For these reasons, the authors have reviewed dozens of Delaware decisions determining whether a stockholder or member is a controller, summarized in the accompanying table the key factors involved in those opinions, and provided high-level guidelines for avoiding controller status based on our review of the case law.
The table and guidance are intended to serve as a guide for corporate stockholders and LLC members, including private equity and venture capital firms, seeking to minimize the risk of being deemed a controlling stockholder or member that owes fiduciary duties under Delaware law. It may be used together with our previously released Flowchart of Delaware Standards of Review, which is designed to serve as a high-level tool to assess which standard of review might apply to a given M&A transaction.
Overview
As depicted in the flowchart, a plaintiff can rebut the business judgment rule and trigger entire fairness review by showing that (i) a controlling stockholder stands on both sides of a transaction, receives consideration different than that received from other stockholders, or receives a unique benefit from the transaction; or (ii) at least half of the directors who approved the transaction were not disinterested or independent. Sciabacucchi v. Liberty Broadband Corp., 2017 WL 2352152, at *16 (Del. Ch. May 31, 2017).
Thus, the first step in assessing the proper standard of review is often analyzing whether there is a conflicted controlling stockholder or member. Delaware law is clear that stockholders and members in manager-managed LLCs do not owe fiduciary duties, unless they are deemed to be controllers. Voigt v. Metcalf, 2020 WL 614999, at *10 (Del. Ch. Feb. 10, 2020). A stockholder or member, such as a private equity or venture capital firm, will be deemed to be a controller (and therefore owe fiduciary duties) only when it owns more than 50 percent of the company’s stock or membership interests, or if the member or stockholder owns less than 50 percent of the company’s stock or membership interests but nevertheless exercises “actual control” over the company in general or the specific transaction at issue. Kahn v. Lynch Commc’n Sys., Inc. 638 A.2d 1110, 1113 (Del. 1994).
The “actual control” test requires the court to undertake an analysis of whether, “despite owning a minority of shares, the alleged controller wields ‘such formidable voting and managerial power that, as a practical matter, it is no differently situated than if it had majority voting control.’” Reith v. Lichtenstein, 2019 WL 2714065, at *7 (Del. Ch. June 28, 2019). “Making this showing is no easy task, as the minority blockholder’s power must be so potent that it triggers . . . concern that independent directors’ free exercise of judgment has been compromised.” Larkin v. Shah, 2016 WL 4485447, at *13 (Del. Ch. Aug. 25, 2016).
Determining whether a less-than-majority stockholder or member exercises actual control over the company is a fact-specific inquiry involving the analysis of multiple factors, including the following:
- ownership or control over a significant portion of the corporation’s equity
- the right or ability to designate directors
- the existence of provisions in governance documents that enhance the power of the stockholder or member, such as negative voting power
- the degree of control the stockholder or member has over particular directors
- the degree of control the stockholder or member has over key managers or advisors that play a critical role in presenting information and making recommendations
- the ability to exercise contractual rights to channel the company into a particular outcome by blocking or restricting other paths
- other commercial relationships with the company that provide the stockholder or member with leverage over the corporation, such as lending relationships
- the ability to influence decisions through high-status roles, such as chief executive officer, chairman, or founder, or through coercive action, such as threats of retribution
Basho Techs. Holdco B, LLC v. Georgetown Basho Inv’rs, LLC, 2018 WL 3326693, at *28 (Del. Ch. July 6, 2018), aff’d sub nom. Davenport v. Basho Techs. Holdco B, LLC, 221 A.3d 100 (Del. 2019).
Given the myriad of factors involved in determining whether a stockholder or member is a controlling one, there are no bright-line rules, and the analysis is often fact-specific. In re GGP, Inc. S’holder Litig., 2021 WL 2102326, at *12 (Del. Ch. May 25, 2021). That said, there are a number of takeaways that can be gleaned from the decisions to help guide a less-than-majority stockholder or member seeking to avoid controller status.
