Lessons for Controlling Stockholders in Squeeze-Out Mergers
In a comprehensive analysis of the standards of review, burdens of proof and potential damages implicated in a fiduciary-duty challenge to a squeeze-out merger, the Delaware Court of Chancery recently examined the harsh potential consequences for controlling shareholders who manipulate special board committees, the fairness opinions of their financial advisers, and proxy materials concerning the value of a company.
In In re Orchard Enterprises Stockholder Litigation,(Del. Ch. February 28, 2014) (Laster, V.C.), the Court of Chancery granted summary judgment, in part, to plaintiff minority stockholders based on a proxy disclosure violation concerning the applicability of the controlling stockholder's liquidation preference to the squeeze-out merger, and held that entire fairness review applied to the plaintiffs' fiduciary-duty claims, with the burden of persuasion on the defendants. The court also granted summary judgment, in part, to the defendants on the grounds that the proxy disclosure concerning the ongoing company liability for the controlling stockholder's liquidation preference was factually accurate, and that Orchard Enterprises itself, as the constituent company in the merger, was not liable for aiding and abetting its directors' alleged breach of fiduciary duties in connection with the merger. The court denied the parties' other grounds for their cross-motions for summary judgment, and bound the case over for trial.
The plaintiffs, minority stockholders of Orchard Enterprises, brought an action for breach of fiduciary duties against the board of directors and the controlling stockholder of Orchard Enterprises in connection with a squeeze-out merger of the minority stockholders by the controlling stockholder. In determining the merger price for the common shares, the key question was whether to value the controlling stockholder's preferred shares on an as-converted-to-common-share basis, amounting to approximately $7 million, or on the basis of the controlling stockholder's $25 million liquidation preference. If the controlling stockholder's preferred shares were valued on an as-converted-to-common-share basis, the common stock had a value of more than double the merger price under then-Chancellor Leo E. Strine Jr.'s ruling in the prior appraisal action in connection with the squeeze-out merger. Unlike a preference that becomes a "put" right by contract after a fixed period of time, the controlling stockholder's liquidation preference here was only triggered by a third-party merger, dissolution or liquidation. In the appraisal decision, Strine had ruled that the possibility of the occurrence of one of these triggering events was too speculative to use the liquidation preference to value the controlling stockholder's preferred shares in the squeeze-out merger, and thus valued the controlling stockholder's preferred shares on an as-converted-to-common-share basis. The notice of the merger in the proxy materials to the stockholders, however, erroneously stated that a charter amendment was necessary to avoid the application of the controlling stockholder's liquidation preference to the squeeze-out merger.
Parties' Cross-motions for Summary Judgment
Before the court were the parties' cross-motions for summary judgment. The plaintiffs claimed entitlement to judgment as a matter of law on the grounds that the defendants breached their fiduciary duty of disclosure, that entire fairness was the operative standard of review, and that the merger was not entirely fair. The defendants opposed these determinations, and asserted that they were entitled to judgment as a matter of law on the grounds that neither rescissory nor quasi-appraisal damages were available remedies, that the directors on the special committee were exculpated from fiduciary liability, and that Orchard Enterprises was not liable for aiding and abetting its directors' alleged breach of fiduciary duties.
The court first ruled that the proxy statement contained a material misrepresentation that the squeeze-out merger triggered the controlling shareholder's right to the liquidation preference. The court explained that the notice of merger erroneously stated that without an amendment to the charter, the controlling stockholder would receive its liquidation preference in the merger. Thus, the notice suggested that the merger price was fair to minority stockholders because without an amendment to the charter, the controlling stockholders would otherwise be entitled to have their liquidation preference satisfied before the common stockholders received their portion of the merger consideration in the squeeze-out merger. But the squeeze-out merger did not trigger the controlling stockholder's liquidation preference under any circumstances, and the proposed amendment to the charter merely allowed the controlling stockholder to consent to its squeeze-out of the minority stockholders in the merger. The court next found that because the liquidation preference was not triggered by the merger, the proxy statement correctly described the preference as an ongoing company obligation. The court then found that if the special committee directed its financial adviser to change its methodology to use the liquidation preference in its valuation of the common stock in the fairness opinion, supporting the merger, instead of relying on the financial adviser's independent judgment, then the proxy statement was also inaccurate for this reason.
