In In re MFW Shareholders Litigation, C.A. No. 6566-CS (Del. Ch. May 29, 2013), the latest effort by the Delaware Court of Chancery to establish a unified standard for controlling stockholder, going private transactions, Chancellor Strine applied the business judgment rule to a one step, controlling stockholder merger transaction where the transaction was subject in advance to both (i) negotiation and approval by a special committee fully empowered to say no and (ii) approval by an uncoerced, fully informed vote of a majority of the minority stockholders.
Background – the evolving standard of review in controlling stockholder, going private transactions
This case, which remains subject to review by the Delaware Supreme Court, is the latest chapter in the evolving standard of review applied to controlling stockholder, going private transactions in Delaware. Nearly 20 years ago, in Kahn v. Lynch Communications Systems,1 the Delaware Supreme Court stated that negotiated mergers with controlling stockholders are subject to Delaware’s heightened “entire fairness” standard of review. The Delaware Supreme Court further held that, from a procedural standpoint, defendants can shift the initial burden of proof to the plaintiff in such circumstances if they employ either of the two protective measures described above. As a result, however, the opinion was often interpreted to mean that there was no pathway for a controlling stockholder to structure a going private transaction as a one step merger and still obtain judicial review pursuant to the deferential business judgment rule.
In the years following Kahn, a dichotomy developed based on transaction structure. One step merger transactions with controlling stockholders remained subject to review under the heightened entire fairness standard. In contrast, under the Siliconix and Pure Resources line of cases, the Court of Chancery held that a unilateral tender offer by a controlling stockholder in a going private transaction would be subject to review under the business judgment rule if the tender offer was found to be non-coercive.2 In Pure Resources, then Vice Chancellor Strine outlined a four-part test to establish non-coercion: (i) the tender offer is subject to a non-waivable majority of the minority tender condition; (ii) the controlling stockholder commits to consummate a prompt short form merger at the same price as the tender offer if it obtains more than 90% of the outstanding shares; (iii) the controlling stockholder has made no retributive threats; and (iv) the independent directors on the target board have free rein and adequate time to react to the tender offer.3
In response to this dichotomy, then Vice Chancellor Strine stated in dicta in In re Cox Communications, Inc. Shareholders Litigation4 in 2005 that the divergent standards for one step and two step,5 controlling stockholder transactions should be reconciled into a unified standard of review. He suggested, in effect, that a negotiated merger potentially could avoid entire fairness, and that a tender offer could be deemed non-coercive and not subject to entire fairness, if the transaction in either case is predicated on both a “majority of the minority” stockholder approval and approval by an independent and disinterested board committee.6
Most recently, in 2010, Vice Chancellor Laster adopted and further refined this unified standard in In re CNX Gas Corp. Shareholders Litigation,7 in which he held that a proposed two step, going private transaction is subject to an entire fairness review unless the first step tender offer is both (i) negotiated and recommend by an informed independent committee of disinterested directors with the power to negotiate with the controlling stockholder and (ii) subject to a “majority of the minority” tender or vote requirement. VC Laster further suggested in dicta that the entire fairness review standard could be avoided in one step, controlling stockholder mergers if the same conditions were met, though the court was not presented at that time with circumstances allowing for it to issue a holding applicable to that transaction structure.
Interestingly, the CNX decision seemingly conflicted with another 2010 Court of Chancery decision in In Re Cox Radio, Inc. Shareholders Litigation,8 which was rendered only weeks before CNX. In Cox Radio, Vice Chancellor Parsons followed the standards previously established in Siliconix/Pure Resources and held that a two step, going private transaction is not subject to an entire fairness review if it is subject to a non-waivable, “majority of the minority” tender condition, the controlling stockholder makes no retributive threats, and a special committee of disinterested directors is free to evaluate the tender offer and make a recommendation to stockholders (though such committee need not necessarily be empowered to negotiate and say no). Taken together, these cases suggested that the Court of Chancery had not necessarily coalesced around a consistent standard of review for these circumstances.
