Kahn v. M&F Worldwide: Delaware Supreme Court Upholds Chancery Decision in MFW, but Opens Door to Challenges Against Controller Mergers

Practical Law Legal Update 4-561-5925 (Approx. 10 pages)

Kahn v. M&F Worldwide: Delaware Supreme Court Upholds Chancery Decision in MFW, but Opens Door to Challenges Against Controller Mergers

by Practical Law Corporate & Securities

Background

The decision is on an appeal of the Delaware Court of Chancery's final judgment entered in In re MFW Shareholders Litigation, 67 A.3d 496 (Del. Ch. 2013). 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 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 shares of MFW had closed the business day before on the NYSE at $16.96. 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.

The MFW board met the following day and formed a special committee of independent directors to consider the proposal. The independent directors resolved that the special committee would be empowered to:

Make whatever investigations of MacAndrews & Forbes' proposal that it deemed appropriate.
Evaluate the terms of the proposal.
Negotiate with MacAndrews & Forbes over any element of the proposal and the terms of any definitive agreement with respect to the proposal.
Report to the full board its conclusions, including a recommendation as to whether the proposal is fair and in the best interests of the stockholders of MFW other than MacAndrews & Forbes and should be approved by the board.
Determine to reject the proposal altogether.
Retain legal counsel and financial advisors as the committee deemed necessary.

The special committee went on to hire its own legal counsel and financial advisors and sought advice from its financial advisors as to other strategic options available to MFW. These options included exploring whether other buyers might be interested in acquiring MFW, in spite of MacAndrews & Forbes' commitment that it would not sell its shares to a third party. The committee also studied other possibilities such as asset divestitures that might have generated 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 negotiations 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 Court of Chancery Opinion

The plaintiffs had sought post-closing damages as a remedy for breach of fiduciary duty, while the defendants had moved for summary judgment on the plaintiffs' claim. The Court of Chancery granted summary judgment. In so doing, the Court of Chancery accepted the defendants' core argument that making the presumptions of the business judgment rule available for review of controlling-stockholder mergers would create a valuable incentive in which controllers would have reason to provide additional procedural protections to the minority stockholders.

Before MFW, a controlling stockholder could only shift the burden of proof to the plaintiffs by conditioning the transaction on either approval of a majority of the minority or a special committee of independent directors (Kahn v. Lynch Comc’n Sys., Inc., 638 A.2d 1110 (Del. 1994)). However, there had been no way under Delaware law to actually get out from under entire-fairness review in controlling-stockholder transactions. Then-Chancellor Strine ruled in MFW that the business judgment rule ought to be made available, subject to agreement by the Delaware Supreme Court (or the Delaware legislature), if the following conditions are met:

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.
The special committee is empowered to freely select its own advisors and to say no definitively.
The special committee acts with care.
The minority vote is informed.
There is no coercion of the minority.

Appeal

The plaintiffs appealed to the Supreme Court, contending on legal and factual grounds that the Chancery opinion should be overturned. The appellants argued that:

The Court of Chancery erred in holding that the business judgment standard should ever be applicable to controlling-stockholder transactions, even if both approval conditions are in place from the outset of the negotiations.
The special committee was in fact not disinterested and independent, was not fully empowered and was not effective in its negotiations with MacAndrews & Forbes.

Outcome

The Delaware Supreme Court rejected the appellants' arguments and accepted in large part the rationale and approach endorsed by the Delaware Court of Chancery.

The Supreme Court first addressed the appellants' legal argument that entire fairness should always be the standard applied to controlling-stockholder transactions. The Supreme Court saw this argument as having two component parts:

That Kahn v. Lynch and its progeny stand for the proposition that controlling-stockholder transactions are always reviewed for entire fairness.
That even though it is optimal to have both procedural protections in place, the two protections do not mimic an arms'-length negotiating dynamic and should not replace entire-fairness review, because:
- the "possible ineptitude and timidity of directors" may undermine the protection of the special committee; and
- a majority-of-the-minority vote may be unduly influenced by arbitrageurs who will always vote for a deal offering a premium of any size.

