Let me begin by thanking Gordon Smith and the other organizers of the Conglomerate for inviting me to guest-blog here for the next two weeks.
As far as I can tell, little has been said here about the Delaware Supreme Court’s decision last month in Kahn v. M&F Worldwide Corp. As many readers will already know, the case concerns the standard of review to be applied to the decision of a board of directors of a controlled corporation when the directors approve a freeze-out merger between the corporation and the controlling stockholder.
Under Weinberger v. OUP, Inc., 457 A.2d 701 (Del. 1983), freeze-out mergers were traditionally reviewed under the entire fairness standard with the burden of proof resting on the controlling stockholder. Under Kahn v. Lynch, 638 A.2d 1110 (Del. 1994), however, if the controlling stockholder can show either (a) the merger was approved by a well-functioning committee of independent directors, or (b) the merger was approved by a fully-informed, uncoerced vote of the majority of the minority stockholders, then the burden would shift to the plaintiff stockholders to show that the transaction was not entirely fair. Such transactions came to be known as Lynch transactions.
Following a suggestion in dicta by then Vice Chancellor Strine in In re Cox Communications Shareholders Litig., 879 A.2d 604 (Del. Ch. 2005), the Delaware Supreme Court has now held that if both procedural safeguards are adopted, then the transaction will be reviewed under the business judgment rule. More accurately, in the words of Justice Holland’s opinion,
[I]n controller buyouts, the business judgment standard of review will be applied if and only if: (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 in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.
The theory here is that combining a well-functioning independent committee and a fully-informed majority-of-the-minority vote replicates the standard structure for the approval of third-party mergers under DGCL Section 251 (i.e., board vote plus stockholder approval), and so the standard of review should be same as it would be for a third-party Section 251 merger.
Like almost everyone else, I find this a sensible outcome, but I want to note a few important points about the case that seem to have been overlooked in much of the commentary I have thus far seen.
To begin with, the mere shifting of the burden of proof in Lynch transactions, while not negligible, was of relatively minor value to controlling stockholders for two reasons. First, the burden was still on the controlling stockholder to demonstrate that one of the procedural safeguards had been adopted, and this required a significant amount of proof: for example, merely saying that a committee was composed of independent directors did not suffice to show that the directors really were independent. Second, even if the controlling stockholder prevailed on this issue, the standard remained entire fairness, and determining whether the transaction was entirely fair often could not be resolved even at the summary judgment phase. Hence, the controlling stockholder was in for a costly litigation. It may seem that M&F solves that problem, but this is not quite right. Rather, the burden is still first on the controlling stockholder to demonstrate the existence and effectiveness of both of the required procedural safeguards, and although Justice Holland emphasizes that this can sometimes be done at the summary judgment phase, it is easy to imagine that sometimes a trial will be required to determine issues of material fact.
Second, there is to my mind a serious ambiguity in the new doctrine. In the summary of its holding quoted above, the court says that, to receive the protection of the business judgment rule, the independent committee must have fulfilled “its duty of care in negotiating a fair price.” This could mean simply that, in approving the merger, the committee fulfilled its duty of care in accordance with Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985)—that is, before deciding to approve the merger, the committee had before it all the material information reasonably available. On the theory that the standard of review will be business judgment review when the usual conditions to the applicability of that standard have been replicated, it would seem logical that the duty of care demanded of the independent committee be this usual kind of care. But that is not quite what the court said, for it also refers to the committee’s having “negotiat[ed] a fair price,” which may suggest that something more is demanded than “process due care only,” Brehm v. Eisner, 746 A.2d 244, 264 (Del. 2000) (emphasis in original), namely, that the board have obtained a fair price.
That result, of course, would entirely subvert the holding in the case, but the point is not so easily dismissed. Although a freezout merger does not involve a change of control (the controlling stockholder controls the corporation both before and after the transaction), if the merger consideration is cash, as it was in M&F, then the transaction represents the last opportunity for the minority stockholders to get a premium for their shares, and, in fact, such transactions are typically done at a premium. This implicates some of the concerns underlying Revlon: it would seem that, besides reviewing the level of care taken by the independent committee in the decision-making process, the court should also review its actions to determine whether it took reasonable steps to get the best price reasonably available for the minority stockholders. Obviously, the range of reasonably possible actions for an independent committee of a controlled corporation, especially when the controlling stockholder announces it has no desire to sell its shares, is much more limited than the range of actions available to a board of an independent company putting itself up for sale. But, it would still seem to me that the court should review the independent committee’s actions under Revlon, taking account of the limits under which the committee is likely to operate. After all, in a Section 251 cash merger, the court reviews the transaction under Revlon, not just the business judgment rule.
Now, although it does not say that it is doing so, the court does seem to be applying some form of enhanced scrutiny to the actions of the independent committee. Thus, in determining whether the committee acted with due care, the court notes factors of clearly procedural significance (e.g., the number of meetings the committee held, its engagement and use of a financial advisor, etc.), but it also enumerates factors that seem to bear more on the substantive question of whether the committee got the best price reasonably available, including where the deal price fell in the financial advisor’s valuation ranges, the extent to which the company’s business was deteriorating, the fact that the committee was able to negotiate a modest increase in the price, and the committee’s studying alternative strategic transactions (presumably because, even though the controlling stockholder had announced it would not sell its shares in an alternative transaction, such alternative transactions could inform the committee’s decision about the fairness of the price to be paid by the controlling stockholder). The inquiry that the court performs under the label of a due care inquiry seems much like a Revlon review.
Finally, there is the question of how M&F will affect the relative attractiveness, from a controlling stockholder’s perspective, of so-called Siliconix transactions in which the controlling stockholder tenders for all the outstanding minority shares, hoping to get above the 90% threshold so that it can follow up the tender offer with a DGCL Section 253 short-form merger. See In re Siliconix Inc. Shareholders Litig., 2001 WL 716787 (Del. Ch. 2001). In such a transaction between stockholders, both of whom are free to act in their self-interest, the controlling stockholder has no duty to offer the minority stockholders a fair price, providing only that the controlling party makes appropriate disclosure and the tender offer is not coercive. Aside from alleging disclosure violations, there is usually little plaintiff stockholders can complain about in a Siliconix transaction, but since the controlling stockholder has to achieve the 90% threshold to make the whole deal worthwhile, such transactions can be difficult to complete if the controlling stockholder is starting from a relatively low percentage interest in the company or the price being offered is not especially attractive. On these important questions, see the fascinating papers by Subramanian here and Restrepo and Subramanian here.
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