Controlling-Shareholder Related-Party Transactions Under Delaware Law

Jonathan Rosenberg is Partner and Chair of the Securities Litigation Practice at O’Melveny & Myers LLP; Alexandra Lewis-Reisen is a senior staff attorney at the New York Legal Assistance Group and formerly counsel at O’Melveny. This post is based on a publication from O’Melveny & Myers, authored by Mr. Rosenberg and Ms. Lewis-Reisen, and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Independent Directors and Controlling Shareholders by Lucian Bebchuk and Assaf Hamdani (discussed on the Forum here).

Under Delaware law, controlling shareholders (much like directors and officers) owe fiduciary duties to the companies they control and their minority shareholders. Historically, therefore, controlling shareholders’ transactions with their own companies were subject to heightened “entire fairness” scrutiny, and not the deferential “business judgment” rule review. Nevertheless, the common-law Delaware rules governing controlling shareholders and their companies are sometimes complex and not always intuitive. The following five practical pointers can be gleaned from Delaware case law:

  • Shareholders holding more than 50% of the are de jure controlling shareholders and, thus, should assume that all their transactions with the company will be evaluated under the entire-fairness standard.
  • Shareholders holding a significant block amounting to less than 50% of the vote should consider whether they have sufficient influence over the board that they may be deemed de factocontrolling shareholders, likewise subjecting their transactions with the company to entire-fairness review.
  • Controlling shareholders should include as a condition of any proposed related-party transaction that the company obtain approval by an independent-director committee. While that will not avoid entire-fairness review, it will significantly enhance the chances of prevailing in litigation, provided that the committee was fully independent and informed, and its process was untainted.
  • Controlling shareholders and directors of their companies should make sure that independent-director committees reviewing transactions with controlling shareholders:
    1. are advised by their own legal and financial advisers who either have no connection or business relationship with the controlling shareholder or have disclosed all such connections and relationships to the committee;
    2. have access to all current financials and projections;
    3. are fully empowered to investigate the transaction and negotiate, and are authorized to decline the proposed transaction in their own discretion;
    4. conduct all of their deliberations in private, without the controlling shareholder’s interference or participation, and without the participation of any company personnel who may be deemed beholden to the controlling shareholder; and
    5. make a record that can be publicly disclosed of all their meetings and negotiations.
  • Controlling shareholders should consider the circumstances under which to include dual-approval—approval by independent directors and independent shareholders—as a condition of the transaction. Dual-approval provides important safeguards in the merger context (where shareholder solicitation is a sunk cost in any event), and its costs and benefits should also be weighed in other contexts involving significant related-party transactions.

We discuss below the key Delaware cases supporting these considerations. Section I provides the history of entire-fairness review for controlling-shareholder transactions and the standards that Delaware courts traditionally have applied. Section II discusses in detail the MFW decision, its rationale, and its aftermath. And Section III discusses possible expansion of the dual-approval process in controlling-shareholder transactions outside the merger context.

History of Entire-Fairness Review for Controlling-Shareholder Transactions

Controlling shareholders—shareholders who “own a majority interest in or exercise control over the business affairs of the corporation”—are company fiduciaries, because they, much like officers and directors, stand in a “trustee-like” position over others’ assets. Courts may consider “controlling” three categories of large shareholders: (i) those who own an outright majority (more than 50%) of the company’s vote, (ii) de facto dominant shareholders who control the company even though they have less than 50% of the vote, and (iii) a group of otherwise unaffiliated shareholders may be considered a controlling-shareholder fiduciary if those shareholders formally establish a group by signing a contract, voting trust, or other agreement that gives them controlling voting power.

Once a controlling shareholder’s interest in a transaction is established, the “related-party” transaction may be subject to “entire fairness” scrutiny. The goal of “entire fairness” is, much like the name implies, to ensure that the transaction is fair to all shareholders and the company.

Although there is no single recipe for an “entirely fair” controlling-shareholder transaction, the following are helpful guidelines:

  1. controlled boards should establish a special committee of independent directors to negotiate the related-party transaction with the controlling shareholder,
  2. the independent directors should hire their own independent legal and financial advisors,
  3. any ties between the advisors and the controlling shareholder should be disclosed to the Board,
  4. independent directors and their advisors should have access to current financials and projections,
  5. independent directors should have the powers necessary to carry out their duties, including the “critical” power to say “no” to the controlling shareholder,
  6. independent directors should preserve their independence by not sharing confidences with the controlling shareholder or allowing the controlling shareholder to participate in negotiations or deliberations, and
  7. the company should fully disclose the negotiation process—not just to fulfill their disclosure obligations, but also to provide a strong record for a motion to dismiss.

