Chapter 19Duties of Controlling Shareholders

Chapter 19Duties of Controlling Shareholders

Outline

(last updated 19 Nov 06)

Chapter 19Duties of Controlling Shareholders

Transactions within Corporate Groups

Sinclair Oil Corp. v. Levien
Parent-subsidiary dealings
nature of control
existence?
how used?
Financing decisions
parental preference?
business judgment rule, if not
Business allocation
parental preference?
identify subsidiary’s interests, expectancies
Inter-subsidiary dealings
parental preference?
intrinsic fairness
measure of fairness in non-market contexts

Cash Out Transactions
Cash out mergers: the Weinberger analytical framework
Weinberger v. UOP, INC.
Business purpose test outside of Delaware
Exclusivity of appraisal after Weinberger
entire fairness: the relationship of fair dealing and fair price
Kahn v. Lynch Communication Sys.(Lynch I)
Kahn v. Lynch Communication Sys.(Lynch II)
Director liability in cash out transaction
In Re Emerging Communications, INC. Shareholders Litigation
Alternatives to cash out merger
In Re Pure Recourses, INC., Shareholders Litigation
In Re Computer Systems, INC. Stockholders Litigation
Sale of a Controlling Interest
Control premium
Duty of care
Harris v. Carter
Duty of loyalty
Perlman v. Feldmann
Sale of office
Essex Universal Corp. v. Yates

Class notes

A. Transactions within Corporate Groups

Duties of controlling shareholders
Sinclair Oil Corp v. Levien
(Del 1971)
Sinclair Oil is a holding company. What does this mean? It has international oil operations that it conducts through many subsidiaries. One of these subs - Sinclair-Venezuela - is 97% owned, the remaining shares traded on the NYSE. SinVen drills for oil in Venezuela and is a lucrative business.
Like any parent, Sinclair thought it knew what was best for SinVen. From 1960-1966 SinVen made lots of money and Sinclair had it pay its earnings as dividends, rather than reinvest. At the same time, Sinclair had SinVen sell all of its oil to Sinclair International, a wholly owned Sinclair sub that coordinates Sinclair's foreign operations.
One of SinVen's minority shareholders brings a derivative suit and complains that Sinclair has been a bad parent. He wants the court to give SinVen a chance to expand and to stop preferring SinIntl - just like a child complaining that his parent plays favorites. What are the claims? / Delaware Court:
By reason of Sinclair's domination [of the SinVen board], it is clear that Sinclair owed SinVen a fiduciary duty. Sinclair concedes this.

Dividend policy
Why should a court allow an interested control shareholder to decide whether and when corporate cash flow goes to shareholders? Shouldn't there be heightened judicial review?
Are the rules on corporate distributions adequate to protect minority shareholders' interests? /
Delaware Court:
If a plaintiff can meet his burden of proving that a divided cannot be grounded on any reasonable business objective, then the courts can and will interfere with the board's decision to pay the dividend.
The dividends resulted in great sums of money being transferred from SinVen to Sinclair. However, a proportionate share of this money was received by the minority shareholders of SinVen. ..
Del GCL § 170

