When a company with a controlling stockholder seeks to sell itself to a third party, the rights of the controlling stockholder and its obligations to minority stockholders are not always clear, tempting plaintiffs to test the boundaries of the controlling stockholder’s duties. The Delaware Chancery Court's decision in the latest such case, In re Synthes, Inc. S’holder Litigation, 2012 WL 3594293 (Del. Ch. Aug. 17, 2012), helps both controlling stockholders of Delaware corporations and the boards of the companies they control to understand the appropriate role of a controlling stockholder in such third-party transactions.
This Update summarizes the key issues from the In re Synthes decision and offers practical advice.
Summary of the In re Synthes Decision
In In re Sythes, Chancellor Leo Strine addressed charges that the controlling stockholder manipulated the sale process due to a desire for liquidity—a breach of the controlling stockholder’s and the board’s duty of loyalty that would have invoked the stringent entire fairness standard of review. The controlling stockholder allegedly blocked consideration of a private equity bid that would have cashed out the minority stockholders but required the controlling stockholder to retain a significant illiquid stake in the post-transaction company, in favor of a merger providing all stockholders the same per share merger consideration in cash and liquid stock.
Chancellor Strine dismissed the complaint with prejudice, concluding that the controlling stockholder was not required to accept a transaction that gave it less than the minority, that pro rata treatment of the controlling stockholder and the minority stockholders is a form of safe harbor from breach of loyalty claims under Delaware law, and that the board and the controlling stockholder had in fact led a robust sale process that merited business judgment rule protection.
Background on the Synthes Merger Process
Synthes, Inc., a global medical device company incorporated in Delaware, was headquartered in Switzerland and its shares were traded on the SIX Swiss stock exchange. Plaintiffs contended that Hansjoerg Wyss, who founded the company, owned 38.5% of its outstanding stock and was chairman of its board of directors, effectively controlled 52% of the outstanding shares through shares owned by family and trusts and “dominated” five of the other members of the 10-person board.
In 2010, the Synthes board began exploring a sale of the company as part of its ongoing strategic planning process. They appointed an independent board member as lead director to manage the process, hired Credit Suisse as their financial advisor and contacted nine strategic buyers. When they attracted only one serious strategic bidder, Johnson & Johnson, they opened the process to financial buyers. When no one financial buyer could independently finance an acquisition, they allowed three private equity funds to club together to bid as a consortium. They then negotiated simultaneously with Johnson & Johnson and the private equity club.
The private equity club offered to purchase the minority stockholders' shares for 151 Swiss francs per share, payable in cash. The catch was, Wyss would be required to “convert a substantial portion of his equity investment in Synthes into an equity investment in the post-merger company,” effectively helping to finance the transaction with his own equity stake. Because the prospect of having to retain an illiquid minority interest with no control did not appeal to Wyss, he allegedly caused the board to abandon negotiations with the private equity club and to negotiate exclusively with Johnson & Johnson. Over three months of negotiation, the company succeeded in causing Johnson & Johnson to increase its bid from 145-150 Swiss francs per share to 159 Swiss francs per share, representing a 26% premium to the company’s average trading price for the month before announcement. The transaction provided for equal treatment of all Synthes stockholders, with 65% of the merger consideration payable in Johnson & Johnson stock and the balance paid in cash. Eight months after the merger agreement was signed and announced, the stockholders approved the merger, which closed a year after the agreement was signed. No alternative bidders emerged during this lengthy process.
The Court's Analysis
Plaintiffs Claim Breaches of Loyalty and Invoke Entire Fairness, Revlon and Unocal. Plaintiffs challenged the merger, arguing primarily that Wyss was a controlling stockholder and had conflicting interests due to a need for liquidity not shared with the other stockholders. They alleged that the 76-year-old Wyss needed liquidity to meet his estate planning objectives and had to sell his shares to a single buyer because open market sales would depress the share price. This disabling conflict, they argued, required the merger to be reviewed under the stringent entire fairness standard in which both the merger process and the price must be entirely fair. According to the plaintiffs, because the other directors bowed to Wyss’ desire to abandon the private equity club's proposal and deal exclusively with Johnson & Johnson, they also breached their duty of loyalty and therefore could not be exculpated from liability under Section 102(b)(7) of the Delaware General Corporation Law. Plaintiffs further argued that the board's actions in connection with the merger process were subject to enhanced scrutiny under Revlon, which applied to the merger decision because it was an “exit” transaction—the last opportunity for Synthes stockholders to receive a control premium for their shares—and that the board failed to satisfy its Revlon duty to obtain the highest value reasonably attainable. Finally, the plaintiffs alleged that the board breached its duties under Unocal, by agreeing to unreasonable deal protections.
