In Books-A-Million, Inc. Stockholders Litigation (Oct. 10, 2016), the Delaware Court of Chancery dismissed at the pleading stage of litigation the plaintiffs' post-closing claims for damages relating to a squeeze-out going-private merger with the company's controlling family.
The merger was structured to comply with the Delaware Supreme Court's 2014 seminal MFW decision. MFW established an important new regime for judicial review of controller transactions, providing for review under the deferential business judgment rule, rather than the more stringent "entire fairness" standard, if, ab initio, the transaction was conditioned on approval by both (i) an independent, adequately empowered special committee that fulfilled its duty of care and (ii) a majority of the minority stockholders in a fully informed, uncoerced vote. Under business judgment review in this context, the only claim that will be entertained by the court will be waste (which may be reasonably inferred from bad faith).
In Books, the plaintiffs challenged the merger on the basis that it provided a price per share that was below an alternative third party offer that the controlling family was not willing to support. Vice Chancellor Laster's succinct summation captures the direct route to early dismissal of challenges to MFW-compliant controller transactions: "The plaintiffs' complaint has not pled grounds to take the transaction outside of the [MFW] framework. The business judgment rule applies. The Merger cannot be viewed as an act of waste. The complaint is therefore dismissed...."
Books demonstrates that there is only a very narrow path to avoiding early dismissal of challenges to a controller transaction that was structured to comply with MFW. The decision indicates that, in the MFW context, claims will be dismissed at the pleading stage unless the facts pled support a reasonable inference that:
an element of the MFW framework was not met;
the transaction constituted "waste" (a standard that the court has characterized previously as almost impossible to meet); or
the independent directors acted in "bad faith" (which was characterized by the court as such a "difficult route" that it provides only "a theoretical basis" for avoiding early dismissal).
Copyright 2016 Fried, Frank, Harris, Shriver & Jacobson LLP A Delaware Limited Liability Partnership
Fried Frank M&A Briefing
While the court stated that a board's supporting a controller transaction at a "grossly inadequate" price "might" constitute bad faith, the court confirmed that (a) a controller's price is not grossly inadequate simply because it is below a third party offer and (b) a controller has a right to refuse to sell its shares or otherwise facilitate a third party offer. We note that a board has no obligation to approve a controller's transaction--thus, if a controller's price is grossly inadequate, a board may face claims of bad faith if it does not "say no" to the transaction.
Background. The founder-controlling family (the "Family") of Books-A-Million, Inc. (BAM), which controlled 58% of the equity and outstanding voting power, took the company private through a squeezeout merger in which each publicly held share was entitled to receive $3.25. The $21 million take-private transaction, which had been structured to comply with the MFW prerequisites, was approved by an independent and disinterested special committee (represented by its own legal and financial advisors) and by a majority (66%) of the minority stockholders. Although the Family had stated that it would not sell its shares, the special committee nevertheless canvassed the market. The committee received a third party offer with a merger price of $4.21 per share. The third party offer was expressly subject to the Family's selling its shares and, because sufficient financing could not be obtained, was also conditioned on the Family's "backstopping" the offer by committing to acquire BAM's real estate and specified other assets for $22 million. Certain minority stockholders brought this post-closing action for damages, alleging that the Family and the directors had breached their fiduciary duties. The plaintiffs contended that the directors' approval of the controller's offer at a price well below the price of a third party offer was inexplicable on any basis other than bad faith.
Compliance with MFW in Books. The court found that the plaintiffs had not pled facts that supported a reasonable inference that the MFW prerequisites had not been met. The court noted that:
In their initial offer letter, the Family conditioned the merger on approval by both a special committee of independent directors and a non-waivable vote of disinterested stockholders;
The special committee was comprised of two independent directors (with the two directors who were Family relatives, and the one director who had "social and civic relationships" with the Family, not serving on the committee);
The committee met 33 times; negotiated with the Family over five months; rejected the Family's initial offer; submitted two counteroffers; considered alternative transaction structures; canvassed the market for third party offers for the whole company; negotiated over non-economic terms; and achieved a price that was 20% higher than the Family's initial offer and 93% higher than the pre-announcement closing price; and
There were no claims that the proxy statement disclosure had been inadequate or that the vote of the minority stockholders had been coerced.
