What should be the standard of review for a merger between a controlling stockholder and its subsidiary, where the merger is conditioned ab initio upon the approval of both an independent, adequately-empowered Special Committee that fulfils its duty of care, and the un-coerced, informed vote of a majority of the minority stockholders?1
This dispute arose in 2011 when MacAndrews & Forbes Holdings, Inc ("M&F" or "MacAndrews & Forbes"), acquired a 43% stockholder in M&F World-wide Corp ("MFW"), of the remaining common stock of MFW (the "Merger"). From the outset, M&F's proposal to take MFW private was made contingent upon two stock holder protective procedural conditions. First, M&F required the Merger to be negotiated and approved by a special committee of independent MFW directors. Second, M&F required that the Merger be approved by a majority of stockholders unaffiliated with M&F. The Merger closed in December 2011, after it was approved by a vote of 65.4% of MFW's minority stockholders.
The opponents initially sought to enjoin the transaction. The same was, however, withdrawn and post-closing relief was sought against M&F, Ronald O. Perelman, and MFW's directors (including the members of the Special Committee) for breach of fiduciary duty. Again, the opponents were provided with extensive discovery. The Defendants then moved for summary judgement, which the Court of Chancery granted. The court concludes that KKR is not a "controlling" shareholder, but that even if the majority of the board is not disinterested (that is, a majority is somehow beholden to the acquirer) the business judgement rule applies if there is approval by a majority of the minority. That seems to me to be inconsistent with Kahn.
The US courts had been following the rule laid down in Kahn v. Lynch2 whereby it was held that the approval by either a Special Committee or the majority of the non-controlling stockholders of a merger with a buying controlling stockholder would shift the burden of proof under the entire fairness standard from the defendant to the plaintiff. Lynch case did not involve a merger conditioned by the controlling stockholder on both procedural protections.
There is, however, a turnaround now and the new rule3 lays down that the business judgement standard of review will govern the private mergers with a controlling stockholder that are conditioned ab initio upon (1) the approval of an independent and fully-empowered Special Committee that fulfils its duty of care and (2) the un-coerced, informed vote of the majority of the minority stockholders. The premises is that the common law equitable rule that best protects minority investors is one that encourages controlling stockholders to accord the minority both procedural protections. Where the transactional structure subject to both conditions differs fundamentally from a merger having only one of those protections, in that:
By giving controlling stockholders the opportunity to have a going private transaction reviewed under the business judgement rule, a strong incentive is created to give minority stockholders much broader access to the transactional structure that is most likely to effectively protect their interests... That structure, it is important to note, is critically different than a structure that uses only one of the procedural protections. The "or" structure does not replicate the protections of a third-party merger under the DGCL approval process, because it only requires that one, and not both, of the statutory requirements of director and stockholder approval be accomplished by impartial decision makers. The "both" structure, by contrast, replicates the arm's-length merger steps of the DGCL by "requiring" two independent approvals, which it is fair to say serve independent integrity-enforcing functions.
To this rule, challenge had been made by contending that statements in Lynch and its progeny could be (and were) read to suggest that even if both procedural protections were used, the standard of review would remain entire fairness by citing Southern Peru and Kahn v. Tremont, where the controller did not give up its voting power by agreeing to a abandoned majority of the minority condition.4
The challenger was of the view that neither procedural protection is adequate to protect minority stockholders, because "possible ineptitude and timidity of directors" may undermine the special committee protection, and because majority of the minority voters may be unduly influenced by arbitrageurs that have an institutional bias to approve virtually any transaction that offers a market premium, however insubstantial it may be. It has further been claimed, these protections, even when combined, are not sufficient to justify "abandoning" the entire fairness standard of review.
In a nutshell, the challenger sought procedural protections in respect of special committee and majority of the minority vote, but the same was denied because the challenger just believed that most investors like a premium will tend to vote for a deal that delivers one and that many long-term investors will sell out when they can obtain most of the premium without waiting for the ultimate vote. The proposition is, however, not one that suggests that the voting decision is not voluntary; it is simply an editorial about the motives of investors and does not contradict the premise that a majority of the minority condition gives minority investors a free and voluntary opportunity to decide what is fair for them.
