Delaware Court Issues Guidance for M&A Transactions with Controlling Stockholders

Editor’s Note: Eduardo Gallardo is a partner focusing on mergers and acquisitions at Gibson, Dunn & Crutcher LLP. This post is based on a Gibson Dunn Client Alert by Mr. Gallardo and Brian M. Lutz, and concerns a judgment by Chancellor Strine of the Delaware Court of Chancery, available here. Another memo regarding the decision, from Sullivan & Cromwell LLP, is available here. This post is part of the Delaware law series, which is co-sponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

On October 14, 2011, Chancellor Strine of the Court of Chancery of the State of Delaware issued a decision in In re Southern Peru Copper Corp. Shareholder Derivative Litig., C.A. No. 961-CS. In the 105-page decision, Chancellor Strine ultimately found that the controlling stockholder defendants had breached their fiduciary duty of loyalty and awarded damages of over $1.2 billion, which may be paid by the controlling stockholder by returning some of the stock consideration received from the controlled company in the transaction. The decision provides important guidance for companies engaging in M&A transactions with their controlling stockholders.

In 2004, Southern Peru Copper Corporation, an NYSE-listed mining company, received a proposal from its majority stockholder, Grupo Mexico, S.A.B. de C.V. Under the proposal, Southern Peru would acquire Grupo Mexico’s 99.15% interest in Minera Mexico, S.A. de C.V., a non-publicly traded Mexican mining company, for $3.1 billion in Southern Peru stock. Because of Grupo Mexico’s self-interest in the transaction, Southern Peru formed a Special Committee of disinterested directors to consider the transaction. The Special Committee retained its own financial and legal advisors.

To evaluate Grupo Mexico’s proposal, the Special Committee’s financial advisor initially performed a discounted cash flow analysis of Minera, as well as a contribution analysis and a sum-of-the-parts analysis of Grupo Mexico’s market capitalization. Each analysis yielded an equity value for Minera that was substantially lower than the $3.1 billion offer price proposed by Grupo Mexico. As a result, according to the financial advisor’s initial analysis, there was a substantial difference between the (in the words of Chancellor Strine) “give” (Southern Peru stock with a market value of $3.1 billion) and the “get” (an asset, Minera, worth no more than $1.7 billion). One month following delivery of this initial analysis, the financial advisor performed an analysis of the “relative valuation” of Minera and Southern Peru based on various metrics, replacing this analytical framework for the earlier give/get analysis. According to the Court, the new analyses obscured the fundamental fact that Southern Peru’s NYSE-listed stock had a proven cash value. But the new analytical framework allowed the Special Committee to get comfortable with the proposed transaction.

The Special Committee and Grupo Mexico ultimately negotiated a transaction in which Southern Peru would acquire Minera for 67 million Southern Peru shares, which, at the time of the agreement, had a value of $3.1 billion. The Special Committee’s financial advisor provided a written fairness opinion. The Southern Peru Board approved the transaction and, four months later, the Southern Peru stockholders did the same. The transaction closed in April 2005.

In his post-trial decision, Chancellor Strine concluded that the transaction failed to meet the entire fairness standard generally applicable to transactions between Delaware corporations and their controlling stockholders. In doing so, Chancellor Strine made a number of key findings that illustrate a number of principles that should be considered by M&A practitioners:

1) Special Committees Should Avoid Operating Under A “Controlled Mindset”: Chancellor Strine repeatedly highlighted that the Special Committee was improperly operating under a “controlled mindset,” which caused the Special Committee to refrain from conducting vigorous, arms-length negotiations with Grupo Mexico. In that regard:

  • Special Committees Should Critically Review the Controlling Stockholder Transaction, Instead of Merely Rationalizing It. Chancellor Strine concluded that the Special Committee went to great lengths to rationalize the transaction at the price proposed by Grupo Mexico by devaluing Southern Peru’s currency and ignoring the cash value of Southern Peru’s publicly traded stock. In particular, Chancellor Strine was critical of the financial advisor’s decision to alter its analysis of the transaction by moving away from a give/get analysis, and instead adopting the “relative valuation” approach that, in the Court’s view, devalued Southern Peru stock consideration.
  • Special Committees Should Have a Broad Mandate And Actively Explore All Alternatives. Chancellor Strine also noted that the Southern Peru Special Committee had a narrow mandate, to “evaluate a transaction suggested by the majority stockholder.” Chancellor Strine highlighted that the Special Committee should have had a broader mandate and considered alternatives to the transaction, such as the possibility that the controlling stockholder make a proposal for the stake in Southern Peru it did not own at a premium to the then-market price.

2) Special Committees Should Continuously Evaluate Advisability of Transaction, Even After Signing. Over five months passed between the time the Southern Peru Board approved the transaction and its stockholders voted to approve the transaction. During that period, Southern Peru’s stock price increased substantially, and Southern Peru performed well–significantly outpacing the EBITDA estimates used in the financial advisor’s fairness opinion. Despite these developments and the fact that the merger agreement contemplated a collarless fixed exchange ratio, the Special Committee made no effort to obtain an update to the fairness opinion or to reevaluate the fairness of the transaction before the stockholder vote, even though the Special Committee had the right to change its recommendation, which Chancellor Strine called a “regrettable and important lapse.”

3) Special Committee Members Should Have Their Interests Aligned With Those of the Minority Stockholders. Although the members of the Special Committee were disinterested in the sense that they were not affiliated with Grupo Mexico, Chancellor Strine found that one member was a poor representative of the minority stockholders because of his incentive to approve a deal with Grupo Mexico. The record showed that, as part of the overall transaction, Grupo Mexico had agreed to provide registration rights to another large stockholder (which had nominated to the Board the Special Committee member in question) so that the stockholder could cash out its investment in Southern Peru. As a result of this stockholder’s liquidity concern and interest in selling its equity position in Southern Peru, Chancellor Strine concluded that this representative was “not well-incentivized to take a hard-line position” with Grupo Mexico or serve as the “defender of interests of minority shareholders in the dynamics of fast moving negotiations.”

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  1. By INDIAN CORPORATE LAW « My Law Journal on Tuesday, November 15, 2011 at 8:24 am

    […] Readers may recall that the Satyam episode was triggered by the company’s proposed acquisition of two related entities, Maytas Properties and Maytas Infra, which was approved by the board of Satyam, but vehemently rejected by its shareholders. One of our readers points to us a decision of the Delaware Chancery Court that considered a similar set of circumstances involving an NYSE-listed company. A summary and discussion of that decision is available here. […]