On March 7, 2017, the Delaware Chancery Court granted a motion to dismiss in In re Columbia Pipeline Group, Inc. Shareholder Litigation, which capped a line of cases starting with Corwin v. KKR Financial Holdings LLC and continued with In re Volcano Corporation Shareholder Litigation that clarified that the business judgment rule applies to tender offers and to mergers that are approved by a “fully informed, uncoerced vote” of disinterested stockholders in which the merger counterparty is a non-controlling stockholder or a non-conflicted controlling stockholder.[i] Read together, these cases provide a roadmap for practitioners to limit post-closing stockholder litigation involving transactions with such stockholders by providing adequate disclosure of the negotiation process, the relationship between the company and its financial advisor and the analysis undergirding any fairness opinion. Here, we will outline the following key questions that directors, financial advisors and practitioners should consider in order to maximize the chance that approval of a transaction will be subject to the protection of the business judgment rule:
1. Is the transaction with a stockholder that is (a) a “controller” and (b) “conflicted”? If not, then the approval of the transaction by a “fully informed, uncoerced vote” of disinterested stockholders will cleanse the transaction and the business judgment rule will apply.
2. If the transaction counterparty is not a “controller” or is a controller that is not “conflicted” and the shareholders vote to approve the transaction, then what determines whether such vote was “fully informed”? In general, stockholders must be provided material information pertaining to the transaction, which information is not misleading or omits material facts. Examples of subsidiary issues relating to the materiality standard for disclosure follow below:
a. Have the material facts pertaining to the negotiation of the transaction been disclosed?
b. Has the relationship between the company and its financial advisor been described?
c. If a fairness opinion is presented in the proxy, have the “key inputs” to the analysis undergirding the fairness opinion been sufficiently disclosed?
(1) Is the transaction with a stockholder that is (a) a “controller” and (b) “conflicted”?
Standing at the center of the analysis under Delaware law of whether one party to a transaction is a “controller” is whether such party could exercise control over the board of directors of the other party to the transaction. The Corwin line of cases distinguishes between this narrow formulation of control and contractual or other commercial relationships between the parties to a transaction that may merely confer rights in favor of one party with respect to the other party.
In Corwin, the company at issue merged with an entity that held 1% of the common stock of the company, but the company and the other entity were parties to a management agreement pursuant to which the company delegated responsibility for its day-to-day operations to the other entity, including providing employees and office space and administering other back-office functions. The Delaware Supreme Court endorsed the analysis of the Delaware Chancery Court, which noted that, while the entity “managed the day-to-day operations of [the company],” the management contract did not demonstrate that the other entity “controlled the [company] board—which is the operative question under Delaware law—such that the directors of [the company] could not freely exercise their judgment in determining whether or not to approve and recommend to the stockholders a merger with [the entity].”[ii] Further, the Delaware Supreme Court explained that the entity “had no right to appoint any directors, and had no contractual right to veto any board action” of the company and that the company had “real assets” and an “independent board” that could choose its own course of action and otherwise could act without the other entity’s consent.[iii]
Standing on the other side of the ledger, as noted in Larkin v. Shah,[iv] is the test for control set forth in In re Cysive, Inc. Shareholders Litigation. In Cysive, the court found that a company’s founder, chairman and chief executive officer who held 35% of the company’s outstanding stock was a controller because he wielded control over two immediate family members and stockholders whom he had installed as officers and directors, which gave him “day-to-day managerial supremacy” and the ability to effectively control a total of 40% of the common stock to his own benefit.[v] A more recent Delaware Chancery Court opinion summarized Cysive and found that, in the absence of a “significant showing” similar to that made in Cysive, “the courts have been reluctant to apply the label of controlling stockholder . . . to large, but minority, blockholders.”[vi]
The analysis does not end simply with control, however, for purposes of whether a transaction constitutes a “conflicted transaction” and, as such, merits the application of the entire fairness standard. Such transactions arise when the controller stands on both sides of a deal (as when, for instance, a parent acquires a subsidiary), as well as when the controller “derived a personal financial benefit to the exclusion of, and detriment to, the minority stockholders.”[vii] If a controller is merely selling its shares and receiving the same consideration as the minority shareholders, then the controller’s and the minority shareholders’ interests are not in conflict and the entire fairness standard is not applied. For example, the Delaware Chancery Court found that the entire fairness standard did not apply in In re Merge Healthcare Inc., in which a putatively-controlling 26% stockholder sought to sell its shares to obtain liquidity and, as such, was “fully aligned with the stockholders’ interest to obtain the highest price possible.”[viii] Further, Delaware courts have reacted skeptically to allegations that a controlling stockholder seeking liquidity for its shares had accelerated the sale process to such an extent that it became a “fire sale” and resulted in a diminution of consideration paid to all shareholders. These theories rely on the counterintuitive notion that in such cases a controller will not seek to maximize its own consideration. The courts have reacted by indicating that such theories will be substantiated only if the plaintiffs make specific allegations describing a unique liquidity need.[ix]
(2) If the transaction counterparty is not a “controller” or is a controller that is not “conflicted” and the shareholders vote to approve the transaction, then what determines whether such vote was “fully informed”?