Key Takeaways Regarding Controller Status
First, limiting the stockholder’s or member’s ownership stake to below 35 percent may help ward off a finding of control. It is recognized in Delaware case law that the “level of stock ownership is not the predominant factor” in a controller analysis (id. at *21; FrontFour Capital Grp. LLC v. Taube, 2019 WL 1313408, at *21 (Del. Ch. Mar. 11, 2019)) and that Delaware courts do not mechanically apply a “linear, sliding-scale approach whereby a larger share percentage makes it substantially more likely that the court will find the stockholder [or member] [to be] a controll[er].” In re Crimson Expl. Inc. Stockholder Litig., 2014 WL 5449419, at *10 (Del. Ch. Oct. 24, 2014). That is evidenced by the fact that stockholders or members owning as little as 15 percent, 17 percent, 22 percent, 26 percent, and 28 percent equity stakes have been deemed controllers FrontFour Capital Group, 2019 WL 1313408 (15 percent); Williamson v. Cox Commc’ns, Inc., 2006 WL 1586375 (Del. Ch. June 5, 2006) (17 percent); In re Tesla Motors, Inc. S’holder Litig., 2018 WL 1560293 (Del. Ch. Mar. 28, 2018) (22 percent); In re Zhongpin Inc. Stockholders Litig., 2014 WL 6735457 (Del. Ch. Nov. 26, 2014) (26 percent); Skye Mineral Inv’rs, LLC v. DXS Capital (U.S.) Ltd., 2020 WL 881544 (Del. Ch. Feb. 24, 2020) (28 percent). It is also evidenced by the fact that stockholders or members owning as much as 49 percent, 47 percent, 46 percent, and 44 percent have been held not to be controllers. Citron v. Steego Corp., 1988 WL 94738 (Del. Ch. Sept. 9, 1988) (49 percent); Odyssey Partners, L.P. v. Fleming Cos., Inc., 735 A.2d 386, 392 (Del. Ch. 1999) (47 percent); In re W. Nat’l Corp. S’holders Litig., 2000 WL 710192 (Del. Ch. May 22, 2000) (46 percent); Puma v. Marriott, 283 A.2d 693 (Del. Ch. 1971) (46 percent); Super. Vision Servs., Inc. v. ReliaStar Life Ins. Co., 2006 WL 2521426 (Del. Ch. Aug. 25, 2006) (44 percent). Indeed, as the Court of Chancery recently held, a person or entity may be deemed to be a controller even if that person or entity does not own any stock at all. In re Pattern Energy Grp. Inc. S’holders Litig., 2021 WL 1812674, at *40 (Del. Ch. May 6, 2021).
That said, it is undeniable that size matters in the controller context. For one, recent case law in particular has emphasized the significant influence that large voting blocks, particularly those 35 percent and greater, have on the outcome of stockholder votes. Compare In re Cysive, Inc. S’holders Litig., 836 A.2d 531, 551 (Del. Ch. 2003) (deeming “about 40% of the voting equity” significant), Neil Ross v. Lineage Cell Therapeutics, Inc., C.A. No. 2019-0822-AGB (Del. Ch. Oct. 5, 2020) (transcript) (“38.9 percent block of shares takes on particular significance” where “voter turnout” is low), and Voigt v. Metcalf, 2020 WL 614999, at *19 (Del. Ch. Feb. 10, 2020) (“[L]arge blocks at levels of 35% . . . carry significant influence.”), with In re GGP, Inc. S’holder Litig., 2021 WL 2102326, at *20 (Del. Ch. May 25, 2021) (“35.3% is ‘not impressive on its own.’”), In re Rouse Props., Inc., 2018 WL 1226015, at *18 (Del. Ch. Mar. 9, 2018) (“33.5% . . . is not impressive on its own.”), and In re PNB Holding Co. S’holders Litig., 2006 WL 2403999, at *10 (Del. Ch. Aug. 18, 2006) (describing 33.5 percent as “relatively low”).
Moreover, anecdotal data from the cases summarized in the accompanying table show that stockholders or members owning 35 percent or more of a company’s voting equity were deemed to be controllers at more than double the rate of stockholders or members with ownership stakes below that threshold. In 6 of 18 (about 33 percent) of the cases in which the stockholders or members owned less than 35 percent, they were deemed to be controllers. In two of six (about 33 percent) of the cases in which the stockholders or members owned between 25 percent and 35 percent, they were deemed to be controllers. In stark contrast, in 13 of 19 (about 68 percent) of the cases in which the stockholders or members owned 35 percent or more, they were deemed to be controllers.
