The Delaware Court of Chancery has issued an important decision clarifying the application of the "entire fairness" and "business judgment rule" standards in a going-private transaction involving a controlling stockholder. In re John Q. Hammons Inc., Shareholder Litigation, C.A. No. 758-CC (Del. Ch. Oct. 2, 2009). The decision provides excellent guidance as to how a special committee should navigate an interested-party transaction.
John Q. Hammons Hotels, Inc., ("JQH") was a publicly traded hotel chain founded and controlled by John Hammons. It merged in 2005 into an acquisition vehicle formed by the acquiror, Jonathan Eilian.
Eilian was previously unaffiliated with the issuer, but Hammons informed the special committee formed to manage this transaction that he would consider a transaction only if he participated in the surviving entity. He ultimately negotiated directly with Eilian to receive a small equity position in the surviving company, a preferred interest with large liquidation preferences and other contractual rights, including a line of credit for further hotel development.
Plaintiffs alleged that John Q. Hammons, JQH's controlling stockholder, used his control position to negotiate an array of private benefits for himself that were not shared with the minority stockholders. Plaintiffs also asserted that the JQH directors breached their fiduciary duties by allowing the merger to be negotiated through an allegedly deficient process, and by voting to approve the merger. They also asserted that the proxy pursuant to which the shareholders approved the merger suffered from material misstatements and omissions.
Key Holdings in the JQH Case
- The court in JQH determined that the use of sufficient procedural protections for the minority stockholders in the case at bar could have resulted in application of the business judgment standard of review, but that the procedures actually used were not sufficient to invoke business judgment review. Accordingly, the court applied the more stringent entire fairness standard of review.
- The court further determined that it would not grant a defense motion for summary judgment, and that sufficient facts were presented to warrant a trial on the issues of fair price and fair dealing.
- Similarly, the court determined that certain of plaintiffs' claims of omissions and misstatements in the proxy would not be dismissed on summary judgment, and warranted a trial.
JQH formed a special committee in 2004 to respond to a different proposed transaction involving a different acquiror. The special committee realized that it lacked the ability to broadly market the company in light of Hammons's controlling interest and his ability to reject any transaction. Thus, the special committee determined that its goal was to pursue the best price reasonably available to minority stockholders.
The Eilian offer came about as a result of the committee's rejection of the initial proposed transaction. On the advice of its counsel, the special committee adopted guidelines that provided that the special committee would conduct a process in which (1) stockholders would be provided a reasonable opportunity to express their views to the committee, (2) all parties interested and willing to explore a transaction would be afforded a level playing field, from the company's perspective, on which to pursue a transaction in terms of timing and access to information, and (3) the committee and its advisors would be fully informed as to the value, merits, and probability of closing any transaction that there was a reasonable basis for believing could be consummated.
On Jan. 31, 2005, the special committee received an offer from Eilian's Group; the full Board then voted to continue the existence and authorization of the special committee. Over the next several months, representatives of Eilian, Hammons, and the special committee continued to negotiate the terms of a potential deal. After Eilian and Hammons reached agreement, they requested the special committee's approval of the deal.
The special committee met with its advisors and reviewed the process the special committee used over the previous nine months, and provided an overview of the various agreements between Hammons and Eilian. The special committee's financial advisor, Lehman, provided a fairness opinion that the $24 per share price was fair to the minority stockholders from a financial point of view. Lehman also advised the special committee of its opinion that the allocation of the consideration between Hammons and the unaffiliated stockholders was reasonable.
The special committee then approved the merger agreement and the related agreements between Hammons and Eilian. The Board met immediately following the special committee meeting and voted to approve the merger and the related transactions.
The merger was contingent on approval by a majority of the unaffiliated Class A stockholders who actually voted (as opposed to a majority of all the minority shares). However, that provision could be waived by the special committee. The merger agreement included a termination fee of up to $20 million and a "no shop" provision that placed limitations on the company's ability to solicit offers from other parties.