By reviewing the said challenges, the new rule5 carved out by courts proposes that in such cases business judgement is the standard of review. The rule 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 stockholders; (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.6
Where a plaintiff can plead a reasonably conceivable set of facts by showing that any or all of those enumerated conditions did not exist, the complaint would be treated as a claim for relief that would entitle the plaintiff to proceed and conduct discovery.7 And where after discovery, tri-able issues of fact remain about whether either or both of the dual procedural protections were established, or if established the same were effective, the case will proceed to a trial in which the court will conduct an entire fairness review.8
This approach is consistent with Weinberger, Lynch and their progeny. A controller that employs and/or establishes only one of these dual procedural protections would continue to receive burden-shifting within the entire fairness standard of review framework. Stated differently, unless both procedural protections for the minority stockholders are established prior to trial, the ultimate judicial scrutiny of controller buyouts will continue to be the entire fairness standard of review.9
Our take is that Kahn only applies to freeze-out mergers. Kahn allows the business judgement rule to be the standard of review when "the merger is conditioned ab initio upon the approval of both an independent, adequately-empowered Special Committee that fulfils its duty of care, and the un-coerced, informed vote of a majority of the minority stockholders." In freeze-out mergers where Kahn does not apply, the entire fairness standard of review applies ab initio.
However, in order to apply Kahn or the entire fairness standard of review ab initio, we must first find that a controlling shareholder exists. KKR's affiliate had a management agreement to manage KFN, but KKR only owned 1% of the company's stock. The court determined that KKR was not a controlling shareholder. If there is no controlling shareholder, then no freeze-out merger. Therefore, neither Kahn nor entire fairness applied ab initio.
So what is the standard of review? Moreover, what would be the standard of review if the board decision was tainted with a lack of independence or interest? The business judgement rule would apply in a non-Revlon merger unless the board decision was tainted. If the board decision was tainted, then entire fairness would be the standard of review unless Wheelabrator Technologies, Inc. Shareholders Litigation, etc 10 applies. Under Wheelabrator (Waste Mgt, a 22% shareholder, acquired control of Wheelabrator in a stock-for-stock exchange), approval by a majority of disinterested stockholders invokes. "The business judgement rule and limits judicial review to issues of gift or waste with the burden of proof upon the party attacking the transaction." Given that such an informed vote did occur in the KKR acquisition, the business judgement rule would have been the correct standard of review even if the board lacked independence or was interested.
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates Karachi)
1. Even where the merger was approved by a majority of disinterested stockholder in a fully informed vote
2. Kahn v. Lynch Commc'n Sys. (Lynch I), 638 A.2d 1110, 1117 (Del. 1994).
3. In re MFW Shareholder Litigation, 67 A. 3d 496, 528 ( Del Ch. 2013) (citing In re Cox Commc'ns, Inc. S'holders Litig, 879 A.2d 604, 618 (Del. Ch. 2005))
4. Ams. Mining Corp v. Theriault, 51 A.3d 1213, 1234 (Del. 2012); Kahn v. Tremont Corp, 694 A.2d 422, 428 (Del. 1997).
5. A.kahn v. M & F World-wide Corporation, No 334 of 2013 decided on March 14, 2014. (The Supreme Court of State of Delware)
6. The Verified Consolidated Class Action Complaint would have survived a motion to dismiss under this new standard. First, the complaint alleged that Perelman's offer "value[d] the company at just four times" MFW's profits per share and "five times 2010 pre-tax cash flow," and that these ratios were "well below" those calculated for recent similar transactions. Second, the complaint alleged that the final Merger price was two dollars per share lower than the trading price only about two months earlier. Third, the complaint alleged particularised facts indicating that MWF's share price was depressed at the times of Perelman's offer and the Merger announcement due to short-term factors such as MFW's acquisition of other entities and Standard & Poor's downgrading of the United States' creditworthiness. Fourth, the complaint alleged that commentators viewed both Perelman's initial $24 per share offer and the final $25 per share Merger price as being surprisingly low. These allegations about the sufficiency of the price call into question the adequacy of the Special Committee's negotiations, thereby necessitating discovery on all of the new prerequisites to the application of the business judgement rule.
7. Cent. Mortg. Co v. Morgan Stanley Mortg. Capital Holdings LLC, 27 A.3d 531, 536- 37 (Del. 2011). See also Winshall v. Viacom Int'l, Inc, 76 A.3d 808 (Del. 2013); White v. Panic, 783 A.2d 543, 549 n.15 (Del. 2001) (We have emphasised on several occasions that stockholder "plaintiffs may well have the 'tools at hand' to develop the necessary facts for pleading purposes," including the inspection of the corporation's books and records under Del. Code Ann. tit. 8, § 220. There is also a variety of public sources from which the details of corporate act actions may be discovered, including governmental agencies such as the US Securities and Exchange Commission)
8. Ams. Mining Corp v. Theriault, 51 A.3d 1213, 1240-41 (Del. 2012).
9. Id. n. 3
10. In re Wheelabrator Technologies, Inc. Shareholders Litigation, 663 A.2d 1194 (Del. Ch. 1995)