Chancellor Strine Creates Path for Business Judgment Rule Review of Controlling Stockholder-Led Buyouts

In 1994, the Delaware Supreme Court ruled in Kahn v. Lynch Communications Systems, Inc., 638 A.2d 1110 (Del. 1994) that, in a one-step controlling stockholder-led buyout, “the exclusive standard of judicial review ' is entire fairness,” with
“[t]he initial burden of establishing entire fairness rest[ing] upon the party who stands on both sides of the transaction.” The Kahn court also ruled that “approval of the transaction by an independent committee of directors or an informed majority of minority shareholders would shift the burden of proof on the issue of fairness to the plaintiff.” Since Kahn, controlling stockholder-led buyouts generally have been conditioned on approval by a special committee of independent directors.

Two-Step Transactions

By contrast, two-step controlling stockholder-led buyouts are “reviewed under an evolving standard far less onerous than Lynch.” See In re Siliconix Inc. Shareholders Litigation, 2001 WL 716787 (Del. Ch. June 19, 2001). In 2002, in In re Pure Resources Shareholders Litigation, 808 A.2d 421 (Del. Ch. 2002), then-Vice Chancellor Leo E. Strine, Jr. “set out a series of requirements for a controlling stockholder tender offer,” including “a non-waivable majority of the minority tender condition,” a promise to consummate a 'prompt' short-form merger at the tender offer price if 90% of the target's shares are obtained in the tender offer, and the absence of any “retributive threats” if the tender offer is not successful. Further, the Vice Chancellor “imposed a duty on the controlling stockholder” to give the target board's independent directors “free rein and adequate time to react to the tender offer” in order to provide the minority “with a recommendation as to the advisability of the offer.” If this approach is taken, neither step in the transaction will be subjected to an entire fairness review.

The Unified Standard

Three years later, in In re Cox Communications, Inc. Shareholders Litigation, 879 A.2d 604 (Del. Ch. 2005), Vice Chancellor Strine promoted, in a footnote to his opinion, adoption of a “unified standard for reviewing controlling stockholder freeze-outs ' .” Under this formulation, for either a one-step or a two-step transaction, appropriate use of a special committee of independent directors and a majority-of-the-minority stockholder vote will trigger presumptive application of “the business judgment standard of review ' .” However, “if the transaction does not incorporate both protective devices, or if a plaintiff can plead particularized facts sufficient to raise a litigable question about the effectiveness of one of the devices, then the transaction is subject to entire fairness review.”

Then, in 2010, Vice Chancellor J. Travis Laster applied the unified standard to a two-step controlling stockholder-led buyout. Because both protective devices were not utilized, the Vice Chancellor subjected the buyout to an entire fairness review. In so ruling, the Vice Chancellor recognized that his promotion of the unified standard and application of a business judgment standard of review to a controlling stockholder-led buyout could not become a permanent part of the fabric of Delaware corporate law until blessed by the Delaware Supreme Court.

The Buyout of MFW by MacAndrews & Forbes

This was the state of play in May 2011 when MacAndrews & Forbes began to explore the acquisition of the publicly held shares of M&F Worldwide (MFW). At the time,
MacAndrews & Forbes owned 43.4% of MFW, and its “stock price traded in the $20 to $24 range.”

When MFW stock closed at $16.96 on June 11, MacAndrews & Forbes immediately presented the MFW board with a letter offering to purchase the publicly held shares for $24 per share in cash. MacAndrews & Forbes' proposal specified that it would not proceed with the buyout unless approved by both a special committee of independent directors and “a majority of the shares of the Company not owned by” MacAndrews & Forbes. The proposal also explained that while MacAndrews & Forbes had “no interest in selling” its MFW stake, the decision by either the special committee or the public stockholders not to approve the transaction “would not adversely affect our future relationship with the Company and we would intend to remain as a long-term stockholder.” Notably, this was exactly opposite to the approach taken by the controlling
stockholder in Kahn v. Lynch, which threatened a hostile takeover if the target board rejected its offer.

The next day, the MFW board appointed a special committee of independent directors. The special committee in turn retained independent counsel and its own financial adviser. The committee's charge was broad indeed, giving it the right not only to investigate, evaluate and negotiate MacAndrews & Forbes' offer, but also to “determine to elect not to pursue the Proposal ' .” The board also stipulated that it would not approve the transaction “without a prior favorable recommendation of the Special Committee ' .”