Of the 5,253,262 issued and outstanding shares of Class A stock, 3,821,005 shares, or more than 72 percent, were voted to approve the merger. In total, more than 89 percent of the Class A shares that voted on the merger voted to approve it. The merger closed Sept. 16, 2005.
Entire Fairness Standard or Business Judgment Standard?
The threshold issue before the court was whether to apply the tougher entire fairness standard or the more lenient business judgment standard of review. The court held that the entire fairness standard was applicable, not because the case was controlled by Kahn v. Lynch Communication Systems, Inc. 638 A.2d 1110 (Del. 1994); rather, the court applied the entire fairness standard because the measures taken by the JQH special committee were not adequate to invoke the business judgment standard of review.
Under Kahn v. Lynch Communication Systems, Inc. 638 A.2d 1110 (Del. 1994), it is well settled in Delaware "that the exclusive standard of judicial review in examining the propriety of an interested cash-out merger transaction by a controlling or dominating shareholder is entire fairness," and that "[t]he initial burden of establishing entire fairness rests upon the party who stands on both sides of the transaction." 638 A.2d 1110, 1117 (Del. 1994). "[A]pproval of the transaction by an independent committee of directors or an informed majority of minority shareholders" would shift the burden of proof on the issue of fairness to the plaintiff, but would not change that entire fairness was the standard of review. Id.
The court concluded that Lynch was not applicable, because, unlike in Lynch, the controlling stockholder did not make the offer to the minority stockholders; an unrelated third party did. Eilian made an offer to the minority stockholders, who were represented by the disinterested and independent special committee. Hammons did not stand on both sides of the transaction.
Why Apply the Entire Fairness Standard?
The court concluded that shareholder and special committee review could be relevant in determining whether to apply business judgment or entire fairness in a case that is not governed by Lynch, and that the business judgment standard would be the applicable if the transaction was (1) recommended by a disinterested and independent special committee, and (2) approved by stockholders in a non-waivable vote of the majority of all the minority stockholders.
The majority of the minority vote allows the stockholders to reject the work of the special committee and veto a transaction they believe is not in their best interests. Moreover, requiring approval of a majority of all the minority stockholders assures that a majority of the minority stockholders truly support the transaction, and that there is not actually "passive dissent" of a majority of the minority stockholders.
To give maximum effect to these procedural protections, they must be preconditions to the transaction. The lack of such requirements cannot be "cured" by the fact that they would have been satisfied if they were in place.
The Entire Fairness of the Merger
The concept of entire fairness has two components: fair dealing and fair price. These prongs are related and are not determined individually. Rather, the court "determines entire fairness based on all aspects of the entire transaction." Fair dealing involves "questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained." Emerald Partners v. Berlin, 787 A.2d 85, 97 (Del. 2001) (quoting Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983)).
The defendants asserted that the special committee process and the fairness opinion from a financial advisor were sufficient under the entire fairness standard to warrant summary judgment in their favor. However, the court found that certain challenges that the plaintiffs mounted against the persuasive value of the fairness opinion (including the alleged failure of the fairness opinion to properly value the line of credit Hammons received, or account for the impact of tax and other benefits Hammons received in the deal) were sufficient to preclude entry of summary judgment in defendants' favor on that issue.
The court also rejected the plaintiffs' argument that the special committee was necessarily ineffective merely based on the fact that Hammons was able to veto any transaction because of his controlling equity interest. If Hammons chose not to sell his shares, the minority stockholders would have remained as minority stockholders. The mere possibility that the situation would return to the status quo is not sufficient "coercion" to render a special committee ineffective for purposes of evaluating fair dealing.
Plaintiffs also asserted that the price of the minority shares before the merger was depressed as a result of Hammons's improper self-dealing transactions. The court concluded that the issues of whether the price of the minority shares was depressed as a result of such conduct, and whether, as a result, the special committee or the minority stockholders were improperly coerced into accepting the merger (because it would be a "worse fate" to remain as minority shareholders), could not be determined on summary judgment.
