The Yale Law Journal

VOLUME
125
2015-2016
NUMBER
3
January 2016
560-795
Article

Corporate Control and Idiosyncratic Vision

Zohar Goshen & Assaf Hamdani

abstract. This Article offers a novel theory of corporate control. It does so by shedding new light on corporate-ownership structures and challenging the prevailing model of controlling shareholders as essentially opportunistic actors who seek to reap private benefits at the expense of minority shareholders. Our core claim is that entrepreneurs value corporate control because it allows them to pursue their vision (i.e., any business strategy that the entrepreneur genuinely believes will produce an above-market rate of return) in the manner they see fit. We call the subjective value an entrepreneur attaches to her vision the entrepreneur’s idiosyncratic vision. Our framework identifies a fundamental tradeoff, stemming from asymmetric information and differences of opinion, between the entrepreneur’s pursuit of her idiosyncratic vision and investors’ need for protection against agency costs. Entrepreneurs and investors address this inevitable conflict through different ownership structures, each with different allocations of control and cash-flow rights.

Concentrated ownership, therefore, should not be viewed as an unalloyed evil. To the contrary, it creates value for controlling and minority shareholders alike. Our analysis shows that controlling shareholders hold a control block to increase the pie’s size (pursue idiosyncratic vision) rather than to dictate the pie’s distribution (consume private benefits). Importantly, when the entrepreneur’s idiosyncratic vision is ultimately realized, the benefits will be distributed pro rata to all investors. Our framework provides important insights for investor protection and corporate law doctrine and policy. We argue that corporate law for publicly traded firms with controlling shareholders should balance the controller’s need to secure her idiosyncratic vision against the minority’s need for protection. While the existing corporate-law scholarship has focused solely on the protection of minority shareholders, we show that it is equally important to pay heed to the rights of the controlling shareholders.

authors.Zohar Goshen is the Alfred W. Bressler Professor of Law, Columbia Law School and Professor of Law at Ono Academic College. Assaf Hamdani is the Wachtell, Lipton, Rosen & Katz Professor of Corporate Law, Hebrew University of Jerusalem. For helpful comments we are grateful to John Coffee, Luca Enriques, Deng Feng, Merritt Fox, Jesse Fried, Ronald Gilson, Andrew Gold, Victor Goldberg, Jeff Gordon, Henry Hansmann, Robert Jackson, Curtis Milhaupt, Gideon Parchomovsky, Ariel Porat, Alex Raskolnikov, Ruth Ronen, Alan Schwartz, Robert Scott, Alex Stein, Yishay Yafeh, and the participants in the following events: the Columbia Law School Faculty Talk; the NYU/Penn Conference on Law & Finance; the 23rd Annual Meeting of the American Law and Economics Association; the Workshop on Responsibility and Accountability of Corporate Ownership 2013, Copenhagen Business School; the Law and Economics Workshops at ETH Zurich, Switzerland and Harvard Law School; and the Law and Finance Seminar, University of Oxford. We are grateful to Daniel Belke, Yosef Kalmanovich, Ray Koh, Jason Schnier, Brooke Sgambati, Anna Shifflet, and Alex Zbrozek for their superb research assistance and thoughtful editing work. We also thank the Milton Handler Faculty Research Gift, the Grace P. Tomei Endowment Fund, and the Hebrew University’s Center for Empirical Legal Studies of Decision Making and the Law for their financial support.


Introduction

Several prominent technology firms that went public in recent years, including Google1 and Facebook,2 adopted the controversial dual-class share structure in which the founders retain shares with superior voting rights. Alibaba, the Chinese company that set the record for the largest ever IPO, decided to list its shares in New York instead of Hong Kong so that it could use this dual-class share structure.3 Essentially, the goal of this structure is to allow the entrepreneur-controlling shareholder to preserve her indefinite, uncontestable control over the corporation.4 Commentators have criticized the dual-class structure for creating governance risks.5 But why do entrepreneurs insist on holding control in the first place?

The answer has important implications for corporate law. Most public corporations around the world have controlling shareholders,6 and concentrated ownership has a significant presence in the United States as well.7 For example, Facebook, Google, and Viacom all have controlling shareholders.8 In the concentrated-ownership structure, a person or an entity—the controlling shareholder—holds an effective majority of the firm’s voting and equity rights.9 The governance concerns raised by firms with controlling shareholders differ from the governance concerns associated with firms with dispersed ownership. Yet, legal scholars have largely overlooked the issues arising from firms with concentrated ownership.10 Moreover, as we explain below, Delaware’s doctrine concerning controlling shareholders has often been puzzling and inconsistent.11

Unlike diversified minority shareholders, a controlling shareholder bears the extra costs of being largely undiversified and illiquid.12 Why, then, does she insist on holding a control block despite having to bear these costs?13

The prevailing answer focuses on private benefits of control.14 According to conventional wisdom, entrepreneurs seek a controlling interest in order to exploit their dominant position and divert value from the company or its investor, thereby capturing private benefits of control. An alternative, and less pessimistic, theory proposes that allowing an entrepreneur to consume some level of private benefits is a necessary cost of incentivizing efficient monitoring and good performance.15 The controller in this explanation still diverts value to herself at the expense of investors, but on balance, her actions benefit the investors and the corporation as a whole.

Both theories explain corporate control as a function of private benefits. However, the depiction of controlling shareholders as being either motivated or rewarded by private benefits of control is unconvincing from both positive and normative standpoints. On the one hand, there may be good reason to doubt that most controlling shareholders around the world are opportunists whose motivation for control is the prospect of exploiting loopholes in minority-investor protection. On the other hand, it is by no means clear that investors, courts, and lawmakers should actually tolerate some level of value diversion by controlling shareholders in order to incentivize them to monitor management.

This Article offers an alternative explanation for the value of control by entrepreneurs. Under our framework, control allows entrepreneurs to pursue business strategies that they believe will produce above-market returns by securing the ability to implement their vision in the manner they see fit. The entrepreneur values control because it protects her against the possibility of subsequent midstream investor doubt and objections regarding either the entrepreneur’s vision or her abilities.

Control matters because business ideas take time to implement. This ongoing process requires numerous decisions, ranging from day-to-day management issues to major strategic choices. Perhaps the most important decision is whether to continue a business, change its course, or close it down. However, investors and entrepreneurs often need to make these decisions under conditions of asymmetric information or differences of opinion. Investors cannot always observe the entrepreneur’s efforts, talents, and actions. Therefore, it is hard for investors to determine the real cause of a corporation’s poor performance: it could be the entrepreneur’s incompetence or laziness, temporary business setbacks, or simply bad luck. Since the entrepreneur commonly knows more about the business and her own efforts and talent than investors, she has the ability to exploit investors by the way she manages the business. Investors will wish to contain this risk of agency costs by maintaining the right to close the business down or fire the entrepreneur. Even when investors and entrepreneurs have the same information, the complexity of the business and the uncertainty of the future might yield different beliefs as to the potential success or failure of the business. Consequently, under conditions of asymmetric information or differences of opinion, entrepreneurs and investors may disagree over whether a business should continue and in what fashion.

Thus, in our framework, both investors and entrepreneurs value control, but for different reasons. The entrepreneur wants to retain control over management decisions to pursue her idiosyncratic vision for producing above-market returns. That is, control enables entrepreneurs to capture the value that they attach to the execution of their idiosyncratic vision.16 Investors, by contrast, value control because it allows them to minimize agency costs.17

Henry Fords story illustrates our theory well. Ford did not invent the automobile, nor did he own any valuable intellectual property in the technology. He was competing with hundreds of other entrepreneurs attempting to create a “horseless carriage.” Ford, however, had a unique vision regarding car production. The Detroit Automobile Company, the first firm that he founded, was controlled by investors.18 While investors demanded that cars be immediately produced and sold, Ford insisted on perfecting the design prior to production, leading to delays and frustration on both sides. The tension eventually led investors to shut down the firm.19

Ford’s second attempt, the Henry Ford Company, was also controlled by investors. Again, after designing a car, Ford resisted the investors’ pressure to move directly into production.20 Ultimately, Ford’s obstinacy prompted investors to replace him with Henry Leland, who changed the company’s name to the Cadillac Automobile Company and successfully produced the car that Ford had designed.21 In Ford’s third attempt—the Ford Motor Company—he insisted on retaining control. This time, with no outside-investor interference, Ford transformed his innovative ideas for car design and production into one of the greatest corporate success stories of all time.22

The entrepreneur’s idiosyncratic vision has two distinctive features in our framework. First, it reflects the parts of the entrepreneur’s business idea that outsiders may be unable to observe or verify. This could be because the entrepreneur cannot persuade investors that she is the best person to continue running the firm or that her business plan will produce superior returns. Second, it reflects the above-market pecuniary return expected by the entrepreneur, which, if the business succeeds, will be shared on a pro rata basis between the entrepreneur and investors. Importantly, idiosyncratic vision need not concern an innovation or new invention: as long as the entrepreneur has a plan that she subjectively believes will result in above-market returns, she has idiosyncratic vision.

