Corporate freezeouts (that is, transactions in which the controlling shareholder of a corporation buys out the minority shares) are subject to enhanced judicial scrutiny in the form of entire fairness review. In contrast, this form of judicial review often does not apply to freezeouts of non-incorporated business entities because the controlling shareholder of those entities can waive the duty of loyalty. In a recent paper, we find that this doctrinal difference is associated with significantly inferior gains for the minority shareholders in non-corporate freezeouts.

In the corporate context, controlling shareholders owe a duty of loyalty to the corporation, which prevents them from advancing their personal interests at the expense of those of the corporation. This duty has special importance in the context of freezeouts not only because of the economic significance of those transactions in the life of a corporation, but also because a freezeout involves a significant conflict of interest: the controlling shareholder stands on both sides of the transaction (as a buyer and as a controller of the seller), which means that there is a high risk that he will pay an unfairly low price for the minority shares. In response to this risk, courts police observance of the duty of loyalty by subjecting freezeouts to entire fairness review, a demanding standard of judicial review in which the court will revise the economic terms of the transaction if the court concludes that the process or substance of the transaction was unfair. A controlling shareholder typically can escape entire fairness review only if he conditions the transaction on approval by a committee of independent directors and the majority-of-the-minority shareholders, which procedural steps are thought to emulate a transaction between unrelated parties.

Things, however, are very different in the context of non-incorporated business entities (such as limited partnerships or limited liability companies). Even though freezeouts of those entities give rise to the same conflicts of interest that corporate freezeouts do, the duty of loyalty can be (and often is) waived in those entities, which precludes the application of entire fairness review. Freezeouts of non-corporate entities constitute approximately one-fifth of total freezeouts by number and one-third by deal volume since 2000, which means that a significant portion of freezeouts today are executed with a business entity (non-corporate form) and a doctrinal regime (no entire fairness review) that are different from the entirety of what the business organization literature has studied to date.

We examine, as mentioned above, whether the less stringent regime that applies to non-corporate freezeouts is associated with inferior economic outcomes for the minority shareholders – and we find that it does: while the minority shareholders receive cumulative abnormal returns (CARs) of 19% in corporate freezeouts, they receive 10% in non-corporate freezeouts. This result holds in various multivariate analyses, including regressions in which we use a matched sample of corporate and non-corporate freezeouts.

In previous studies, we have found that the absence of entire fairness review in freezeouts can generate a social welfare loss. However, equity holders in non-corporate freezeouts come in “eyes wide open” with respect of the rules of the game, and fiduciary duty waivers might have been necessary to induce the controller to permit minority owners in the first place. To reconcile these competing policy points, we recommend the continued enforcement of fiduciary duty waivers in non-corporate entities, but at the same time, we recommend a “light touch” monitoring of these transactions, which is discussed in the paper.

The paper is available here: https://ssrn.com/abstract=4899225