Delaware courts have recently had opportunities to address the dual conditions for management of controlling stockholder conflict transactions under Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”) and its progeny. That MFW structure provides a valuable tool for deal planners seeking to avoid litigation risk despite the presence of a controlling stockholder. The courts’ analysis under MFW provides extensive guidance regarding the effective implementation of measures for conflict management at both the board- and stockholder-levels, and that guidance may be applied in the context of transactions with and without a controlling stockholder conflict.
Dual Conditions Under MFW
Through the MFW framework the court will review a transaction involving a conflicted controlling stockholder under the business judgment standard when the transaction is conditioned, from the beginning of substantive economic negotiation, on approval by (1) an independent, fully empowered board committee that fulfills its duty of care and (2) the uncoerced, informed vote of a majority of the unaffiliated stockholders. The requirements for that standard are meant to disable the influence of a controller; because a controller’s influence is viewed by Delaware case law as affecting transactions from early stages of negotiation, it is perhaps understandable that implementation of the MFW dual conditions must also occur before substantive economic bargaining (e.g., signing NDAs, signing term sheets, participating in detailed valuation exercises involving company management and the potential buyer). Since adoption of this standard and in recent decisions, Delaware courts have continued to refine its requirements. Although it can be hard to detect when a glimmer of an idea might turn into a prospect worth incurring legal costs associated with imposing additional procedure, deal planners must nevertheless attempt to be vigilant about where a potential transaction might lead, and how it might intersect with various directors’ and stockholders’ interests, to ensure that a company desiring to take advantage of MFW has the opportunity.
In two decisions regarding Tesla Motors, Inc., Vice Chancellor Joseph Slights examined the MFW standard. First, the court addressed a challenge to the executive compensation package of Tesla’s largest stockholder and CEO. Tornetta v. Musk, C.A. No. 2018-0408-VCS (Del. Ch. Sept. 20, 2019) (denying a motion to dismiss following stockholder-plaintiffs’ inspection of books and records pursuant to Section 220). The court held that, if the CEO were found to be a controlling stockholder, claims regarding his compensation would be subject to entire fairness unless MFW was satisfied. In this regard, the court rejected the defendants’ argument that MFW should only apply to transformative transactions or transactions where Delaware law requires board and stockholder approval: “Having found no principled basis to distinguish the coercive implications of controller compensation transactions from other (even transformational) conflicted controller transactions, I can find no basis to conclude, on the pleadings, that the stockholder vote approving the Award would not be subject to the coercive forces inherent in controlling stockholder transactions.” The court also indicated that, although the compensation package was conditioned on approval of a majority of the disinterested shares present at the stockholder meeting – not a majority of the company’s outstanding disinterested shares, because the stockholder vote met the quorum and voting requirements of Section 216 of the DGCL and no other DGCL provision required a majority of the outstanding stockholder voting power – this disinterested stockholder vote was sufficient to shift the burden of proving unfairness to the plaintiff.
Second, Vice Chancellor Slights found flaws with the approval by Tesla stockholders of its $2.6 billion merger with SolarCity Corporation, two public companies with the same significant stockholder. In re Tesla Motors, Inc. Stockholder Litig., C.A. 12711-VCS (Del. Ch. Feb. 4, 2020) (denying defendants’ motion for summary judgment following stockholder-plaintiffs’ inspection of books and records pursuant to Section 220 and litigation discovery). In this decision, the court found deficiencies with respect to the company’s disclosures and rejected the defendants’ argument that the plaintiff was required to plead facts that the alleged controller actually coerced or threatened the public stockholders. With respect to the latter argument, the court stated that there was no support in the case law for that position, concluding that a controller’s influence is “inherently coercive,” which warrants the application of the entire fairness standard of review. This could be viewed as demonstrating the sensitivity of the trigger for entire fairness once a controller is found to exist.
In Brown v. Empire Resorts, Inc., C.A. No. 2019-0908-KSJM (Del. Ch. Feb. 20, 2020) (TRANSCRIPT) (granting stockholder-plaintiff’s petition for inspection of books and records pursuant to Section 220), Vice Chancellor Kathaleen McCormick addressed a $129 million going-private transaction between Empire Resorts and its 88 percent stockholder. The parties had attempted to follow the MFW framework, and this decision arose in the context of a dispute between the parties over the plaintiffs’ books and records demand to investigate wrongdoing in connection with the transaction. The court found that the plaintiffs had stated a credible basis for wrongdoing given several potential flaws in the committee process. The court expressed concern that the board had met on June 21, 2019, and decided to form a committee, but the committee’s powers were not effective until July 1, 2019. In the interim, the financial adviser the committee came to use, which had historically advised the board, met with the controller without any committee members present. The court next found that it appeared that a committee member had leaked discussions to the controller and that the controller threatened to cease negotiations at one point if a deal wasn’t signed within days – all of which indicated to the court that the committee’s process potentially had been undermined. The court also addressed potential disclosure deficiencies in the proxy relating to projections, which constituted shortcomings in the MFW process and justified the stockholder-plaintiff’s inspection of various books and records (including directors’ emails, which the court found would be necessary for the plaintiffs to explore some of the potential allegations, such as the possible leak by a committee member).
