Friday, June 12, 2020

Coercion factors heavily into decision that entire fairness, not MFW, applied to Dell-VM Ware consolidation

By Mark S. Nelson, J.D.

The Delaware Chancery Court held that, at the pleading stage, the case brought by shareholders who sued Dell and its board of directors over Dell’s attempt to acquire EMC Corporation and to consolidate EMC’s VMware, Inc., through an offering of cash and discounted shares could proceed because Dell would be unable to assert MFW applies because Dell failed to adequately condition the procession of the consolidation transaction on the approval of both the special committee and a majority of the minority stockholders. The bulk of the opinion explained how the coercive nature of Dell’s offer factored into denial of the MFW approach. The court also concluded that two directors were potentially subject to liability, but dismissed claims against a third director (In Re Dell Technologies, Inc. Class V Stockholders Litigation, June 11, 2020, Laster, J.).

Discounts, consolidation, and conversion. Dell sought to acquire EMC in 2016 and to later consolidate all of EMC’s VM Ware stake (EMC held an 81.9 percent stake in VM Ware). Dell, strapped for cash, acquired EMC for a combination of cash and publicly listed Class V shares. Dell then considered three options to consolidate VM Ware: (1) a transaction with VM ware; (2) redemption of Class V shares; or (3) a forced conversion of Class V shares. In 2018, an existing special committee began to mull these options and settled on a redemption supposedly in compliance with MFW (business judgment rule applies instead of entire fairness) with the option of a forced conversion, but the committee discovered that one of its members was conflicted.

A second special committee, without the conflicted member, subsequently mulled the same approach. After many large shareholders objected to the redemption (shares were significantly discounted because of the prospect of a forced conversion), Dell negotiated directly with six large shareholders while also preparing for a forced conversion. The directly-negotiated deal, marginally better than the earlier one negotiated by the special committee, ultimately closed upon approval of 61 percent of shareholders at a special meeting of the Class V shareholders.

Dell deviated from MFW. Under Delaware’s MFW decision, a conflicted controller who disables herself before a transaction begins can pursue a path that results in application of the irrebuttable business judgment rule to the transaction instead of the more typical, and far less deferential, entire fairness standard of review. But this can only happen if: (1) the controller conditions the procession of the transaction on the approval of both a special committee and a majority of the minority stockholders; (2) the special committee is independent; (3) the special committee is empowered to freely select its own advisors and to say no definitively; (4) the special committee meets its duty of care in negotiating a fair price; (5) the vote of the minority is informed; and (6) there is no coercion of the minority.

The court here concluded that there was a reasonable inference that Dell failed to establish the twin-MFW conditions contained in MFW’s first prong. The court explained that this was so because the forced conversion was beyond the scope of the MFW conditions spelled out in the transaction, and Dell bypassed the special committee. The court explained its reasoning in series of paragraphs in the opinion (taken verbatim from the opinion):

MFW’s dual protections contemplate that the Special Committee will act as the bargaining agent for the minority stockholders, with the minority stockholders rendering an up-or-down verdict on the committee’s work. Those roles are complements, not substitutes. A set of motivated stockholder volunteers cannot take over for the committee and serve both roles (footnote omitted). (p.36)

The defendants contend that the Company should not be penalized for negotiating with the Stockholder Volunteers. They claim it would be “bad policy” to conclude that “if a controller knew that once it had negotiated with a special committee, it could not further improve the transaction consideration in response to shareholder feedback without foregoing the protection of MFW and subjecting itself to an entire fairness review.” The Delaware Supreme Court’s decisions make clear that a controller should not be able to bypass the committee, which is expected to act as the stockholders’ bargaining agent. The Delaware Supreme Court’s decisions view this outcome as good policy, not bad policy (citations omitted). (p. 41)

This decision does not hold that a controller loses MFW protection when it improves its offer after reaching agreement with the special committee. Instead, this decision holds that to fall within the scope of MFW, obtain the protection of the irrebuttable business judgment rule, and receive a pleading-stage dismissal, any improvement must result from continued negotiations with the special committee, not a process that bypasses a now passive committee in favor of direct negotiations with stockholders. In this case, the Company bypassed the Special Committee by negotiating directly with the Stockholder Volunteers. (p. 41)

Coercive aspects of transaction. The court next examined in detail whether the structure of the redemption/forced conversion offer led to coercion because, under MFW, the minority vote must not be the result of coercion. Here, the court briefly paused to observe that Delaware’s law of coercion has multiple variants that render it a “multi-faceted concept” before analyzing each of those variants in the context of the case against Dell. The court’s analysis often liberally cites decisions authored by the late Chancellor Allen.

The court first ruled out two variants of Delaware coercion law because they would be inapt in the MFW setting. For one, the variant addressing coercion by a non-fiduciary in a contractual setting does not address fiduciary cases like the one involving Dell, although the court noted that this variant is one of the most “permissive” variants of coercion law. Second, the court said the variant addressing coercion by a non-fiduciary that elicits a fiduciary response was inapt because, unlike the Unocal scenario, here it is the fiduciary that is suspected of coercion, not an external source; as an aside, the court noted that this variant of coercion often arises regarding the “two-tiered, front-loaded offer” in which shareholders worry about getting much less in the second step or back-end portion of the transaction.