Delaware courts also acknowledge the business reality that a “fair” controlling-shareholder deal is only an approximation of an arm’s-length transaction; it cannot be an exact replica. One important difference is that a majority shareholder cannot be compelled to sell his shares to another bidder. Independent directors considering a controlling shareholder’s buy-out offer therefore do not need to go through the “futile” exercise of seeking out alternative buyers.

While controlling shareholders initially bear the burden of proving entire fairness, that burden may shift to plaintiffs if the controlling shareholder can demonstrate that the conflict transaction was approved by a “well functioning committee of independent directors,” with “no compulsion” to reach an agreement. Unlike independent approval of related-party transactions that do not involve a controlling shareholder, however, the business-judgment rule still would not apply. Rather, independent-director or independent-shareholder review in the controlling-shareholder context only shifts the entire-fairness burden to plaintiffs (except in dual-approval control-shareholder mergers, discussed below). Shifting that burden does, however, correlate with court approval.

Deferential Review of Dual-Approved Controlling-Shareholder Mergers

Controlling shareholders have two main methods of obtaining additional shares: (i) a traditional long-form merger transaction negotiated with the controlled board that recommends the merger to its shareholders, who then vote on the merger, or (ii) a tender offer made directly to the minority shareholders, followed by a statutory short-form merger to cash out any remaining minority shareholders once the controlling shareholder owns at least 90% of the shares.

The Delaware Supreme Court in MFW adopted a new review standard for controlling-shareholder mergers: business-judgment, not entire-fairness review would be available upon dual approval (by both the Company’s independent directors and a majority of the Company’s minority shareholders). The Court has not yet ruled on or changed the tender-offer standard. The MFW Court listed the following six prerequisites for dual-approved controlling-shareholder mergers to receive business-judgment review:

  1. “the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders”;
  2. “the Special Committee is independent”;
  3. “the Special Committee is empowered to freely select its own advisors and to say no definitively”;
  4. “the Special Committee meets its duty of care in negotiating a fair price”;
  5. “the vote of the minority is informed”; and
  6. “there is no coercion of the minority.”

Swomley v. Schlecht was the first successful application of the post-MFW standard-shifting review. There, the Court of Chancery granted a motion to dismiss a complaint that focused on alleged price deficiencies (the fourth MFW prerequisite). The Swomley Chancery opinion disagreed that MFWestablished a new or separate “fair price” requirement, explaining that any price-negotiation failures must rise to the level of “gross negligence” and “recklessness,” which was the existing “duty of care” standard before MFW. The court went on to discuss areas in which the special committee in Swomleycould have valued assets differently, or negotiated harder, but stated that none of those price choices rose to the level of “grossly negligent” conduct required to breach the duty of care. The Delaware Supreme Court affirmed en banc “for the reasons stated in [the Court of Chancery’s] August 27, 2014 bench ruling.”

Less than a year after Swomley, the Chancery Court in Books-A-Million again relied on MFW in dismissing a complaint that alleged a controlling shareholder’s fiduciary-duty breach in purchasing the remaining shares in a going-private transaction. The court focused on plaintiffs’ argument that the special-committee members were not independent (i.e., the transaction did not satisfy the secondMFW prerequisite) because they had acted in bad faith by agreeing to a deal at $3.25 (a 95% premium over the average closing price for the prior 90 trading days), when another bidder had offered $4.21 (even though the controlling shareholder refused to sell). The court explained that “the difficult route of pleading subjective bad faith is [a] theoretically viable means of attacking the M&F Worldwide framework,” but held that plaintiffs did not meet their pleading burden because the committee had (i) explored third-party offers to test whether the controlling shareholder would stick to its buyer-only stance when given an opportunity to sell (it did); and (ii) used third-party offers to assess whether the controlling shareholder’s $3.25 bid was so low as to warrant rejecting it outright (it was not). The court concluded that “[r]ather than supporting an inference of bad faith, the Committee’s actions support an inference of good faith.” The Delaware Supreme Court recently affirmed without comment.

Potential future expansion of dual-approval process in other controlling-shareholder transaction contexts

Outside of the merger context (with its existing disclosure and voting requirements), companies will likely resist availing themselves of the MFW dual-approval framework because of the expense, delay, and uncertainty that adding a shareholder voting process would entail. There would be precedent, however, for applying MFW business-judgment review to non-merger controlling shareholder transactions. During the 1990s and 2000s, Delaware courts expanded the Lynch entire-fairness test from merger cases to other controlling-shareholder transactions, with Chancellor Allen stating that there is “no plausible rationale for a distinction between mergers and other corporate transactions.” Since then, the entire-fairness standard has been applied to controlling-shareholders’ management-services agreements, loans, non-competition payments, and third-party “brokering” payments. It stands to reason, therefore, that the MFW recipe for avoiding entire-fairness review in the merger context should also apply to non-merger control-shareholder transactions.

The complete publication, including footnotes, is available here.

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