Tunneling is a term economists use to describe when a controlling stockholder uses its control right to cause a corporation to enter into related party transactions that have the effect of making non-pro rata transfers of cash flow to the controlling stockholder or its affiliates. Delaware corporate law seeks to protect minority stockholders from the abuses of tunneling by providing a cause of action under which the court will examine a transaction with a controlling stockholder under an entire fairness standard of review, which requires the defendants to prove fair price and fair dealing. The standard of review can be shifted back to the business judgment rule if the transaction is approved by a sufficiently authorized board committee comprised solely of independent and disinterested directors. For public companies, additional protection is provided by the NYSE and Nasdaq listing rules, which require that the audit committee of all companies, including controlled companies, be comprised exclusively of independent directors. The duty of independent directors of family-controlled companies to protect the minority stockholders can weigh heavily when considering a related party transaction proposed by the controlling stockholder, who ultimately has the power to decide whether the director will be re-elected to the board. The decision in the recent EZCORP consulting agreement stockholder litigation1 provides a cautionary reminder for independent directors of family-controlled public companies.
In EZCORP, a minority stockholder alleged that a series of consulting agreements between EZCORP and affiliates of its controlling stockholder were “not legitimate contracts for services but rather a means by which [the controlling stockholder] extracted a non-ratable cash return from EZCORP.” Although the audit committee had approved the consulting agreements, the minority stockholder challenged the independence of the audit committee members, claiming that they acted “to preserve their cozy positions” (including significant pay) as directors of EZCORP and of other companies affiliated with the controlling stockholder. As a result, the Delaware Chancery Court held that the entire fairness standard of review would apply.
If a corporation enters into a commercial agreement with a controlling stockholder or affiliate of a controlling stockholder, a court will apply the entire fairness framework to the commercial agreement - the entire fairness doctrine is not confined to acquisition agreements. The entire fairness framework generally applies to any transaction where a controlling stockholder obtains a benefit from the controlled company not available to the minority stockholders on a pro rata basis, ie, tunneling. This standard applies to consulting, compensation, service, license, or other business transaction agreements between a corporation and its controlling stockholder and its affiliates, including expense reimbursements for directors and officers of controlled corporations who are also affiliates of the controlling stockholder.
While most controlled companies likely already have procedures in place for approval by an independent committee of transactions with affiliates of controlling stockholders, such processes will not prevent application of the entire fairness framework. Such procedures are essential to good corporate governance, important to a company’s minority stockholders and critical in connection with the defense of any related shareholder litigation. However, as demonstrated by EZCORP, these procedures will not prevent a review under the entire fairness doctrine - even though, under that framework, board and/or stockholder ratification can result in a shift in the burden of proof or a shift to the business judgment rule standard of review.
In the context of IPOs and spin-offs, prudent planning should include putting into place whatever commercial arrangements with the controlling stockholder-to-be that are necessary or desired. If these arrangements are properly disclosed in connection with the IPO or spin-off and approved in advance, they will not be subject to later judicial review, because they would be pre-existing stockholder-approved agreements. In addition, to the extent the IPO company or spin company may want to enter into agreements with affiliates of the controlling stockholder after the IPO or spin-off, the company should consider including in the pre-IPO or spin charter a process for approval of related party transactions. If the approval process is adequately disclosed and closely followed, those arrangements should pass judicial review.
What Is the “Entire Fairness” Doctrine?
The entire fairness framework of review applies to transactions with controlling stockholders and affiliates of controlling stockholders under the following principles:
- Defendants’ Burden to Prove Fairness - The defendants have the burden of proving both:
- fair process - for example, that the agreement was approved by a majority of the independent and disinterested directors after full consideration, based on an informed and reasoned view of the best interests of the company
- fair price - the economic terms of the agreement reflect what would have been customary or reasonable if the agreement had been entered into with a non-affiliated third party. In the case of a consulting agreement where it is unclear that any additional consulting services were actually provided, this task may be difficult.