Chancery Court Applies Business Judgment Rule; Finds No Conflict of Interest. Chancellor Strine begins the court's decision with a reminder that the business judgment rule generally applies to the review of a board’s decision to enter into a merger transaction unless plaintiffs can rebut the presumption that the board’s decision should be entitled to such protection by showing, for example, that the board or a controlling stockholder stood on both sides of a transaction or that the board otherwise failed to act in accordance with its duties of loyalty and care. If the company has a controlling stockholder, but the merger is with an unrelated third party, plaintiffs can rebut the presumption by alleging that the controlling stockholder abused its control by causing the company to enter into a transaction that unfairly diverted to the controller proceeds that should have been shared ratably with all stockholders.
The chancellor describes the Synthes plaintiffs as advancing a “chutzpah” version of this theory. He acknowledged that a controlling stockholder’s need for liquidity could create a disabling conflict of interest, even if the transaction consideration were pro rata, but only under narrow circumstances. Such a conflict could exist, for example, where the controlling stockholder forced a fire sale without negotiation, diligence or consideration of the true market value of the company in order to satisfy its own pressing financial needs, such as meeting a margin call or avoiding an imminent default in another investment. Chancellor Strine found none of those circumstances in the Synthes case. There were no allegations that Wyss had tried to sell his stock; the board, not Wyss, initiated the sale process; the sale process was deliberate and calculated to generate the highest value for Synthes by seeking both strategic and financial buyers; and the board negotiated extensively to improve the price, agreeing in the end to deal protections after it believed it had extracted the best price. There was no evidence that by disengaging from the private equity club, Wyss or the board somehow discouraged any further bids from the private equity club or failed to effectively use the private equity club's bid to extract more from Johnson & Johnson.
For these reasons, Chancellor Strine found that Wyss’ interest in receiving liquidity for his shares, which was “precisely aligned” with the interests of the minority stockholders, did not constitute a disabling conflict of interest that either justified application of the entire fairness standard of review or a finding that the directors had breached their duty of loyalty in a manner that removed them from the protection of the Delaware exculpation statute. Delaware law does not “impose on controlling stockholders a duty to engage in self-sacrifice for the benefit of the minority shareholders.” Where the minority stockholders receive pro rata treatment, the controlling stockholder has “docked within the safe harbor created by the business judgment rule.”
Revlon Did Not Apply to a 65% Stock Merger—But if it Had, the Standard Was Met. Chancellor Strine quickly disposed of the argument that the board’s actions were subject to enhanced scrutiny under Revlon, which only applies if a transaction results in a sale or change of control. Here, the Synthes stockholders were selling their stock in a controlled corporation and receiving 65% of their consideration in stock of Johnson & Johnson, “whose shares are held in [a] large, fluid market”. Since control would reside in that fluid market, the transaction did not result in a change of control for purposes of Revlon. Even if Revlon had applied, Chancellor Strine concluded that there was no inference that the board had failed to take “a reasonable course of action to ensure that Synthes stockholders received the highest value reasonably attainable,” thereby meeting the Revlon standard.
Unocal Claims Were Not Supported. Plaintiffs’ Unocal claims attacked the deal protections in the transaction with Johnson & Johnson as preclusive of a competing bid. Those protections included
an agreement with Wyss and his family trusts to vote 37% of the outstanding stock in favor of the merger (less than the 48.83% that this group controlled);
a no-shop clause with a fiduciary out to consider a superior proposal;
a force-the-vote provision;
matching rights; and
a termination fee of $650 million (3.05% of the equity value and 2.9% of enterprise value).
If the force-the-vote provision applied, the shares covered by the voting agreement dropped to only 33%. Chancellor Strine found that there was no showing that the deal protections would have “unreasonably precluded the emergence of a genuine topping bidder willing to make a materially higher bid.” The voting agreement covered “far less than a majority” of the outstanding shares (even less in a force-the-vote situation). Because all the deal protections were agreed to after an open sale process that winnowed interested bidders to one, the board had “a firm market basis” on which to decide whether a topping bid was likely to emerge and to judge what protections were necessary to secure the bird in hand.
Lessons for Controlling Stockholders and Target Boards. The Synthes case, together with other Delaware cases, provides important guidance for both controlling stockholders and boards of target companies in considering a possible sale of the company to a third party.
Carefully Assess Potential Controlling Stockholder Conflicts. First, it is critical that the board understand fully whether the interests of the controlling stockholder diverge from those of the minority stockholders in order to assess whether the course of action favored by the controlling stockholder is in the best interest of the minority stockholders. N.J. Carpenters Pension Fund v. InfoGroup, Inc., 2011 WL 4825888 (Del. Ch. Sept. 30, 2011) was another case where the controlling stockholder received the same consideration as the minority stockholders. In InfoGroup, the controlling stockholder not only had a compelling need for liquidity not shared by the other stockholders, but he bullied and dominated the board of directors into pursuing a flawed sale process that resulted in a transaction that arguably undervalued the corporation. The Synthes plaintiffs tried to dress their claims in an InfoGroup wrapping, but the facts did not support their arguments: in Synthes, the controlling stockholder’s desire for liquidity and that of the minority stockholders were completely aligned; therefore, there was no conflict of interest. In both cases, the board had a duty to explore and fully understand the controlling stockholder's motivation to sell his shares.
