Adverse Selection and Gains to Controllers in Corporate Freezeouts

Adverse Selection and Gains to Controllers in Corporate Freezeouts

Description

An important element in the governance scheme of a corporation is its ownership structure. Most publicly traded companies in the United States have a dispersed ownership structure: no single shareholder owns sufficient shares to control the company. A substantial minority of companies, however, have a controlling shareholder.’ A controlling shareholder exercises powers that are available neither to the dispersed shareholders in a company without a controlling shareholder nor to the minority shareholders in a company with a controlling shareholder. As the Delaware Supreme Court recently summarized, a controlling shareholder can “(a) elect directors; (b) cause a break-up of the corporation; (c) merge it with another company; (d) cash-out the public stockholders; (e) amend the certificate of incorporation; (f) sell all or substantially all of the corporate assets; or (g) otherwise alter materially the nature of the corporation and the public stockholders’ interests.” This paper focuses on one of these enumerated powers-the power to cash out, or “freeze out,” the minority shareholders. Such freezeouts are accomplished by a merger with a corporation wholly owned by the controlling shareholder. After the freezeout, the controlling shareholder emerges as the sole equityholder of the company. In most states, mergers require the approval of the company’s board of directors as well as of holders of a majority of outstanding shares. A shareholder who holds a majority of shares can effectively control both approval prongs and thus unilaterally set the price at which minority shareholders are frozen out (the “freezeout price”). The power to freeze out the minority shareholders on potentially unfavorable terms is one of several ways through which a controlling shareholder can derive benefits from control to the exclusion of, and at the expense of, the minority shareholder. While the power of the controlling shareholder to freeze out the minority shareholders and to set the freezeout price is unfettered, minority shareholders have some remedies if they feel that the freezeout price has been set too low. First, they can seek a judicial appraisal of their shares, in which case they will receive the value of their shares as assessed by the court (rather than the freezeout price). Second, in some circumstances, minority shareholders can seek judicial review of the freezeout merger under the “entire fairness” standard, in which case the court will award them damages if the value of the minority shares, as assessed by the court, exceeds the freezeout price.6 While these two types of proceedings differ in certain respects, they both rely on a judicial assessment of the value of minority shares. Both types of proceedings can, in principle—if the assessment is accurate—protect minority shareholders from being denied the “no-freezeout value”—the value that their shares would have in the absence of the considered freezeout. This paper identifies and analyzes a fundamental problem involved in the regulation of corporate freezeouts. When deciding whether to effect a freezeout, a controlling shareholder might take advantage of its private information. When freezeouts take place under conditions of asymmetric information, we demonstrate, allowing controlling shareholders to effect a freezeout at a price equal or close to the pretransaction price of minority shares would enable controlling shareholders to effect such transactions on favorable terms and to extract in this way substantial private benefits of control. As this paper shows, courts face some difficult, inherent problems in trying to reach an accurate assessment of the no-freezeout value. These problems arise from the fact that controllers, who decide whether to effect a freezeout, are also likely to have private information concerning the firm’s value. As a result, the prefreezeout market price of minority shares, which is often used by courts in the assessment of the minority shares’ no- freezeout value, is likely to underestimate the no-freezeout value. Our analysis is organized as follows. Section 8.1 contains a short discussion of the use of market prices to assess the value of minority shares in freezeouts and a numerical example illustrating the adverse selection effect that results from such use. Section 8.2 contains a game-theoretic model demonstrating that, if a controlling shareholder can freeze out the minority shareholders at the prefreezeout market price, that market price will reflect the per share value of the company assuming that the controlling shareholder has the worst possible private information about the value of the company. A right to freeze out the minority shareholders at such a market price would therefore confer substantial profits on the controlling shareholder. The model uses several simplifying assumptions, but our work in progress suggests that its main result—that the presence of private information enables a controlling shareholder to gain systematically at the expense of minority shareholders—holds in a more general setting. Section 8.3 provides a concluding discussion that reports on some of the findings of our work in progress and considers the implications of our model for the controlling shareholder’s incentive to pursue investment projects and to reveal information.

Source Publication

Concentrated Corporate Ownership

Source Editors/Authors

Randall K. Morck

Publication Date

2000

Adverse Selection and Gains to Controllers in Corporate Freezeouts

Find @ NYU

Share

COinS