All directors and officers know their two principal fiduciary duties of care and loyalty. While these duties have been crystallized through generations of case law and commentary, the legal landscape is murkier for the controlling shareholder, whose duty to the minority and the corporation is far less clear.
As a basic premise, a controlling shareholder has generally enjoyed considerable liberty in how it deals with the corporation and its own interests. To guard against the potential for abuse, the law provides that a controlling shareholder must not take action intended to oppress the minority, use its control for purposes adverse to the corporation, or exclude the minority from its proper share of the benefits of the enterprise. The distinction between what is in a controlling shareholder's legitimate self-interest and what constitutes oppression of the minority can be vague, and so the legal tests have yielded a hazy doctrine.
A recent Pennsylvania case, Stilwell Value Partners I, L.P. v. Prudential Mutual Holding Company, breaks new ground on the duties of controlling shareholders and has rendered the landscape even more murky.
The plaintiff in the Stilwell case sued to prevent the majority shareholder from voting in favor of proposed equity compensation plans. Among other claims, the plaintiff asserted that, because the majority shareholder had not paid for its shares, the stock plans would dilute the minority shareholders unfairly, imposing a disproportionate burden on them and thereby breaching the majority shareholder's duty. The majority shareholder countered that the stock plans would dilute the ownership of all shareholders ratably. The court found that the plaintiff had failed to put forth any evidence that the minority shareholders would be disproportionately financially harmed by the stock plans.
This failure should have been fatal to the case. Absent self-dealing, a controlling shareholder generally has not needed to defend its actions. Nevertheless, the court allowed the case to proceed to trial, where the majority shareholder would have to prove the fairness of its intended vote in favor of the stock plans.
The court said that to prove fairness, the majority shareholder had to convince the court, among other things, that its vote in favor of the stock plans was in the best interests of the corporation. And, in determining the best interest of the corporation, the court would consider all of the corporate constituencies that directors of Pennsylvania corporations may consider when they act — namely, the impact of the action not only on shareholders but also on employees, suppliers, customers, creditors, and surrounding communities — and relevant public policy.
This constituencies analysis was codified in Pennsylvania's Business Corporation Law primarily as part of the board's antitakeover arsenal. It allows directors to consider the effects of corporate action on a broad range of groups and specifically provides that the directors need not put the interests of shareholders before those of other constituencies. Directors also may consider the short- and long-term interests of the corporation and the resources, intent, and conduct of any person seeking to acquire control of the corporation. More than half of the states have a constituencies statute.
While these statutes can provide important flexibility for directors, they would create significant problems if applied to controlling shareholders. The Stilwell case suggests that whenever a controlling shareholder takes action, it must balance the impact on others against its own self-interest. This case was decided by a federal court, so it does not create binding precedent as to Pennsylvania law; nevertheless, federal courts' interpretations of state law often serve as the underpinning of decisions by state and federal courts in the same and even different states.
The plaintiff in the Stillwell case withdrew its breach of duty claim before trial. But it is troubling that the court intended, without any claim of self-dealing, to review the merits of the stock plans. For Pennsylvania corporations in particular, this opens the door to much mischief by minority shareholders, and raises the possibility that courts may end up deciding the validity of business decisions and the appropriateness of corporate policy, all in the name of determining what is “fair.” This is exactly what the longstanding protections of the business judgment rule seek to avoid. The Stilwell case is just one opinion and may be an anomaly, but it shrouds this legal landscape with that much more fog. â
The author can be contacted at douglas.raymond@dbr.com. Kathy Wynn and Bill McSwain, associates with Drinker Biddle & Reath, assisted in the preparation of this column.