We note that the Family had stated when it made its proposal that it would not be willing to sell its shares to a third party; and, after the third party offer was received, the Family advised the board that it would not support the offer. Further, the third party offer was subject not only to the Family's selling its shares (as would be typical) but also to the Family's providing "backstop" financing (by committing to acquire significant BAM assets at a stated price)--both of which the Family was unwilling to do, making the third party offer essentially illusory (although the court, in its opinion, did not rely on the conditional nature of the third party bid).
Fried Frank M&A Briefing
The court dismissed the plaintiffs' claims in this MFW-compliant controller transaction, even though the facts alleged challenged the price and process. Books confirms the approach taken by Vice Chancellor Laster in Swomley v. Schecht, the court's first application of MFW. In Swomley, in an oral opinion, the Vice Chancellor dismissed at the pleading stage claims challenging an MFW-compliant merger notwithstanding what appeared to be non-trivial challenges to price and process. Swomley and Books indicate that the court will not view challenges on price and process as necessarily raising issues as to compliance with the MFW prerequisites to business judgment review (which would then require that the case proceed to discovery for resolution of those issues). The Vice Chancellor's view has been that the "promise" of MFW is that cases reflecting essentially a dispute over price (rather than a breach of fiduciary duties) should be dismissed early and "channeled" instead to appraisal proceedings.
Claims of "bad faith" by independent directors could, in theory, defeat early dismissal of claims under MFW--but pleading bad faith is a very "difficult route." In a non-MFW context, a well-pled claim of bad faith by directors will avoid early dismissal of claims--as, by statute, directors cannot be exculpated from personal liability for actions taken in bad faith. Noting that there has been uncertainty with respect to "how an argument regarding bad faith fits within the [MFW] framework," Vice Chancellor Laster concluded in Books that satisfaction of the MFW prerequisites would not preclude a reasonable inference of waste based on well-pled claims of bad faith. However, the court confirmed that pleading bad faith is a very "difficult route," requiring the allegation of facts that support a reasonable inference that a board "intentionally acted with a purpose other than that of advancing the best interests of the corporation." The Books plaintiffs contended that the independent directors' rejection of a substantially superior offer was so irrational that they must have had some ulterior motive to favor the controller's interests--that is, that they were "independent in appearance, [but] not independent in fact." They also contended that the board's bad faith could be inferred from its supporting the Family's bad faith in not supporting a superior offer. The Vice Chancellor rejected these arguments on the basis that a controller does not have an obligation to sell his shares or to support a third party's offer for the company and that the committee could have rationally believed that the shareholders would prefer the opportunity to achieve liquidity at a premium to market.
A board's facilitating a controller's "grossly inadequate" offer may indicate "bad faith"--but a higher third party offer does not by itself establish "gross inadequacy" of a controller's offer. The court stated in Books that bad faith might be reasonably inferred if directors facilitate a "grossly inadequate" offer by a controller--i.e., an offer price that contains an "extreme" minority discount, does not "fall within a rational range of discounts and premiums," or reflects a "difference [as compared to a higher third party offer]...so facially large as to suggest...a sweetheart deal for the [controller]." The court found that the Family's offer (which, based on the third party offer, reflected a minority discount of about 23%) was not grossly inadequate. The court noted the market canvass and minority protections that had been part of the process and the result that the price represented a 93% premium to the preannouncement stock closing price. The court also commented that a lower controller offer might be fair and a higher third party offer inadequate because of the "fundamental difference" between them that one reflected a minority discount (because the controller already has control) and the other a control premium (because the third party seeks to acquire control). We note further, as discussed above, that the third party offer was essentially illusory and not in reality an available alternative transaction.
Fried Frank M&A Briefing
Observations regarding Books:
Open questions relating to a board's "responding to a "grossly inadequate" offer by a controller. In Books, Vice Chancellor Laster cites then Chancellor William Allen's holding in the 1994 Mendel v. Carroll decision, where the court stated that a controller does not act in bad faith by exercising its right to retain its shares, and that a board may not intervene to dilute or disrupt that control unless the controller was "abusing its power and exploiting" the minority stockholders. The court found in Books that the controller's offer was not grossly inadequate and that the controller had not been "exploitative." Books does not answer, however, the open issue whether a controller's offering a price that is "grossly inadequate" in and of itself may constitute "exploitation," without further abuse, coercion or overreaching by the controller. Books also does not answer whether a committee would be acting in bad faith if it did not "just say no" to a grossly inadequate offer by a controller and left it to the minority stockholders to decide for themselves whether to approve the transaction.
