DE Court Applies Business Judgment Rule in Reviewing LBO

Background

SRA International is “a leading provider of technology solutions and professional services, primarily to the federal government.” Founded in 1978 by Ernst Volgenau, SRA completed its initial public offering in 2002. Volgenau retained his control position following the IPO through ownership of a class of multiple-vote common stock ' giving him approximately 72% of the voting power despite an approximate 22% equity position ' and his status as CEO. Even after Volgenau stepped down as CEO, he remained as Chairman of the Board, continued to have “considerable influence over the operations of the Company” and “actively participated in the selection of” his successor CEOs.

When SRA's performance began to flag in 2008, “Volgenau became interested in the prospect of a leveraged buy-out ' [to] provide stockholders with a substantial premium to SRA's current stock price ' .” Although Volgenau was initially skeptical that a strategic buyer would be willing to “preserv[e] the Company's values and culture,” which he held dear, he acknowledged that “the eventual acquirer might very well be a strategic competitor.”

Providence Equity Partners LLC, a private equity fund, developed an interest in acquiring SRA, even going so far as retaining Volgenau's immediate successor as CEO and another former SRA executive to assist its business review and gain credibility with Volgenau. Following introductions made by these former executives, Volgenau and various members of SRA management began “preliminary discussions” with representatives of Providence over a potential buyout and “shared proprietary information.”

Following a failed attempt at a transformative acquisition, the SRA board formed an “independent special committee” authorized with “evaluating, soliciting third-party interest in, and negotiating potential strategic transactions.” The committee retained its own financial and legal advisers and instructed Volgenau not to have “any further discussions with Providence [or any other bidder] except as may be approved and coordinated by the Committee ' .” Providence was given the first opportunity to negotiate a buyout, but after it made a disappointing $27.25 initial offer, the committee denied Providence exclusivity, and determined “to explore and assess additional third-party interest ' .”

To that end, in early 2011, the committee solicited interest from six potential financial buyers and one potential strategic buyer. No other strategics were contacted at the time “in order to safeguard confidential and proprietary information and avoid 'leaks into the marketplace.'” When rumors circulated that the potential strategic buyer had made an offer and SRA's stock price jumped by 19%, SRA “confirmed publicly that it had received 'a series of inquiries regarding the company's willingness to consider offers'” and retained a financial adviser “to provide advice.”

The committee in turn decided to “open up the bidding process to other strategic sponsors to extract the maximum possible value for SRA.” To address concerns raised by Volgenau ' whose support as controlling stockholder was obviously essential ' the committee agreed to a “bifurcated process in which it would exclusively address issues of price and certainty while Volgenau would meet with strategic acquirers to discuss his 'humanistic concerns.'”

Despite significant outreach to both potential financial and strategic bidders, only two financial bidders became actively engaged: Providence and Veritas Capital. After much back and forth in which Veritas secured temporary exclusivity, Providence emerged as the winning bidder at $31.25 per share in cash, representing a “52.8% premium over SRA's stock price on Dec. 31, 2010.” Providence agreed to a 30-day, post-signing “go-shop” provision and limited its termination fee in the event of a topping bid during the go-shop period of 1.5% of deal value, which increased to 2.5% after the go-shop period if an unsolicited topping bid emerged.

Providence also agreed to subject the deal to a “majority of the minority vote that was not waivable by the Special Committee.” Although 50 potential bidders were contacted during the go-shop period ' 29 strategic and 21 financial ' no new bidder emerged. SRA's public stockholders overwhelmingly approved the deal, which closed on July 20, 2011.

To secure the higher bid from Providence, Volgenau was convinced to play a role in the buyout quite different from SRA's public stockholders.

First, Volgenau agreed to exchange 41% of his SRA equity for stock of the ongoing enterprise, thereby reducing the funding required by Providence to finance the buyout. The remainder of his shares would be converted into the same $31.25 per share in cash paid to the other stockholders. To “protect” his new minority position, Volgenau was named Chairman of the surviving company and “obtained a commitment from Providence to uphold and preserve the values of honesty and service” so highly valued by Volgenau.

