Crackdown on Corporate Insiders Collides With New Era of Control

Iconic founders engineering new forms of corporate control are complicating a crackdown on self-dealing by the leading US business court.

First-of-their-kind decisions this year involving Tesla Inc., TripAdvisor Inc., Moelis & Co., and Sears Hometown and Outlet Stores Inc. sought to tighten the standards for conduct by controlling stockholders. Those cases resolved pressing issues surrounding CEO pay, reincorporation in another state, and governance agreements with preferred backers.

But the seven judges on Delaware’s Chancery Court are struggling to apply age-worn legal doctrines to a landscape in which many of the most important companies are run by “idiosyncratic billionaires” rather than traditional controlling stockholders like publicly traded corporate parents, according to University of Iowa law professor Robert Miller.

“With a Mark Zuckerberg or an Elon Musk or an Eddie Lampert, it’s often very hard to tell them, ‘You really can’t do that, or if you do, the Delaware courts are going to intervene,’” Miller said. “You tend to get the reaction, ‘What are you talking about? This is my company.’”

The judge who invalidated Musk’s $55 billion pay package, for example, cited his almost messianic role at Tesla in finding that his 22% stake—despite falling well short of a majority—was enough to give him de facto control over his own compensation decision. She called Musk a “superstar CEO,” stressing that he said at trial he was “negotiating against myself.”

The Sears decision articulated a new legal framework for instances when Lampert dominated an ordinary shareholder vote rather than exploiting any special levers of inside influence.

Read More: Musk’s $55 Billion Loss Threatens Soaring Pay for Superstar CEOs

The wave of rulings has raised the stakes for corporate insiders tagged with the controlling stockholder label by imposing heightened scrutiny on virtually anything they do without special protections for minority investors.

But the sophisticated new strategies from founders and financial backers have forced the elite business court—which specializes in heavyweight buyout battles and shareholder cases targeting boards of directors—to keep confronting slippery questions about the contours and boundaries of corporate control.

“People are trying to exercise control in new, clever, and more complicated, less visible ways than just having a lot of stock,” said University of Michigan law professor Gabriel Rauterberg. “And we’re seeing a certain appetite on the court for scrutinizing those exercises.”

Converging Dynamics

The court has found itself caught between creative governance arrangements and novel theories for identifying conflicts of interest, such as the successful argument in the TripAdvisor case that relocating the company to Nevada conferred unique benefits on its controlling stockholder, Greg Maffei.

“What we have in the real world is a lot of people who exercise control through a variety of different mechanisms: Dual-class stock, being a superstar CEO,” said University of Pennsylvania law professor Jill Fisch. “What happens when an activist investor signs a shareholder agreement? Do they all count as controllers?”

Other trends are placing additional pressure on the controlling stockholder label even as they muddy the waters around it. One is seen in the most recent major ruling on the subject, an April 4 decision by Delaware’s top court in a case involving Match Group Inc. The justices said all deals conferring special benefits on a corporate controller—not just buyouts—are subject to heightened scrutiny unless they include onerous protections for minority investors.

Read More: Match.com Ruling Stresses Investor Protections in Insider Deals

But the ruling didn’t touch on the dynamics “that are actually really making this really difficult,” according to Tulane University law professor Ann Lipton. “One is: How do you define control?” she said. “And secondly: What counts as a conflicted transaction? Those await another day.”

Other judges have started playing catch-up. The Moelis decision upended the popular corporate practice of handing the reins to significant shareholders—venture capital firms leading a public listing or activist investors signing a truce—by giving them a constellation of bespoke rights, such as a veto over key corporate decisions or a pledge that the sitting board will support their director candidates.

Read More: Novel Corporate Rulings Fuel Charged Debate on Delaware’s Role

An influential state bar committee has recommended statutory changes aimed at restoring the status quo. Lipton called the proposals premature, saying they would undercut an appeal process that might yield more clarity from the Delaware Supreme Court about controlling stockholders.

Miller, though, said the changes couldn’t come fast enough. Although the Moelis ruling was legally defensible, its practical effect was to make it impossible for corporate boards to reach settlements with activist investors on terms that benefit everyone, something that happens “every day,” he said.

‘This Mess’

Entrepreneurial shareholder attorneys, meanwhile, are zeroing in on transactions not traditionally viewed as conflicts of interest. They include TripAdvisor’s relocation to Nevada, where Maffei will face looser accountability rules. The ruling that paved the way for damages against Maffei—but allowed the reincorporation—is set for an unusually swift appeal.

A group of pension funds has also challenged the decision by Meta Platforms Inc. to resolve a privacy probe into the Cambridge Analytica data-harvesting scandal at Facebook by paying a $5 billion penalty. The lawsuit says Zuckerberg and other company leaders agreed to pay more than they had to—out of the corporate coffers—in exchange for a settlement that ensured they wouldn’t face personal liability.

“That sounds like a conflicted transaction to me,” but “this is all new,” Lipton said. “You put this together and you get this mess.”

Read More: Zuckerberg, Thiel Sued Over Facebook’s $5 Billion FTC Fine

After the Match decision, controlling stockholders who don’t set up an independent board committee and hold a shareholder vote on a wide range of corporate actions—some of them relatively routine—will have to defend them in court by showing they were fair to minority investors, meaning both the process and the deal price were adequate.

The fairness question may be relatively straightforward in the context of a buyout, but it’s not clear how the standard translates to other types of corporate actions being challenged, according to Fisch.

“The range of situations in which we’re not only saying entire fairness is going to have to apply, but we don’t even have very good tools for analyzing when something is fair—that could kind of spin out of control,” she said.

‘A Lot of Frictions’

It’s surprising the court in the Match case didn’t “carve back a little middle ground for certain kinds of de minimis transactions,” such as corporate jet policies or compensation decisions, according to Lipton.

“It really does create a lot of frictions, especially if you’re a controlling shareholder who’s also a corporate officer” such as Musk or Zuckerberg, she said. “Everything they do is potentially conflicted.”

The decision did leave one potential safety valve, albeit perhaps inadvertently. Although a special committee set up to get around the fairness framework has to be completely independent, corporate boards can shut down shareholder derivative lawsuits—which are technically filed on a company’s behalf against its leaders—so long as a majority of their members have no conflicts of interest. The justices dismissed concerns that they were opening a loophole.

The discrepancy reflects “a doctrinal absurdity,” Lipton said. “But it may work out to be an appropriate compromise. In practice, something may need to be a fairly big deal before it gets past a motion to dismiss, and those are the decisions that we want directors to take care with.”

—With assistance from Jennifer Kay.