Dual-Class Stock Archives - Columbia Law Review

Introduction 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.[footnote]Steven Davidoff Solomon, New Share Class Gives Google Founders Tighter Control, N.Y. Times: Dealbook (Apr. 13, 2012), https://dealbook.nytimes.com/2012/04/13/new-share-class-gives-google-founders-tighter-control (on file with the Columbia Law Review ).[/footnote] 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.[footnote]See Google Inc., Annual Report (Form 10-K) 23–24 (Jan. 29, 2013), https://www.sec.gov/Archives/edgar/data/1288776/000119312513028362/d452134d10k.htm [https://perma.cc/5H4D-UMX4]; see also Paul Lee, Protecting Public Shareholders: The Case of Google’s Recapitalization, 5 Harv. Bus. L. Rev. 281, 283 (2015).[/footnote] Under this dual-class structure,[footnote]See Anita Anand, Complexities in Firms with Dual Class Shares, 3 Annals Corp. Governance 184, 193 (2018) (defining “dual-class shares” as a type of capital structure involving “the issuance of two or more different classes of shares whereby one class (the ‘superior’ class) has more voting rights than shares held, while the other class (the ‘subordinate’ class) has fewer voting rights relative to the shares held”).[/footnote] 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.[footnote]To understand the intuition, assume that at the start there were 100 Class A shares and 100 Class B shares. Since Class B has 10 times the votes of Class A, the founders would have 1,000 votes and the public would only have 100 votes (almost 91% of the voting rights was in the hands of the founders). But if over time the number of Class A shares increased and reached 1,000 shares, then both classes of shares would have 1,000 votes (only 50% of the voting rights would accrue to the founders). From then on, any increase in the number of Class A shares would leave the founders with fewer than 50% of the votes.[/footnote] 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.[footnote]Google Settlement Means Stock-Split Can Proceed, CBS News (June 17, 2013), https://www.cbsnews.com/news/google-settlement-means-stock-split-can-proceed [https://perma.cc/9YQ5-PGGP] (“By creating a new class of non-voting shares, Google will be able to keep rewarding other employees with more stock and financing potential acquisitions of stock without undermining the voting power of Page and Brin.”).[/footnote] 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.[footnote]See Geeyoung Min, Shareholder Voice in Corporate Charter Amendments, 43 J. Corp. L. 289, 294 (2018) (“Under both the Model Business Corporation Act and the corporate law of all 50 states, including the Delaware General Corporation Law, amending a corporate charter requires both directors’ and shareholders’ approvals.”).[/footnote] 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.[footnote]Steven Davidoff Solomon, Google’s Stock Settlement May Not Do Much for Shareholders, N.Y. Times: Dealbook (Sept. 11, 2013), https://dealbook.nytimes.com/2013/09/11/googles-stock-settlement-may-not-do-much-for-shareholders (on file with the Columbia Law Review ) (“Only about 12.7 percent of Google’s Class A stockholders . . . voted in support of issuing the Class C stock. That’s a pretty poor showing by any measure.”).[/footnote] Class A shareholders swiftly responded to the recapitalization by bringing a breach of fiduciary duty lawsuit in Delaware.[footnote]See Plaintiffs’ Opening Pretrial Brief, In re Google Inc. Class C S’holder Litig., No. 7469-CS (Del. Ch. filed June 10, 2013), 2013 WL 2728583.[/footnote] 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.[footnote]Id. at 32 (“Self-dealing is present where, as here, special benefits from a potential transaction flow to the controller.”).[/footnote] The Google defendants, however, claimed that the decision ought to receive the deferential business judgment protection.[footnote]See infra note 90 and accompanying text.[/footnote] Ultimately, the parties settled the dispute on the eve of the trial.[footnote]See Settlement Hearing and Rulings of the Court at *29, In re Google Inc. Class C S’holder Litig., No. 7469-CS (Del. Ch. argued Oct. 28, 2013), 2013 WL 6735045 (“We settled on the eve of trial, literally on the eve of trial.”).[/footnote] 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.