Delaware's New Focus on Deal Process and Disclosure: Part I
Pepper Hamilton LLP
Boards of Delaware corporations contemplating proposed mergers, together with qualified Delaware counsel, should focus their efforts on designing and adhering to a fair, reasonable and fully disclosed merger process.
This article was published in the Corporate, Mergers & Acquisitions and Securities sections of Law360 on March 1, 2017. Portfolio Media, Inc., publisher of Law360.
Four recent developments in Delaware law reduce the liability exposure of corporate boards and controlling stockholders in merger transactions, and also benefit minority stockholders. Together, these developments clarify the path for designing a fair sale process that will be subject to deferential business judgment review, and enhance the weight given by Delaware courts to the negotiated merger price in post-merger appraisal litigation.
- First, in cases that involve a merger between a company and its controlling stockholder, Delaware courts will now apply the director-friendly business judgment rule if the merger is authorized by an independent special committee and conditioned on approval by a fully informed, uncoerced majority of minority stockholders.
- Second, where a company with a controlling stockholder merges with a third party, and the controlling stockholder receives only a pro rata share of the merger consideration — i.e., the same pro rata consideration as other stockholders — Delaware courts again will apply the business judgment rule.
- Third, in mergers that do not involve a controlling stockholder, Delaware courts will now apply an “irrebuttable” business judgment presumption if the transaction is approved by a fully informed, uncoerced majority of disinterested stockholders, even when the merger process is flawed.
- Fourth, in a number of post-merger appraisal cases, the Delaware Court of Chancery has accepted the merger price as the most reliable indicator of fair value when the price was the result of a fair and adequate sale process.
Collectively, these four developments signal a renewed focus on deal process in merger litigation involving controlling stockholders and full disclosure in arm’s-length mergers. The developments with respect to process favor corporate defendants and controlling stockholders in merger litigation because they reduce the risk of fiduciary liability in inevitable merger litigation. The developments with respect to both process and disclosure are also good for minority stockholders because they encourage a fair process, which of itself tends to maximize price and reduces unnecessary litigation cost. And finally, lest plaintiffs lawyers seek out other jurisdictions perceived as more plaintiff-friendly, Delaware law now allows Delaware corporations to adopt forum-selection bylaws requiring stockholder litigation to be brought in Delaware courts. In light of these developments, boards of Delaware corporations contemplating proposed mergers, together with qualified Delaware counsel, should focus their efforts on designing and adhering to a fair, reasonable and fully disclosed merger process.
This first part in this two-part series will address the first and second developments above, both of which involve mergers with controlling stockholders. The second part will address the third and fourth developments, which involve mergers without controlling stockholders and mergers subject to post-closing appraisal actions.
The decay of emphasis on deal process in entire fairness review.
A number of opinions issued before 2010 suggested that the Delaware Court of Chancery’s review of mergers with controlling stockholders focused increasingly on the adequacy of the merger price and less on the sale process that determined that price. Delaware courts traditionally review mergers with controlling stockholders using the rigorous entire fairness standard of review, which is the highest level of scrutiny applied by Delaware courts. Under the entire fairness standard of review, director defendants have the burden to prove that a challenged transaction is entirely fair to minority stockholders and that the transaction was the product of a fair process that resulted in a fair price.
In Weinberger v. UOPInc., the 1983 case that defined “entire fairness,” the Delaware Supreme Court stated, “the test for fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness.”1 It is infamously difficult for a defendant to prevail on a motion to dismiss a case that is subject to entire fairness review prior to summary judgment or trial and after the conclusion of costly and risky discovery. Thus, a preliminary finding that a transaction is subject to entire fairness review has often forced an expensive settlement. When defendants have accepted the challenge to litigate entire fairness on the merits, however, it has often been the case that the fairness of price determined the outcome, regardless of the quality of the process. Thus, contrary to the entire fairness analysis as envisioned in Weinberger, the analysis had become increasingly “bifurcated” in the last decade, with price becoming the predominant determining factor.
