New Risk of Below-Deal-Price in Appraisal Results
Last quarter, the Delaware courts issued the first post-Dell appraisal decisions—Aruba and AOL (issued by the Court of Chancery) and SWS Group (issued by the Delaware Supreme Court, affirming the Court of Chancery decision below). In Dell, the Supreme Court had held that, in the case of an arm’s-length merger with a “robust” sale process, the deal price is generally the best “proxy” for appraised fair value and should be given “heavy, if not determinative weight” in determining fair value. The Supreme Court had also directed that, even if the deal price were not fully reliable for determining appraised fair value (for example, because the sale process was not fully robust), the Court of Chancery still should consider the deal price and accord it an appropriate weight. In Aruba and AOL, however, as well as previously in SWS, the Court of Chancery ascribed no weight to the deal price and determined that fair value was below the deal price.
These decisions indicate that there is now a meaningful risk of a below-the-deal-price appraisal result in most cases involving arm’s-length mergers—whether the court deems the sale process to have been fully robust (as in Aruba) or not (as in AOL and SWS). At the same time, in our view, generally, the court is more likely to continue to reach above-the-deal-price results in non-arm’s-length merger cases (such as controller transactions, squeeze-outs, and certain MBOs-unless the transaction complies with the MFW prerequisites), and may also do so in arm’s-length merger cases involving a seriously flawed sale process. The new, meaningful risk of a potentially significant loss from seeking appraisal rather than accepting the merger consideration in an arm’s-length merger will accelerate the trend already underway of appraisal claims becoming rarer in this type of transaction. Further development awaits the possible appeal of Aruba and AOL and decisions by the Court of Chancery in Dell and DFC Global on remand. Please see here the in-depth analysis in our Briefing, When Appraisal is Likely to be Below the Deal Price in Arm’s-Length Mergers—And When It Is Not—The Meaning of Aruba, AOL and SWS.
Minority Stockholders with “Outsized Influence” May Be Deemed Controllers
Also in the last quarter, the Court of Chancery issued a number of decisions relating to controllers. These decisions highlighted that a minority stockholder can be deemed to be a controller if the stockholder possesses truly “outsized influence,” even though the stockholder does not have an equity stake or contractual rights that enable control. In the case of a transaction in which a minority stockholder was self-interested, if the stockholder is deemed to have been a controller, the transaction, if challenged, will be subject to “entire fairness,” which is the most stringent standard of judicial review (unless the MFW prerequisites of approval by an independent board committee and the unaffiliated stockholders are satisfied—in which case business judgment review would apply). Whether a minority stockholder will be viewed as a controller will be determined on a continuum based on (a) the extent of the stockholder’s influence over the board (with respect to the transaction at issue and generally) and (b) the extent of the process (if any) that was in place to separate the stockholder from the board’s consideration of the transaction (for example, recusal of the stockholder’s board designees from the board’s discussions and vote, a special committee with independent advisors, a fairness opinion, and/or a vote of the unaffiliated stockholders).
Rouse reflects that a minority stockholder (in this case, a 33% holder) generally will not be considered to be a controller with respect to a transaction in which it is self-interested—especially when there is no history of its having dominated the board, a special committee process was utilized, and the stockholder and its board designees were fully separated from the board’s consideration of the transaction. Tesla highlights that a minority stockholder may be deemed to be a controller if he had truly “outsized influence” (in this case, Elon Musk, a 22% holder)—when the stockholder, although he abstained from voting, had a history of dominating the board and was fully involved in the board’s consideration of the transaction in which he was self-interested. Oracle underscores that a minority stockholder with “outsized influence” (in this case, Larry Ellison, a 29% holder) may be deemed to be a controller even when a special committee process was utilized—if the stockholder had a history of dominating the board and there is evidence that others may have been acting as his agents to ensure completion of the transaction in which he was self-interested. Because in Oracle the court viewed the stockholder as likely having stealthfully acted through the company’s co-CEO (who was his “chief lieutenant” who was “unusually deferential” to him) to influence the special committee process, it remains an open question whether, in a case where a minority stockholder with “outsized influence” is involved, a regular special committee process would be sufficient for the stockholder not to be deemed a controller (or whether extraordinary steps would have to be taken to “disable” the stockholder’s outsized influence). It is to be emphasized that in most cases a minority stockholder, even if influential, does not have the type of outsized influence that the court addressed in Tesla and Oracle—and, in these cases, a state-of-the-art special committee process will meaningfully reduce litigation risk with respect to a transaction in which the stockholder is self-interested.
