Print

Toward a Controlling Shareholder Safe Harbor

This Note surveys the law governing transactions between public corporations and their controlling shareholders. It explains that Delaware courts review these “controlling shareholder transactions” under the “entire fairness” standard. Yet, Delaware and the Model Act provide safe harbors to review independently approved transactions between corporations and their directors under the business judgment rule. This Note questions the disparate treatment and suggests that the same constraints on interested directors—namely, disinterested approval and market checks—are at least as effective in supervising controlling shareholders.

Next, this Note proposes that a safe harbor doctrine extend to controlling shareholder transactions. The premise is that, so long as the interests of controlling and minority shareholders are aligned, independent approval and market checks together provide sufficient constraints that challenge the utility of the current entire fairness rule. Yet, because these constraints fail when shareholder interests diverge in the so-called “final period,” this Note suggests that controlling shareholder transactions be separated into (1) final period and (2) non-final period categories. Business judgment is appropriate when shareholder interests are aligned, but entire fairness is necessary in the final period to protect the minority from the controlling shareholder’s self interest.

This argument relies on two principal Delaware cases: Puma v. Marriott (1971) and Kahn v. Lynch Communications (1994). It suggests that Lynch implicitly recognized the final period problem, while Puma declined judicial review because the aggregate interests of shareholders were aligned. Thus, read together, they are seen as wholly consistent with the theory underlying a controlling shareholder safe harbor.

The Option Element in Contracting

The law of contracts has often treated options quite differently from other contractual transactions; for example, the characterization of a transaction as an option contract calls forth specially required formalities, but on the other hand often has the effect of releasing parties from doctrinal limitations on their contractual freedom, such as the duty to mitigate damages or the rule that holds excessively high liquidated damages void as penalties. Such differential treatment is challenging to explain from a functional viewpoint, in part because all contracts resemble options to the extent they are enforceable in terms of monetary damages, and in part because contracts that are nominally structured as explicit options can be close economic substitutes for contracts that are nominally structured as unconditional.

This Article sets out a theoretical account of the efficient design of option contracts—one that explains how contracting parties should strike the balance among option premium, option life, and exercise price, in order to maximize the expected surplus from their transaction. It shows that the tradeoffs between these various aspects of option contracts can affect the parties incentives to acquire and disclose information, to invest in relation specific investments, and to take efficient precautions against the event of breach. It then goes on to develop an organizing framework for private parties choosing whether and how to structure their contractual arrangements as options, and for policymakers choosing whether or how to regulate such private choices. In short, the appropriate balance between option premium, option life, and exercise price will depend on the relative importance that the one attaches to these various dimensions of incentives.

Enforcement Costs and Trademark Puzzles

The standard account holds that trademark law, at its core, aims to protect consumers from deceptive and confusing uses of source-identifying marks. However, there is a problem with the standard account. It cannot explain a number of important trademark doctrines, many of which, like the protection accorded trade dress, have expanded the scope of trademark rights in recent years. Some critics argue that these puzzling doctrines reflect a radical shift away from the standard account and toward a new property theory of trademark law that focuses not so much on the quality of information available to consumers as on the seller’s ability to appropriate the full commercial value of its mark. 

This Article offers a different, and less alarming, explanation for many of the puzzling doctrines, one that does not require a radical departure from the standard account. This alternative explanation focuses on the enforcement costs of implementing law based on the standard account. Enforcement costs include the administrative costs of adjudicating trademark lawsuits and the error costs of over- and under-enforcing trademark rights. For a number of reasons, trademark law generates high enforcement costs, and many of the puzzling features of trademark doctrine can be understood as legal tools to manage these high costs. In particular, courts adopt general rules or standards that protect trademarks more broadly than the standard account’s substantive policies support, but those rules and standards can be justified by the administrative and error costs they save. In the end, the Article uses the enforcement cost approach to suggest two reforms to trademark law—the broader acceptance of disclaimers especially in merchandising rights cases, and the abolition of trade dress protection.

©Virginia Law Review Association. All rights reserved.