While it may seem intuitive that entrepreneurs enter a business aiming to beat the market and that they fear that differences of opinion with their investors might frustrate their vision, this explanation is absent from the existing economic literature. Economists reject the idea of beating the market because, in equilibrium, investments yield only normal market returns. And economists have thus far rejected the idea of differences of opinion—as opposed to asymmetric information—because rational actors with rational expectations will not have differences of opinion when they share the same information.23 Thus, economists have focused on private benefits as the principal motivation for holding control. This Article recognizes that controlling owners are often entrepreneurs who hope to increase the value of their firms by implementing their idiosyncratic visions. Building on this insight, we offer an explanation of controlling ownership that is more aligned with real-world experiences and therefore offers superior policy prescriptions. Indeed, only recently, and gradually, economists have started to acknowledge the pursuit of above-market returns24 and the existence of differences of opinion.25 Our Article thus makes an important contribution to the theory of corporate control.

Our argument unfolds as follows. In Part I, we describe the limits of the existing explanations of corporate control. The minority-expropriation theory views controlling shareholders around the world as opportunists aspiring to expropriate minority shareholders and extract private benefits of control at their expense. The optimal-reward theory views controlling shareholders as providing a valuable service of monitoring management and suggests that an optimal level of private-benefit extractions should be allowed to induce efficient monitoring. However, these accounts fail to explain the prevalence of firms with controlling shareholders in countries with robust regimes of investor protection, such as the United States. They also offer very limited guidance concerning the corporate legal rules that should govern firms with controlling shareholders.

In Part II, we develop our theory of corporate control and use it to analyze the building blocks of corporate-ownership structures. We identify a fundamental tension that arises whenever entrepreneurs raise funds from investors under the conditions of asymmetric information and differences of opinion: while entrepreneurs want the freedom to pursue their idiosyncratic vision, investors seek protection from agency costs. We then show that the entrepreneur and investors can use different combinations of control and cash-flow rights to balance the investors’ concern regarding agency costs against the entrepreneur’s interest in pursuing her idiosyncratic vision.

In Part III, we use our theory to uncover the essence of the bargain between outside investors and controlling shareholders. We first show that corporate ownership structures can be recast as combinations of cash-flow and control rights that entrepreneurs and investors adopt to balance the conflicting objectives of minimizing agency costs for the investors and maximizing the entrepreneurs’ ability to pursue their idiosyncratic vision. We then explore the spectrum of public-company ownership structures: concentrated-ownership (the controlling shareholder holds a control block of shares having equal cash-flow and voting rights), dispersed-ownership (shares are widely held by investors), and dual-class firms (the controlling shareholder holds shares with superior voting rights that allow it to hold a majority of voting rights without holding a majority of cash-flow rights). Both dispersed-ownership and the dual-class structures represent variations on the separation of cash flow and control,26 thereby exposing investors to management agency costs (i.e., mismanagement). Concentrated ownership, by contrast, bundles cash-flow rights and control together. While dispersed ownership, with its contestable control, constrains the ability of entrepreneurs to pursue their idiosyncratic vision, an entrepreneur in the concentrated-ownership structure enjoys permanent and uncontestable control,27 much as she does in the dual-class structure. The controlling owner values permanent and uncontestable control because it allows her the freedom of action that is often necessary to realize her idiosyncratic vision. At the same time, the controller-entrepreneur’s large equity stake limits investors’ exposure to management agency costs.

Finally, in Part IV, we outline the corporate-law implications of our framework. The existing corporate-law literature focuses solely on protecting minority shareholders from agency costs.28 Our new theory of corporate control, however, requires lawmakers and courts to balance minority protection against controllers’ rights to secure their idiosyncratic vision. This tension between minority protection and controller rights underlies our blueprint of the policy considerations that should guide lawmakers crafting the legal regimes that govern firms with controlling shareholders.

As we demonstrate, a one-sided theory of corporate control, focusing only on minimizing agency costs, is blind to the cost of minority-protection regimes. Our theory, by contrast, uncovers the hidden cost of regulation—that is, interference with the entrepreneur’s freedom to pursue her idiosyncratic vision—and presents the legal challenge of balancing these goals. We show that one-sided theories inexorably lead to self-defeating suggestions of increasing minority protection while neglecting the essence of the concentrated-ownership contract. We also demonstrate that the recognition of controllers’ rights may justify legal outcomes that are contrary to the traditional notions of shareholder-value maximization. Specifically, we (1) offer a new rationale for applying the business-judgment rule to firms with controlling shareholders, (2) call for caution in adopting governance reforms aimed at enhancing director independence, and (3) argue for close scrutiny of controlling shareholders’ attempts to unbundle the link between control and cash-flow rights.

I. existing explanations and their limits

The prevailing explanations of concentrated ownership focus primarily on the availability of private benefits of control.29 As we explain in this Part, however, these accounts cannot explain the prevalence of concentrated ownership around the world and fail to offer a coherent theory of corporate law for firms with controlling shareholders.

A. The Minority-Expropriation View

According to conventional wisdom, the controlling shareholder seeks a controlling interest in the corporation to exploit her dominant position and consume private benefits at the expense of minority shareholders.30 She can pursue pecuniary benefits by entering into self-dealing transactions,31 engaging in tunneling,32 or employing family members. She can also pursue nonpecuniary benefits by boosting her ego and her social or political status through her influence on corporate decisions.33 In short, it’s good to be the king (or the queen).

With private benefits commonly perceived as a precondition motivating concentrated ownership, it is unsurprising that this ownership structure is often frowned upon.34 Empirical studies have confirmed that concentrated ownership is more widespread in countries that provide minority shareholders with weak legal protection.35 Control premiums—the difference between the price for shares in a control block and the market price of the minority shares—in countries with weak minority protection are also higher than in countries with strong minority protection.36 Concentrated ownership appears to thrive where weak legal protections allow a controlling owner to line her own pockets by taking advantage of minority shareholders.

The premise underlying the standard account of concentrated-ownership states that holding a control block is costly because it involves management monitoring, loss of liquidity, and reduced diversification.37 At the same time, the controlling position allows controllers to enjoy private benefits of control. It thus follows, according to the conventional view, that the more the controller can exploit the minority, the greater her interest in holding the block. The explanation concludes that low-quality investor protection encourages entrepreneurs to hold a controlling stake.

There are two problems with this explanation. First, it assumes that most controllers around the world are opportunists who take advantage of imperfect markets and weak protections for minority shareholders. Second, it cannot explain the significant presence of concentrated ownership in the United States and other countries with strong investor-protection laws.38 Nor can it explain the practice of retaining control blocks in a portfolio of firms by holding companies such as Berkshire Hathaway or by private-equity funds.39

Our analysis, by contrast, identifies reasons other than private benefits that motivate entrepreneurs to hold a controlling position and explains why concentrated ownership exists even in countries with strong investor-protection laws. In our framework, entrepreneurs value control even when they genuinely intend to share all of the firm’s cash flows and assets on a pro rata basis with minority shareholders.

B. The Optimal-Reward View

An alternative, less cynical view explains concentrated ownership by focusing on the value of monitoring. Instead of relying on imperfect markets to monitor management, investors rely on the controller to fulfill this role. Controllers play a constructive governance role because their substantial equity investment encourages them to monitor management more effectively than imperfect markets.40 However, because holding a control block imposes costs (i.e., illiquidity, reduced diversification, and monitoring), an entrepreneur would not agree to hold a control block without the prospect of securing a disproportionate share of cash flows—or equally valuable nonpecuniary benefits.41 Minority investors therefore should allow the controller to consume some degree of private benefits in exchange for her valuable monitoring service.42 Under this view, corporate law should tolerate the optimal level of private-benefit consumption by controlling shareholders. Put differently, this approach perceives (optimal) private benefits as an appropriate reward for the costs of holding a control block, including the cost of monitoring management.

Monitoring indeed plays an important function in assuring efficient management and corporate law assigns the role of monitoring to the board of directors.43 But why does monitoring require one to own a controlling block?

One possible answer is that the controller’s substantial equity stake aligns her interests with those of the minority shareholders, thereby providing superior incentives to monitor.44 But why rely on a controlling shareholder to monitor management rather than increase directors’ incentives to monitor effectively by improving their compensation?45 The answer could be that designing a compensation package replicating the incentives produced by a substantial equity block is too difficult or prohibitively costly.46 This could be the case, for example, in countries where financial markets or legal institutions are underdeveloped. This answer, however, fails to explain the variance of ownership structures within the countries. In other words, why can investors rely on market mechanisms to provide adequate monitoring at some companies, but not others?

