In 2014, the Delaware courts issued several key decisions – perhaps the most important to date – concerning the legal standards governing going-private transactions involving controlling stockholders. Taken together, these cases underscore the fact-intensive nature of establishing whether and under what circumstances a minority equity stake in a corporation may be deemed a controlling one and provide a clearer roadmap to obtaining the deferential business judgment standard of review, rather than the more stringent entire fairness standard, when engaging
in controlling stockholder transactions. With almost 95% of public company take-private transactions resulting in stockholder litigation in 2013, it is critical for private equity funds, other controlling and minority stockholders, and their financial and legal advisors to be aware of and fully understand these developments.
This article summarizes the key Delaware cases in this area from 2014 and their impact on the applicable legal standards of review. It then provides recommended process steps and considerations for Delaware corporations and their controlling and minority stockholders when engaging in take-private transactions, as well as key litigation takeaways from this latest string of decisions, including their impact on defendants’
ability to seek early resolution of cases challenging such transactions.
The Key Cases from 2014
Kahn v. M&F Worldwide Corp. (Del. March 2014), affirming In re MFW Shareholders Litigation (Del. Ch. May 2013)
MacAndrews & Forbes (“MacAndrews”), which owned approximately 43% of the common stock of M&F Worldwide (“MFW” or the “Company”), offered to purchase the remainder of MFW’s outstanding equity for $24 per share. At the close of trading on the last business day prior to MacAndrew’s offer, MFW’s stock was trading
at $16.96. At the outset of negotiations, MacAndrews conditioned consummating any going-private transaction upon the deal being approved by both (i) an independent special committee of MFW’s board of directors and
(ii) a vote of a majority of the Company’s disinterested stockholders (a “majority-of-the-minority” provision). Following negotiations, MacAndrews raised its offer to
$25 per share, which was approved both by the special committee and, in turn, by 65% of the Company’s minority stockholders. Several other stockholders, however, brought suit challenging the merger, alleging that it was unfair and seeking a post-closing damages remedy for alleged breaches of fiduciary duty.
In a landmark decision issued in 2013, then Chancellor Strine of the Delaware Court of Chancery held that the appropriate standard of review for assessing the
plaintiffs’ claims was the deferential business judgment rule, rather than entire fairness, and granted summary judgment in favor of the defendants. In March 2014, the Delaware Supreme Court upheld that decision, expressly affirming that controller-led take-private transactions are subject to review under the business judgment standard when they are conditioned – from the outset – on the approval of both (i) a fully-empowered, disinterested and independent special committee, and (ii) a fully-informed and uncoerced majority-of-the-minority vote. The court articulated a six-part test for determining the applicability of business judgment review under these circumstances:
- the transaction is conditioned at the outset, prior to any negotiations taking place, on the approval of both a special committee and a majority-of-the-minority vote;
- the special committee is independent; (iii) the special committee has the power to select its own advisors and to say no to any proposed transaction; (iv) the special committee fulfills its duty of care in negotiating a fair price;
(v) the vote of the minority is informed; and (vi) there is no coercion of minority stockholders.
In re Orchard Enterprises, Inc. Stockholder Litigation
(Del. Ch. February 2014)
Dimensional Associates, LLC (“Dimensional”) held 42% of the common stock of Orchard Enterprises, Inc. (“Orchard” or the “Company”), along with 99% of the Company’s preferred stock, giving Dimensional a combined 53%
of the voting power. Dimensional offered to buy out Orchard’s minority stockholders for $1.68 per share. Orchard formed a five-member special committee, which was authorized to negotiate with Dimensional, and any other potential bidders, and to hire its own
independent legal and financial advisors. Orchard’s public announcement of Dimensional’s initial proposal led to a higher offer from a third party. Dimensional first responded by raising its offer to $2.10 per share without a majority-of- the-minority approval condition, before finally agreeing on a price of $2.05 per share with both a “go-shop” provision and a majority-of-the-minority condition. The special committee’s financial advisor issued an opinion that the
$2.05 per share price was fair from a financial point of view, and Orchard’s proxy statement recommended approval of the merger. Holders of a majority of the minority approved the merger.