(a) The directors of every corporation ... may declare and pay dividends ... either (1) out of its surplus ..., or (2) in case there shall be no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year.
Allocation of business opportunities
Why should a parent be able to allocate business opportunities to its wholly-owned subs, disadvantaging the expansion potential of its partially-owned subsidiaries? Didn't the minority shareholders expect the parent would grow their business? / Delaware Court:
Sinclair made no real effort to expand SinVen. [While] Sinclair actively pursued a company-wide policy of developed through its subsidiaries new sources of revenue, but SinVen was not permitted to participate and was confined in its activities to Venezuela.
.... with which subsidiaries should these opportunities have been shared? No evidence indicates a unique need or ability of Sinven to develop these opportunities. The decision .... was one of business judgment. ...
Dealings between subsidiaries
Why is it a problem how Sinclair allocates profits among its subsidiaries? IF it has discretion to make cash flow decisions, why not profit allocation decisions?
Don't shareholders in a partially-owned subsidiary assume the risk that the parent might not treat them as favorites? / Delaware Court:
Sinclair caused SInVen to contract with International whereby SinVen agreed to sell al of is crude oil and refined products to International at specified prices. The contract provided for minimum and maximum quantities and prices. .... International's payment lagged as much as 30 days after receipt. International did not comply with the [fixed minimum] requirement.
Under the intrinsic fairness standard, Sinclair must prove that its causing SinVen no to enforce the contract was intrinsically fair to the minority shareholders.
Hypothetical
Sinclair and SinVen's tax returns are consolidated. This allows the parent to sue the losses of the subsidiary to offset the parent's income, thus reducing the parent's tax. This is valuable to the parent. How much should the parent pay the subsidiary for using its favorable tax position?
Sinclair's shareholders would want Sinclair to pay nothing - what is 97% for, anyway?
SinVen shareholders would argue they are creating something of value for the parent, and should be compensated. How much? What is the fair value of subsidiary tax losses - when there is no market? / Delaware Chancery Court (Trans World Airlines v. Summa Corp - 1977)
[parent corporation] bargained on both sides on the [purchase of jet aircraft]. Accordingly, by refusing to allow TWA to select and finance the purchase of its own jet aircraft, the defendants were in position to mete out to TWA such jet aircraft as they chose. .... [parent corporation] retained the capability of arranging the terms of such acquisitions so as to benefit themselves.
... the minority shareholders of TWA received nothing in exchange for the strictures imposed by [parent corporation] on plaintiff's operations.

B. Cash Out Transaction

Entire fairness- squeeze-out merger
Weinberger v. UOP, Inc
(Del 1983)
The Signal Companies is a diversified oil and gas company. Three years ago Signal made a $21 per share tender offer and acquired a majority (50.5%) interest in UOP, a oil and gas service company.
Signal has some extra cash. Instead of distributing it to shareholders for them to invest, management wants to invest it by acquiring all of UOP. / What are the reasons for acquiring 100% control?
(1) Signal 50.5% > UOP
(2) Signal 100% > UOP
What if --

Signal enters into below-market service contracts with UOP?
Signal takes big dividends rather than reinvesting UOP's excess cash flow?
UOP has investment tax credits, but no tax liability?

Standard of review
You are Brewster Arms, general counsel of Signal. William Walkup, the company's CEO, has come to you, "Brew, the executive committee has been thinking of acquiring 100% of UOP. The 49.5% interest looks like a good investment."
Signal is incorporated in Delaware. Will shareholders sue? What will be the standard of review? Why not review under business judgment rule? Any advice? / Delaware Supreme Court:
"When directors of a Delaware corporation are on both sides of a transaction, they are required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain..... There is no dilution of this obligation where one holds dual ... directorships, as in a parent-subsidiary context.
Delaware Supreme 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 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 ... assets, market value, earnings, future prospects ...
Structuring squeeze-out - fair dealing
What should you think of to make sure the merger passes scrutiny under the "fair dealing" prong? / (1) Who and when initiate?
(2) How structure?
(3) Who negotiates?
(4) What sub directors told?
(5) How sub directors approve deal?
(6) How sub shareholders approve deal?
(1) Initiation of squeeze-out
Is it fatal that the idea came from the parent's management?
(2) Structuring squeeze-out
Would a voluntary tender offer work? In this context, is there any differencebetween a merger and sale of assets?
(3) Who negotiates
Who should negotiate? Who negotiated in the actual Signal-UOP transaction? / Delaware Supreme Court:
"Although perfection is not possible, or expected, the result her could have been entirely different if UOP had appointed an independent negotiating committee of its outside directors deal with Signal at arm's length.
(4) Disclosure to subsidiary?
Who were Arledge and Chitiea? What did their report say? Must the subsidiary's directors always be toldthe parent's reservation price?
Would Weinberger v. UOP have come out differently had this information had been disclosed to the board?
(5) Process of approval -- sub directors
Must the subsidiary directors receive a fairness opinion? Should Lehman Brothers share some blame (liability) in this case?
(6) Process of approval - sub shareholders
Must the transaction be approved by --
 50.1% of all shareholders?
 50.1% of the minority shares at the meeting?
 50.1% of all the minority shares?
What did the UOP directors impose as a condition for the merger with UOP? What information must the minority shareholders receive, even though their vote may be pointless?
Structuring squeeze-out - fair price
What should you do to make sure the merger passes scrutiny under the "fair price" prong of judicial review? What was the method of pricing --

Delaware applied before Weinberger?
Delaware applies after Weinberger?