After obtaining updated management projections, the special committee's financial adviser applied traditional methodologies to arrive at a valuation range for MFW of $15 to $45 per share. Although MacAndrews & Forbes' $24 offer price fell within this valuation range, the committee rejected MacAndrews & Forbes' offer and countered at $30 per share. When MacAndrews & Forbes made its “best and final” offer of $25, the special committee, following receipt of a fairness opinion from its financial adviser, “unanimously decided to accept ' .” At the stockholders meeting that followed, “65% of the shares not owned by
MacAndrews & Forbes voted to accept the offer.” Nevertheless, the inevitable stockholder lawsuit “seeking a post-closing damages remedy for breach of fiduciary duty” proceeded.

On May 29, 2013, in In re MFW Shareholders Litigation, C.A. No. 6566-CS (Del. Ch. May 29, 2013), Chancellor Strine surprised many commentators by accepting MacAndrews & Forbes' argument that the business judgment rule could, under the right circumstances, apply to a one-step controlling stockholder-led buyout. In the Chancellor's view, the controlling stockholder in MFW did everything right, thus entitling it to summary judgment in its favor.

The Chancellor's Analysis

Satisfaction of the Duty of Care

Chancellor Strine began his analysis by examining the process employed to negotiate and approve the transaction.

First, the Chancellor concluded that the special committee consisted of truly independent directors. Despite “various business and social ties” between committee members and MacAndrews & Forbes, the Chancellor found that plaintiffs had not satisfied their burden of establishing that any committee member “is 'beholden' to the controlling party 'or so under [the controller's] influence that [the director's] discretion would be sterilized.'” Indeed, “mere allegations that directors are friendly with, travel in the same social circles, or have past business relationships with the proponent of a transaction ' are not enough to rebut the presumption of independence.”

Next, the Chancellor commented favorably on the process followed by the special committee, including its utilization of an independent financial adviser, its negotiation of MacAndrews & Forbes' original offer price, its frequent meetings, and the “rich body of financial information” that it reviewed.

Finally, the Chancellor found the majority-of-the-minority stockholder approval to be “fully informed and uncoerced.” Specifically, the Chancellor credited the proxy statement disclosure furnished to stockholders, including the presentation of “five separate ranges for the value of MFW's stock” prepared by the special committee's financial adviser. Further, the Chancellor refused to give any weight to plaintiff's argument that “many of these stockholders were arbitrageurs who had bought them from longer-term stockholders and whose views should be discounted ' .”

According to the Chancellor, “[t]hese conditions are sufficient ' as to a conflict transaction not involving a controlling stockholder ' to invoke the business judgment rule standard of review.” [emphasis added] The key question for the Chancellor to address, therefore, was whether the business judgment rule standard also could apply to a controlling stockholder-led buyout in which these conditions are satisfied?

Applicable Supreme Court Precedent

Before Chancellor Strine addressed this question, he considered whether past decisions of the state Supreme Court precluded him from applying a business judgment standard of review to the MFW buyout. The answer to this was not clear-cut. On the one hand, the Chancellor found that “the Supreme Court has never been asked this question and ' none of its prior decisions hinged on this question.” On the other hand, he acknowledged “broad statements in certain Supreme Court decisions that, if read literally and as binding holdings of law, say that the entire fairness standard applies to any merger with a controlling stockholder, regardless of the circumstances.”

Among the cases cited in this regard were Kahn v. Lynch and a very recent decision, Americas Mining Corporation v. Michael Theriault, 51 A.2d 1213 (Del. 2012). Chancellor Strine distinguished Kahn v. Lynch on the basis of the very different approach taken by MacAndrews & Forbes, particularly the lack of any retributive threat if the transaction was not approved, and its requirement of a majority-of-minority stockholder approval. In Americas Mining Corporation, the Supreme Court had quoted extensively from Kahn v. Lynch, explaining that “[w]hen a transaction involving self-dealing by a controlling shareholder is challenged, the applicable standard of review is entire fairness, with the defendants having the burden of persuasion.” The Chancellor noted, however, that “the defendants had expressly eschewed any argument that any standard of review other than entire fairness applied. Given that concession, there was no need to address the question now presented and no answer was given by ' the Supreme Court in that case.”