The Disclosure Claims
The fiduciary duty of disclosure, which is a specific formulation of the duties of care and loyalty, requires the Board to "disclose fully and fairly all material information within the board's control . . . ." Skeen v. Jo-Ann Stores, Inc., 750 A.2d 1170, 1172 (Del. 2000) (quoting Stroud v. Grace, 606 A.2d 75, 84 (Del. 1992)).
The court rejected plaintiffs' argument that the proxy statement was flawed because the proxy suggested that the special committee process was effective and independent of Hammons, and did not disclose that the committee adopted a "subservient, deferential approach." It is well settled that directors are not required to disclose the plaintiffs' characterization of the facts or engage in self-flagellation. Khanna v. McMinn, 2006 WL 1388744, at *29, 34 (Del. Ch. May 9, 2006).
Because the proxy statement described the special committee process and disclosed that it lacked the authority and ability to broadly market the company in light of Hammons's ability to block any transaction, summary judgment was granted in favor of defendants on this disclosure claim.
However, the court let stand plaintiffs' assertion that there were undisclosed conflicts of interest on the part of the special committee's financial and legal advisors. Plaintiffs claimed that Lehman faced a potential conflict of interest because it had contacts with Eilian about the possibility of underwriting the nearly $700 million commercial mortgage-backed security offering planned by Eilian, after completion of the merger survived the summary judgment motion.
The court stressed the importance of full disclosure of potential conflicts of interest of financial advisors, and noted that such disclosure is particularly important where there was no public auction of the company. Because of the great weight shareholders may be forced to place upon the opinion of such an expert, it is critical that stockholders be able to decide for themselves what weight to place on a conflict faced by the financial advisor.
Plaintiffs also asserted that the proxy should have disclosed that the committee's law firm simultaneously represented the financial firm that provided Eilian the financing to complete the merger. The special committee was informed of and waived the conflict, and it was agreed that the financial firm would be represented by a separate team of attorneys that was prohibited from discussing the matter with the team of attorneys advising the special committee.
The law firm conflict, however, was not disclosed to stockholders in the proxy statement. Potential conflicts of interest of the special committee's advisors are important facts that generally must be disclosed to stockholders before a vote, especially where the minority stockholders are relying on the special committee to negotiate on their behalf in a transaction where they will receive cash for their minority shares.
The court also let stand, to be resolved at trial, a claim based on the failure to disclose in the proxy statement a presentation Eilian made to the special committee that arguably reflected a range of values for JQH shares significantly above the merger price.
The Aiding and Abetting Claims
Plaintiffs also pressed claims against the acquisition vehicles formed by Eilian to effect the merger assert aiding and abetting a breach of fiduciary duty. To prevail on an aiding and abetting claim, a plaintiff must establish "'(1) the existence of a fiduciary relationship, (2) a breach of the fiduciary's duty, . . . (3) knowing participation in that breach by the defendants,' and (4) damages proximately caused by the breach." Malpiede v. Townson, 780 A.2d 1075, 1096 (Del. 2001) (quoting Penn Mart Realty Co. v. Becker, 298 A.2d 349, 351 (Del. Ch. 1972)).
Eilian was permitted to bargain at arm's-length for the lowest possible price and to negotiate both with Hammons and the special committee, so long as he did not have knowledge that those negotiations and the resulting transaction would cause a breach of duty by Hammons or the committee to the minority stockholders.
Plaintiffs asserted that Eilian was aware of conflicts that Hammons labored under that may have had an adverse effect on the price of the minority shares. In a letter to the special committee, Eilian cited "[p]erceived conflicts of interest with the controlling Class B shareholder" as an explanation for the underperformance of JQH shares; another Eilian presentation cited "unique issues of controlling shareholder" as a source of the company's trading discount
These facts raised issues that could not be resolved on a summary judgment as to whether Eilian was aware that JQH's stock price was depressed as a result of Hammons's alleged improper self-dealing conduct.