MFW Pitfalls: Bypassing the Special Committee and Pursuing Detrimental Alternatives

Christopher B. Chuff is an associate and Joanna Cline and Matthew Greenberg are partners at Pepper Hamilton LLP. This post is based on a recent Pepper memorandum by Mr. Chuff, Ms. Cline, Mr. Greenberg, and Taylor Bartholomew. This post 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).

On June 11, the Delaware Court of Chancery issued important guidance [1] to boards of directors of Delaware corporations and their controlling stockholders seeking to utilize the dual protections of MFW [2]—a special committee and a majority of the minority vote—to insulate themselves from fiduciary liability in connection with various corporate transactions.

First, the court held that when a corporation’s board or the corporation’s controller bypasses the special committee and negotiates directly with the corporation’s minority stockholders, MFW cleansing and the resulting application of business judgment review will be unavailable.

Second, the court held that when a corporation and its controller empower a special committee to consider and “say no” to various transaction alternatives, but retain the authority to pursue an alternative that is detrimental to the minority, any resulting special committee and stockholder approval of the transactions submitted for their approval will be found to be tainted by coercion, such that MFW cleansing will be unobtainable.

Thus, while the court’s decision confirms that the dual protections of MFW can be effective to protect against fiduciary liability claims, boards of directors and controlling stockholders who wish to maximize the effectiveness of those protections must be sure to avoid these and other pitfalls.

Background

In 2016, Dell purchased EMC Corporation, a data storage firm, for $67 billion. One of EMC’s most valuable assets was its ownership of 81.9 percent of the equity of VMware, Inc., a publicly traded cloud computing and virtualization company.

The consideration paid by Dell to EMC’s stockholders consisted of cash and newly issued shares of Class V common stock in Dell, which tracked the performance of VMware. The Class V shares were subject to a conversion right: If Dell listed its Class C shares on a national exchange, then Dell could forcibly convert the Class V shares into Class C shares pursuant to a contractually set pricing formula (the Forced Conversion).

The Class V shares, collectively, constituted less than 4 percent of Dell’s voting power. Meanwhile, even taking into account the EMC acquisition, Michael Dell, the company’s chief executive officer, maintained control over 73 percent of Dell’s outstanding voting power.

After the EMC acquisition closed, Dell began exploring ways to consolidate its ownership of VMware. There were three potential paths: (1) a transaction with VMware, (2) a redemption of the Class V stock, or (3) a Forced Conversion.

In January 2018, Dell formed a special committee to negotiate a redemption of the Class V shares from the former stockholders of EMC. In an attempt to qualify for the safe harbor established by Kahn v. M & F Worldwide Corp. (MFW), 88 A.3d 635 (Del. 2014), the board conditioned any redemption or similar transaction on both committee approval and approval from holders of a majority of the outstanding Class V shares.

Notably, however, Dell reserved the right to bypass the MFW process by engaging in a Forced Conversion. During the ensuing months, Dell negotiated with the committee. During those negotiations, Dell and the committee’s advisers repeatedly told the committee that if they did not agree to the redemption, then the company would proceed with a Forced Conversion, which, they stressed, was least attractive option for the Class V stockholders.

On July 1, 2018, the committee recommended a negotiated redemption, which valued the Class V shares at $21.7 billion. Large holders of Class V stock objected. In response, Dell began negotiating the redemption directly with the six large holders of Class V stock rather than negotiating further with the committee. While Dell negotiated with the six large Class V stockholders, it also began publicly taking steps to prepare for a Forced Conversion, underscoring the reality of this alternative.

Ultimately, Dell agreed to terms with the six large Class V stockholders. The new terms valued the Class V shares at $23.9 billion, an increase of more than $2 billion from the committee-sponsored redemption.

The committee was not involved in the negotiations between Dell and the six large Class V stockholders. When Dell informed the committee of the terms of the redemption, the committee met for an hour and approved it. Subsequently, 61 percent of the outstanding Class V shares voted in favor of the transaction, and the redemption closed.

Former holders of the Class V stock brought suit against Michael Dell, as Dell’s alleged controlling stockholder, and the members of Dell’s board, claiming that they breached their fiduciary duties when negotiating and approving the redemption. The defendants moved to dismiss, contending that the redemption was negotiated in accordance with the strictures of MFW and should therefore be reviewed under the deferential business judgment rule and dismissed.