A subsequent appraisal proceeding concluded that the fair value of Orchard’s common stock at the time of the merger was $4.67 per share – more than twice what Dimensional had paid. Stockholder-plaintiffs brought suit challenging the merger, alleging that it was unfair and seeking a post-closing damages remedy for alleged breaches of fiduciary duty. In a 90-page opinion issued
two weeks prior to the Delaware Supreme Court’s decision in MFW (discussed above), Vice Chancellor Laster granted summary judgment in favor of plaintiffs on their argument that entire fairness, rather than the business judgment rule, would be the appropriate standard of review at trial. In so holding, the court found that the transaction did not qualify for the exception to entire fairness review recognized by the Court of Chancery (and subsequently the Delaware Supreme Court) in MFW because Dimensional did not condition the consummation of the transaction on the approval of both an independent special committee and a majority-of-the-minority vote before the commencement of negotiations.
The court further agreed with plaintiffs that defendants should bear the burden throughout trial of establishing
entire fairness. Acknowledging that the presence of a special committee or a majority-of-the-minority provision can justify shifting the burden under Delaware law, the court declined to do so here because defendants did not establish as a matter of law – as required at the summary judgment stage – that the majority-of-the-minority vote was fully-informed (given the inclusion of at least one material misstatement in the proxy) or that the special committee was disinterested and independent (given disputed issues of material fact concerning the chair’s ties to, and consulting work for, Dimensional and his later consulting work for Orchard).
Notably, the court declined to grant summary judgment in plaintiffs favor on whether the merger was entirely fair, notwithstanding the earlier appraisal decision calculating the “fair value” of Orchard common stock at the time of the merger as $4.67 per share. While it acknowledged
that a fair value assessment more than double the merger price is “certainly evidence of financial unfairness,” it is not dispositive because, unlike the fair value determination
in the appraisal context, which requires a specific point calculation, fair price is not so specific. In other words, a merger price can fall below the precise fair value
calculation demanded by the appraisal statute and still fall within a range of fair values.
Frank v. Elgamal (Del. Ch. Mar. 2014)
Unaffiliated private equity fund Great Point Partners (“Great Point”) sought to acquire American Surgical Holdings,
Inc. (“American Surgical” or the “Company”). Four key employees of American Surgical owned a total of 68% of the Company’s stock, although no one employee owned more than 50%. The board of American Surgical formed a special committee of independent, non-executive directors to oversee the negotiation process for the Company’s sale, and the committee engaged a financial advisor to solicit offers. Three potential buyers, including Great Point, submitted offers. Great Point presented the special committee with three choices with varying mixes of cash and equity to be provided to management as “rollover stockholders” maintaining an investment in the Company post-sale. The option selected by the special committee provided the greatest ratio of cash to equity to
the rollover stockholders, but provided slightly less overall consideration to the minority stockholders (4 cents per share) than if the rollover stockholders took more equity.
The special committee considered but declined to use a majority-of-the-minority condition because of concerns that such condition would endanger the deal with Great Point.
The Court of Chancery granted summary judgment in part and denied it in part in connection with claims asserted by the minority stockholders. The court held that it could not determine whether the merger was subject to entire fairness review because there were issues of material fact as to whether the “rollover group” was a control group, the existence of which, held the court, could change throughout the course of the transaction. Although there was no evidence of a control group prior to the sale of the Company, the court found that there may have been a control group at the time the board approved the merger. Assuming that entire fairness review applied, there were also material issues of fact remaining with respect to
whether the special committee shifted the burden of proof to plaintiff, because it was unclear if the special committee was well functioning and fully informed.
KKR Financial Holdings LLC Stockholder Litigation
(Del. Ch. Oct. 2014)
Private equity fund KKR & Co. L.P. (“KKR”) owned less than one percent of KKR Financial Holdings LLC (“KFN”). The board of KFN approved a $2.6 billion merger of KFN with KKR, representing a 35% premium. A KKR affiliate managed the day-to-day operations of KFN under a management agreement. The management agreement
provided for the payment to KKR’s affiliate of a $256 million fee for early termination of the agreement, which payment severely limited KFN’s value in a potential sale, essentially limiting the field of potentially interested buyers to KKR.