The Supreme Court rejected these arguments. On the matter of precedent case law, the court noted that in Kahn v. Lynch and other cases like Southern Peru and Kahn v. Tremont, the controller had never agreed to a non-waivable majority-of-the-minority condition (see In re Southern Peru Copper Corp. S'holder Deriv. Litig., 52 A.3d 761 (Del. Ch. 2011) and Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997)). Those cases were therefore inapposite.

The Supreme Court also rejected the appellants' substantive arguments, affirming the Court of Chancery's opinion on those issues. As the Court of Chancery had explained, Delaware jurisprudence does not hold such a skeptical view of the ability of independent directors to be effective at protecting stockholder interests, even if there are some directors who have little regard for their duties. As for the argument that the majority-of-the-minority vote will be undermined by short-term premium-seeking arbitrageurs, the Court of Chancery had explained that that argument does nothing to weaken the voluntary nature of the vote. As long as the vote was not made under coercive conditions, the fact that some stockholders' motive is to seek short-term gain does not make the vote any less free or fair.

Business Judgment Review Standard Adopted

Having rejected the appellants' arguments, the Supreme Court adopted the rule that business judgment is the standard of review to apply to mergers between a controlling stockholder and its subsidiary when the merger is conditioned on both the approval of an independent, adequately empowered special committee that fulfills its duty of care and the approval of the uncoerced, informed vote of a majority of the minority stockholders.

The Supreme Court gave four reasons for this rule:

Entire fairness, the highest standard of review in corporate law, does not need to apply to every single controlled-merger setting, as long as the controller has irrevocably and publicly disabled itself from using its control to dictate the outcome of the negotiations.
The dual procedural structure provide the best opportunity to protect the minority stockholders.
The application of business judgment is consistent with the central tradition of Delaware law, which is to defer to the informed decisions of impartial directors.
Both the dual-protection structure and the entire-fairness standard ultimately fulfill the same function: to obtain the best price. As the court explained, price has been the predominant factor in entire-fairness analysis since the decision in Weinberger v. UOP, Inc., which held that although entire fairness requires review of both price and process, in a non-fraudulent transaction price becomes the "preponderant consideration outweighing other features of the merger" (457 A.2d 701, 711 (Del. 1983)). The dual-protection structure adequately focuses on the obtainment of the best price because the special committee will seek to obtain the best price and the minority stockholders will have voted for that price.

The New Standard

After providing these rationales, the Delaware Supreme Court reworded the six conditions for application of the business judgment standard to controller buyouts:

The controller conditions the procession of the transaction on the approval of both a special committee and a majority of the minority stockholders.
The special committee is independent.
The special committee is empowered to freely select its own advisors and to say no definitively.
The special committee meets its duty of care in negotiating a fair price.
The vote of the minority is informed.
There is no coercion of the minority.

Of perhaps great significance (to be clarified in the future), the Supreme Court changed the Court of Chancery's formulation of the fourth condition. Where the lower court required that "the special committee acts with care," the Supreme Court added particular focus on the duty of care in negotiating the price. This apparently flows from the Supreme Court's fourth rationale for the new rule, that entire fairness and the dual-protection structure converge when they obtain the best possible price.

The Supreme Court immediately added in a footnote that the class complaint would have in fact survived a motion to dismiss under this new standard, precisely because of certain arguments that could have been made on price, specifically. The arguments cited by the Supreme Court were that:

The ratio of the offer price to profits per share and to pre-tax cash flow were well below those for similar recent transactions.
The final merger price was two dollars per share lower than the company's trading price two months earlier.
Short-term factors had depressed the value of the shares at the time of the offer.
Commentators viewed both the offer price and final merger price as surprisingly low.

According to the court in that footnote, these allegations about the sufficiency of the price would have called the adequacy of the special committee's negotiations into question and necessitated discovery on all the prerequisites to application of the business judgment rule. This does not mean that business judgment would not have ultimately been applied, especially in light of the court's positive factual findings about the special committee's conduct (see The Special Committee Exercised Due Care). However, these types of allegations are common to complaints over buyouts and raise questions as to whether controlling stockholders will ever be able to conduct themselves during the negotiation with an assumption that the merger process will be reviewed deferentially.