For a stockholder vote to be “fully informed,” the corresponding proxy statement must contain “material information” pertaining to the “integrity or financial fairness of the transaction” and not contain “materially misleading disclosure and omissions.” By the same token, “‘fully informed’ does not mean infinitely informed” and, as such, “[r]edunant facts, insignificant details, or reasonable assumptions need not be disclosed. Nor must information be disclosed simply because a plaintiff alleges it would be helpful or interesting.”[x] Rather, information is material if “from the perspective of a reasonable stockholder, there is a substantial likelihood that it significantly alters the total mix of information made available.”[xi] Claims pertaining to the adequacy of disclosure to stockholders arise in the context of both pre-closing disclosure claims, heard on a motion for preliminary injunctive relief, post-closing disclosure claims alleging a breach of fiduciary duty by the board of directors.[xii] A discussion of various manifestations of this standard in both contexts follows below.
(a) Have the material facts pertaining to the negotiation of the transaction been disclosed?
Regarding disclosure of the negotiation process, the proxy must include disclosure of “all of the objective facts regarding” the interests of the company’s board of directors and the stockholder at issue, the negotiation process and any “troubling facts regarding director behavior . . . that would have been material to a voting stockholder.”[xiii] Notably, in emphasizing the importance of disclosing “objective facts,” a proxy statement need not include, for instance, how certain directors or officers were selected to lead a negotiation, as “asking ‘why’ does not state a meritorious disclosure claim.”
The standard requiring only disclosure of material objective facts serves as a useful lens through which to understand how particular events in a negotiation should be conveyed. For instance, in Corwin, the plaintiffs alleged an inadequacy in the proxy disclosure as to the whether certain allegedly non-independent directors played a role in negotiating the transaction at issue. The court responded by noting the detail with which the directors’ role was explained in the proxy and concluded that the gravamen of the plaintiffs’ complaint was that the proxy did not explain why the directors at issue spearheaded the negotiations, and that merely asking this question is insufficient to raise a claim.[xiv] Similarly, in In re Solera Holdings, Inc. Stockholder Litigation, the plaintiffs alleged that a proxy statement did not provide sufficient detail regarding a supposed shift in compensation strategy for the company’s senior officers away from long-term performance and towards consummating a transaction. However, the proxy statement did include detailed factual disclosure about the nature of the cash and stock awards granted to management, including the milestones for obtaining such awards. As such, the court found no deficiency because all the relevant facts pertaining to management’s compensation were provided, and the absence of one potential explanation for the shift was insufficient to merit a disclosure claim.[xv]
A frequently litigated issue is whether and to what extent the details of other offers that a company may have received constitutes “material information” that necessitates disclosure. The touchstone of whether other offers should be disclosed generally is whether the company had determined that negotiations with a potential counterparty had merit. For instance, in City of Miami v. Comstock, the plaintiffs alleged deficiencies in a proxy statement that referenced in passing an acquisition proposal from a third party that the special committee determined, based on the advice of its legal counsel and financial advisor, was not reasonably likely to lead to a superior proposal. The plaintiffs claimed that the proxy statement should have contained the financial terms of the third party’s proposal and statements to the effect that the special committee’s financial advisor did not analyze certain forecasts and synergy projections relating to the bid of the third party. The court rejected these arguments on the premise that they recast the plaintiffs’ substantive disagreement with the special committee’s decision as a disclosure claim and held that Delaware law “does not require disclosing details about offers that directors conclude are not worth pursuing.” Rather, disclosure that adheres to the objective facts of a negotiation without speculating as to a particular party’s motivation is sufficient.[xvi] Even where a company does view a competing bid in the first instance as having merit, the good-faith determination that such bid could not, following negotiation, be improved so as to constitute a superior proposal will correspondingly obviate the need to provide detailed disclosure on such bid, as explained in In re OM Group, Inc. Stockholders Litigation.[xvii]
(b) Has the relationship between the company and its financial advisor been adequately described?