[footnote]See id. at *37 (describing the case as “interesting and novel” such that then-Chancellor Leo E. Strine, Jr. thought “it would be hazardous for anyone to predict how it would have come out”).[/footnote] 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.[footnote]See Facebook Inc., Schedule 14A Information: Proxy Statement Pursuant to Section 14(a) of the Securities Exchange Act of 1934, at 55–73 (May 2016) [hereinafter Facebook, May 2016 Proxy Statement], https://www.sec.gov/Archives/edgar/data/1326801/000132680116000053/facebook2016prelimproxysta.htm [https://perma.cc/48JQ-5SP3]; IAC/InterActiveCorp, Schedule 14A Information: Proxy Statement Pursuant to Section 14(a) of the Securities Exchange Act of 1934, at 16 (Nov. 2016), http://ir.iac.com/static-files/409d5e1a-a42c-4af9-a6ed-8dd9ad20feb4 [https://perma.cc/Y35V-ZHNQ].[/footnote] 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.[footnote]See infra note 98 and accompanying text.[/footnote] Another company adopted a more cautious approach, and structured the recapitalization ex ante in a way that complied with the entire fairness review.[footnote]See IRA Tr. FBO Bobbie Ahmed v. Crane, No. 12742-CB, 2017 WL 7053964, at *6–9 (Del. Ch. Dec. 11, 2017) (noting that “entire fairness review” would apply to the plaintiff’s claim); see also infra notes 99–104 and accompanying text.[/footnote] 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.[footnote]See CBS Corp. v. Nat’l Amusements, Inc., No. 2018-0342-AGB, 2018 WL 2263385, at *2 (Del. Ch. May 17, 2018). The plan would have diluted the controller’s voting power from approximately 80% to about 17%. Id.[/footnote] 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.[footnote]Id.[/footnote] Yet again, the resulting suit ended in settlement.[footnote]See CBS Corp., Current Report (Form 8-K), at exh. 10(a) (Sept. 9, 2018), https://www.sec.gov/Archives/edgar/data/813828/000119312518269601/d622048dex10a.htm [https://perma.cc/5T4U-V4XF].[/footnote] 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?[footnote]By “controlled company,” this Article refers to those companies whose shareholder base is such that one shareholder owns a majority of the company’s voting stock.[/footnote] This question has not been explored,[footnote]In his article on hostile takeovers, Ron Gilson argues that courts lack competence to determine whether it is “fair” to leave control with management or the bidder. See Ronald J. Gilson, A Structural Approach to Corporations: The Case Against Defensive Tactics in Tender Offers, 33 Stan. L. Rev. 819, 824–27 (1981). Gilson, however, does not address conflicts over the reallocation of control rights in controlled companies. Moreover, he explains that the problem with fairness review of control contests is that courts lack the competence to review what are essentially business decisions. See id. at 827 (arguing that such a fairness inquiry “raises the same issue of judicial competence which justifies a restrictive judicial role with respect to the duty of care”). By contrast, this Article posits that the problem is the absence of acceptable methodologies for valuing control rights.[/footnote] 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.[footnote]See Blair Nicholas & Brandon Marsh, Dual-Class: The Consequences of Depriving Institutional Investors of Corporate Voting Rights, Harv. Law Sch. Forum on Corp. Governance (May 17, 2017), https://corpgov.law.harvard.edu/2017/05/17/dual-class-the-consequences-of-depriving-institutional-investors-of-corporate-voting-rights [https://perma.cc/TKC2-HSAA] (noting a continuing trend of “issuing dual-class or multi-class stock”).[/footnote] Yet, while a long line of Delaware case law has addressed disputes over various forms of midstream reallocations of control rights,[footnote]See infra section I.B.[/footnote] the Delaware courts have not yet adopted a clear approach concerning the standard of review that applies to these reallocations of control rights.[footnote]Even if parties to recapitalization litigation continue to settle their disputes, the correct standard of review remains central for bargaining at the settlement stage. In particular, uncertainty in the case law risks not only inaccurate assessments of the strength of cases but also increased aversion to pursuing midstream recapitalizations at all. For instance, Facebook not only paid a huge sum of money in attorney’s fees but also withdrew its recapitalization altogether. Jef Feeley & Sarah Frier, Facebook to Pay $67.5 Million in Fees in Suit over Shares, Bloomberg: Technology (Oct. 25, 2018), https://www.bloomberg.com/news/articles/2018-10-24/facebook-to-pay-67-5-million-in-fees-in-non-voting-shares-suit (on file with the Columbia Law Review ). It is the latter distortion in the settlement process that poses the greatest danger. See infra note 98.