Moreover, the claim that corporate law should tolerate the controllers’ optimal consumptions of private benefits is questionable even if controlling shareholders do provide effective monitoring that cannot be achieved through a compensation package.47 This claim is based on the assumption that the duty of loyalty prevents the parties from rewarding controllers for their monitoring effort.48 However, if the investors value the controller’s monitoring, minority shareholders can contract with her for compensation without the controller resorting to stealth consumption of private benefits.49

Under our framework, entrepreneurs value control because it allows them to pursue their idiosyncratic vision, thereby possibly producing above-market returns. Since controllers do not rely on private benefits to reward them for monitoring management and other costs of holding a control block, investors need not provide controllers with some degree of private benefits. Thus, our framework is more consistent with corporate-law doctrine, which does not tolerate controllers’ consumption of private benefits.

Having delineated two prevailing views on the incentives of controlling shareholders, we next present our competing explanation in which controlling shareholders value control because it allows them to pursue their idiosyncratic visions.

II. a theory of corporate control

Like the conventional explanations, we begin with the premise that holding a control block—the number of shares required to provide the controller with an effective majority of the votes—is costly. In our framework, however, controllers are willing to incur these costs because they expect the firm to produce an above-market rate of return. Despite this expectation, controllers cannot own the whole firm because they are wealth constrained and must raise funds from investors. The controller intends to share with investors on a pro rata basis the pecuniary benefits of her vision. But why would entrepreneurs insist on holding control and thus incurring costs if they genuinely intend to capture only their pro rata share of the firm’s cash flows?

The answer, we argue, relates to the fact that differences of opinion threaten to prevent the entrepreneur from pursuing her idiosyncratic vision. In our framework, both investors and entrepreneurs would like to maximize the firm’s expected return. Each party, however, may hold different beliefs concerning the best way to achieve this goal. Thus, control matters for an entrepreneur because it allows her to ensure that the firm will pursue her idiosyncratic vision even against the investors’ objections.

We do not argue that control offers no private benefits—pecuniary or nonpecuniary. Nor do we rule out the possibility that—especially in countries with weak protection of investor rights—private benefits will motivate some controllers to hold a control block. Rather, our analysis shows that controllers-entrepreneurs may value control even if they have no intention to consume private benefits. Put differently, one novelty of our framework is that it offers a theory that can explain why even investors who genuinely intend to consume no private benefits may nevertheless insist on retaining control.

The prevailing theories of concentrated ownership are an outgrowth of the financial-contracting literature, which assumes that entrepreneurs value control because it enables them to enjoy private benefits.50 Our analysis, however, is part of a growing body of literature that studies the implications of differences of opinion between entrepreneurs and investors.51 Specifically, we argue that a fundamental tradeoff between entrepreneurs’ pursuit of their idiosyncratic vision and investors’ desire for protection from agency costs underlies many corporate-ownership structures.

In Section II.A, we discuss the value of control for both entrepreneurs and investors under conditions of asymmetric information, differences of opinion, and agency costs. In Section II.B, we discuss the role of cash-flow rights.

A. Idiosyncratic Vision, Agency Costs, and Control

1. The Entrepreneur’s Idiosyncratic Vision

Our analysis of the value of control starts with an entrepreneur who has a business idea. This idea can be an invention of a new product, but it does not have to be an invention or a discovery. It can be an innovative method of marketing an existing product, capitalizing on a new market niche, motivating employees, creating an optimal capital structure, or utilizing new sources of capital.52 The entrepreneur might, of course, eventually be proven wrong about her idea. What matters for our analysis, however, is that the entrepreneur genuinely believes that successful implementation of the idea will produce an above-market rate of return on the total resources invested in the business (i.e., money, time, and effort).53 Think of an entrepreneur opening a shoe store on a street where ten other shoe stores already exist because she believes she can do better than the competitors.

We refer to the entrepreneur’s belief that a proper implementation of her strategy will produce above-market returns as her idiosyncratic vision.54 The entrepreneur’s idiosyncratic vision can relate to the business idea itself or the entrepreneur’s belief in her unique ability to execute it.55

For expositional convenience, our analysis in this Part focuses on a simplified setting of an entrepreneur with a business idea. Our notion of idiosyncratic vision, however, is not limited to individuals who open a new business. Even investment funds or managers of well-established publicly traded companies may have idiosyncratic vision. Consider, for example, a private-equity fund that buys control of an industrial conglomerate with famous brands but poor financial results and intends to increase profits by implementing its own management methods.56 Or the manager of a large, mature publicly traded corporation who genuinely believes that her business strategy will outperform the competition.57

If the entrepreneur has sufficient wealth, she can fund the entire business by herself, including the research required for development and the costs of implementation and marketing. As the sole owner, the entrepreneur holds all rights to the income from the business (cash-flow rights). She will assume all the risks and capture all the returns associated with the business. The entrepreneur will also make all the decisions, minor and major, associated with the business’s execution. She can pursue her idea for as long as she wants and in whatever manner she prefers, even if the business is losing money and every expert in the field believes that she is pursuing a surefire failure of an idea. No matter how much money she loses, no one can force her to sell the business, hire a professional manager, or close the business down. If in the end she fails, she might be called “stupid” or “smart but ahead of her time.” If she succeeds, she might be called “a visionary” or “a genius.”58

2. Outside Investors and the Value of Control

Assume, however, that the entrepreneur is short on funds and must rely on investors to provide funding. The parties must then decide on the allocation of control—will the entrepreneur or investors make decisions concerning the business? In our framework, the entrepreneur and investors share the objective of maximizing the firm’s expected return. At first sight, this common objective should make the parties indifferent to the allocation of control. As we explain below, however, problems of asymmetric information, differences of opinion, and agency costs make control valuable for both the entrepreneur and the outside investors.

The entrepreneur’s idiosyncratic vision will often include elements that outsiders, including the firm’s minority shareholders, cannot observe or verify. This could be because sharing the information with outsiders would destroy its value (e.g., competitors could copy the idea) or simply because the entrepreneur can present outsiders with nothing more than her strong conviction concerning the value of her idea. The uncertainty regarding the feasibility of the idea and differences of opinion are also possible reasons. An entrepreneur’s idiosyncratic vision can be shaped by her experience, management talent, knowledge, character, or intuition, all variables that are difficult to quantify.59 In our framework, the entrepreneur’s idiosyncratic vision thus becomes a source of asymmetric information and differences of opinion that cannot be overcome by increased monitoring, investigation, or disclosure.60

Asymmetric information and differences of opinion can arise ex ante when the entrepreneur tries to persuade investors to make the initial investment. Assume that the entrepreneur presents her business idea to potential investors, and they consult with experts who all opine that the idea is impossible. Even if our entrepreneur is successful in convincing investors to make the initial investment, informational asymmetry and differences of opinion may inhibit her ability to implement her business idea.

Business ideas take time to implement. This ongoing process requires many decisions, ranging from day-to-day management issues to major strategic choices. Assume that the entrepreneur convinces investors to make the initial investment, but then fails to deliver the product on time or at the quality initially promised. Persuading investors to continue the business at this stage might prove more difficult than convincing them to make the initial investment because the setback may cause investors to doubt either the entrepreneur’s ability to execute the business idea or her vision for the business.61 Asymmetric information and differences of opinion may lead investors to discontinue the business even when the entrepreneur genuinely believes that, notwithstanding the initial setback, the business will surely produce above-market returns. This is essentially what we believe occurred when investors shut down Ford’s first company.

Another famous example is Jobs’s failure, in 1985, to convince Apple’s board to pursue his proposed strategy for increasing the sales of the Macintosh Office, the suite of second-generation office software. The board sided with the company’s CEO, and Jobs, one of Apple’s founders, had to leave the Macintosh division and then the company.62

The risk of investors disrupting the entrepreneur’s pursuit of her idiosyncratic vision exists even when the firm is publicly traded and investors are using stock prices as a proxy for the firm’s performance. Markets do not necessarily overcome differences of opinion and asymmetric information. Moreover, markets might be myopic, preferring short-term over long-term investments, either because investors have different investment horizons or because it is too costly to correct inefficient pricing.63

Information asymmetry and differences of opinion are further exacerbated by the well-known phenomenon of agency costs, which arises whenever principals hire an agent to act on their behalf.64 In our context, agency costs are commonly divided into two types.65 Controllers can engage in mismanagement, including reduced commitment, shirking, pursuit of acquisitions just to increase firm size or achieve diversification without creating shareholder value,66 and investment of resources in entrenchment.67 Controllers can also engage in takings, directly diverting pecuniary private benefits to themselves by, for example, consuming excessive pay and perks68 or conducting favorable related-party transactions.69 In the typical case of a widely held public company, mismanagement dominates takings and the problem is labeled “management agency costs,” while in the typical controlling shareholder case, takings dominate mismanagement and the problem is labeled “control agency costs.”70

Agency costs have two potential effects on investors. First, the risk of agency costs could make investors less willing to trust the entrepreneur’s ongoing judgment about the business’s fate. Assume the entrepreneur informs investors about a delay in the business’s execution and asks for more time and money. Is the delay due only to temporary obstacles, with success still attainable? Or is the entrepreneur, who already knows that the business is doomed, attempting to exploit investors?71 Second, the existence of agency costs may heighten the value investors place on control, because this provides a means to mitigate agency costs, such as by firing the entrepreneur or closing down the business.