The “broad language” in these cases, therefore, represented for Chancellor Strine “dictum” that is “without precedential effect.” Because “no case has turned on the question of the effect of conditioning a merger up front on the approval of a special committee and a majority of the noncontrolling stockholders,” the Chancellor ruled, “the question remains an open one for this court to address in the first instance.”

Applicability of the Business Judgment Rule

Tackling the question he had raised at the outset, the Chancellor concluded “that the rule of equitable common law that best protects minority investors is one that encourages controlling stockholders to accord the minority this potent combination of procedural protections.” Most important to the Chancellor was fashioning an approach that “replicate[s] the protections of a third-party merger under the DGCL approval process ' .” The Chancellor explained that the burden-shifting approach of Kahn v. Lynch falls short “because it requires that one, but not both, of the statutory requirements of director and stockholder approval be accomplished by impartial decisionmakers.” [emphasis added]. By contrast, “[t]he 'both' structure ' replicates the arm's-length merger steps of the DGCL by 'requir[ing] two independent approvals, which it is fair to say serve independent integrity-enforcing functions.'”

So long as these two “cleansing devices” are present, Chancellor Strine recognized significant benefits to creating a path for business judgment rule review of controlling stockholder-led buyouts, including:

1. 'Currently, controlling stockholders favor the “intrinsically more coercive setting of a tender offer” followed by a second-step merger, enabling them to take advantage of the Pure Resources line of cases to escape “the full force of equitable review” of a one-step merger under Kahn v. Lynch. By dangling the carrot of a business judgment rule review, Chancellor Strine sought to provide controlling stockholders with “a strong incentive ' to accord minority investors the transactional structure that respected scholars believe will provide them with the best protection '.” “In fact,” the Chancellor noted, “this incentive may make this structure the common one, which would be highly beneficial to minority stockholders.”
2. Under the current regime, “absent the ability of defendants to bring an effective motion to dismiss, every case has settlement value, not for merits reasons, but because the costs of paying ' attorneys' fees to settle litigation and obtain a release without having to pay the minority stockholders in excess of the price agreed to by the special committee” are less than the costs inherent in a time-consuming trial on the merits to establish entire fairness. When the business judgment standard of review is available, on the other hand, controlling stockholders have a means to prevail on an early motion to dismiss.

Conclusion

In summary, Chancellor Strine ruled in MFW that a one-step controlling stockholder-led buyout will be subject to a business judgment standard of review if:

• “the controller conditions the procession of the transaction on the approval of both a special committee and a majority of the minority stockholders”;
• the special committee is “independent,” “empowered to freely select its own advisors and to say no definitively,” and “meets its duty of care”; and
• “the vote of the majority is informed ' and ' there is no coercion of the minority.”

Further, the controlling stockholder must offer these “cleansing devices” from “inception.” It “cannot dangle a majority-of-the-minority vote before the special committee late in the process as a deal-closer rather than having to make a price move.”

Whether Chancellor Strine's decision in MFW will jump-start a new normal in terms of structuring controlling stockholder-led buyouts remains, for the moment, an open question. First, dealmakers will have to decide whether the benefits of potentially obtaining a business judgment standard of review outweigh the potential risks of placing approval of a transaction in the hands of what may become a newly empowered and increasingly aggressive minority stockholder group. Second, because CNX's proposed “unified standard” is not binding, dealmakers presumably may still elect to utilize the two-step Pure Resources approach, with its less onerous level of judicial scrutiny. And, third, the Delaware Supreme Court may, at some point, be asked to weigh in. In this regard, Chancellor Strine recognized that “rational minds can disagree ' and our Supreme Court will be able to bring its own judgment to bear if the plaintiffs appeal.””

Robert S. Reder, Professor of the Practice of Law at Vanderbilt Law School, has been serving as a consulting attorney at Milbank, Tweed, Hadley & McCloy LLP since his retirement as a partner in April 2011. Mr. Reder is a member of this newsletter's Board of Editors.