Second, Volgenau agreed to make a $30 million non-recourse loan to Providence that would only be repaid from the proceeds of contemplated sales of two SRA subsidiaries following closing. The committee “concluded that Volgenau would not be receiving any 'additional economic benefit under the loan if the proceeds of such subsidiary sales were to exceed $30 million.'” For his part, Volgenau viewed this as a “rotten deal for me” with “no upside and all downside.”

A former minority stockholder sued the SRA directors in the Court of Chancery, asserting breach of fiduciary duty “relating to their conduct in approving the merger ' .” Defendants moved for summary judgment. According to Vice Chancellor Noble, “[a]t the center of the Defendants' motion is whether robust procedural protections were used that entitle the merger to [be] reviewed under the deferential business judgment rule instead of the exacting entire fairness standard.” The Vice Chancellor first opted to review the transaction under the business judgment rule, and then granted defendants' summary judgment motion.

The Vice Chancellor's Analysis

MFW Shareholders Litigation

At the outset, Vice Chancellor Noble noted that Chancellor Leo E. Strine, Jr.'s recent ground-breaking ruling in In re MFW Shareholders Litigation, C.A. No. 6566-CS (Del. Ch. May 29, 2013), “illuminates many of the procedural protections at issue in this case.” In particular, the Vice Chancellor referenced the policy underlying MFW that “because these procedural protections had the effect of replicating an arms' length transaction, they had a 'cleansing' effect on the transaction that justified judicial review under the deferential business judgment rule.” For a more complete discussion of Chancellor Strine's ruling in MFW, please see The Corporate Counselor, “Chancellor Strine Creates Path for Business Judgment Review of Controlling Stockholder-Led Buyouts,” by Robert S. Reder, Vol. 28, No. 4 (August 2013).

Next, the Vice Chancellor distinguished the situation in MFW, “which involved a controlling stockholder on both sides of the transaction,” from the facts before him, involving “a merger between a third-party and a company with a controlling stockholder. ' Volgenau is not a buyer in this transaction ' [and as] a seller, his interest is generally aligned with that of minority stockholders to the extent that he receives equal consideration for his shares.” [emphasis added] Nevertheless, the Vice Chancellor recognized that “a controlling stockholder may, even in this context, inappropriately influence the outcome of the sale process ' .” As such, the key question for the Vice Chancellor was whether the parties to the SRA buyout had successfully utilized “the procedural protections necessary for a third-party transaction involving a controlling stockholder to qualify for review under the business judgment rule ' .”

Business Judgment As the Appropriate Standard of Review

As an initial matter, the Vice Chancellor found that plaintiff's contention that Volgenau stood on both sides of the transaction “is not supported by the factual record or Delaware law.” Among the many factors cited in support of this position, plaintiff noted that “Providence, in a presentation to lenders, referred to Volgenau as its partner and highlighted its special relationship with him.” The Vice Chancellor rejected that view, noting that:

• There was no “prior affiliation between Volgenau and Providence,” and their preliminary conversations concerning a buyout “did not somehow magically transform Volgenau into an affiliate of Providence.”
• Under Delaware law, a controlling stockholder “does not 'stand on both sides' of the merger” merely because he “receives a minority interest in the surviving company.”
• “Volgenau, who had the right to vote or not to vote his shares, did not become a buyer in the Merger because he engaged in separate discussions with Providence regarding his humanistic concerns.” The decision to allow Volgenau to have these
  discussions “was reasonable given that Volgenau, as the controlling stockholder, had the right to vote his shares as he wished.”

Vice Chancellor Noble turned next to the procedural protections employed by Providence and the SRA board. With respect to the appropriateness of the Special Committee, the Vice Chancellor found that the plaintiff did not successfully dispute “that the Special Committee executed a robust process in which all interested bidders were afforded an equal opportunity to buy SRA.” The members of the Committee “attended numerous ' meetings and calls, participated in discussions, and voiced their views on various issues.” Further, they “bargained hard against Providence, forcing it to increase its bid from $27.25 per share to $31.25 per share” and “repeatedly rejected Providence's requests for exclusivity ' .” They “solicited a plethora of other financial and strategic sponsors to participate in the bidding process, even though Volgenau had initially expressed concerns about strategic buyers.” Finally, the Committee “was fully functioning and had authority to select its advisors freely,” and “had the authority to recommend or not to recommend any transaction.” In sum, the defendants “were fully informed and exercised due care in approving the Merger.”

