In the recent decision of Flood v. Synutra International, Inc.,1 a divided Delaware Supreme Court affirmed the Court of Chancery’s dismissal2 of a challenge to a controlling stockholder’s take-private transaction. The Court in an opinion by Chief Justice Strine held, among other things,3 that the deferential business judgment review applied to the merger because the controlling stockholder had timely satisfied the dual requirements of Kahn v. M&F Worldwide Corp.4 (“MFW”) in proposing those requirements in the initial stages of the process but after submitting its initial proposal letter.
The plaintiff challenged the application of MFW on the grounds that the controlling stockholder had failed to satisfy MFW’s “ab initio” requirement that the merger be conditioned on MFW’s dual requirements upfront. The controlling stockholder had submitted an initial written proposal to the target board and attached the proposal as an exhibit to its Schedule 13D filing.5 That initial proposal did not condition the merger on MFW’s dual requirements, but a follow-up proposal two weeks later did.6 Nevertheless, in rejecting the plaintiff’s argument for the “brightest of lines”7 — the initial offer — the Court held that the follow-up proposal was sufficient because the MFW conditions were in place before any “economic horse trading” had begun.8
The decision has been well-received by the M&A bar as a flexible and equitable application of the MFW doctrine. But the holding drew a powerful 25-page dissent from Justice Valihura who noted that the Court’s holding “invites factual inquiries that defeat the purpose of what should be more of a bright line and narrower pathway for pleading-stage dismissals in this context.”9 Justice Valihura forcefully argued that the burden should be on the controlling stockholder to include the MFW conditions in its “initial formal written proposal” given that the outset of the process is within its control.10 She noted that a bright line test would “avoid the factual morass” when intervening events and other issues potentially infect the special committee process.11 In Synutra, the two-week gap between the initial and revised proposals of the controlling stockholder was complicated by a conflict of the target company’s outside counsel, a waiver for it to represent the controlling stockholder, and management’s involvement in the selection of the special committee’s advisors.12
Justice Valihura’s dissent alone gives one pause. However, there is another potential problem with the majority’s holding which raises both legal and policy issues. That is, does the Court’s holding in Synutra give a controlling stockholder too much optionality at the beginning of the process?
Consider the following scenario, based loosely on typical going-private hypothetical facts but with some embellishments. It involves a controlling stockholder attempting to test the waters of its bid in the analyst and stockholder community before ineluctably committing to the MFW framework.
The controlling stockholder owns 60% of the voting power of the target and has both legal and de facto control. There are no supermajority vote requirements or other obstacles establishing “negative control” by any other stockholders. The controlling stockholder wants to take the target private. The controlling stockholder has some preliminary, non-substantive discussions, not negotiations, about a potential deal with some of the target’s board members, and discusses the matter procedurally with the target’s general counsel. The general counsel discusses the matter with the full target board and outside counsel, but the substance of the bid is not reviewed. The procedural process continues, and the controlling stockholder executes a standard confidentiality agreement with the target in order to obtain additional information about the target solely to facilitate financing and valuation related to a possible consensual bid. The confidentiality agreement is not disclosed.13 The target’s board is advised by the general counsel and outside counsel that some subset of target independent board members will constitute a special committee to review any bid by the controlling stockholder, but that it is premature to establish that apparatus at this point because the controlling stockholder has not made, and may never a make, a bid.
The controlling stockholder completes its preliminary due diligence in a couple weeks and decides to make a non-binding bid. In structuring its bid, the controlling stockholder’s goals are threefold: Avoid (i) participating in an auction or alternative transaction; (ii) paying anything above the lowest possible fair price; and (iii) being dragged into protracted target stockholder litigation which will potentially delay the deal or result in additional consideration paid to the minority stockholders.
As to (i), the controlling stockholder is advised by its counsel that to avoid an auction, the controlling stockholder should state in the bid letter that it is only a buyer, not a seller. This will limit the target’s special committee to a binary “yes” or “no” choice as to the bid, and only the bid. The controlling stockholder recognizes that in assessing the fairness of its bid, the special committee will consider third party potential valuation and, as in Synutra, may even solicit potential bids in a market check to establish this value, recognizing that it may be a dubious strawman exercise in view of the controlling stockholder’s blocking position.
Unfortunately, the interplay between goals (ii) and (iii) are proving more problematic for the controlling stockholder to resolve. It wants to pay the lowest price it can, but is equally concerned that if the bid is too low, the resulting run-up in market price, or analyst and target stockholder blowback, arising after announcement of the bid may bolster the special committee to either reject the bid or materially alter the valuation universe in which the special committee will negotiate with the controlling stockholder. Building on these considerations regarding price, the controlling stockholder would like the special committee’s review of the bid to be covered by the business judgment rule under the MFW safeguards. This will give the target a good shot at dismissing the inevitable stockholder litigation at the preliminary pleadings stage and at the margins relieve some pressure on the special committee. However, providing an MFW majority of minority stockholder vote provision will open up potential deal uncertainty and “bumpitrage” or appraisal opportunities for enterprising activists. In light of its aggressive pricing, the controlling stockholder mulls over whether it might be better to just bull ahead with only a special committee framework, secure in the knowledge that the target stockholder vote is a done deal with the controlling stockholder’s voting bloc, and fight out the litigation with the burden of proving unfairness shifted to the plaintiff due to the special committee process.14
The controlling stockholder wants its cake and to eat it too, so it decides not to irretrievably cross the MFW bridge at the outset. It delivers to the target board of directors its initial expression of interest, containing a price designed to be near the lower end of the fairness range, but with some powder dry so that the controlling stockholder can give the special committee a price concession. The bid includes a confirmatory due diligence condition and other customary terms, but is silent on MFW safeguards. The controlling stockholder promptly amends its Schedule 13D to include the bid under Item 4,15 so the bid is public. Substantive economic negotiations have still not taken place between the target and the controlling stockholder. At this point, the target forms its special committee of independent board members to review the bid. The special committee runs its advisor bake-offs, first for an independent law firm and then for an independent investment banker to represent the special committee. This process involves four law firms and three investment banking candidates. It takes one or two weeks to select advisors. Thereafter, the selected advisors may take another one or two weeks to conduct due diligence.