An Unconflicted Controlling Stockholder Can Participate in the Sale Process, But Should Not Lead It. Where, as in Synthes, the controlling stockholder does not have a disabling conflict and its interests are aligned with those of the minority, there should be no impediment to that stockholder participating in a third-party sale process either as a director or through its representative(s) on the board. In fact, as Chancellor Strine acknowledged: “Controlling stockholders typically are well-suited to help the board extract a good deal on behalf of the other stockholders 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.” Nevertheless, to avoid any appearance that the controlling stockholder adversely influenced the sale process, it is still advisable for that process to be conducted under the guidance of independent board members. Synthes demonstrates that, depending on the circumstances, it may not be necessary to form a special committee of independent directors, as would be required if the board were negotiating with the controlling stockholder for the sale of the company.
In Synthes, the lead independent director worked with a largely independent board, with the participation of the controlling stockholder, and with the company’s independent advisors to identify potential buyers, expand the pool of potential buyers when the initial overtures did not pull in multiple bidders and negotiate with the bidders to obtain the best terms reasonably available for the stockholders. This robust process helped the court to conclude that the board had met the requirements for application of the business judgment rule, as well as for the enhanced scrutiny required by Revlon (had it applied).
Revlon Should Dictate the Level of Care in a Third-Party Merger. As in Synthes, a company exploring its strategic alternatives may undergo a broad-based search for acquisition partners while still preserving the opportunity to enter into a transaction that, because the consideration consists primarily of widely held stock, does not implicate Revlon-enhanced scrutiny. When a board contacts potential buyers, it does not know at the outset whether it will ultimately judge a transaction to be in the best interests of its stockholders and, if so, the nature of that transaction. Because an eventual transaction may constitute a change of control under Revlon, it is safest to assume that courts will apply Revlon’s enhanced scrutiny and, consequently, that the process should be conducted with commensurate rigor. Although Revlon requires a focus on the best alternative reasonably available in the short term, the board may determine that, in the end, the best transaction for stockholders is one that provides the best long-term value in the form of a continuing interest in the company through the stock of its acquirer.
Pro Rata Consideration to All Stockholders is Generally a Safe Harbor for Controlling Stockholders. Where a controlling stockholder receives different consideration than the minority stockholders, there is a risk that the controlling stockholder has abused its position by negotiating more favorable terms for itself—a breach of the duty of loyalty. In In re John Q. Hammons Hotels Inc. S’holder Litig., 2009 WL 3165613 (Del. Ch. Oct. 2, 2009), the majority stockholder negotiated potentially lucrative side transactions not available to the minority stockholders in a third-party merger. Chancellor Chandler denied summary judgment, sending the case to trial, and ruled that the transaction would be governed by the entire fairness standard of review because the procedural protections employed by the board were not sufficient to warrant application of the business judgment standard. (After trial, Chancellor Chandler found that the board had satisfied the entire fairness standard because the testimony demonstrated that the merger consideration received by the controlling stockholder was worth less per share than the merger consideration received by the minority stockholders. In re John Q. Hammons Hotels Inc. S’holder Litig., 2011 WL 227634 (Del. Ch. Jan. 14, 2011), at 7.)
Where the controlling stockholder and the minority stockholders receive the same consideration in kind and amount, as in Synthes, their interests are aligned and courts will view such pro rata consideration as a powerful indicator that the price received by the minority was fair. Nevertheless, if a dominant stockholder bullies a target's board into quiescence to force a transaction that may not be in the best interests of the other stockholders, as in InfoGroup, a conflict may exist notwithstanding the payment of the same pro rata consideration to all stockholders. The board’s responsibility in a third-party transaction must be not only to understand and evaluate any side transactions between the buyer and the controlling stockholder that might pass additional value to the controller that is not available to the minority, but in all cases, to actively negotiate the best price for all the shares.
A Controlling Stockholder Need Not Sacrifice its Interests in Order to Promote a Transaction that Favors Minority Stockholders. Delaware cases have made clear that a controlling stockholder is generally free to sell its controlling interest for a premium, even if the minority stockholders do not participate in the sale. As a practical matter, that right may be limited by the fact that, unless the controlled corporation has opted out of the Delaware takeover statute, the corporation’s board must approve the sale of 15% or more of its outstanding shares to any would-be acquirer, providing the board of the controlled corporation with leverage to negotiate for the sale of the entire company. Nevertheless, a controlling stockholder need not sell at all if it does not like an offered transaction and cannot be compelled to do so. Synthes simply states what logically follows: the controlling stockholder has no duty to approve a transaction that might be more favorable to the minority stockholders than to the controller simply to confer a benefit on the minority.
You can find the full text of the Delaware Chancery Court's decision in In re Synthes, Inc. S’holder Litigation, 2012 WL 3594293 (Del. Ch. Aug. 17, 2012) here.
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