With respect to the viability of the non-waivable majority of the minority stockholder vote to approve the buyout, Vice Chancellor Noble found no fault with the disclosures made to the stockholders in connection with soliciting that approval. In his view, plaintiff failed to carry its burden of showing that the directors did not satisfy their “fiduciary duty to disclose fully and fairly all material information within the board's control when it seeks shareholder action.”

Accordingly, Vice Chancellor Noble sided with defendant directors in ruling that Providence's buyout of SRA should be reviewed “under the business judgment standard.”

Application of the Business Judgment Standard of Review

Once Vice Chancellor Noble concluded that business judgment was the appropriate standard of review, “the directors' decisions are entitled to 'great deference'” and will not be upset if attributable “'to any rational business purpose.'” In view of a variety of factors, including that “[t]he Merger was effected at a 52.8% premium,” the price “was the highest price that any party was willing to pay after a six month public sale process and a thirty-day go-shop,” and “[t]he Board wisely and properly decided to form a special committee,” the Vice Chancellor determined that “the Court will not substitute its judgment for that of the SRA Directors, whose actions can plainly be attributed to a rational business purpose.”

Alleged Violation of Certificate of Incorporation

Finally, Vice Chancellor Noble considered whether Providence's arrangements with Volgenau violated a provision in SRA's certificate of incorporation that, in the event of a merger, “holders of each class of Common Stock will be entitled to receive equal per share payments or distributions ' .” The Vice Chancellor answered this question in the negative, finding that:

• “the plain language of the equal treatment clause plainly permits differing forms of consideration”; and
• there was “no genuine issue of material fact that the Board acted rationally when it assumed that Volgenau's rollover interest was equal to or less than” amounts received by the other stockholders for their shares. In this regard, the Vice Chancellor found that the note received by Volgenau for his loan “had considerable risk and no upside” and the other rights he received “were defensive in nature, and thus, necessary to preserve his rollover interest.”

Conclusion

Vice Chancellor Noble summed up his decision to grant summary judgment in favor of SRA's directors by noting that “[a]s does MFW, this case serves as an example of how the proper utilization of certain procedural devices can avoid judicial review under the entire fairness standard and, perhaps in most instances, the burdens of trial.” Inasmuch as the transaction before him: 1) “was recommended by a fully functioning, independent special committee that was empowered to negotiate on behalf of the minority stockholders ' [and] had the ability to hire independent advisors and not recommend a transaction”; and 2) was approved by “[f]ully informed shareholders vot[ing] overwhelmingly in favor of the Merger in a non-waivable majority of the minority vote,” the defendants were “entitled to judgment on all counts.”

The Vice Chancellor's detailed opinion presents a helpful roadmap for structuring and processing third party buyouts of controlled companies in which the controlling stockholder receives consideration different from that received by the public stockholders. Presumably, this analysis ' and the result ' would have followed even if the consideration and rights obtained by the Volgenau had been superior to that received by the public stockholders.

Given the wide acceptance of well-functioning special committees of independent directors in transactions involving controlling stockholders, the key question for M&A practitioners is whether the procedural benefits of also seeking a majority-of-the-minority stockholder vote outweigh the risk of affording significant minority stockholders with the potential hold-up value inherent in such a vote. A thorough analysis of the target company's minority stockholder population should certainly be conducted before making that decision.

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.

M&A transactions involving publicly traded companies with controlling stockholders often present thorny issues for dealmakers and their legal counsel. Even in the case of a purchase by an unaffiliated third party, controlling stockholders understandably may seek to leverage their control positions to achieve results that best suit them. Further, private equity buyers in particular often require controlling stockholders to “roll over” a portion of their stock into equity of the continuing corporation and/or enter into other arrangements to facilitate the transaction.

As a result, litigation challenging the fairness of these transactions to the public stockholders is a staple of M&A practice. In an effort to assure a degree of fairness to the public stockholders, the Delaware courts traditionally have imposed more intrusive standards of review than are customarily employed in buyouts of companies without controlling stockholders.

