Saturday, October 13, 2018
This week, the Delaware Supreme Court decided Flood v. Synutra, and began to clear up some of the questions left open after its earlier decision in Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”). Flood itself is relatively straightforward but, for me, it inevitably calls to mind some larger issues regarding the relationship between independent directors and controlling shareholders under Delaware law.
For many years, the regime in Delaware was that a controlling shareholder squeeze-out transaction would be reviewed for entire fairness, but the burden to prove lack of fairness would be placed on plaintiffs if the deal was approved by either a majority of the minority shareholders, or by a committee of independent directors who acted freely, without coercion, had the power to say no, etc. See Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994).
In MFW, the Delaware Supreme Court held that if a controlling shareholder employs both protections, and makes clear from the outset that any deal will be conditioned on their satisfaction, and there is no reason to think the protections were circumvented (i.e., the committee acted with care, was fully empowered, and so forth), the resulting deal will get business judgment review. But a lot was still left open.
For one thing, MFW had this odd footnote that suggested that an independent committee’s lack of care/bargaining power might be demonstrated, for pleading purposes, by a showing that the deal price was insufficient. The footnote was odd because normally a lack of care is not pled by challenging a substantive outcome; allowing it in this instance suggested the Court was not entirely confident that MFW’s dual protections truly substituted for an arm’s-length deal. And for another thing, MFW did not specify how early in the process the controller would have to disable itself to be entitled to business judgment protection.
So in Flood, per Chief Justice Strine, the Court began to close the holes.
First, it basically did away with MFW’s baffling footnote, which to be honest is more housekeeping than anything else.
And second, the Court held that “so long as the controller conditions its offer on the key protections at the germination stage of the Special Committee process, when it is selecting its advisors, establishing its method of proceeding, beginning its due diligence, and has not commenced substantive economic negotiations with the controller, the purpose of the pre-condition requirement of MFW is satisfied.”
In other words, a controlling shareholder may still take advantage of the MFW framework if it proposes the deal without the protections, and adds them later, so long as no “substantive economic negotiations” (and possibly other steps) have taken place in between.
Justice Valihura, in dissent, argued that the majority’s rule would inevitably draw courts into factual disputes as to what constitutes “substantive economic negotiations.” (And I admit, even I’m unclear what happens if the deal is proposed, and the special committee hires advisors and conducts due diligence without any negotiations, but before the conditions are added). Valihura would have preferred that the MFW rule kick in only if the conditions appear in the first formal written proposal (with, it must be said, exceptions if plaintiffs can show there was intentional evasion via oral negotiations before that point – so factual disputes are always possible).
Which brings me to the issue of independent directors.
In Flood, the controlling shareholder submitted a letter proposing a deal without either of MFW’s protections. Over the next two weeks, a new independent director – one previously proposed by the controller – was added to the Board, a special committee was formed to consider the proposal, and the newly-added director was placed on that committee. Also (and this was the focus of the Valihura dissent) there were other arrangements involving each side hiring counsel, and the directors being briefed on their fiduciary duties. After that, the controller submitted a revised letter conditioning the deal on the MFW protections. Despite the intervening events between the first proposal and the revised letter, the majority held that the MFW framework would apply. The majority was untroubled by the new addition to the Board, or his presence on the special committee. In other words, the Court was confident that, even under these circumstances, he could perform his duties fairly.
So here’s why this all strikes me as odd.
It has never been entirely clear whether the Delaware Supreme Court believes that independent directors can be trusted to stand up to controlling shareholders.
In Kahn v. Lynch, the Court held that squeeze out mergers would get entire fairness review even if approved by independent directors who acted diligently, fairly, etc. But it did not justify its holding on the ground that independent directors are likely to be coerced by a controller; rather, it only explicitly said that minority shareholders might feel coerced. Standing alone, then, Kahn might be interpreted to mean that since mergers ordinarily have dual protections (disinterested director plus disinterested shareholder approval), then if only one is present (disinterested director approval), there must be heightened scrutiny, with no suggestion that independent directors are likely to bow to a controller’s wishes.
Subsequent Chancery cases – including one authored by Chief Justice Strine when he was Vice Chancellor – interpreted Kahn to mean that independent directors might be cowed by the presence of a controller, and therefore their decisions are suspect. See, e.g., In re Pure Res., Inc., S'holders Litig, 808 A.2d 421 (Del. Ch.2002) (where then-VC Strine characterized controllers as 800-pound gorillas). As a result, a series of Chancery cases have subjected controlling shareholder transactions to entire fairness review, even if approved by the independent directors, and even if the transaction wouldn’t ordinarily require shareholder approval. See discussion in In re Ezcorp Inc. Consulting Agreement Derivative Litigation, 2016 WL 301245 (Del. Ch. Jan. 25, 2016).
