Delaware and the Perils of Small Minority Controllers

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

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

The General Costs of Small-Minority Controllers:

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

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

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