• 20 November 2009

Internal Poison Pills: Managing the Governance Tension Between Majority and Minority Shareholders with a Novel Financial Instrument

George S. Geis - University of Virginia School of Law

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Large corporations harbor dark corners, and these shadows shelter a daunting collection of governance concerns.  There are at least three internal governance problems.  First, lazy or dishonest managers might use their control of a firm’s daily operations to make poor decisions or steal that which rightfully belongs to shareholders.  Second, greedy shareholders may leverage their influence over managers to siphon wealth from other investors, such as lenders or preferred shareholders.  Third, a controlling majority shareholder, again working through compliant managers, may wrongfully extract value from minority owners.  Corporate law tries, with varying degrees of success, to arrest the guns of all actors in this Quentin Tarantino-style standoff.

The first two contests have already been carefully dissected in the academic literature.  This Editorial seeks to offer a partial solution to the third problem:  the civil war between majority and minority shareholders.  Several incongruous Delaware cases, the rise of private equity, and a flood of post-Sarbanes-Oxley freezeout mergers have underscored the need for lawmakers to confront the governance problems presented in this context.

The tension between majority and minority shareholders is especially interesting because lawmakers must walk a tightrope between two alternative hazards.  On the one hand, granting the majority shareholder untrammeled discretion can promote abuses of power that will depress the ex ante value of a firm.  Controlling shareholders enjoy many strategies for fleecing minority investors, but none are more potent than using a freezeout merger to take full ownership of the firm.  It is easy to see how an overly permissive freezeout policy might lower a firm’s market value:  Potential investors will fear that a controlling shareholder might price the merger at a ridiculously low level.  This fear will, in turn, depress the upfront price that minority investors would be willing to pay for the stock.

On the other hand, assigning too much power to minority shareholders can lead to a holdout problem, with recalcitrant dissenters demanding private payouts before blessing a beneficial merger.  Even if minority owners do not maintain an express veto over the transaction, generous remedial statutes or very strict standards of review present a risk of costly strike suits.  The legal challenge, of course, is how to balance the dual extremes of majority expropriation and minority holdout.

 
I.
Regulating Freezeout Mergers

Thus far, corporate law has dealt with the majority-minority governance problem, as it appears in the merger context, through a troika of regulatory policies.  First, under federal securities law, firms undergoing a freezeout merger must disclose detailed financial information to all shareholders.  Second, freezeout mergers are subject to judicial review (often in Delaware) to determine whether the firm’s directors or controlling shareholders have breached a fiduciary obligation to the minority owners.  And third, dissenting shareholders may have the right to file an appraisal claim, which theoretically ensures—again through a judicial proceeding—that minority owners receive fair value for their shares.  In a perfect world, these protections should act in concert to get the balance right.

Unfortunately, this three-part framework has not been very satisfying in practice.  Disclosure seems like a reasonable idea, but it often does not have much practical effect and is subject to loopholes.  Judicial review of fiduciary duties in freezeout mergers is messy, at least in Delaware, because inconsistent standards attach to similar economic transactions:  Courts will either adopt a strict “entire fairness” standard or award defendants the protection of the deferential “business judgment rule” depending on whether the deal is structured as a statutory merger or a tender offer.  And the appraisal remedy has long been criticized as a weak cure due to its stringent (and outdated) procedural requirements and its protracted use of costly adversarial litigation to value shares.

So if the current legal framework is not working, how should we deal with the freezeout problem?  Are there other sensible ways to divide the levers of power between majority and minority shareholders to help deter abusive deals and facilitate sensible ones?  Better yet, can we create rules that encourage firms to make reasonable tradeoffs themselves, using private contractual arrangements instead of costly judicial resources?