For example, in 2003, in Emerald Partners v. Berlin, the Delaware Supreme Court affirmed the Court of Chancery’s ruling that a merger was entirely fair despite its condemnation of the process and suggestion of bad faith: “[w]here director conduct is reviewed under the entire fairness standard, process laxity of this kind cannot be condoned.”2 “[T]he many process flaws in this case raise serious questions as to the independent directors’ good faith” when the directors “evidenced a ‘we don’t care about the risks’ attitude.” Nonetheless, the court concluded that “we need not address the good faith claim” because there were no monetary damages — i.e., the price was reasonable — and the directors therefore would not be liable.
Similarly, in 2006, in Gesoff v. IIC Industries Inc., the Court of Chancery chastised a corporation’s directors for their conduct in negotiating a going-private merger with the corporation’s parent company, finding that the process designed by the board to freeze out the minority stockholders “fail[ed] at the very threshold to establish fair dealing,” was “muddled [and] dishonest,” and served “as a singular example of the pitfalls inherent in organizing any sort of self-dealing transaction.”3 “[S]o transparently corrupt a process cannot possibly be found to satisfy the high standard of entire fairness.”4
Nonetheless, turning to fair price, the court conducted a conventional discounted cash flow (DCF) analysis based on the competing experts’ reports and largely adopted the defendants’ expert’s DCF analysis. Although the burden of proof is on defendants under the entire fairness standard, the court gave no indication that it was presumptively favoring the plaintiff’s valuation or that the defendants carried any added burden of persuasion. In short, the defendants’ “cynical,” “corrupt” and “dishonest” process had no apparent bearing on the court’s determination of fair value.
More recently, in 2010, the Delaware Court of Chancery candidly acknowledged that fair price was the predominant consideration in analyzing the entire fairness of a merger with a controlling stockholder. In Monroe County Employees’ Retirement System v. Carlson, the court dismissed the case, relegating its discussion of the plaintiff’s process allegations to a footnote and rejecting the allegation that the board’s audit committee, charged with overseeing the challenged transactions, “wholly abdicated its duties in bad faith.”5 The court stated, “[q]uite frankly, Delaware law focuses on fair dealing in controlling shareholder transactions primarily because a fair price is more likely to follow fair dealing. Fair price, however, is often the paramount consideration.”
Underscoring this pronouncement, the Court of Chancery in Fackelmayer v. Hanover Direct Inc. (In re Hanover Direct, Inc. Shareholders Litigation), conducted its entire fairness review by largely disregarding the process allegations and relying instead on the defendants’ expert’s report in determining fair value.6 The corporation’s majority stockholder initially offered to cash out the minority stockholders at $1.25 per share after the stock closed at $2.75 per share. A special committee of independent directors rejected the offer, after which the committee was disbanded and its members resigned, leaving management and the board entirely in the hands of the majority stockholder, who then offered 25 cents per share. The board approved the merger at that price three days later. In a seven-page opinion, the court rejected the plaintiffs’ expert’s report as unreliable and found that, because the company was “under water,” any price above $0.00 was entirely fair. The court devoted one paragraph to process, finding that “no credible evidence was offered at trial that would suggest the transactional process was manipulated, timed, or tainted by an improper motive.” The plaintiffs’ argument that the company’s legal and financial advisers were not independent was rejected without discussion.
These cases suggest that fair process was becoming practically irrelevant, even in squeeze-out mergers with controlling stockholders, and that corporate defendants would be well-advised to focus on retaining the best available valuation experts with proven track records in the Court of Chancery in order to minimize their fiduciary liability risk, regardless of process.
The business judgment rule now applies to a merger with a controlling stockholder, if approved by a special committee and the vote of a majority of the minority stockholders.
The importance of fair process in a merger with a controlling stockholder has now reclaimed center stage with the Delaware courts’ pronouncement of a process that avoids entire fairness review and adopts the deferential business judgment rule. If such a merger is conditioned from the outset on both the approval of a fully functioning, independent special committee and a fully informed, uncoerced majority-of-the-minority vote, the business judgment rule applies. In In re MFW Shareholders Litigation, then-Chancellor LeoStrine addressed a long-standing anomaly in Delaware jurisprudence regarding the standard of review to be applied to a merger with a controlling stockholder.7 Almost 20 years earlier, the Delaware Supreme Court in Kahn v. Lynch Communication Systems held that the use of either a special committee or a majority-of-the-minority vote would shift the burden of proof under the entire fairness standard from the defendants to the plaintiff.8 But Kahn v. Lynch did not address the effect of using both procedural protections and did not say that using both would invoke the business judgment rule. The result was that controlling stockholders had little or no incentive to assume the risk and expense of subjecting a merger to a stockholder vote.
