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June 03, 2014 Articles

Business Judgment Rule Now Available for Going-Private Mergers

Read about the Delaware cases that have become significant for corporate law.

By Travis Patterson

The rule seemed well settled. When a controlling shareholder attempts to take a company private, and the minority shareholders challenge the transaction alleging a breach of fiduciary duty, the court reviews the transaction under the entire fairness standard—under which the controlling shareholder has the initial burden to prove the transaction was fair. The only questions were how and when the burden would shift to the minority shareholders to show it was unfair.

Delaware Supreme Court cases from 1981 to 2012—including Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1981), Rosenblatt v. Getty Oil Co., 493 A.2d 929 (Del. 1983), Kahn v. Lynch Commc’n Sys., Inc., 638 A.2d 1110 (Del. 1994), and Americas Mining Corp. v. Theriault, 51 A.3d 1213 (Del. 2012)—provide the general principle that the controlling shareholder can shift the burden of proving entire fairness if the transaction is approved by either (a) an independent, well-functioning special committee, or (b) a fully informed and uncoerced vote of the majority-of-the-minority shareholders. Because the rule was disjunctive—special committee approval or a majority-of-the-minority vote shifts the burden—controlling shareholders had no incentive to do both and risk rejection of the transaction due to the additional safeguard.

But then somebody did both, challenging the status quo. Instead of merely shifting the burden to the minority shareholders under the entire fairness standard, the Delaware Court of Chancery and the Delaware Supreme Court applied the business judgment rule in what has become a significant line of cases for corporate law.

Chancery Court Applies the Rule When a Going-Private Merger Employs Both Safeguards
In In re MFW Shareholders Litigation, 67 A.3d 496 (Del. Ch. 2013), the Delaware Court of Chancery dealt with “a novel question of law” regarding how to review a going-private transaction when the controlling shareholder conditions the transaction on both (a) approval by an independent, well-functioning special committee, and (b) a fully informed and uncoerced approving vote of the majority-of-the-minority shareholders. The Chancery Court ruled that, where both safeguards are in place, courts should apply the business judgment rule to review the transaction instead of the entire fairness standard, agreeing with the defendants’ argument that such a transaction is “analogous to that of a third-party merger.”

MacAndrews & Forbes—a holding company whose equity is solely owned by Ronald Perelman—owned 43 percent of M&F Worldwide Corp. (MFW). MacAndrews & Forbes offered to purchase the rest of MFW’s equity in a going-private merger for $24 per share. From the outset, MacAndrews & Forbes conditioned the transaction on the approval by both(a) an independent special committee, and (b) a vote of the majority of the shareholders unaffiliated with MacAndrews & Forbes (i.e., the “majority of the minority”).

A special committee was formed and hired its own legal and financial advisors to evaluate and negotiate the proposal with MFW and its advisors. The special committee responded to MFW’s $24-per-share offer with a $30-per-share counteroffer, which was rejected by MFW. After extensive negotiations and eight meetings, the special committee, and then the remaining MFW directors, unanimously approved MFW’s final offer of $25 per share. Then, 65 percent of the minority shareholders, once fully informed of the proposal and the details of the negotiations, approved the deal.

The discontented minority shareholders (presumably those who voted against the proposal) filed suit for breach of fiduciary duty against MacAndrews & Forbes, Perelman, and the other MFW directors. The defendants moved for summary judgment, arguing that because both safeguards were employed, the court should apply the business judgment rule to review the transaction.

In the Court of Chancery’s opinion, then-Chancellor Strine stated that “[t]his case presents a novel question of law.” The court noted that in Kahn v. Lynch, the Delaware Supreme Court “held that the approval by either a special committee or the majority of the noncontrolling stockholders of a merger with a buying controlling shareholder would shift the burden of proof under the entire fairness standard from the defendant to the plaintiff.” But the MFWcourt also noted that because both safeguards had never been used together, any general principles from prior Delaware Supreme Court opinions—such as “controlling or dominating shareholder standing on both sides of a transaction . . . bears the burden of proving its entire fairness”—are “dictum” in this case because this was the first time both safeguards were employed.

The court stressed that a “transactional structure with both these protections is fundamentally different from one with only one protection.” While a special committee ensures “that there is a bargaining agent who can negotiate price and address the collective action problem facing stockholders,” a “majority-of-the-minority vote provides stockholders a chance to vote on a merger proposed by the controller-dominated board.” Although these protections are “incomplete” on their own, they are “complementary and effective in tandem.” Thus, because a going-private transaction conditioned on both safeguards is “analogous to that of a third-party merger,” the court ruled that the MFW defendants were entitled to the protections of the business judgment rule.

