2005 Developments in Delaware Corporate Law

Introduction

While the issuance of the much anticipated Court of Chancery decision involving hiring and firing of Michael Ovitz by The Walt Disney Company stole much of the national limelight in 2005, the Delaware courts rendered several other notable decisions over the course of the past year on topics of interest to corporate practitioners.

In the area of deal protection, the Court of Chancery issued the Toys “R” Us decision, an analytical roadmap for judicial examination of the reasonableness of board decisions in the Revlon context.  In the TCI decision, the Court of Chancery highlighted the importance of a properly structured and independent special committee process in the context of a transaction that contemplates a premium to high-vote stock over low-vote stock, emphasizing the need in such a context for targeted financial advice and an appropriate fairness opinion.  The Court of Chancery in its Unisuper decision raised interesting questions relating to the ability of a board of directors to bind itself contractually to its stockholders to submit the continuation of a stockholder rights plan to a stockholder vote.  Finally, in Frontier, the Court of Chancery addressed in depth for the first time since the Tyson opinion[2] the ability of a party to a merger agreement to invoke a “material adverse effect” clause, and confirmed the need for directors of Delaware corporations to maintain the ability to reconsider their recommendation in a favor of a transaction in light of changing circumstances.  Each of those decisions is described in more detail below.

II. The Business Judgment Rule is Alive and Well: In re The Walt Disney Co. Derivative Litig. [3]

Front and center on the national legal stage this year was the Disney trial, which consumed thirty-seven trial days in the Court of Chancery.  The post-trial decision promised corporate practitioners a long anticipated explication of the parameters of the business judgment rule, and in light of the newly fashionable fiduciary duty of good faith.

A. Background Facts

The story begins with the untimely death of Disney’s president and chief operating officer, Frank Wells, in April 1994.[4]  Disney began a search for his replacement and Michael Eisner, Disney’s then-Chairman and CEO, placed a particular focus on Michael Ovitz, a long-time friend, who had founded and was running the Creative Artist Agency (“CAA”), arguably the most successful talent agent business in Hollywood.  At the helm of CAA, Ovitz earned approximately $20 million a year and was one of the most powerful men in Hollywood.[5]

Despite his friendship with Eisner, Ovitz had been reluctant to join Disney for many years.  However, when another key member of CAA’s management announced he was leaving CAA in the spring of 1995, Ovitz began to more seriously consider Eisner’s overtures.  Eisner and Irwin Russell, the chairman of Disney’s compensation committee, reached out to Ovitz and attempted to convince him to join Disney.[6]  Russell assumed the lead role in negotiating the non-financial terms of Ovitz’s employment contract.  By the end of the summer of 1995, the basic terms of Ovitz’s employment had been negotiated and by the fall of 1995, they were memorialized in the Ovitz Employment Agreement (“OEA”).  The OEA contained a non-fault termination (“NFT”) clause, which provided Ovitz with certain payments in the event that Disney fired him for any reason other than gross negligence or malfeasance.[7]  On September 26, 1995, the compensation committee unanimously approved the general terms of the OEA and at a meeting of Disney’s board that immediately followed, Ovitz was unanimously elected president of Disney.  Upon the announcement of Ovitz’s hiring, Disney’s market capitalization increased by more than $1 billion.[8]

Ovitz began his tenure at Disney as president on October 1, 1995.  By 1996, however, it started to become clear that Ovitz was not fitting into the Disney “culture” as well as everyone had hoped.  Although he was not without some successes in his tenure as president, as Chancellor Chandler explained, “Ovitz’s time as President was marked by more, “woulda, coulda, shoulda” than actual success.”[9]

By the fall of 1996, it became clear to the Disney directors, including Eisner, that Ovitz would have to be terminated.  Eisner initially hoped to “trade” Ovitz to Sony, with the hope of relieving Disney of having to pay Ovitz under the OEA.[10]  The discussions with Sony failed, however, and Ovitz told Eisner he was going to recommit himself to Disney.[11]

Eisner and Sandford Litvack, Disney’s general counsel, began looking at the OEA to determine how and at what cost Ovitz could be terminated.[12]  Litvack concluded that Ovitz could not be terminated “for cause” and, therefore, would be entitled to the NFT payment.[13]  Following discussions with Ovitz regarding the terms of his termination, Ovitz was terminated by Eisner on December 12, 1996, just over one year after his tenure began.[14]

The Court of Chancery analyzed in detail all the evidence and arguments and concluded that the defendant directors had not breached their fiduciary duties nor committed waste in connection with the hiring or termination of Michael Ovitz and entered judgment in favor of defendants on all counts.

