Court Leaves it to Stockholders to Decide on El Paso Merger Transaction
Authored by Lewis H. Lazarus
This article was originally published in the Delaware Business Court Insider | March 14, 2012
Chancellor Leo E. Strine Jr. has long had a high regard for the ability of stockholders to decide for themselves what is in their own best interests. A corollary of that is judicial restraint when stockholders on full information of flaws and conflicts of interests in a sales process have the opportunity to approve or reject a merger transaction with a substantial 47.8 percent control premium, albeit one likely not as robust as a well-run sales process may have generated.
This is particularly true when the record does not reflect any alternative buyers. In In re El Paso Corp. Shareholder Litigation, Strine declined to enjoin a merger transaction even though he found on a preliminary record that plaintiffs likely could prove a high probability of success on their claims for breach of fiduciary duty and irreparable harm. Although it may be argued that this is inconsistent with the maxim that "equity will not allow a wrong without remedy," a better view is that the Court of Chancery will not use the strong arm of equity paternalistically to deprive stockholders of a premium-generating transaction if, on full information, they choose to take it.
LEAD NEGOTIATOR AND TARGET'S FINANCIAL ADVISER HAVE MATERIAL CONFLICTS
The El Paso decision involved a sale of El Paso Corp. to Kinder Morgan Inc. Kinder Morgan intended to keep El Paso's pipeline business but sell off its exploration and development business (E&P) to finance the acquisition. According to the opinion, El Paso's CEO was the lead negotiator who also had an interest with other El Paso managers in possibly buying the E&P business from Kinder Morgan. He failed to disclose this interest to the El Paso board. El Paso's financial adviser, Goldman Sachs, owned 19 percent of Kinder Morgan and controlled two Kinder Morgan board seats. And the lead banker for Goldman failed to disclose that he personally owned approximately $340,000 of Kinder Morgan stock.
Goldman's conflict was known, so El Paso retained a second financial adviser, Morgan Stanley. This may have had more of a curative effect were it not for a fee structure that, in the words of the court, gave the new investment adviser "an incentive to favor the merger by making sure that this bank only got paid if El Paso adopted the strategic option of selling to Kinder Morgan." In other words, the fee structure of the second bank provided no incentive for it to opine that a transaction with Kinder Morgan was unfair, as it only got paid if it preferred the option that Goldman favored. These facts led the court to conclude that the conflicts affected the board's "less than aggressive negotiating strategy" and its failure to test the Kinder Morgan bid in the market. In these circumstances, the court concluded that the plaintiffs had proven a likelihood of success on the merits of their fiduciary duty claim.
In assessing irreparable harm, the court noted that the plaintiffs would have a difficult time proving damages against the independent directors in the face of a charter provision that included the protections of Section 102(b)(7) of the Delaware General Corporation Law. The court found no reason on the preliminary record to doubt the board's good-faith reliance on the CEO for negotiations, as he himself was a large stockholder. The court noted that the directors could claim reliance on advisers in approving the fee structure with Morgan Stanley. Moreover, the record did not reflect that they knew that certain insiders were considering their own bid for the company's E&P assets. Taken together, the plaintiffs were unlikely to be able to recover damages from the independent directors.
The court reached the same conclusion regarding potential claims against Goldman Sachs and Kinder Morgan for aiding and abetting liability. As to the former, the court found that the plaintiffs would be unlikely to prove liability against Goldman because its conflicts were "surfaced fully and addressed" (albeit inadequately). As to the latter, Kinder Morgan bargained hard, as it was entitled to do. And from its perspective, the Goldman conflict was addressed and the interest of the CEO in possibly buying the E&P assets was not disclosed to Kinder Morgan until after the deal terms had been negotiated. The court acknowledged that the plaintiffs may have a claim against the CEO, but expressed doubt that he could satisfy personally a potential judgment of more than $500 million. The court thus concluded that the plaintiffs had established irreparable injury, the second prong of the preliminary injunction standard.
BALANCE OF HARDSHIPS DID NOT FAVOR THE PLAINTIFFS
Nonetheless, the court concluded that the balance of hardships tipped in favor of the defendants. Three facts drove this conclusion. First, the plaintiffs themselves did not seek to enjoin the merger. Instead, they sought to require El Paso to run a market check, but if no buyer emerged, then to allow the merger to close. To do so would have required the court to allow El Paso to violate covenants in the merger agreement. The court thought that such an injunction would likely relieve Kinder Morgan of its obligation to close due to material breaches of its contractual rights. Second, the form of relief was more akin to a mandatory injunction, which can only issue a full trial and careful attention to the interests of Kinder Morgan. Finally, no buyer had emerged since the fall of 2011, so an injunction would deprive the stockholders of the opportunity to decide for themselves whether to approve a merger with a 47.8 percent premium.
STOCKHOLDERS MUST CHOOSE
This case illustrates the practical balancing for which the court is well-known. Even with likely breaches of fiduciary duty and irreparable harm, the balance of hardships did not tip in favor of the plaintiffs. Some form of monetary damages against the CEO and possibly other El Paso managers and Goldman may be available if the merger is approved. And if the stockholders believe that a process without the flaws identified in the opinion would yield a better result, then they have the power to vote down the transaction.
The court likely is correct that "if stockholders continue to display a reluctance to ever turn down a premium-generating deal," then "the kind of troubling behavior exemplified here can result in substantial wealth shifts from stockholders to insiders that are hard for the litigation system to police." In short, the court can only do so much if stockholders are not willing to vote where they say their economic interests are best served.