Delaware Decision Reinforces Need for Proper Procedure in Squeeze-Out Merger

The private equity firm that was the controlling stockholder of Orchard Enterprises effected a squeeze-out merger of the minority public stockholders. Two years later, a Delaware appraisal proceeding determined that Orchard’s shares at the time of the merger were worth more than twice as much as was paid in the merger. Public shareholders then brought suit, claiming that the directors who had approved the merger and the controlling stockholder had breached their fiduciary duties and should be held liable for damages. The Orchard decision [1] issued by the Delaware Chancery Court this past Friday adjudicates the parties’ respective motions for summary judgment before trial.

Key Take-away:

The Orchard decision is a follow-up to the Court’s recent MFW decision, which provided that a controlling stockholder can lower the standard of review applied to a squeeze-out merger (from the entire fairness standard to the business judgment rule) if the controlling stockholder puts procedural protections into place that are sufficiently “disabling” so that the stockholder then does not stand on both sides of the transaction. In MFW, which is being appealed to the Delaware Supreme Court, the Court held that sufficient procedural protection to lower the standard of review would be provided by the controlling stockholder’s agreeing not to proceed with the proposed transaction without both the affirmative recommendation of a (fully authorized and effectively functioning) special committee and approval by a majority of the minority stockholders. Orchard underscores the need to ensure the integrity of these procedural protections—providing a reminder that the special committee must be independent and must operate vigorously; the proxy disclosure must be complete and correct, so the stockholder vote will be fully informed; and the controlling stockholder must have agreed before any negotiations begin that both procedural protections—the special committee and the majority-of-the-minority vote—will be used. If only one of these protections is used, or if both are ultimately used but the controlling stockholder had not agreed to both before deal negotiations began, then the standard of review will not be lowered.

Practical Points:

In a squeeze-out merger of minority stockholders by a controlling stockholder under Delaware law:

• Procedural protections must be in place before deal negotiations begin. For the business judgment rule standard of review to apply to a squeeze-out merger, both the independent special committee, and the majority-of-the-minority stockholder vote condition, must be in place from the outset of the process, before any deal negotiations begin. As the controlling stockholder in Orchard agreed to a majority-of-the-minority stockholder vote only after negotiations between the controlling stockholder and the special committee were underway, the Court determined that the entire fairness standard of review would apply at trial. [2]
• Special committee directors must be independent—especially those playing a lead role. The special committee of the board considering the transaction must be independent and disinterested. An even higher standard for independence will be applied to any director who takes a lead role on the committee. All committee members, but especially the lead director (who serves as chair, functions as the primary negotiator, or controls the flow of information to or from the committee), should not have meaningful business or social connections with the controlling stockholder or post-merger arrangements with the corporation. In Orchard, the lead director on the special committee had continuing social contacts with the controlling stockholder, and, most troubling to the Court, had arranged for a post-merger consulting agreement with the corporation. Further, the Court stated that, in a transaction that is subject to the entire fairness standard and is found not to be entirely fair, special committee directors cannot be exculpated from personal liability for breaches of the duty of loyalty (that is, the duty to act in the stockholders’ interest and not the director’s self-interest), but only for breaches of the duty of care.
• The special committee’s independence should not be undermined by the controlling stockholder. Alternative proposed transactions presented by the controlling stockholder—with one proposal including a minority stockholder vote condition and the alternative proposal not including it—will create a conflict of interest for the special committee, since the alternative with the vote condition will provide the committee members with greater personal protection against liability. In Orchard, the controlling stockholder’s final deal proposal provided the special committee with alternative transactions: (a) one, at a lower price for the minority stockholders, with a majority-of-the-minority vote required; and (b) the other, at a higher price, without the minority vote required. The Court noted that the controlling stockholder’s proposal presented the special committee with a “stark and self-interested choice” (emphasis added). In addition, even if a special committee were to choose the alternative with a stockholder vote condition, it is not clear that that would satisfy the MFW requirement that the proposal be conditioned on a minority stockholder vote from the outset.
• A controlling stockholder has a duty to share with the special committee “negotiation information” that an unrelated party would not be expected to share. A controlling stockholder seeking to effect a squeeze-out merger must fully disclose to the special committee material facts and circumstances regarding the transaction, including information that would not have to be disclosed by an unrelated third party—such as information regarding “hidden value” known to the controlling stockholder and the controlling stockholder’s plans. In Orchard, the Court was highly critical of the fact that the controlling stockholder arguably misinformed the committee regarding the stockholder’s willingness to sell. (The Court did note that a controlling stockholder nonetheless need not disclose its top price.)
• Correct proxy statement disclosure is critical—certain misstatements may be material as a matter of law; and misstatements can lead to severe damages remedies, even many years after the merger. (a) A misstatement included in a section of the proxy statement that is part of an item required by the Delaware General Corporation Law will be deemed by the Court to be material as a matter of law. The Orchard proxy statement included two correct, and two incorrect, descriptions of whether the liquidation preference on the corporation’s preferred stock was triggered by the squeeze-out transaction. The Court held that, because one of the misstatements was contained in the Notice of Meeting section, as part of an item required by the Delaware General Corporation Law, that misstatement was material as a matter of law—with no need to consider the “total mix of information” in the proxy statement relating to triggering of the liquidation preference. (b) The Court refused to grant the defendants’ motion for summary judgment on the damages claims based on the plaintiffs’ not having filed their suit soon after the merger. The Court emphasized that it would consider actions for damages for breaches of the merger proxy disclosure duty even many years after the merger. The Court also refused to grant the respective parties’ motions for summary judgment to dismiss as possible remedies for disclosure breaches both rescissory damages and quasi-appraisal damages (which can potentially be very large). [3]
• Bankers must not be directed or influenced by the parties when doing valuations. Bankers must strive for independence in their valuations. Disclaimers in the fairness opinion may not resolve issues that arise when the valuation has not been done independently. Further, Orchard demonstrates that the Court will look carefully at, and look for justification where there has been, a shift in valuation methodology over the course of a transaction. In Orchard, the post-merger appraisal proceeding had determined that the liquidation preference was not payable. The corporation’s own proxy statement indicated that utilizing the liquidation preference as a basis for valuation of the preferred could be incorrect. Nonetheless, the board had used the liquidation preference as the basis for its valuation of the preferred; and the banker had accepted that valuation in its fairness opinion, stating in the opinion that it had not done any independent valuation of the preferred stock. In prior presentations to the special committee, the banker had used going concern value as the basis for valuing the preferred (consistent with the corporation’s audited, and post-merger pro forma, financial statements). The Court held that, if it were established at trial that the advisor used the liquidation preference valuation because the special committee had “told” it to do so, then the proxy statement disclosure about the fairness opinion and the valuation of the preferred stock would be materially incomplete. [4]

