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Conflicted Merger Transactions and the Latest Lessons from the Court of ChanceryJanine M. Salomone
Gesoff v. IIC Industries Inc. The Gesoff Facts In 2000, management of CP Holdings, a foreign holding company (“CP”), determined that the costs associated with owning a majority stake in IIC Industries, a publicly traded Delaware corporation (“IIC”), outweighed the benefits and decided to take IIC private. Upon the advice of its U.S. counsel, who also acted as counsel for IIC (“U.S. Counsel”), CP’s management determined to proceed with a tender offer designed to increase CP’s equity interest from 79% to at least 90% of the outstanding shares of IIC. The tender offer, if successful, would enable IIC to cash out the remaining minority holders through a short-form merger. CP management was concerned, however, that the minority stockholders of IIC were likely to negotiate aggressively regarding the price at which they would be cashed out and initiated the search for an investment bank to prepare a valuation to support the tender offer price. CP management ultimately began to consult with Jesup & Lamont, a small investment bank that had been recommended by U.S. Counsel. Shortly thereafter, the CP board met and authorized management to make a tender offer to the IIC board at a price of $13.00 per share for the minority interest. In addition, at the recommendation of U.S. Counsel, the board of directors of IIC appointed a special committee. The only member of the special committee was the sole available IIC director who was independent of CP.[3] The IIC board authorized the special committee to “examine the Tender Offer and to prepare and present a recommendation to the Board and the public stockholders on the Company’s position on the Tender Offer.”[4] Soon after its formation, the special committee met with representatives of, and eventually retained the services of, Jesup & Lamont. Jesup & Lamont did not volunteer information about their prior relationship with CP. In addition, U.S. Counsel was appointed to advise the special committee but continued to provide advice both to the parent, CP, and the subsidiary, IIC.[5] At trial, the evidence revealed that CP’s management, with the active assistance of U.S. Counsel and Jesup & Lamont, had devised a cynical strategy for acquiring IIC’s minority shares: (i) CP would present a relatively “lowish bid” to the IIC board, (ii) IIC, already represented by CP’s U.S. Counsel, would hire Jesup & Lamont to evaluate the bid for the special committee, (iii) Jesup & Lamont would recommend a price slightly higher for the minority shares of IIC, (iv) CP would meet the higher price, and (v) Jesup & Lamont would support it and CP would proceed with the tender offer.[6] Over the next several months, the parties adhered to the agreed upon scheme during negotiations. CP made a “lowish” initial offer for IIC of $10.00 per share, an amount significantly lower than the $13.00 bid the CP board had authorized management to make.[7] After the receipt of the initial offer, Jesup & Lamont conducted a valuation of IIC for the special committee. Meanwhile, unbeknownst to the special committee, Jesup & Lamont continued to have surreptitious discussions with CP management that included valuation ranges for IIC. The parties ultimately agreed on a tender offer price of $10.50 per IIC share, Jesup & Lamont agreed to deliver its fairness opinion to the special committee at that offer price and the special committee announced its decision to recommend the tender offer to the stockholders.[8] Notwithstanding the special committee’s endorsement, the tender offer failed to garner sufficient support to allow for the acquisition of the remaining shares of IIC through a short-form merger. CP, undaunted, determined to accomplish the desired result by way of a long-form merger. The special committee agreed that a merger was in the best interests of the stockholders, particularly after the events of September 11. Without the benefit of an additional fairness opinion or any modification to its initial mandate, the committee concluded that the merger was fair and recommended it to the full board.[9] The full board of IIC and CP, the company’s majority stockholder, subsequently approved the merger. The Gesoff Decision Plaintiffs challenged the going private transaction, asserting that the merger was the product of unfair dealing and that the merger consideration of $10.50 per share was an unfair price. The Court found that the entire fairness standard of review was applicable and determined that defendants had failed to satisfy their burden to establish fair dealing and fair price.[10] When examining the special committee process, the Court noted that the question of fair dealing was completely dependent on the quality of negotiations between the special committee and CP. In this case, the process employed by the IIC special committee was the result of the manipulative scheme designed by the CP board, its management and advisors that “fails at the very threshold to establish fair dealing.”[11] The Court continued:
In support of its conclusion, the Court noted that the initial flaw in the process lay in the appointment of a single member special committee, noting that the facts of this case illustrate precisely the reason why such committees have been viewed traditionally by the Delaware courts as a “worrisome portent of unfair dealing”[13] that in and of itself requires a higher level of judicial scrutiny. The Court emphasized that a second committee member might have provided a moderating influence throughout the negotiation process and could well have ameliorated missteps in judgment by the sole committee member. The Court also found the special committee’s mandate to be fatally flawed because it failed to articulate clearly whether the special committee had the unilateral power to recommend or disapprove the merger. Indeed, the Court found that the testimony of the sole member of the special committee evidenced that he was unsure whether he had the power to veto the transaction.[14] Third, and most critically, the Court expressed dismay concerning the lack of independent legal and financial advice. With regard to the financial advisors, the Court remarked:
The Court determined that the divided loyalties displayed by Jesup & Lamont effectively undermined the special committee’s ability to negotiate with CP in an arm’s-length manner consistent with the fundamental concept of fair dealing. The Court found the special committee’s choice of counsel even more damaging to the process. Since U.S. Counsel had advised CP from the beginning on its approach to the tender offer and since U.S. Counsel was beholden to a board entirely dominated by CP for his job as IIC’s outside counsel, the Court concluded he was irreparably conflicted. The Court found that the legal advisor’s lack of independence constituted substantial evidence that the merger resulted from unfair dealing.[16] Beyond the conflict of interest, however, the Court expressed serious doubts regarding U.S. Counsel’s ability competently to advise the special committee:
Collectively, the Court concluded, this case presented the rare situation “in which the special committee’s advisors are of little use in establishing the entire fairness of the merger transaction.”[18] Moreover, the Court found that the negotiations between CP and the special committee were suffused with substantive unfairness. In particular, the Court found an email exchange between U.S. Counsel, CP management and Jesup & Lamont, which outlined the steps for the transaction, including the making of a “lowish” offer, disturbing “enough to cast a dark shadow over the entire merger process”[19] and evidence that CP was orchestrating an unfair process with a predetermined result from the start.[20] The Gesoff Lessons For those corporate practitioners working with special committees, the Gesoff decision offers a number of useful lessons, including the following:
Oliver v. Boston University The Oliver Facts Boston University (“BU”) was the controlling stockholder in Seragen, Inc. (“Seragen”), a financially troubled biotechnology company. Seragen’s board had six members, three of whom were closely affiliated with BU. From its initial public offering in 1992, Seragen suffered frequent and substantial cash crises due to its failure to launch a product in the marketplace. As a result, Seragen, BU and certain of its directors and affiliates entered into a series of financial transactions pursuant to which those insiders contributed or facilitated the company’s access to much needed capital in exchange for additional equity or contractual rights.