Delaware Court Adopts Unified Standard for Controlling Stockholder Going Private Transactions

In a recent Delaware decision issued in In re CNX Gas Corp. Shareholders Litigation, C.A. No. 5377-VCL (Del Ch. May 25, 2010), Vice Chancellor Travis Laster imposed additional requirements for controlling stockholders and boards to obtain the benefit of the more deferential business judgment standard of review by a court in litigation over a going private tender offer, and advocates a unified standard of review for going private transactions generally, whether structured as a merger or a tender offer. Vice Chancellor Laster endorsed the reasoning first set forth in dicta in Cox Communications (Del. Ch. 2005), in which Vice Chancellor Leo Strine, Jr. argued that the Delaware courts should reject the notion that negotiated mergers with controlling stockholders are subject to the stringent “entire fairness” review, while certain two-step transactions (i.e., a tender offer followed by a short-form merger) with the same controlling stockholders are subject to the business judgment rule. In CNX, Vice Chancellor Laster held that the business judgment rule (and not entire fairness) will apply to a going private transaction by its controlling stockholder only if the transaction is both (1) negotiated and recommended by an active and informed special committee of independent, disinterested directors and (2) subject to a “majority-of-the-minority” tender or vote condition.

The CNX decision thus is the latest (although surely not the last) step in resolving the longstanding dichotomy in the standard of review applied to controlling stockholder going private transactions.  It is well settled under the Delaware Supreme Court’s holding in Kahn v. Lynch (Del. 1994) that negotiated mergers with controlling stockholders are subject to Delaware’s heightened entire fairness review, which requires a court to determine whether the process employed and the price to be paid in the transaction are fair to the minority stockholders.  As set forth in Lynch, the companies can shift the initial burden of proof to plaintiffs if they employ either of the protective devices described above.  In stark contrast, the often-cited decisions by the Delaware Court of Chancery in Pure Resources (Del. Ch. 2002) and Siliconix (Del. Ch. 2001) (reiterated earlier this month by Vice Chancellor Parsons in Cox Radio (Del. Ch. 2010)) provide that entire fairness may not apply to non-coercive two-step transactions that contain certain procedural protections, including a non-waivable majority-of-the-minority tender condition, a commitment by the controlling stockholder to consummate a prompt short-form merger at the same price, and the absence of retributive threats.  (This line of cases has not yet been reviewed by the Delaware Supreme Court.)

This distinction provided controlling stockholders with a powerful incentive to structure freeze-outs as two-step transactions, thereby lessening the role played by a special committee.  Under CNX’s holding, a controlling stockholder cannot structure a two-step freeze-out to avoid entire fairness simply by including a majority-of-the-minority condition (as required in Pure Resources).  Rather, CNX requires that the transaction also be negotiated and recommended by an active and informed special committee.  Notably, with respect to negotiated, one-step mergers, the CNX decision suggests that a controlling stockholder, for the first time, can avoid entire fairness altogether by satisfying both of the two conditions articulated in CNX.  However, the CNX court was not presented with a negotiated, one-step merger to review, and the application of the unified standard to such a transaction likely would require overturning Delaware Supreme Court precedent.

Applying the unified standard to the facts in CNX, Vice Chancellor Laster found that the proposed going private tender offer did not satisfy these requirements.  The special committee (which consisted of one director) did not recommend the transaction and was not authorized to negotiate with the buyer or to consider other alternatives, implement a rights plan or commence litigation against the buyer.  The absence of “authority comparable to what a board would possess in an arms-length transaction” was sufficient to trigger an entire fairness review.  Vice Chancellor Laster also found a reasonable basis to question the effectiveness of the majority-of-the-minority condition, because the company’s most significant minority shareholder was fully hedged in the transaction and, in addition, was required to tender its shares pursuant to a tender agreement with the acquiror.

However, because the Court rejected plaintiffs’ disclosure allegations and accepted the adequacy of post-closing money damages, Vice Chancellor Laster denied plaintiffs’ motion to preliminarily enjoin the transaction.

It remains to be seen whether the other Delaware Vice Chancellors will follow the CNX decision and whether and if the Delaware Supreme Court will decisively resolve these issues. Nonetheless, the CNX decision has a number of practical implications, including:

• Pure Resources gave the controlling stockholder the option of proposing a going private transaction without first engaging in negotiations with a special committee, or after determining that negotiations with the special committee were not progressing to its satisfaction.  The CNX decision further empowers the role of special committees and confirms the advice given by practitioners that a special committee must have full and clearly articulated powers, including the authority to negotiate with the controlling stockholders and to pursue other strategic alternatives.
• Though not the final word on the issue, the CNX decision provides case-law support for demands by special committees to include a majority-of-the-minority condition in controlling stockholder mergers.  One reason why this condition is not the default in these transactions is that they increase transaction risk, as they reduce the amount of shares required to block a transaction.  This in turn may incentivize hedge funds and others to exploit a blocking effort to extract a higher price.  In the end, assuming that the law crystallizes around CNX, buyers will have to weigh the benefits of avoiding entire fairness altogether against the practical risks associated with satisfying a majority-of-the-minority condition.  A controlling stockholder might find it more desirable to employ a burden-shifting device and engage in an entire fairness inquiry rather than to accept increased transaction risk.
• Assuming that the Delaware courts extend CNX and apply the unified standard to negotiated mergers with a controlling stockholder, transactions that satisfy both CNX requirements would avoid entire fairness review altogether, thereby limiting the leverage available to stockholder plaintiffs who file “strike suits” challenging such transactions.  Under the status quo, a buyer can employ a process to shift the burden in—but not avoid—entire fairness review, thereby rendering “strike suits” effectively immune from dismissal on the papers (without some degree of discovery) regardless of whether plaintiffs can allege particularized facts demonstrating a breach of fiduciary duty.

See a copy of In re CNX Gas Corporation Shareholders Litigation, C.A. No. 5377-VCL (May 25, 2010).