As the result of an opinion recently issued by the Pennsylvania Supreme Court, minority stockholders whose shares in Pennsylvania corporations are to be exchanged for cash in freeze-out mergers have limited recourse beyond a judicial appraisal of their shares after the merger closes. In Mitchell Partners v. Irex. (July 24, 2012), the Supreme Court held that in the absence of "exceptional circumstances" amounting to fraud or "fundamental unfairness," minority shareholders are precluded from bringing suit against corporate directors, officers or majority shareholders for breach of fiduciary duties and other common law claims. The court did recognize an exception, however, where a stockholder is able to demonstrate fraud or fundamental unfairness that cannot be compensated through the statutory appraisal process.
Mitchell Partners was presented to the Pennsylvania Supreme Court on a certified question from the U.S. Court of Appeals for the Third Circuit regarding the interpretation of Section 1105 of the Pennsylvania Business Corporation Law. It was clear that Section 1105 bars stockholders from seeking injunctions against proposed mergers in the absence of "fraud or fundamental unfairness," but it was unclear how Section 1105 affects post-merger stockholder actions.
BCL Section 1105
Section 1105 of the BCL is titled "Restriction on Equitable Relief." Its first sentence provides that a shareholder "shall not have the right to obtain, in the absence of fraud or fundamental unfairness, an injunction against any proposed plan [of merger] ... nor any right to claim the right to valuation and payment of the fair value of his shares because of the plan ... except that he may dissent and claim such payment" where Subchapter D of the BCL (15 Pa. Cons. Stat. §§1571-1580, titled "Dissenters Rights") provides shareholders the "rights and remedies" of post-merger judicial appraisal. The second sentence of Section 1105 states: "Absent fraud or fundamental unfairness, the rights and remedies so provided shall be exclusive."
In the underlying case, Mitchell Partners v. Irex, 656 F.3d 201, 209 (3d Cir. 2011), the Third Circuit observed that Section 1105 is "difficult to dissect." The court found that the second sentence, stating that dissenters' statutory rights "shall be exclusive" in the absence of fraud or fundamental unfairness, "modifies" the first sentence with respect to both injunctive relief and valuation, but, beyond that, the sentence "creates some confusion and raises some questions: exclusive to what and exclusive against whom?"
In Mitchell Partners, Irex, a privately held Pennsylvania corporation, engaged in a merger that cashed out its minority stockholders. After the merger, Mitchell Partners initiated both a diversity action in the U.S. District Court for the Eastern District of Pennsylvania and post-merger appraisal proceedings in the Lancaster County Court of Common Pleas. In the federal action, Mitchell Partners sought common law remedies against the corporation, its directors and officers and the buyer for breaches of fiduciary duty, including self-dealing and disclosure violations, aiding and abetting breaches of fiduciary duty and unjust enrichment.
The Federal Proceedings
The federal district court dismissed the action, 2010 U.S. Dist. LEXIS 103248 (E.D. Pa. Sept. 29, 2010), holding that Section 1105 of the BCL makes appraisal the exclusive post-merger remedy for dissenting stockholders. The court relied on a 1980 decision of the Pennsylvania Supreme Court, In re Jones & Laughlin Steel, 412 A.2d 1099, in which the court affirmed the dismissal of post-merger equitable claims asserted in a statutory appraisal proceeding, but also stated the broader view that "appellants' post-merger remedies were limited to the appraisal of the fair value of their stock." The district court in Mitchell Partners found that the broad language of Jones does not merely limit the appraisal court's subject-matter jurisdiction, but bars stockholders from asserting claims for common law remedies in any post-merger action.
A divided panel of the Third Circuit reversed, holding that the statutory appraisal remedy "coexists" with common law causes of action, including those against corporate directors and officers to recover damages for breaches of fiduciary duty. The court found that although Jones specifically allowed the continuation of suits that were instituted pre-merger, that case did not involve post-merger suits other than appraisal actions and did not determine whether shareholders may institute suits for damages based on alleged breaches of fiduciary duty after a merger.
Because it found that the issue had not been decided by Pennsylvania state courts, the Third Circuit looked to other authorities for guidance. Looking to Delaware as "the vanguard of corporate law," the court found persuasive the holdings of the Delaware Supreme Court in Weinberger v. UOP, 457 A.2d 701 (1983), in which the court ruled that, even with an expanded view of "fair value" in appraisal actions that allows consideration of "all relevant factors," the appraisal remedy "may not be adequate in certain cases, particularly where fraud, misrepresentation, self-dealing, deliberate waste of corporate assets or gross and palpable overreaching are involved," and Cede v. Technicolor, 542 A.2d 1182 (1988), holding that appraisal and suits for self-dealing "serve different purposes and are designed to provide different, and not interchangeable, remedies."
The Third Circuit also considered Section 1105's purpose, finding that the statute was intended to prevent minority shareholders from blocking transactions favored by the majority and "to allow the merger to proceed and avoid suits which stymied corporate consolidation and growth." The court found that the statute's purpose is carried out by its restrictions on pre-merger injunction actions, and that allowing post-merger suits against fiduciaries does not interfere with that purpose. The court therefore predicted that the Pennsylvania Supreme Court would find that Section 1105 does not place any restriction on post-merger actions brought apart from appraisal actions.
