Controllers Unbound

We just placed on SSRN our study Controllers Unbound. This post is part of a series of posts, based on this study, about the expected dire consequences of the recent relaxing of constraints on controlling shareholders.

Delaware’s recent SB21 legislation substantially weakened the constraints on controllers of public companies. Weak constraints exist in other states—notably Texas and Nevada—and Delaware’s legislation appears intended, at least in part, to induce companies to avoid reincorporating to those jurisdictions. These weaker constraints, our study concludes, should be expected to produce large and detrimental effects for public investors and the broader economy.

Even among those who have expressed concern about SB 21 and the loosening of controller constraints, we believe, there is substantial underestimation of the expected harm. This underestimation, we contend, is also prevalent among institutional investors. We believe it is crucial for all those interested in protecting public investors and ensuring the efficient operation of corporate America to fully understand the looming risks, and we seek to contribute to that understanding. We hope our work will help educate investors and market participants about the significant dark clouds gathering over the U.S. capital markets.

The analysis of our study has several components, which we outline in turn below.

Our study begins by discussing the steady increase in the importance of controlled companies, especially dual-class companies, in the U.S. economy. Furthermore, we explain why this increase should be expected to continue and even accelerate its pace. When the incidence and economic significance of controlled companies grow, so does the importance of protecting public investors in such companies.

Our study next discusses the consequential weakening of controllers’ constraints by SB 21. We explain that, in a vast number of conflicted (non-freezeout) settings, SB 21 will greatly facilitate controllers’ ability to obtain the outcomes they desire, even when those outcomes do not serve the interests of public investors. Controllers will succeed in obtaining such outcomes so long as they can identify two individuals who are formally independent from the controller and willing to go along with the controller’s desired outcome—a task that, we explain, controllers will commonly be able to accomplish. Furthermore, even if the independent directors initially selected by the controller unexpectedly block the controller’s desired outcome, the controller will be able to replace them with two new independent directors and try again.

We then turn to identifying and analyzing a number of key channels through which controllers should be expected to obtain large benefits at the expense of public investors. While SB 21 has been opposed by many, some key channels through which weaker constraints will benefit controllers have received little attention. Among other things, we explain, benefits will flow to controllers in the following ways: (i) controllers will generally be able to cash out as much of their equity capital as they like without weakening their lock on control; (ii) controllers will generally be able to get rid of any sunset provisions in their companies’ charters and thereby fully perpetuate their lock on control; (iii) controllers will be able to obtain additional benefits through partial freezeouts and related party transactions; (iv) the compensation floodgates will open up and facilitate the payment of large compensation packages to controllers; and (v) controllers will be able to unilaterally reincorporate in states with lax constraints to the detriment of public investors. Overall, a sharp increase in controllers’ wealth is on the horizon.

Our study then proceeds to analyzing another important expected consequence of the relaxation of controller constraints: a transformation of U.S. ownership patterns. Whereas companies without a controller have long been dominant in the U.S., the incidence of controlled companies should be expected to grow substantially over time. This outcome should be expected both because controllers now have an increased incentive to retain control—due to the increased benefits associated with it—and because retaining the controller’s lock on control no longer requires the controller to abstain from or limit cashing out some of their equity capital. Importantly, whereas the incidence of control blocks will rise, the fraction of equity capital held by controllers will considerably decline. As explained, this expected move to structures with small-minority controllers will produce substantial efficiency costs and thereby harm both public investors and the economy.

We next analyze efficiency consequences more broadly. Whereas controllers are expected to gain significantly from the loosening of constraints, we show that these gains are expected to be substantially smaller than the large losses to public investors and to corporate value. Each of the channels through which private benefits will be obtained by controllers, we explain, will produce substantial distortions and deadweight efficiency costs. Due to these deadweight efficiency costs, the loss to public investors and corporate value should be expected to be considerably larger than the gains to controllers, with the excess being especially large in companies with small-minority controllers.

To highlight the severity of the effects we identify, our analysis also examines how the relaxation of controllers’ constraints will affect the quality of investor protection in the U.S. compared with that of other countries. This relaxation, we explain, will cause the quality of U.S. investor protection for controlled companies to decline substantially relative to the protection of controlled company investors in other advanced economies.

Some might question our conclusions on the grounds that, even if SB 21 were expected on its own to weaken investor protections, various mechanisms could provide substitute protections. Our study therefore addresses such objections. In particular, we consider possible arguments that (i) charter amendments could be adopted to provide such protections; (ii) institutional investor oversight could provide such protections; (iii) controllers might be deterred from taking advantage of opportunities to benefit themselves at the expense of public investors by the prospect of a decline in the market value of the controllers’ blocks; and/or (iv) controllers might be deterred from exploiting such opportunities by the prospect that doing so would impede or make more costly the raising of additional capital in the future. We explain that each of these four “mechanisms,” whether individually or collectively, will fail to adequately address the weakening of controller constraints brought about by SB 21.

Before concluding, we would like to make three general comments about our analysis and how it differs from existing work. First, our study’s aim is not to relitigate SB 21 and add to the extensive debate about it. The pressures on Delaware that led to its relaxing controller constraints are not expected to abate, and U.S. state corporate law is not expected to tighten such constraints in the coming years. Accepting the relaxation of constraints as given, we seek to provide institutional investors and all others interested in good corporate governance with a realistic assessment of the risks and challenges that should be expected to arise over time.

Second, we would like to emphasize how our views differ from those of others who have expressed concerns about SB 21 and the problems it exposed regarding state competition for corporate law. Some prominent commentators have opined that SB 21 itself is unlikely to have significant detrimental consequences, and their primary concerns seem to be with the potential implications if the processes producing SB 21 continue to operate. By contrast, and for the reasons explained in this Article, we claim that SB 21 is expected to generate considerable efficiency costs and reductions in corporate value that should concern anyone interested in investor protection and the performance of U.S. capital markets.

Third, whereas our study focuses on Delaware law, our policy analysis and conclusions are also relevant to other jurisdictions that have adopted or are considering the adoption of lax rules for controller conflicts. For example, there have been recent debates in some European countries as well as Brazil about the extent to which approval by independent directors should be sufficient to cleanse decisions involving controller conflicts. Our analysis can, we hope, also contribute to such debates.

Our study is available here, and any comments on it would be most welcome.