Vice Chancellor Laster of the Delaware Court of Chancery recently applied the business judgment standard of review at the pleading stage to dismiss a complaint challenging a cash-out merger involving a controlling stockholder. This is one of the first decisions applying the Delaware Supreme Court’s recent decision in Kahn v. M&F Worldwide Corp. (“MFW”), which provided a framework for how a transaction with a controlling stockholder could be structured to obtain the protections of the business judgment rule. After MFW, it was unclear whether and how the business judgment rule would be applied at the pleading stage in cases where defendants sought to rely on the framework adopted by the Delaware Supreme Court. This ruling suggests that defendants will, in appropriate cases, be able to take advantage of the MFW decision at the pleading stage and obtain dismissal without the need for potentially costly discovery.
Where a transaction involving a controlling stockholder takeover is challenged - such as a going-private transaction - the standard of judicial review traditionally applied under Delaware law is “entire fairness,” an onerous standard that requires a defendant to demonstrate both fair dealing and fair price. The demands of “entire fairness” review make it difficult for a defendant to prevail on a motion to dismiss before having to engage in costly discovery or to obtain summary judgment.
The Delaware Supreme Court’s recent decision in MFW provided a way for defendants to avoid entire fairness review of these types of transactions. In MFW, the Delaware Supreme Court held that the far more deferential business judgment review standard applies to controlling stockholder mergers 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 in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority. Under the more liberal business judgment standard, breach of fiduciary claims must be dismissed unless no rational person could have believed that the merger was favorable to the minority stockholders.
After MFW, however, questions remained about the ability of defendants to obtain the benefits of this structure to prevail at the dismissal stage. In a footnote, the MFW Court noted that the complaint in that case would have survived a motion to dismiss even under the new standard based on allegations about the sufficiency of the price negotiated by the Special Committee. From that footnote, it appeared that allegations suggesting the price was too low might suffice to call into question whether the Special Committee met its duty of care in negotiating a fair price, thereby precluding application of the business judgment rule at the pleading stage and precluding dismissal. This language could be read to suggest that allegations of poor outcome (the alleged inadequacy of the price) might suffice at the pleading stage to support an inference that the Special Committee failed to act with due care.
The Court of Chancery Grants Dismissal under MFW
Vice Chancellor Laster’s transcript ruling last week in Swomley v. Schlecht reflects at least his view on how MFW operates at the pleading stage. The Vice Chancellor granted a motion to dismiss under MFW, holding that the plaintiffs had failed to adequately plead facts undermining the six factors required for application of the business judgment rule in the controlling stockholder merger context. The Vice Chancellor rejected the argument that it was procedurally inappropriate to dismiss under MFW because the defendants should have to establish that the requirements of MFW were met. The Vice Chancellor reasoned that “MFW contemplates that one can establish a structure where, at the pleading stage, it would stand up, and the plaintiff would have the burden to attack it by pleading facts that would undermine each of its elements.”
The Vice Chancellor also held that the plaintiffs had not pled facts sufficient to call into question whether the Special Committee had met its duty of care, despite allegations that the Special Committee should have negotiated for a higher price. Focusing on the process that the committee undertook, the Court noted that “[d]uty of care is measured by a gross negligence standard,” which “really requires recklessness” and is “a very tough standard to satisfy.” That the committee could have negotiated differently, or that there were bases to disagree with the committee’s strategy or tactics, were not enough to plead a duty of care violation. Because the plaintiffs failed to plead facts sufficient to call into question the existence of the six elements established in MFW, the Court applied the business judgment standard and granted the defendants’ motion to dismiss.
The Swomley decision is important because it provides useful guidance regarding the contours of MFW. The Vice Chancellor’s decision suggests that the benefits of complying with the structural requirements of MFW are not illusory: defendants may be able to take advantage of the business judgment rule at the pleading stage and obtain dismissal before discovery. Under the Vice Chancellor’s reasoning, plaintiffs should not be able to avoid application of the business judgment rule at the dismissal stage simply by alleging that a Special Committee should have negotiated for a higher price in a controlling-party takeover. Based on comments made by plaintiffs’ counsel on the record about a likely appeal,Swomley may also provide an opportunity for the Delaware Supreme Court to address how its MFWdecision applies at the pleading stage. In the meantime, this decision demonstrates that there can be tangible litigation benefits to structuring a controlling stockholder transaction to comply with the MFWstructural requirements for obtaining business judgment rule review.