In re MFW: Delaware Court of Chancery Applies Business Judgment Rule to Controlling Stockholder Transaction

Practical Law Legal Update 2-531-0845 (Approx. 8 pages)

In re MFW: Delaware Court of Chancery Applies Business Judgment Rule to Controlling Stockholder Transaction

by PLC Corporate & Securities

Background

The case arose from the going-private acquisition of M&F Worldwide Corp. (MFW) by its controlling stockholder, MacAndrews & Forbes Holdings Inc., a holding company wholly owned by Ron Perelman. For a summary of the merger agreement, see PLC What's Market, MacAndrews & Forbes Holdings Inc./M&F Worldwide Corp. Merger Agreement Summary. Before the closing of the merger, MacAndrews & Forbes was MFW's controlling stockholder, owning 43.4% of the equity of MFW.

In June 2011, MacAndrews & Forbes sent a proposal to the MFW board to buy the shares of MFW that it did not already own for $24 per share in cash. The proposal letter, in relevant part, made three key statements:

MacAndrews & Forbes would not proceed with the transaction unless the transaction were approved by a special committee of independent directors of MFW.
The transaction would include a non-waivable condition requiring the approval of a majority of the shares of MFW not already owned by MacAndrews & Forbes or its affiliates.
MacAndrews & Forbes had no intention of selling its shares of MFW if MFW's special committee or minority stockholders were to reject the deal, and had no intention of approving any alternative transaction. It would either remain a long-term stockholder of a publicly traded MFW or successfully take MFW private.

In response to the proposal, the MFW board formed a special committee of independent directors not associated with MacAndrews & Forbes. The special committee was empowered to hire its own legal and financial advisors, negotiate the terms of any agreement with MacAndrews & Forbes and choose to not pursue a transaction at all. The board resolved to not approve a transaction without the special committee's approval.

Although MacAndrews & Forbes had committed not to sell its stake in MFW, the special committee did seek advice from its financial advisor about other strategic options available to MFW. The committee explored whether there were other buyers who might be interested in acquiring MFW and also studied other options, including asset divestitures, that might generate more value for the minority stockholders than a sale to MacAndrews & Forbes.

The MFW special committee eventually countered MacAndrews & Forbes's offer with a proposal of $30 per share, which MacAndrews & Forbes rejected. At the special committee's eighth meeting over a three-month period, the committee accepted a revised offer from MacAndrews & Forbes of $25 per share, which the full board then recommended to the stockholders.

The proxy statement provided to the stockholders contained the history of the merger and made clear that the special committee had made a $30 counteroffer, but could only obtain a final offer of $25 per share. In the stockholder vote, 65% of the shares not owned by MacAndrews & Forbes voted to accept the offer. The merger closed on December 21, 2011.

The plaintiffs in this case sought post-closing damages as a remedy for breach of fiduciary duty. The defendants moved for summary judgment on the plaintiffs' claim.

Key Litigated Issues

As the opinion begins, "[t]his case presents a novel question of law." Ordinarily, in a transaction where a controlling stockholder stands on both sides of the negotiation, the target board's conduct is reviewed under a standard of entire fairness, in which the court analyzes both the substantive fairness of the price and the process leading up to the sale. Since Kahn v. Lynch, the defendants' only recourse has been to shift the burden of proof to the plaintiffs by conditioning the transaction on approval of either:

A special committee of independent directors.
A majority of the minority of stockholders unaffiliated with the controlling stockholder.

However, no "extra legal credit," in the Court's words, has ever been provided to defendants for making use of both of these conditions. Entire fairness has always been the only standard for reviewing controlling-stockholder transactions.

The defendants argued that because they did offer both protections from the outset, the transaction should not be analyzed under the entire-fairness standard. Instead, they claimed, they should be entitled to the presumptions of the business judgment rule, under which a board's business decision will not be overturned if it can be attributed to any rational business purpose. As they argued, if a controlling stockholder provides both minority protections at the outset of the negotiations, it can mimic an arms'-length dynamic, in which case the merger ought to be reviewed deferentially like any other business decision.

The Court's opinion considered three primary issues:

Whether this was an appropriate test case, which turned on whether the special committee was in fact independent, and empowered to negotiate the transaction and reject it if it so chose.
Regardless of the strength of the defendants' argument, whether the Delaware Supreme Court had already decided that controlling-stockholder transactions must always be reviewed for entire fairness.
Whether the benefits of applying the business judgment rule in this situation outweigh the benefits of reviewing the transaction for entire fairness.