Dealmakers and their legal advisers have an important choice to make when structuring a controlling stockholder-led buyout. The first alternative is a long-form merger of the controlled corporation, requiring both controlled company board approval and a positive vote of stockholders (a “one-step transaction“). Under the second alternative, the controlling stockholder launches a tender offer for the controlled corporation's publicly held shares which, if successful in bringing the controlling stockholder's ownership level to at least 90%, is followed by a short-from merger in which the approval of neither the board nor the stockholders of the controlled corporation is required (a “two-step transaction“). The larger the percentage ownership of the controlling stockholder, the more likely it is to choose the two-step approach. The Delaware courts traditionally have applied quite different standards of review to these two transactions.

Historical Perspective

One-Step Transactions

In 1994, the Delaware Supreme Court ruled in Kahn v. Lynch Communications Systems, Inc. , 638 A.2d 1110 (Del. 1994) that, in a one-step controlling stockholder-led buyout, “the exclusive standard of judicial review ' is entire fairness,” with
“[t]he initial burden of establishing entire fairness rest[ing] upon the party who stands on both sides of the transaction.” The Kahn court also ruled that “approval of the transaction by an independent committee of directors or an informed majority of minority shareholders would shift the burden of proof on the issue of fairness to the plaintiff.” Since Kahn, controlling stockholder-led buyouts generally have been conditioned on approval by a special committee of independent directors.

Two-Step Transactions

By contrast, two-step controlling stockholder-led buyouts are “reviewed under an evolving standard far less onerous than Lynch.” See In re Siliconix Inc. Shareholders Litigation, 2001 WL 716787 (Del. Ch. June 19, 2001). In 2002, in In re Pure Resources Shareholders Litigation, 808 A.2d 421 (Del. Ch. 2002), then-Vice Chancellor Leo E. Strine, Jr. “set out a series of requirements for a controlling stockholder tender offer,” including “a non-waivable majority of the minority tender condition,” a promise to consummate a 'prompt' short-form merger at the tender offer price if 90% of the target's shares are obtained in the tender offer, and the absence of any “retributive threats” if the tender offer is not successful. Further, the Vice Chancellor “imposed a duty on the controlling stockholder” to give the target board's independent directors “free rein and adequate time to react to the tender offer” in order to provide the minority “with a recommendation as to the advisability of the offer.” If this approach is taken, neither step in the transaction will be subjected to an entire fairness review.

The Unified Standard

Three years later, in In re Cox Communications, Inc. Shareholders Litigation, 879 A.2d 604 (Del. Ch. 2005), Vice Chancellor Strine promoted, in a footnote to his opinion, adoption of a “unified standard for reviewing controlling stockholder freeze-outs ' .” Under this formulation, for either a one-step or a two-step transaction, appropriate use of a special committee of independent directors and a majority-of-the-minority stockholder vote will trigger presumptive application of “the business judgment standard of review ' .” However, “if the transaction does not incorporate both protective devices, or if a plaintiff can plead particularized facts sufficient to raise a litigable question about the effectiveness of one of the devices, then the transaction is subject to entire fairness review.”

Then, in 2010, Vice Chancellor J. Travis Laster applied the unified standard to a two-step controlling stockholder-led buyout. Because both protective devices were not utilized, the Vice Chancellor subjected the buyout to an entire fairness review. In so ruling, the Vice Chancellor recognized that his promotion of the unified standard and application of a business judgment standard of review to a controlling stockholder-led buyout could not become a permanent part of the fabric of Delaware corporate law until blessed by the Delaware Supreme Court.

The Buyout of MFW by MacAndrews & Forbes

This was the state of play in May 2011 when MacAndrews & Forbes began to explore the acquisition of the publicly held shares of M&F Worldwide (MFW). At the time,
MacAndrews & Forbes owned 43.4% of MFW, and its “stock price traded in the $20 to $24 range.”

When MFW stock closed at $16.96 on June 11, MacAndrews & Forbes immediately presented the MFW board with a letter offering to purchase the publicly held shares for $24 per share in cash. MacAndrews & Forbes' proposal specified that it would not proceed with the buyout unless approved by both a special committee of independent directors and “a majority of the shares of the Company not owned by” MacAndrews & Forbes. The proposal also explained that while MacAndrews & Forbes had “no interest in selling” its MFW stake, the decision by either the special committee or the public stockholders not to approve the transaction “would not adversely affect our future relationship with the Company and we would intend to remain as a long-term stockholder.” Notably, this was exactly opposite to the approach taken by the controlling
stockholder in Kahn v. Lynch, which threatened a hostile takeover if the target board rejected its offer.

