Must be Conditioned Up Front on Dual Approval Safeguards, But, Do the Benefits of Doing This Outweigh the Execution Risks in Every Case?
In a significant case of first impression, the Delaware Supreme Court, in Kahn v. M&F Worldwide Corp. (M&F Worldwide), No. 334, 2013 (Del. Mar. 14, 2014), unanimously affirmed that a controller’s buyout of its subsidiary in a negotiated merger is entitled to judicial review under the deferential “business judgment” standard — instead of the exacting “entire fairness” standard — if certain procedural safeguards are locked in place at the outset of the transaction. In doing so, the Delaware Supreme Court answered an important 20-year-old question never raised directly in Kahn v. Lynch Commc’ns Sys. (Lynch), 638 A.2d 1110 (Del. 1994) and upheld the Delaware Court of Chancery’s (Delaware Chancery Court) post-merger (summary judgment) decision in In re MFW S’holders Litig., 67 A.3d 496 (Del. Ch. 2013).
In Lynch, the Delaware Supreme Court was faced with the use of a special committee of independent directors (Special Committee) only, and held that in a controller’s buyout merger the existence and effective use of either a Special Committee or a majority-of-the-minority stockholders vote (M-O-M Vote) condition shifts the burden of persuasion on entire fairness from the defendants to the plaintiff, but that entire fairness nonetheless remains the default standard of judicial review. The premise for this is that the entire fairness standard cannot (and should not) be altered if only one of the aforementioned procedural safeguards is used because neither one is sufficient, alone, to sterilize the self-dealing, potential informational imbalances, conflicts of interest and undermining influences inherent in a controller’s buyout merger.
In M&F Worldwide, the Delaware Supreme Court confirmed that Lynch did not address whether a controller’s going-private merger ever could be subject to business judgment review if both a Special Committee were established and used to prosecute the transaction and a M-O-M Vote condition were obtained to adopt the merger agreement. The Court then announced that the business judgment review standard will apply to controller buyouts if, and only if, (1) the controller conditions the transaction on both the approval of a Special Committee and a M-O-M Vote (2) the Special Committee is independent, (3) the Special Committee is empowered to freely select its own advisors and to say no definitively, (4) the Special Committee meets its duty of care in negotiating a fair price, (5) the M-O-M Vote is informed, and (6) there is no coercion of the minority. If any one of these elements is absent or ineffective, entire fairness will remain the unaltered standard of review.
The Court noted that the existence and proper use of both a Special Committee and M-O-M Vote condition — as dual, instead of disjunctive, safeguards — serve “independent integrity enforcing” functions and that the M-O-M Vote provides minority stockholders with a voluntary opportunity to decide for themselves whether the deal is fair. An uncoerced and fully informed vote of disinterested stockholders always has been accorded substantial weight under Delaware law. A vote is informed if there are no omissions, misstatements or other disclosure defects in the disclosure documents submitted to stockholders that they would consider material in making a voting decision.
Key facts and findings in M&F Worldwide included MacAndrews & Forbes Holdings, Inc.’s (MacAndrews) statements in its initial proposal letter that it would not proceed with the merger unless it was approved by a Special Committee, that the merger must be approved by a non-waivable M-O-M Vote, and that if the merger was not approved and recommended by the Special Committee or the requisite M-O-M Vote condition failed, the future long-term relationship between MacAndrews and its 43 percent owned subsidiary, M&F Worldwide Corp. (MFWC), would not be adversely affected. In other words, MacAndrews committed on day one not to do an “end run” around the Special Committee by launching a unilateral tender offer for the 57 percent of MFWC’s outstanding shares it didn’t already own, and the full Board was effectively bound by the Special Committee’s recommendation — the Special Committee could say “no” definitively.
The Special Committee’s mandate was clear and explicit, and stated that “the Board [would] not approve the [merger] without a prior favorable recommendation of the Special Committee” and the independent directors’ resolutions expressly authorized the Special Committee to retain independent legal and financial advisors and to negotiate the terms of the transaction with MacAndrews (not just vote up or down on pre-baked terms).
The Delaware Supreme Court affirmed that the Special Committee exercised due care in discharging its mandate, including obtaining all relevant information and reviewing with its professional advisors the range of values obtainable in various strategic and financial alternatives to MacAndrews’ merger proposal and the viability of undertaking such transactions, notwithstanding the Special Committee’s inability to conduct a market check and shop MFWC because MacAndrews made clear in its initial proposal letter that it was a buyer of MFWC only and would not sell its stake in a competing deal. Lastly, the Delaware Supreme Court affirmed the Delaware Chancery Court’s findings that plaintiffs proferred no convincing evidence that any of the Special Committee directors were beholden to or under the influence or domination of MacAndrews (or to its sole stockholder) or that they otherwise lacked requisite “independence.”
