More than 25 years ago, the Delaware Supreme Court established the "entire fairness" test for analyzing transactions in which a controlling stockholder stands on both sides of the deal. Under this test, a controlling stockholder must demonstrate both fair dealing and fair price. However, the burden of persuasion for proving entire fairness can be shifted to a plaintiff if the transaction was either approved by a majority of independent directors or a special committee of independent directors, or, under certain conditions, by an informed vote of the majority of the minority stockholders.
A recent decision by the Delaware Chancery Court applying the "entire fairness test" demonstrates that both special committees and controlling stockholders must take special care in analyzing and proposing insider transactions in the future. The Delaware Chancery Court held in In re Southern Peru Copper Corp. Stockholder Litig. that, notwithstanding the approval of a special committee of independent directors, a controlling stockholder breached its fiduciary duty when it forced a publicly traded company to pay for the controlling stockholder's subsidiary.
This decision by Chancellor Strine of the Chancery Court, and the corresponding damages award of $1.263 billion entered against a controlling stockholder, represents the largest monetary award in the history of Delaware fiduciary duty cases and the second largest award for fiduciary duty cases ever in the United States. Chancellor Strine found that, rather than "acting like a third-party negotiator with its own money at stake and with the full range of options," the special committee found a way to rationalize the controlling stockholder's proposal while ignoring market realities. The case involved a proposal by a controlling stockholder to the board of directors to buy the controlling stockholder's wholly-owned subsidiary. Because the target company was wholly-owned by the controlling stockholder, a special committee of independent directors was formed to consider the proposal. The special committee hired numerous outside advisers including accountants to advise it on the proposal. The accountant's initial valuation suggested that the controlling stockholder's asking price was significantly higher than the value of its subsidiary. Notwithstanding this initial evaluation, the accountant and the special committee conducted a "relative valuation" analysis which significantly increased the projected value of the subsidiary and ultimately the special committee approved the proposal and the transaction closed.
Chancellor Strine found that, rather than looking to alternative proposals, "the special committee and its financial advisor instead took strenuous efforts to justify a transaction at the level originally demanded by the controller." Chancellor Strine also noted that neither the special committee nor the accountant "made any effort to update its fairness analysis in light of the fact that Southern Peru had blown out its EBITDA projections ... and its stock price was steadily rising in the months leading up to the stockholder vote." Ultimately, Chancellor Strine concluded that the transaction was unfair regardless of which party carried the burden of persuasion. Interestingly, the individual special committee defendants were dismissed from the case due to the company's exculpatory provisions adopted under 8 Del. Code § 102(b)(7), and only the controlling stockholder and its affiliates were liable for the damages.
This case demonstrates that an insider cannot simply rely on a special committee's approval of an insider transaction, but instead insiders must ensure that the special committee's analysis itself is of sufficient quality to ensure that the rights of minority stockholders are protected. If a committee is forced to conduct multiple valuations to find one that makes the offer attractive, as happened here through the use of "relative valuation," this may be a sign that the insider's offer is not "fair." A controlling stockholder making a proposal must strike a delicate balance between getting a fair value in the transaction without breaching its fiduciary duty.
Even though the special committee defendants in this case were not held liable, future committees should ensure that their analysis does not simply find a way to rationalize a transaction proposed by a controlling stockholder and instead looks at all possible options. In other words, special committees should assess an insider's proposal as if it were being offered by a third party in order to avoid the "confined mindset" of the committee in this case. This means that committees must always keep the option of refusing an insider's proposal as a viable one to avoid the perception that a committee is simply rationalizing an otherwise unfair transaction as Chancellor Strine believed occurred in this case.
In re S. Peru Copper Corp., CIV.A. 961-CS, 2011 WL 4907799 (Del. Ch. 2011)