The inevitable tension between idiosyncratic vision and asymmetric information, differences of opinion, and agency costs makes one thing clear: control matters for both investors and entrepreneurs. Since contracts between entrepreneurs and investors are incomplete,72 the party with control over decision making will have more power in determining the business’s fate.73 On the one hand, control empowers the entrepreneur to make the decisions that she believes are necessary for the firm to produce above-market returns, even against investors’ objections. On the other hand, while they expect to enjoy their pro rata shares if the entrepreneur is successful, investors know that granting control to the entrepreneur creates a risk of agency costs.

These conflicting interests make contracting between entrepreneurs and investors challenging. It is impossible to provide investors with full protection from agency costs and the entrepreneur with unlimited freedom to pursue idiosyncratic vision; therefore, the parties must agree on an acceptable compromise between these two goals.

B. Control and Cash-Flow Rights

We have thus far explained why control matters for both entrepreneurs and investors. We now explain the interplay between control and cash-flow rights in allowing entrepreneurs to pursue their idiosyncratic vision while protecting investors against agency costs.74

1. The Role of Cash-Flow Rights

The execution of the business idea will generate income that, after paying all fixed claims (e.g., to suppliers and employees), represents the return on the business idea and the parties’ investments. The parties should allocate these cash flows between the entrepreneur and the investors.75 This allocation of cash flows is traditionally understood to determine the parties’ risk and expected return.76

Our framework, however, suggests that the allocation of cash flows can play two additional roles. First, the entrepreneur’s cash-flow rights shape her incentives, thereby affecting agency costs. Stock options (a form of residual cash-flow rights), for example, can reduce agency costs by aligning the entrepreneur’s interests with those of the investors. Second, the allocation of cash-flow rights can determine the boundaries of the entrepreneur’s control. For instance, if all of the investment is made at the start of the business, the entrepreneur will have more autonomy than if the investment is made in several stages according to milestones.77 Similarly, an investment based on a commitment to unconditionally pay fixed amounts on predetermined dates (i.e., debt) will provide the entrepreneur with more discretion than an investment with a commitment to pay residual cash flows on a discretionary basis but subject to termination at will (i.e., equity).

2. Control and Cash-Flow Rights as Substitutes

Control rights and cash-flow rights sometimes serve as substitutes for each other when balancing idiosyncratic vision and agency costs. Control and cash-flow rights may thus serve as building blocks that can be used in different combinations to balance idiosyncratic vision and agency costs.78

In some cases, cash-flow rights can provide their holders with de facto control. For instance, consider a case where the entrepreneur has full control over managerial decisions, but investors commit to make their investments in stages. In this case, investors’ cash-flow rights—in the form of staged financing—provide them with de facto control over an important subset of management decisions, namely, the decision whether to continue the business. In other cases, cash-flow rights can compensate for the loss of control. For example, assume that investors can design a compensation package that provides the entrepreneur with the same (above-market) expected return that she would receive from implementing her idiosyncratic vision.79 In this case, the entrepreneur might agree to assign control rights to investors.80

3. Bargaining Power and Competition

We have thus far shown that investors and entrepreneurs can adopt different combinations of cash-flow and control rights to balance entrepreneurs’ interest in pursuing their idiosyncratic vision and investors’ desire for protection from agency costs.The specific combination that the parties adopt will reflect the outcome of the negotiations between investors and entrepreneurs. This outcome depends on each party’s relative bargaining power. The same business could thus result in different allocations of control and cash-flow rights. When capital is generally scarce (e.g., when interest rates are high) or when capital for a specific area of business is scarce (e.g.,a shortage of venture capital funding), investors can attain a better deal.81 By contrast, when capital is chasing business ideas, or when the entrepreneur has a particularly appealing idea or track record, she can bargain for more favorable terms.82 Furthermore, agency costs and idiosyncratic vision are not necessarily valued symmetrically. Thus, the entrepreneur might proportionally value control rights much more than the increase in price that the investors will demand due to their increased exposure to agency costs.83 In other words, competition and relative bargaining power can result not just in different pricing, but also in variations in a contract’s quality of terms (from the investors’ or the entrepreneur’s perspective) for the same basic deal.

III. concentrated ownership revisited

Our analysis thus far can be summarized as follows: first, while investors value control because it offers them protection from agency costs, entrepreneurs value control because it allows them to pursue their idiosyncratic vision. Second, any contract between entrepreneurs and investors must balance the entrepreneurs’ freedom to secure their idiosyncratic vision and the investors’ protection against agency costs. Third, the investors and entrepreneurs will allocate cash-flow and control rights to achieve this balance.84

Our theory of corporate control offers two novel insights. First, corporate ownership structures can be recast as different combinations of cash-flow and control rights. Second, each combination of cash-flow and control rights represents a different balance between idiosyncratic vision and agency costs. As this Part will show, these insights offer a new understanding of the fundamental tradeoffs underlying concentrated-ownership, widely held, and dual-class firms.

A. Toward a New Theory of Corporate Ownership Structures

1. The Spectrum of Ownership Structures

To appreciate the fundamental tradeoffs underlying corporate ownership structures, it may be helpful to think about both control and cash-flow rights as a pie with a fixed size85: as more control (cash-flow) rights are provided to investors, less control (cash-flow) rights are available for entrepreneurs. Essentially, control rights are divided between entrepreneurs and investors along one dimension, as are cash-flow rights. The zero-sum nature of control and cash-flow rights enables us to recast all corporate ownership structures as alternative contracts lying along this two-dimensional spectrum.

Consider two examples located on opposite ends of the spectrum of ownership patterns. In the first example, investors hold full control rights and all residual cash flows, while the entrepreneur receives only a fixed salary. One can describe this arrangement as an employment contract in which the investors hire the entrepreneur. The entrepreneur, however, retains some degree of control even in this case. The investors can fire the entrepreneur at will, but as long as she is in office, the entrepreneur maintains control over the day-to-day decisions. This allocation of cash-flow rights therefore leaves investors exposed to agency costs (of the mismanagement type) caused by the misaligned interests of the entrepreneur who only receives a fixed salary. Investors’ exposure to agency costs is limited, however, by their control rights—they can terminate the entrepreneur at will. In turn, the uncertainty of her employment term limits the entrepreneur’s freedom to pursue her idiosyncratic vision.86

At the other end of the spectrum, the entrepreneur holds all control and cash-flow rights, whereas the investors hold only a fixed claim on the business’s cash flows. This setting is commonly described as a loan contract in which the entrepreneur borrows from creditors (investors). As financial economists have long recognized, however, even creditors with fixed claims retain contingent control rights.87 As long as she pays creditors on time, the entrepreneur can make all the decisions, but in the event of a default, control may shift to the investor creditors.88 By holding full control rights, the entrepreneur has nearly unlimited freedom to pursue her idiosyncratic vision. However, this same freedom exposes investors to the agency costs of debt (e.g., increasing the riskiness of the business).89 This exposure is limited only by their contingent control rights, which, in turn, set a ceiling on the entrepreneur’s freedom to pursue her idiosyncratic vision.90

2. Dual-Class Firms and Dispersed Ownership

As our focus here is on the concentrated-ownership structure, we apply our framework only to publicly traded firms. We start with the two ends of the spectrum: dispersed-ownership and dual-class firms. We then show that concentrated ownership represents an optimal solution between these extremes.

In the dispersed-ownership structure, shareholders hold nearly all residual cash flows, while management receives a salary and a small fraction of residual cash flows through options and bonuses included in its compensation package.91 Leaving management with only a small fraction of residual cash flows exposes investors to management agency costs.92 Those costs, however, are curbed by shareholders’ control rights, which provide shareholders with the ability to terminate management.93 At the same time, the threat of replacement curtails management’s ability to implement its idiosyncratic vision.94

Control in a dispersed-ownership structure is contestable. The degree of contestability presents a tradeoff between agency costs and idiosyncratic vision: less-entrenched managers expose investors to lower agency costs, but at the expense of the managers having less ability to pursue their idiosyncratic visions.95

In the dual-class structure, the entrepreneur holds shares with superior voting rights, while investors’ shares have voting rights that are inferior or nonexistent.96 Notable examples of corporations with dual-class structures are Facebook97 and Google.98 By owning a majority of the voting rights, the entrepreneur retains full control over business decisions and can block any hostile-takeover bids. Uncontestable and indefinite control provides the entrepreneur with maximum ability to realize her idiosyncratic vision, which, under our framework, can ultimately benefit both the entrepreneur and investors (if the entrepreneur turns out to be right).99 However, the entrepreneur’s uncontestable and indefinite control, coupled with the entrepreneur’s smaller fraction of residual cash flows, leaves investors with high exposure to both management agency costs100 and control agency costs (the takings type).101 Indeed, although prominent technology firms such as Google, Facebook, LinkedIn, Groupon, Yelp, Zynga, and Alibaba adopted the dual-class structure, this ownership structure is used infrequently because of investors’ substantial exposure to agency costs.102

B. Concentrated Ownership

Conventional wisdom links concentrated ownership to private benefits of control. In our framework, however, concentrated ownership, which is situated between the extremes of dispersed-ownership firms (low idiosyncratic vision and low agency costs) and dual-class firms (high idiosyncratic vision and high agency costs), represents yet another way to balance idiosyncratic vision and agency costs. Specifically, by tying the entrepreneur’s freedom to pursue her idiosyncratic vision to her large equity stake, concentrated ownership significantly alleviates shareholders’ agency costs associated with relinquishing control to the entrepreneur.