- Burden Shift - If either a fully authorized, well informed and effectively functioning committee of independent and disinterested directors, or a majority of the minority stockholders in a fully informed vote, approved the agreement with the controlling stockholder or its affiliate, then the burden would shift to the plaintiffs to prove that the transaction was not fair as to price or process.
- Flip to Business Judgment Rule Standard of Review - In 2014, the Delaware Supreme Court in the MFW case established a framework under which the standard of review would flip to business judgment rule.2 If the transaction complies with the MFW standards - ie, from inception, the transaction was subject to approval by a fully authorized and effectively functioning committee of independent and disinterested directors and by a majority of the minority stockholders in a fully informed vote, and both approvals were obtained, then the more deferential business judgment rule should apply. In the case of commercial transactions, however, because it is not customary to obtain stockholder approval, a company would need to balance the benefits of a business judgment rule standard of review against the relative likelihood of a stockholder no vote and the consequences flowing from that vote.
The EZCORP Case
The Delaware Chancery Court opinion summarized different ways controlling stockholder have historically attempted to obtain non-ratable benefits from a company, including:
- cash flow tunneling, where the controlling stockholder “removes a portion of the current year’s cash flow, but does not affect the remaining stock of long-term productive assets”
- asset tunneling, where the controlling stockholder transfers “major long-term (tangible and intangible) assets” to or from the company, often not at market value3
- equity tunneling, where the controlling stockholder “increases [its] share of the firm’s value, at the expense of minority shareholders, but does not directly change the firm’s productive assets or cash flows”
While cases involving equity tunneling (eg, going private transactions) had been well documented and consistently subjected to entire fairness, the Court reasoned that heightened scrutiny should also apply to the other forms of potential value extraction so that a controlling stockholder would subject to the same standard of review regardless of the form of tunneling employed.
As is often the case, bad facts led to the inference of unfairness despite the facially valid procedures put into place by the defendant. Due to the procedural posture of the hearing, the court concluded that the plaintiff’s complaint supported a reasonable inference that the challenged agreements were not entirely fair and represented a means by which the controlling stockholder impermissibly extracted a non-ratable return from the company. Specifically:
- Six of the seven directors were likely not independent and disinterested because of their ties to the controlling stockholder.
- The controlling stockholder owned 100% of the voting power yet held only a 5.5% economic interest, which created an incentive for the controlling stockholder to obtain returns through non-ratable transfers of cash flow and an economic disincentive to pay dividends.
- Assuming the facts set forth in the plaintiff’s pleadings to be correct, when the audit committee terminated the contracts at issue due to concerns of propriety, the controlling stockholder replaced the directors on the audit committee and had a history and reputation for retributive behavior for perceived disloyalty. Further, the affiliate consulting company did not have sufficient staff to provide the services described in the consulting agreement and did not appear to have any other public company clients. The consulting services did not appear to extend beyond the tasks that senior management were already performing with experienced and highly compensated personnel. Another bad fact included that the annual consulting fee represented 5% to 20% of the company’s net income at a time when the company paid no dividends and declared that it had no intention of paying dividends.
Conclusion - The Benefits of Established Processes
In addition to the legal reasons related to obtaining the best possible result in stockholder derivative litigation, controlled companies should consider the non-legal benefits of having established policies and procedures for a fair and reasonable process to approve commercial transactions with affiliates of controlling stockholders regardless of the standard of judicial review that will be applied. These benefits include:
- a potential increase in stock price resulting from increased confidence of unaffiliated stockholders that conflict situations will be dealt with in a fair and reasonable manner
- increased liquidity in the stock due to the larger pool of potential institutional investors that have investment guidelines limiting investments in controlled companies lacking sufficient policies and procedures
- avoidance of negative publicity by proxy advisory firms and business press
- a potential shift in the burden of proof to the plaintiffs in stockholder derivative litigation
The EZCORP case serves as a cautionary tale about the allure of tunneling and provides a road map for controlled companies to mitigate the risk of liability to themselves, their directors and their controlling stockholders.