On May 29, 2013, Chancellor Leo F. Strine of the Delaware Court of Chancery issued a decision in In re MFW Shareholders Litigation that, if upheld, effectively serves as a roadmap for controlling stockholders who want to have a going private merger transaction reviewed under the business judgment rule.
Prior to this decision, the Delaware courts had consistently applied an entire fairness standard to controlling person merger transactions, although the courts would consider whether the burden of proving fairness shifted from the defendants to the plaintiffs. This approach was based largely on Kahn v. Lynch Commc’n Sys. (Lynch I), 638 A.2d 1110 (Del. 1994), in which the Delaware Supreme Court held that approval of a merger with a buying controlling stockholder by either the majority of the non-controlling stockholders or a special committee would shift the burden of proof under the entire fairness standard to the plaintiff.
Chancellor Strine distinguishes the question before him in In re MFW from the question decided by the Delaware Supreme Court in Kahn v. Lynch by virtue of the fact that here the controlling stockholder conditioned his offer up front on the approval of both an independent special committee and the majority of the minority stockholders. Because the offer was conditioned from the outset on both approvals, Chancellor Strine found that first, the proper review standard to be applied in this setting was a novel question of law not yet answered by the Delaware Supreme Court, and second, that a merger transaction conditioned up front by the controlling stockholder on approvals by both an independent, properly empowered special committee and an informed, uncoerced majority-of-the-minority stockholder vote was entitled to be reviewed under the business judgment rule.
Chancellor Strine explains that a transactional structure with both of these protections is fundamentally different from one with only one of the two protections because "stockholders get the benefits of independent, empowered negotiating agents to bargain for the best price and say no if the agents believe the deal is not advisable for any reason, plus the critical ability to determine for themselves whether to accept any deal that their negotiating agents recommend to them." He points out that until now, the controlling stockholder had no incentive to provide both protections, but now these controlling stockholders will have a strong incentive to condition their proposal on these two fundamental protections for the unaffiliated stockholders to obtain the business judgment rule standard for judicial review of the transaction.
The effect of this shift in standards is profound in cases where it applies. Instead of reviewing under an entire fairness standard, which necessitates a lengthy and costly trial on fair price and fair process, a court will be able to determine whether the business judgment rule standard applies, and if so, must simply consider whether a rational person could or could not conclude the merger was favorable to the minority. This is good news for controlling stockholders and director defendants, because the availability of the business judgment rule theoretically increases the likelihood of a summary judgment dismissal.
There are, of course, a number of conditions that must be met before a controlling stockholder can avail itself of the protections of the business judgment rule, thus subjecting these transactions to continuing judicial scrutiny:
- from the outset, the controlling stockholder’s offer needs to be conditioned on approval by both an independent special committee and a majority of the stockholders unaffiliated with the controlling stockholders (the "minority," for our purposes)
- the special committee must be truly independent
- the special committee must be empowered to engage its own financial and legal advisors
- the special committee must be fully empowered to negotiate the merger and definitively to say no to the transaction
- the special committee must satisfy its duty of care
- the majority-of-the-minority stockholder vote must be uncoerced and fully informed
Chancellor Strine offers some useful commentary on several of these conditions. He explains that for a plaintiff to show that a director is not independent, the plaintiff must demonstrate that the director is "beholden" to the controlling party "or so under [the controller’s] influence that [the director’s] discretion would be sterilized." He reminds us that "mere allegations that directors are friendly with, travel in the same social circles, or have past business relationships with the proponent of the transaction...are not enough to rebut the presumption of independence." He observes that the inquiry is whether alleged financial ties are material, in the sense that they could have affected the director’s impartiality, with specific reference to that particular director’s financial circumstances, which plaintiffs here had failed to show. He also notes that the New York Stock Exchange rules governing director independence "are a useful source for this court to consider when assessing an argument that a director lacks independence." Chancellor Strine rejected a variety of general attacks on the independence of the special committee members.