In both the concentrated-ownership and the dual-class structures, the entrepreneur controls the company by virtue of owning the largest share of the company’s voting equity. In both structures, the entrepreneur’s uncontestable control provides her with the freedom to pursue her idiosyncratic vision. But uncontestable control also provides controllers in both structures with similar ability to exploit minority shareholders and thus aggravate the control agency problem. However, the incentive to expropriate the minority is not similar under both structures. The higher the controller’s share of cash-flow rights, the lower her incentive to expropriate the minority.103 Unlike in the dual-class structure, equity in a concentrated-ownership structure is issued at a ratio of one share to one vote.104 As control rights are distributed pro rata according to each shareholder’s investment, the controller cannot preserve her control without holding a substantial fraction of cash-flow rights. Thus, while the exposure to the control-agency problem is high in a dual-class structure (high incentive due to small equity), it is only moderate in the concentrated-ownership structure (low incentive due to large equity).

In the dispersed-ownership and the dual-class structures, those with de facto control do not necessarily hold a majority of cash-flow rights.105 Thus, these structures expose investors to management agency costs. The concentrated-ownership structure, however, provides a middle-ground solution: it bundles cash-flow rights and control. Under a “one share, one vote” regime, the entrepreneur can retain control only if she holds cash-flow rights sufficient to give her control. Indeed, holding a control block inflicts costs on the entrepreneur. She needs to put her equity at risk, reducing liquidity and diversification, and to work either directly by serving as a manager or indirectly by monitoring professional managers. Under the conventional view, the entrepreneur is willing to pay this price in order to enjoy the private benefits of control. Under our framework, however, the entrepreneur is willing to bear these costs in order to hold indefinite and uncontestable control, which enables her to pursue her idiosyncratic vision. After all, this is a comparatively small cost, as the entrepreneur herself is (subjectively) confident she will make above-market returns on her investment and costs.106

From the investors’ perspective, the entrepreneur’s bundling of control and cash-flow rights alleviates both asymmetric information and agency-cost concerns. First, asymmetric information and differences of opinion as to the entrepreneur’s idiosyncratic vision are priced differently when the entrepreneur’s own equity—for example, the equity investment required to secure a majority of voting rights—is placed at risk (thereby putting a lot of “skin in the game”). Second, substantial equity investment by the entrepreneur strongly aligns her interests with those of the investors, thereby reducing management agency costs. Third, since control blocks are relatively illiquid, bundling control and cash-flow rights restricts the ability of the entrepreneur to quickly walk away from the business. This type of lock-in effect increases the entrepreneur’s commitment to the business and in turn reduces agency costs for the investors.

To be sure, even entrepreneurs with a lot of “skin in the game” might make costly mistakes, such as making the wrong predictions about the market’s future direction. Yet, compared to entrepreneurs with relatively insignificant cash-flow rights—under both dispersed-ownership and dual-class structures—they have substantial incentives to avoid these mistakes.

Our analysis thus shows that concentrated ownership is not necessarily inferior to dispersed ownership. Each ownership structure presents a different balance between agency costs and idiosyncratic vision. The spectrum of ownership structures according to our framework can be summarized as follows:

Table 1.

spectrum of ownership structures

image002.gif

In sum, while contestable control constrains the entrepreneur’s ability to pursue her idiosyncratic vision under dispersed ownership, the concentrated-ownership structure allows her to enjoy indefinite and uncontestable control without subjecting investors to the high management agency costs associated with the dual-class structure. Control enables the entrepreneur to pursue her idiosyncratic vision for both herself and investors. However, the entrepreneur must pay for her position in the form of lost diversification and liquidity, and increased execution and monitoring costs. While the entrepreneur’s large equity stake protects minority shareholders from management agency costs, investors are nevertheless exposed to control agency costs. But, by tying the entrepreneur’s freedom to pursue her idiosyncratic vision to her large equity stake, concentrated ownership moderates the control agency cost by decreasing her incentive to exploit the minority shareholders.

IV. corporate law: controller rights and minority protection

In this final Part, we present the principal implications of our theory for corporate law. We offer a blueprint of the policy considerations that should guide lawmakers in the United States and around the world in crafting corporate legal regimes for firms with controlling shareholders. While recognizing the importance of minority protection, our theory also underscores the importance of allowing controllers to pursue their idiosyncratic vision. Thus, we argue that controlling shareholders’ rights play, and should play, a critical role in corporate law. We further argue that the interplay of minority protection with controllers’ rights sheds light on some of the most puzzling aspects of Delaware case law and jurisprudence concerning firms with controlling shareholders.

In Section IV.A, we argue that any legal regime governing firms with controlling shareholders encounters an inevitable tradeoff between the goals of protecting investors and allowing controllers to maximize idiosyncratic vision. As we explain in the subsequent Sections, this tradeoff should shape both governance arrangements and corporate doctrine moving forward.

In Section IV.B, we discuss the rights that controlling shareholders should have, demonstrating that recognition of the controllers’ rights may justify legal outcomes that are contrary to the traditional notions of shareholder-value maximization.

Section IV.C analyzes the main elements of minority protection. We advance two specific points. First, the need to balance idiosyncratic vision and minority protection may undermine the protection against self-dealing. Some self-dealing should be tolerated not because we believe that controllers deserve to be rewarded with private benefits, but because regulation would result in excessive interference with the controller’s pursuit of her idiosyncratic vision. Second, we argue that Delaware’s approach to identifying self-dealing transactions should be modified to account for the need to protect the minority from midstream changes to the firm’s governance structure.

Lastly, Section IV.D uses our framework to reevaluate several difficult corporate law cases and shed new light on their appropriate resolutions.

A. The Tradeoff Between Minority Protection and Controller Rights

Under our framework, the nature of the bargain underlying concentrated ownership is as follows: controllers-entrepreneurs retain control because of their concern that asymmetric information or differences of opinion may lead investors to prevent them from pursuing their idiosyncratic visions. Investors relinquish control in exchange for the substantial equity investment made by the controller-entrepreneur and the right to a pro rata share of cash flows.107

This understanding of the nature of concentrated ownership offers three basic prescriptions for corporate law. First, the law should protect investors’ right to a pro rata share of cash flows by containing agency costs and preventing controllers from capturing private benefits at the expense of minority investors.108 Second, the law should also recognize controllers’ rights to pursue their idiosyncratic vision. Finally, corporate law should preserve the link between controllers’ freedom to pursue their vision and their significant equity investment.

Corporate-law scholarship generally focuses on the first prescription: the need to protect outside investors against agency costs, i.e., controlling shareholders’ self-dealing and other forms of minority expropriation. Under our framework, however, the concentrated-ownership structure is based not only on the investors’ need for protection from agency costs, but also on the controller’s willingness to make a significant equity investment in exchange for the uncontestable right to implement her idiosyncratic vision. Our analysis, therefore, calls for corporate law to protect the controller’s right to pursue her idiosyncratic vision while simultaneously protecting minority investors from expropriation through self-dealing and other methods of value diversion.

Moreover, we argue that finding the appropriate doctrinal balance between minority protection and controller rights is challenging because of the inevitable tension between these goals. Ideally, corporate law should be designed to achieve both of these goals. Corporate law should secure minority shareholders’ rights to a pro rata share of the corporate pie, while preserving the controller’s freedom to pursue her idiosyncratic vision to maximize the corporate pie. As we explain below, this ideal goal is an elusive one.

First, it is difficult to distinguish those corporate decisions or transactions that genuinely concern the controller’s idiosyncratic vision from those designed to produce unequal distributions of gains between controlling and minority shareholders. Second, legal measures intended to protect investors from value diversion could also produce costly errors. Third, prohibiting non-pro-rata distributions might require interventionist measures that could undermine the controller’s right to execute her idiosyncratic vision.

To illustrate the interplay between minority protection and controller rights, assume the entrepreneur owns sixty percent of a firm. The entrepreneur genuinely believes that a specific component or material produced only by one other company is necessary for the development of a new product. It so happens, however, that the company producing the component is 100% owned by the entrepreneur. Accordingly, the entrepreneur wishes for her sixty-percent-owned firm to buy the components from her wholly owned company. If the entrepreneur were the sole owner of both firms, she could simply buy the component under any terms she desired. But with investors owning forty percent of the firm’s shares, there is an understandable suspicion that the entrepreneur is abusing her ownership stake to divert value from minority shareholders to her wholly owned corporation for her own benefit.