Conclusion

The Orchard squeeze-out merger situation included features one does not typically see in going-private transactions—such as a post-merger appraisal determination that the value of the stock at the time of merger was more than twice the amount of the merger consideration; a lead special committee director who had substantial connections with the controlling stockholder and a post-merger consulting arrangement with the corporation; and a financial advisor who disclaimed independent valuation of the controlling stockholder’s preferred stock and used a valuation that was based on a mistaken interpretation of law. These peculiarities likely affected the Court’s thinking, especially in the context of ruling on summary judgment motions, where the inquiry necessarily focuses on whether there are underlying issues of fact that bear on whether there was a valid arms-length negotiation of the squeeze-out. Nonetheless, the decision serves as a reminder that directors and a controlling stockholder in a going-private transaction will get the benefit of the business judgment rule only if the integrity of the procedural protections prescribed in MFW is ensured.

Endnotes:

[1] C.A. No. 7840-VCL, Feb. 28, 2014.
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[2] When the entire fairness standard applies, these procedural protections potentially can result in a shift of the burden of proof, so that the plaintiffs challenging the transaction would have to prove the unfairness of the transaction (rather than the controlling stockholder having to prove the entire fairness of the transaction). In Orchard, the Court would not provide a pre-trial determination to shift the burden of proof based on either of the protections, since there was evidence that at least one of the directors on the special committee might not have been independent and disinterested, and that the stockholder vote might not have been fully informed as a matter of law because there was at least one material misrepresentation in the proxy statement.
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[3] Rescissory damages are the monetary equivalent of rescission of the transaction, intended to substitute for actual rescission of the transaction when rescission is impractical (such as because the merger has already closed and it would not be feasible to unwind it). Quasi-appraisal damages are the monetary equivalent of what a shareholder would have received in an appraisal—that is, the fair value of the stockholder’s proportionate share of the equity of the corporation as a going concern (since, without the faulty disclosure, stockholders could have voted down the merger and would have retained their equity in the corporation as a going concern). The Court stated that rescissory damages would be considered when entire fairness applies, the merger is found not to have been entirely fair, and one or more directors have been found to have breached their duty of loyalty to stockholders.
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[4] In Orchard’s preferred stock (unlike most preferred stock), the liquidation preference was payable only in an actual liquidation, dissolution or winding up of the corporation—without a broader definition of those events than is provided in the Delaware General Corporation Law, and without a provision for the preference to become a put right by contract at a certain date. In these circumstances, the Court said, where the triggers for payment of the preference were too “speculative” for a valuation to be based on the existence of the preference, the preferred stock would appropriately be valued on an as-converted basis (that is, based on the preferred stock’s proportionate share of the total value of the corporation as a going concern, assuming conversion of the preferred to common stock).
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