 
II.
Reframing Freezeouts as a Cathedral Problem

Except for the ubiquitous Coase Theorem,1 there may be no more famous law and economics framework than Guido Calabresi and Douglas Melamed’s “view of the cathedral.”2 This line of scholarship—dealing with the design, allocation, and transfer of legal entitlements—shows how rights can be protected either through property rules or liability rules.  Property rules vest the legal entitlement in one party, who may then sell that entitlement to another party if she wishes, but who cannot be required to sell it.  Liability rules, by contrast, allow the second party to force the first party to sell the entitlement at a judicially determined price.  Under either rule, the entitlement should end up with the party who values it most.

The freezeout problem can be perfectly mapped onto the cathedral framework by conceptualizing the right of minority shareholders to block a freezeout—or, alternatively, the right of a majority controller to conduct one—as a legal entitlement.  A property rule would unconditionally award minority owners the right to block a freezeout merger, which is effectively what the unanimous merger voting requirements of the early 1900s accomplished.  A liability rule, by contrast, gives the entitlement to conduct a freezeout merger to the majority shareholder, subject to the dissenting minority shareholders receiving a judicially determined price under appraisal.  The switch from unanimous shareholder voting to majority rule with appraisal rights can thus be understood as a move from a property regime to a liability regime for freezeouts.

This model is helpful in the freezeout context because recent work in this area has started to show how it is possible to parse legal entitlements even more finely.3 Instead of adopting a strict property or liability rule for freezeouts, we should consider intermediate strategies where embedded options are used as a form of mechanism design to award partial rights to each side.  If successful, this compromise might help to balance the dual concerns of holdout and expropriation by smoking out the concealed subjective valuations that form the heart of the freezeout problem.

The main idea is to replace a naked entitlement with a conditional one where the party receiving the entitlement has an obligation to write the other parties their own option as an additional part of the exercise price for the entitlement.  For example, a factory could be given a liability entitlement to pollute on neighboring land, but only if it writes the neighbor an option to purchase this entitlement at a strike price reflecting the factory’s subjective valuation of this right.  In other words, a privileged party is not just an option taker but also an option maker.  This means that those not receiving the entitlement would be allowed (and may be willing) to “buy back” the right under certain conditions.  The ultimate goal is to move away from judicial determination of an entitlement’s value by encouraging the parties to set private mechanisms (embedded options) that elicit their relative subjective values.  That is, laws are used not to allocate or price an entitlement, but rather to persuade private parties to expose their subjective valuations.

 
III.
Pressing an Internal Poison Pill

Along these lines, I believe that a new type of economic instrument can better balance the tension between majority and minority shareholders in the freezeout context.  I call it an “internal poison pill”—in obvious reference to the antitakeover device that famously sets the balance of power between target firms and third-party acquirers in the hostile takeover context.  An internal poison pill is similar to its cousin in that it seeks to craft economic disincentives to the trampling of the rights of impacted shareholders (minority owners in this context) as a way of restoring balance to merger deliberations.  Indeed, a traditional “external” poison pill (with only slight modifications) might be used to address this problem, although this is not the approach that I ultimately recommend.

Instead, I argue that a more flexible, though weaker, “internal” pill can offer a better compromise than the conventional medicine.  The focus of my proposed modification is on the power of redemption.  The main trick is to use embedded options to qualify the pill’s de facto veto power.  For example, as a requirement for exercising the pill’s discounted call option, minority shareholders would be required to write the triggering controlling shareholder an embedded option setting a price under which the minority shareholders’ poison pill rights could be redeemed.  Economic incentives (what I call a “catch”) should also be adopted to discourage the minority shareholders from demanding outrageous terms—such as requiring a redemption payment of $1,000,000 per share.  The procedures and economic incentives of this “internal” pill are more complex than those of a conventional pill; the easiest way to understand how it would work is to set out the basic design in the form of an extended example.