For a stockholder vote to be considered “fully informed,” a proxy must contain “full disclosure of investment banker compensation and potential conflicts”[xviii] that permits stockholders to “understand what factors might influence the financial advisor’s analytical efforts.”[xix]
The Delaware Chancery Court’s decision in OM Group provides helpful instruction on this point. The plaintiffs challenged the adequacy of a proxy that disclosed the amount of the payment to be made to the investment bank providing the fairness opinion by the company. The disclosure made clear that such payment was contingent upon the consummation of the merger and indicated that the investment bank had previously received over €140 million in fees from the company’s merger counterparty for a variety of investment and commercial banking services over the prior three-year period. The proxy further indicated that the company’s board knew that the investment bank had received “significant fees,” but that the board did not know the amount when it engaged such bank.
The plaintiffs alleged that the proxy was inadequate because it did not disclose the fact that the company’s board initially considered retaining the investment bank on a fixed-fee basis before switching to a contingency fee structure and because it did not make clear that the board did not know the amount of the fees previously received by the investment bank from the merger counterparty. As to the first point, the court found that such internal deliberations constituted non-material “play-by-play” information and cited approvingly an earlier holding that a “board’s underlying reasons for acting” are generally not deemed material. As to the second point, the court emphasized that the information would not have added to the total mix of information available to stockholders and noted, in a footnote, that such disclosure might have exposed the board to a potential claim for a breach of the duty of care. Yet, in such circumstances, the court noted that a “board is not required to engage in ‘self-flagellation’ and draw legal conclusions implicating itself in a breach of fiduciary from surrounding facts and circumstances prior to a formal adjudication of the matter.”[xx] More recently, in Columbia Pipeline Group, in refuting the plaintiffs’ argument that a proxy statement failed to disclose that directors stood to benefit personally from engineering a spinoff (notwithstanding that the proxy did disclose certain change-of-control benefits to which such directors would be entitled in the event of such a transaction), the court observed, “When a proxy statement describes the facts that create differing incentives for fiduciaries, it need not explain how those differing incentives could produce a self-interested outcome.”[xxi]
Correspondingly, Volcano involved a transaction in which the company’s investment bank had previously helped finance the company through the purchase of certain warrants. Upon the consummation of the contemplated transaction, the company would be obligated to pay the investment bank a spread based upon the value of those warrants. The proxy disclosed that the investment bank had received the warrants and that the value of the warrants would decline over time, which would incentivize the investment bank to consummate the transaction as soon as possible; however, the plaintiffs alleged a deficiency in that the proxy failed to describe the “exponential” rate at which the warrants would decay, which would presumably accentuate the investment bank’s incentive. Nonetheless, the court rejected this argument in part because disclosure of the objective fact that the warrants would decline in value was sufficient to illustrate the incentive that the investment bank had in working to consummate the transaction, and adding detail about the rate at which the warrants would decline in value would only marginally improve the stockholders’ understanding of the incentives at work.[xxii]
(c) Have the “key inputs” to the fairness opinion been sufficiently disclosed?
In presenting the analysis underlying a fairness opinion, “the valuation methods used to arrive at that opinion as well as the key inputs and range of ultimate values generated by those analyses must also be fairly disclosed.”[xxiii] As such, “a disclosure that does not include all financial data needed to make an independent determination of fair value is not per se misleading or omitting a material fact.”[xxiv]
The Delaware Chancery Court’s recent decision in Merge Healthcare provides a useful gloss on this standard. The proxy statement at issue contained a fairness opinion with a discounted cash flow analysis of the company, indicated that the net present value of net operating losses was included in such analysis and stated the discount rate applied to such net operating losses. The Plaintiffs alleged that the board failed to disclose the standalone net present value of the company’s net operating losses because such net present value comprised a material portion of the valuation of the company. The court rejected this argument on the premise that the proxy already included “key inputs,” which it listed as revenue, gross profit, EBITDA, EBIT, net income, earnings per share and unlevered free cash flows, and further concluded that the addition of information pertaining to the net operating losses would not “alter the total mix of information available to the stockholders given the fair summary of [the financial advisor’s] work already contained in the Proxy.”[xxv]
* * *
In recent months, Corwin and its progeny have been adopted or cited favorably by several non-Delaware courts.[xxvi] As such, directors, financial advisors and practitioners across jurisdictions would be well-served in understanding the path set forth by the Delaware courts towards ensuring that disinterested stockholders approve transactions through a “fully informed, uncoerced vote.”