Analysis

The court disagreed with the defendants, holding that the plaintiffs’ complaint alleged facts that make it reasonably conceivable that the defendants failed to comply with MFW, making entire fairness the operative standard of review.

The court began its analysis by summarizing the MFW requirements that the redemption must have complied with to be reviewed under the business judgment rule.

At a high level, to satisfy MFW, a controller must structure a transaction so that the controller-proposed transaction acquires the stockholder-protective characteristics of a third party, arm’s length transaction. More specifically, to obtain MFW cleansing, the transaction must meet the following six requirements:

  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 disinterested and independent.
  3. The special committee is empowered to freely select its own advisers and to say no definitively to the proposed transaction.
  4. The special committee meets its duty of care in negotiating a fair price.
  5. The vote of the minority is informed.
  6. There is no coercion of the minority.

As to the first requirement, the court stated that this element is met only if the controller completely disables itself from using its control to dictate the outcome of the corporation’s negotiations with the special committee and the stockholder vote. What is critical, the court explained, is that the negotiations are structured such that the controller must accept that no transaction will go forward without special committee and disinterested stockholder approval.

The court found that this requirement was not met in Dell for two reasons:

  • First, Dell excluded the Forced Conversion from the special committee’s purview. Although Dell had identified three potential transactions that it was considering—(1) a negotiated transaction with VMware, (2) a redemption of the Class V stock, or (3) a Forced Conversion—the special committee’s mandate included only the first two paths, excluding a Forced Conversion. Because the committee did not have the power to “say no” to the Forced Conversion—which was indisputably detrimental to the Class V stockholders—the redemption failed to meet the first requirement of MFW.
  • Second, Dell bypassed negotiating with the committee and, instead, negotiated directly with certain of the Class V stockholders. Per the court, MFW’s dual protections contemplate that the special committee will act as the bargaining agent for the minority stockholders, with the minority stockholders rendering an up-or-down verdict on the committee’s work. Those roles are complements, not substitutes, and a controller cannot circumvent that process by negotiating directly with the stockholders themselves. Thus, the court concluded, Dell’s bypassing of the special committee to negotiate directly with the Class V stockholders prevented MFW cleansing and the resulting application of the business judgment rule.

The court also engaged in a thorough analysis of the sixth element of the MFW test—whether approval of the challenged transaction was tainted by coercion. The court identified four potential types of coercion that are applicable to determining whether a transaction may be cleansed under MFW. [3]

  • The first type of coercion identified by the court is “fiduciary coercion”—i.e., where a fiduciary takes action to induce stockholders to act, whether by voting or choosing to tender shares—for some reason other than the merits of the proposed transaction. In short, this coercion exists where fiduciaries force stockholders into a choice between two new positions, one of which is compromised in some fashion. A classic example is where fiduciaries propose a two-step transaction in which the second step of the transaction would be demonstrably worse for stockholders that did not accept the consideration offered in the first step. Another classic example is where fiduciaries make retributive threats to stockholders that do not accept or vote in favor of the proposed transaction. Because, in these scenarios, the stockholders are not in a position to vote against the proposal and maintain the status quo, the transaction structure is necessarily coercive.
  • A second type of coercion identified by the court is “situational coercion”—i.e., where external circumstances or pressures not intentionally created by fiduciaries, such as the risk of insolvency, cause the corporation’s status quo to be so unattractive to a stockholder that it, in essence, has no other choice but to approve the proposed transaction. In short, a court will find that stockholders face coercion in considering a proposed transaction where the stockholders’ vote reflects their mere preference for a marginally better alternative over an already bad situation rather than their endorsement of the merits of the transaction.
  • A third type of coercion identified by the court is “structural coercion”—i.e., where the transaction is structured in a manner that makes a court question whether the stockholders voted for the transaction because of the merits of the transaction or because of the way it was structured. A common example is where a transaction that is clearly beneficial to the stockholders is cross-conditioned on the stockholders’ approval of the challenged transaction, the benefits of which are questionable in some respect. Again, in that scenario, a court cannot readily determine whether the vote of the stockholders in favor of the challenged transaction was based on the merits or the stockholders’ desire to approve the other, clearly beneficial transaction.
  • A fourth type of coercion identified by the court is “committee coercion”—i.e., where by one or more of the methods discussed above, the special committee negotiating the challenged transaction is coerced into recommending the transaction or recommends the transaction in a coercive environment.