The next day, the MFW board appointed a special committee of independent directors. The special committee in turn retained independent counsel and its own financial adviser. The committee's charge was broad indeed, giving it the right not only to investigate, evaluate and negotiate MacAndrews & Forbes' offer, but also to “determine to elect not to pursue the Proposal ' .” The board also stipulated that it would not approve the transaction “without a prior favorable recommendation of the Special Committee ' .”

After obtaining updated management projections, the special committee's financial adviser applied traditional methodologies to arrive at a valuation range for MFW of $15 to $45 per share. Although MacAndrews & Forbes' $24 offer price fell within this valuation range, the committee rejected MacAndrews & Forbes' offer and countered at $30 per share. When MacAndrews & Forbes made its “best and final” offer of $25, the special committee, following receipt of a fairness opinion from its financial adviser, “unanimously decided to accept ' .” At the stockholders meeting that followed, “65% of the shares not owned by
MacAndrews & Forbes voted to accept the offer.” Nevertheless, the inevitable stockholder lawsuit “seeking a post-closing damages remedy for breach of fiduciary duty” proceeded.

On May 29, 2013, in In re MFW Shareholders Litigation, C.A. No. 6566-CS (Del. Ch. May 29, 2013), Chancellor Strine surprised many commentators by accepting MacAndrews & Forbes' argument that the business judgment rule could, under the right circumstances, apply to a one-step controlling stockholder-led buyout. In the Chancellor's view, the controlling stockholder in MFW did everything right, thus entitling it to summary judgment in its favor.

The Chancellor's Analysis

Satisfaction of the Duty of Care

Chancellor Strine began his analysis by examining the process employed to negotiate and approve the transaction.

First, the Chancellor concluded that the special committee consisted of truly independent directors. Despite “various business and social ties” between committee members and MacAndrews & Forbes, the Chancellor found that plaintiffs had not satisfied their burden of establishing that any committee member “is 'beholden' to the controlling party 'or so under [the controller's] influence that [the director's] discretion would be sterilized.'” Indeed, “mere allegations that directors are friendly with, travel in the same social circles, or have past business relationships with the proponent of a transaction ' are not enough to rebut the presumption of independence.”

Next, the Chancellor commented favorably on the process followed by the special committee, including its utilization of an independent financial adviser, its negotiation of MacAndrews & Forbes' original offer price, its frequent meetings, and the “rich body of financial information” that it reviewed.

Finally, the Chancellor found the majority-of-the-minority stockholder approval to be “fully informed and uncoerced.” Specifically, the Chancellor credited the proxy statement disclosure furnished to stockholders, including the presentation of “five separate ranges for the value of MFW's stock” prepared by the special committee's financial adviser. Further, the Chancellor refused to give any weight to plaintiff's argument that “many of these stockholders were arbitrageurs who had bought them from longer-term stockholders and whose views should be discounted ' .”

According to the Chancellor, “[t]hese conditions are sufficient ' as to a conflict transaction not involving a controlling stockholder ' to invoke the business judgment rule standard of review.” [emphasis added] The key question for the Chancellor to address, therefore, was whether the business judgment rule standard also could apply to a controlling stockholder-led buyout in which these conditions are satisfied?

Applicable Supreme Court Precedent

Before Chancellor Strine addressed this question, he considered whether past decisions of the state Supreme Court precluded him from applying a business judgment standard of review to the MFW buyout. The answer to this was not clear-cut. On the one hand, the Chancellor found that “the Supreme Court has never been asked this question and ' none of its prior decisions hinged on this question.” On the other hand, he acknowledged “broad statements in certain Supreme Court decisions that, if read literally and as binding holdings of law, say that the entire fairness standard applies to any merger with a controlling stockholder, regardless of the circumstances.”

Among the cases cited in this regard were Kahn v. Lynch and a very recent decision, Americas Mining Corporation v. Michael Theriault , 51 A.2d 1213 (Del. 2012). Chancellor Strine distinguished Kahn v. Lynch on the basis of the very different approach taken by MacAndrews & Forbes, particularly the lack of any retributive threat if the transaction was not approved, and its requirement of a majority-of-minority stockholder approval. In Americas Mining Corporation, the Supreme Court had quoted extensively from Kahn v. Lynch, explaining that “[w]hen a transaction involving self-dealing by a controlling shareholder is challenged, the applicable standard of review is entire fairness, with the defendants having the burden of persuasion.” The Chancellor noted, however, that “the defendants had expressly eschewed any argument that any standard of review other than entire fairness applied. Given that concession, there was no need to address the question now presented and no answer was given by ' the Supreme Court in that case.”

