Friday, August 24, 2012

Delaware Chancery Court Rejects Application of Revlon and Entire Fairness Doctrines to Merger Transaction Involving Controlling Shareholder


In a wide-ranging opinion, the Delaware Chancery Court ruled that minority shareholders did not state facts supporting an inference that a controlling shareholder’s interest in obtaining liquidity in a sale of the company constituted a conflict of interest justifying the invocation of the entire fairness standard and supporting a non-exculpated duty of loyalty claim.  The facts demonstrated that the controlling shareholder received equal treatment in the merger and that the business judgment rule applied to the decision of the board of directors to approve the merger. The facts did not support an inference that there was any breach of fiduciary duty on the part of the controlling stockholder or members of the board of directors. (In re Synthes, Inc. Shareholder Litigation, Del Chan Ct, Civil Action No. 6452, August 17, 2012)

In addition, the court held that Revlon duties did not apply where shareholders received mixed consideration of 65 percent stock and 35 percent cash for their stock. Revlon is centered on the notion that when a board engages in a change of control transaction, the board should try to get the highest immediate value reasonably attainable.

Revlon duties only apply when a corporation undertakes a transaction that results in the sale or change of control, noted Chancellor Strine, and a change of control does not occur for purposes of Revlon where control of the corporation remains, post-merger, in a large, fluid market. Here, the 65 percent stock portion of the merger consideration was stock in a company, Johnson & Johnson, whose shares are held in a large, fluid market.

In addition, the Board had deliberately searched the market and was seeking to close a favorable deal with the last remaining bidder and  had a firm market basis to make the decision about how likely a later emerging bid was and to judge what concessions in terms of deal protections were necessary in order to land the ``one huge fish it actually had on the hook.’’

The case was not governed by Revlon, said the court, and even if it were, no stated facts supported an inference that the board failed to take reasonable steps to maximize the sale price of the company. The complaint in fact illustrated that the board actively solicited logical strategic and private equity buyers over an unhurried time period, and afforded these parties access to due diligence to formulate offers, cited no discrimination among interested buyers, and revealed that the board did not accept the offer from J&J even after it seemed clear no other bidder would top that offer, but instead bargained for more.

The controlling stockholder worked with the other company directors and, after affording a consortium of private equity buyers a chance to make an all-cash, all-shares offer, ultimately accepted a bid made by Johnson & Johnson for 65 percent stock and 35 percent cash, and consummated a merger on those terms. The controlling stockholder received the same treatment in the merger as the other stockholders. Although the controller was allowed by Delaware law to seek a premium for his own controlling position, observed the Chancellor, he did not. Instead, he allowed the minority to share ratably in the control premium.

There was thus no basis for the court to conclude that the controlling stockholder had any conflict with the minority justifying the imposition of the entire fairness standard. The controlling stockholder had more incentive than anyone to maximize the sale price of the company, said Chancellor Strine, and Delaware does not require a controlling stockholder to penalize itself and accept less than the minority in order to afford the minority better terms. Rather, pro rata treatment remains a form of safe harbor under Delaware corporation law.

The burden is on the plaintiff challenging the corporate decision to allege facts that rebut the presumption that a boards decision is entitled to the protection of the business judgment rule. When a merger transaction is with a third party, however, plaintiffs have sought to invoke the entire fairness standard by arguing that the controlling stockholder received materially different terms from the third party in the merger than the minority stockholders and that the third-party merger should therefore be subject to fairness review irrespective of the fact that the controlling stockholder was not on both sides of the table The argument in that context is that the controller used its power over the company to cause the company to enter into a transaction that was not equal to all the stockholders, and unfair to the minority because the controller unfairly diverted proceeds to itself that should have been shared ratably with all stockholders.

In this case, the minority shareholders advanced what Chancellor Strine called ``a chutzpah version’’ of that theory involving the notion that if a controlling stockholder has a liquidity issue not shared by small stockholders and does not wish to continue to be a stockholder in the selling corporation, and expresses its desire for a transaction that affords it the same liquidity and ability to sell out as all the other stockholders get, the controlling stockholder nonetheless has a disabling conflict if it refuses to assent to an alternative proposal on terms that afford all of these benefits to the minority, but not to itself, even if the ultimate transaction that is agreed to shares the control premium ratably between the controller and the other stockholders.

By the same theory, the independent directors who assented to the transaction that treated all stockholders equally and that gave the minority its full pro rata share of the control premium have supposedly violated the duty of loyalty by subordinating the best interests of the minority to the outrageous demand of the controller for equal treatment. The Chancellor said that this aggressive argument is not consistent with settled Delaware corporation law.

Under venerable and sound Delaware authority, the plaintiffs must plead that the controlling shareholder had a conflicting interest in the merger in the sense that he or she derived a personal financial benefit to the exclusion of, and detriment to, the minority stockholders. A controlling shareholder’s desire for the same liquidity as other stockholders does not amount to a conflicting interest, ruled the court.

A fiduciarys financial interest in a transaction as a stockholder, such as receiving liquidity value for shares, does not establish a disabling conflict of interest when the transaction treats all stockholders equally, as does the merger in this case. This notion stems from the basic understanding that when a stockholder who is also a fiduciary receives the same consideration as the rest of the shareholders, their interests are aligned. It also stems from the desire of the common law of corporations to make common sense, emphasized the Chancellor.

Controlling stockholders typically are well-suited to help the board extract a good deal on behalf of the other stockholders, reasoned the Chancellor, because they usually have the largest financial stake in the transaction and thus have a natural incentive to obtain the best price for their shares. If, however, controlling stockholders are subject to entire fairness review when they share the premium ratably with everyone else, they might as well seek to obtain a differential premium for themselves or just sell their control bloc, and leave the minority stuck-in.

A primary focus of Delaware corporate jurisprudence has been ensuring that controlling stockholders do not use the corporate machinery to unfairly advantage themselves at the expense of the minority. Delaware law does not, however, go further than that and impose on controlling stockholders a duty to engage in self-sacrifice for the benefit of minority shareholders.

The duty to put the best interest of the corporation and its shareholders above any interest not shared by the stockholders generally does not mean that controlling shareholders must subrogate their own interests so that the minority stockholders can get the deal that they want. Controlling shareholders, while not allowed to use their control over corporate property or processes to exploit the minority, are not required to act altruistically towards them.

The controlling shareholder was thus entitled to oppose a deal that required him to subsidize a better deal for the minority stockholders by subjecting him to a different and worse form of consideration. To hold otherwise would turn on its head the basic tenet that controllers have a right to vote their shares in their own interest. The Chancellor emphasized that minority stockholders are not entitled to get a deal on better terms that what is being offered to the controlling shareholder, and the fact that the controller would not accede to that deal does not create a disabling conflict of interest.

The minority shareholders here are US based institutional investors who knowingly bought shares in a Swiss-headquartered company whose shares were listed on the SIX Exchange. They also argue that the entire fairness doctrine should apply to the merger based on the notion that the controlling shareholder and presumably the other Swiss-domiciled directors were conflicted because Swiss law did not impose the same level of taxation on the exchange of company shares for the merger consideration as US law did on US taxpayers. The court said that no stated facts supported the inference that the board had a choice of structuring a transaction that was favorable to U.S. stockholders and somehow preferred a transaction that was tax-efficient for Swiss stockholders.

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