KFN stockholders brought suit challenging the merger, alleging that it was unfair and seeking damages for breach of fiduciary duty. The Court of Chancery granted defendants’ motion to dismiss, finding that the business judgment rule – not the entire fairness standard – applied to the plaintiffs claims. In so doing, the court rejected plaintiffs’ contention that, although KKR owned less
than one percent of KFN stock, it was nevertheless a controlling stockholder because KKR’s affiliate allegedly exercised control over the day-to-day management of KFN. In his decision, Chancellor Bouchard emphasized that the key question was not whether the stockholder exercised control over the company’s operations, but
whether it exercised control over the decision to approve the merger. Here, that decision remained vested in KFN’s board, a majority of which plaintiffs had failed to allege was beholden to KKR. Indeed, even though KKR could nominate directors of KFN, KKR could not remove or appoint directors or block board decisions. Moreover,
a majority of the outstanding KFN shares, including a majority of shares not owned by KKR and its affiliates, approved the merger.
In re Crimson Exploration Stockholder Litigation
(Del. Ch. October 2014)
The board of directors of Crimson Exploration (“Crimson” or the “Company”) approved a stock-for-stock merger of Crimson with Contango Oil & Gas, representing a small 7.7% premium to Crimson’s stockholders. Private equity fund Oaktree Capital (“Oaktree”) owned approximately 34% of Crimson and was also a large creditor of the Company. Three of Crimson’s seven directors were Oaktree employees. Stockholders of Crimson brought suit challenging the merger, alleging that it was unfair and seeking damages for breach of fiduciary duty.
The Court of Chancery declined to apply entire fairness review to plaintiffs’ claims, notwithstanding allegations that Oaktree was a controller. En route to dismissing the action under the business judgment rule, the court conducted
an extensive survey of the decisional law addressing “controller” status for minority stockholders, concluding that those cases “do not reveal any sort of linear, sliding- scale approach whereby a larger share percentage makes it substantially more likely that the court will find the stockholder was a controlling stockholder,” but show instead that “a large blockholder will not be considered a controlling stockholder unless they actually control the board‘s decision about the challenged transaction.”
The court also rejected the plaintiffs’ argument that a 15% stockholder unaffiliated with Oaktree should be aggregated with Oaktree to find a “control group” due to “concurrence of self interest.” To aggregate, the court held, there needed to be a legally significant actual agreement to work together toward a shared goal.
Moreover, and in any event, the court observed, there is a presumption that all stockholders, controlling and minority alike, are aligned in seeking to maximize the value of
their shares. The court likewise rejected the argument
that the Oaktree members on the Crimson board lacked independence on the ground that the buyer’s agreement to prepay Crimson debt held by Oaktree at a one percent premium was a unique additional benefit to Oaktree that would make the deal a conflicted transaction.
In re Zhongpin Inc. Stockholders Litigation
(Del. Ch. Nov. 2014)
The board of directors of Zhongpin Inc. (“Zhongpin” or the “Company”) put the Company in play by seeking a buyer. The board sought a $13.75 per share price from Zhongpin’s founder, chairman and chief executive officer, who owned 17% of the Company’s stock, making him the largest stockholder. The CEO rejected the $13.75 sale price and instead offered $13.50 per share, which was ultimately accepted. Stockholder-plaintiffs brought a post-closing challenge to the transaction.
The Court of Chancery denied the defendants’ motion to dismiss for failure to state a claim, concluding that the stockholder plaintiffs’ allegations sufficiently raised an inference that the Company’s chairman and CEO could control the Company – and, accordingly, that
entire fairness rather than the business judgment review applied – notwithstanding the CEO’s mere 17% percent ownership stake. Specifically, the court determined that such allegations suggested that the CEO possessed both “latent” control (via his stock ownership) and “active” control (with respect to the day-to-day operations) of Zhongpin. The court went on to conclude that entire fairness review applied notwithstanding the approval of
a special committee and the fact that the deal (signed prior to the Delaware Supreme Court’s decision in MFW ) was subject to (i) non-waivable majority-of-the-minority approval (which it obtained), (ii) a 60-day go-shop period (that was later extended) and (iii) a unilateral right on the part of the Company to terminate the agreement for any reason during the go-shop period with no breakup fee, because the majority-of-the minority condition had not been included in the CEO’s proposal at the outset.
