Court of Chancery Explains Why Not All Sale Processes Require Entire Fairness or Revlon Review
Since Kahn v. Lynch in 1994, the Delaware Supreme Court has subjected cash-out merger transactions proposed by controlling stockholders to a higher level of entire fairness scrutiny than the more deferential business judgment review, regardless of whether disinterested directors negotiated the transaction or a majority of the disinterested minority stockholders approved the transaction. Even in a third-party transaction where a controlling stockholder is not on both sides, courts have applied the test of entire fairness where stockholders can allege that a controlling party used its power to cause the company to enter into a transaction that diverted proceeds unfairly to the controlling stockholder at the expense and to the detriment of the minority stockholders. Likewise, since the landmark Revlon decision in 1986, the Delaware Supreme Court in sale-of-control transactions has required defendant directors to prove they followed a reasonable decision-making process and acted reasonably in light of the available information. Because in any of these circumstances the standard of review is less deferential, a minority stockholder attacking a transaction materially increases the prospects of surviving a motion to dismiss if able to plead facts that demonstrate that either entire fairness or intermediate Revlon-level scrutiny applies. In In re Synthes Shareholders Litigation, C.A. No. 6452, 2012 WL 3641014 (Aug. 17, 2012), the Court of Chancery dismissed a complaint attacking a sale transaction in an opinion that demonstrates that mere conclusory allegations that a controlling stockholder favored a sale transaction will not suffice to trigger a higher level of judicial scrutiny where the plaintiff cannot allege a genuine conflict of interest.
Synthes was a global medical device company headquartered in Switzerland. In April 2011, its board agreed to a merger transaction with Johnson & Johnson in which the stockholders of Synthes would receive merger consideration consisting of 65 percent of J&J stock and 35 percent cash. In attacking the transaction, plaintiffs alleged that Hansjorg Wyss, the Synthes board chair, also was its controlling stockholder and that he controlled a majority of its board through familial and business ties. According to the plaintiffs, Wyss' core personal interest different from the interest of the other Synthes stockholders was to divest his stockholdings for estate planning and tax goals. Here is how the court summarized the plaintiffs' key allegation:
"Doing so piecemeal would be problematic, however, because unloading that much stock on the public market in blocs would cause the share price to drop, thus reducing his sale profits. So, the plaintiffs contend, in order to achieve his liquidity goals in view of Synthes' allegedly thin public float, Wyss needed to sell his personal holdings to a single buyer. Wyss was by far the largest stockholder of Synthes (with the next largest non-affiliated stockholder holding only a 6 percent stake), and thus was the only stockholder who could not liquidate his entire Synthes stake on the public markets without affecting the share price."
In assessing that claim, the court noted several pleading deficiencies. First, the plaintiffs substantially relied upon the amended proxy statement, which indicated that the impetus to explore a sale transaction came from the board, not Wyss. Second, the board thereafter embarked upon a lengthy, two-year sales process that included reaching out to nine potential strategic and four potential financial buyers. Finally, the court found that a controlling stockholder has no disabling conflict simply because he or she elects to agree to a transaction where all stockholders are treated ratably the same as opposed to one that might have offered more to the minority stockholders at the expense of the majority stockholder.
The latter point is significant. The court noted that the plaintiffs pleaded no facts that Wyss faced a solvency issue or was in any particular hurry to sell his shares. The board-initiated patient sales process of over two years with no allegations that the sales process discriminated against strategic or financial buyers further undermined the plaintiffs' theory. The plaintiffs ultimately argued that Wyss was conflicted because "no matter when a deal occurred, Wyss would only accept one in which he received liquidity for his shares and unfairly blocked [a bid] that required him to remain as an investor in Synthes." The court's reasons for rejecting this theory provide important guidance regarding Delaware's controlling stockholder jurisprudence.
First, the plaintiffs conceded that they preferred a transaction that provided liquidity for their shares. Therefore, the plaintiffs shared the majority shareholders' interest in liquidity at the highest dollar value possible. Particularly harmful to the plaintiffs' theory was their allegation that Wyss supported Synthes allowing three private equity buyers to pool their resources in a club deal to facilitate their ability to improve their bid. On these pleaded facts, the court found no basis to infer a conflict of interest.
Second, the court found that a controlling stockholder is under no duty to consider an all-cash deal that would have required him to accept different and less liquid consideration by retaining equity in the post-merger company. In short, while controlling stockholders may not use the corporate machinery to benefit themselves at the expense of the minority stockholders, they are not required to disadvantage themselves or engage in self-sacrifice to benefit the minority stockholders. "Put simply, minority stockholders are not entitled to get a deal on better terms than what is being offered to the controller, and the fact that the controller would not accede to that deal does not create a disabling conflict of interest."
The court also found that the pleaded allegations did not demonstrate that Revlon-level scrutiny was appropriate. The board ultimately accepted a bid consisting of 65 percent stock and 35 percent cash, where the stock portion was from a company, Johnson & Johnson, whose shares are held in a large, fluid market. In the absence of an allegation that the stock portion of the consideration was in a controlled company, the court relied upon the Delaware Supreme Court's decision in In re Santa Fe Pacific Shareholder Litigation, 669 A.2d 59,71 (Del. 1995), to conclude that the business judgment rule applied. The Supreme Court so held in assessing a transaction where the merger consideration was 33 percent cash and 67 percent stock, so the Court of Chancery reasoned that the same result should apply where the merger consideration was substantially similar - 65 percent stock and 35 percent cash.
The court's dismissal demonstrates that stockholder plaintiffs cannot state a claim merely by asserting that a controlling stockholder preferred a merger transaction. Plaintiffs instead must make well-pleaded allegations that the controlling stockholder's interest in the transaction was in fact different from the remaining stockholders. An allegation that a controlling stockholder favored a transaction that resulted from a deliberative sale process in which the control premium is shared ratably with the minority stockholders will not suffice to rebut the business judgment rule. In that circumstance, a controlling stockholder could reject a transaction that would have required him or her to obtain less liquidity and incur greater risk without violating his or her duty of loyalty. The lesson to practitioners is that, absent well-pleaded allegations that the controlling stockholder used the corporate machinery to benefit itself at the expense of the minority stockholders, a rote incantation that a majority stockholder favored a transaction will not suffice to rebut the business judgment rule.