On the mandate for the special committee, Chancellor Strine notes that "the special committee was empowered not simply to evaluate the offer, like some special committees with weak mandates, but to negotiate..." Since the controlling stockholder had promised it would not proceed with any going private transaction that did not have the support of the special committee, the special committee was fully empowered to say no and make that decision stick. Chancellor Strine further notes approvingly that although the special committee did not have the practical authority to market the company to other buyers, since the controlling stockholder had also stated it was not interested in selling its 43 percent stake and had no duty to do so, the special committee nonetheless considered whether there were other potential interested buyers or other strategic alternatives such as asset divestitures that could generate more value for minority stockholders. This work by the special committee showed due care, as the special committee fully informed itself of other alternatives available to the company in deciding whether to approve this transaction.
In evaluating the special committee’s due care, Chancellor Strine also comments favorably on the committee’s banker selection process, which entailed what is colloquially termed a "bake-off" with interviews of four bankers. Chancellor Strine notes that this process gave the committee a chance to hear preliminary thoughts from a variety of well-qualified financial advisors, "a process that therefore helps the committee begin to get fully grounded in the relevant economic factors."
Plaintiff questioned the negotiating strategy of the special committee and argued that they were too conservative in valuing the company’s future prospects. Making crystal clear the value of the business judgment rule standard for review, Chancellor Strine dismisses these challenges in two sentences: "These are the sorts of questions that can be asked about any business negotiation and that are, of course the core of an appraisal proceeding and relevant when a court has to make a determination itself about the financial fairness of a merger transaction under the entire fairness standard. What is not in question is that the plaintiffs do not point to any evidence indicating that the independent members of the special committee did not meet their duty of care in evaluating, negotiating and ultimately agreeing to a merger..."
Chancellor Strine notes that the stockholder vote was uncoerced and fully informed. Full information appeared to be particularly robust, including the five different ranges of values in analyses prepared by the banker and considered by the special committee, the history of negotiations over the price with the controlling stockholder, and the fact that management had updated and lowered its short-term and long-term outlook of the company.
Interestingly, Chancellor Strine declined to find that the committee was "effective," holding that this determination is beyond the inquiry required by the business judgment rule standard, and is only required if the standard of review is entire fairness. He explains that where a committee is structurally independent, has a sufficient mandate, cannot be bypassed, and fulfills its duty of care, it should be given standard-shifting effect.
It is clear the facts in this case are well-suited to the findings that the special committee was truly independent and adequately discharged its duties to the minority stockholders, and that the majority-of-the-minority stockholder approval was fully informed and non-coercive. Chancellor Strine lays out the numerous procedural steps that were put in place that allowed the controlling stockholder in MFW to benefit from the business judgment rule. If, however, the process employed in a control transaction meets these rigorous conditions, Chancellor Strine’s conclusion is this structure – an independent, adequately empowered special committee that fulfills its duty of care, and a fully informed, uncoerced vote of a majority of the minority stockholders – effectively replicates the protections available to stockholders in an arm’s-length, negotiated merger transaction with a non-controlling buyer that is approved by a majority of the stockholders, transactions long-recognized as subject to the business judgment rule.
This ruling will likely not reduce litigation in cases where these fundamental protections are in place from the beginning of a controlling person merger transaction, but rather will shift plaintiff’s focus in such cases to the facts underlying the independence of the special committee, whether the committee had the proper mandate and fulfilled its duty of care, and whether the majority-of-the-minority vote was truly uncoerced and fully informed. The record for controlling person mergers will continue to have significant judicial scrutiny applied, but this favorable review standard will reduce the cost of such litigation for well-advised controlling persons and the boards of directors of the controlled target, where applicable. It also seems clear that this case provides an incentive, heretofore missing, for a controlling person who seeks a going private transaction for its controlled company to condition the proposal for such a transaction at the outset on both having approval by an independent special committee and by an uncoerced, fully informed vote of the minority stockholders. It will be interesting to see whether other controlling persons act on this ruling by offering both of these fundamental protections, and how the Delaware Supreme Court will view Chancellor Strine’s bold new addition to Delaware jurisprudence.