In March 2014, the Delaware Supreme Court affirmed a 2013 Court of Chancery decision holding that a going private merger with a controlling stockholder will be subject to the business judgment rule, rather than the far more stringent test of entire fairness, if the transaction is conditioned from its inception on (1) approval by an independent and fully empowered special committee of directors and (2) the uncoerced, informed vote of a majority of the shares held by persons unaffiliated with the controlling stockholder (a so-called majority-of-the-minority vote). The case, In re MFW Shareholders Litigation, represents an important development for private equity sponsors considering going private transactions with controlling stockholders.
The entire fairness test – the most rigorous test under Delaware law – is not only challenging to satisfy as a substantive matter, it is also highly fact intensive. This makes it very difficult to dispose of entire fairness litigation at a preliminary stage, which, in turn, means that entire fairness litigation can be expensive to resolve. Even though previous Delaware case law shifted the burden to the plaintiff to show that the merger was not entirely fair if one of the protective procedural steps described above was taken, the MFW case may be helpful (from the perspective of the private equity controlling stockholder) because, if the conditions the Court enumerated in its decision are met, the question of fairness need not be addressed at all by a reviewing Delaware court – the merger would instead be reviewed under the protection of the business judgment rule.
Entire Fairness vs. Business Judgment
Previously, the Delaware Supreme Court had consistently applied the entire fairness standard of review to all mergers where controlling stockholders were part of the acquiring group. The Court held in Kahn v. Lynch that where such a transaction was approved by either a special committee of independent directors or a majority-of-the-minority vote, the burden shifts to the plaintiff to show that the merger was not entirely fair. However, neither Lynch nor any of the cases following it, where a controlling stockholder stood on both sides of the transaction, involved a transaction that was conditioned on both special committee approval and a majority-of-the-minority vote (“procedural protections”). The Court called this a “vital distinction,” and approached the MFW case as one of first impression.
The Court articulated the following four reasons for holding that business judgment, not entire fairness, is the appropriate standard of review where both procedural protections are implemented:
- Where the controlling stockholder “irrevocably and publicly disables itself from using its control to dictate the outcome,” the controlling stockholder merger resembles a third-party, arm’s-length merger, which is reviewed under the business judgment standard.
- Conditioning the transaction on both special committee approval and a majority-of-the-minority vote “optimally protects” the minority stockholders by providing “a potent tool to extract good value for the minority.”
- Adopting the business judgment standard is consistent with Delaware law’s tradition of deferring to the informed decisions of impartial directors, particularly where ratified by the approval of disinterested stockholders, and will encourage controlling stockholders to provide these protections to minority stockholders.
- The underlying purposes of entire fairness review and the dual protection structure—ensuring a fair price—are consistent.
Procedural Protections and Conditions
The Court emphasized that to be eligible for business judgment review, a controlling stockholder merger must satisfy each of the following conditions:
- the controlling stockholder from the beginning must condition the transaction on both special committee approval and a majority-of-the-minority vote;
- the special committee must be independent;
- the special committee must be empowered to select its own advisors and to say no to a proposed transaction definitively;
- the special committee must meet its duty of care in negotiating a fair price;
- the vote of the minority must be informed; and
- there must be no coercion of the minority.
How Useful is the Roadmap?
The Court provided a detailed roadmap. How often will it be followed? There are a few reasons for skepticism.
First, the extensive list of requirements to be satisfied may itself make it difficult to dispose of litigation at a preliminary stage. According to the Court, a plaintiff will survive a motion to dismiss and be entitled to discovery if it can plead a “reasonably conceivable” set of facts showing that a transaction fails to satisfy any of these conditions. Indeed, in a footnote the Court said that the MFW plaintiffs’ complaint would have survived a motion to dismiss.
Moreover, if, after discovery, there remain triable issues of fact as to whether the conditions were satisfied, the case will proceed to trial under an entire fairness review. This apparently means that if the defendants do not succeed in obtaining summary judgment on the applicability of the business judgment standard, then even if they can show at trial that all conditions were actually met, they will not be entitled to review under the business judgment standard – although satisfaction of all of the conditions will be powerful evidence that the deal was entirely fair.
Finally, private equity sponsors involved in going private transactions with controlling stockholders will continue to face a difficult choice, because the requirement to condition the deal on approval by holders of a majority of the unaffiliated shares can impose a significant degree of transaction risk. As we saw in the Dell transaction, the existence of such a vote can invite gamesmanship by activists. Sponsors considering such transactions should review carefully the size and composition of the unaffiliated stockholder base before deciding whether to take the route prescribed in MFW.