In 2014, the Delaware Supreme Court in Kahn v. MFW held that the business judgment standard could apply to review of a controlling stockholder merger if at the outset the controlling stockholder conditioned the squeeze-out transaction on negotiation and approval by a committee of independent and disinterested directors and the informed, uncoerced approval of a majority of the minority stockholders (dual stage approvals). The Delaware Supreme Court later affirmed a Delaware Court of Chancery transcript opinion holding that MFW could apply to a pleadings-stage dismissal where the controlling stockholder did not condition its initial proposal on the dual stage approvals, at least where the board, with the majority stockholder’s participation, did so in a resolution establishing a special committee to negotiate prior to any substantive negotiations. The question remained, however, how much latitude the court would afford a controlling stockholder who did not ab initio condition its merger transaction on the requisite dual stage approvals. In Flood v. Synutra International, C. A. No. 101, 2018 (Del. Oct. 9, 2018), the Supreme Court in a majority opinion provided additional guidance, holding that the MFW standard of review could apply to a transaction where the controlling stockholder did not from the beginning condition its transaction on the requisite dual stage approvals, as long as those conditions were established prior to any substantive economic negotiations. The court’s holding and its reasoning provide important guidance to transactional planners and litigators assessing whether to challenge a controlling stockholder merger transaction.
In Flood the majority stockholder proposed a merger transaction to acquire the shares of Synutra International Inc. he did not already own. Prior to a board meeting to consider the proposal, the company’s CFO waived a conflict that allowed the company’s longtime counsel to represent the controlling stockholder. One week after the controlling stockholder made his initial proposal, the board met and appointed a special committee. The board took no other action regarding the merger proposal at this meeting. One week later, the controlling stockholder sent a second letter in which he indicated he would not go forward with the transaction unless it included the dual stage approvals. Actual price negotiations did not begin until seven months after this second offer. Independent legal and financial advisers advised the special committee during the negotiations. Eventually, the special committee approved a transaction at a price 2.4 percent greater than the original offer, at a 58 percent premium to the company’s trading price when the offer first became public, and at a price that the financial adviser deemed fair. The special committee met fifteen times over a nine-month period to achieve the negotiated price. Thereafter a majority of the minority stockholders approved the transaction.
The Plaintiff’s Claims
The plaintiff claimed the transaction was unfair and subject to entire fairness review because the controlling stockholder did not condition his offer ab initio on the dual stage approvals. The Court of Chancery disagreed, holding that because the controlling stockholder conditioned his merger proposal on the dual stage approvals “before any negotiations took place,” and the plaintiff failed to plead that the controlling stockholder did not comply with any of the six MFW factors, the transaction was subject to the business judgment standard of review. The court therefore dismissed the plaintiff’s complaint. The plaintiff appealed, arguing that the court should have subjected the transaction to entire fairness review and sustained the complaint because the plaintiff had pleaded that the controlling stockholder did not condition his merger proposal on the dual stage approvals at the outset. The plaintiff also argued that the unfair price demonstrated a lack of due care, thereby negating the application of MFW. As explained below, the Supreme Court in a majority opinion rejected both arguments, although a dissenting justice would have reversed by reading MFW to require a controlling stockholder to include the dual stage proposals in its first offer to obtain business judgment review.
Delaware Supreme Court Adopts a Less Rigid Reading of an Ab Initio Offer
The core issue on appeal was how rigidly to read the MFW requirement that a merger with a controlling stockholder be subject ab initio to the dual stage approvals. Critical to the majority opinion was that the complaint lacked allegations that any economic negotiations had occurred prior to the controlling stockholder’s second offer which was conditioned on the dual stage approvals. The court conceded that the Delaware Supreme Court and Court of Chancery’s MFW opinions’ use of phrases like “from inception,” “from the time of the controller’s first overture” and “upfront” may have created an ambiguity as to the prerequisites for the application of MFW. However, the court emphasized that the policy rationale for an MFW dismissal was that the controlling stockholder self-disable at the outset. This means that the dual stage approvals “cannot be dangled in front of the special committee, when negotiations to obtain a better price from the controller have commenced, as a substitution for a bare-knuckled contest over price.” In affirming the Court of Chancery’s dismissal, the majority opinion held that the plaintiff failed to plead facts that the controlling stockholder “did not condition the merger on MFW’s dual procedural protections before any economic negotiations took place.” The court also affirmed that a plaintiff must plead gross negligence to plead a lack of due care by a special committee. The special committee’s extensive negotiations and receipt of expert advice from its independent legal and financial advisers supported the Court of Chancery’s conclusion that the plaintiff failed to plead gross negligence. The plaintiff’s disagreement over the price obtained thus did not suffice to raise a due care claim.
The Flood majority rejects a bright-line test for application of MFW. Thus, even if a controlling stockholder does not condition a merger proposal in its first offer on the dual stage approvals, it still can obtain an MFW pleadings stage dismissal if the dual stage approvals are agreed to before substantive economic negotiations begin. From a policy standpoint, this will require the Court of Chancery to examine whether a plaintiff has pleaded adequate facts that show the dual stage approvals were not in place before economic negotiations began. The Supreme Court expressed confidence in the Court of Chancery to make that judgment and to refuse to dismiss a case where appropriate and thus declined to impose the bright-line rule favored by the dissenting justice. From the point of view of practitioners, however, the best advice is to cause the controlling stockholder to condition a squeeze-out merger on the dual stage approvals in its first proposal and then a plaintiff would have no argument that its complaint cannot be dismissed at the pleadings stage because it is subject to entire fairness review.