Second, independence of the board, special committee, and key officers and advisors is often paramount in determining whether a stockholder or member is a controller. There is authority for the proposition that the mere fact that at least half of the directors lack independence from a stockholder or member does not necessarily make the stockholder or member a controller. See In re Rouse Props., Inc., 2018 WL 1226015, at *15 (Del. Ch. Mar. 9, 2018) (“[I]t does not necessarily follow that an interested party also controls directors, simply because they lack independence.”); Sciabacucchi v. Liberty Broadband Corp., 2017 WL 2352152, at *17–19 (Del. Ch. May 31, 2017) (same). It should come as no surprise, however, that stockholders or members were deemed controllers in all of the cases in the table in which there were well-pled allegations or proof that at least half of the board or special committee charged with considering or approving the challenged transaction lacked independence from the stockholders or members, either because of their close ties to the alleged controller or because of the alleged controller’s outsized influence in the boardroom. See e.g., FrontFour Capital Grp. LLC v. Taube, 2019 WL 1313408 (Del. Ch. Mar. 11, 2019); In re Tesla Motors, Inc. S’holder Litig., 2018 WL 1560293 (Del. Ch. Mar. 28, 2018); Voigt v. Metcalf, 2020 WL 614999 (Del. Ch. Feb. 10, 2020); Reith v. Lichtenstein, 2019 WL 2714065 (Del. Ch. June 28, 2019); In re Loral Space & Commc’ns Inc., 2008 WL 4293781 (Del. Ch. Sept. 19, 2008); In re Tri-Star Pictures, Inc., Litig., 634 A.2d 319 (Del. 1993); Harbor Fin. Partners v. Sugarman, 1997 WL 162175 (Del. Ch. Apr. 3, 1997); Zimmerman v. Braddock, 2005 WL 2266566 (Del. Ch. Sept. 8, 2005). That is so even where their ownership interest was relatively small. FrontFour Capital Group, 2019 WL 1313408 (15 percent); In re Tesla Motors, 2018 WL 1560293 (22.1 percent).
Third, although the mere exercise of contractual rights, such as blocking rights, will not render a stockholder or member a controller, if such rights are used to channel the company into a particular outcome that is unfair to the company, then the stockholder or member may be deemed to be a controller and be required to demonstrate the fairness of its actions. Indeed, although Delaware case law is clear that “a significant shareholder [or member], who exercises a duly-obtained contractual right that somehow limits or restricts the actions that a [company] otherwise would take, does not become, without more, a controll[er],” there “may be circumstances where the holding [or exercise] of contractual rights, coupled with a significant equity position and other factors, will support the finding” of controller-status. Super. Vision Servs., Inc. v. ReliaStar Life Ins. Co., 2006 WL 2521426, at *5 (Del. Ch. Aug. 25, 2006). As summarized in the accompanying table, stockholders or members were deemed controllers in all of the cases we reviewed in which there were well-pled allegations or proof that those stockholders or members weaponized certain contractual rights to secure benefits for themselves at the expense of other stockholders or members. Skye Mineral Inv’rs, LLC v. DXS Capital (U.S.) Ltd., 2020 WL 881544 (Del. Ch. Feb. 24, 2020); Basho Techs. Holdco B, LLC v. Georgetown Basho Inv’rs, LLC, 2018 WL 3326693 (Del. Ch. July 6, 2018); Hamilton Partners, L.P. v. Highland Capital Mgmt., L.P., 2014 WL 1813340 (Del. Ch. May 7, 2014); O’Reilly v. Transworld Healthcare, Inc., 745 A.2d 902 (Del. Ch. 1999); Kahn v. Lynch Commc’n Sys., Inc., 638 A.2d 1110, 1113 (Del. 1994); see also In re Pattern Energy Grp. Inc. S’holders Litig., 2021 WL 1812674, at *45 (Del. Ch. May 6, 2021). Again, that is so even where their equity interest was relatively small. See Skye Mineral Investors, LLC, 2020 WL 881544 (weaponization of blocking rights resulted in 28.07 percent member being deemed a controller at motion to dismiss stage).