Meanwhile, the controlling stockholder has been assessing the full flowered analyst and stockholder reaction to its bid and the market price. Assume the analysts are right out of the gate with a uniformly positive review, with no real surprises as to how they analyze the metrics. The controlling stockholder also receives some feedback from key target stockholders, all guardedly favorable. The market reaction indicates just a small premium to the initial bid’s price. The controlling stockholder updates its review of the target stockholder demographics, including basis information, types of investors and depth of the market. It is feeling confident its bid is in the special committee’s fairness zone and the committee is not going to have too much leeway in pushing back. With a large target market cap and about 35% of the shares in the public float, the specter of bumpitrage or appraisal is always omnipresent, but this is viewed as a manageable risk. The minority stockholders look like they'll take the bid.
Its calculus completed, the controlling stockholder now decides to cross the MFW rubicon. It lobs in a new bid, again amending its Schedule 13D. This is approximately three to four weeks after the first bid was made, a week or two longer than in Synutra. The revised bid contains the same price but with the MFW safeguards. Advisored-up, the special committee is ready to go and substantive economic negotiations now begin. The special committee, aware of the generally favorable market reaction, secures a modest price bump from the controlling stockholder and some other window dressing in the negotiations. A majority of the minority target stockholders vote approvingly. The deal is done. The inevitable going-private litigation is still floating around.
Assume the record is clear that the controlling stockholder intentionally did not put in the MFW safeguards in its initial expression of interest. Assume the record is also clear that had the initial market and stockholder reaction to the controlling stockholder’s initial expression of interest been negative, it would not have revised its bid to put in the MFW safeguards. The controlling stockholder knows in this latter situation that the special committee will ask for these safeguards as part of the subsequent negotiations, but the controlling stockholder will not agree to the majority of minority stockholder condition. The price is within the range of fairness, and the controlling stockholder feels confident the special committee is a little over the barrel and will not turn down a deal in the fairness region just because an MFW safeguard is missing.
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With this hypothetical in mind, here is the fundamental question. Does the controlling stockholder, as the “master of its offer,” get the benefits of Synutra in this scenario? Would it have made any difference if the controlling stockholder just innocently missed the MFW safeguards in its initial bid, or wasn’t initially represented by counsel? What if the time gap before MFW safeguards were proffered by the controlling stockholder was five or six weeks after the initial bid, not two weeks, but there were still no intervening negotiations? What if the special committee had convened, or had hired its independent counsel, prior to submission of the revised bid, though no negotiations had commenced? Does the fact that the bidder negotiated and executed a confidentiality agreement and conducted some preliminary due diligence matter? What if there are intervening negotiations, but they are not economic in nature? The Synutra Court noted that its holding may give rise to “close cases,” but emphasized that the MFW “ab initio” requirement was clarified in Swomley v. Schlect16 to be “satisfied if the controller ‘disables [itself from using its control] before any negotiations t[ake] place.’”17 Further, “the key concern of MFW was ensuring that the controllers could not use the [MFW] conditions as bargaining chips during economic negotiations.”18
In the end, Synutra’s “negotiation” — or “economic negotiation” — definitional and policy marker leaves potential uncertainty, to say the least. Justice Valihura noted in her dissent that the Synutra rule, like any rule, could be subject to gamesmanship and that trial courts should maintain the ability to address a “deliberate circumvention of the MFW [f]ramework”, such as secret negotiations before formal bids are presented.19 In light of this, practitioners should be wary of pushing the limits of the Synutra Court’s holding too far. The stakes for an early, pre-discovery dismissal of deal litigation are real and significant. Many variables, such as the timing of negotiations, are outside the bidder’s control. And any perceived benefits, such as the early market read in our embellished scenario described above or other motives to preserve optionality with respect to the majority of minority stockholder vote condition, may very well not be worth the candle of pushing the outer bounds of MFW, Swomley and Synutra. Prudence therefore suggests that, if a bidder wants to be certain of not forfeiting the benefits of this trilogy, the MFW conditions should be contained in the very first proposal. By the same token, a special committee should appreciate the potential uncertainty of the Synutra holding and in certain circumstances consider demanding that a noncommittal controlling stockholder take a firm position on MFW’s majority of the minority condition before any negotiations begin.
Sometimes, “the brightest of lines” may not be so bad after all.