Further raising questions is the court's immediate warning after formulating the new rule that if a plaintiff can plead a reasonably conceivable set of facts showing that any of the enumerated conditions did not exist, the plaintiff will be entitled to conduct discovery. Furthermore, the court added, if triable issues of fact remain after discovery about the effectiveness of the procedural protections, the case will proceed to trial under entire-fairness review.

Factual Inquiry

Having laid out the new standard for application of business judgment, the Supreme Court addressed whether the conditions for business judgment were in place during the merger negotiations. Here the court adopted much of the Court of Chancery's analysis of the independence, powers and conduct of the special-committee directors and the efficacy of the stockholder vote.

The Special Committee Was Independent

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 have been "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.

The Special Committee Was Empowered

The court noted that it was undisputed that the special committee was empowered to hire its own legal and financial advisors, which the committee did hire. The committee was also empowered to not merely evaluate the offer, but to negotiate its terms, say no definitively and "make that decision stick." Finally, although MacAndrews & Forbes had told the board that it would not entertain any other transaction alternatives, the special committee considered other alternatives in case MacAndrews & Forbes would become more open to that possibility, including the possibility of selling to a third party.

The Special Committee Exercised Due Care

The court reviewed the conduct of the special committee to ensure that it had properly evaluated the offer. The court noted that:

The special committee had screened off any employees who worked for MacAndrews & Forbes.
The special committee instructed management to produce up-to-date projections for the business.
The financial advisors had created a range of valuations for the company based on a variety of methods, including a discounted cash flow analysis.
The special committee had directed its financial advisors to investigate the value of strategic alternatives, even though the offer price was within the range of the advisors' fair values.
The special committee successfully bargained for an additional dollar per share, even as the business was deteriorating and certain geopolitical and macroeconomic developments had created uncertainty for the company's future performance.

For these reasons, the court found that the special committee had satisfied the due-care prong of the test for applying business judgment. However, this entire section of the Supreme Court's opinion only buttresses the questions raised by the court's formulation of the standard. Much of this analysis reads like the type of analysis that would go into the process prong of entire-fairness review, not merely as a condition to qualifying for business judgment. Practitioners must consider carefully whether, as a practical matter, there is any meaningful distinction between this type of review and review for entire fairness, at least with respect to the process.

The Minority Stockholder Vote

The court noted that the appellants did not dispute that the majority-of-the-minority vote was fully informed in light of the disclosures in the proxy statement, and that the vote was uncoerced. Having rejected the argument that the vote of arbitrageurs should be discounted, the court ruled that the vote was free and fair.

Practical Implications

The Supreme Court's opinion establishes that the presumptions of the business judgment rule are available to controlling stockholders wishing to acquire majority-owned corporations. The decision confirms the legal benefit to be had for controlling stockholders to condition their offers at the outset on the approval of both an independent, empowered special committee and an informed, uncoerced majority of the minority stockholders. However, as discussed in The New Standard and The Special Committee Exercised Due Care, the Supreme Court's emphasis on due care in obtaining the best price and its review of the special committee's conduct raise questions as to how far that legal benefit extends. It will fall to the Delaware Court of Chancery to apply the test laid out in this case. Until then, controlling stockholders are best advised to assume that a review akin to entire fairness of the process undertaken by the target board (although not a review of the price itself) will still be applied to controller mergers.

The Supreme Court also left unaddressed the question of whether the business judgment rule is available to non-coercive tender offers by controlling stockholders that fulfill the same set of conditions. The Court of Chancery's MFW decision strongly intimated that it would apply the same standard of review in a tender offer situation, assuming a non-coercive tender offer is made. The Supreme Court's opinion, however, is completely silent on the issue. Until it is squarely addressed, practitioners can argue that the Court of Chancery's opinion in CNX Gas, which would apply the business judgment rule to qualifying tender offers, is the currently controlling law (see In re CNX Gas Corp. S'holders Litig., 4 A.3d 397(Del. Ch. 2010) and Practice Note, Going Private Transactions: Overview: Key Issues for a Controlling Stockholder Acquiror: Tender or Exchange Offer Followed by a Short-form Merger).

Kahn v. M&F Worldwide: Delaware Supreme Court Upholds Chancery Decision in MFW, but Opens Door to Challenges Against Controller Mergers | Practical Law