Fourth, in contrast to weaponizing contractual rights, agreeing to certain contractual limitations may guard against a finding of control. For instance, the Court of Chancery has held that a stockholder was not a controlling one, in part because a stockholders agreement prohibited the stockholder from accumulating more than 35 percent of the stockholder vote, designating more than 4 of 10 directors, and soliciting proxies or consents, and the corporation’s charter required the transaction in question to be approved by independent directors and unaffiliated stockholders. Sciabacucchi v. Liberty Broadband Corp., 2017 WL 2352152, at *117–19 (Del. Ch. May 31, 2017); cf. Dell, Inc. v. Magnetar Glob. Event Driven Master Fund Ltd, 177 A.3d 1, 20 (Del. 2017).
Fifth, while perhaps the least influential factor, statements in public disclosures often affect the court’s analysis as to whether the stockholder or member in question is a controller, particularly at the pleading stage. See e.g., In re Tesla Motors, Inc. S’holder Litig., 2018 WL 1560293 (Del. Ch. Mar. 28, 2018); In re Zhongpin Inc. Stockholders Litig., 2014 WL 6735457 (Del. Ch. Nov. 26, 2014), rev’d on other grounds sub nom. In re Cornerstone Therapeutics Inc, S’holder Litig., 115 A.3d 1173 (Del. 2015); In re Primedia Inc. Derivative Litig., 910 A.2d 248, 258 (Del. Ch. 2006).
Ways to Minimize the Risk of Controller Status
Based on the above, a stockholder or member seeking to minimize the likelihood of being deemed a controller and owing fiduciary duties should consider the following:
1. Limit ownership stake.
While not dispositive and perhaps obvious, maintaining a lower ownership stake will decrease the likelihood of being deemed a controller. As explained above, recent Delaware decisions have seemingly given greater weight to the influence that large voting blocks have on the outcome of stockholder votes than earlier decisions, which focused more heavily on board control. Moreover, there is at least an anecdotal basis to observe that Delaware courts have held that stockholders and members owning less than 35 percent of a company’s equity are controllers at less than half the rate of stockholders or members owning equity at or above that threshold, which supports the notion that block size matters.
2. Ensure board and committee independence.
Large stockholders or members should ensure that a majority of the board of directors/managers or special committee members are undeniably independent. That means that more than half of the board or committee should have no material financial or personal ties to the stockholder or member. It also means that substantial stockholders or members should give the members of the board or committee tasked with considering a transaction the freedom to exercise their business judgment free from interference, threats, and coercion from the stockholder or member.
3. Foster officer and advisor independence.
Relatedly, the officers and advisors tasked with presenting information and making recommendations to the board with respect to a proposed transaction should also be independent. Thus, the officers and advisors tasked with those roles should not have material financial or personal ties to the significant stockholder or member. Moreover, stockholders, members, and their board designees should avoid interfering or appearing to interfere with or circumvent such officers’ and advisors’ information-sharing and decision-making processes. Independent and disinterested officers and advisors should be given the latitude to reach their own conclusions and make their own recommendations.
4. Avoid weaponizing contractual rights.
Significant stockholders or members should feel free to exercise their bargained-for contractual rights, such as blocking or veto rights. That said, stockholders or members should avoid weaponizing those rights. That is, they should not use such rights to channel the company into a particular outcome that benefits that stockholder or member to the detriment of the company and the other stockholders or members, such as by forcing the company to accept the stockholder’s or member’s proposed transaction, even though that transaction has more onerous terms than other available alternatives.
5. Consider agreeing to contractual limitations on control.
Although it is not necessary to do so, a stockholder or member can reduce the risk of being deemed a controller by agreeing to certain contractual limitations on its ability to control the company, such as agreements not to accumulate more than a certain percentage of the company’s equity; designate, nominate, or elect more than a minority of a company’s directors; or solicit proxies or consents. The stockholder or member could also agree to contractual requirements that require approval of certain transactions by directors and stockholders unaffiliated with the large stockholder or member.
6. Consider the necessity of public statements regarding control.
As noted above, when analyzing whether a stockholder or member is a controller, Delaware courts often cite public statements made by the stockholder, the member, or the company regarding the stockholder’s or member’s ability to influence company decisions. While federal securities laws and other disclosure obligations must be considered, those requirements should be weighed against the possibility of such disclosures being used against the company’s stockholders or members and directors or managers in breach of fiduciary duty actions. Even if some disclosure is required, the specific substance of such disclosures should be carefully crafted. For instance, disclosures that conclude that a stockholder or member is a controlling one may be neither required nor advisable; the facts underlying such a conclusion may suffice.