In MFW, the Court of Chancery took the extra step, holding that, in a transaction with a controlling stockholder, the business judgment rule is invoked if and only if:
(i) the controller conditions the procession of the transaction on the approval of both a special committee and a majority of the minority stockholders; (ii) the special committee is independent; (iii) the special committee is empowered to freely select its own advisors and to say no definitively; (iv) the special committee meets its duty of care; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.9
The Delaware Supreme Court affirmed this holding in Kahn v. M&F Worldwide Corp.10 These process standards benefit corporate defendants by requiring the Delaware courts to defer to the business judgment of disinterested, independent directors, while also benefiting minority stockholders by providing them with the dual protections of the special committee as an independent bargaining agent and the ability to decide for themselves whether to accept the deal negotiated for them by the special committee.
The MFW framework has been followed in at least one subsequent case. In In re Books-A-Million Inc. Stockholders Litigation, the corporation’s controlling stockholders conditioned their offer from the outset on approval by an independent special committee and the vote of a majority of the minority stockholders.11 The Court of Chancery found that the special committee members were independent, that they retained independent legal and financial advisers, and that they were empowered to negotiate and ultimately say “no” to the controlling stockholders. The court also found that the special committee acted in good faith and fulfilled its duty of care. The plaintiffs did not contend that the stockholder vote was either coerced or uninformed. The court therefore concluded that the requirements of the MFW framework were met and dismissed the complaint.
Thus, under MFW and Books-A-Million, controlling stockholders can avoid fiduciary liability for themselves and their corporate directors in going-private mergers by structuring their offers to require approval by an independent special committee and an affirmative vote of a majority of the minority stockholders. Those cases define the best process to be followed in order to minimize fiduciary liability exposure and litigation risk in mergers with controlling stockholders.
The business judgment rule also now applies to a merger with a third party when a controlling stockholder receives only pro rata consideration.
In another recent development, the Court of Chancery held that the business judgment rule should apply when a company that has a controlling stockholder enters into a merger with a third party, so long as the controller receives only the same pro rata consideration as other stockholders. In In re SynthesInc. Shareholder Litigation, then-Chancellor Strine (now chief justice of the Delaware Supreme Court) stated, “when controlling stockholders afford the minority pro rata treatment, they know that they have docked within the safe harbor created by the business judgment rule.”12 As the court explained, such a rule benefits minority stockholders because the alternative application of the entire fairness standard would give controlling stockholders an incentive “to obtain a differential premium for themselves or just to sell their control bloc, and leave the minority stuck-in.”13
Chief Justice Strine followed the Synthes reasoning in Iroquois Master Fund Ltd. v. Answers Corp., confirming that “[w]hen a large stockholder supports a sales process and receives the same per share consideration as every other stockholder, that is ordinarily evidence of fairness, not of the opposite, especially because the support of a large stockholder for the sale helps assure buyers that it can get the support needed to close the deal.”14
Endnotes
1 457 A.2d 701, 711 (Del. 1983).
2 840 A.2d 641 (Table).
3 902 A.2d 1130, 1149 (Del. Ch. 2006).
4Id. at 1152.
5 C.A. No. 4587-CC (Del. Ch. June 7, 2010).
6 Consol. C.A. No. 1969-CC (Del. Ch. Sept. 24, 2010).
7 67 A.3d 496, 535 (Del. Ch. 2013).
8 638 A.2d 1110, 1117 (Del. 1994).
9 67 A.3d at 535.
10 88 A.3d 635 (Del. 2014).
11 Consol. C.A. No. 11343-VCL (Del. Ch. Oct. 10, 2016).
12 50 A.3d 1022, 1035 (Del. Ch. 2012).
13Id. at 1035-36.
14 105 A.3d 989 (Table) (Del. 2014).