Distinction between a "dispute over pricing" and a "grossly inadequate price." As noted, Vice Chancellor Laster reiterated in Books that disputes as to price (as opposed to issues of breach of fiduciary duties) should be channeled to appraisal proceedings. At the same time, he stated that a "grossly inadequate price" could lead to a reasonable inference of "bad faith." We note that there is no bright line test to distinguish between (a) a controller's price being "grossly inadequate" (suggesting bad faith and thus precluding early dismissal of fiduciary claims) and (b) there being a "pricing dispute" (which, according to the court, should be dealt with in appraisal and would result in early dismissal).
Appraisal as a "further check" on a controller's expropriation or unfairness. There has not yet been any appraisal case decided in the context of an MFW-compliant controller transaction. We note that MFW relates to directors' fiduciary duties and does not relate to "fair value" for appraisal purposes. Vice Chancellor Laster commented in Books that appraisal rights serve as a "further check on expropriation" by a controller because, in appraisal, the court would exclude any minority discount. This comment suggests that MFW compliance itself would not lead the court to view the merger price as the most reliable indicator of fair value in an appraisal involving a controller transaction, notwithstanding the procedural protections for minority stockholders inherent in the MFW process. Indeed, our review of Delaware appraisal decisions since 2010 reflects that, in every case involving a controller or other self-interested transaction, the court has not relied solely on the merger price to determine fair value and the court's appraisal awards have been above (often significantly above) the merger price. We observe also that, in the context of a controller transaction, depending on the circumstances, even when the board conducts a market canvass of third party interest (as it did in Books), the ability of a controller to block a third party transaction may be viewed as inherently undermining the reliability of the market canvass, and thus of the merger price as a sole indicator of fair value.
Analysis of "bad faith" as a breach of the duty of loyalty. We note that, pursuant to the Delaware statute, directors face personal liability for damages only for breaches of the duty of loyalty (including bad faith), which by statute cannot be exculpated. While Vice Chancellor Laster, in Books, cites the Delaware courts' duty of loyalty decisions in defining "bad faith," he did not choose to analyze Books under the Cornerstone rubric of early dismissal when the facts plead do not indicate an unexculpated breach of the duty of loyalty. The choice to
Fried Frank M&A Briefing
analyze the case instead based on the waste standard invoked under MFW business judgment review appears to parallel the court's recent increased focus on the effects of shareholder approval of transactions.
The court confirmed the continued validity of certain well-established principles relating to controller transactions: (i) a controller does not have an obligation to sell its shares or facilitate a third party offer; (ii) a controller does not breach its fiduciary duties by offering to buy the minority shares at a price below an alternative third party offer (unless the controller's actions are exploitative); and (iii) a board is not obligated, and does not have the right, to intervene with respect to a majority stockholder's control (such as by acting to dilute the stake) in order to facilitate a third party offer that the controller has rejected (again, unless the controller is being exploitative). As discussed, the decision provides little context to the contours of "exploitive."
Other recent decisions have also narrowed the path for successful post-closing challenge of an MFW-compliant controller transaction. In addition to the confirmation in Books that "bad faith" is an extremely unlikely route to successfully avoiding early dismissal, the court, in other recent decisions, has relaxed the substantive legal standards for what constitutes (a) "independence" and "disinterestedness" of directors and (b) a "fully informed" stockholder vote. Based on Vice Chancellor Laster's approach in Books, the court will likely view appraisal (not post-closing damages) as the appropriate remedy in most MFW-compliant controller transactions.
A controller who seeks to comply with MFW, and has made a prior proposal that did not comply, should seek to ensure that the new offer will not be considered a "continuation" of the prior offer. In Books, the court disagreed with the plaintiffs' view that the Family's offer was a continuation of its prior offer. The court reasoned that the prior offer (i) had been formally considered and rejected by a special committee; (ii) was made three years earlier; and (iii) contained different terms and a different price.