Start with the most elementary of freezeout scenarios.  A firm is divided among thirty-one owners:  a majority controller holding seventy shares and thirty minority owners, each holding one share.  The controller wants to conduct a freezeout and offers $55 per share ($5 above the prevailing market price of $50), conditioned on the tender of at least twenty shares, which would give the controlling shareholder 90% of the shares and unlock the use of a short-form merger to buy the other shares.  Some subset of the minority owners resist this transaction, arguing that the shares are worth more.  One of two things is happening here:  (1) $55 is a fair price and the dissenters are jockeying for more than they deserve; or (2) the shares really are worth more (perhaps because the market price is depressed by threat of expropriation), and the controller is attempting to pay less than she should.

Historically, the 70% owner enjoyed a unilateral option to execute the merger—subject only to the dissenting shareholders’ willingness to file a fiduciary duty lawsuit or seek appraisal rights.  Suppose, however, that the firm has an “internal” poison pill.  This pill contains three main features:  the primary call, the embedded redemption option, and the catch.

 
1.     The Primary Call

Under an internal poison pill, each shareholder receives the right—typically through the issuance of convertible preferred stock—to obtain additional common shares for a discounted price (which I will assume here to be zero for simplicity) if the pill is triggered through a control acquisition (i.e., the contemplated freezeout).  The pill discriminates against the triggering acquirer, however, and she is precluded from exercising her primary call.  So far, then, the pill operates exactly like the “flip-in” feature of a conventional poison pill by making it painfully expensive for the acquirer to trigger these rights.  If five shareholders sell their shares to the controlling shareholder, for instance, the collective stake of the other twenty-five owners doubles to fifty shares, hamstringing the controlling shareholder’s position.

 
2.     The Embedded Redemption Option

Importantly, however, the internal pill also includes an embedded redemption option.  Before suffering any dilution, the controlling shareholder enjoys an opportunity to disarm the pill by redeeming the preferred stock rights.  Any minority shareholder seeking to exercise the primary call must pay a price (in addition to the discounted strike price):  He must write a return option to the triggering controlling shareholder allowing her to redeem the pill by purchasing his common stock at a price set by that minority holder.  For example, “pushover” shareholder A may set a price of $56, “average” shareholder B may set a price of $60, and “hardball” shareholder C may set a price of $100.  If the controlling shareholder is willing to buy any (or all) of these shares at those stated prices, then the attached poison pill flip-in right expires.  Of course, the controller is not obligated to redeem; she simply possesses that option.

The goal of this second feature is to elicit an honest statement from the minority shareholder of her valuation that can be compared to the controlling shareholder’s valuation of the freezeout.  If the shares in this example are really worth $60 (and shareholder B knows this), then B can set his reservation price at $60 through the pill redemption option.  The majority shareholder can then work her way up from the lowest to the highest redemption price and decide whether to buy a 90% stake, which would trigger short-form merger rights.  (There is another important ramification of exceeding this 90% threshold, which I will discuss momentarily.)

 
3.     The Catch

There is one final problem that has perhaps already crossed your mind.  What prevents all minority shareholders from acting like shareholder C, selfishly demanding a very high redemption price in order to keep their pill armed, thereby blocking the merger?  Indeed, greedy shareholder D could set a redemption price of $1,000,000 to virtually assure himself that the controlling shareholder will not redeem his pill.  The third feature of our internal pill, then, needs to address this problem by placing a “catch,” or ceiling, on a minority shareholder’s temptation to exaggerate his subjective value.

This potential solution comes from an insight of mechanism design:  In order to elicit honest valuations, the minority holder must be placed under a veil of ignorance—unaware of whether he will have to buy or sell at his stated price.  Specifically, to mitigate the greedy shareholder problem, the internal pill should contain one last feature:  If the majority shareholder reaches or exceeds the 90% ownership threshold (or, conceivably, some other preset target), then all remaining preferred stock dissolves, and the controlling shareholder gains the right (but not the obligation) to sell shares to each remaining minority shareholder at exactly the price that each minority shareholder just demanded in the redemption option.  This is really just a conditional put option with the price set at the dissenter’s stated valuation.