B. The Contours of the Duty of Good Faith

In its opinion, the Court observed that the existing precedent did not clearly declare whether Delaware law recognized a free-standing fiduciary duty of good faith.  The Chancellor suggested that the concept of good faith is not an independent duty, comprising autonomous standards of conduct, but rather an overarching concept inherent in a fiduciary’s duties of due care and loyalty:

Fundamentally, the duties traditionally analyzed as belonging to corporate fiduciaries, loyalty and care, are but constituent elements of the overarching concepts of allegiance, devotion and faithfulness that must guide the conduct of every fiduciary.  The good faith required of a corporate fiduciary includes not simply the duties of care and loyalty, in the narrow sense that I have discussed them above, but all actions required by a true faithfulness and devotion to the interests of the corporation and its shareholders.[15]

The Court noted that the presumptions of the business judgment rule could be rebutted if a plaintiff were to prove by a preponderance of the evidence an act of bad faith on the part of fiduciaries.  While the Court explicitly refused to “create a definitive and categorical definition of the universe of acts that would constitute bad faith,” stating that to do so, would “misconceive how…the concept of good faith operates in our common law of corporations,”[16] the Court nonetheless provided a non-exclusive list of examples of acts of bad faith, each such example positing an element of intent.  In particular, the Chancellor noted that a failure to act in good faith may be shown where a fiduciary:

• “intentionally acts with a purpose other than that of advancing the best interests of the corporation;”
   

• “acts with the intent to violate applicable positive law;” or
   

• “intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.”[17]
   

In applying the facts of the case, the Court concluded that the Disney board had not acted in bad faith in connection with the hiring of Ovitz and the approval of his compensation arrangement.[18]  Although chastising the board members for not acting in accordance with best practices, most particularly the failure of the CEO to keep the board informed, and the manner in which the CEO stretched the bounds of his authority to act without specific board direction,[19] the Court refused to find that a breach of duty had occurred.  The Chancellor found that the CEO had acted in good faith and in the best interests of the Company,[20] and that the remaining board members who ultimately approved Ovitz’s hiring did not intentionally shirk or ignore their duties.[21]  The Court also concluded that Eisner did not act in bad faith when he decided to terminate Ovitz. In particular, the Court found that Eisner, as the Chief Executive Officer, had the authority to terminate Ovitz and that the board was not required to act in connection with that termination.[22]

C. The Business Judgment Rule is Alive and Well

In reaching those conclusions, the Chancellor leaned heavily and, to many, reassuringly, on the business judgment rule, as it has been understood traditionally.  The Chancellor noted that “the greatest strength of Delaware’s corporation law” – and the business judgment rule in particular – is the fact that corporate fiduciaries, although held to “a high standard in fulfilling their stewardship over the assets of others,” are granted “wide latitude in their efforts to maximize shareholders’ investments” when they act “faithfully and honestly on behalf of those whose interests they represent.”[23]

Differentiating between the role of the Court to provide a remedy for breaches of fiduciary duty and the role of the market to provide a remedy for bad business decisions, the Court reasoned as follows:

Even where decision-makers act as faithful servants, however, their ability and the wisdom of their judgments will vary.  The redress for failures that arise from faithful management must come from the markets, through the action of shareholders and the free flow of capital, and not from this Court.  Should the Court apportion liability based on the ultimate outcome of decisions taken in good faith by faithful directors or officers, those decision-makers would necessarily take decisions that minimize risk, not maximize value.  The entire advantage of the risk-taking, innovative, wealth-creating engine that is the Delaware corporation would cease to exist, with disastrous results for shareholders and society alike.  That is why, under our corporate law, corporate decision-makers are held strictly to their fiduciary duties, but within the boundaries of those duties are free to act as their judgment and duties dictate, free of post hoc penalties from a reviewing court using perfect hindsight.  Corporate decisions are made, risks are taken, the results become apparent, capital flows accordingly, and shareholder value is increased.[24]

The Court’s decision in Disney thus resoundingly reaffirms the importance of the business judgment rule and offers much needed guidance to directors and officers with respect to the still-elusive concept of good faith as an element of fiduciary responsibility.

