When a controlling stockholder’s buyout of a company has been challenged by minority stockholders, Delaware courts have generally subjected the transaction to entire fairness review, the most rigorous standard of review in corporate law. The Delaware Supreme Court’s recent decision in Kahn v. M&F Worldwide Corp., 2014 WL 996270 (Del. Mar. 14, 2014) (“M&F Worldwide”), however, affirmed former Chancellor Strine’s finding in a Delaware Chancery Court decision that the more director-favorable business judgment standard of review can be applied to a controlling stockholder transaction conditioned from the outset on approval by both a properly empowered special committee of independent directors and an informed, uncoerced majority of the minority vote.
Our update summarizes the M&F Worldwide decision and discusses the court’s analysis in the case and its practical implications.
The Delaware Supreme Court Upholds Business Judgment Review if a Six-Factor Test Is Met
In M&F Worldwide, the Delaware Supreme Court upheld a Chancery Court decision by former Chancellor Strine that for the first time determined that a controlling stockholder buyout should be entitled to business judgment review if certain procedural protections were implemented at the outset of the transaction. Prior to this case, controlling stockholder buyouts had traditionally been reviewed under an entire fairness standard, an exacting, fact-intensive review of the fairness of both the price and the process. Generally, defendants in entire fairness cases bear the burden of proving that the transaction was entirely fair to minority stockholders. However, since Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994) (“Lynch”), defendants in such cases can shift the burden of persuasion to the plaintiff by showing that the transaction was either approved by a properly empowered and functioning special committee of independent directors, or approved by an informed vote of a majority of the minority stockholders.
In this case, however, the controlling stockholder had conditioned its offer on both procedural protections – a fully empowered special committee and a majority of the minority vote. When the transaction was challenged, the defendants argued (and Chancellor Strine ultimately agreed) that, because of these dual protections, the transaction should be reviewed under the business judgment rule rather than the entire fairness standard. In re MFW S’holders Litig., 67 A.3d 496 (Del. Ch. 2013) (“MFW Shareholders Litigation”), aff’d, M&F Worldwide, 2014 WL 996270. On appeal, the Delaware Supreme Court acknowledged that the question of which standard of review should apply to controlling stockholder transactions that include both procedural protections was a novel one.
The Delaware Supreme Court’s decision provides that the business judgment standard of review will be applied to a controlling stockholder buyout if (and only if) the following six factors are satisfied:
the controlling stockholder conditions the transaction at the outset on the approval of both a special committee and a vote of a majority of the minority stockholders;
the special committee is independent;
the special committee is empowered to select its own advisors and definitively say no to the transaction;
the special committee exercises its duty of care in negotiating a fair price;
the minority stockholder vote is informed; and
the minority stockholder vote is uncoerced.
Background: An Empowered Special Committee Conducts Robust Negotiations
MacAndrews & Forbes Holdings, Inc. (M&F), owned by Ronald Perelman, was a 43% stockholder in M&F Worldwide Corp. (MFW). M&F proposed to take MFW private through a merger at a price of $24 per share in cash for shares not already owned by M&F. From the outset, M&F unambiguously conditioned its offer on approval by a special committee of independent directors and approval by a majority of stockholders unaffiliated with M&F. In its proposal to the MFW board, M&F stated that it would not expect to support any alternative transaction in its capacity as a stockholder.
After M&F’s proposal was received, the MFW board established a special committee of independent directors, which among other things was empowered to retain its own advisors, evaluate and negotiate any element of the M&F proposal, and elect not to pursue the proposal . The MFW special committee, which hired its own legal and financial advisors, followed a robust process in considering the proposal and negotiating with M&F. The special committee eventually made a counterproposal of $30 per share, which M&F rejected, noting that MFW’s businesses had continued to decline in the interim between its initial proposal and the special committee’s counterproposal. M&F’s best and final offer was $25 per share, which the special committee approved and recommended to the board. When the merger was submitted to MFW’s stockholders for a vote, it was approved by holders of over 65% of the shares not owned by M&F.
The Court’s Analysis: Business Judgment Rule Review Encourages Controllers to Employ the Two-Part Approval Process
The Delaware Supreme Court reasoned that a structure that implements these dual procedural protections from the beginning of negotiations duplicates the disinterested board and stockholder approval process involved in third party transactions. By employing the dual procedural protections, the controlling stockholder cannot exercise control over either the board process or the stockholder approval process, and therefore the business judgment standard of review is appropriate.
In addition, the court stated that the structure employed in the M&F Worldwide case provides optimal protection to minority stockholders in a controlling stockholder buyout. In support of the benefits of the structure, the court cited Chancellor Strine’s decision in MFW Shareholders Litigation, which noted that if a controlling stockholder commits at the outset to a transaction conditioned upon both protections, the controller cannot later circumvent the special committee by shifting to a more coercive tender offer structure and cannot “dangle” a majority of the minority vote late in the process as a bargaining chip to avoid having to give on price. This structure permits the special committee to bargain for the best price and reject the proposed transaction and allows the minority stockholders to determine for themselves whether to accept the deal. These protections work together to achieve a fair price.