Outcome

The Court granted summary judgment and established that, until the Delaware Supreme Court rules otherwise, the business judgment rule applies when the controlling stockholder has conditioned its offer upfront on both of the following:

Approval by an independent special committee empowered to negotiate and choose to reject the deal.
Approval by a majority of the unaffiliated minority stockholders.

The Procedural Protections Qualified

The Court first considered whether the procedural protections provided to the minority stockholders qualified to be given "cleansing credit" under the business judgment rule. In determining that they did, the Court analyzed:

The independence of the directors on the special committee.
The special committee's negotiating power.
Whether the stockholder vote was uninformed or undermined by a lack of disclosure.

Directors Were Independent

The Court reviewed the relationships between each of the four members of the special committee and MacAndrews & Forbes and Perelman. In its review, the Court emphasized that under Delaware law, there is a presumption of director independence that must be rebutted. This presumption cannot be rebutted with mere allegations of friendliness or past business relations. Rather, the directors must be shown to be "beholden" to the controlling party through material ties. Moreover, the materiality of those ties is not based on a "reasonable person" standard, but on the personal financial circumstances of the directors in question.

Here, the plaintiffs could only demonstrate that three of the four directors on the committee had had previous business dealings with Perelman or had been in his home on occasion. Although some of these dealings had payoffs that would be significant for many, they were not material to the directors in question, who were quite wealthy. The members of the special committee were therefore found to be independent.

Special Committee Empowered to Negotiate, Not Just Evaluate

There was no dispute that the special committee was empowered to hire its own financial and legal advisors. There was also undisputed evidence that the special committee:

Could, and did, negotiate the terms of a transaction with MacAndrews & Forbes, rather than simply evaluate a fully formed deal.
Was empowered at the outset to reject a transaction with MacAndrews & Forbes altogether, as opposed to receiving this right later on in the negotiations.
Could, and did, consider a full range of financial information and strategic options as alternatives to a sale to MacAndrews & Forbes.

For these reasons, the Court found that the special committee had fulfilled its duty of care in its review of the MacAndrews & Forbes offer. The Court also emphasized that the special committee had its rights to negotiate and reject the deal from the outset, which meant that from the beginning, the minority stockholders were represented by an agent that had complete bargaining power, as in an arms'-length transaction.

In determining that the special committee was properly empowered and had fulfilled its duty of care, the Court did not evaluate the "effectiveness" of the special committee's negotiations, meaning whether it could have done better in its negotiations with MacAndrews & Forbes. This type of evaluation would have amounted to a review of entire fairness and would not be appropriate when the business judgment rule is applicable.

Stockholder Vote Was Fully Informed

The plaintiffs brought no allegations that the stockholder vote was anything other than fully informed and uncoerced. There were no claims that the disclosures to the stockholders were in any way lacking.

Delaware Supreme Court Precedent Does Not Apply

Next, the Court analyzed several statements of the Delaware Supreme Court from Kahn v. Lynch and other decisions that, if read in isolation, could indicate that the Delaware Supreme Court had already taken the view that all controlling-stockholder transactions must be subjected to entire-fairness review, regardless of the layering of minority protections. For example, the Delaware Supreme Court in Lynch had said that "a controlling or dominating shareholder standing on both sides of a transaction, as in a parent-subsidiary context, bears the burden of proving its entire fairness" (see Kahn v. Lynch Communications Systems, 638 A.2d 1110, 1115 (Del. 1994)).

However, the Court in MFW determined that this judicial statement, as well as others in cases cited by the plaintiffs, were dicta and without precedential effect. The Court reasoned that in all these cases, the transaction before the Delaware Supreme Court only involved one of the two minority protections, which afforded the Supreme Court no opportunity to opine directly on a case where the controlling stockholder has offered both protections. Because the parties in those cases had not fully debated the point raised in MFW, the Supreme Court's pronouncements, to the extent they could be read as applicable, were dicta.

The Lynch situation, for example, differed from MFW in several significant ways. In Lynch, not only was the merger only conditioned on approval of a special committee and not of the unaffiliated stockholders, but the special committee was not empowered to reject the deal. On the contrary, the controlling stockholder had threatened to make a tender offer at a lower price directly to the stockholders if the special committee would not recommend the deal to the full board. This stands in stark contrast to the terms offered by MacAndrews & Forbes to MFW and renders inapplicable any statements in Lynch that would seem to apply to a situation akin to MFW.