Recently, in Southeastern Pennsylvania Transportation Authority v. Volgenau, C.A. No. 6354-VCN (Del. Ch. Aug. 5, 2013), Vice Chancellor John W. Noble of the Delaware Court of Chancery had an opportunity to weigh in on the process followed in a third-party buyout of SRA International, a controlled corporation. Vice Chancellor Noble ruled that, in such a case, “robust procedural protections” can achieve business judgment rule review, even where the controlling stockholder retains a material interest in the ongoing company following the buyout. If utilized, this approach will secure a more limited degree of judicial scrutiny and thereby enable the deal proponents to achieve early dismissal of stockholder litigation.

Background

SRA International is “a leading provider of technology solutions and professional services, primarily to the federal government.” Founded in 1978 by Ernst Volgenau, SRA completed its initial public offering in 2002. Volgenau retained his control position following the IPO through ownership of a class of multiple-vote common stock ' giving him approximately 72% of the voting power despite an approximate 22% equity position ' and his status as CEO. Even after Volgenau stepped down as CEO, he remained as Chairman of the Board, continued to have “considerable influence over the operations of the Company” and “actively participated in the selection of” his successor CEOs.

When SRA's performance began to flag in 2008, “Volgenau became interested in the prospect of a leveraged buy-out ' [to] provide stockholders with a substantial premium to SRA's current stock price ' .” Although Volgenau was initially skeptical that a strategic buyer would be willing to “preserv[e] the Company's values and culture,” which he held dear, he acknowledged that “the eventual acquirer might very well be a strategic competitor.”

Providence Equity Partners LLC, a private equity fund, developed an interest in acquiring SRA, even going so far as retaining Volgenau's immediate successor as CEO and another former SRA executive to assist its business review and gain credibility with Volgenau. Following introductions made by these former executives, Volgenau and various members of SRA management began “preliminary discussions” with representatives of Providence over a potential buyout and “shared proprietary information.”

Following a failed attempt at a transformative acquisition, the SRA board formed an “independent special committee” authorized with “evaluating, soliciting third-party interest in, and negotiating potential strategic transactions.” The committee retained its own financial and legal advisers and instructed Volgenau not to have “any further discussions with Providence [or any other bidder] except as may be approved and coordinated by the Committee ' .” Providence was given the first opportunity to negotiate a buyout, but after it made a disappointing $27.25 initial offer, the committee denied Providence exclusivity, and determined “to explore and assess additional third-party interest ' .”

To that end, in early 2011, the committee solicited interest from six potential financial buyers and one potential strategic buyer. No other strategics were contacted at the time “in order to safeguard confidential and proprietary information and avoid 'leaks into the marketplace.'” When rumors circulated that the potential strategic buyer had made an offer and SRA's stock price jumped by 19%, SRA “confirmed publicly that it had received 'a series of inquiries regarding the company's willingness to consider offers'” and retained a financial adviser “to provide advice.”

The committee in turn decided to “open up the bidding process to other strategic sponsors to extract the maximum possible value for SRA.” To address concerns raised by Volgenau ' whose support as controlling stockholder was obviously essential ' the committee agreed to a “bifurcated process in which it would exclusively address issues of price and certainty while Volgenau would meet with strategic acquirers to discuss his 'humanistic concerns.'”

Despite significant outreach to both potential financial and strategic bidders, only two financial bidders became actively engaged: Providence and Veritas Capital. After much back and forth in which Veritas secured temporary exclusivity, Providence emerged as the winning bidder at $31.25 per share in cash, representing a “52.8% premium over SRA's stock price on Dec. 31, 2010.” Providence agreed to a 30-day, post-signing “go-shop” provision and limited its termination fee in the event of a topping bid during the go-shop period of 1.5% of deal value, which increased to 2.5% after the go-shop period if an unsolicited topping bid emerged.

Providence also agreed to subject the deal to a “majority of the minority vote that was not waivable by the Special Committee.” Although 50 potential bidders were contacted during the go-shop period ' 29 strategic and 21 financial ' no new bidder emerged. SRA's public stockholders overwhelmingly approved the deal, which closed on July 20, 2011.