NEA involved a different context—a majority stockholder (thus, definitively, a controller) that allegedly caused the company to engage in transactions to benefit its other portfolio companies. The decision reaffirms the essential principle that a controller can act in its own self-interest when acting solely in its capacity as a stockholder, but cannot utilize the “corporate machinery” (directly, as a manager or director, or, indirectly, by dominating directors) to benefit itself at the expense of the other stockholders. Please see here our Briefing, Minority Stockholders With “Outsized Influence” May Be Deemed to be Controllers Even When There Is a Special Committee Process—and Other Points from Controller Decisions Issued in 1Q 2018.
Delaware Supreme Court Finds Corwin Inapplicable Because Stockholder Vote Not “Fully Informed”
In Appel v. Berkman (Feb. 20, 2018), the Delaware Supreme Court, reversing the Court of Chancery, held that Corwin was not applicable because the stockholder vote that approved the challenged transaction had not been “fully informed.” Under Corwin, if stockholders have approved a transaction in a fully informed and uncoerced vote, then business judgment review applies and “cleanses” any breaches of fiduciary duties by the company’s directors in connection with the transaction. The Delaware courts have only three times found Corwin to be inapplicable due to the stockholder vote having been “coerced,” and this is the first case in which Corwin was found to be inapplicable due to the vote not having been “fully informed.”
- Under certain circumstances, the reason for a director’s objection to a sale of the company approved by the board, and for his abstention from the board’s vote, must be disclosed. The Supreme Court was clear that the reason for a director’s abstention need not always be disclosed. In this case, the information that the director thought it was not the right time to sell the company was material, the court held, due to the director’s unique perspective on the company as he was also the founder, largest stockholder, longtime past CEO and still Chairman of the company.
Background. “CJ” founded Diamond Resorts International in 2007 and served as its CEO and Chairman from its inception through 2012. When the company went public in 2013, CJ remained as its Chairman. In 2016, the Diamond board formed a committee to review strategic alternatives for the company and the committee commenced a sale process. Two bids were received: one from private equity firm Apollo and one from another party that was at a lower price and subject to due diligence. After successfully negotiating with Apollo for a higher price, the board recommended that the stockholders sell their shares to Apollo. The proxy statement included expansive disclosure of reasons for and against the transaction and disclosed that all of the directors had unanimously approved it, other than CJ, who had abstained. Apollo acquired Diamond in a two-step cash tender offer followed by a merger under DGCL 251(h). Certain stockholders brought a post-closing action alleging breaches of fiduciary duties by the directors in connection with the transaction. The Court of Chancery had dismissed the case, at the pleading stage, under Corwin, as the court found that the facts pled in the complaint did not lead to a reasonable inference that the stockholders approving the transaction had not been fully informed or had been coerced. The Delaware Supreme Court, in an opinion written by Chief Justice Strine, reversed and remanded the case, holding that the alleged facts supported a reasonable inference that the vote had not been fully informed because the reasons for CJ’s objection to the deal and abstention from the vote had not been disclosed.
Under certain circumstances, reasons for an abstention may be material information that must be disclosed. The Supreme Court rejected the argument that, based on a long line of cases on which the Court of Chancery had relied, the reasons for a directors’ abstaining or dissenting vote on a sale of the company can never be material information that must be disclosed. CJ had abstained, he had told the board, because, in his view, mismanagement of the company (since its IPO and his steeping down as CEO) had “negatively affected the sale price and it was therefore not the right time to sell the company.” The Supreme Court reasoned that stockholders would have wanted to know this information and that it would have changed the total mix of information available to the stockholders amidst the “acres and acres” of space in the company’s Schedule 14D-9 devoted to disclosing the reasons for the sale.
