Delaware and the Perils of Small Minority Controllers

Senate Bill 21 (SB21), currently pending in the Delaware legislature, proposes amending the Delaware General Corporation Law (DGCL) to weaken constraints on related party transactions between a corporate controller and its company. (See description of the Proposal in a Morris Nichols post on the Forum here.) The proposed change seems to be at least partly driven by fears that companies with a controlling shareholder would leave Delaware. While the proposed legislation is attracting a significant commentary, we are writing to highlight an important issue that has received insufficient attention: the substantial distorting effect that controllers with a minority equity stake have on the incorporation choices of their companies and thereby on Delaware’s attempts to maintain its leadership position in the incorporations market.

An earlier article by two of us, The Perils of Small-Minority Controllers, defined small-minority controllers as shareholders that have control, due to a dual-class structure or some other factors, despite having a minority or sometimes even a small minority of the equity capital. Companies with a small-minority controller seem to have played a significant role in the recent pressures on Delaware. The Trade Desk, Tripadvisor, Dropbox, and Meta – companies that reincorporated out of Delaware or were reported to be contemplating doing so – are all dual-class companies with small-minority controllers. This significant role of small-minority controllers, we argue below, can be understood by considering their incentives.

The General Costs of Small-Minority Controllers:

The analysis of The Perils of Small-Minority Controllers showed that “small-minority controllers” have distorted incentives which operate to increase considerably agency costs and governance risks. In companies with a controller that is, say, a majority owner, the controller’s ownership stake forces her to bear the majority of the economic effect of her choices on firm value.  This provides a strong ownership incentive that operates to align the interests of the controller with those of public investors and thereby limit agency costs.

By contrast, a different calculus arises when a small-minority controller considers a possible corporate action that would provide the controller with a significant private benefit but would reduce firm value. Consider a controller with a small, 10% stake of the equity capital (but has a lock on control due to a dual-class structure or otherwise) that is considering an action that would provide her with a private benefit of 20 but reduce cash flows shared by all shareholders by 100. In this case, although the action would be substantially value-destroying overall, it would serve the controller’s interests, as her private benefit of 20 would exceed the 10% fraction of the 100 reduction in cash flows that she would have to bear. Due to this calculus, the analysis shows, small-minority controllers have substantially distorted incentives with respect to a wide array of corporate choices, including with respect to related party transactions, taking of corporate opportunities, potential sales of the company, and management turnover. These substantially distorted choices are expected to produce considerable agency costs (see, e.g., Cremers, Lauterbach, and Pajuste (2024)).

The Potential Migration Decisions of Small-Minority Controllers:

This brings us to the current moment.  Small-minority controllers have been frustrated by the attempts by the Delaware Supreme Court and the Court of Chancery to place effective limits on the powerful conflicts of interest presented by transactions between companies and their small-minority controllers. Among other things, in In re Match Group, Inc. Derivative Litigation (April 4, 2024), the Delaware Supreme Court reaffirmed that, in controller conflict transactions, the controller bears the burden of establishing “entire fairness” unless the transaction is approved both by fully informed and independent directors and by fully informed and disinterested shareholders.

This naturally and rationally led small-minority controllers to consider reincorporating their company from Delaware to another jurisdiction, such as Nevada or Texas, that would place fewer limits on controllers’ decisions. Here again the distorted incentives of small-minority controllers will be at work. The logic of distorted incentives, which we explained above, implies a severe distortion in controllers’ choice whether and where to reincorporate.

Consider again a small-minority controller with a 10% stake of the equity capital that is considering whether to migrate from Delaware to Nevada or Texas. And suppose that the move to the other state would be overall value-decreasing and reduce the total cash flows shared by all shareholders by 100. In this case, as long as the laxer rules of the other state would provide the controller with a private benefit exceeding 10 (and thus exceeding the fraction of the reduction in cash flows that the controller would have to bear), the small-minority controller would be better off using its control to migrate from Delaware to Nevada or Texas.

We note that as long as reincorporation does not require the approval of public investors (as the recent Tripadvisor decision of the Delaware Supreme Court makes clear), small-minority controllers would be able to use their control to induce the company to reincorporate if they so choose. At Trade Desk, the votes of Jeff Green, the small-minority controller, made the outcome a fait accompli.  Similarly, at Tripadvisor, the reincorporation passed with the votes of Maffei, its small-minority controller. At Dropbox, the reincorporation was approved through written consents, and the small-minority controller had enough votes to approve the reincorporation. Should Mark Zuckerberg decide to reincorporate Meta away from Delaware, the company’s dual-class structure would enable him to get the proposal approved despite the small fraction of equity capital he owns.

Thus, when a small-minority controller would be able to obtain more favorable legal rules in in another jurisdiction, they would have the power to move their company to that jurisdiction – regardless of how the move would affect the interests of public investors. And the prospect of such moves by Delaware-domiciled companies with a small-minority controller poses a threat to Delaware.

Delaware’s Response:

With the backing of Delaware’s governor, SB21 attempts to fight off and prevent an exodus of controlled companies from the state. It does so by considerably relaxing the rules that constrain controlling shareholders in Delaware companies, and thereby making staying in Delaware more attractive for such controllers.

Some supporters of the proposed legislation might view it as a natural part of healthy competition for incorporations. But our analysis above indicates that this is not the case. The reason is that, in putting forward SB21, Delaware public officials are trying to compete not by making Delaware law on controlling shareholders better for firm value and investors at large.

Rather, the supporters of SB21 are seeking to compete by making Delaware law on controlling shareholders more attractive to the controlling shareholders. Our analysis above indicates that making Delaware law more attractive to controlling shareholders might be very different from making Delaware law best for investors and firm value.

SB21 has not been proposed because small-minority controllers and those promoting their interests have demonstrated that relaxing the constraints on controllers would best serve firm value and the interests of shareholders. Rather, SB21 has been proposed to induce controllers to retain their Delaware incorporation. Whereas relaxing such constraints could achieve this goal, there is good basis for concerns that doing so would adversely affect public investors and firm value.