Delaware Insider: A Fully Informed and Disinterested Stockholder Vote Cleanses Transactions Tainted by Board Conflicts

Recently, in In re Merge Healthcare Inc., C.A. No. 11388-VCG, 2017 WL 395981 (Del. Ch. Jan. 30, 2017), the Delaware Court of Chancery dismissed a complaint, which alleged that the board of directors of Merge Healthcare, Inc. breached its fiduciary duties in connection with its approval of a merger with IBM, because a majority of the disinterested, fully informed, and uncoerced stockholders of Merge approved the acquisition. The decision is the latest in a series of opinions from the court in the wake of the Delaware Supreme Court’s decision in Corwin v. KKR Financial Holdings LLC, 125 A.3d 304 (Del. 2015) and confirms that, where a majority of a corporation’s fully informed, disinterested, and uncoerced stockholders approve a transaction other than with a controlling stockholder, the business judgment rule will apply absent waste even if the transaction was approved by a conflicted board majority. The decision also helps to clarify some uncertainty created by various decisions of the Court of Chancery as to the effect of Corwin on interested director transactions.

Corwin and Interested Director Transactions

In Corwin, the Delaware Supreme Court held that “when a transaction not subject to the entire fairness standard is approved by a fully informed, uncoerced vote of the disinterested stockholders, the business judgment rule applies.” Because of Corwin’s literal holding, the decision created some uncertainty over whether all transactions subject to the entire fairness standard of review were incapable of being cleansed by a fully informed, uncoerced, and disinterested stockholder vote or whether just controlling stockholder transactions were not capable of being cleansed. Historically, transactions tainted by a conflicted board majority, but not a controlling stockholder, were reviewed under the entire fairness standard of review unless the transaction had been approved by a fully informed and disinterested stockholder vote or a special committee of disinterested and independent directors. The effect of a single cleansing mechanism on controlling stockholder transactions was merely to shift the burden of proof of entire fairness from defendants to plaintiffs because of the inherent coercion deemed present when a controller either stands on both sides of the transaction or extracts personal benefits from the transaction. Thus, there was some reason to believe that not all transactions subject to the entire fairness standard were incapable of being cleansed under Corwin—just transactions subject to the entire fairness standard ab initio because of a controlling stockholder.

Corwin suggested that fully informed, uncoerced, and disinterested stockholder approval of a conflicted board decision should be given cleansing effect, but the issue was not squarely before the court. Specifically, the court did not consider allegations that the entire fairness standard applied to its review of a merger because of a conflicted board majority, but rather whether entire fairness applied to the court’s review because of a controlling stockholder. Nevertheless, the court’s dictum was instructive. The court noted that “[f]or sound policy reasons, Delaware corporate law has long been reluctant to second-guess the judgment of a disinterested stockholder majority that determines that a transaction with a party other than a controlling stockholder is in their best interests.” In addition, the decision affirmed the Court of Chancery’s holding below, which stated that “even if the plaintiffs had pled facts from which it was reasonably inferable that a majority of [] directors were not independent, the business judgment standard of review still would apply to the merger because it was approved by a majority of the shares held by disinterested stockholders . . . in a vote that was fully informed.”

Subsequently, in City of Miami General Employees v. Comstock, C.A. No. 9980-CB, 2016 WL 4464156 (Del. Ch. Aug. 24, 2016), the Court of Chancery gave cleansing effect to a fully informed, uncoerced stockholder vote approving a merger only after determining that plaintiff failed to allege facts sufficient to establish that a majority of the members of the target’s board of directors were belaboring under disabling conflicts. In this case, the alleged conflicts related to the directors’ purported desire to obtain board seats in the surviving entity and inability to act independently from an interested party. The court ultimately dismissed plaintiff’s claims because the transaction was not subject to entire fairness review and the business judgment presumption applied under Corwin. The fact that the court determined that Corwin’s cleansing effect applied only after concluding that a majority of the members of the board were disinterested and independent suggested that the court did not believe that Corwin’s cleansing effect would have applied if a majority of the members of the board were conflicted.

By contrast, in Larkin v. Shah, C.A. No. 10918-VCS, 2016 WL 4485447 (Del. Ch. Aug. 25, 2016), the Court of Chancery stated that “[i]n the absence of a controlling stockholder that extracted personal benefits,” where a majority of a corporation’s fully informed, disinterested, and uncoerced stockholders approve the transaction, the business judgment rule will apply “even if the transaction might otherwise have been subject to the entire fairness standard due to conflicts faced by individual directors.” Like Comstock, Larkin involved claims that a majority of the members of a target’s board faced disabling conflicts when approving a merger. The alleged conflicts related to certain board members having contemporaneous employment with venture capital firms that held stock in the target corporation and the directors’ expectation of employment with the surviving entity following the merger. In rejecting plaintiffs’ claims and applying Corwin to dismiss plaintiffs’ complaint, the court made clear “that [] proper stockholder approval of [a] transaction [will] cleanse any well-pled allegations that [a] transaction was the product of board-level conflicts that might trigger entire fairness review . . . .”

Consistent with the court’s decision in Larkin, Merge Healthcare clarifies that, with respect to conflicted board transactions, a disinterested, fully informed stockholder vote will have a cleansing effect on the transaction.

