Has the Merger Defense to Derivative Litigation Ended?
Directors of a Delaware corporation have one sure defense to a derivative suit — eliminate the pesky stockholder plaintiff's standing to sue. Of course, that tactic involves also eliminating all of the other stockholders as well by a cash-out merger and that requires a willing merger partner who is willing to pay fair value for all of the stock. But when there is a controlling stockholder involved and the cash is available, the cash-out merger ends what may be costly litigation.
That is no small benefit. For when the derivative litigation challenges a transaction that allegedly benefited a controlling stockholder, that stockholder and his or her affiliated directors bear the burden of proving what they did was "intrinsically fair" to the corporation. While few such cases go to trial, the few that do have occasionally resulted in very big verdicts. The $1 billion threshold for such a verdict has now been crossed, for example. The costs to defend such claims are also worth considering, particularly for closely-held corporations that may find those costs to outweigh the expense of a cash-out merger.
Plaintiffs lawyers have sought to keep their cases alive despite their clients' loss of their stock and their standing to sue because of a merger. Until just recently, however, those efforts were not successful. For example, in In re Massey Energy Derivative and Class Action Litigation, 2011 Del. Ch. LEXIS 83 (Del. Ch. May 31, 2011), the plaintiff contended that the cash-out merger was itself unfair because the merger consideration did not include an element of value representing what the corporation would receive in the pending derivative litigation. By filing a class action based on that alleged unfairness, the plaintiffs lawyers hoped to still be able to litigate their derivative claims now recast as part of their class action. The Massey court ruled that the derivative claim's net value was too small, after considering how hard it was to win and the cost of litigation, to require the corporation to include that value in its decision of what was a fair price to pay to cash-out stockholders.
But just recently, the Court of Chancery upheld such a claim. Does that mean that the cash-out merger is now less useful to eliminate derivative litigation? As is often the case, the answer is "that depends on the facts." Hence, the court decision in In re Primedia Shareholders Litigation, Del. Ch. 6511-VCL (May 10, 2013), is worth a closer look.
The class action complaint in Primedia alleged that KKR used nonpublic information to purchase Primedia preferred stock at a steep discount to its face value and then realized a profit of $150 million when Primedia redeemed that stock following an improvement in Primedia finances. Under the Delaware Brophy decision, that use of nonpublic information could expose KKR to a damage claim for all of its profits from the preferred stock. The class action complaint alleged that the cash-out merger that mooted the prior derivative claims was itself unfair because the Primedia board had failed to include any element of value for the Brophy claim in considering the price to be paid to Primedia's stockholders and the merger protected KKR from that Brophy claim while it controlled Primedia. Defendants moved to dismiss the class action.
The Court of Chancery denied the motion to dismiss. It reasoned that the class action complaint met the three-part test to state a claim under Parnes v. Bally Entertainment, 722 A.2d, 243 (Del. 1999), and its progeny. First, the complaint's Brophy claim had substantial merit because there was evidence KKR had traded on nonpublic information obtained by the Primedia directors controlled by KKR. Second, the Brophy claim was material in the sense that it was large enough when compared to the value of Primedia as a business that it should have been considered in valuing the merger consideration paid to the Primedia stockholders. Third, the court concluded that the acquirer of Primedia would not assert the Brophy claim and, therefore, did not include the value of that claim in what it paid for Primedia. Hence, the Primedia stockholders were shortchanged and KKR benefited by avoiding a potential $190 million suit. That meant the class action complaint stated a claim for the violation of the duty of entire fairness owed by KKR to the minority stockholders of Primedia.
What then does Primedia mean for the ability to use a cash-out merger to eliminate a pending derivative suit? That tactic will have much less value if the derivative plaintiff can simply recast his or her allegations as a class action attacking the fairness of the merger. However, a proper reading of Primedia and the appropriate steps taken to approve a cash-out merger will continue to permit a cash-out merger to end disruptive derivative litigation.
First, it is important to recognize that the facts of Primedia are unusual, we hope. The Brophy claim alleged in the derivative litigation was supported by a memo the court characterized as a "smoking gun" establishing improper trading on nonpublic information by a corporate fiduciary. The claim was for a lot of money, both in absolute terms and compared to the value of Primedia as a business without that claim. Finally, the special litigation committee (SLC) that evaluated the Brophy claim gave it little consideration in dismissing its value. All these factors combined led to a set of bad facts for the defendants.
The result in Primedia may well have been different if the facts were not so extreme and if the SLC had done a more complete job in its analysis. For example, in Massey, the court declined to enjoin a merger when the plaintiff alleged that the merger price unfairly treated a valuable derivative claim. Massey involved a much harder claim to prove before any recovery would result, leading the court to conclude that the claim's value was not material to the merger terms. When an SLC or a board of directors fails to even consider the value of a claim, it is much harder to convince a court later that the claim had little value.
In the end, Primedia may not often affect the usefulness of a cash-out merger to end derivative litigation. But when the derivative claim has substantial value, it should be part of the considerations of a board of directors considering a merger. Hence, if anything, Primedia adds support for the validity of using a cash-out merger to end derivative litigation in the proper circumstances and following a proper review of that litigation.