In re Loral Space and Communications Inc. Consolidated Litig., C.A No. 2808-VCS (Del. Ch. Sept. 19, 2008) (Strine, V.C.)
In this post-trial opinion, Vice Chancellor Strine evaluated the fairness of a $300 million convertible preferred stock transaction entered into between Loral and its largest stockholder, MHR Fund Management LLC (“MHR”). This case was brought as a derivative and class action by stockholders of Loral who alleged that the MHR Financing was an interested, unfair transaction approved through a flawed special committee process. The Court of Chancery concluded that the MHR Financing was unfair to Loral. As a remedy, the Court reformed the transaction by converting MHR’s preferred stock into non-voting common stock at a price set by the Court.
The Court first determined that the entire fairness standard applied to the MHR Financing because a majority of the Loral board was affiliated with MHR, including the CEO of Loral (Michael Targoff) and the chairman of the special committee (John Harkey). Three of the eight Loral directors were directly controlled by MHR. Targoff, who previously occupied rent-free office space at MHR and advised MHR on certain investments, was made CEO of Loral at the behest of MHR. Harkey and MHR’s founder, Mark Rachesky, were business school classmates and remained close friends. In addition, Harkey solicited investments from MHR and was listed as one of MHR’s “Selected Investment Advisors.” The Court also found that MHR, which held 36% of the votes and maintained a majority of the board, possessed practical power and control over Loral. Having determined that the entire fairness standard applied, the Court went on to consider the two components of that standard – fair dealing and fair price.
With regard to fair dealing, the Court held that the special committee failed to conduct an adequate process for numerous reasons. Those reasons included: (1) the flawed composition of the special committee – Harkey had close business and personal relationships to MHR and Rachesky, and Arthur Simon, the other special committee member, was an inexperienced, passive member of the committee who had been retired for many years; (2) Harkey solicited investments in another potential transaction (unrelated to Loral) from MHR during the special committee process; (3) the special committee's financial advisor, North Point, had little experience or expertise in convertible securities, and was “outgunned and outwitted” throughout the process; (4) North Point conducted no market check before advising the special committee to agree to the basic terms of the MHR financing, only seven days after it was hired; (5) the special committee was formed with a narrow mandate to raise $300 million in equity financing, which amounted to nearly 54% of Loral’s then existing market capitalization, as quickly as possible; (6) the special committee only focused on the $300 million figure and refused to even consider other offers, including a $100 proposal from Goldman Sachs; (7) rather than consider whether a sale of all of Loral may have been possible, the special committee framed the deal to avoid triggering Revlon duties; and (8) the special committee never followed up with another shareholder’s offer of the same financing with improved economic terms.
With respect to fair price, the Court determined that the financial terms of the MHR Financing were unfair to Loral. Among other complicated terms not material to the Court’s analysis, the MHR Financing involved $300 million in convertible preferred stock that would be issued to MHR with a 7.5% coupon (i.e., dividends in “paid in kind” securities) and a 12% conversion premium ($30.15) over Loral’s stock price ($26.92). In total, these terms gave MHR the right to 63% of Loral’s equity, 39.99% of the voting power, and a unilateral veto over any strategic initiative of Loral. MHR also received a $6.75 million “placement fee.” In rejecting MHR’s argument that the significant risk it was taking justified the above-market terms, the Court found that MHR took on risk at its own insistence for its own advantage and that MHR rejected two options for eliminating risk – a pursuit of selling the company or sharing the risk with other shareholders. The Court concluded that MHR received unfairly advantageous terms from Loral.
After concluding that the MHR financing failed the entire fairness standard, the Court determined that the most equitable remedy would be to convert the preferred stock that MHR received into non-voting common stock. In setting the conversion price, the Court took into account MHR’s access to inside information, its insulation of itself from market pressures, as well as Loral’s actual stock trading price. The Court gave 50% weight to the mid-range of MHR’s own internal valuation of Loral ($34.78) and 50% weight to the actual trading price of Loral ($26.92) to arrive at a valuation of $30.85. As a result of the Court’s remedy, MHR would hold 57% of the total equity, but remain at its prior level of voting power (35.9%). The Court determined that such a remedy would rectify the harm to Loral and its public stockholders from “an unfair, non-market tested transaction that saddled the corporation with an unwieldy capital structure and a future in which MHR held unilateral veto power over virtually any major decision.”