The dissent took a more extreme view, starting with the general rule that appraisal is always the exclusive remedy, and finding that fraud or fundamental unfairness is an exception allowed solely in pre-merger injunction actions. According to the dissent, the broad language in Jones holds "unambiguously" that appraisal is "to be the exclusive post-merger remedy available to dissenting stockholders." In the dissent's view, a stockholder may seek an injunction to stop the merger based on fraud or fundamental unfairness, but if the stockholder fails to make a sufficient showing to halt the merger, appraisal becomes the stockholder's sole post-merger remedy, with no exception for fraud or fundamental unfairness. Because the dissent believed that the Pennsylvania Supreme Court had ruled on the matter, it disagreed with the majority's view that it was necessary to predict the court's interpretation of Section 1105. The dissent further criticized the majority because its "prediction" was made "not by referring to Pennsylvania law, but relying on Delaware law."
The defendants sought rehearing en banc, and the Third Circuit, with urging from Governor Tom Corbett and business groups concerned with what they perceived as an expansion of dissenters' rights in federal courts, certified the following question to the Supreme Court:
"Does 15 Pa. [Cons. Stat.] §1105, providing for appraisal of the value of the shares of minority shareholders who are 'squeezed out' in a cash-out merger, preclude all other post-merger remedies including claims of fraud, breach of fiduciary duty and other common law claims?"
Although the panel's majority holding was that Section 1105 does not preclude any post-merger remedies other than appraisal, the issue presented to the Supreme Court was whether Section 1105 precludes all post-merger remedies other than appraisal.
The Pennsylvania Supreme Court's Ruling
The Third Circuit majority predicted that the Supreme Court would find that Section 1105 generally permits other suits, making appraisal an "exclusive" remedy only with respect to pre-merger injunction suits in cases that do not involve fraud or fundamental unfairness. The dissent, by contrast, predicted a holding that Section 1105 makes appraisal the exclusive remedy in all cases, with an exception for pre-merger injunction actions that involve fraud or fundamental unfairness. However, the Supreme Court defied prediction and landed in-between, holding that Section 1105 makes appraisal the exclusive remedy, but applying the exception for suits that involve fraud or fundamental unfairness in both pre- and post-merger cases.
In an opinion by Justice Thomas G. Saylor, the Supreme Court accepted the district court's view that the broad language of Jones excludes post-merger actions other than appraisal. It rejected the use of Delaware law, accepting the defendants' view that "Delaware law is not an appropriate polestar for interpreting Pennsylvania law," because the Delaware appraisal statute does not make the valuation remedy exclusive in any sense. The court referred to the second sentence of Section 1105, which states that in the absence of "fraud or fundamental unfairness," the appraisal remedy "shall be exclusive," concluding its analysis with a "straightforward implication" that the statutory appraisal remedy is exclusive, subject to the exception for fraud or fundamental unfairness, across the board. The court was untroubled by the "confusion" that afflicted the Third Circuit majority in interpreting the second sentence of Section 1105. Answering the questions "exclusive to what and exclusive against whom," the court found that the second sentence of Section 1105 makes the appraisal remedy exclusive to all other remedies, against corporations or individuals, except in cases of fraud or fundamental unfairness.
Mitchell Partners is not just an exercise in the statutory interpretation of Section 1105. More importantly, the Pennsylvania Supreme Court emphasized that the exception for fraud or fundamental unfairness "may not be invoked lightly." Although the court did not attempt to define or describe the circumstances that would constitute fraud or fundamental unfairness, it did provide examples, saying that a suit may not be brought merely because a merger is structured to cash out minority stockholders or avoid dissenters' rights, and that "mere inadequacy in price is not sufficient." It concluded that appraisal is "the usual remedy in the absence of exceptional circumstances."
In a concurring opinion, Justice Max Baer further stressed the narrow circumstances in which remedies other than appraisal may be available, stating that because fair price can be addressed in the appraisal proceeding, the fraud-or-fundamental-unfairness exception "is not to be invoked to compensate financial unfairness." Baer added, significantly, that aggrieved shareholders who would invoke the exception must demonstrate that their injuries resulted from fraud or fundamental unfairness and that the harm cannot be compensated through the appraisal proceeding. Thus, the concurrence suggests that even in conflict transactions with majority stockholders, the burden will not fall on corporate fiduciaries to show "entire fairness." Instead, the burden will be on stockholders to show "fundamental unfairness" and, furthermore, to show that money damages for diminution in the fair value of their shares are inadequate.
Back in federal court, Mitchell Partnerswill now be required to meet a higher standard to sustain its separate fiduciary duty action. As a shareholder plaintiff, it will be required to demonstrate that the Irex merger involved fraud or fundamental unfairness that resulted in harm to minority shareholders, and that appraisal does not provide adequate remedies.
In general, Pennsylvania corporations in merger negotiations or in the process of consummating business combinations should continue to avoid any conduct by the corporation or its officers or directors that could suggest the existence of fraud or fundamental unfairness. After Mitchell Partners, however, shareholder plaintiffs will have more limited legal recourse, and directors and officers of Pennsylvania corporations will be insulated to a greater extent from suits for breach of fiduciary duty and other common law torts arising from mergers and other corporate actions.