Avoiding the Entire-Fairness Standard of Review
The Delaware Supreme Court's recent affirmance in Kahn v. M&F Worldwide, No. 334, 2013 (Del. Mar. 14, 2014),referred to as MFW,allows controlling stockholders to avoid the entire fairness standard of review if at the outset of a self-dealing transaction the controlling stockholder effectively relinquishes control over the outcome to an independent committee of disinterested directors and a nonwaivable, fully informed vote of a majority of the minority stockholders. In that circumstance, reasoned the Supreme Court, the transaction would reflect arm's-length bargaining and afford an independent majority of the stockholders the opportunity to decide for themselves whether to approve the transaction.
The recent decision in Hamilton Partners v. Highland Capital Management, C.A. No. 6547-VCN (Del. Ch. May 7, 2014), demonstrates that the entire fairness standard of review remains alive and well for transactions where a controlling stockholder does not follow the MFW process. At the same time, a plaintiff who fails to allege that a majority of the directors who approved the transaction was not disinterested or independent or was dominated and controlled by an arguably interested director may not be able to state a claim against a director of the target corporation. Thus, in Hamilton Partners,the court sustained a plaintiff's complaint against the controlling stockholder but dismissed its complaint against a lone director. The case provides important guidance for plaintiffs and defendants in controlling stockholder transactions regarding the circumstances under which a plaintiff may state a claim.
The plaintiff filed a class action attacking a merger between a Nevada corporation, American HomePatient Inc., which was the successor-by-merger to a similarly named Delaware corporation, and an affiliate of one of the company's stockholders, Highland Capital Management. As the court recounted, the merger was the last step in a six-part restructuring that involved: "(1) a small debt repurchase by AHP; (2) a reincorporation by merger of AHP into New AHP; (3) a self-tender by New AHP; (4) a debt refinancing by New AHP; (5) director resignations from the New AHP board; and (6) the merger."
The plaintiff claimed that the transaction was not entirely fair and that the controlling stockholder breached its fiduciary duties to the class. It also claimed that one director of AHP and New AHP, Joseph F. Furlong III, breached fiduciary duties to and aided and abetted the controlling stockholder in its breaches. The plaintiff's allegations included that AHP formed a four-person special committee consisting of every director but Furlong to negotiate the restructuring agreement with Highland.
Claim Against Controlling Stockholder
The threshold issue in a claim against an alleged controlling stockholder when that stockholder holds fewer than 50 percent plus one of the outstanding shares is whether the stockholder in fact is a controlling stockholder. Here, Highland controlled 48 percent of the stock of AHP and contended that because its actions vis-à-vis the contested conduct were as a creditor holding 82 percent of AHP's debt and creditors owe no fiduciary duties, the plaintiff's claim that it breached duties as a majority stockholder failed for lack of a factual predicate. The court first determined that under the parties' restructuring agreement, "Highland, AHP and New AHP agreed to the merger when they executed the restructuring agreement." The merger, thus, "was agreed to as the last step in a going-private transaction between Highland and AHP (a Delaware corporation)." This meant that Delaware law governed the plaintiff's claims of breach of fiduciary duty against Highland and aiding and abetting against Furlong.
The court recognized that under Delaware law the analysis of whether a 48 percent stockholder is controlling is contextual, and that even a holder of a majority of a company's debt does not by that fact alone owe fiduciary duties. Nonetheless, the court held that the plaintiff had alleged sufficient facts to sustain a reasonable inference that Highland as the holder of 48 percent of AHP's shares and 82 percent of its debt, which was in default, was the controlling stockholder when, pursuant to the restructuring agreement, the parties agreed to the merger.
Critically, the plaintiff had alleged facts concerning both process and price to sustain this conclusion: "Highland's alleged willingness to enter into a series of strategic, short-term forbearance agreements with AHP until just after the expiration of the three-year waiting period under Section 203, at which point Highland withheld its consent to prevent AHP from refinancing its defaulted debt or considering other acquirers in order to force the company to agree to a transaction with it at a price that was below the stock's trading price when announced, supports the reasonable inference that Highland controlled AHP."
The court thus sustained the claim against Highland for breach of fiduciary duty as a controlling stockholder. This meant as well that the plaintiff had adequately pleaded that the transaction was subject to the entire fairness standard of review. The court emphasized that while the plaintiff had overcome a motion to dismiss, if the plaintiff were to fail to prove that Highland controlled AHP, then Highland may not be liable to the plaintiff.
This decision illustrates another consequence of not following the MFW process. Under MFW, where a controller ab initio eschews its control by ceding authority to a disinterested and independent special committee and a fully informed, nonwaivable vote of the majority of disinterested and independent stockholders, the court does not assess the special committee's effectiveness. Rather, its inquiry is limited to whether the special committee was independent, empowered and exercised due care. Here, because Highland did not follow the MFW process, and the court could not determine from the pleadings whether the special committee was well-functioning, the court noted that it could not determine whether Highland would be entitled to a burden shift under an entire fairness standard of review.
Claim Against Furlong
As noted, the plaintiff alleged that only one director of five breached his fiduciary duty. Although Nevada law applied, the court found that it was not dissimilar to Delaware law and the court applied the business judgment standard of review to these allegations. That is because the plaintiff failed to allege facts showing that at least half of the directors on the board were interested or not independent. Moreover, due to the presence of an exculpatory charter provision pursuant to Section 102(b)(7) of the Delaware General Corporation Law, the plaintiff was required to allege conduct demonstrating bad faith or disloyalty, which it failed to do.
The court found that the plaintiff's allegations that Furlong was interested in seeing a merger transaction go forward due to change-in-control payments he would receive did not suffice because the plaintiff failed to allege that the special committee did not know about these payments or that Furlong dominated and controlled the special committee. Finally, the court declined to extend Delaware law to hold a director liable for aiding and abetting a controlling stockholder's alleged breach when the director is protected by an exculpatory provision in the company's charter and the transaction was approved by a majority of disinterested and independent directors.
This decision demonstrates that outcomes at the pleadings stage on a motion to dismiss depend on the well-pleaded allegations of the complaint. Here, the court applied two different standards of review: entire fairness to the conduct of the controlling stockholder and business judgment to the conduct of the lone director defendant. Because the plaintiff adequately alleged a self-dealing controlling stockholder and a transaction whose process and price were unfair, the plaintiff stated a claim for breach of fiduciary duty against the controlling stockholder.
Having done so, and the controlling stockholder having failed to follow the MFW process, the court at the pleading stage could not determine that the special committee was well-functioning, so the burden remained on the controlling stockholder to prove the fairness of the transaction. Nonetheless, because the plaintiff failed to allege any disabling interest or lack of independence among the special committee members who approved the restructuring transaction, or that Furlong improperly dominated or controlled or improperly interfered with the special committee process, Furlong was protected both under the business judgment rule and exculpatory charter provisions.
Having a majority of disinterested and independent directors negotiate and approve a merger remains the best defense for directors, even if at the pleadings stage a plaintiff may be able to state a claim against a controlling stockholder.