[/footnote] 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[footnote]See infra section I.A. CBS was an exceptional case that did not raise concerns for self-dealing by a controlling shareholder but rather a conflicted action by the board. See infra note 109 and accompanying text.[/footnote]—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.[footnote]Under so-called “entire fairness” review, defendants face the burden of establishing both (1) a fair price for the disputed transaction and (2) a fair process (“fair dealing”) followed by the defendant board in considering and approving the disputed transaction. See Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983).[/footnote] 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.[footnote]See infra section I.A.1.[/footnote] Similar economic models for valuing the reallocation of control rights simply do not exist .[footnote]A look at the table of contents of the leading corporate finance textbooks reveals that there is no chapter about valuation of control rights. See, e.g., Richard A. Brealey, Stewart C. Myers & Franklin Allen, Principles of Corporate Finance (12th ed. 2017); Stephen A. Ross, Randolph W. Westerfield & Bradford D. Jordan, Fundamentals of Corporate Finance (12th ed. 2018). Section II.B.2, infra, discusses the studies that attempt to overcome the absence of a method to evaluate control rights and explains why these methods do not even purport to value the effect of control by a specific individual over a specific company.[/footnote] 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,[footnote]See Zohar Goshen & Assaf Hamdani, Corporate Control and Idiosyncratic Vision, 125 Yale L.J. 560, 617 (2016) [hereinafter Goshen & Hamdani, Idiosyncratic Vision]. That article assumes that entrepreneurs value control because it allows them to pursue their vision. For other explanations for why control of public corporations may be valuable to controllers, see generally Ronald Gilson, Controlling Shareholders and Corporate Governance: Complicating the Comparative Taxonomy, 119 Harv. L. Rev. 1641 (2006) (arguing that controlling shareholders are driven by nonpecuniary private benefits, rather than pecuniary benefits of control).[/footnote] 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.[footnote]See infra section II.B; cf. Zohar Goshen & Richard Squire, Principal Costs: A New Theory for Corporate Law and Governance, 117 Colum. L. Rev. 767, 811 (2017) (“If firms were identical . . . then any reallocation of control rights between investors and managers would increase one type of cost and decrease the other type by equal amounts . . . . [O]nly when firms have different attributes [do] differences in governance structures matter, as each firm aims at finding its optimal structure.”).[/footnote] 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.[footnote]See infra section III.A.1.[/footnote] 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.[footnote]See infra section III.B.[/footnote] 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.[footnote]Applications of contract law principles are not uncommon in the corporate law space. In particular, the rights of bondholders in Delaware have traditionally been resolved as a matter of contract interpretation. See, e.g., Dale B. Tauke, Should Bonds Have More Fun?: A Reexamination of the Debate over Corporate Bondholder Rights, 1989 Colum. Bus. L. Rev. 1, 8 (“In determining what rights and protections holders of publicly issued bonds of solvent corporations have against adverse corporate action, courts have traditionally looked to contract law.”).[/footnote] 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).[footnote]See infra Part II.[/footnote] 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.[footnote]See infra section III.B.2.[/footnote] 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.

Dual-Class Stock

CORPORATE CONTROL, DUAL CLASS, AND THE LIMITS OF JUDICIAL REVIEW

SEIZING THE FIRST-MOVER ADVANTAGE: RESOLVING THE TENSION IN DELAWARE LAW BETWEEN BOARDS OF DIRECTORS AND CONTROLLING SHAREHOLDERS