Giving the controlling shareholder the protection of this catch should discourage minority dissenters from naming outrageous redemption terms.  The controlling shareholder will begin to buy shares (and simultaneously redeem pills) from minority shareholders—starting at the lowest named price and working her way up to a 90% (or more) stake.  She can then force a sale of extra shares on greedy overreachers.  In our earlier example, the controlling shareholder might buy ninety-one shares and sell that one extra share to shareholder D for $1,000,000.  Or, more likely, the threat of releasing the catch would preclude shareholder D from setting an outrageous redemption price in the first place.  After any catch sales are executed, the controlling shareholder can complete the short-form merger to take unified control.

If designed correctly, these (admittedly more complex) securities might be used to elicit and compare the subjective values that each party places on a transaction.  If the freezeout is a rip-off (because the majority shareholder has set an artificially low price), then the internal pill would have bite, and the minority shareholders could receive additional discounted shares—or, more likely, the majority shareholder would not attempt the abusive freezeout in the first place.  If, on the other hand, a minority shareholder is simply stonewalling a sensible deal, he will be unwilling to put his money where his mouth is for fear of springing the catch, and the majority shareholder can economically redeem the internal pill.  This three-part internal pill may seem overly complicated at first, but my longer Article explains the detailed mechanics of the pill and works through a few short scenarios that quickly elucidate the inner gears and springs of the idea.4

 
IV.
Concluding Thoughts

Even if the internal pill works as designed, it is fair to ask why a firm would ever wish to implement one.  Indeed, we might expect majority shareholders to resist vehemently any effort to water down their current freezeout prerogative with a more restrictive governance regime.  Yet there are at least three possible reasons to adopt the pill:  (1) It may be in the majority shareholder’s economic interest to do so as a form of precommitment that would increase the value of the company’s stock; (2) private gadfly shareholders or advisory organizations may lobby for the pill; or (3) the law could evolve to encourage or require firms to adopt internal pills.

One of the more exciting developments in economic theory posits that incentive-molding rules can corral parties toward optimal social ends strictly by appealing to their rational self-interest.  If these ideas can be put into practice, it may become possible for policymakers to craft intermediate legal entitlements—somewhere in between the property and liability rules of Calabresi and Melamed—that promote welfare-enhancing substantive outcomes without large administrative costs or expensive litigation.

The device is not flawless, however, and inside information or colluding dissenters may undermine the effects of an internal pill.  Moreover, powerful controlling shareholders could resist adoption efforts.  But there are strong theoretical justifications for promoting internal pills as an improved form of corporate governance.  Lawmakers should consider donning the white coat of pharmacists in order to improve the incentives that influence the ongoing balance between public and private corporate status.dingbat

 

Acknowledgments:

Copyright © 2009 New York University School of Law.

George S. Geis is the John V. Ray Research Professor of Law at the University of Virginia School of Law.

This Legal Workshop Editorial is based on the following Article: George S. Geis, Internal Poison Pills, 84 N.Y.U. L. REV. 1169 (2009).

  1. R.H. Coase, The Problem of Social Cost, 3 J.L. & ECON. 1 (1960).
  2. Guido Calabresi & A. Douglas Melamed, Property Rules, Liability Rules, and Inalienability: One View of the Cathedral, 85 HARV. L. REV. 1089 (1972).
  3. See, e.g., Ian Ayres & J.M. Balkin, Legal Entitlements as Auctions: Property Rules, Liability Rules, and Beyond, 106 YALE L.J. 703, 743-44 (1996) (describing auction mechanisms for parsing legal entitlements); Lee Anne Fennell, Revealing Options, 118 HARV. L. REV. 1399, 1411-16 (2005) (discussing concept of embedded options, primarily in property law context); Saul Levmore, Unifying Remedies: Property Rules, Liability Rules, and Startling Rules, 106 YALE L.J. 2149, 2153-57 (1997) (exploring variety of intermediate property-liability rules).
  4. George S. Geis, Internal Poison Pills, 84 N.Y.U. L. REV. 1169 (2009).

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