Thursday, October 20, 2011

Delaware Chancery Court Says Board Special Committee Breached Duty of Loyalty in Deal with Controlling Shareholder

Applying the entire fairness doctrine, the Delaware Chancellor ruled that a board special committee formed to evaluate a proposition by the company’s controlling shareholder engaged in a deal that was unfair to the company and breached its fiduciary duty of loyalty. Chancellor Strine found that the cramped perspective of the special committee put it in a position where there was only one strategic option to consider, the one proposed by the controlling shareholder. This resulted in a strange deal dynamic in which a majority stockholder kept its eye on the ball, actual value benchmarked to cash, and a special committee lost sight of market reality in an attempt to rationalize doing a deal of the kind the majority stockholder wanted, which was for the company to buy its non-public company for approx $3.1 million of the company’s stock. In Re Southern Peru Copper Corporation Shareholder Derivative Litigation, C.A. No. 961-CS, Oct. 14, 2011.

After this game of controlled mindset twister and the contortions it involved, noted Chancellor Strine, the special committee agreed to give away over $3 billion worth of actual cash value in exchange for something worth demonstrably less, and to do so on terms that by consummation made the value gap even worse, without using any of its contractual leverage to stop the deal or renegotiate its terms.

Under Delaware law, the entire fairness standard has two aspects: process and price. Although the concept of entire fairness has two components, the entire fairness analysis is not bifurcated. Rather, the court determines entire fairness based on all aspects of the entire transaction. The Delaware Supreme Court has recognized, however, that, at least in non-fraudulent transactions, price may be the preponderant consideration.

Although the members of the special committee were competent and well-qualified, noted the Chancellor, from inception the special committee fell victim to a controlled mindset and allowed the controlling shareholder to dictate the terms and structure of the deal. The special committee did not insist on the right to look at alternatives; rather, it accepted that only one type of transaction was on the table, a purchase of the non-public company.

The special committee was trapped in a controlled mindset where the only options to be considered were those proposed by the controlling stockholder. This mindset took off the table other options that would have generated a real market check, noted the court, and also deprived the special committee of negotiating leverage to extract better terms. In fact, said the court, the negotiations were stilted and influenced by the committee’s uncertainty about whether it was actually empowered to negotiate.

When a special committee confines itself to this world, reasoned the Chancellor, it engages in the self-defeating practice of negotiating with itself, perhaps without even realizing it, through which it nixes certain options before even putting them on the table. Although the special committee members were competent businessmen and may have had the best intentions, said the court, they allowed themselves to be hemmed in by the controlling stockholder’s demands. Throughout the negotiation process, the special committee and its outside advisor only focused on finding a way to get the terms of the merger structure proposed by the controlling shareholder to make sense, rather than aggressively testing the assumption that the merger was a good idea in the first place.

While it is not a breach of faith for directors to determine that the present stock market price of shares is not representative of true value or that there may be several market values for the company’s stock, continued the court, here the special committee did not believe that the company was undervalued by the stock market. To the contrary, its financial advisor rendered analyses suggesting that the company was being overvalued by the market.

The special committee did not respond to its intuition that the company was overvalued in a way consistent with its fiduciary duties or the way that a third-party buyer would have. What it did was to turn the gold that it held, namely the market-tested company stock worth in cash its trading price, into silver, by equating itself on a relative basis to a financially-strapped, non-market tested, non-public selling company, thereby devaluing its own acquisition currency.

The Delaware Chancery Court has broad discretion to fashion equitable and monetary relief under the entire fairness standard. Also, unlike the more exact process followed in an appraisal action, damages resulting from a breach of fiduciary duty are liberally calculated. As long as there is a basis for an estimate of damages, and the plaintiff has suffered harm, mathematical certainty is not required. In addition to an actual award of monetary relief, the court has the authority to grant pre-and post-judgment interest, and to determine the form of that interest.

Here, the plaintiff’s delay in litigating the case rendered it inequitable to use a rescission-based approach, said the Chancellor. So, instead of entering a rescission-based remedy, the Chancellor crafted from the panoply of equitable remedies within the court’s discretion a damage award that approximates the difference between the price that the special committee would have approved had the merger been entirely fair, for example, absent a breach of fiduciary duties, and the price that the special committee actually agreed to pay.