To secure the higher bid from Providence, Volgenau was convinced to play a role in the buyout quite different from SRA's public stockholders.

First, Volgenau agreed to exchange 41% of his SRA equity for stock of the ongoing enterprise, thereby reducing the funding required by Providence to finance the buyout. The remainder of his shares would be converted into the same $31.25 per share in cash paid to the other stockholders. To “protect” his new minority position, Volgenau was named Chairman of the surviving company and “obtained a commitment from Providence to uphold and preserve the values of honesty and service” so highly valued by Volgenau.

Second, Volgenau agreed to make a $30 million non-recourse loan to Providence that would only be repaid from the proceeds of contemplated sales of two SRA subsidiaries following closing. The committee “concluded that Volgenau would not be receiving any 'additional economic benefit under the loan if the proceeds of such subsidiary sales were to exceed $30 million.'” For his part, Volgenau viewed this as a “rotten deal for me” with “no upside and all downside.”

A former minority stockholder sued the SRA directors in the Court of Chancery, asserting breach of fiduciary duty “relating to their conduct in approving the merger ' .” Defendants moved for summary judgment. According to Vice Chancellor Noble, “[a]t the center of the Defendants' motion is whether robust procedural protections were used that entitle the merger to [be] reviewed under the deferential business judgment rule instead of the exacting entire fairness standard.” The Vice Chancellor first opted to review the transaction under the business judgment rule, and then granted defendants' summary judgment motion.

The Vice Chancellor's Analysis

MFW Shareholders Litigation

At the outset, Vice Chancellor Noble noted that Chancellor Leo E. Strine, Jr.'s recent ground-breaking ruling in In re MFW Shareholders Litigation, C.A. No. 6566-CS (Del. Ch. May 29, 2013), “illuminates many of the procedural protections at issue in this case.” In particular, the Vice Chancellor referenced the policy underlying MFW that “because these procedural protections had the effect of replicating an arms' length transaction, they had a 'cleansing' effect on the transaction that justified judicial review under the deferential business judgment rule.” For a more complete discussion of Chancellor Strine's ruling in MFW, please see The Corporate Counselor, “Chancellor Strine Creates Path for Business Judgment Review of Controlling Stockholder-Led Buyouts,” by Robert S. Reder, Vol. 28, No. 4 (August 2013).

Next, the Vice Chancellor distinguished the situation in MFW, “which involved a controlling stockholder on both sides of the transaction,” from the facts before him, involving “a merger between a third-party and a company with a controlling stockholder. ' Volgenau is not a buyer in this transaction ' [and as] a seller, his interest is generally aligned with that of minority stockholders to the extent that he receives equal consideration for his shares.” [emphasis added] Nevertheless, the Vice Chancellor recognized that “a controlling stockholder may, even in this context, inappropriately influence the outcome of the sale process ' .” As such, the key question for the Vice Chancellor was whether the parties to the SRA buyout had successfully utilized “the procedural protections necessary for a third-party transaction involving a controlling stockholder to qualify for review under the business judgment rule ' .”

Business Judgment As the Appropriate Standard of Review

As an initial matter, the Vice Chancellor found that plaintiff's contention that Volgenau stood on both sides of the transaction “is not supported by the factual record or Delaware law.” Among the many factors cited in support of this position, plaintiff noted that “Providence, in a presentation to lenders, referred to Volgenau as its partner and highlighted its special relationship with him.” The Vice Chancellor rejected that view, noting that:

• There was no “prior affiliation between Volgenau and Providence,” and their preliminary conversations concerning a buyout “did not somehow magically transform Volgenau into an affiliate of Providence.”
• Under Delaware law, a controlling stockholder “does not 'stand on both sides' of the merger” merely because he “receives a minority interest in the surviving company.”
• “Volgenau, who had the right to vote or not to vote his shares, did not become a buyer in the Merger because he engaged in separate discussions with Providence regarding his humanistic concerns.” The decision to allow Volgenau to have these
  discussions “was reasonable given that Volgenau, as the controlling stockholder, had the right to vote his shares as he wished.”

