On October 14, 2011, the Delaware Court of Chancery issued an opinion that sends a firm reminder to company boards considering a transaction with a controlling stockholder of the importance of the transaction being entirely fair to the company and its minority stockholders. In In re Southern Peru Copper Corp. Shareholder Derivative Litigation, Chancellor Strine found that the controlling stockholder defendants breached their fiduciary duty of loyalty in a transaction involving the controlling stockholder’s subsidiary (see Practice Note, Fiduciary Duties of the Board of Directors: Duty of Loyalty). Although the board of Southern Peru Copper Corporation (Southern Peru) created a special committee to evaluate the proposed transaction with the controlling stockholder, Chancellor Strine found significant shortcomings on the part of the committee when assessing whether the transaction was subject to a fair process and had a fair price.

Finding that Southern Peru overpaid by over a billion dollars when it acquired the controlling stockholder's subsidiary, the Court of Chancery awarded the plaintiffs $1.263 billion in damages (with interest at the statutory rate from the date of the judgment) to remedy the breach of the controlling stockholders fiduciary duties.

Grupo Mexico, S.A.B. de C.V. (Grupo Mexico), is the controlling stockholder of Southern Peru, a mining company listed on the NYSE. In February 2004, Grupo Mexico, while holding 54.17% of Southern Peru's capital stock (and 63.08% of its voting power), proposed that Southern Peru acquire its 99.15% ownership interest in a privately-held Mexican mining company, Minera Mexico, S.A. de C.V. (Minera). Grupo Mexico initially asked that Southern Peru pay approximately $3.05 billion in its common stock for the Minera stake.

Recognizing the self-interest inherent in the proposed acquisition, Southern Peru's board formed a special committee of disinterested directors to evaluate the transaction. The special committee hired its own financial and legal advisors, including Goldman Sachs, to assist it in reviewing the proposed merger. However, no alternative transactions were considered during the special committee's deliberations.

Goldman initially performed an "Illustrative Give/Get Analysis" which determined that Minera was worth no more than $1.7 billion. However, with a valuation gap of about $1.4 billion, the special committee and Goldman Sachs soon after revised the valuation method to include a relative discounted cash flow analysis instead of Minera's standalone analysis. At the meeting where the special committee unanimously approved the merger, Goldman presented various "relative DCF analyses" and a "contribution analysis at different EBITDA scenarios" which ultimately resulted in Goldman issuing a written fairness opinion.

Over eight-months, the special committee and Grupo Mexico negotiated a deal in which the parties entered into a definitive agreement providing for, among other things:

The value of Southern Peru's stock increased significantly while the merger was pending, primarily because of the company's performance and the price of copper. Despite the escalating value of the Southern Peru stock after signing the merger agreement, the special committee did not request an updated fairness opinion before closing. At the company's special meeting, over 90% of Southern Peru's stockholders voted to approve the merger. In April 2005, when the transaction closed, the Southern Peru shares issuable in the merger had a market value of $3.75 billion.

Southern Peru stockholders filed a derivative suit challenging the merger on the basis that the merger was "entirely unfair" to Southern Peru and its minority stockholders. Chancellor Strine characterized the plaintiff's argument as one in which the controlling stockholder received something "demonstrably worth more than $3 billion … in exchange for something that was not worth nearly that much …."

The Southern Peru decision examined the main issue of whether the merger was entirely fair, satisfying the conditions of both a:

In his decision, Chancellor Strine found that the merger was not entirely fair, in process or in price, and that the defendants breached their duty of loyalty. While a special committee is usually formed to refute potential claims by minority stockholders that the controlling stockholder acted only in its best interests (and not the best interests of all stockholders), Chancellor Strine was particularly critical of the Southern Peru special committee. He suggested that the special committee, while comprised of qualified and competent members, failed to discharge a fair process because it "fell victim to a controlled mindset and allowed Grupo Mexico to dictate the terms and structure of the merger."

In its ruling, the Court described many key areas where the special committee's shortcomings heavily impacted the fairness of the transaction, some of which include:

For a discussion on why and how to establish a special committee, including when a special committee is needed, a proper mandate for the special committee and how to conduct a proper process, see Practice Note, Making Good Use of Special Committees. For information on fairness opinions, including the reasons to obtain a fairness opinion, its main components, disclosure obligations and the key issues that counsel should consider when advising clients, see Practice Note, Fairness Opinions.

The Court of Chancery awarded damages in the amount of $1.263 billion which is roughly the difference between the value of the Southern Peru stock issued at the closing and its determination of Minera's value during that same period ($2.43 billion). Chancellor Strine noted that Grupo Mexico could satisfy the judgment by returning Southern Peru's stock back to it.

The Southern Peru decision highlights the Court of Chancery's sensitivity to transactions with controlling stockholders. This case illustrates the point that when a special committee is assembled to consider a transaction with a controlling stockholder, it must have the broad discretion and power to evaluate alternatives to the controlling stockholder's proposal in earnest. Evaluating only the controlling stockholder's transaction in the face of other strategic options may well render the committee's process unfair to the minority stockholders and the company. Further, the committee's acceptance of its limited mandate may suggest that it is already susceptible to a controlled mindset.

Along the same vein, special committees must act and establish a record to demonstrate that their negotiations were in line with negotiations that would take place between unrelated third parties. Chancellor Strine pointed out that the special committee seemed to stretch itself in accepting an untraditional valuation analysis to justify the price demanded by the controlling stockholder, rather than to leverage the position that it had in the transaction.

Lastly, Chancellor Strine's opinion included a considerable discussion on the special committee's failure to seek out an update to the fairness opinion from its financial advisor.

Boards of companies undertaking stock-for-stock transactions should consider this case when determining whether or not to request a bring-down fairness opinion, especially in situations where the merger agreement does not include a collar or a walk-away right to protect it from a considerable increase in the acquiror's stock price, resulting in overpayment for the target company.