Then came MFW. In response, some Chancery cases clarified that controllers can get the benefit of business judgment review if they employ the MFW framework, including transactions that ordinarily wouldn’t require shareholder approval at all. See In re Ezcorp Inc. Consulting Agreement Derivative Litigation, 2016 WL 301245 (Del. Ch. Jan. 25, 2016); IRA Trust FBO Bobbie Ahmed v. Crane,(Del. Ch. Dec. 11, 2017) (endorsing Ezcorp).
In other words, Chancery courts seem (?) to have coalesced around the view that controlling shareholders are likely to overwhelm both stockholders and independent directors, and therefore we can only trust the fairness of an interested-controller transaction if both approve, without any additional evidence of coercion.
If I’m not mistaken, the Delaware Supreme Court did eventually explicitly endorse the idea that directors can never be truly independent of a controller, but only twice. In Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997), the Court held:
Entire fairness remains applicable even when an independent committee is utilized because the underlying factors which raise the specter of impropriety can never be completely eradicated and still require careful judicial scrutiny….The risk is thus created that those who pass upon the propriety of the transaction might perceive that disapproval may result in retaliation by the controlling shareholder. Consequently, even when the transaction is negotiated by a special committee of independent directors, no court could be certain whether the transaction fully approximated what truly independent parties would have achieved in an arm's length negotiation.
(quotations and alterations omitted). Later, the Court said the same thing in Ams. Mining Corp. v. Theriault, 51 A.3d 1213 (Del.2012), quoting Tremont. But these cases are the only ones that I know of where the Delaware Supreme Court explicitly said that we cannot fully trust even independent directors when they stand opposite controlling shareholders. And I note that earlier cases held in dicta that independent directors could cleanse transactions involving controlling shareholders. See, e.g., Summa v. Trans World Airlines, Inc., 540 A.2d 403 (Del. 1988); Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993).
(Am I wrong? Is there another case where the Delaware Supreme Court was explicit about the fact that independent directors should be distrusted as a matter of law – even absent a showing of some specific dysfunction – when across the table from a controlling shareholder?)
But if that’s right, there’s an odd incongruity, which Vice Chancellor Laster explored in detail in In re Ezcorp Inc. Consulting Agreement Derivative Litigation, 2016 WL 301245 (Del. Ch. Jan. 25, 2016), and that then-Vice Chancellor Strine flagged in In re Pure Res., Inc., S'holders Litig, 808 A.2d 421 (Del. Ch.2002). Namely, it is well-established that independent directors are presumed to be unbiased for the purposes of the demand requirement in a derivative lawsuit, even if the defendant is a controlling shareholder. In other words, we always trust that independent directors can make a fair determination as to whether it is in the corporation’s interest to file a lawsuit against the controller. That much goes back to Aronson v. Lewis, 473 A.2d 805 (Del. 1984).
The Aronson rule does not seem to have changed – mostly. I’ve previously blogged about how in Delaware Cty. Emps. Ret. Fund v. Sanchez, 124 A.3d 1017 (Del. 2015) and Sandys v. Pincus, 152 A.3d 124 (Del. 2016), the Delaware Supreme Court addressed demand futility in cases against controlling shareholders, and employed a much more nuanced inquiry than it had performed in the past. Specifically, the Court was willing to hold that nebulous social and business ties could, collectively, compromise a director’s independence. Neither case, however, limited its holding to the controlling shareholder context (and Chancery has not interpreted the cases to be so limited). So Sanchez and Sandys, as far as we know, are not cases about controlling shareholders generally; they are cases about what constitutes independence.
So now here we are, back in the context of a controlling shareholder squeeze-out, and we have a prima facie reason to distrust the decisionmaking of the independent directors: A whole new one was added to the board, at the controller’s behest, and added to the special committee, after the controller had proposed the deal.
But does the Court suspect wrongdoing? No! To the contrary, it cites Aronson – the original case to hold that independent directors are unlikely to be cowed by controllers – to justify its faith in the directors’ fortitude. See Flood, slip op. at 8 n.37. The Court does not invoke Tremont, with its explicit doubts whether independent directors can resist controllers.
Point being, which is it? Do we trust independent directors to protect minority shareholders when their interests diverge from the controller, or don’t we? If we do, then MFW should only apply in the context of transactions that legally cannot be consummated without both director and shareholder approval; if the transaction does not require both, approval by independent directors should be sufficient. And if we don’t trust independent directors to stand up to controllers, then MFW should apply to all situations where a controlling shareholder has interests that diverge from the minority, including determinations of whether demand is futile. And if we don’t fully trust independent directors to defy controlling shareholders, we should be much more suspicious of squeeze-outs that are initiated without the MFW protections, even if the directors only engage in minimal preparations before those protections are added. Or perhaps the demand requirement is its own separate world - which is what VC Laster seemed to think in Ezcorp - in which case, Aronson should not be used to support an inference of director independence in other contexts.
Anyhoo, these incongruities have persisted for many years; it’s quite possible they’ll continue for many years more, and I guess we’ll have to live with the uncertainty for now.