Amtrust Financial Services
In In re Amtrust Financial Services, Inc. Stockholder Litig., No. 2018-0396-AGB (Del. Ch. Feb. 26, 2020) (denying the motion to dismiss a complaint based on public disclosures), Chancellor Andre Bouchard addressed claims arising from the $2.9 billion Amtrust, Inc. going-private transaction. There, as in Empire Resorts, the board attempted to implement the MFW framework, but the court found shortfalls including that three out of four special committee members had a disabling conflict in the dismissal of pending derivative litigation that was extinguished in the transaction. The court noted that, by seeing the company entirely into the hands of the controlling family, the three directors who were also defendants in the other litigation could be viewed as sitting on both sides of the negotiation. The court held that this conflict was critical because, although “the second MFW condition speaks in terms of the ‘independence’ of members of a special committee . . . the committee members must have no disabling personal interest in the transaction at issue.” In addition to the committee-level conflict, the stockholder vote allegedly approved a different deal than that negotiated and approved by the special committee through its deliberations. The committee’s deal had met resistance from a major disinterested stockholder who, after the committee approved the initially priced deal, proposed a higher deal price in a meeting with the CEO and a member of the control group. Based on the fact that this higher price was the term that was submitted to the disinterested stockholders, the plaintiffs argued that the transaction at this price was not the product of the special committee’s work but rather a product of the stockholder’s negotiations with the control group and that, consequently, the committee had not been “effective” as contemplated by MFW. Because the motion to dismiss was denied on the basis of the special committee issue, the court did not reach the “interesting and seemingly novel question” of whether every aspect of the transaction need be negotiated by the special committee to satisfy MFW.
More recently, Vice Chancellor Travis Laster addressed the MFW protections in the context of the $22 billion transaction in which Dell Technologies Inc. collapsed its tracking stock structure by exchanging shares of its tracking stock – which tracked the performance of VMware – for a combination of cash and another class of stock of Dell. In re Dell Technologies Inc. Class V Stockholders Litigation, Consol. C.A. No. 2018-0816-JTL (Del. Ch. June 11, 2020) (denying a motion to dismiss following stockholder-plaintiffs’ inspection of books and records pursuant to Section 220). The court held that the parties had failed to satisfy four of the six MFW conditions. First, independent committees established under MFW must be given the power to say “no” to the controller, but the controlled company retained its preexisting ability to trigger a conversion of the tracking stock into a different class of Dell stock if Dell chose to go public, at a predetermined market-based price formula that could be suboptimal for the tracking stockholders. The court concluded that the controller could use this charter-based right to force the minority into a different outcome and that the controller did in fact use it as leverage in negotiations with the special committee by issuing statements that constituted threats to undertake an IPO at a lower price. Second, the court came to the conclusion that the special committee had abdicated its obligations to protect the minority by allowing larger minority stockholders to negotiate directly with the controller after the deal was announced and it appeared that the tracking stockholders would not vote in favor of the deal. Third, the court drew an inference that the two special committee members were conceivably not independent as a result of business and personal relationships with the company and controller. Fourth, the court determined that the minority vote was not fully informed, with the company failing, among other things, to disclose prior valuations of the company from before negotiations began that indicated a low value for the stock into which the tracking stock would be converted in the transaction, as well as price details about a counterproposal that the committee made to Dell.
In the most recent MFW decision, Chancellor Bouchard addressed an exchange by HomeFed Corporation’s 70 percent stockholder of its own stock for the $189 million of HomeFed shares that it did not already own. In re HomeFed Corporation Stockholder Litigation, Consol. C.A. No. 2019-0592-AGB (Del. Ch. July 13, 2020) (denying a motion to dismiss a complaint based on public disclosures). The court first addressed the fact that the controller had entered into a stockholders agreement subjecting certain stock acquisitions to special committee approval. The court held that the stockholders agreement, which only applied to transactions within the purview of Rule 13e-3 of the Securities Exchange Act, didn’t create sufficient protection to return the litigation to the business judgment standard when the committee had not been established before substantive economic negotiations that anchored price. As in Dell Technologies, Chancellor Bouchard stated that the exception to the HomeFed stockholders agreement could have allowed the HomeFed controller to circumvent the special committee, and the court further observed that the transaction structure may in fact have met the exception. The court also found that, after the special committee paused its process (in response to the controller’s indication that it would not proceed with a transaction), the controller held discussions with minority stockholders. The court found this to have been problematic, particularly where this special committee denied the controller a request to hold such discussions once the committee process actively resumed.
