Inre CNX Gas Corporation Shareholders Litigation, Cons. C.A. No. 5377-VCL (Del. Ch. July 5, 2010) (Vice Chancellor Laster)
In this memorandum opinion, Vice Chancellor Laster granted defendants’ application to certify the Chancery Court’s May 26, 2010 decision for interlocutory appeal to the Delaware Supreme Court to address various issues regarding unilateral two-step freeze-outs, including the proper standard of review for such transactions.
Plaintiff minority stockholders sought to preliminarily enjoin the defendants, including a controlling stockholder, from completing a freeze-out of the minority stockholders following a tender offer. In his May 26, 2010 decision (the “Injunction Decision”), Vice Chancellor Laster held that under In re Cox Communications, Inc. S’holders Litig., entire fairness applied to the transaction, but denied plaintiffs’ preliminary injunction application because post-trial money damages would serve as a sufficient remedy. Subsequently, on June 1, 2010, CONSOL (the controlling stockholder), announced that it had completed the second-step short-form merger to eliminate the remaining minority shares. Although the preliminary injunction had been denied and the transaction was completed, on June 4, 2010, defendants sought certification for interlocutory appeal of the Injunction Decision to determine whether entire fairness was the proper standard of review for a unilateral two-step freeze-out. The Court held, as a preliminary matter, that defendants had standing to appeal the Injunction Decision. Although the general rule is that the prevailing party may not appeal a decision in its favor, there are two exceptions that allow the prevailing party to appeal, the second being if the judgment includes a collateral adverse ruling that could serve as law of the case. Because the Injunction Decision’s holding that entire fairness was the appropriate standard of review would serve as law of the case going forward, and should therefore not be disturbed absent a compelling reason, the Court held that the second exception applied and the defendants had standing to appeal.
The Court also held that the Injunction Decision met the criteria for interlocutory appeals under Supreme Court Rule 42 because it determined a substantial legal issue, as well as a legal right, and met the criteria of Rule 41. The three criteria under Rule 41 are that the decision include: (i) an original question of law; (ii) conflicting decisions; or (iii) an unsettled question. Although only one of the criteria needs to be met in order to satisfy Rule 42, the Court found that all three were indeed met by the Injunction Decision.
The Court found conflicting decisions regarding the appropriate standard of review in a controlling stockholder’s unilateral two-step freeze-out in In re Siliconix, Inc. S’holders Litig. (Siliconix), In re Pure Resources, Inc. S’holder Litig. (Pure Resources), and In re Cox Communications, Inc. S’holders Litig. (Cox Communications). Under Siliconix, a unilateral two-step freeze-out is only reviewed for entire fairness if the offer is structurally coercive. According to Pure Resources, entire fairness will not be applied as long as: (i) the transaction is subject to a non-waivable majority of the minority tender condition; (ii) the controlling stockholder promises to consummate a prompt short-form merger at the same price if it obtains more than 90% of the shares; (iii) the controlling stockholder has made no retributive threats; and (iv) the independent directors on the target board have free rein and adequate time to react to the tender offer. Lastly, under Cox, the business judgment standard of review, and not entire fairness, will apply to a unilateral two-step freeze-out merger if the first-step tender offer is: (i) recommended by a duly empowered special committee of independent directors and (ii) conditioned on the affirmative tender of a majority of the minority shares. The Court noted that several Chancery Court decisions exist which were reviewed under the Siliconix framework that would not pass even the Pure Resources test, and similar cases decided under Pure Resources that would not pass the Cox Communications test. The Court held that this conflict warranted certification to the Delaware Supreme Court.
The Court also found these decisions were in conflict over the concept of inherent coercion in transactions, and that this conflict also warranted Supreme Court review. In Kahn v. Lynch Communication Systems, Inc. (Lynch), the Delaware Supreme Court held that entire fairness always applies to transactions involving a controlling or dominating shareholder because even without actual coercion, stockholders would not feel free to tender their shares as they pleased for fear of some type of retribution. The Delaware Supreme Court held that this inherent coercion was always present, and the standard of review in transactions with a controlling or dominating shareholder could not be altered through protective devices such as a majority of the minority condition, but would merely shift the burden of proof to the plaintiff. Vice Chancellor Laster summed up the conflicts between the holdings in Lynch, Siliconix, Pure Resources and Cox Communications regarding inherent coercion by noting that “the Injunction Decision, Cox Communications, and the Pure Resources line of cases implicitly conflict with Lynch by holding that a combination of protective devices can compensate sufficiently for inherent coercion to alter the standard of review. The Siliconix line of cases implicitly conflicts with Lynch by declining to recognize the threat of inherent coercion in a controller transaction.”
The last conflict found by the Court was over the role of a target board in a unilateral two-step freeze-out. The Siliconix decision stated there was “no statutory role” for a target board in a controlling stockholder tender offer because it deals with the sale of stockholders’ property and does not require any corporate action. The Pure Resources court noted the prominence of a target board’s role in the third-party tender offer context, especially under the landmark holding in Unocal, which held that the target board had “both the power and duty to oppose a bid it perceived to be harmful to the corporate enterprise.” Although the Pure Resources court required that the independent directors have free rein and adequate time to react to a controlling stockholder’s tender offer, the court allowed the controlling stockholder to limit the special committee’s authority to respond to the tender offer, and held that the committee need only operate in an advisory role. In contrast, the Injunction Decision relied on Cox Communications and the concept of board centrism found in § 141(a) of the Delaware General Corporation Law in holding that “a special committee should be granted the same authority to respond to a controller’s freeze-out that a target board would possess when responding to a third-party tender offer.” Therefore, the Court held that the conflict over a target board’s role in a unilateral two-step freeze-out warranted certification to the Delaware Supreme Court.
Even though the Court found certification of defendants’ interlocutory appeal proper under Rule 41(b)(ii) for the various conflicts found in trial court decisions, it also noted that certification would be proper under Rule 41(b)(i) and (iii) for original questions of law and unsettled questions. As the Court stated, “only the Supreme Court can determine definitively whether different policies, duties, and standards should govern unilateral two-step freeze-outs,” as opposed to single-step freeze-outs or negotiated two-step freeze-outs, and that the “standard of review for a controller’s unilateral two-step freeze-out thus presents an issue of first impression for the Delaware Supreme Court.”
The Court also held that, as required by Rule 42(b), the interlocutory ruling would determine a substantial legal issue and establish a legal right. A ruling on the standard of review for a unilateral two-step freeze-out was considered a substantial legal issue in Pure Resources, and the Court held that the present case was no different. The Court stated that the determination of an issue essential to the parties regarding the merits of the case establishes a legal right, and that a holding that entire fairness applied to the transaction at issue did in fact determine an issue essential to the parties regarding the merits of the case. In addition, a legal right was established by the Court’s holding that the defendants could close the unilateral two-step freeze-out instead of enjoining it.
Lastly, the Court clarified that its Injunction Decision was not attempting to resuscitate the business purpose test by expressly stating that the “Injunction Decision does not require an independent business purpose for a freeze-out.” Rather, the Court stated that its injunction Decision merely “concluded that Solomon II does not support a blanket rule that all controller tender offers are voluntary and non-coercive, nor a blanket rule of non-review absent structural coercion for unilateral two-step freezeouts.”
Therefore, the application for interlocutory appeal satisfied Supreme Court Rule 42(b) by determining a substantial legal issue, establishing a legal right, and satisfying at least one if not all of the criteria in Supreme Court rule 41(b). Accordingly, the Court granted the application for interlocutory appeal.