Sullivan & Cromwell discusses In re Orchard Enterprises, Inc. Stockholder Litigation

In October 2009, Dimensional Associates, LLC (“Dimensional”), the controlling stockholder of The Orchard Enterprises, Inc. (“Orchard”), which held 42% of Orchard’s outstanding common stock and 99% of its outstanding convertible preferred stock that collectively gave it approximately 53% of Orchard’s outstanding voting power, formally proposed a squeeze-out merger at a price of $1.68 per share, representing a 25% premium to the then-current stock price. Orchard’s board responded by forming a special committee with a mandate that included the right to negotiate or reject a transaction with Dimensional and to solicit interest from other third parties. While four of the five members of the special committee were facially independent, its chair had deep ties to members of the family of the controlling founder of Dimensional. The special committee retained independent legal and financial advisors and negotiated a 16 cent increase in the deal price to $1.84 per share. At a November 2009 meeting, the special committee received its financial advisor’s preliminary analysis concluding that Orchard’s minority shares had a value of $4.48 per share for purposes of a squeeze-out merger, valuing the convertible preferred stock on an as-converted basis, and not on the basis of its aggregate $25 million liquidation preference that they and Orchard’s CFO concurred was not owed by its terms upon a minority buyout by Dimensional.

A former executive of Orchard’s predecessor company (the “Third-Party Bidder”) thereafter submitted a proposal to acquire all of Orchard’s common stock at a price between $2.36 and $2.94 per share and all the convertible preferred stock for a combination of cash and stock in the surviving entity, conditioned on obtaining financing. When the special committee’s chair informed it of the higher Third-Party Bidder offer, Dimensional indicated that it would be willing to sell to a third party if it received its full liquidation preference. Based on that representation, the special committee directed the Third-Party Bidder to negotiate directly with Dimensional. Dimensional later informed the special committee that it was not interested in the alternate proposal because it said it had concerns about the financing contingency and the Third-Party Bidder was unwilling to pay the full liquidation preference; according to the plaintiffs, Dimensional was unwilling to sell even though the Third-Party Bidder offered a premium to the full liquidation preference of more than $7 million. On December 11, 2009, the Third-Party Bidder withdrew his proposal.

The special committee ultimately recommended a squeeze-out merger with Dimensional at $2.05 per share with a majority of the minority approval requirement and a go-shop (and a kicker if Dimensional flipped 80% or more of Orchard within six months). Valuing the convertible preferred stock using the full face amount of the liquidation preference, rather than on the as-converted basis of its preliminary analysis, the special committee’s financial advisor rendered its opinion that the squeeze-out merger was fair from a financial point of view to Orchard’s common stockholders.

During the extended 30-day go-shop period, 23 strategic bidders and 12 financial buyers were contacted, but no formal proposals were submitted.

The Third-Party Bidder thereafter reemerged with a revised proposal that the special committee determined (on the basis of the lack of committed financing) was not reasonably likely to lead to a superior proposal and therefore they could not pursue under the merger agreement’s no-shop. On July 29, 2010, the squeeze-out merger was approved by 58% of Orchard’s minority stockholders and closed.

Before the stockholders meeting, the chair of the special committee expressed an interest to Orchard in continuing to help Orchard following the merger; he received approximately $40,000 for the consulting work; thereafter he entered into a longer term consulting agreement with Orchard under which he was granted equity and was entitled to receive cash compensation greater than $100,000 annually; his total 2011 remuneration amounted to approximately $270,000.

After the merger closed, various Orchard stockholders pursued a statutory appraisal action that resulted in then Chancellor (now Delaware Supreme Court Chief Justice) Strine ruling that the “fair value” of Orchard’s common stock was $4.67 per share, $2.62 more than the per share merger price, based on his decision to value Orchard’s convertible preferred stock on an as-converted basis because the liquidation preference was not triggered by the transaction. Following the appraisal judgment, and two years after the merger closed, certain Orchard stockholders filed suit in the Court of Chancery, asserting that Dimensional, the Orchard directors who approved the merger and Orchard’s interim CEO breached their fiduciary duties by favoring the controlling stockholder’s interests (and, in the case of the special committee chair, his own interests) over the interests of Orchard’s minority stockholders. The plaintiffs also named Orchard itself as a defendant, arguing that Orchard could be directly responsible for breaches by its directors and that Orchard aided and abetted breaches of fiduciary duty by Orchard’s directors.

The plaintiffs sought summary judgment that Orchard and its directors and Dimensional breached their duties of disclosure insofar as the proxy statement disseminated to stockholders included materially false or misleading statements by (i) stating that the merger triggered the convertible preferred stock’s liquidation preference, (ii) allegedly not disclosing that the financial advisor was instructed by the special committee to value the convertible preferred stock based on its liquidation preference, (iii) not disclosing the full extent of the special committee chair’s financial and personal connections to the family of the founder of Dimensional and (iv) allegedly omitting the fact that Dimensional’s willingness to sell its position depended on third-party bidders paying a premium over the liquidation preference for the convertible preferred stock. The plaintiffs also sought summary judgment that entire fairness was the applicable standard of review for the merger and that as a matter of law the merger was not entirely fair. Among other things, the defendants asserted that the special committee members were exculpated from liability based on Orchard having an exculpatory charter provision under Section 102(b)(7) of the DGCL. Both sides moved for summary judgment on the remedies available under the plaintiffs’ theories of liability.

The full and original memo was published by Sullivan & Cromwell LLP on March 14, 2014 and is available here.