M&F Worldwide is an Important Decision: For the first time, the Delaware Supreme Court has created a tangible incentive to avoid entire fairness review of controller buyout mergers by irrevocably deploying, up front, dual independent approval mechanisms (i.e., the Special Committee plus the M-O-M Vote condition). The substitution of business judgment review for entire fairness review is not merely an esoteric benefit. An entire fairness review involves detailed substantive analyses by a Delaware court of the fairness of the deal price and fairness of the deal process. Where entire fairness is applied, if a comprehensive factual record has not yet been developed through discovery, a motion to dismiss on the pleadings is virtually unobtainable. By contrast, the deferential business judgment standard requires the dismissal of claims against the controller and the directors and dismissal of the action challenging the transaction unless it can be demonstrated that no rational person would find the transaction favorable to the minority stockholders.
Indeed, the Delaware Supreme Court conceded that “deciding whether an independent committee was effective in negotiating a price is a process so fact-intensive and inextricably intertwined with the merits of an entire fairness review ... that a pretrial determination of burden shifting [where, either, an effective Special Committee or M-O-M Vote condition is used] is often impossible.” Accordingly, the ability to shift the exacting entire fairness standard to the deferential business judgment standard should help deter the commencement of frivolous strike suits. Escaping entire fairness review also should reduce the settlement value of weak litigation, where little or no deal price increase or additional disclosure benefit will or can be obtained by the minority stockholders. Thus, the framework for obtaining business judgment review of a controller’s freeze-out merger has now been articulated definitively by the final arbiter of Delaware’s corporate fiduciary law.
A Cautionary Note: At the same time, M&F Worldwide should not be over read. It is important for deal principals and their professional advisors to note that the decision did not (and, indeed, the Delaware Supreme Court and Delaware Chancery Court never would) announce a “blueprint” whereby controllers or directors can perfunctorily “check a box,” consummate a deal and foreclose any possibility that a plaintiff’s well-pled factual challenge to the use and efficacy of the dual procedural protections will survive the defendants’ motion to dismiss.
Indeed, M&F Worldwide cautioned that if a complaint sufficiently pleads “a reasonably conceivable set of facts” demonstrating that any or all of the six requisite elements (recited above) are absent or ineffective, the complaint should survive the defendants’ motion to dismiss and the plaintiff can proceed with pre-trial discovery. In addition, “if, after discovery, 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.”
Moreover, and quite notably, in footnote 14 (on page 18) of the decision, the Delaware Supreme Court offered that the complaint in the litigation would have survived a motion to dismiss under the “reasonable conceivability” standard because it contained four fact-based, price insufficiency allegations that were pled well enough to raise issues concerning the adequacy of the Special Committee’s negotiations. Thus, the Court noted that discovery would have been necessary to obtain further facts before applying the business judgment standard to review the transaction. The Court continued that the dual protection structure requires two price-related determinations before trial: “that a fair price was achieved by an empowered, independent committee that acted with care, and second, that a fully-informed, uncoerced majority-of-the-minority stockholders voted in favor of the price that was recommended by the independent committee.” Accordingly, future plaintiff’s counsel now have a roadmap to better articulate their allegations and more precisely draft their complaints with factual details (assuming such facts exist) regarding the absence of one or more of the six requisite elements and, specifically, to attack the deal price, independence and effectiveness of the Special Committee.
Because the Delaware Supreme Court noted that sufficiently well-plead allegations of price inadequacy concomitantly implicate whether the Special Committee’s negotiating process was adequate, the court in such instance is effectively undertaking a mini-entire fairness review at the first stage of the litigation to determine whether to apply the business judgment rule subsequent to the development of a more complete factual record through discovery. Also, if the factual allegations are well-plead and complex and uncertain enough, the court still may not be in a position to grant defendant’s motion for summary judgment after a period of initial discovery and the standard of review may not be determined much before (or until the eve of) trial. If this is so, query whether the settlement value of controller buyout merger litigation will really decrease even where M&F Worldwide’s dual-approval model is used at the outset of the transaction?
A Practical Choice for Transaction Planners and Deal Principals: One of the important premises of the M&F Worldwide decision is that the presence and effective use, in tandem, of the Special Committee and the M-O-M Vote condition (in the context described above) replicates the disinterested and independent approval process in a merger transaction negotiated at arms’ length with an unaffiliated third party under Section 251 of the DGCL because (1) binding decisional authority is granted to the Special Committee in its capacity as the fiduciary and independent bargaining agent for minority stockholders and (2) dispositive voting authority is relinquished by the controller and transferred to the holders of minority (non-affiliate) shares.
