On February 27, the Delaware Court of Chancery issued important guidance to boards of directors seeking to utilize special committees of disinterested and independent directors to insulate themselves from fiduciary liability in connection with merger and acquisition transactions.1
Most notably, the court held that, even outside of the controlling stockholder context, one of the necessary prerequisites that must be met in order for the formation of a special committee to alter the standard of review from entire fairness to business judgment where at least half of the board is conflicted is the so-called ab initio requirement — that is, the special committee must be formed before the company undertakes any substantive economic negotiations.
Thus, while the court’s decision in Salladay v. Lev confirms that special committees of disinterested and independent directors can be effective vehicles to protect a company’s directors against fiduciary duty claims, boards of directors wishing to maximize the effectiveness of those committees and invoke business judgment review must be sure to form those committees before any substantive economic negotiations take place.
In early 2018, Intersections, Inc., an identity protection services company, sought to raise additional capital. It formed a special committee of three independent directors to explore various alternatives. Ultimately, the process did not bear fruit, and the special committee was disbanded.
In September 2018, a group of investors — referred to in the Salladay opinion as the iSubscribed Investor Group — proposed a transaction under which the investor group would purchase Intersections through a merger. As part of the deal, certain directors that held significant equity stakes in the company would be permitted to roll their ownership interests in the company into the combined entity (the roll-over directors). The remaining stockholders would be cashed out.
Within a week, the iSubscribed Investor Group entered into a nondisclosure agreement and began conducting due diligence. After some initial diligence, a representative of the iSubscribed Investor Group met with one of the roll-over directors, Intersections’ CEO, to discuss the transaction. At that meeting, the roll-over director told the iSubscribed Investor Group representative that the Intersections board of directors would be receptive to an acquisition offer of $3.50 to $4.00.
After the meeting, Intersections reconstituted the previously disbanded special committee to consider any offer made by the iSubscribed Investor Group and resolved that Intersections’ board would not approve any offer from the investor group unless supported by the special committee. A few days later, the iSubscribed Investor Group proposed to acquire Intersections at $3.50 per share. The transaction also contemplated that the roll-over directors could convert their stock in Intersections into an ownership stake in the combined entity.
Days later, the special committee engaged legal counsel, retained a financial adviser, and determined that any acquisition would be conditioned upon approval by a majority-of-the minority vote. Negotiations continued, and the iSubscribed Investor Group revised its merger offer to $3.68 per share. Ultimately, the special committee recommended approval of the offer, the board adopted the committee’s recommendation, the parties executed a merger agreement, Intersections issued its proxy statement soliciting stockholder approval of the merger, the stockholders voted in favor of the merger, and the merger closed.
On January 22, 2019, certain stockholders of Intersections filed suit challenging the merger. The stockholders claimed that the roll-over directors breached their fiduciary duties by approving the merger. The director defendants moved to dismiss. One of the grounds that the director defendants asserted in favor of dismissal was that the formation of a special committee to consider the merger warranted the application of business judgment review, which required dismissal of the action.
The Salladay court disagreed with the director defendants, finding that, while a special committee could potentially change the standard of review from entire fairness to business judgment, it did not do so here because the special committee was not formed until after one of the roll-over directors and a representative of the iSubscribed Investor Group had substantive discussions regarding the merger consideration to be offered by the group. In so holding, the court extended the ab initio requirement enunciated in Kahn v. M & F Worldwide Corp. (MFW), 88 A.3d 635, 644 (Del. 2014), to transactions that do not involve conflicted controllers.
Under MFW’s ab initio requirement, in conflicted controller transactions, both procedural safeguards — the formation of a special committee and the conditioning of any offer upon approval by a majority of the minority stockholders — must be adopted before substantive negotiations begin in order for business judgment review to be retriggered. The court in Salladay found that the rationale underlying the application of the ab initio requirement to controlling-stockholder situations applied equally in the context of a majority-conflicted board. Accordingly, the court ruled that, for a special committee to justify the alteration of the standard of review of an M&A transaction, it must “be sufficiently constituted and authorized ab initio — before substantive economic negotiations.”
Because one of the roll-over directors had price negotiations with one of the representatives of the iSubscribed Investor Group before the special committee was formed, the court held that the ab initio requirement was not met here. As a consequence, Intersections’ formation of a special committee was not sufficient to regain business judgment review.
Some of the key takeaways from the Salladay decision, particularly as it relates to guidance regarding special committee formation, are as follows:
The Two Safeguards. Under well-established Delaware law, once entire fairness review has been presumptively triggered — whether because there is a conflicted controlling stockholder or a majority-conflicted board — there are two procedural safeguards that may be used either separately or in conjunction with one another to either shift to the plaintiff the burden of proving that the transaction is not entirely fair or change the standard of review from entire fairness to business judgment. These safeguards are a properly functioning special committee and stockholder ratification.
Both Safeguards Needed in the Controller Context. Prior case law, including the Delaware Supreme Court’s decision in MFW, leaves no doubt that both protections are needed to regain business judgment rule protection in controlling stockholder situations.
Only One Safeguard Needed Outside of Controller Context. As the Salladay court held, only one of the two procedural safeguards is necessary to invoke business judgment review when there is no controlling stockholder. That is so, per the court in Salladay, even when the transaction is one that may not be unilaterally approved by a special committee, but must also be ultimately approved by the full, conflicted board of directors under 8 Del. C. § 141(c)(2), as in the case of statutory mergers.
The Ab Initio Requirement. The court in Salladay also made clear that the special committee must be formed and empowered before the company engages in any substantive economic negotiations for the special committee to have the effect of changing the standard of review from entire fairness to business judgment in conflicted transactions. To the authors’ knowledge, no prior Delaware case extended the ab initio requirement to conflicted transactions when there was no controlling stockholder involved. The Court of Chancery has now definitely done so in Salladay, however, and unless the Delaware Supreme Court reaches a contrary conclusion in the future, boards of directors wishing to utilize special committees to trigger business judgment review in M&A transactions must be sure to form those committees before any economic negotiations take place.
Effective Special Committees. Under prior Delaware case law and the court’s Salladay decision, a special committee will be deemed to be properly formed, sufficiently empowered, and well-functioning when it has the following attributes: (1) all members are disinterested and independent; (2) the committee is formed before substantive economic negotiations begin; (3) the committee is composed of more than one member; (4) the special committee is given a clear mandate, with the power to “say no” to the transaction; (5) the special committee is authorized to retain its own advisers and those advisers are not the same ones that are advising any interested parties; and (6) negotiations between the counterparty and the special committee are conducted in a way that is consistent with arms-length negotiations.