Protecting Your Business Judgment: Recent Developments in Delaware Law on M&A Deals Involving Controlling Stockholders
This summer, the Delaware Court of Chancery twice ruled that if robust procedural protections are used, a merger involving a company with a controlling stockholder will be reviewed under the deferential business judgment rule instead of the much more exacting entire fairness standard. As deal litigation has become the norm—many say a cost of doing business—in large M&A and financing transactions, businesses should consider employing the right procedural safeguards that could put a swift end to shareholder deal litigation.
In a May opinion, Chancellor Leo Strine held that a going-private transaction led by the company’s controlling stockholder can be reviewed under the deferential business judgment rule if the company, upfront, conditions the transaction on (1) approval by a special committee of independent directors and (2) a vote by a majority of the stockholders unaffiliated with the controlling stockholder (the so-called “majority-of-the-minority” vote). If these two procedural devices are employed effectively, a company can avoid judicial review of the transaction under the exacting entire fairness standard.
Deferential business judgment review enables corporate directors to dispose of shareholder breach of fiduciary duty suits early in the litigation process (potentially at the motion to dismiss stage), so long as they adequately discharged their duties of care in evaluating, negotiating and agreeing to the transaction, which typically means they acted in an informed, deliberate manner in deciding whether to approve the deal and submit it to stockholders.
However, if a plaintiff shows that a controlling stockholder or director stood on both sides of the disputed transaction, the transaction is subject to rigorous scrutiny of the fairness of both the process by which the board negotiated and approved the transaction, and the price paid to minority stockholders. The company and its directors, not the plaintiff, bear the burden of proving fair process and fair price—that is, entire fairness. Once it is established that entire fairness applies, it is nearly impossible for defendants to succeed on a motion to dismiss. The case will proceed through the costly phases of discovery and perhaps trial.
Traditionally, corporate defendants could shift the burden of proof to plaintiffs in an entire-fairness case, if the company required approval of the transaction by either a properly-functioning special committee of independent directors or an informed, uncoerced majority-of-the-minority vote. But the traditional burden-shifting rule does nothing to avoid costly discovery and summary judgment proceedings.
In In re MFW Shareholders Litigation, the Court of Chancery dramatically altered the landscape of M&A deals involving controlling stockholders by applying “the business judgment rule standard of review when a going private merger is conditioned upfront on both the negotiation and approval of an empowered independent committee and an uncoerced, fully informed majority-of-the-minority vote.” There, MacAndrews & Forbes—a holding company whose equity is solely owned by Ronald Perelman—owned 43% of M&F Worldwide (MFW). MacAndrews & Forbes offered to purchase the rest of MFW’s equity in a going private merger for $24 per share. But upfront, MacAndrews & Forbes said it would not proceed with any going private transaction that was not approved: (1) by an independent special committee, and (2) by a majority-of-the-minority vote. Because MacAndrews & Forbes used both of these robust procedural safeguards to protect the interests of minority stockholders, the court applied the business judgment rule and granted summary judgment in favor of the defendants.
In August, Vice Chancellor John Noble followed suit. In Southeastern Pennsylvania Transportation Authority v. Volgenau, the court confirmed that the MFW holding extends beyond just the going-private context and held that a transaction involving a third-party purchaser and a target company with a controlling stockholder is entitled to review under the business judgment rule if both procedural safeguards are employed. Such transactions are generally subject to heightened scrutiny when the controlling stockholder receives different consideration than minority stockholders. However, relying on MFW, the court applied the business judgment rule and granted summary judgment in favor of the target company (SRA International), its directors and the private-equity purchasers.
Both courts cautioned that to receive deferential business-judgment review, the special committee and majority-of-the-minority vote procedures must be employed properly. A properly-functioning special committee (i) is comprised of independent directors who are not beholden to the controlling stockholder, (ii) is empowered to freely select its own advisors and to say “no” to the transaction definitively, and (iii) meets its duty of care by fully informing itself and shopping the deal terms to other potential purchasers. A majority-of-the-minority vote is effective if it is (i) fully informed, (ii) uncoerced, and (iii) non-waivable. If these criteria are met, the business judgment rule will likely apply to transactions involving controlling stockholders (unless the Delaware Supreme Court eventually overrules the Court of Chancery’s holdings in these cases).
Companies with controlling stockholders that are considering M&A or financing transactions (or other liquidity events) involving the controlling stockholder should take care to implement the right procedural safeguards that can defeat expensive, protracted shareholder lawsuits and reduce the cost of completing major deals.