Turning to the standard of review, the court ruled that entire fairness review governed this squeeze-out merger, which involved alleged self-dealing by a controlling shareholder, with the defendants having the burden of persuasion. Following its decision in In re MFW Shareholders Litigation, 67 A.3d 496 (Del. Ch. 2013), which was recently affirmed by the Delaware Supreme Court, the court ruled that if a controlling stockholder agrees up front that the proposed merger with the controlling stockholder will not proceed unless approved by both a special committee of disinterested directors and a majority of the disinterested minority stockholders, then the court will not apply entire fairness, but rather business judgment review. If the controller agrees to only one of these protections, or does not agree to both protections up front, then the most the controller can achieve is to shift the burden to the plaintiff to prove unfairness. Here, the controlling stockholder did not agree to both protections up front, and thus the court found that entire fairness was the operative standard of review.
Because the above proxy statement disclosure violation prevented a fully informed stockholder vote, the court found that the majority-of-the-minority stockholder vote, to which the controlling stockholder eventually agreed, was insufficient to shift the burden of proof to plaintiffs on entire fairness review. The court also found that the special-committee protection was insufficient to shift the burden of proof on entire fairness. The court reasoned that there were significant questions regarding the special committee's disinterest, independence and real bargaining power due to alleged personal ties of the special-committee chair to the controlling stockholder, allegations that the special committee had directed its financial adviser to change its methodology to use the liquidation preference in its valuation of the common stock, and allegations that the controlling stockholder misled the special committee to believe that the controller would sell its interest to a third party for the amount of its liquidation preference, which, if true, undermined the special committee's ability to evaluate the fairness of the merger price compared to third-party offers and through the go-shop process. Accordingly, the court ruled that the burden of persuasion on entire fairness review would remain on the defendants through trial.
The court then quickly noted that the material misrepresentation in the proxy statement, together with other potential disclosure violations, and the controlling stockholder allegedly misleading the special committee to believe that the controller would sell its interest to a third party for the amount of its liquidation preference would probably meet the unfair process element of the entire fairness test if proved at trial. The court also noted that Strine's ruling in the prior appraisal action that the fair value of Orchard Enterprises was more than two times the merger price was strong evidence of an unfair price for trial.
Next, the court explained that because entire fairness review was applicable, the interested nature of the merger was inextricably tied to the issue of director loyalty, and thus the court could not determine on summary judgment that members of the special committee were only subject to a potential duty of care violation that would be exculpated under Section 102(b)(7) of the Delaware General Corporation Law. Instead, the court would evaluate on a director-by-director basis at trial whether each member of the special committee's fiduciary liability solely implicated the duty of care, and was thus subject to exculpation under Section 102(b)(7).
Finally, even after the closing of the merger, the court ruled that awards of rescissory or quasi-appraisal damages against directors liable for disclosure violations, implicating the duty of loyalty and causing a deprivation to stockholders' economic interests and an impairment of their voting rights, were appropriate for the class of minority stockholders in the amount of the shortfall between the merger price and the intrinsic or fair value of the company as a going concern. The court reasoned that because the merger was ultimately conditioned on a majority-of-the-minority stockholder vote, full and accurate disclosure of the applicability of the controlling shareholder's right to the liquidation preference in the squeeze-out merger might have resulted in the minority stockholders voting against the merger, stopping a transaction that significantly undervalued their common stock, and allowing them to remain common stockholders in a going concern.
The court's decision serves as an important lesson for controlling shareholders who manipulate special board committees, the fairness opinions of their financial advisers and proxy materials concerning the applicability of the controlling stockholders' liquidation preference to a merger and its effect on the value of the common stock. The decision clarifies that disclosure violations that impair the voting rights of minority stockholders will survive the closing of the merger, be subject to entire fairness review, and could result in awards of rescissory or quasi-appraisal damages to the class of minority stockholders against the disloyal board members and controlling stockholders in the amount of the shortfall between the merger price and the intrinsic or fair value of the company as a going concern.