Zohar Goshen Columbia Law School & Ono Academic College Assaf Hamdani Hebrew University; ECGI

1. Regulating Controlling Shareholders’ Conflicts Corporate Governance, Family Firms, and Economic Concentration December 19, 2011 Zohar Goshen Columbia Law School & Ono Academic College Assaf Hamdani Hebrew University; ECGI

2. Overview • What should be the legal test for identifying related-party transactions? • Delaware approach is problematic: • Formal test: (i) expressly excludes “indirect” conflicts; and (ii) has not been consistently applied • Legal treatment of controlling shareholders’ conflicts should depend on: • Controlling shareholders rights/duties • Enforcement concerns • Tentative approach concerning boundaries of control

3. Controlling Shareholders and Investor Protection • Dominant shareholders have incentive and power to discipline management • Principal concern: minority expropriation through self-dealing, tunneling, and conflicted transactions • OECD (2009): one of the biggest corporate governance challenges facing the business landscape in Asia

4. Implications for Corporate Law • Dominant shareholders have incentive and power to discipline management • Law generally should not interfere with business decisions • Principal concern: minority expropriation • Closer regulation of self-dealing and conflicts “Transactional Approach”

5. Corporate Law for Controlled Firms • Identify self-dealing or conflict transactions • Regulation of conflicts/self-dealing: • Majority-minority vote (Canada; UK; Israel) • Independent directors • Disclosure • Judicial review (shareholder lawsuits) Ex post Ex ante

6. Anti-Self-Dealing IndexDjankov et. al., The Law and Economics of Self-Dealing (2008) Mr. James 90% 60% Public Co. Private Co.

7. Corporate Law for Controlled Firms • Identify self-dealing or conflict transactions • Atanasov, Black & Ciccotello(2011) • Regulation of conflicts/self-dealing: • Majority-minority vote (Canada; UK; Israel) • Independent directors • Disclosure • Judicial review (shareholder lawsuits) Ex post Ex ante

8. Our Project: • What should be the legal test for identifying tunneling or other transactions that deserve closer scrutiny? • Not question of acquiring evidence • Use Delaware case law • Entire fairness v. business judgment

9. Sinclair Oil Corporation v. Levien, 280 A.2d 717 (Del. 1971) • Sinclair Venezuelan Oil Company • Sinclair Oil: 97%; Public: 3% • 1960-1966: $108 million (pro-rata) dividends • Plaintiffs: ? • “Sinclair caused Sinven to pay out such excessive dividends that the industrial development of Sinven was effectively prevented” • “these dividends … resulted from an improper motive -- Sinclair's need for cash”

10. Partner CommunicationsDec. 1, 2011 Press Release • Partner Communications Company Ltd. … (Nasdaq:PTNR)(TASE:PTNR), a leading Israeli communications operator, announces that it was served with a motion to approve the filing of a derivative claim. • The Claim alleges, inter alia, that the said directors breached their duty of care towards the Company …by approving dividend distributions, in order to assist the parent company in repayment of the financing it undertook to acquire the controlling stake in the Company.

11. Levien v. Sinclair Oil Corporation, 261 A.2d 911 (Del. 1971) (Chancery) • “Whether dividends will be paid is within the sound discretion of the directors and, in the ordinary course of events, they are entitled to a presumption of good faith….” • “But given the special circumstances which obtain here (including Sinclair's fiduciary obligation …), Sinclair has the burden of showing that .. payment of the dividends were fair to Venezuelan after careful scrutiny by the Court.” • “I find that Venezuelan was not treated fairly because of the extraordinary and large cash withdrawals … The result was a drying up of the subsidiary and the only reasonable conclusion is that this was done because it was in the interest of Sinclair to do so.”

12. Sinclair Oil Corporation v. Levien, 280 A.2d 717 (Del. 1971) • “Self-dealing occurs when the parent, by virtue of its domination of the subsidiary, causes the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment to, the minority stockholders of the subsidiary.” • Business judgment rule applies

13. Dividend Example: I Controller 60% Parent Buyer 90% Sub Control bloc: $100 million Premium: $10 million Controller: $60 million (6 premium)

14. Dividend Example: I Controller 60% Parent In-kind pro-rata distribution 90% Sub

15. Dividend Example: II Controller Buyer 54% 60% Sub Parent Control bloc: $64 million Premium: $10 million Before: $ 60 million

16. Fairchild Corp. ExampleAtanasov, Black & Ciccotello, Law and Tunneling (2011) • Steiner: 25% ownership • Dual class recapitalization: • All shareholders could exchange their A shares for B shares • B share: 10 votes, but unlisted and 50% dividends • Steiner ended up with more than 50% of votes • Charter later amended to allow free conversion of B shares to A shares

17. Williams v. Geier, 671 A.2d 1368 (Del. 1994) • Geier family controls more than 50% of total voting power of Milacron, Inc. • Tenure-voting recapitalization (change of certificate): • Each holder of common entitled to 10 votes per share. • Upon sale voting rights would revert to 1 vote per share. • Until the new stockholder held share for 36 consecutive months.