In a transaction structured to comply with MFW, the board should consider using its leverage to "just say no." MFW, by conditioning a controller transaction on special committee approval, provides a board with leverage to just say no to the transaction. A committee should consider whether to just say no--either for the purpose of rejecting the transaction or negotiating with the controller for a higher price and/or better terms. As noted, a board may face claims of bad faith if it does not say no to a "grossly inadequate" offer by a controller.
Should a special committee solicit third party proposals even if the controller has stated that it is not willing to sell its shares? In Books, the court stated that the committee's decision to canvass the market to explore potential third party transactions, notwithstanding the Family's statement that it would not sell its shares, bolstered the conclusion that the directors had not acted in bad faith. The court noted that the canvass permitted the committee (i) to doublecheck the adequacy of the Family's price, (ii) to test the Family's conviction not to sell its shares, and (iii) to obtain a "data point" on pricing that could be used in any post-closing appraisal action ("giving the Family a reason to bump their offer"). We note that a market
Fried Frank M&A Briefing
canvass may also more generally create additional negotiating leverage with the controller. Importantly, however, there is no requirement that a board expend time and expense on canvassing the market for third party offers when it would be an idle gesture in the face of a controller's refusal to sell its shares. To be sure, a board should review the extent to which there may be uncertainty about a controller's professed unwillingness to sell its shares. In the case of a control block, a board should review the extent to which it may not be monolithic-- which is more likely to be the case when control is held by a family (particularly if the holdings are widely dispersed), given that, if there are not voting agreements binding the family members, they may not all have (or continue to have) the same view about selling. (We note that, in Books, the Family's holdings appear to have been widely dispersed and the court did not indicate that there were any voting agreements or other arrangements among the family members to ensure a coordinated approach.) Of course, the potential negative impact of a solicitation process also should be considered--for example, the possibility of (and stigma from) no bids for the company emerging, the possible adverse impact of access by third parties to the company's confidential information, and the potential effect on the company's employees, customers and other constituencies of a public process.
Continuing importance of the factual context notwithstanding the court's evolution toward greater deference to boards and stockholders in M&A matters. As we have advised in previous Briefings, while MFW and other decisions reflect an evolution of the substantive law to much greater deference than in the past to boards and stockholders in M&A matters, it seems evident that the overall factual context of a case will continue to influence the court. Thus, M&A participants continue to be advantaged--from a legal, as well as a reputational, viewpoint--by conforming to best practices, notwithstanding the more relaxed legal standards now applied by the courts.
Abigail Pickering Bomba Warren S. de Wied Steven Epstein Arthur Fleischer, Jr. David J. Greenwald
Scott B. Luftglass Philip Richter Robert C. Schwenkel Peter L. Simmons Gail Weinstein
Fried Frank M&A Briefing
This memorandum is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions about the contents of this memorandum, please call your regular Fried Frank contact or an attorney listed below:
Jeffrey Bagner Abigail Pickering Bomba Andrew J. Colosimo Warren S. de Wied Aviva F. Diamant Steven Epstein Christopher Ewan Arthur Fleischer, Jr.* Andrea Gede-Lange David J. Greenwald Randi Lally Mark H. Lucas Scott B. Luftglass Philip Richter Steven G. Scheinfeld Robert C. Schwenkel David L. Shaw Peter L. Simmons Matthew V. Soran Steven J. Steinman Gail Weinstein*
Jerald S. Howe, Jr. Brian T. Mangino Brian Miner
+1.212.859.8136 +1.212.859.8622 +1.212.859.8868 +1.212.859.8296 +1.212.859.8185 +1.212.859.8964 +1.212.859.8875 +1.212.859.8120 +1.212.859.8862 +1.212.859.8209 +1.212.859.8570 +1.212.859.8268 +1.212.859.8968 +1.212.859.8763 +1.212.859.8475 +1.212.859.8167 +1.212.859.8803 +1.212.859.8455 +1.212.859.8462 +1.212.859.8092 +1.212.859.8031
+1.202.639.7080 +1.202.639.7258 +1.202.639.7340
email@example.com firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com firstname.lastname@example.org email@example.com
firstname.lastname@example.org email@example.com firstname.lastname@example.org
New York Washington, DC London Paris Frankfurt friedfrank.com