When the reasons for an abstention may be material. The Supreme Court emphasized a “contextual approach” to determining whether the reasons for an abstention would be material. The court focused on CJ’s role as the founder, longtime CEO, still Chairman, and largest stockholder of the company. “For a Chairman to abstain from voting on the sale of the business he founded and led is no common thing….” The court appeared to suggest that CJ’s key roles provided him with a unique perspective on the company that made his reasons for objecting to the sale of particular interest to the stockholders. The court noted that the company had described CJ in its most recent proxy statement as having “a unique understanding of the opportunities and challenges that [the company] faces and in-depth knowledge of [the company’s] business, including [its] customers, operations, key business drivers and long-term growth strategies, derived from his 30 years of experience in the…industry and his service as [the company’s] founder and past Chief Executive Officer.” It was material, the court concluded, that CJ—“the Chairman of the Board, the very person who founded [the company] and under whose leadership as CEO the company flourished and became a global operation”—thought it was the wrong time to sell the company. The court also noted the “high stakes context” of a sale of the company in further supporting the materiality of the information that CJ—“a key board member if ever there were one”—objected to the timing of the transaction.
Practice Points. The decision is a reminder of the need for even greater focus on disclosure than in the past given the downside risk of flawed disclosure precluding the application of Corwin. If a “key director” who may have a unique perspective on the company due to his special roles (for example, as a founder) abstains from a vote, the company should consider whether disclosure of the reasons for the abstention should be disclosed.
Superior Court Rules on D&O Insurance for Director Loyalty Breach Based on Fraud
In Arch v. Murdock (Mar. 29, 2018), the Delaware Superior Court ruled that Delaware public policy does not preclude an insurer from indemnifying officers and directors for breaches of the duty of loyalty based on fraudulent conduct. The plaintiff insurance companies sought to apply California law, which expressly prohibits insuring directors against liability for willful misconduct. The Delaware court ruled that Delaware applied to Dole Food Company, Inc. (which is a Delaware corporation); and that “no Delaware case” has held, and no Delaware statute provides, that D&O liability insurance cannot cover fraudulent conduct.
Background. The plaintiff insurance companies provided Dole’s overall D&O liability insurance package. Dole, its former CEO and its former COO sought indemnification under the policies for the $222 million that they had agreed to pay in settlement of two stockholder suits in connection with the 2013 Dole take-private transaction. In one of these suits, the defendants were found to have breached the duty of loyalty through fraudulent misconduct and were assessed liability of almost $150 million. In a settlement of the suit, they agreed to pay 100% of the assessed damages plus interest, in lieu of appealing. In the other suit, a settlement was reached through mediation. When Dole and the officers sought indemnification for the settlement amounts under its D&O insurance, the insurance companies sought a declaratory judgment that public policy precluded their being obligated to fund a settlement of claims for fiduciary breaches that are based on fraudulent conduct. The Delaware Superior Court ruled to the contrary and subsequently refused to certify the case for expedited appeal to the Delaware Supreme Court.
No Delaware precedent that insuring against fraud claims is against public policy. The insurance companies contended that (i) California law applied, which expressly prohibits insuring against fraud; and (ii) if Delaware law applied, public policy precludes insuring against fraud. The Superior Court ruled that Delaware law applied and that, “[a]lthough it may strain public policy to allow a director to collect insurance on a fraud,” there is “no Delaware case” that has held that an insurance company providing indemnification for fraud would violate public policy and no explicit prohibition in Delaware statutory law. The Superior Court found that, in one of the underlying actions, the Court of Chancery’s post-trial rulings relating to fraud were “sufficiently definite to be a final judgment on the merits”—and therefore the parties were collaterally estopped from re-litigating those findings. The Superior Court refused to dismiss the case on the motion for summary judgment, however, finding that material issues of fact remained with respect to the breach of contract claims relating to whether Dole sufficiently cooperated with the insurance company as required under the policy and whether the insurance companies unreasonably withheld consent of the settlements.