Considerations Regarding Management of Potential Conflicts
Management of potential conflicts has long been a hallmark of deal planning from the Delaware law perspective. The new era of Delaware corporate litigation, characterized by technical legal claims, allegations informed by greater information, litigation continuing beyond pleading stages, and an expanded Court of Chancery, has amplified the depth and volume of cases and guidance on measures for managing potential conflicts – we would expect this to continue in greater force during economic slowdowns. Our three articles in this series outline some of the most recent lessons from Delaware cases. Some related points for consideration:
- Conflict-management as context specific. As illustrated by recent Delaware cases mentioned in this series of articles, the identification, management, and mitigation of potential conflicts are fact-specific endeavors. Counsel and directors may benefit from thoughtful deliberation, beginning in the early stages of a transaction process and continuing during that process as part of the directors’ fiduciary duties, over whether a strategic transaction has the possibility, after the twists and turns of negotiating and exploring a transaction, to implicate interests of certain directors. If such a possibility exists, then consideration (if not implementation) of the costs and benefits of conflict-cleansing measures is likely warranted. Deliberation over potential conflicts from the earliest stages of consideration of a transaction also brings the benefit of availing the company of greater options that are premised on timely implementation, such as designation of an independent committee or conditioning a transaction on disinterested stockholder approval before substantive economic bargaining or recusal of interested directors entirely from the process. Delaware law does not necessarily present a blueprint or stock answer for these questions, but the extensive precedent and ever-developing case law provides valuable guidance.
- Heightened technical focus on conflicts. In recent years, private companies are finding greater access to financing from many different corners of the world, and as a result are growing more valuable, and staying private longer, all the while often filling their board rooms with directors who have industry experience and affiliations with management and with significant investors in those companies. Plaintiffs lawyers are finding more inroads into accessing stockholder plaintiffs willing to sue these private companies. They are also finding success probing conflicts and making more sophisticated, technical claims in Delaware litigation. The amounts at issue in the recent Delaware cases mentioned above vary from the tens of millions of dollars to the multiple billions. Likewise, MFW litigation has arisen with respect to a wide range of transactions, including public company deals involving equity values around $20 million and $15 billion.
- Contemporary documentation and corporate records. As noted in these articles, stockholders and directors are demanding and obtaining inspection of company books and records pursuant to Section 220 of the DGCL. These inspections are producing information that finds its way into complaints around significant corporate actions, board decisions, and related conflict-management measures. Although beyond this article, the scope of information and types of documents that are subject to such inspections, along with the additional litigation discovery that is coming with claims that survive early dismissal, are important for directors and corporate counsel to appreciate. Each of these may be expected to affect the quality of claims and effectiveness of defenses in subsequent litigation.
- Distressed market dynamics. In a distressed market, the expediency of – or even the need for – insider-led transactions can quickly create tension as the limited resources available and exigency of shoring-up business prospects place greater pressure on the practicability of the time and cost involved in implementing the conflict-management measures addressed in this article. In these situations, documenting directors’ deliberations regarding material decisions, as well as consideration and use of (or the decision to forgo) conflict-management measures, remains important, even as the entire process of negotiating a transaction may be concentrated in a smaller number of meetings than usual (assuming decisions, such as approval of transactions or financings, will be made on a tighter timeline). However, Delaware courts have remained sensitive to the potential for inequitable behavior when a company’s performance trends downward. See, e.g., Drivetrain, LLC v. Hall, C.A. No. 2019-0365-JTL (Del. Ch. Jan. 21, 2020) (TRANSCRIPT) (denying a motion to dismiss claims related to an alleged “pump-and-dump scheme” against a controller who, along with affiliated directors, was alleged to have had real time data that the company was failing but then disclosed a rosy outlook and sold shares); K-Bar Holdings LLC v. Rucker, C.A. 2019-0892-SG (Del. Ch. Nov. 8, 2019) (TRANSCRIPT) (permitting expedited discovery and proceedings) (granting a temporary restraining order against deregistration and stock purchases by directors, where the court found a credible basis that there could otherwise be an improper transfer of wealth).
- Conflict management in insolvency. In addition, when a corporation becomes insolvent, fiduciary duties are owed to the enterprise including creditors, which may have the effect of reorienting the typical conflicts analysis around the boardroom. Under those circumstances, related measures for managing potential conflicts may also shift and require reconsideration by counsel and directors.
This post comes to us from Nate Emeritz, who is of counsel, and Brian Currie and Jason Schoenberg, who are associates, at the law firm of Wilson Sonsini Goodrich & Rosati, P.C. in Wilmington, Delaware. The views expressed herein are those of the authors and do not necessarily reflect the views of the firm or its clients. This is the third in a series of three articles regarding Delaware case law on board- and stockholder-level measures for managing potential conflicts.