In addition, while the Court made clear that Delaware law does not hold fiduciaries liable for a failure to comply with corporate governance “best practices” prevailing at the time a corporate decision is taken,[25] it also indicated instances in which, in its view, the Disney board failed to comply with the best practices of ideal corporate governance, in furtherance of its expression of hope that the opinion “may serve as guidance for future officers and directors — not only of The Walt Disney Company, but of other Delaware corporations.”[26]

* * *

Practical lessons from Disney for fiduciaries to consider in assessing their continuing compliance with the duty of care and, to the extent implicated by an intentional or conscious failure to satisfy the duty of care, good faith, include the following:

• Meetings Matter:  The need for consultation between an executive and board members, or among board members, that occurs on an individual basis and outside of a formal board or committee meeting may be less helpful than consultation in the context of a formal meeting. Informal consultation on an individual basis can result in members of the board or committee being unevenly informed.[27]  Also, informal consultation outside of a formal meeting is largely undocumented, leaving the board with an insufficient record to establish that proper deliberation and care with respect to a matter occurred.  Analogously (though not a consideration in Disney), where action is taken by a board pursuant to unanimous written consent in lieu of a meeting, care should be taken to properly document that the directors acted in an informed manner.
   

• Revisit Potential Conflicts:  A board should continually assess potential conflicts of interest in the performance by officers and other board members of their respective duties.  The Court expressly found that Mr. Eisner’s twenty-five year friendship with Mr. Ovitz did not prevent him from being disinterested in his negotiation of the transactions between Mr. Ovitz and The Walt Disney Company.
   

• Build the Record:  Adequate time should be allotted at scheduled board meetings for consideration of material matters.  Board meeting minutes should be detailed enough that it is later possible for the board to establish, or a neutral fact finder to determine, the approximate length of time spent considering a matter of importance and the general nature of the matters discussed.
   

• No Free Passes:  Every board member needs to be prepared to have to establish his or her own fulfillment of fiduciary duties.  At least where a case goes to trial, Delaware courts may evaluate compliance, and liability, on an individual by individual basis.[28]  While it is neither realistic nor desirable that an entire board or committee conduct negotiations on behalf of a corporation, directors taking the early lead in negotiations need to keep other members of the board informed of the substance of such negotiations, and communicate all material information to them for their consideration before action is taken.
   

• Require Patience:  The taking of action by an executive with respect to a matter prior to formal board action could give rise to an inference that the board’s later approval is a mere “rubber stamp” of the executive’s action.[29]
   

• Preserve Review Time:  All board or committee members should have the opportunity to review written materials regarding an important action prior to their decision.  In significant transactions, where the action involves execution of an agreement on behalf of the corporation, although not strictly required, the directors should ideally review the agreement itself.  At a minimum, they should review a written summary of the agreement’s material terms.[30]  Where further negotiation of an agreement results in a material change in the terms most recently reviewed by the board, these changes should be clearly communicated to the board prior to taking of action on behalf of the corporation.
   

• Document Expert Advice: Reliance on the advice of experts or outside counsel, including care in the selection of experts, should be properly documented.  The expert’s advice should ideally be memorialized in writing. It is helpful to the record to have an expert relied upon present at the board of committee meeting at which the action is considered, though not strictly required.[31]

An appeal of the Court of Chancery’s Disney II decision is currently pending before the Delaware Supreme Court. Briefing and oral argument on that appeal have been completed and the litigants currently are awaiting a decision.  One may reasonably expect that the Delaware Supreme Court will offer in its ruling a further explication of the duty of good faith and its place among the elements of fiduciary responsibility under Delaware law.