Vice Chancellor Noble turned next to the procedural protections employed by Providence and the SRA board. With respect to the appropriateness of the Special Committee, the Vice Chancellor found that the plaintiff did not successfully dispute “that the Special Committee executed a robust process in which all interested bidders were afforded an equal opportunity to buy SRA.” The members of the Committee “attended numerous ' meetings and calls, participated in discussions, and voiced their views on various issues.” Further, they “bargained hard against Providence, forcing it to increase its bid from $27.25 per share to $31.25 per share” and “repeatedly rejected Providence's requests for exclusivity ' .” They “solicited a plethora of other financial and strategic sponsors to participate in the bidding process, even though Volgenau had initially expressed concerns about strategic buyers.” Finally, the Committee “was fully functioning and had authority to select its advisors freely,” and “had the authority to recommend or not to recommend any transaction.” In sum, the defendants “were fully informed and exercised due care in approving the Merger.”

With respect to the viability of the non-waivable majority of the minority stockholder vote to approve the buyout, Vice Chancellor Noble found no fault with the disclosures made to the stockholders in connection with soliciting that approval. In his view, plaintiff failed to carry its burden of showing that the directors did not satisfy their “fiduciary duty to disclose fully and fairly all material information within the board's control when it seeks shareholder action.”

Accordingly, Vice Chancellor Noble sided with defendant directors in ruling that Providence's buyout of SRA should be reviewed “under the business judgment standard.”

Application of the Business Judgment Standard of Review

Once Vice Chancellor Noble concluded that business judgment was the appropriate standard of review, “the directors' decisions are entitled to 'great deference'” and will not be upset if attributable “'to any rational business purpose.'” In view of a variety of factors, including that “[t]he Merger was effected at a 52.8% premium,” the price “was the highest price that any party was willing to pay after a six month public sale process and a thirty-day go-shop,” and “[t]he Board wisely and properly decided to form a special committee,” the Vice Chancellor determined that “the Court will not substitute its judgment for that of the SRA Directors, whose actions can plainly be attributed to a rational business purpose.”

Alleged Violation of Certificate of Incorporation

Finally, Vice Chancellor Noble considered whether Providence's arrangements with Volgenau violated a provision in SRA's certificate of incorporation that, in the event of a merger, “holders of each class of Common Stock will be entitled to receive equal per share payments or distributions ' .” The Vice Chancellor answered this question in the negative, finding that:

• “the plain language of the equal treatment clause plainly permits differing forms of consideration”; and
• there was “no genuine issue of material fact that the Board acted rationally when it assumed that Volgenau's rollover interest was equal to or less than” amounts received by the other stockholders for their shares. In this regard, the Vice Chancellor found that the note received by Volgenau for his loan “had considerable risk and no upside” and the other rights he received “were defensive in nature, and thus, necessary to preserve his rollover interest.”

Conclusion

Vice Chancellor Noble summed up his decision to grant summary judgment in favor of SRA's directors by noting that “[a]s does MFW, this case serves as an example of how the proper utilization of certain procedural devices can avoid judicial review under the entire fairness standard and, perhaps in most instances, the burdens of trial.” Inasmuch as the transaction before him: 1) “was recommended by a fully functioning, independent special committee that was empowered to negotiate on behalf of the minority stockholders ' [and] had the ability to hire independent advisors and not recommend a transaction”; and 2) was approved by “[f]ully informed shareholders vot[ing] overwhelmingly in favor of the Merger in a non-waivable majority of the minority vote,” the defendants were “entitled to judgment on all counts.”

The Vice Chancellor's detailed opinion presents a helpful roadmap for structuring and processing third party buyouts of controlled companies in which the controlling stockholder receives consideration different from that received by the public stockholders. Presumably, this analysis ' and the result ' would have followed even if the consideration and rights obtained by the Volgenau had been superior to that received by the public stockholders.

Given the wide acceptance of well-functioning special committees of independent directors in transactions involving controlling stockholders, the key question for M&A practitioners is whether the procedural benefits of also seeking a majority-of-the-minority stockholder vote outweigh the risk of affording significant minority stockholders with the potential hold-up value inherent in such a vote. A thorough analysis of the target company's minority stockholder population should certainly be conducted before making that decision.

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.