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Delaware Supreme Court's Determination That Record Does Not Permit Interlocutory Review of Court of Chancery's CNX Gas Decision Leaves for Another Day Questions Concerning Standard of Review in Two-Step Unilateral Freeze-out Transactions

  In re CNX Gas Corp. Shareholders Litig., Consol. C.A. No. 5377-VCL (July 5, 2010)

The standard of review applicable to two-step unilateral freeze-out transactions remains uncertain following the Delaware Supreme Court’s decision[1] to deny interlocutory review of the Court of Chancery’s decision[2] to refrain from enjoining a majority shareholder’s tender offer even though the Court of Chancery had certified the Injunction Decision for interlocutory review[3]. In the Interlocutory Appeal Decision, the Court outlined its views of conflicts in the Court of Chancery’s determination of the appropriate standard of review as a factor that would justify interlocutory appeal. Although the Supreme Court declined interlocutory review, for practitioners seeking guidance among the competing standards, the Court of Chancery’s Interlocutory Appeal Decision provides a clear overview.

 

Three Choices

 

The Court of Chancery will apply one of three standards of review to a unilateral two-step freeze-out transaction: (i) entire fairness unless the transaction is structured to simulate arms’ length third party approvals by both the board and the stockholders (“Cox Communications[4] test” or “Unified Standard”)[5]; (ii) no substantive review as long as the transaction is subject to a non-waivable majority of the minority condition; the controlling stockholder promises to consummate a short-form merger at the same price if it obtains more than 90% of the shares; the controlling stockholder makes no retributive threats; and the independent directors have free rein and adequate time to react to the tender offer (“Pure Resources[6] test” or “Hybrid Standard”); and (iii) no substantive review for entire fairness unless the transaction is structurally coercive (“Siliconix[7] test”).

 

Standard of Review May Determine Outcome

 

As the Court noted in its Interlocutory Appeal Decision, the standard the court applies may be outcome-determinative.  Thus, the Court of Chancery in its Interlocutory Appeal Decision states that the outcome in Siliconix would have differed because had either the Hybrid or Unified Standard applied, the Siliconix defendants would have failed both tests, primarily because the controlling stockholder did not commit to a cash-out merger on the same terms as the tender offer.  The Interlocutory Appeal Decision also noted similar deficiencies in other cases that preceded and followed Siliconix and were not substantively reviewed, but would not have passed muster under the Hybrid or Unified standards.

 

Cases Differ in What Constitutes “Inherent Coercion”

 

The Interlocutory Appeal Decision also identified conflicts in the case law concerning whether inherent coercion is present when a controlling stockholder tenders to buy the stock held by minority stockholders. The Court noted that certain cases pre- and post-Siliconix held that unlike in a cash-out merger by a controlling stockholder, a controlling shareholder’s tender offer was not coercive as long as the majority shareholder did not unduly pressure the minority such as by threatening to de-list if the tender offer failed. But the Court of Chancery in other cases found no distinction between the inherent coercion that the Delaware Supreme Court has recognized in single-step freeze-out transactions by controlling stockholders and that present when a majority shareholder tenders for the shares it does not own. Compare Siliconix and Pure Resources. The Court also noted that the Injunction Decision, Cox Communications and Pure Resources may conflict with Kahn v. Lynch Communication Systems Inc., 638 A.2d 1110 (Del. 1994) over the effect that protective devices such as independent director or majority of minority approval may have on the standard of review. Lynch held that the possibility of retribution if the stockholders defied the wishes of the majority stockholder required the application of the more searching entire fairness standard of review even if the transaction were negotiated with a committee of independent directors and approved by a majority of fully informed minority stockholders. By contrast, Pure Resources, Cox Communications and the Injunction Decision would allow for the application of business judgment review if the controlling stockholder’s transaction is negotiated and approved by disinterested and independent directors and a fully informed majority of the minority stockholders.

 

Cases Differ in Role of the Board in Responding
to a Tender Offer by a Controlling Stockholder

 

The Court also pointed out a conflict in the proper role of the board under the past decisions.  The Siliconix line of cases holds that the target board has no necessary role, the Pure Resources line of cases provide for an advisory role, and the Injunction Decision holds that the target board has the same role responding to a controlling stockholder’s tender offer as it does in responding to a third-party tender offer.  The Court emphasized that its holding in the Injunction Decision was grounded on its understanding of the board-centric foundation of Delaware corporate law with which the Siliconix line of cases was inconsistent.

 

Court Cites Scholarly Research Finding that Stockholders
Receive Greater Consideration in Single-Step Freeze-outs

 

Finally, the Court cited scholarly work indicating that stockholders receive greater consideration in single-step freeze-outs and in negotiated two-step freeze-outs than in unilateral two-step freeze-outs.  The Court thus concluded that:

All else equal, a legal regime that makes it easier for controllers to freeze out stockholders will increase the number of transactions but result in lower premiums. Conversely, a legal regime that imposes greater procedural requirements will enable target stockholders to receive higher premiums but reduce the overall level of transactional activity. Either approach is legitimate and defensible. Either approach could result in the greatest aggregate benefits for stockholders, depending on the typical premium and overall level of deal activity.

Interlocutory Appeal Decision at *12.

 

Supreme Court Declines Interlocutory Appeal
So Foregoing Differing Approaches Will Remain

 

            Notwithstanding the Court of Chancery’s delineation of the conflicts in the lower court concerning the proper standard to apply, on July 8, 2010 the Delaware Supreme Court determined in its discretion that the application for interlocutory review should be denied “based upon the current state of the record.” CNX Gas III at *1. In the absence of definitive guidance, practitioners would be well-advised to review the Court’s Interlocutory Appeal Decision for a concise statement of the standards of review that may apply to unilateral two-step freeze-out transactions with controlling stockholders.



[1] In Re CNX Gas Corporation Shareholders Litigation, 2010 WL 2690402 (July 8, 2010) (“CNX Gas III”)

[2] In Re CNX Gas Corporation Shareholders Litigation, 2010 WL 2349097 (May 26, 2010)(“Injunction Decision”)

[3] In re CNX Gas Corporation Shareholders Litigation, 2010 WL 2705147 (July 5, 2010) (“Interlocutory Appeal Decision”).

[4] In Re Cox Communications, Inc. Shareholders Litig., 879 A.2d 604 (Del. Ch. 2005)

[5] This is the standard the Court of Chancery applied in the Injunction Decision.

[6] In Re Pure Resources, Inc. Shareholders Litig., 808 A.2d 421 (Del. Ch. 2002)

[7] In Re Siliconix Inc. Shareholders Litig., 2001 WL 716787 (Del. Ch. June 19, 2001)