III. Revlon Duties and Deal Protections: In re Toys ‘R’ Us S’holders Litig. [32]

The nature and scope of deal protection provisions often are at the center of merger negotiations.  Acquirors have an interest in obtaining the strongest deal protections permissible under the law, while target boards often have an interest in limiting deal protections to preserve their options and, most particularly, to provide increased flexibility in the event of a later arriving topping bid.  The recent Toys “R” Us decision confirms that, except in the most egregious situations,[33] Delaware law typically disdains the application of bright-line rules when determining whether challenged deal protections are legally permissible.[34]  The Toys “R” Us decision indicates that Delaware courts more often will engage in a contextually specific analysis of deal protections in an effort to determine, under the particular facts presented, whether the target board acted reasonably in accepting the deal protections at issue.

A. Background Facts

In late 2003 and early 2004, Toys ‘R’ Us, Inc. (the “Company”) began to consider ways to increase shareholder value.[35]  Following the public announcement of the Company’s decision to considered strategic options, the Company received indications of interest from a variety of potential bidders for all or part of the Company.  In June 2004, the board met and considered the results of the strategic review.  Four options were deemed worthy of more in-depth analysis, none of which included a sale of the entire Company.[36]  Credit Suisse First Boston (“First Boston”), the Company’s financial advisor did not recommend selling the company as a whole at this time because it did not believe there was a buyer for the entire company.

Eventually, the board settled on the sale of the toys business and the retention of its baby products business.  The Company sought bids from the most logical buyers for the toys business and four competing bidders emerged.  In the midst of the process, one of the bidders expressed a serious interest in buying the entire company.[37]  The board then reconsidered its decision to sell only the toys business and began to consider selling the company as a whole.  An executive committee of the board (comprised of the Company’s CEO and the chairs of the board’s other committees), decided to conduct a limited auction (in order to protect the process they’d already employed for the sale of the toys business) for the entire Company.[38]  When the bids for the entire Company came in, the highest bid was from the KKR group, at $26.75 per share.  This bid was more than a $1.50 more than the next highest bid.  The board reviewed all of its options and the facts and circumstances and decided that acceptance of the $26.75 per share offer was the best way to maximize shareholder value.[39]

The proposed merger agreement from the KKR Group included a 4% termination fee, as opposed to the 3% fee proposed by the Company.  Knowing that it could lose the $26.75 per share offer and that the next highest offer was $1.50 lower, the Company nevertheless managed to decrease the termination fee to 3.75%.[40]

Plaintiffs sought a preliminary injunction enjoining the shareholder vote on the merger, alleging that the Company’s board failed to fulfill its duty to act reasonably in pursuit of the highest attainable value for the Company’s stockholders as required by Revlon.  Plaintiffs argued that the board devoted too little time to soliciting and reviewing bids for the Company as a whole, resulting in a merger at a price lower than the highest attainable value.  They also alleged that the board unreasonably locked up the $26.75 bid by agreeing to “draconian” deal termination measures that precluded any topping bid.

The plaintiffs asserted two primary arguments in support of their contention that the directors failed to satisfy their Revlon duties.  First, the plaintiffs alleged that the directors acted too hastily when they finally decided to accept bids for the entire company.  In particular, the plaintiffs argued that the directors should have opened up the process to new bidders and canvassed the market.  Second, the plaintiffs claimed that the directors “compounded the unreasonableness of its initial process by agreeing to deal protection measures that precluded the emergence of a later, topping bid.”[41]  Although the plaintiffs conceded that the deal protections in the merger agreement allowed for a later bid to emerge, they argued that the “cumulative effect of the termination fee and matching rights created an unreasonably large bidding advantage for the KKR Group that has dissuaded any other bidder from presenting a topping offer.”[42]