Factual Background: In re Merge Healthcare

This case involved the acquisition of Merge Healthcare, Inc. by IBM. Prior to the merger, Merge’s Chairman, Michael Ferro, owned approximately 26 percent of Merge’s outstanding stock through an affiliated fund which also provided consulting services to Merge. As a result of the consulting agreement, Merge would have paid Ferro’s affiliated fund a $15 million cash fee in connection with Merge’s acquisition by IBM but for the fact that Ferro subsequently agreed to waive the fee in exchange for an increase in the offer price. The merger was completed on October 13, 2015. Nearly 80 percent of Merge’s stockholders voted in favor of the merger.

Following closing, plaintiffs brought this action, alleging, among other things, that (i) the Merge board ran an unfair sales process and deprived stockholders of the true value of Merge and (ii) the Merge board breached its duty of disclosure by disseminating materially misleading and incomplete information to the stockholders in connection with the proxy statement filed as part of the merger. Defendants moved to dismiss plaintiffs’ complaint on the basis of the ratifying effect of the Merge stockholder vote.

Parties’ Arguments: In re Merge Healthcare

Plaintiffs argued that the entire fairness standard of review should apply to the merger between Merge and IBM because a majority of the members of Merge’s board were conflicted, and Ferro was a controller. According to plaintiffs, Ferro’s relationships with the other board members, as well as his stock ownership in Merge, allowed him to control Merge and its board. Plaintiffs maintained that Ferro used the merger with IBM to satisfy an urgent need to sell illiquid stock holdings in Merge. Finally, to demonstrate that the merger vote had not been fully informed, plaintiffs alleged various disclosure violations related to the financial analysis performed by Goldman Sachs, Merge’s financial adviser. Specifically, plaintiffs argued that (i) the proxy statement failed to disclose Goldman’s treatment of stock based compensation as a cash expense, (ii) the unlevered free cash flows used by Goldman were not those disclosed in the proxy statement, and (iii) the proxy statement inadequately described the present value of Merge’s net operating losses. In addition, plaintiffs contended that defendants failed to disclose that the true purpose of Ferro’s waiver of the consulting fee was to avoid the creation of a special committee rather than to obtain a price increase from IBM.

In response, the director defendants relied upon the cleansing effect of Corwin, contending that, because the vote of the stockholders approving the merger was fully informed, disinterested, and uncoerced, defendants were entitled to the presumptions of the business judgment rule absent waste.

The Court’s Holdings: In re Merge Healthcare

The court held that the vote of Merge’s stockholders cleansed the transaction, entitling the Merge directors to the presumptions of the business judgment rule under Corwin. In so doing, the court, citing Larkin, held that, in the absence of a controlling stockholder that extracted personal benefits from the transaction, a fully informed, uncoerced, and disinterested stockholder vote results in the application of the business judgment rule “even if the transaction might otherwise have been subject to the entire fairness standard due to conflicts faced by individual directors.” Thus, the court found largely irrelevant the allegations that Merge board members were conflicted and focused on whether Ferro was a controller who extracted personal benefits not shared equally with the minority. The court assumed for purposes of its analysis that Ferro was a controlling stockholder of Merge and found Ferro’s interests were fully aligned with the minority stockholders because of his pro rata treatment in the merger. The court rejected plaintiffs’ claim that Ferro had orchestrated the merger to sell his Merge stock because Ferro had been selling his stock in Merge for the past six years. Additionally, the court emphasized that Ferro’s waiver of the fee under the consulting agreement removed any unique benefit that he might have received in the merger.

Next, the court held that plaintiffs’ disclosure claims arising from Goldman Sachs’ summary of the analysis underlying its fairness opinion failed. Regarding plaintiffs’ contention that the reason for Ferro’s waiver of the fee under the consulting agreement was not disclosed, the court found that disclosure of Ferro’s subjective intent to waive the fee was not required.

Conclusion

The court’s decision in Merge Healthcare highlights the evolution of the court’s jurisprudence under Corwin. Specifically, Merge Healthcare confirms that a fully informed stockholder vote will cleanse a transaction in order to apply the business judgment rule to a board’s decision to approve the transaction even if a majority of the directors are interested in the transaction. Such a holding is not necessarily surprising—prior to Corwin, numerous Court of Chancery decisions held that the business judgment rule applied to a conflicted board’s decision to approve a merger where the stockholder vote approving the transaction was fully informed, disinterested, and uncoerced. Some confusion ensued after the Delaware Supreme Court held in Gantler v. Stephens, 965 A.2d 695 (Del. 2009) that stockholder ratification of a transaction is limited to “circumstances where a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective.” However, in Corwin, the Delaware Supreme Court narrowly interpreted Gantler as a decision focused on the common law doctrine of ratification and not on the question of what standard of review applies if a transaction not involving a controller is approved by an informed, voluntary vote of disinterested stockholders. The court’s decision in Merge Healthcare clarifies that, with respect to the approval of interested director transactions by a fully informed, disinterested, and uncoerced stockholder vote, the effect of Corwin was to remove any doubt cast on the cleansing effect of a stockholder vote created by Gantler v. Stephens.