Practice Points. The decision raises the issue whether, in their D&O policies, insurance companies will seek to expressly exclude indemnification for fraud. The decision also serves as a reminder that choice of law provisions in merger agreements should take into account the differences in state law with respect to fraud claims. In addition, the decision serves as a reminder to companies to carefully comply with the terms of insurance policies with respect to notice, consent and cooperation requirements relating to the settlement of claims.
Court of Chancery Says Violations of Industry Best Practices Do Not Excuse Demand
In Wilkin v. Orexigen (Feb. 28, 2018), the Court of Chancery dismissed claims against the directors of Orexigen Therapeutics Inc. for alleged breaches of fiduciary duties in connection with their having mishandled clinical drug trials the company was conducting.
- Violations of industry best practices do not excuse demand on directors to bring litigation. The decision reaffirms that the likelihood of personal liability for a majority of directors for violations of “positive law” will support a claim of demand futility and highlighted that violations of industry best practices will not support a claim of demand futility.
Background. Orexigen was developing an obesity drug that, in early trials, indicated unexpectedly that it might have “revolutionary” positive effects on cardiovascular health. Due to flawed handling of the confidentiality of the processes for seeking regulatory approval and patent protection for the drug, more people than anticipated became aware of the preliminary data. This threatened the integrity of the trial and necessitated the substantial expense of commencing a new trial. In addition, through the patent process, the preliminary data became public and, although the market initially reacted positively, when later data revealed that the preliminary results relating to cardiovascular benefits were an aberration (although the drug was still viable as a treatment for obesity), the stock price declined on the news. Stockholder-plaintiffs brought an action, claiming breaches of fiduciary duties. The defendants moved to dismiss the action for failure to plead demand futility and to state a claim. Vice Chancellor Montgomery-Reeves dismissed the case for failure to plead demand futility.
Failure to plead demand futility cannot be based on violations of best practices. The plaintiff alleged that seven of the eight directors knowingly caused the company to violate regulations and breach its confidentiality obligations with respect to the test results. The court concluded, however, that the directors’ actions, while they had violated industry best practices, did not violate any actual “legal obligations.” The court wrote: “A failure to follow best practices does not create a substantial likelihood of liability” that results in demand futility.
Proposed Amendment Would Limit Appraisal in Two-Step Stock-for-Stock Deals
Section 251(h) of the Delaware General Corporation Law, which was adopted in 2013, permits a “short-form,” two-step acquisition structure, without a stockholder vote being required in the second-step merger if, after the first-step, the acquiror holds the percentage of shares that would be required for approval of the merger if there were a vote. Under the Delaware appraisal statute as currently written (Sections 262(b)(1) and (2)), there is a “market-out exception” to appraisal rights in the case of long-form mergers (i.e., appraisal rights are not available if the merger consideration in a long-form merger consists solely of securities that are listed on a securities exchange or held by more than 2,000 holders). However, appraisal rights for short-form mergers are granted under Section 262(b)(3), which does not contain a market-out exception. Therefore, appraisal rights have applied in short-form mergers even when the merger consideration is comprised solely of marketable securities. An amendment to the appraisal statute, which was proposed on March 20, 2018, would extend the market-out exception to Section 251(h) mergers—which would then provide the advantage to companies of insulation from appraisal claims for these transactions. We note that, even though a Section 251(h) merger does not involve a stockholder vote, a Corwin defense is still available to directors in the case of a challenge to the merger (based on the Volcano decision, where the Court of Chancery, affirmed by the Delaware Supreme Court, held that the tender of shares by stockholders was the equivalent of a vote for Corwin purposes). Notably, however, other features of the 251(h) structure may continue to limit its attractiveness to companies—including that the timing advantage over a long-form merger may be obviated due to the requirement that the acquiror’s shares be registered, as well as the fact that, where a regulatory review period is applicable (and stockholders have the right to withdraw their shares until expiration of the period), the acquiror will be exposed to the potential of a topping bid during the extended offering period.
This post comes to us from Fried, Frank, Harris, Shriver & Jacobson LLP. It is based on the firm’s “M&A/PE Quarterly,” for April 2018, which is available here.