The Delaware Supreme Court Affirms
After the Court of Chancery granted the MFW defendants’ motion for summary judgment, the plaintiffs appealed, and the Delaware Supreme Court granted review. Kahn v. M&F Worldwide Corp., No. 334, 2013, 2014 Del. LEXIS (Del. Mar. 14, 2014). The Delaware Supreme Court was tasked with deciding whether (1) the question was one of first impression for the court; (2) both safeguards used in the MFW transaction properly qualified as “cleansing devices”; and, most important, (3) courts should apply the business judgment rule to review going-private mergers where both safeguards have been properly employed.

The minority shareholders argued that (1) entire fairness applies in all going-private mergers, whether or not both safeguards are used, based on the Delaware Supreme Court’s rulings in Kahn v. Lynch and Americas Mining Corp; and (2) there were material issues of fact regarding the independence of the special committee and whether the majority-of-the-minority provisions were effective in this case. The MFW defendants countered that the application of the business judgment rule was proper because (1) the Delaware Supreme Court had never addressed the appropriate standard of review for dual-protection controlling-shareholder mergers; (2) application of the business judgment rule to controlling-shareholder mergers employing the dual protective devices is the rule of equitable common law that best protects minority shareholders; and (3) application of the business judgment rule to dual-protection controlling-shareholder mergers will give controlling shareholders an appropriate incentive to structure transactions in a way that will most adequately protect minority shareholders’ interests.

The Delaware Supreme Court sided with the MFW defendants and affirmed the Court of Chancery’s opinion, holding that  

business judgment is the standard of review that should govern mergers between a controlling stockholder and its corporate subsidiary, where the merger is conditioned ab initio upon both the approval of an independent, adequately-empowered Special Committee that fulfills its duty of care; and the uncoerced, informed vote of a majority of the minority stockholders.

Kahn, 2014 Del. LEXIS, at *17.

The Delaware Supreme Court gave four main reasons for affirming the Court of Chancery. First, the court agreed with the analogy to a third-party merger: “[W]here the controller irrevocably and publicly disables itself from using its control to dictate the outcome of the negotiations and the shareholder vote, the controlled merger then acquires the shareholder-protective characteristics of third-party, arm’s-length mergers, which are reviewed under the business judgment standard.” Second, the court also agreed that “the dual procedural protection merger structure optimally protects the minority shareholder in controller buyouts.” Third, “applying the business judgment standard to the dual protection merger structure ‘is consistent with the central tradition of Delaware law, which defers to the informed decisions of impartial directors, especially when those decisions have been approved by the disinterested stockholders on full information and without coercion.’” Fourth, the “dual protection merger structure requires two price-related pretrial determinations: first, that a fair price was achieved by an empowered, independent committee that acted with care; and, second, that a fully-informed, uncoerced majority of the minority stockholders voted in favor of the price that was recommended by the independent committee.”

Why These Rulings Are a Big Deal
These rulings are important because, as the Delaware Supreme Court has previously recognized in lawsuits challenging board action, “[t]he choice of the applicable ‘test’ to judge director action often determines the outcome of the case.” Stroud v. Grace, 606 A.2d 75, 90 (Del. 1992). When the entire fairness standard applies, “the board must present evidence of the cumulative manner by which it discharged all of its fiduciary duties. An entire fairness analysis then requires the [court] to consider carefully how the board of directors discharged all of its fiduciary duties with regard to each aspect of the non-bifurcated components of entire fairness: fair dealing and fair price.” Emerald Partners v. Berlin, 787 A.2d 85, 97 (Del. 2001). On the other hand, the business judgment rule creates “a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).

The practical difference between these two standards is that when the entire fairness standard applies, a company can expect expensive and lengthy litigation to defend a transaction. But when the business judgment rule applies, a company could have a lawsuit dismissed early on. This decision by the Delaware Supreme Court is therefore a great relief to companies entertaining going-private mergers. While the additional safeguard may increase the risk of rejection of the proposed merger, the protection of the business judgment rule will dramatically reduce the chances of litigation. Likewise, the rule will benefit minority stockholders because it will encourage deals to be structured such that minority shareholders will reap the “benefits of independent, empowered negotiating agents to bargain for the best price and say no if the agents believe the deal is not advisable for any proper reason,” and minority shareholders will also have the “critical ability to determine for themselves whether to accept any deal that their negotiating agents recommend to them.” MFW, 67 A.3d at 503.

The New Standard Going Forward
The Delaware Supreme Court articulated exactly what a company should do to avail itself of the business judgment rule:

[I]n controller buyouts, the business judgment standard of review will be applied if and only if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority shareholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.

Kahn, 2014 Del. LEXIS, at *21.

Keywords: litigation, business torts, going-private merger, entire fairness, business judgment rule, minority shareholder, minority stockholder, majority of the minority

Travis Patterson – June 3, 2014