'Fair Value' as a Default Rule of Corporate Law: Minority Discounts in Conflict Transactions

At the center of every management buyout or freezeout is the question, how should minority shares be valued?, and in valuing minority shares, the principal valuation question is, should value be "discounted" to reflect the non-controlling status of minority shares? Minority discounts impact both ex post deal prices and ex ante share value. For example, in the 1996 Levi Strauss buyout, a minority discount of 35% would have reduced total fair value by $1.5 billion. Yet the law governing minority discounts is unpredictable and obscure. Although the Delaware Supreme Court has rejected discounts in theory, case law analysis reveals that lower courts have (erratically) applied them in practice. While the law on fair value is thought to be mandatory, it is not. Firms and investors may contract around law regarding discounts, as with nearly all rules of corporate law (a fact that has led Bernard Black to ask whether corporate law should be characterized as "trivial"). Firms can contract around the currently unpredictable discount law by adopting fair price charter provisions, entering into buy/sell agreements, or issuing redeemable stock. These two legal facts present an economic puzzle. Parties have an incentive to contract around nonmandatory (or "default") rules that create uncertainty. Yet issuing firms have generally not contracted for a clear discount rule. In fact, firms rarely contract around unclear default rules of corporate law. Economic theory provides three compatible answers: First, the cost of contracting for a ban on discounts -- including the cost of potential signalling effects -- may exceed the benefits of such a contract. Second, firms that attempt to contract around discount rules may encounter network and innovation externalities. Third, investors may overpay for minority shares by taking Delaware law at face value, an answer that is at odds with the efficient market hypothesis but supported by the lack of adequate disclosure and commentary regarding discount law. These constraints suggest that default rules of corporate law may be far from trivial. Minority discounts raise two difficult legal policy questions. First, what should the discount rule be? I argue that a rule excluding discounts is the better rule because it appears more likely to be the efficient rule and because non-efficiency rationales for accepting discounts are weak. This conclusion is contrary to a recent proposal by Benjamin Hermalin & Alan Schwartz, who argue for using minority share market prices in setting fair value, but who are too sanguine about the ability of existing laws to adequately constrain value-reducing transactions. This conclusion is supported by evidence of actual bargains and theoretical approaches that take account of the asymmetric information confronting firms and investors in the securities markets. Excluding discounts is also more likely to reduce transaction costs. Second, should the discount rule remain nonmandatory? I argue that, in the context of initial public offerings accompanied by adequate disclosure, the rule should remain nonmandatory. In my concluding remarks, I describe the practical difficulties of separating minority discounts from control premiums, and propose a procedural rule to assist courts in doing so.