In Re Sanchez Energy Derivative Litigation
(Del. Ch. Dec. 2014)
Sanchez Energy Corporation (“Sanchez Energy”) entered into a joint venture transaction with Sanchez Resources, LLC (“Sanchez Resources”) for the purchase of rights to develop land and extract oil, subject to royalty payments
owed to landowners. Two members of Sanchez Energy’s five-person board of directors were the controlling stockholders of Sanchez Resources and collectively owned 21% of the stock of Sanchez Energy. The joint venture transaction was approved by Sanchez Energy’s three-person audit committee, none of whom had a financial interest in Sanchez Resources or the joint venture transaction.
Stockholder-plaintiffs brought a derivative suit, alleging claims of breach of fiduciary duty against the directors of Sanchez Energy in connection with the transaction. Specifically, the plaintiffs alleged that the transaction was tainted by the conflicts of interest and lack of
independence on the part of the two members of Sanchez Energy’s board who were the controlling stockholders of Sanchez Resources. The Court of Chancery dismissed the action, noting, among other things, that an effectively mandated audit committee of disinterested directors
had approved the transaction. While acknowledging that plaintiffs had highlighted various friendships and outside business relationships between the disinterested and allegedly conflicted directors, the court, citing the decisions in KKR and Crimson Exploration discussed above, emphasized that, given their combined 21.5% stake in Sanchez Energy, in order to adequately allege that the two purportedly conflicted directors were
controlling stockholders, plaintiffs must plead specific facts demonstrating actual control of the board in connection with the transaction being challenged, which the court described as the “defining and necessary feature of a controlling minority stockholder.” Allegations of day-to-day operational control were insufficient.
Deal Roadmap and Standards of Review
The decisions described above provide a roadmap for parties to follow in structuring a deal in a manner most likely to achieve business judgment protection. When mapping out the course of a transaction, dealmakers should pay particular care as to whether the intentions, actions, agreements and record will demonstrate that a minority stockholder had actual control over the board of directors in the subject transaction (and was thus a controlling stockholder) or whether that stockholder took a backseat and allowed the board to function on its own without influence or interference from the stockholder. While a controlling stockholder is not legally required
to assist the company in obtaining competing bids, the controlling stockholder’s position in any subsequent plaintiff stockholders’ action will be significantly advantaged to the extent the controlling stockholder can demonstrate that it cooperated with the company’s sale process and negotiated with or was willing to participate with competing bidders.
If there is a finding of a control stockholder in a challenged transaction, the plaintiff must demonstrate that the resulting transaction was conflicted in order to cause the standard of review to shift from the business judgment rule to entire fairness. Conflicted transactions will be found when any of the following exist:
- A controlling stockholder stands on both sides of a transaction (e.g., a parent buying a subsidiary or a private equity fund taking a portfolio company private, thereby squeezing out the minority);
- A controlling stockholder competes with the common stockholders for consideration by receiving additional or different consideration (e.g., an extra premium); or
- A controlling stockholder extracts some unique benefit (e.g., a release of claims or obtaining much needed liquidity by forcing a fire sale), even where other stockholders nominally receive the same consideration.
Even if there is a controlling stockholder, a challenged transaction will be subject to the less stringent business judgment rule if all of the following are met:
- The controlling stockholder conditions the transaction on both a special committee approval and a majority- of-the-minority vote of stockholders;
- The special committee is independent;
- The special committee is empowered to freely select its own advisors and definitively say “no” to the transaction;
- The special committee fulfills its duty of care in negotiating a fair price;
- The vote of the minority stockholders is informed, and
- There is no coercion of the minority stockholders. If there is a controlling stockholder and any of these
conditions above are not satisfied, the transaction will be reviewed under the more exacting entire fairness standard. The entire fairness standard requires both substantive fairness (a fair price) and procedural fairness (a fair process) which are very exacting standards for a
defendant to prove in litigation. The courts may choose to shift the burden of proving entire fairness to the plaintiffs if it can be shown that the transaction was either approved by a well-functioning committee of independent directors or approved by an informed and uncoerced vote of a majority of the minority stockholders.
