors to favor the controller are just as strong—and indeed may even be stronger—in non-freezeout conflicted settings than in freezeout settings. Among other things, unlike freezeout decisions, non-freezeout decisions are not end-game decisions in a company that is expected to cease to exist. Consequently, continuing to have the support of the controller is critical to any future reelection of the independent directors in any on-going controlled company.

Our article thus contributes to the ongoing debate surrounding SB21. This legislation, we explain, has shifted Delaware law on controlled companies in a decidedly negative direction. On an expected-value basis, the legislation should considerably benefit controllers at the expense of minority investors, resulting in a substantial transfer of wealth from the latter to the former.

The main contribution of our article, however, is in putting forward a consistent and conceptually coherent approach for regulating controller conflicts. Following this approach would effectively protect outside public shareholders and would do so without requiring any additional shareholder votes beyond those that are already statutorily required.

Under our proposed approach, the cleansing mechanism would depend on whether the conflicted decision is one for which shareholder approval is statutorily required. For all decisions requiring a statutory vote—including not only freezeouts but also charter amendments and reincorporations—the case for applying the MFW framework is strong and cleansing should require MOM approval. However, for decisions where a vote is not statutorily required, cleansing could also be achieved through approval by “enhanced-independence” directors (Bebchuk and Hamdani (2017))—that is, directors whose appointment received MOM approval.

Finally, we would like to highlight one important set of public companies for which the issues discussed in this article are especially important. Although U.S. corporate law scholars have long focused on widely held public companies as the paradigmatic case, companies with a controlling shareholder have grown increasingly important. This trend is partly driven by the growing use of dual-class structures among companies going public. At present, two of the “Magnificent Seven”—Google and Meta—are dual-class companies, with a combined market value of about $4 trillion. The S&P 500 also includes many other dual-class companies.

In dual-class companies, controllers are commonly “small-minority controllers” (as defined by Bebchuk and Kastiel (2019)) by virtue of having a lock on control with an ownership stake that often represents a small minority, or even a very small minority, of the equity capital. In such companies, agency problems are especially severe and costly (Bebchuk, Kraakman and Triantis (2000), and Bebchuk and Kastiel (2017)). These companies also seem to have played a significant role in the pressures that led the Delaware legislature to adopt the recent legislation relaxing constraints on controlling shareholders, and the shareholders of these companies should be expected to be adversely affected to an exceptionally strong extent (Bebchuk, Kastiel and Rock (2025)).

Identifying the best way to address the severe agency problems posed by controlled companies is a challenge of first-order economic importance for corporate law. Our article seeks to contribute to addressing this challenge.

Our article is available for download here.