Chancellor Strine therefore concluded, as did Vice Chancellor Laster in CNX Gas, that the question of the standard of review in this case was open (see Legal Update, In re CNX Gas: DE Chancery Court Revisits Proper Standard of Review for Tender Offers by Controlling Stockholders).

Applying Business Judgment Rule Provides Incentive to Use Both Protections

Because the Court determined that the minority protections provided in MFW deserved "cleansing credit" and the case presented a "novel question of law," it could establish a rule for the novel situation before it, until either the legislature or the Delaware Supreme Court says otherwise.

Do Transactions with Both Protections Add Value for Minority Stockholders?

The core legal issue was framed by the parties' positions. The defendants argued that:

Under the current system of entire-fairness review, there is no incentive for controlling stockholders to condition their transactions on approval by both a special committee and the minority stockholders. This explains precisely why the question at issue has never come up before.
Entire-fairness review adds little benefit if the stockholders have already had the opportunity to vote no after a properly empowered special committee has already negotiated and evaluated the transaction.
There is currently inconsistency in Delaware law that the Court should address, as tender offers by controlling stockholders can escape entire-fairness review according to a certain line of Delaware cases, even though tender offers are by nature more coercive than mergers (for more on the uncertainty over the standard of review for tender offers by controlling stockholders, see Practice Note, Going Private Transactions: Overview: Key Issues for a Controlling Stockholder Acquiror: Tender or Exchange Offer Followed by a Short-form Merger).

The plaintiffs argued in response that:

Subjecting every controlling-stockholder transaction to review for their fairness benefits the minority stockholders.
The added protection of a majority-of-the-minority vote adds little value once the special committee has negotiated the transaction, because the stockholders who have not already sold their shares to arbitrageurs before closing will always vote for a premium.

Minority Stockholders Best Protected by Rule that Encourages Both Protections

The Court concluded that the rule of equity that best protects the interests of the minority investors is one that encourages controlling stockholders to accord the minority the combination of a condition of special-committee approval with a condition of the approval of the minority stockholders.

The Court reasoned that:

Under Delaware law, courts have a preference to defer to the business decisions of disinterested directors, who are expert in financial decisions and better placed to determine the best way forward for the corporation.
By giving controlling stockholders the opportunity to obtain the presumptions of the business judgment rule, courts create a strong incentive for controlling stockholders to give minority stockholders the benefit of both minority protections.
When the two protections are established upfront, the controlling stockholder knows it can neither:
- bypass the special committee's ability to reject the deal; nor
- offer up a majority-of-the-minority condition as a carrot in later stages of the negotiations, instead of offering a higher price.

Because of the benefit of these added incentives and protections, the Court concluded that the business judgment rule is the appropriate standard of review if:

The controlling stockholder conditions the transaction on the approval of both a special committee and a majority of the minority stockholders.
The special committee is independent, and empowered to engage its own advisors and potentially reject the deal.
The special committee meets its duty of care (such as by informing itself of all relevant financial information and evaluating other options to the controlling stockholder's offer).
The vote of the minority is informed and not coerced.

Practical Implications

With this decision, unless and until it is overturned by the Delaware Supreme Court (which Chancellor Strine openly concedes could very well happen), the Court of Chancery establishes that the presumptions of the business judgment rule are available to controlling stockholders wishing to acquire majority-owned corporations. As a result of this guidance, practitioners should advise clients in this position that they now have a benefit available if they offer, at the outset, both special-committee approval and minority-stockholder approval as conditions to completion of a transaction.

Although the Court in MFW strongly intimates that it would apply the same standard of review in a tender offer situation, by the Court's own reasoning as applied to Lynch and other Delaware Supreme Court decisions, its decision here would likely have to be considered dictum as applied to tender offers. However, if a test case were to be brought before the Court of Chancery, Chancellor Strine would almost certainly apply the same reasoning, assuming a non-coercive tender offer has been made. Until that time, practitioners can argue that Vice Chancellor Laster's opinion in CNX Gas, as the last word on the subject, is controlling.

In re MFW: Delaware Court of Chancery Applies Business Judgment Rule to Controlling Stockholder Transaction | Practical Law