Chancery Court Reaffirms Entire-Fairness Application
The standard of review for a transaction involving a controlling stockholder may determine whether the proponents can expect a Delaware court to approve a contested transaction without a trial. If the controlling stockholder is on both sides of a self-dealing transaction, entire fairness is the standard of review and defendants likely cannot avoid a trial because the question of the fairness of the process and price normally raises a triable issue of fact under Kahn v. Lynch Communication Systems, 638 A.2d 1110 (Del., 1994), and its progeny. The Court of Chancery's recent decision in In re MFW Shareholders Litigation, C.A. No. 6566-CS, which is on appeal to the Delaware Supreme Court, provides an exception if the controlling stockholder at the outset of a going-private transaction conditions consummation on negotiation and approval by a fully-informed special committee of disinterested and independent directors and a nonwaivable vote by a majority of the minority stockholders, and forgoes coercive measures that would prevent arm's-length bargaining.
The mere fact that a seller in a merger has a controlling stockholder who favors the transaction, however, does not by itself mean that entire fairness applies, as the Court of Chancery held in In re John Q. Hammons Hotels Shareholder Litigation, C.A. No. 758-CC (October 2, 2009), and In re Synthes Shareholder Litigation, C.A. No. 6452 (Aug. 17, 2012). The recent case of Southeastern Pennsylvania Transportation Authority v. Volgenau, C.A. No. 6354-VCN (Del. Ch. Aug. 5, 2013), applies that principle and provides important lessons for practitioners concerning the effect of different, but nonpreferential, treatment of a controlling stockholder and how a court assesses whether allegations that a special committee member is not independent raise a triable issue of fact.
Ernst Volgenau was the controlling stockholder of SRA International Inc. The company came upon hard times after Volgenau stepped down as CEO in 2002. By 2008, Volgenau favored the company pursuing a strategic transaction including a sale, although he wanted to ensure that the buyer would preserve the company's ethics of honesty and service. He therefore favored a financial buyer to a strategic acquirer, believing that the latter would be less likely to preserve the company's core values. Thus, after failed attempts to grow by acquisition, Volgenau favored pursuing discussions of a sale transaction with one private equity buyer. The company at that point formed a special committee consisting of five directors whose chair was Michael R. Klein. The board of directors authorized the committee to solicit third-party bidders and authorized the retention of independent legal and financial advisers.
Following retention of its advisers, the special committee informed Providence Equity Partners LLC and its affiliates, the private equity firm with whom Volgenau had preliminary discussions, that its offer of $27.25 per share was inadequate. It then commenced a solicitation process that eventually involved six financial buyers and four strategic buyers who signed confidentiality agreements and performed due diligence. Two financial buyers were the only interested bidders. Following multiple rounds of bidding, Providence emerged as the winner at $31.25 per share. The board approved a merger agreement at that price and with terms including a 30-day go-shop, certain termination fees in customary ranges (about which plaintiffs did not complain), and a nonwaivable majority of the minority vote condition. During the go-shop, the company's financial adviser contacted 50 potential bidders, including 29 strategic and 21 financial buyers. None of these parties submitted a topping bid. The company issued a proxy statement and an overwhelming majority of the minority stockholders approved the deal (81.3 percent). At $31.25 per share, the stockholders received a 52.8 percent premium.
Majority Stockholder Not on Both Sides of Transaction
The plaintiff attempted to show that Volgenau was self-dealing because he sought to preserve the company's core values by favoring Providence. The court rejected this contention for three reasons. First, the record showed no prior affiliation between Volgenau and Providence. Mere preliminary discussions between Volgenau and Providence concerning a leveraged buyout "did not magically transform Volgenau into an affiliate of Providence." Second, under Hammons, a controlling stockholder's retention of an equity interest does not mean that the controller stands on both sides of a transaction, at least where the bidder is unaffiliated with the target and controlling stockholder and the transaction is negotiated by a committee of disinterested and independent directors. Here, the record reflected that the special committee conducted a robust sale process, which belied the plaintiff's allegation that Volgenau dominated the board to effectuate his favored transaction. The court also found that the majority stockholder's rollover interest was valued at the same price as the merger consideration. Finally, the court found that Volgenau "did not become a buyer in the merger because he engaged in separate discussions with Providence regarding his humanistic concerns."
Special Committee Chair Found to Be Disinterested
Early in the process, the board approved compensation to Klein of $75,000 and to the other special committee members of $37,000. At the signing of the merger agreement, the board — at Volgenau's urging — increased the compensation of Klein by an additional $150,000 and of the special committee members to $75,000. Following stockholder approval of the merger, Klein wrote a memo to Volgenau expressing disappointment in his board-approved additional compensation of $150,000 in light of his role in leading a successful sale process over many months, particularly when measured against the $30 million in fees to the company's outside advisers. Klein had declined the $150,000 approved by the board on the signing of the merger agreement as premature. The board had then donated $150,000 to two charities supported by Klein. Shortly before the mailing of the proxy, Klein disclosed to the board his expectation of compensation of $1.3 million payable to two charities with which he was affiliated. The board rebuffed this request.
The court was troubled that this conduct could have reflected Klein's subjective expectation of a possible bonus, raising "a serious question regarding Klein's motivation for completing the deal." Nonetheless, the court noted that Klein requested the bonus be payable to charities, not himself. In that circumstance, "to find that Klein had a material self-interest in the merger, the court would have to conclude that, had the bonus been distributed to Klein's affiliated charities, he would have materially benefited in some way from donating the money." The record showed no evidence, however, that "Klein would have received any backdoor remuneration, measured in dollars or accolades, for a donation." Finally, the court found no other evidence of self-dealing or that his actions infected the process and deliberations of the remaining members of the special committee.
This case reaffirms that in a contested transaction where the seller is controlled by a majority stockholder, the Court of Chancery will focus on whether the seller's board properly acted to represent the interests of the minority stockholders. As in Hammons, the mere fact that a controlling stockholder interacts with bidders or favors a particular bidder will not suffice to prevent summary judgment for defendants where the record reflects that a special committee of independent and disinterested directors conducted a robust sale process and coordinated the interactions of the bidders with the majority stockholder, the transaction was conditioned on a nonwaivable majority of the minority vote, and a majority of fully informed minority stockholders in fact approved the transaction. Where the result of a six-month process that includes solicitation of strategic and financial buyers and a well-run go-shop is a sale to a party unrelated to the majority stockholder at a price that reflects a 52.8 percent premium over the unaffected price, a plaintiff will have a hard time proving material interference by the controlling stockholder. Similarly, while the court will scrutinize whether the conduct or compensation of the special committee members compromises their independence or makes them interested, a failure to provide record evidence that compensation received would have been subjectively material to the director is fatal to such a claim. Allegations of potential conflicts or interference by the controlling stockholder may suffice to sustain a complaint on a motion to dismiss, but in the absence of plaintiffs offering proof raising a triable issue of fact following discovery, proponents of a sale transaction may expect to avoid a trial by prevailing on summary judgment.