This illustration underscores the sometimes opaque line between the controller’s unfair self-dealing and legitimate decisions that ultimately affect the controller’s ability to implement her idiosyncratic vision. Protecting the minority against inappropriate value diversion requires some constraints on the entrepreneur’s ability to exercise control. These constraints can take the form of ex post review by courts as to the fairness of related-party transactions, or an ex ante requirement to secure approval of such transactions by a majority of the minority shareholders.109 Regardless of its form, minority protection against agency costs will necessarily require curtailing some of the freedom to pursue an idiosyncratic vision that the controller would have otherwise enjoyed as a single owner.110

One might argue that constraining self-dealing need not interfere with the controller’s ability to pursue her idiosyncratic vision. After all, the argument goes, if the controller does not intend to expropriate value from the minority, why would she care about the extra scrutiny? If the transaction is executed on arm’s-length terms, the court will find it to be fair ex post,111 or minority shareholders will grant their approval ex ante. This argument would be correct under the conditions of symmetrical information and zero transaction costs. In the real world, however, asymmetric information or differences of opinion may cause minority shareholders to err in evaluating the proposed transaction. Moreover, it is costly to screen self-dealing; plaintiffs sometimes bring suits without merit,112 courts make mistakes,113 and minority shareholders might strategically attempt to hold out.114 Other prophylactic measures aimed at creating an effective minority-protection regime also produce significant costs.115 Accordingly, protecting minority shareholders against agency costs may interfere with the controller’s right to pursue her idiosyncratic vision.

The tradeoff between minority protection and controller rights has obvious implications for the design of corporate law. Lawmakers and courts should seek an optimal balance between providing minority protection and preserving the freedom of controlling shareholders to make managerial decisions. More practically, the nature of minority protection should depend on the considerations of enforcement. Enforcing a given protection may be prohibitively costly not only because of the direct compliance costs incurred by corporations or courts but also because of constraints placed upon the entrepreneur’s pursuit of her idiosyncratic vision.116

B. Controller Rights

We start by analyzing the scope of the rights of a controlling shareholder in a concentrated-ownership structure and the type of protection that should accompany these rights.

1. Management Rights: The Business-Judgment Rule and Board Composition

The entrepreneur is willing to make a significant equity investment in exchange for the right to implement her idiosyncratic vision. The allocation of control matters in light of the asymmetric information and differences of opinion between the entrepreneur and the market. Some of the greatest breakthroughs in business ideas came from “crazy” or “visionary” entrepreneurs (e.g.,Ford’s assembly line and production design).117 These ideas might never have come to fruition in the absence of the entrepreneurs’ control. What then should be the nature of a controller’s right to pursue her idiosyncratic vision?

Corporate law should recognize the controlling shareholder’s right to exercise control over any issue that could affect the firm’s value. Controlling shareholders should be free to set the firm’s future direction and make all management decisions. This includes the right to assume a managerial role as well as the right to appoint and fire managers.

These rights seem to follow directly from the prevailing regime under which shareholders with a majority of the votes appoint all members of the board. Our analysis, however, has two implications for corporate-law doctrine and policy.

First, courts should generally refrain from interfering with nonconflicted business decisions that controllers or their representatives make. In other words, our analysis suggests a new explanation for the application of the business-judgment rule, which generally insulates disinterested directors from liability for negligence,118 to firms with controlling shareholders. Our analysis also questions some statements that Delaware courts made on the application of the duty of care to controlling shareholders.119 The controller-entrepreneur opts to retain control because of her expectation that asymmetric information or differences of opinion would otherwise lead minority investors to make decisions that would prevent her from pursuing her idiosyncratic vision. The ownership structure reflects a contractual agreement in which minority investors do not get any say in the management of the firm in exchange for the substantial equity investment staked by the controller-entrepreneur. In other words, the business judgment was sold to the controller-entrepreneur. Thus, a suit brought to court by a minority investor asking for judicial intervention in the controller-entrepreneur’s nonconflicted business decision runs contrary to the implicit contractual agreement embedded in the controlling ownership structure. Courts should apply the business-judgment rule to avoid intervention and ensure that the minority investors stick to their bargain.

Moreover, the existence of asymmetric information and differences of opinion should, independent of the contractual bargain claim, cause courts to pause before they attempt to intervene in business decisions. The asymmetric information and differences of opinion between the controller-entrepreneur and the court are more severe than between investors and controllers-entrepreneurs because courts require verifiable facts as the basis for their rulings. Thus, for the same reason that controllers are willing to bear additional costs in order to gain independence from investors, courts should not be empowered to make decisions that, from the entrepreneur’s perspective, would destroy her idiosyncratic vision. Empowering courts to do otherwise will nullify the ability of controllers-entrepreneurs to contract with investors for uncontestable control.

This rationale differs from the conventional justifications for noninterference with controlling shareholders’ business decisions.120 The conventional corporate-law literature assumes that judicial review of nonconflicted transactions is simply unnecessary in a concentrated-ownership environment, as the controller’s significant equity stake provides her with incentives to maximize value for all investors.121 Given their reduced agency costs, controlling shareholders are thought to be better positioned than either the courts or minority shareholders to make business decisions. Our explanation, by contrast, focuses on the need to offer the controller the freedom to implement her business plan even when investors (and courts) believe that such a plan would not enhance share value. Indeed, courts should refrain from interfering even when all minority shareholders agree that the controller is hopelessly wrong and that her business plan is certain to reduce share value in the future.122

Second, our diagnosis of the importance of controllers’ management rights sheds new light on corporate-governance reforms designed to enhance board independence at firms with controlling shareholders. Controllers’ voting power enables them to appoint any candidate they wish to the board. Recent corporate-governance reforms, however, constrain the controller’s power to appoint directors. Listing requirements, for example, require boards or board committees to maintain a certain percentage of directors who are independent, not only from the company, but also from the controller.123 Some legal systems go further and empower minority shareholders to influence board composition by, for example, appointing the minority shareholders’ representatives to the board.124

These prophylactic measures may be necessary to enforce the rule against self-dealing.125 Our analysis, however, explains why lawmakers should proceed cautiously when constraining controllers’ power to appoint board or management positions. Board reforms aim to make the board more effective in monitoring those with power—the CEO or the controlling shareholder. But asymmetric information and differences of opinion could prevent the controller-entrepreneur from credibly communicating her idiosyncratic vision not only to investors, but also to skeptical independent board members. Therefore, the need to balance controller rights and minority protection should also shape board reforms at firms with controlling shareholders. At a minimum, the controller should have the power to appoint a majority of the board, which in turn should have the power to appoint the CEO and other members of management.126

2. Property-Rule Protection: Preserving Control

To preserve the entrepreneur’s uncontestable control, her right to make management decisions should be afforded a property-rule protection.127 In other words, the market (i.e.,minority shareholders) or courts should not be able to unilaterally take control rights away from the controller-entrepreneur in exchange for objectively determined compensation; the controller should be able to prevent a nonconsensual change of control from ever taking place.128 The property-rule protection of controller rights has some straightforward implications that are consistent with existing doctrine and are no different from those associated with the standard protection of private property. As courts in Delaware have long recognized, controllers cannot be forced to sell their control blocks even when doing so would clearly benefit the corporation or its minority shareholders.129 The controller is generally free to exit her investment by selling her control block whenever she wants and for whatever price she sees fit.130

Nonetheless, the controller’s property-right protection extends to a broader—and less intuitive—range of corporate actions, where corporate-law doctrine is less clear. Controllers can lose control not only when they sell their shares, but also when the company takes action—like issuing shares—that dilutes the controllers’ holdings. We claim that companies with controlling shareholders should not be required to take actions that would cause the controller to lose her control even when doing so would benefit the corporation or minority investors.

Consider the following hypothetical: a bank must increase its capital to meet new capital adequacy requirements. The bank has two options: issue new shares or sell one of its subsidiaries. The bank’s controlling shareholder, who owns fifty-one percent of the shares, has her own liquidity problems that prevent her from buying additional shares of the bank. Issuing new shares would therefore dilute the controller and may cause her to lose her control position. How should the board decide between the two options? At first glance, the directors’ fiduciary duties would require them to choose the option that best serves the company’s interests while disregarding the controller’s interest in preserving control. Our analysis, however, calls for another approach. Under our framework, the controlling shareholder cannot and should not be forced to lose her control. The board, therefore, should be prohibited from taking steps that would force the controller to lose control even when doing so would enhance share value. The board should thus decide to sell a subsidiary simply because issuing new shares would force the controller to lose control.131

While it is consistent with at least two Delaware cases,132 our approach leads to an outcome that contradicts the traditional notions of shareholder-value maximization, as the need to preserve control might drive firms with controlling shareholders to take value-reducing actions. Yet, a regime under which minority shareholders, the board, or courts could compel the controller to lose control—whether by a forced sale, dilution, or any other action—is inconsistent with the need to provide controllers with a property-rule protection for their right to make management decisions and to pursue their idiosyncratic vision. Importantly, this outcome is not justified by the need to provide controllers with private benefits to reward them for their willingness to monitor management. Rather, it is based on the parties’ mutual ex ante consentto an arrangement that enables entrepreneurs to pursue their idiosyncratic vision.