[24] Seragen nonetheless was unable to overcome its financial problems and the board began to explore strategic alternatives. In August 1998, Seragen agreed to merge with Ligand Pharmaceuticals, Inc. (“Ligand”) in a transaction that provided approximately $75 million in total merger consideration and was conditioned upon no more than 10% of the shares of common stock seeking appraisal. The expected merger consideration was not, however, sufficient to satisfy all of Seragen’s obligations to its creditors and stockholders. As a result, BU and the other large holders of preferred stock negotiated among themselves both the discount that each would take on its investment and the amount of the merger proceeds that would be allocated to the common stockholders. While BU and the other large holders of preferred stock ultimately reached an agreement on how to allocate all of the merger consideration (the “Accord Agreement”), they did so without the input of the minority common stockholders and without adopting any procedures to ensure the fairness of the allocation to the minority stockholders. The Oliver Decision After the consummation of the merger, the minority stockholders of Seragen commenced an action asserting a variety of derivative and direct claims relating to the effect of the Accord Agreement on their share of the merger consideration. In evaluating those claims, the Court applied the entire fairness standard because a majority of the Seragen board was either directly interested in the allocation of the merger consideration or otherwise beholden to the controlling stockholder. The defendants were unable to demonstrate that the allocation of the merger consideration was the product of fair dealing, because they had not employed any process to represent the interests of the minority stockholders. The Court ultimately concluded that the relative allocation to the minority stockholders was insufficient. Perhaps the most interesting of the several challenges asserted by the plaintiffs from the perspective of the M&A practitioner were those relating to the value of certain unasserted derivative claims that existed as of the date of the merger. Plaintiffs alleged in this regard that the board had failed to account for the value of those claims springing from the pre-merger financial transactions that had occurred between Seragen and its controlling stockholder, BU, and BU affiliates.[25] In examining those derivative claims, the Court adopted a standard of “inquiry notice” for determining which claims should have been considered in the allocation of merger proceeds. The Court stated that, under the inquiry notice standard, knowledge of a claim on the part of the directors occurs when the directors become “aware of facts sufficient to put a person of ordinary intelligence and prudence on inquiry which, if pursued, would lead to the discovery of injury.”[26] Applying this standard, the Court concluded that the directors were on notice of the potential derivative claims arising from a series of earlier self-interested transactions between the corporation and BU and its affiliates and the Court found that the Seragen board effectively ignored the potential derivative claims when negotiating the Accord Agreement. In the Court’s view, those claims could have been used to bolster the position of the minority stockholders in dividing the merger proceeds. [27] The Oliver Lessons As with Gesoff, several lessons may be gleaned from the Oliver decision, including the following:
Conclusion Gesoff and Oliver are timely reminders that conflicted merger transactions require careful attention to process and form. Delaware courts will critically evaluate a special committee process to determine whether the committee is a fully functioning and independent body that is effectively representing the minority stockholders’ interests. When providing advice on the formation of special committees, corporate practitioners should focus on the composition of the special committee, the clarity of its mandate, and the independence, competence and expertise of its financial and legal advisors. If a special committee has been properly formed and has hired independent and knowledgeable advisors, a court is more likely to conclude that it is able to function properly and engage in arm’s-length negotiations. The Gesoff decision also sounds a cautionary note for legal advisors -- special committees should select a legal advisor who has the requisite expertise to advise the committee with respect to the committee’s fiduciary duties (and other legal responsibilities). The Oliver decision highlights the peculiar concerns that may arise when a corporation is considering how to allocate merger consideration. In that circumstance, Delaware courts view potential derivative claims, whether of low or even no value, as an important bargaining tool for minority stockholders. Therefore, corporate practitioners should advise boards to consider whether such potential derivative claims exist and, if so, seek to determine their value with the assistance of appropriate experts.