The defendants in M&F Worldwide argued that affording transactions that employ the dual procedural protections the benefit of the business judgment rule encourages controlling stockholders to use the structure. Following Lynch, controlling stockholders had an incentive to provide some procedural protections, but as Chancellor Strine pointed out in MFW Shareholder Litigation, an “either/or” structure does not replicate an arm’s length third party transaction. In M&F Worldwide, the Delaware Supreme Court endorsed the view that a structure that effectively employs both protections replicates that arm’s length process, and the benefit of business judgment - instead of entire fairness - review creates a powerful incentive for controlling stockholders to use this structure.
A Note of Caution: The Fact-Specific Inquiry Means Plaintiffs Will Likely Be Permitted Discovery
Although the M&F Worldwide decision is generally salutary from the perspective of controlling stockholders and the boards of controlled companies, it is not an unqualified win. The six-factor inquiry into the procedural protections is very fact specific. The Delaware Supreme Court emphasized that, “[i]f a plaintiff . . . can plead a reasonably conceivable set of facts showing that any or all of [the six factors] did not exist,” its complaint should survive a motion to dismiss and it should be permitted to conduct discovery. If, following discovery, “triable issues of fact remain” about whether the dual protections were properly established, the case would proceed to trial under an entire fairness standard of review (with burden shifting available if one of the procedural protections was effective). This part of the opinion raises questions about whether judicial scrutiny of controlling stockholder buyouts that employ the dual protections structure may in fact be a more active process than the business judgment standard of review would normally imply.
In M&F Worldwide, the court noted that this case would have survived a motion to dismiss under the newly articulated standard because of facts relating to the price negotiated by the special committee. The proposal from M&F came at a time when MFW’s market price had recently declined, and the complaint alleged that the price was depressed due to short-term factors, including recent acquisitions by MFW and Standard & Poor’s downgrading of the United States’ credit rating. The court stated that these allegations would call into question the adequacy of the special committee’s negotiations at the motion to dismiss stage.
Establishing Dual Procedural Protections: Some Helpful Guidance
In articulating the six-factor test for obtaining business judgment rule review in controlling stockholder transactions, the Delaware Supreme Court provided helpful guidance on many of the individual factors.
Material Relationships Required to Undermine Director Independence. The Delaware Supreme Court first rejected arguments by the plaintiffs that three of the independent directors on the special committee were not independent. Although the plaintiffs established some business, social and/or financial connections between M&F or Mr. Perelman, on the one hand, and the members of the special committee, on the other, the court emphasized settled Delaware law that a materiality standard applies in deciding whether a director’s ties to the person whose proposal or actions the director is evaluating disqualifies that director from being considered independent. Specifically, for a director to be considered not independent, the ties in question must be so substantial as to make the director not capable of objectively discharging his or her fiduciary duties.
Empower the Special Committee; Allow It to Exercise Its Power. The court also looked carefully at the power of the special committee and its exercise of that power. In this review, the court focused on the special committee’s strong mandate, which included the power to negotiate with the controlling stockholder, recommend whether the transaction was fair and in the best interests of MFW’s minority stockholders, and elect not to proceed with the transaction. Although M&F stated in its initial proposal that it would not be willing to sell its block of shares to another buyer in an alternative transaction, the special committee explored alternative strategic options, including the potential interest of other buyers if M&F had been willing to sell and asset divestitures that might provide more value to minority stockholders. In addition, because M&F had conditioned the transaction on approval by the special committee, the committee knew that M&F could not circumvent the process with a tender offer directly to stockholders if the committee bargained too hard.
The Special Committee Must Use Available Resources and Negotiate Actively. Finally, the court found that the special committee had exercised due care through screening M&F-related employees from the special committee’s process, obtaining up-to-date management projections for the company’s businesses, and reviewing a range of valuations prepared by the committee’s financial advisor. The committee also made a counterproposal, although the effect of which was only to raise the final offer price by $1 per share. Based on this review, the court determined that the price was effectively negotiated by an empowered independent committee that acted with due care.
Inform the Stockholders with Full Disclosure. With respect to the stockholder vote, the court easily found that the majority of the minority vote was fully informed and uncoerced because the proxy statement disclosed the background of the special committee’s work and included the five separate price ranges for the company’s stock prepared by the committee’s financial advisor.
After determining that the special committee and majority of the minority vote procedures met the six-factor test, the court applied the business judgment rule and upheld the dismissal of the claims because it could not be credibly argued that no rational person would find the transaction favorable to the minority stockholders. Under the new structure set out in M&F Worldwide, a controlling stockholder buyout transaction that effectively implements the six factors described above can avoid an entire fairness inquiry, although the facts surrounding a particular transaction may survive a motion to dismiss and require defendants to proceed through discovery.