Whether to subject a transaction to a majority-of-the- minority condition is a crucial business decision to be made by any board of directors and to be offered from the outset by any controlling stockholder. At a minimum, it may lead to a higher price being paid to the minority stockholders or may put the overall transaction at risk due to a failed stockholder vote (or delay as a higher price is negotiated in the face of an actual or threatened failed stockholder vote). As a practical matter, the critical decision may be whether to pay more now (in order to achieve a majority-of-the-minority approval) or pay more
later (through the time and expense of protracted litigation under the entire fairness standard of review).
Key Litigation Takeaways
Taken together, the decisions discussed above suggest that, in determining whether a stockholder with a minority interest may be deemed a controller, the Court of Chancery’s primary focus will be on assessing the extent to which the alleged controller influenced the board’s decision with respect to the transaction at issue. Although the Zhongpin decision suggests that a minority stockholder’s alleged control over the company’s day- to-day operations also remains relevant to this inquiry,
it is clearly of lesser significance (if any at all to certain members of the court). Given the fact-specific nature of both inquiries, however, dismissals at the pleading stage on this basis may be difficult to come by.
Where a transaction is deemed to involve a controlling stockholder, the Delaware Courts have now provided a pathway for avoiding entire fairness review. The Court of Chancery’s decisions in both MFW and Orchard viewed this exception – conditioning the transaction at the outset on approval by an independent special committee and
a majority-of-the-minority vote – as a potential avenue for controllers and directors to dispose of squeeze-out litigation at the pleading stage (i.e., prior to discovery), if plaintiffs could not plead facts indicating that either the special committee or the majority-of-the-minority provision was ineffective or otherwise flawed. In so
doing, the Court of Chancery lamented plaintiffs’ ability to extract settlement value and attorney’s fees in meritless suits solely on the basis of leverage generated by the unavoidable application of entire fairness.
The Delaware Supreme Court, however, signaled a very different vision in its affirmance in MFW. In a footnote that, in legal discourse, has seemingly eclipsed the holding itself as the key takeaway from the case, the high court went out of its way to note that the plaintiffs’ complaint would have survived a motion to dismiss under the court’s proposed framework, notwithstanding that the procedural protections were implemented at the outset and faithfully honored by the parties to the merger. More importantly, the allegations on which the court based that conclusion are prototypically the sort of canned, generic allegations about merger consideration levied in nearly every
merger suit, e.g., that the merger price was lower than the company’s trading price x months prior and that analysts viewed the merger price as lower than expected. Yet the court found that these allegations raised doubts about the efficacy of negotiations by the special committee and, thus, would have warranted discovery on all six elements articulated by the court as prerequisites to business judgment application. In sum, while the court blessed the advent of a mechanism by which controllers and target boards can secure business judgment protection in the freeze-out context, it also erected potential hurdles that could mitigate the benefits – or, at a minimum, shift the cost/benefit analysis for controlling stockholders – of constructing the procedural devices in the first instance.
The Supreme Court also stated that in order to avoid entire fairness under MFW, defendants are required to establish entitlement to business judgment protection, i.e., satisfy each of the six prerequisites – prior to trial, or be stuck with the entire fairness burden for the duration. In other words, if after discovery and summary judgment, “triable issues of fact remain about whether either or both of the dual procedural protections were established, or if established were effective, the case will proceed to a trial
in which the court will conduct an entire fairness review.” If followed to the letter, the holding would preclude business judgment protection in situations where it has been historically available.
The Delaware courts have provided defendants with additional tools for combatting the inevitable stockholder litigation that comes along with public company M&A deals. The courts are more clearly applying a narrow definition of “control stockholder,” one that is not based on a sliding, numerical scale, but rather a flexible, fact specific approach that requires a demonstration of actual control over the decision-making process of the target company’s board of directors. Thus, the courts will apply the deferential business judgment standard of review to challenges to deals involving (i) minority stockholders, even when directors approving such a non-controller transaction are not independent or (ii) involving controlling stockholders where the transaction is conditioned at
the outset on approval by both a properly formed and functioning special committee and a fully-informed, non- coerced vote by a majority of the minority. The courts remain willing, however, to apply the more stringent entire fairness standard (requiring defendants to show both fair process and a fair price) in other circumstances, including in connection with challenges to self-dealing transactions or where there is a blatantly flawed sales process.