The MFW decision and Chancellor Strine’s six conditions for application of the business judgment rule in one step, controlling stockholder mergers
In MFW, Chancellor Strine was finally presented with an opportunity to consider the unified standard in the context of a controlling stockholder using a one step merger structure to effect a going private transaction. MacAndrews and Forbes owned 43% of M&F Worldwide and proposed a going private merger to allow it to acquire the remaining equity of the company. MacAndrews and Forbes agreed from the outset that it would not consummate the transaction unless it was approved both by a special committee of disinterested directors and by a majority of the minority stockholders. Both conditions were satisfied and, when faced with stockholder litigation, MacAndrews and Forbes sought summary judgment, including application of the business judgment rule.
Chancellor Strine opened his opinion by stating, perhaps unsurprisingly given the Delaware Supreme Court’s prior statements in Kahn, that “[t]his case presents a novel question of law.”9 After a lengthy discussion of whether Kahn had already determined if entire fairness applies to all one step, merger transactions with a controlling stockholder, he ultimately concluded that any such statements in Kahn were dicta not central to the case’s holding. Chancellor Strine then set out his own policy argument for applying the business judgment rule in these circumstances.
Ultimately, Chancellor Strine held that the business judgment rule should be applied in one step mergers with controlling stockholders if the following six conditions are satisfied: “(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; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.”10 This standard largely conforms to the standard applied by Vice Chancellor Laster in CNX in the two step, going private context, thereby laying the groundwork for the Delaware Supreme Court to potentially approve (or reject) a unified standard of review for both circumstances.
Pending potential review by the Delaware Supreme Court, the MFW decision represents the latest movement toward a possible unified standard of review for controlling stockholder, going private transactions (or the Delaware Supreme Court’s consideration and clarification of these issues). Assuming that the holding withstands further review, the case provides a potential pathway for controlling stockholders to consummate going private transactions structured as one step mergers without facing the challenge of a heightened entire fairness standard of review. Chancellor Strine stated that the alternative pathway created by his holding “will be of benefit to minority stockholders because it will provide a strong incentive for controlling stockholders to accord minority investors the transactional structure that respected scholars believe will provide them the best protection, a structure where 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 proper reason, plus the critical ability to determine for themselves whether to accept any deal that their negotiating agents recommend to them.”11
In Chancellor Strine’s view, the approach he advocates will create a strong incentive for controlling stockholders to agree in advance to these minority stockholder procedural protections, as the agreement to condition the transaction on both negotiation and approval by a special committee of independent directors fully empowered to say no, as well as an uncoerced, fully informed vote of a majority of the minority stockholders, would place the controlling stockholder in a much stronger position when defending against subsequent suits by plaintiffs’ attorneys. In particular, the “benefit-to-cost ratio of litigation challenging controlling stockholders for investors in Delaware corporations will improve, as suits will not have settlement value simply because there is no way for defendants to get them dismissed on the pleadings”12 (as is frequently the case when an entire fairness standard applies – even if the controlling stockholder has successfully achieved the application of “burden shifting”).
In practice, the adoption of Chancellor Strine’s approach may not result in a universal change in controlling stockholders’ approaches to these situations, particularly in situations where a “majority of the minority” voting condition creates substantial transaction risk. Of course, whether substantial transaction risk exists will depend on the unique circumstances of each transaction; in particular, the size of the controlling stockholders’ initial position, as well as the ownership of and market for the minority stockholdings, will need to be carefully evaluated, as a smaller minority stake may make it easier for one or more stockholders (such as activist stockholders or hedge funds) to attempt to wage a blocking effort, potentially causing the controlling stockholder to be forced to pay a higher price.
Furthermore, while being availed of the business judgment rule may enable controlling stockholders to dismiss litigation at an earlier stage (as plaintiffs may not be able to state a case on the pleadings alone), transactions approved in advance by a fully empowered and independent special committee, even without an additional “majority of the minority” voting condition, may already be in a strong position to withstand an entire fairness review given the benefits provided by the “burden shifting” that results from the use of such a special committee.
For these reasons, a controlling stockholder may determine, based on the circumstances, that an entire fairness review with the potential for “burden shifting” to the plaintiffs is ultimately less costly and/or risky than accepting the additional conditions required to achieve the application of the business judgment rule. Thus, even if Chancellor Strine’s approach is upheld, controlling stockholders seeking to effect going private transactions should nevertheless continue to strategically evaluate each unique set of circumstances, including with respect to the target’s stockholder base, the number and percentage of minority shares outstanding, the likelihood of involvement by activist stockholders, and the individual circumstances of the particular transaction.