[i] See In re Columbia Pipeline Grp., Inc. S’holder Litig., C.A. No. 12152-VCL (Del. Ch. filed Mar. 7, 2017); In re Volcano Corp. S’holder Litig., 143 A.3d 727 (Del. Ch. 2016), aff’d, No. 372, 2016, 2017 WL 563187 (Del. Sup. Ct. Feb. 9, 2017) (Strine, C.J.); Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015), aff’g, In re KKR Fin. Holdings LLC S’holder Litig., 101 A.3d 980 (Del. Ch. 2014); see, e.g., In re Merge Healthcare, Inc., Consol. C.A. No. 11388-VCG, 2017 WL 395981 (Del. Ch. Jan. 30, 2017); In re Solera Holdings, Inc. S’holder Litig., C.A. No. 11524-CB, 2017 WL 57839 (Del. Ch. Jan. 5, 2017); In re OM Grp., Inc. S’holders Litig., Consol. C.A. No. 11216-VCS, 2016 WL 5929951 (Del. Ch. Oct. 12, 2016); Larkin v. Shah, C.A. No. 10918-VCS, 2016 WL 4485447 (Del. Ch. Aug. 25, 2016); City of Miami Gen. Emps. & Sanitation Emps. Ret. Trust v. Comstock, C.A. No. 9980-CB, 2016 WL 4464156 (Del. Ch. Aug. 24, 2016).
[ii] KKR Fin. Holdings, 101 A.3d at 991-95; accord Corwin, 125 A.3d at 306-08.
[iii] Corwin, 125 A.3d at 307-09 & n.7.
[iv] Larkin, 2016 WL 4485447, at *14.
[v] In re Cysive, Inc. S’holders Litig., 836 A.2d 531, 551-52 (Del. Ch. 2003).
[vi] In re Crimson Exploration Inc. S’holder Litig., C.A. No. 8541-VCP, 2014 WL 5449419, at *11-12 (Del. Ch. Oct. 24, 2014).
[vii] In re Synthes, Inc. S’holder Litig., 50 A.3d 1022, 1034 (Del. Ch. 2012) (internal quotations marks omitted); see Larkin, 2016 WL 4485447, at *8 & nn. 45-46.
[viii] Merge Healthcare, 2017 WL 395981, at *8.
[ix] Synthes, 50 A.3d at 1035-36; accord Larkin, 2016 WL 4485447, at *16 & n.96.
[x] Merge Healthcare, 2017 WL 395981, at *9.
[xi] In re Trulia, Inc. S’holder Litig., 129 A.3d 884, 899 (Del. Ch. 2016) (internal quotation marks omitted).
[xii] See, e.g., Nguyen v. Barrett, C.A. No. 11511-VCG, 2016 WL 5404095, at *3 (Del. Ch. Sept. 28, 2016).
[xiii] Corwin, 125 A.3d at 312 & n.27.
[xiv] KKR Fin. Holdings, 101 A.3d at 1000-01 (internal quotation marks omitted).
[xv] Solera Holdings, 2017 WL 57839, at *11-12.
[xvi] City of Miami, 2016 WL 4464156, at *14-15.
[xvii] OM Grp., 2016 WL 5929951, at *12-14.
[xviii] In re Del Monte Foods Co. S’holders Litig., 25 A.3d 813, 832 (Del. Ch. 2011).
[xix] David P. Simonetti Rollover IRA v. Margolis, C.A. No. 3694-VCN, 2008 WL 5048692, at *8 (Del. Ch. June 27, 2008).
[xx] OM Grp., 2016 WL 5929951 at *16-17 & nn. 92, 95 (internal quotation marks omitted).
[xxi] Columbia Pipeline Grp., slip op. at 6.
[xxii] Volcano Corp., 143 A.3d at 749.
[xxiii] In re Netsmart Techs., Inc. S’holders Litig., 924 A.2d 171, 203-04 (Del. Ch. 2007).
[xxiv] Nguyen v. Barrett, C.A. No. 11511-VCG, 2015 WL 5882709, at *4 (Del. Ch. Oct. 8, 2015).
[xxv] Merge Healthcare, 2017 WL 395981, at *12.
[xxvi] See, e.g., In re Xtreme Power Inc., 563 B.R. 614, 633 (Bankr. W.D. Tex. 2016); In re Tribune Co. Fraudulent Conveyance Litig., No. 12-CV-2652 (RJS), 2017 WL 82391, at *7 (S.D.N.Y. Jan. 6, 2017); Quinn v. Knight, C.A. No. 3:16-cv-610, 2016 WL 6471462, at *3 (E.D. Va. Nov. 1, 2016); MAZ Partners LP v. Shear, C.A. No. 11-11049-PBS, 2016 WL 4574640, at *7 (D. Mass. Sept. 1, 2016).
This post comes to us from Gibson, Dunn & Crutcher LLP. It is based on the firm’s memorandum, “Transactions with Non-Conflicted Controlling Stockholders and Obtaining the ‘Fully Informed, Uncoerced Vote’ of Disinterested Stockholders,” dated March 29, 2017, and available here.