The “broad language” in these cases, therefore, represented for Chancellor Strine “dictum” that is “without precedential effect.” Because “no case has turned on the question of the effect of conditioning a merger up front on the approval of a special committee and a majority of the noncontrolling stockholders,” the Chancellor ruled, “the question remains an open one for this court to address in the first instance.”

Applicability of the Business Judgment Rule

Tackling the question he had raised at the outset, the Chancellor concluded “that the rule of equitable common law that best protects minority investors is one that encourages controlling stockholders to accord the minority this potent combination of procedural protections.” Most important to the Chancellor was fashioning an approach that “replicate[s] the protections of a third-party merger under the DGCL approval process ' .” The Chancellor explained that the burden-shifting approach of Kahn v. Lynch falls short “because it requires that one, but not both, of the statutory requirements of director and stockholder approval be accomplished by impartial decisionmakers.” [emphasis added]. By contrast, “[t]he 'both' structure ' replicates the arm's-length merger steps of the DGCL by 'requir[ing] two independent approvals, which it is fair to say serve independent integrity-enforcing functions.'”

So long as these two “cleansing devices” are present, Chancellor Strine recognized significant benefits to creating a path for business judgment rule review of controlling stockholder-led buyouts, including:

1. 'Currently, controlling stockholders favor the “intrinsically more coercive setting of a tender offer” followed by a second-step merger, enabling them to take advantage of the Pure Resources line of cases to escape “the full force of equitable review” of a one-step merger under Kahn v. Lynch. By dangling the carrot of a business judgment rule review, Chancellor Strine sought to provide controlling stockholders with “a strong incentive ' to accord minority investors the transactional structure that respected scholars believe will provide them with the best protection '.” “In fact,” the Chancellor noted, “this incentive may make this structure the common one, which would be highly beneficial to minority stockholders.”
2. Under the current regime, “absent the ability of defendants to bring an effective motion to dismiss, every case has settlement value, not for merits reasons, but because the costs of paying ' attorneys' fees to settle litigation and obtain a release without having to pay the minority stockholders in excess of the price agreed to by the special committee” are less than the costs inherent in a time-consuming trial on the merits to establish entire fairness. When the business judgment standard of review is available, on the other hand, controlling stockholders have a means to prevail on an early motion to dismiss.

Conclusion

In summary, Chancellor Strine ruled in MFW that a one-step controlling stockholder-led buyout will be subject to a business judgment standard of review if:

• “the controller conditions the procession of the transaction on the approval of both a special committee and a majority of the minority stockholders”;
• the special committee is “independent,” “empowered to freely select its own advisors and to say no definitively,” and “meets its duty of care”; and
• “the vote of the majority is informed ' and ' there is no coercion of the minority.”

Further, the controlling stockholder must offer these “cleansing devices” from “inception.” It “cannot dangle a majority-of-the-minority vote before the special committee late in the process as a deal-closer rather than having to make a price move.”

Whether Chancellor Strine's decision in MFW will jump-start a new normal in terms of structuring controlling stockholder-led buyouts remains, for the moment, an open question. First, dealmakers will have to decide whether the benefits of potentially obtaining a business judgment standard of review outweigh the potential risks of placing approval of a transaction in the hands of what may become a newly empowered and increasingly aggressive minority stockholder group. Second, because CNX's proposed “unified standard” is not binding, dealmakers presumably may still elect to utilize the two-step Pure Resources approach, with its less onerous level of judicial scrutiny. And, third, the Delaware Supreme Court may, at some point, be asked to weigh in. In this regard, Chancellor Strine recognized that “rational minds can disagree ' and our Supreme Court will be able to bring its own judgment to bear if the plaintiffs appeal.””

Robert S. Reder, Professor of the Practice of Law at Vanderbilt Law School, has been serving as a consulting attorney at Milbank, Tweed, Hadley & McCloy LLP since his retirement as a partner in April 2011. Mr. Reder is a member of this newsletter's Board of Editors.