In this case, the court found it reasonably conceivable that Dell created a coercive situation, foreclosing MFW cleansing and the application of the business judgment rule, by retaining the authority to pursue the Forced Conversion and by publicly preparing to move forward with the Forced Conversion while the special committee was negotiating the redemption transaction. Because of the specter of the Forced Conversion, the court found, the committee’s ability to effectively bargain and the ability of the stockholders to vote down the redemption were undermined. Thus, MFW cleansing was inappropriate and entire fairness review conceivably applied.

Takeaways

Some of the key takeaways from the Dell decision are as follows:

  • The Two Safeguards. Once entire fairness review has been presumptively triggered—whether because there is a conflicted controlling stockholder or a majority-conflicted board—there are two procedural safeguards that may be used either separately or in conjunction with one another to either shift to the plaintiff the burden of proving that the transaction is not entirely fair or change the standard of review from entire fairness to business judgment. These safeguards are a properly functioning special committee and stockholder ratification.
  • Both Safeguards Needed in the Controller Context. Delaware case law, including MFW and Dell (discussed herein), leaves no doubt that both protections are needed to regain business judgment rule protection in controlling stockholder situations.
  • The Six Requirements of MFW. To obtain MFW cleansing, the dual protections must meet the following six requirements: (1) the controller must condition the procession of the transaction on the approval of both a special committee and a majority of the minority stockholders before substantive economic negotiations begin; (2) the special committee must be disinterested and independent; (3) the special committee must be empowered to freely select its own advisers and to say no definitively to the proposed transaction; (4) the special committee must meet its duty of care in negotiating a fair price; (5) the vote of the minority must be informed; and (6) there must be no coercion of the minority.
  • Bypassing the Committee Precludes Cleansing. As the court in Dell makes clear, MFW’s dual protections contemplate that the special committee will act as the bargaining agent for the minority stockholders, with the minority stockholders rendering an up-or-down verdict on the committee’s work. Those roles are complements that work in conjunction with one another, not substitutes. Thus, when a controller circumvents that process by bypassing the committee and negotiating directly with the minority stockholders, MFW cleansing is not warranted.
  • Coercion Precludes Cleansing. As the court in Dell also makes clear, when a question is raised as to whether a special committee’s or the stockholders’ decision is made because of the merits of a challenged transaction or some extraneous influence, then MFW cleansing is unavailable. Extraneous influences include direct threats by a controller (i.e., fiduciary coercion); external circumstances or pressures not intentionally created by fiduciaries, such as potential insolvency, that cause the corporation’s status quo to be so unattractive to a stockholder that it, in essence, has no other choice but to approve the proposed transaction (i.e., situational coercion); or where the transaction is structured in a manner that makes a court question whether the stockholders voted for the transaction because of the merits of it or because of the way it was structured (i.e., structural coercion), such as where clearly beneficial transactions are cross-conditioned on approval of questionable transactions. These types of coercion would also preclude the application of Corwin [4] to cleanse a transaction outside of the controlling-stockholder context.
  • Empowering Approval of All Alternatives. When a corporation and its controller are considering various transaction alternatives—one or more of which are detrimental to the minority stockholders—the corporation and its controller should empower the special committee to consider and “say no” to all of those alternatives in order to obtain MFW cleansing and business judgment review. When a corporation or its controller retain authority over a transaction alternative that is detrimental to the minority, a court may view that fact as creating a coercive decision-making environment such that MFW cleansing will be unobtainable.

Endnotes

1In re Dell Technologies Inc. Class V Stockholders Litig., C.A. No. 2018-0816-JTL (Del. Ch. June 11, 2020).(go back)

2Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014).(go back)

3The court also analyzed other types of coercion that are not readily applicable in the MFW context. For brevity, we do not summarize those types of coercion in this article.(go back)

4Corwin v. KKR Financial Holdings LLC, 125 A.3d 304 (Del. 2015).(go back)

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