/ Delaware Supreme Court:
"... the discounted cash flow method [ie - earnings potential of UOP] was essentially the focus ... of Messrs. Arledge and Chitiea in the evaluation of the merger.
"We believe that a more liberal approach must include proof of value by any techniques or methods which are generally considered acceptable in the financial community ... "
Delaware block method / Assume UOP has the following blocks:
Avg earnings (present value) $120
Book value (historic asset cost) $100
Market value (price X # shares) $ 75
Proportionate weight of each block:
Avg earnings (present value) 55%
Book value (historic asset cost) 35%
Market value (price X # shares) 10%
Then figure a weighted value:
Avg earnings $120 X .55 = $ 66.00
Book value $100 X .35 = $ 35.00
Market value $ 75 X .10 = $ 7.50
TOTAL = $108.50
Voila! The total value of the company.
Discounted cash flow / WONDERFUL NEWS
You have just won $1,000,000 in the state lottery. You will be able to repay some of your student loans. You will receive your prize in installments -- $50,000 each year for 20 years?
***********
How much did you really win?
Assume different discount rates:
10% discount rate: 5% discount rate:
Year 1: $45,455 Year 1: $47,619
Year 2: $41,322 Year 2: $45,351
Year 3: $37,566 Year 3: $43,192
Year 4: $34,151 Year 4: $39,176
......
Year 19:$ 8,175 Year 19:$19,787
Year 20:$ 7,432 Year 20:$18,844
TOTAL $425,678 TOTAL $623,111
What is UOP worth if you expect the company will have net earnings each year of $50 million into the foreseeable future?
In computing how much the company will earn (and thus how much it is worth) should you take into account added earnings potential as a result of the merger? Must you include the non-speculative future - the results produced by the transaction? / Delaware Supreme Court:
"It is significant that § 262 [the appraisal statute] excludes only the speculative elements of value that may arise from the "accomplishment or expectation of the merger .... We take this to be a very narrow exception ... designed to eliminate use of pro forma data and projections of a speculative variety relating to the completion of merger. "
Business purpose
Fair dealing and fair value -- the shareholder plaintiffs win in this case!! But is this sufficient protection for minority shareholders in a squeeze-out that they neither chose nor necessarily voted for? Shouldn't the majority also have to articulate a "business purpose" for the transaction? / Delaware Supreme Court:
"We do not believe that any additional meaningful protection is afforded minority shareholders by the business purpose requirement of Singer, Tanzier, Najjar, and their progeny.
CHOICE OF REMEDY
HYPOTHETICAL
After Kerkorian acquires 81% of Chrysler, his acquisition company (Tracinda) proposes a squeeze-out merger. Shareholders who did not tender their shares (19% minority) will receive the same $50 offered in the tender offer.
Non-tendering shareholders bring a class action. Can they have the merger rescinded? Shouldn't their only remedy be appraisal? / Delaware Supreme Court:
"While a plaintiff's monetary remedy ordinarily should be confined to the more liberalized appraisal proceeding herein established. ... The appraisal remedy we approve may not be adequate in certain cases, particularly where fraud, misrepresentation, self-dealing, deliberate waste of corporate assets, or gross and palpable overreaching are involved....
"Under such circumstances, ... equitable and monetary relief [may] be appropriate, including rescissory damages"
What about MBCA? / NC Bus Corp Act § 55-13-02 Right to dissent.
(b) A shareholder entitled to dissent and obtain payment for his shares under this Article may not challenge the corporate action creating his entitlement, including without limitation a merger solely or partly in exchange for cash or other property, unless the action is unlawful or fraudulent with respect to the shareholder or the corporation.

Corporations: Law & Policy Page

Chapter 19 – Duties of Controlling Shareholders