3. Right To Sell Control for a Premium

Whether controlling shareholders can sell their shares for a premium is one of the most important and controversial questions for firms with controlling shareholders.133 Delaware recognizes the right of controlling shareholders to sell at a premium, subject to the restriction on selling control to a looter.134 As explained above, the controller’s right to sell at any time is the essence of her property right.135 But what about the right to sell for a premium not shared by minority shareholders?136

A key premise underlying the objection to controllers’ right to sell for a premium is that a control premium is a proxy for private benefits and thus also a proxy for minority expropriation. Under this view, imposing constraints on controllers’ ability to sell for a premium would decrease the risk of inefficient sales motivated by the prospect of consuming private benefits at the expense of minority shareholders.137

Under our framework, however, a control premium is not necessarily a proxy for private benefits of control or the magnitude of minority expropriation. Instead, it could reflect the value that either the buyer or the seller entrepreneur attaches to her idiosyncratic vision. A seller who believes that she could earn above-market returns on her shares would insist on a premium for selling her stake even if, had she stayed in control, she would have shared the realized returns on a pro rata basis with minority shareholders. For the seller, the premium merely reflects the pro rata share of what she expected to receive had she stayed in control. Likewise, a buyer who believes he could make an even greater above-market return on the new investment would be willing to pay such a premium even if he intends to share these returns pro rata with the minority shareholders.138

C. Minority Rights

Our analysis of the minority shareholders’ side of the corporate contract focuses on the threats facing minority shareholders in a controlling shareholder structure and the type of protection that should be provided to enforce minority rights.

1. Pro Rata Share: Identifying Self-Dealing

Minority shareholders’ main concern is that the controller-entrepreneur will engage in self-dealing, tunneling, or other methods of capturing more than her pro rata share of cash-flow rights. The principal form of minority protection is the strong regulation of non-pro-rata distributions of the firm’s assets. In exchange for the controller’s freedom to pursue her idiosyncratic vision by executing her business idea as she sees fit, the controller commits to share proportionally with the minority any cash flows that the business will produce. If she seeks any preference over the minority, she should negotiate with investors and obtain their approval—either before entering the joint investment or before receiving the preference. Otherwise, any non-pro-rata distribution will be subject to strict judicial scrutiny.139

A legal regime governing companies with controlling shareholders thus should accomplish two important tasks: first, it should create a workable distinction between legitimate business decisions and self-dealing; and second, it should implement adequate mechanisms to govern self-dealing transactions. We discuss below the choice between different mechanisms to govern self-dealing. In this Section, we focus on the first element—the test for identifying those transactions that deserve closer scrutiny.

The distinction between self-dealing and other legitimate transactions is an important one. Under Delaware law, for example, this distinction determines whether a lawsuit challenging a transaction is carefully reviewed under the plaintiff-friendly entire-fairness standard or quickly dismissed under the defendant-friendly business-judgment rule.140 However, drawing the line between cases that deserve close scrutiny and those that do not is often difficult. For example, when the controller sells her privately owned asset to the publicly traded firm that she controls, she engages in clear self-dealing. In many cases, however, it is unclear whether close scrutiny is justified solely because the controller’s interests with respect to certain corporate actions are not fully aligned with those of the minority.141 We have no intention of resolving this issue here. Rather, we would like to use one famous example to argue that the test for identifying self-dealing should take into account the need to balance minority protection and controller rights.

Consider the dividend distribution question underlying Sinclair Oil Corp. v. Levien.142 In this seminal case, Delaware’s Supreme Court held that pro rata dividend distributions do not require close judicial scrutiny even when the company decides to pay these dividends in order to satisfy the controller’s liquidity needs.143 Should courts protect the minority against the risk that a controlling shareholder will use a pro rata dividend distribution to advance its own liquidity needs or other interests? The Sinclair court provided a clear answer to this question: no. It held that pro rata dividend distributions do not amount to self-dealing and should thus be reviewed only under the business-judgment rule.144 Is this truly the most desirable outcome?

Indeed, a pro rata distribution could be used to satisfy the controller’s own liquidity needs while denying the corporation highly profitable growth opportunities. In other words, a pro rata dividend distribution could be harmful to minority shareholders. Nevertheless, as we explain next, a legal rule that attempts to supervise the controller and prevent such abusive distributions would not only be too costly, it would also violate the implied contract underlying concentrated ownership.

Any rule that would try to scrutinize pro rata dividend distributions would necessarily interfere with the controller’s management rights and her ability to secure her idiosyncratic vision. First, control over the firm’s capital structure—the amount of capital that is required and how to finance the firm’s operations—might be an integral part of implementing an entrepreneur’s strategy.145 Outside intervention would therefore significantly interfere with the controller’s ability to make managerial capital decisions. Second, efforts to distinguish legitimate dividend distributions from illegitimate ones are prone to error because of asymmetry of information and differences of opinion.146 Third, even if courts were able to accurately determine that a certain dividend is illegal, effective enforcement would itself require excessive intervention in the firm’s management. A disgruntled controller who is prohibited from paying a dividend to meet her liquidity needs may decide, for example, to avoid risky investments and instead deposit the dividend amount in the firm’s bank account in order to distribute the same amount in the near future. Will courts, in such a case, allow minority shareholders a cause of action to force the controlling shareholder to invest the funds in a more profitable alternative? Clearly, courts will not create a cause of action that will require them to assume responsibility for management decisions in which the controller is forced to put the money to other, more profitable uses. In other words, effectively policing the pro rata distribution of dividends would ultimately require courts to abandon the business-judgment rule.

Our discussion of Sinclair thus shows that the inevitable tension between controller rights and minority protection should shape the legal distinction between self-dealing and other legitimate transactions. The interests of controlling shareholders, to be sure, are not always fully aligned with those of minority investors—even when it comes to pro rata dividend distributions. Yet not every conflict of interest justifies legal intervention to protect the minority.

2. Midstream Changes

The preceding analysis provides support for Delaware’s approach to self-dealing transactions. In this Section, however, we explain that the same approach fails to protect minority shareholders against controlling shareholders making unilateral changes to the firm’s governance midstream. Controlling shareholders could theoretically enjoy more than their pro rata share of the business by using their control to change the firm’s governance arrangements midstream either directly through changes in the charter and/or bylaws or indirectly through some business combination, such as a merger. These changes could be inconsistent with the initial contract between the entrepreneur and investors underlying the concentrated-ownership structure.147

Consider, for example, the link between control and cash-flow rights. As we explained in the last Part, under the one share, one vote rule, bundling control with a significant equity investment mitigates management agency costs and asymmetric information concerns. Once the controller raises funds from investors, however, she might be tempted to unravel this arrangement and find ways to preserve uncontestable control without having to incur the costs associated with holding a large equity block. For example, a controller might attempt to amend the corporation’s certificate of incorporation to provide for tenure voting, whereby the governance right of the minority would be diluted (a change similar in its effect to forcing the minority into a dual-class structure).148 A necessary element in any minority-protection scheme is, therefore, a protection against unilateral, midstream changes to the firm’s governance arrangement.

Indeed, on several occasions, minority shareholders unsuccessfully attempted to challenge such changes in Delaware courts. Courts refused to review these changes under the entire-fairness standard, holding that the disparate economic impact of such changes on the controller did not amount to self-dealing as long as the legal effect was equal.149

Under our theory, however, courts should protect minority shareholders against the controller’s attempt to back away from her commitment to bundle control and cash-flow rights.150 Part of the problem may be that Delaware courts use a single test for two distinct tasks—identifying self-dealing and preventing midstream governance changes. The problem of midstream governance changes by controlling shareholders requires its own legal framework. Similar to self-dealing cases, this framework should consist of two elements: first, identifying cases of midstream changes that deserve some level of scrutiny, and second, making a decision as to the nature of protection that minority shareholders should enjoy.

3. Type of Protection

Minority rights, like controller rights, could be protected by a liability or property rule.151 Under a liability rule, the controller can engage in self-dealing transactions without minority shareholders’ consent, subject to her duty to pay an objectively fair price (a commitment supervised by courts ex post). Under a property rule, the controller cannot engage in self-dealing without securing the minority’s consent (typically by a majority-of-the-minority vote ex ante).

The need to balance controller and minority rights affects the desirable form of minority protection. A property rule provides the minority with consent-based protection that is vulnerable to holdout, thereby creating a risk of the minority interfering with the controller’s management right. By contrast, a liability rule provides the minority with fair, compensation-based protection vulnerable to judicial mistakes, but it is less likely to interfere with the controller’s management rights.152 That is, under a liability rule, the transaction takes place and only its price is litigated, while under a property rule the minority can terminally block the transaction. As a result, we believe that the tradeoff between minority protection and controller rights supports a liability-rule protection for minority shareholders to better balance minority protection against agency costs and preservation of idiosyncratic vision.153 As we explained earlier, Delaware’s corporate law indeed relies on judicial review to scrutinize controllers’ self-dealing. Given Delaware’s ecosystem of specialized courts and vibrant private enforcement, we find this approach desirable.154

D. Difficult Cases

In this Section, we consider two examples of transactions that have captured the attention of courts and scholars alike and are not easily classified as dealing with either minority protection or controller rights. We first address freezeout transactions. As we will explain, transactions of this type raise an inevitable and difficult tension between minority protection and controller rights. We then address Delaware’s indeterminate approach concerning transactions in which both the controller and the minority sell, for equal consideration, 100% of the firm to a third party. In this case, the need for minority protection is substantially weaker than in a freezeout transaction. At the same time, however, subjecting these transactions to closer scrutiny is unlikely to interfere with the controller’s right to secure her idiosyncratic vision.

