Business Negotiations: Imposing Procedural Constraints

By Guhan Subramanian — on / Business Negotiations

Adapted from “When You Hold All the Cards” by Guhan Subramanian for the September 2005 issue of the Negotiation newsletter.

Sometimes the courts will be unwilling to get involved in the substantive terms of the deal but will impose procedural constraints on the more powerful party.

Consider the case of a controlling shareholder in a publicly traded company – someone who holds more than 51% – who wants to “cash out” the minority shareholders.

Under the corporate law of every state, the board of directors and majority shareholders must approve the terms of the offer.

But because the controlling shareholder typically controls the board of directors and, by definition, owns a majority of the shares, she can, in theory, cash out the minority shareholders unilaterally, at whatever price she wants.

In fact, in the 1960s and 1970s, many commentators expressed concerns that controlling shareholders were cashing out minority shareholders at low-ball prices, well below the fair value of the minority shares.

In response, the Delaware courts (which prove corporate law for about half of all U.S. public companies and whose rulings are generally followed in most other states) have imposed procedural restrictions on the way in which a controlling shareholder can cash out minority shareholders.

First, the company must set up a special committee of directors who are independent from the controlling shareholder.

To shore up its bargaining power, the special committee must hire its own investment bankers and lawyers.

The special committee then negotiates with the controlling shareholder over the price the minority shareholders will receive.

If the two sides reach an agreement, the deal must be submitted to the shareholders for their approval.

Typically the controlling shareholder can cashout the minority shareholders only if a majority of the minority shareholders approve the terms of the deal.

While recent twists in Delaware corporate law have provided an alternative route with fewer procedural hurdles, research indicates that approximately two-thirds of deals still follow the traditional route.

If the controlling shareholder decides to use her bargaining power to cash out minority shareholders unilaterally, courts will step in to scrutinize the terms of the deal to make sure they are “entirely fair” to the minority shareholders.

The controlling shareholder bears the burden of proving fairness.

Needless to say, this is an onerous standard of review, and controlling shareholders often have been forced to pay significantly more to the minority shareholders after a court has intervened in this way.

But if the controlling shareholder “plays nice” with this special committee – avoiding threats, giving ample time to deliberate – the courts will shift the burden of proof. In this case, the minority shareholders must demonstrate that the outcome of the negotiation wasn’t fair to them

Note that this third approach differs from the first two discussed previously (see, “Dealmaking – When You Hold All the Cards”).

Through unconscionability and implied terms, the courts regulate outcomes.

With cash-out transactions, the courts seek to regulate the process by which the negotiation takes place. In all cases, however, the goal of the legal rule is to protect the weaker party from the one holding all the cards.

Negotiating from a position of power doesn’t mean that you can squeeze every last penny out of your counterpart.

Courts can, and sometimes do, step in to protect the weaker party: by policing the terms of the deal, reading additional terms into your agreement, and imposing procedural constraints on your negotiation.

This doesn’t mean you shouldn’t seek to increase your bargaining power. But if you are successful, be aware that legal rules may constrain the extent to which you can take advantage of your strength.

Related Article: Dealmaking Negotiations – Reading Additional Terms Into the Deal

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