Although the use of a properly constituted, properly empowered and well-functioning Special Committee has been de rigueur in controller buyout mergers for many years, a decision to irrevocably transfer veto power to minority stockholders at the outset of the transaction — especially where a target’s stockholder base is not institutionally concentrated — could be a “bridge-too-far” for certain controllers depending on the circumstances. As with any cost-benefit analysis, prior to submitting its initial buyout proposal to the target’s board of directors, controllers are certain to weigh, with their professional advisors, the benefits of obtaining business judgment rule review vis-a-vis the increased execution risk of the transaction and the fact that the judicial review standard may not be determined at the early stages of the deal litigation. Many controllers may simply conclude that burden-shifting through the use of a Special Committee alone suffices, especially if the facts are such that it remains uncertain whether the litigation will get knocked out on defendant’s first motion for judgment on the pleadings or motion to dismiss.
An Open Question Remains: Although a very important open question in Lynch has now been answered definitively by the Delaware Supreme Court regarding the use, ab initio, of a Special Committee and a M-O-M Vote condition in controller buyout mergers to obtain business judgment review, it is unclear how M&F Worldwide impacts the judicial review dichotomy between controller going-private transactions effected pursuant to a negotiated merger agreement, on the one hand, and the same transaction effected pursuant to a controller’s unilateral tender offer and subsequent short-form merger, on the other hand.
Historically, the Delaware Supreme Court has articulated that a freeze-out merger is inherently “less voluntary” and potentially more vulnerable to coercion and structural bias than a controller’s unilateral tender offer to cash out minority stockholders followed by a subsequent short-form merger. Accordingly, even after M&F Worldwide, entire fairness remains the default standard of judicial review for controller freeze-out mergers (if any, or all, the six elements announced in M&F Worldwide are absent or, if present, ineffective); whereas business judgment review pertains to the latter deal structure. To address this judicial incongruity — which seemingly exalts transaction form over substance — the Delaware Chancery Court has announced in a number of its decisions over the past 13 years, a so-called “unifying standard” of business judgment review for all controller going-private transactions, irrespective of its one-step or two-step form and irrespective of whether it is negotiated or unilaterally commenced at the outset. See e.g., In re Siliconix Inc. S’holders Litig., 2001 WL 716787 (Del. Ch. June 21, 2001); In re Pure Res., Inc. S’holders Litig., 808 A.2d 421 (Del. Ch. 2002); Next Level Commc’ns, Inc. v. Motorola, Inc., 834 A.2d 828 (Del. Ch. 2003); In re Cox Commc’ns, Inc. S’holders Litig., 879 A.2d 604 (Del. Ch. 2005); and, In re CNX Gas Corp. S’holders Litig., 4 A3d 397 (Del. Ch. 2010).
It remains to be seen how the Delaware Supreme Court will weigh in to clarify this dichotomy if, and when, it addresses this issue on appeal in a future case. All-in-all, going-forward M&F Worldwide will impact the structuring, negotiation and execution of controller buyout mergers , and the Delaware Supreme Court’s decision is an important and positive development for deal principals, transaction planners and minority stockholders.
“At the outset” means ab initio.
In In re Orchard Enterprises, Inc. Shareholder Litigation,2 the Delaware Chancery Court, on cross-motions for summary judgment following consummation of Dimensional Associates, LLC's squeeze out merger of its subsidiary, Orchard Enterprises, Inc., ruled, among other things, that the business judgment standard of review was inapplicable to Dimensional's squeeze out merger irrespective of Dimensional's agreement to condition the merger both on approval by a Special Committee and adoption of the merger agreement pursuant to a M-O-M Vote. This was so because Dimensional did not agree to be bound by a fully informed M-O-M Vote until later in the negotiation process with the Special Committee. To obtain the benefit of business judgment review in a controller's buyout merger, every element espoused in M&F Worldwide must be present, including the controller's agreement to both approval mechanisms at the outset of the proposed transaction. Accordingly, entire fairness remained the default standard of judicial review in this case. Notably, the Delaware Chancery Court also held that the defendants were not entitled to a shift in the burden of persuasion (via Lynch) because (i) the plaintiff demonstrated that the merger proxy statement contained one or more omissions of material fact (thereby, negating the informed nature of the M-O-M Vote); and (ii) (at least at the summary judgment stage of the litigation) the plaintiffs sufficiently established the existence of a factual dispute regarding the independence of the Special Committee chairman and the fairness of the process undertaken by the Special Committee to, among other things, negotiate the cash out price.