Last summer, in our post titled Protecting Your Business Judgment: Recent Developments in Delaware Law on M&A Deals Involving Controlling Stockholders, we alerted you that two trial courts in the nation’s leading forum for disputes over corporate M&A deals held that transactions involving controlling stockholders will be reviewed under the deferential, defendant-friendly business judgment rule rather than the more exacting entire fairness standard. In a landmark decision, the Delaware Supreme Court recently affirmed the Chancery Court’s holding in In re MFW Shareholders Litigation, establishing the new standard applicable to controlling stockholder buyouts—if the company utilizes the right transactional structure.
When a transaction involving a controlling stockholder is challenged, the applicable standard of judicial review is generally “entire fairness”—an exacting standard that requires corporate defendants to prove that the transaction was the product of fair dealing and produced a fair price for all stockholders. Put another way, the defendants must prove the deal was entirely fair to minority, unaffiliated stockholders. Consequently, major deals involving controlling stockholders often result in expensive shareholder litigation because, once plaintiffs allege self-dealing by a controlling stockholder, the case usually proceeds to lengthy and costly discovery and trial proceedings.
As we explained last summer, the Delaware Chancery Court, in two cases of first impression, ruled that (1) a buyout of the company by a controlling stockholder (sometimes referred to as a “freeze-out” or “going-private” merger) and (2) a sale of a company with a controlling stockholder to a third party can be reviewed under the deferential business judgment rule if the company uses two robust procedural safeguards when structuring the transaction. Such deferential review could allow for the early dismissal of a shareholder lawsuit if corporate defendants show that the requisite procedural safeguards were implemented properly.
Specifically, deferential business judgment review will apply if the company and its board of directors condition the transaction, upfront, on approval by (1) a special committee of independent directors that satisfies its duty of due care in negotiating the transaction and is empowered to select its own advisors and “say no” to the transaction definitively, and (2) a majority of stockholders unaffiliated with the company or its controlling stockholder, upon a fully informed, uncoerced vote (a so-called “majority-of-the-minority vote”).
Earlier this month, on appeal by shareholder plaintiffs in Kahn v. M&F Worldwide Corp., the Delaware Supreme Court endorsed the application of business judgment review in the case of a buyout by the controlling stockholder. The high court reasoned that the use of both procedures renders a going-private transaction analogous to that of a third-party arm’s-length merger and, therefore, adequately protects the rights of minority stockholders by ensuring a process that will yield a fair purchase price.
The court further provided companies with a roadmap for how to deploy these two procedures effectively so as to enable deference to their business judgment and put an early end to shareholder litigation:
To summarize our holding, in controller buyouts, the business judgment standard of review will be applied if and only if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.
It will be interesting to see whether the Delaware Supreme Court will extend its endorsement of the business judgment rule beyond the “going-private” context. Chancellor Leo Strine, the Chancery Court judge who authored the decision in In re MFW Shareholders Litigation, has been appointed as the next Chief Judge of the Delaware Supreme Court. It seems likely that the new standard could be extended to transactions in which a target company with a controlling stockholder is purchased by a third party, as the rationale is generally the same: The robust procedural safeguards disable the controlling stockholder from using its control to dictate the outcome of the negotiations and the stockholder vote.