Next, the court addressed the remaining three variants of Delaware coercion law, which the court said could apply in the MFW setting. The first of these variants involves coercion by a fiduciary of beneficiaries. In a corporate setting, the key question is whether the fiduciary induced the shareholders to act for reasons other than the merits of a transaction. For example, there would be no breach of fiduciary duty if shareholders were given an option, such as to reject a transaction in favor of the status quo, even if the status quo was not ideal. In the MFW setting, however, a plaintiff who pleads this variant of coercion would show, at least at the pleading stage, that the coercion “undermines the reliability of the stockholder vote.”

The second relevant variant addresses coercion that is “unique” to cleansing transactions. Specifically, Corwin can rescue some transactions if, among other things, the transaction was not the product of coercion. Here, the court highlighted the “situational coercion” and “structural coercion” discussed in Saba Software and Liberty Broadband, respectively, while offering a few comments on each of these decisions (once again taken verbatim from the opinion):

The arguably innovative step taken by the Saba Software court was to recognize that when determining whether a stockholder vote should have a cleansing effect and result in the application of the irrebuttable business judgment rule, the court must have confidence that the vote reflects an endorsement of the merits of the transaction, not just a preference for a marginally better alternative over an already bad situation. The resulting inquiry differs from the question of whether fiduciaries have acted disloyally by making coercive threats or creating a coercive, two-tiered structure. The situational backdrop of an unacceptable status quo does not give rise to a fiduciary breach, but it calls into question the meaning of a stockholder vote such that it should not be given cleansing effect. (p. 58)

The Liberty Broadband decision thus built on the arguably innovative step taken in Saba Software by integrating the concepts of situational and structural coercion into the broader doctrinal landscape of cleansing votes. As a matter of policy, giving cleansing effect to a stockholder vote avoids judicial second guessing where stockholders inferably made a decision that the transaction was in their own best interests. If a plaintiff can identify a reasonably conceivable basis to doubt that the stockholders made that determination, then the vote should not be given cleansing effect. The Saba Software decision demonstrates the a sufficiently unattractive status quo can give rise to such an inference, because the favorable stockholder vote only implies that the stockholders regarded the transaction as relatively better than the status quo, not that it was in their best interests. The Liberty Broadband decision demonstrates that cross-conditioned votes can give rise to such an inference, because the favorable stockholder vote only implies that the transaction as a whole is relatively better than the status quo, not that the challenged aspect of the transaction is in the corporation’s best interests. Neither form of coercion would support a claim for fiduciary breach; its effect is limited to raising a sufficient question about the meaning of the stockholder vote to prevent it from having cleansing effect. (pp. 62-63)

Although the Saba Software and Liberty Broadband cases applied the concepts of situational coercion and structural coercion to cleansing votes under Corwin, their reasoning applies equally to the majority-of-the-minority vote under MFW. Under this line of authority, situational or structural dynamics that do not rise to the level of a breach of fiduciary duty, but which nevertheless call into question the inference to be drawn from the stockholder vote, will prevent the stockholder vote from triggering the application of the irrebuttable business judgment rule. (p. 63)

The third variant of Delaware coercion law is one in which there is coercion of a committee. The court explained that here the emphasis is on the committee, not the shareholder vote. As an example, the court cited a case in which a company threatened a hostile takeover if the special committee failed to approve the transaction at the price offered by the company.

In applying these latter three theories of coercion to Dell’s behavior, the court concluded that, at the pleading stage, it was “reasonably conceivable” that Dell’s threat to force a conversion created a coercive environment because that threat could have upset the special committee’s ability to negotiate at arms-length and it could have upset the shareholders ability to vote against the transaction. The court noted that the scenario created by Dell involved multiple forms of coercion, but the court need only find that one form is present to reject Dell’s bid to apply MFW. The court cited Dell’s repeated threats to force a conversion and allegations that the special committee understood its limited options. As a result, Dell’s gambit to use the discounted shares to force a conversion left shareholders with a choice between an “unappealing status quo” and a marginally better, but still “unfair,” alternative.

Other issues. The court addressed several other issues in the case. First, the court rejected three defense arguments that there had been no coercion. Under Delaware’s twice-tested paradigm, the court said Dell had the power to do the conversion in its certificate of incorporation, but that Dell would still have to answer for whether its use of the power was equitable. Dell also had argued that there was no coercion because the directly negotiated deal resulted in a price better than the committee-negotiated offer. The court said the marginally better outcome still did not show there was no coercion or that the deal was fair. The court also rejected the argument that shareholders could have voted for the status quo because the shareholders would still be stuck with discounted shares.

The court then concluded that, at least under the deferential standard applied at the motion to dismiss stage, the two-member special committee was not independent. The court would later conclude, on an interlocutory basis, that the one conflicted member of the original special committee likely would not face personal liability because she had recused herself and did not participate in later negotiations.

Lastly, the court concluded that the shareholder vote was not fully informed. According to the court’s analysis, there were at least three types of information about the deal that were either omitted or presented in a manner that was materially misleading.

The case is No. 2018-0816-JTL.