A fundamental question in corporate law is the nature of the stockholders’ ownership interest in the firm. Should a share of stock be viewed as a simple chattel, the value of which can be measured for all purposes by its trading price? Or should it be viewed as a partial claim on the firm as a whole, the value of which—for some purposes—cannot be determined without reference to the value of the entire firm to a single owner? This question arises in a number of contexts involving intra-corporate disputes, the most important of which is the merger. When examining whether a target board has satisfied its fiduciary duties, or when determining the “fair value” of the stockholders’ shares, a court must confront this fundamental question of the shareholders’ entitlement.
Delaware law has long entitled stockholders to a proportionate share of the value of the firm as a whole to a single owner and not simply the trading value of their fractionalized shares. This conception—the “single-owner” standard—was first articulated in the context of appraisal rights, and it has served for a century as the Atlas of Delaware’s corporate law, providing the theoretical foundation for its entire doctrinal universe, including merger landmarks like Unocal, Revlon, and the long line of their offspring. The single-owner standard provides the justification for allowing target boards to employ takeover defenses to fend off bids at a premium to the stock price and for the traditional measures of fair value in appraisal and breach of fiduciary duty actions.
Despite its long pedigree and foundational status, the rejection of market prices as the measure of a stockholder’s entitlement in internal disputes has remained stubbornly controversial. In the 1980s, an influential group of law and economics scholars—led by Frank Easterbrook, Daniel Fischel, and Alan Schwartz—put forward a rival “market standard,” arguing that where stock is publicly traded, the market price is the only proper measure of the value of the stockholders’ entitlements. As a result, any takeover bid at a premium to the market price—no matter how small—would be fair to stockholders. This leaves boards with no justification for employing takeover defenses to fight off a hostile bid and no leverage to negotiate for a better deal. Advocates claim such a regime would: facilitate the market for corporate control; reduce agency costs; maximize economic efficiency by assuring the transfer of corporate assets to higher-value uses; and avoid capricious judicial valuations that are bound to be less accurate than the judgment of the market. In practical terms, the primary distinction is that the single-owner standard permits (and may require) the board to negotiate with bidders to secure a portion of the gains from any merger, just as a single owner would, while the market standard would permit a bidder to capture the entirety of the gains from trade by paying only a whisker more than the market price.
While the Delaware courts have thus far refused to embrace the market standard, they have struggled to refute it definitively. Courts have largely failed to articulate a straightforward, compelling set of functional justifications for the single-owner standard. Academics have only done slightly better, often falling back on ontological-style arguments over “director primacy” and “stockholder primacy” rather than engaging directly with the teleological questions more central to a practical field like corporate law. Lucian Bebchuk has probably been the most compelling academic defender of the single-owner standard on functional grounds. Yet, even the justifications he provides largely turn on slippery empirical questions of market efficiency, or which standard offers fewer opportunities for managerial opportunism, or which is more likely to promote value-enhancing transactions while avoiding value-destroying transactions.
In a recent paper, we present a novel and compelling functional justification for the single-owner standard. The justification is rooted in dynamic considerations and the desire to avoid disincentives for raising capital through the corporate form and issuing publicly-traded stock. The debate over the single-owner standard has taken the existing world of publicly traded companies for granted, tacitly presuming that it will continue to exist in more or less the same form, whichever standard may apply. But if the law were to disadvantage public stockholding as a form of ownership, entrepreneurs seeking to raise capital would pay a penalty for raising capital by operating in a corporate form with dispersed ownership by public stockholders. Instead, they would face powerful incentives to remain private or otherwise maintain plenary control. To the extent that public markets and dispersed ownership are socially beneficial—for reducing the cost of capital; for generating information and allocating capital efficiently; for allowing small investors to share in the wealth creation of large enterprise; and so on—penalizing this form of ownership would be a bad thing.
The key insight of our argument is that any alternative to the single-owner standard would disadvantage the public corporation as a form of ownership. It can be easy to forget that a corporation is nothing but a form of joint ownership of property. In most forms of property, the owner is entitled to refuse to sell an asset for any reason or for no reason, exercising what Blackstone called the “sole and despotic dominion” over the asset. The owner has the exclusive authority to set the price at which they are willing to sell and can bargain for a portion of any higher value the buyer may place on the property. Although this approach is not without its social costs, it is generally regarded as not only tolerable but affirmatively desirable because it gives owners the ex ante incentive to invest in the resources they own, secure in the knowledge that they may harvest the fruits of that investment through sale at some future date. This feature of property law is so basic that legal rules against the involuntary transfer of entitlements are conventionally known as “property rules.”
Stock ownership is crucially different. In the conventional analytical framework for analyzing legal entitlements, the stockholder’s entitlement to their shares in a public corporation is protected by a form of liability rule rather than a property rule. In a merger, unless a stockholder maintains voting control over the company, their shares can be taken away whether they like it or not, at a price not of their choosing, so long as the transaction is approved by the board and a majority vote of the shares. Absent a breach of fiduciary duties by the board, dissenting stockholders cannot prevent having their shares taken from them. They are protected only by the right to receive “fair value” in a statutory appraisal action.
The most familiar context in which property rights in assets are protected by a liability rule is where the government forcibly acquires assets through eminent domain. This context offers vital insight into analogous questions in the corporate context. In determining the fair value of property taken via eminent domain, courts will value the underlying estate as a whole, disregarding how that estate may have been divided. Thus, for example, when the government seizes via eminent domain a house that has been divided into four condominium units, the relevant question for a court determining fair compensation is the value of the house as a whole, not the individual units. This approach promotes investment efficiency by giving the condominium association the same incentive to invest in the property as any other owner. Perhaps more importantly, it also promotes efficient selection of ownership structure by not penalizing joint or otherwise fractionalized forms of ownership.
The single-owner standard in corporate law serves the same function. By empowering (or even requiring) a board to hold out for a premium to the market price—backed by legal remedies entitling the stockholders to their proportionate share of the value of the firm as a whole—the single-owner standard allows stockholders to share in the gains from the sale of corporate assets just as a single owner would. A market standard, on the other hand, would deprive them of this ability, forcing minority stockholders to discount their shares relative to what they would be worth to a single owner. Not only would this increase the cost of capital for existing firms but, working backward in the lifecycle of a firm, it would give entrepreneurs a powerful disincentive against employing the classic public corporation form in the first place.
As a result, far more is at stake in the debate over the single-owner standard than simply the division of spoils from any individual merger. The single-owner standard plays a crucial role in preserving the viability of the publicly-traded corporation as a form of enterprise. Understanding its importance is particularly vital in light of recent appraisal decisions by the Delaware Supreme Court that appear to cast doubt on the Court’s continuing commitment to the single-market standard. A move away from the traditional single-owner standard would reinforce the current trend of large firms remaining or going private, with negative effects on the economy as a whole.
The complete paper is available for download here.