[*] This article was published in Deal Points, The Newsletter of the Committee on Negotiated Acquisitions, Volume XI, Issue 2, Summer 2006, Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. [1] Ms. Salomone is a partner in the Wilmington, Delaware law firm of Potter Anderson & Corroon LLP. The views expressed are solely those of the author and do not necessarily represent the views of the firm or its clients. The author wishes to acknowledge the contributions and assistance of Mark A. Morton and Michael K. Reilly in the preparation of this article. Mr. Morton is a partner and Mr. Reilly is an associate with Potter Anderson & Corroon LLP. [2] Gesoff v. IIC Industries Inc., 2006 WL 1458218 (Del. Ch. May 18, 2006); Oliver v. Boston University, 2006 WL 1064169 (Del. Ch. April 14, 2006). [3] There were in fact two independent directors, but one was too ill to serve. [4] 2006 WL 1458218, at *4. The board also authorized the special committee to appoint outside auditors and/or counsel to assist the special committee in preparing its recommendation. Id. [5] At trial, the sole member of the special committee testified that U.S. Counsel “had been appointed, and I had accepted him, as my counsel” and when questioned regarding the conflict of interest in representing IIC and CP on the one hand and the special committee on the other, U.S. Counsel stated that no conflict existed. Id. at *5 nn. 38 & 40 (emphasis omitted). [6] Id. at *5. [7] Although this price was never formally offered to the special committee for consideration, there was evidence that the special committee knew the CP board initially authorized a $13.00 bid. [8] The full IIC board, however, declined to make a recommendation with respect to the tender offer. [9] The special committee did make some inquiries and obtained additional information as to whether the price continued to be fair. The sole member of that committee testified that he determined that the price remained fair because he believed the events of September 11, 2001 had negatively impacted the company’s principal assets which consisted of a hotel chain. He also expressed concern that a revised fairness opinion might have produced a lower valuation. [10] The Court further noted that while most of the case law surrounding parent–subsidiary mergers has focused on the ways in which a defendant can effectively shift the burden of entire fairness, by the time a case comes to trial, the standards for shifting the entire fairness burden and those factors establishing fair dealing are intertwined. The Court ultimately awarded the appraisal claimants $14.30 per share and all other claimants damages based on the difference between the merger consideration and $14.30 per share. [11] Gesoff, at *13. [12] Id. [13] Id. [14] The Court also noted that serious doubt existed as to whether the special committee’s mandate was sufficient to permit it to evaluate only the initially contemplated tender offer or both that offer and the merger proposal that it ultimately recommended. Id. [15] Id. at *14. [16] Id. at *15. [17] Id. [18] Id. [19] Id. [20] The Court also rejected the defendant’s argument that the merger price was fair because it reflected the significant negative impact of the terrorist attacks on September 11, 2001, finding that the defendants had failed to produce sufficient evidence to demonstrate that IIC’s value actually declined as a result of September 11th. Although the Court found the merger was unfair to the minority stockholders, the Court concluded that the sole member of the special committee was entitled to exculpation under Section 102(b)(7) as the Court found no evidence to suggest that he was personally conflicted or received a personal benefit from the transaction, nor was there any evidence of his collusion with CP. Moreover, the Court found no evidence that the special committee member knew or should have known the price and process were unfair. [21] Gesoff, at *15. [22] See, e.g., In re Tele-Communications, Inc. S’holders Litig., 2005 WL 3642727 (Del. Ch. Dec. 21, 2005); In re Emerging Communications, Inc. S’holders Litig., 2004 WL 1305745 (Del. Ch. May 3, 2004). [23] See also, 8 Del. C. § 141(e) (“A member of the board of directors, or a member of any committee designated by the board of directors, shall, in the performance of such member’s duties, be fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporation’s officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other person’s professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation.”). [24] The challenged transactions included a loan guarantee transaction in which BU and two BU affiliates provided the guarantees, two separate issuances of preferred stock to BU and its affiliates, and a sale of Seragen’s operating division to BU, in which Seragen retained the right to buy back the division for the sale price plus expenses and interest. [25] The notion that a corporation should consider the value of its derivative claims in connection with a determination of the value of the corporation in a merger is not unprecedented in the Delaware courts. See Kohls v. Duthie, 765 A.2d 1274, 1287-88 (Del. Ch. 2000) (denying derivative plaintiffs’ motion for a preliminary injunction against management buy-out transaction where the special committee’s expert valued existing derivative claims and such valuation was the product of “logical methodology” and could properly be accounted for in the context of any subsequent appraisal action if the derivative plaintiffs lost standing to maintain their claim as a result of the consummated merger). [26] 2006 WL 1064169, at *20. The Court added that a decision by the board as to the value of those potential claims would be accorded the protection of the business judgment presumptions (unless rebutted by the plaintiffs). [27] For reasons beyond the scope of this discussion, however, the Court ultimately concluded that a nil value should be assigned to the derivative claims and found that the failure to consider those derivative claims therefore amounted to a mere procedural flaw in negotiating the Accord Agreement, which warranted an award of only $1.00 in nominal damages for the directors’ breach of their duty of loyalty. |