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Chancery Enjoins Unfair Merger Orchestrated by Controlling Stockholder Pending Corrective Disclosures
Under Delaware law, majority or controlling stockholders owe fiduciary duties to the company and its minority stockholders. Under certain circumstances, however, a stockholder that owns less than 50 percent of the company’s outstanding stock can be deemed a controlling stockholder and therefore subject to the same fiduciary obligations. This determination involves a fact-intensive analysis regarding the alleged controller’s dominance of the board generally, or dominance of the corporation, board or the deciding committee with respect to a challenged transaction.
The Delaware Court of Chancery recently addressed this issue in FrontFour Capital Group v. Taube, C.A. No. 2019-0100-KSJM (March 11, 2019), where the court issued a post-trial decision on the plaintiffs’ claims to enjoin a proposed combination of Medley Management (a publicly traded asset management firm) with two corporations it advised, Medley Capital Corp. and Sierra Income Corp. (the proposed transactions). In FrontFour, the court held that twin brothers Brook and Seth Taube, who collectively owned less than 15 percent of Medley Capital’s stock, were nonetheless controlling stockholders because they exercised de facto control over the Medley Capital special committee negotiating the proposed transactions, thereby triggering entire fairness review. Although the defendants failed to show that the proposed transactions were entirely fair, the court could not order the most equitable result—a sales process free from influence and onerous deal protections—because plaintiffs failed to prove that Sierra aided and abetted the breaches of fiduciary duty. Therefore, pursuant to the Supreme Court’s decision in C & J Energy Services v. City of Miami General Employees’ and Sanitation Employees’ Retirement Trust, 107 A.3d 1049 (Del. 2014), the court could not “strip an innocent third party of its contractual rights” under a merger agreement. However, the court did enjoin the stockholder vote pending corrective disclosures regarding the conflicted sales process.
Prior to the proposed transactions, Medley Capital was in a steady financial decline. Due to this poor performance, Medley Management in 2017 embarked on a process to consider a range of strategic transactions. Medley Management eventually signed confidentiality agreements with 24 potential strategic partners that, importantly, prevented these third parties from offering to enter into any transaction with funds managed by Medley Management, including Medley Capital, for a standstill period ranging from 12 to 24 months.
After a failed sales process, the Taube brothers proposed a three-way combination between Medley Management, Medley Capital and Sierra. Each of the three entities empowered a special committee to negotiate, and, if appropriate, approve the transaction. As the court’s decision highlights, however, the Medley Capital special committee was not well functioning. For example, the special committee, inter alia, failed to assert control over the timing of the process, did not consider alternative transactions, failed to conduct a pre-signing market check and did not inform themselves of the basic aspects of two prior sales processes. And, “critically,” the special committee did not know that the prior confidentiality agreements contractually precluded potential third parties from proposing a transaction with Medley Capital.
On Aug. 9, 2018, the Medley Capital special committee unanimously recommended that the board approve the merger agreement with Sierra. Under the proposed transactions, Sierra would first acquire Medley Capital and then Medley Management in two cross-conditioned mergers, with Sierra as the surviving combined entity. Medley Management would receive $3.44 per share in cash, plus $0.065 in cash dividends, and the right to receive 0.3836 shares of Sierra stock, which represented a 100 percent premium to Medley Management’s trading price. Medley Capital stockholders, including the plaintiffs, received the right to 0.8050 shares of Sierra stock, which provided no premium against Medley Capital’s net asset value. The merger agreement contained a “suite of deal protections,” including a “no shop” provision.
The Court of Chancery’s Decision
The court held that the Taube brothers were controlling stockholders because they exercised de facto control over at least half of the Medley Capital special committee. Among other facts, certain special committee members had frequent communications with the Taube brothers during the negotiations, received several hundred thousand dollars of fees during their board service (which reflected half of one of the special committee member’s annual income), and desired to continue as directors after the proposed transactions. The special committee “also sat supine in negotiations concerning the proposed transactions” and allowed the Taube brothers to dominate the process and control the flow of information.
Moreover, the plaintiffs’ expert credibly testified that the price offered for Medley Capital was below the fair value of Medley Capital. As the court held, “ultimately, this was a case in which a deeply flawed process obscured the fair value of Medley Capital.” The deal protections also failed to pass enhanced scrutiny under the circumstances here, where there was no pre-signing auction or market check, and no risk that Sierra was being used as a stalking horse bidder. The court also held that the defendants violated their duties of disclosure because they failed to inform the stockholders of the flawed process in connection with the proposed transactions and expressions of interest from third parties.
As a remedy, the court held that the “most equitable relief” for Medley Capital stockholders—a curative shopping process devoid of Medley Management’s influence, free of deal protections and full disclosures—was not available because plaintiffs failed to prove that Sierra knowingly participated in the other defendants’ breaches of fiduciary duty. Because the plaintiffs failed to prove their aiding and abetting claim against Sierra, the court could not strip Sierra, an innocent third party, of its contractual rights under the Delaware Supreme Court’s decision in C & J Energy. The court did, however, enjoin the merger until corrective disclosures were made consistent with the court’s decision.
Key Takeaways and Practice Points
A finding that a party is a controlling stockholder materially affects litigation. Had the Taube brothers not improperly dominated and controlled the special committee, their 15 percent stock ownership would not have sufficed to trigger the entire fairness standard of review.
This decision provides guidance to practitioners who may cite the court’s holding in advising clients of the importance of enabling special committees to act independently. When the record reflects lack of knowledge by the special committee of important issues and willful deference to the opposing party, the parties will not get the benefits of the special committee process thereby putting an interested transaction at risk. While the stockholders after corrective disclosure may yet approve the transaction, the additional costs and uncertainty could have been avoided had the parties acted to enable the special committee to function in a manner that reflected genuine arm’s-length negotiation.