18. Williams v. Geier, 671 A.2d 1368 (Del. 1994) • Plaintiff: • “…the sole purpose of the Recapitalization was to … allow the majority bloc to sell a portion of its holdings while retaining control of the company.” • Court: • “There was on this record: … no non-pro rata or disproportionate benefit which accrued to the Family Group on the face of the Recapitalization, although the dynamics of how the Plan would work in practice had the effect of strengthening the Family Group's control….” • Business judgment rule applies

19. eBay Domestic Holdings v. Newmark, 16 A.3d 1 (Del. Ch. 2010) Facts • Cumulative voting (allow eBay to elect director) • Jim & Craig: modify charter to provide for staggered board eBay: • “the Staggered Board Amendments treat eBay… differently than …the majority stockholders … by eliminating eBay's ability to unilaterally elect a director to the craigslist board but having no effect on Jim and Craig's abilities to elect craigslist directors” • “this disparate treatment … requires application of the entire fairness standard of review. “

20. eBay Domestic Holdings v. Newmark, 16 A.3d 1 (Del. Ch. 2010) • “The cases eBay relies on do not support a rule of law that would invoke entire fairness review any time a corporate action affects directors or controlling stockholders differently than minority stockholders.” • “Entire fairness review ordinarily applies in cases where a fiduciary either literally stands on both sides of the challenged transaction or where the fiduciary “expects to derive personal financial benefit from the [challenged] transaction in the sense of self-dealing, as opposed to a benefit which devolves upon the corporation or all stockholders generally.”

21. NJ Carpenters Pension Fund v. INFOGROUP, (Del. Ch. Sep. 30 2011) • Gupta: 37% of shares • Sale of 100% for cash • Plaintiffs: • Sale was orchestrated so that Gupta could obtain desperately needed liquidity • Settlement of derivative claim for self-dealing • SEC settlement (disgorgement and penalties) • Not alleged to have obtained other financial benefit different from merger price paid to all shareholders

22. NJ Carpenters Pension Fund v. INFOGROUP, (Del. Ch. Sep. 30 2011) • “… the liquidity benefit received by Gupta was a personal benefit not equally shared by other shareholders. All shareholders, including Gupta, received $8 per share in cash …. There are no allegations that Gupta received any additional compensation as a result of the Merger from, for example, side deals, a golden parachute, or compensation as an executive ….” • While all of the shareholders received cash in the Merger, liquidity was a benefit unique to Gupta… “

23. Our Claims: • All conflicts should be taken into account; but • Not all conflicts deserve same legal treatment • Legal treatment of controllers’ conflicts should take into account: • The scope of controlling shareholders rights/duties • Enforcement concerns • Note: we do not address non-pecuniary benefits • Some conflicts are inevitable/permissible notwithstanding their impact on firm/minority investors

24. Controlling Shareholder Rights/Duties: • Controlling shareholders v. directors • “A controlling stockholder has the right to control and to vote its shares in its own interest. It is not objectionable that the motive may be for personal profit or determined by whim or caprice as long as the controlling stockholder violates no duty owed to other stockholders.”; Richard Booth, 57 Bus. Law. 127 (2001) • Optimal level of private benefits?

25. Example • Forced Exit? • “Clearly, a stockholder is under no duty to sell its holdings in a corporation, even if it is a majority shareholder, merely because the sale would profit the minority”; Bershad v. Curtiss-Wright Corp., 535 A.2d 840 (Del. 1987) • But: • Dammann (2007): Corporate Ostracism: Freezing Out Controlling Shareholders

26. Controlling Shareholder Rights: • eBay: • “It is true that by approving the … Amendments, Jim and Craig implemented a … structure that had a disparate and … unfavorable impact on eBay. This is not the sort of disparate treatment, however, that can be classified as self-dealing because the law expressly allows majority stockholders to elect the entire board.”

27. Boundaries of Control: Tentative Approach • Exit • Sell control (timing) • Sell control (premium) • Force minority exit • Pro-rata dividends • Preserve control position • Firm-level decisions that may affect control position • Mid-stream change of governance structure • Including with respect to control position • Acquiring lock on control • Non pro-rata distributions

28. Exit: I • Not selling control • “Clearly, a stockholder is under no duty to sell its holdings in a corporation, even if it is a majority shareholder, merely because the sale would profit the minority”; Bershad v. Curtiss-Wright Corp., 535 A.2d 840 (Del. 1987) • Selling control • Control over timing of sale • Right to premium • Force minority to sell • Freeze-outs • Sale to third party; Non-equal terms • Sale to third part; Equal terms

29. Exit II • Pro-rata dividend distributions • Determine scope of assets under joint ownership • Enforcement-practical concerns • Legal rule: minority shareholders cannot challenge pro-rata dividends

30. Other Examples • Change rules of the game mid-stream • Undermining minority protection; eBay • Secure control position (modifying link between cash flow and control); Geier • Providing a dominant shareholder with lock on control

31. Standards of Review: Tentative Approach (DE) • Hard-core self-dealing ; Entire fairness • going private; related-party transactions • Conflicted transactions; Intermediate standard • control-enhancing measures; mid-stream governance changes • Controlling shareholders’ power; BJR • dividends; sale of control block • No conflicts; BJR

32. Other Implications • Supplement “transactional” approach with market measures • Minority board representation • Directors’ fiduciary duties in controlled corporations

33. Thank You

34. Section 270(4) of Companies Act of 1999 • [Material] transaction with controlling shareholder • Material transaction in which the controlling shareholder has a “personal interest”