1. Freezeout Transactions

In a freezeout transaction, the controlling shareholder of a publicly traded company buys out minority shareholders in order to take the company private.155 Although freezeouts have been the subject of extensive analysis by legal scholars,156 courts continue to struggle with the proper approach to regulating these transactions.157 Our analysis offers a new perspective on the difficulty of crafting an optimal freezeout regime.

Let us start with controller rights. In our view, the inevitable conflict between minority protection and controller rights calls for providing controllers with an option to discontinue their partnership with the minority by taking the firm private. Buying out the minority may be required when keeping the firm public interferes with the realization of the entrepreneur’s idiosyncratic vision.158 Additionally, bolstering minority protection increases the likelihood that such protections would interfere with the realization of idiosyncratic vision, thereby creating an increased need to make it possible for controllers to take the corporation private.159 Finally, there is an obvious difficulty in forcing an entrepreneur to work for others—minority investors—for as long as minority investors wish.160 As a matter of legal doctrine, the need to provide the controller with an option to buy out the minority explains why Delaware courts have abandoned the requirement that freezeout transactions satisfy a business purpose test.161

For minority shareholders, however, freezeout transactions present a substantial risk of expropriation on a large scale. Controlling shareholders might opportunistically use the option to buy out the minority at unfair prices while taking advantage of their superior access to information regarding the firm’s value.162 The risk of expropriation calls for effective measures to protect minority shareholders in freezeout transactions.

But a property-rule protection—that is, making a freezeout conditional on a mandatory majority-of-the-minority vote—might undermine the controller’s option to take the firm private in order to preserve her idiosyncratic vision in two respects.163 First, asymmetric information or strategic voting considerations might lead minority shareholders to vote against proposals of going private that are actually fair to the minority, thereby preventing the controller from making an exit that could secure her idiosyncratic vision. Second, forcing the controller to stay has the same consequence as preventing dividend distribution.164 The court will have to interfere with management’s decisions, normally protected by the business-judgment rule, to make sure the controller continues to work efficiently for the minority. Therefore, despite the high risk of expropriation, minority shareholders’ protection should tilt toward a liability-rule protection.165

Our analysis thus calls for a narrow reading of the Delaware Chancery Court’s decision in In re CNX Gas Shareholders Litigation, which addressed the scope of judicial review for going-private transactions structured as tender offers. It is possible to read the decision as requiring controlling shareholders to allow the board to use a poison pill to prevent a freezeout.166 Under this interpretation, a controlling shareholder would be significantly limited in her ability to complete a going-private transaction. However, in a subsequent decision, the court seemed to suggest that a poison pill is required only if the controller wishes to avoid judicial review of the transaction under the entire-fairness standard.167 In other words, the court essentially allowed controllers to choose between a liability rule (judicial review) and a property rule (majority-of-the-minority vote and board veto). Allowing controllers to choose the regime that would apply to their going-private transaction seems consistent with the pursuit of idiosyncratic vision.168 However, a regime that would compel controllers to subject their going-private transaction to the substantial delays associated with a board’s deployment of a poison pill would unnecessarily delay the freezeout by forcing the controller to replace the directors before merging.

2. Sale to a Third Party

The last case we consider is a transaction in which a third party, unrelated to the controller, buys all of the company’s shares from both the controller and the minority shareholders. In a transaction of this type, the controller—with a majority of the votes—can effectively force the minority to sell their shares (an implied drag-along option).169 Delaware courts have reviewed such transactions under different levels of scrutiny, depending on whether the controller and the minority received equal consideration. A sale to a third party raises genuine minority-protection concerns when the consideration for the controller differs from that payable to the minority. Cases of this type create a conflict between the controller and the minority over the allocation of the sale proceeds. The controller might abuse her control over the target to divert value from the minority by creating a transaction with the third-party buyer that would benefit the controller at the expense of the minority. Not surprisingly, courts have subjected these transactions to the searching entire-fairness test.170

By contrast, when a third-party buyer offers equal consideration to all shareholders, minority shareholders apparently need no protection. After all, with the largest equity stake and no apparent conflict, the controller could be relied upon to work hard to achieve the most feasible and fairest bargain. Yet, Delaware case law on this issue is in remarkable disarray. While some decisions hold that these transactions do not require close scrutiny,171 others have allowed minority shareholders to proceed with claims that the controller’s need for cash—liquidity—created a conflict that justified the court’s closer review of the transaction.172

Delaware courts’ willingness to treat the controller’s liquidity needs as creating a conflict that justifies judicial review is especially puzzling given the courts’ reluctance to treat the controller’s liquidity needs as justifying judicial review in other contexts. As we explained in the last Section, the Delaware Supreme Court rejected minority shareholders’ claims that the controller’s unique liquidity needs create a disabling conflict that should subject even a pro rata dividend to the strict entire-fairness review.173 How can one explain this inconsistent treatment of controllers’ liquidity needs?

From this perspective, our framework sheds new light on the Delaware approach: we believe that the answer lies not in the nature of the conflict, but rather in the absence of concerns about the controller’s idiosyncratic vision.

To begin, the controller can sell her block at a premium, thereby taking her share of the expected value of idiosyncratic vision and enabling the minority to stay in and share the profits derived from the buyer’s idiosyncratic vision. Alternatively, the controller can freeze the minority out to pursue her idiosyncratic vision in a wholly owned corporation, subject only to minority shareholders receiving an appraisal right and entire-fairness protection.174 However, by contrast to these situations, the right to drag along the minority (by using the controller’s voting power to force a sale) does not protect the controller’s ability to pursue her idiosyncratic vision: the controller sells the corporation and ends her pursuit of her business strategy. Why, then, does the controller receive the right to force the minority to sell its shares together with her?

The answer is to allow the buyer to pursue his idiosyncratic vision in a wholly owned corporation. Instead of buying just the control block and then freezing out the minority, subject to appraisal rights and entire-fairness review, the buyer is willing to pay an equal premium to the minority to avoid the costs of a freezeout (i.e., time, effort, uncertainty, and litigation). In this scenario, the seller who forces the minority to sell together with her assumes the role of an auctioneer. However, while the controller has substantial holdings that normally induce her to maximize sale price, the same substantial holdings might also create a financial conflict over the type and structure of the consideration. Thus, while a board of directors of a widely held firm assumes the role of an auctioneer only subject to a heightened duty of care (i.e., Revlon duties)175 because it does not have a substantial financial interest, the controller might be subject to a fairness test due to her substantial financial interest in the deal.176

Therefore, it is clear that the controller’s liquidity needs should be treated differently. A regime that would impose scrutiny on dividend distributions would inevitably interfere with controllers’ management rights and might undermine their ability to pursue their idiosyncratic visions. These concerns cease to apply when the controller decides to sell the whole corporation to a third party. By putting her management rights up for sale, and also forcing the minority to sell, the controller signals that she is no longer concerned with her idiosyncratic vision. Moreover, a sale to the highest bidder also means that asymmetric information is no longer an issue. It is much easier to compare differences in considerations between bidders. In other words, employing judicial review is less likely to have negative consequences. Thus, a risk of a conflict of interest may correctly call for judicial scrutiny.

Conclusion

In this Article, we demonstrated that corporate-ownership structures represent a spectrum of contracts allocating control and cash-flow rights between entrepreneurs and investors. Our theory identifies the inevitable tension between the entrepreneur’s desire to pursue her idiosyncratic vision and the investors’ need for protection against agency costs as the main explanation for the various forms of ownership structures. Concentrated ownership is one such structure on this spectrum. It bundles control and cash-flow rights to foster the controller’s idiosyncratic vision and reduce the minority shareholders’ exposure to agency costs.

From this framework, we questioned the views that private benefits of control are vital to controlling shareholders and that improvement in monitoring explains the controlling-shareholder structure. In so doing, our theory marks a significant departure from the existing scholarship on corporate control. Instead of assuming that controlling owners are expropriators who are motivated by a desire to consume private benefits at the expense of minority shareholders, we assert that many controlling owners are instead motivated primarily by a desire to pursue their idiosyncratic visions that they believe will increase the value of their firms to the benefit of all shareholders. In addition to challenging the existing theories of concentrated ownership, we further explained how the tension between idiosyncratic vision and agency costs informs, and should inform, the shape of corporate law doctrines concerning corporations with controlling shareholders.