B. The Holdings

The Court first noted that this case did not present the “paradigmatic context for a good Revlon claim, which is when a supine board under the sway of an overweening CEO bent on a certain direction, tilts the sales process for reasons inimical to the stockholders’ desire for the best price.”[43]  Rather, the Court noted, the present case involved a “majority independent board that publicly initiated a broad search for strategic options to increase shareholder value, ruling out no option.”[44]  As a result, the Court stated, plaintiffs had attempted to “sketch out a picture of a passive board who deferred too easily to the wishes of a CEO . . . and financial advisor.”[45]  According to the plaintiffs, the CEO favored a deal that led to a sale of the entire company because of certain change of control provisions.  In addition, the CEO allegedly favored a deal with the KKR Group because they had offered the best potential for future employment.  The plaintiffs alleged that the financial advisor was interested because it stood to receive an additional $7 million in fees as a result of a sale of the entire company.[46]

The Court rejected the plaintiffs’ arguments for three primary reasons.  First, the Court found that the allegations that the CEO and financial advisor had improper motives did not ring true.  Second, the Court found the board process that culminated in the KKR Group’s bid was reasonable.  Finally, the Court concluded that the board’s decision to approve the merger agreement containing the deal protections was reasonable.[47]

The Court did express some concern regarding the financing of the deal.[48]  After the merger agreement with the KKR Group had been signed, First Boston sought permission from the Company to provide financing on the buy-side to the KKR Group.  The Company consented.  The Court indicated that the decision was “unfortunate,” but only because it created the appearance of impropriety.[49]  The Court found that First Boston’s “questionable desire to provide buy-side financing” did not influence it to advise the board to sell the whole Company rather than pursue a sale of the toys division, or to discourage bidders other than the KKR Group, or otherwise negatively influence the process.  In a footnote, Vice Chancellor Strine indicated that so-called “stapled financing” was not always to be perceived as troublesome. As he stated:

One can imagine a process when a board decides to sell an entire division or the whole company, and when the board obtains a commitment from its financial advisor to provide a certain amount of financing to any bidder, in order to induce more bidders to take the risk of an acquisition.  These and other scenarios might exist when roles on both sides for the investment banker would be wholly consistent with the best interest of the primary client company.[50]

Finally, the terms of the deal itself was evidence that the board had acted properly and that the merger was in the best interest of the shareholders.  The Court listed the following factors in support of its conclusion: the price represented a 123% premium over the unaffected stock price; the price exceeded the top range of the valuation presented to the board in the summer 2004; the price exceed the top range of CSFB’s DCF analysis and comparable companies analysis, and was close to the top range of the comparable transactions analysis; and the next highest offer was more than $350 million less than the $26.75 offer (a different of 6%).[51]

* * *

Practical lessons from Toys “R” Us for fiduciaries (and practitioners) to consider include the following:

• Context Defines Reasonableness: The Toys “R” Us decision confirms that, in the absence of coercive or preclusive deal protection provisions, Delaware courts are reluctant to apply bright-line rules when determining whether a board has acted reasonably.  When considering a sale of part or all of the company, a board should hire capable advisors at an early stage and structure a process that demonstrates a careful, deliberative and engaged analysis of the various alternatives and risks.  With a properly structured process, a plaintiff will have a difficult time attacking the reasonableness of the board’s decision-making even under the heightened standard of proof mandated by Revlon.
   

• Scale May Matter:  While the Toys “R” Us decision emphasizes that judicial intrusion is generally not warranted when a board reasonably agrees to a particular termination fee after a good faith negotiation process, the court suggests two possible exceptions to that general rule.  First, the court observes that it will not turn “a blind eye” to the adoption of excessive termination fees – such as the 6.3% termination fee condemned by the court in Phelps Dodge.[52]  Second, by noting the “preclusive differences between termination fees starting with a ‘b’ rather than an ‘m’”, the court appears to be suggesting that the termination fee percentage should fall as the value of the deal increases.[53]
   

• The Hazards of Buy-Side Financing:  While the board rebuffed First Boston’s initial request to allow it to provide buy-side financing to bidders for Global Toys, the board ultimately acquiesced to First Boston’s later request (after the merger agreement was signed) to allow it to provide buy-side financing for the winning bidder.  The Court characterized that decision by the Board as “unfortunate” because it “tends to raise eyebrows” and “play[] into already heightened suspicions.”[54]  The Court acknowledged, however, that there may be circumstances where the offer to provide buy-side financing will facilitate the sales process.[55]  As a result, before agreeing to permit its investment banker to provide buy-side financing, a board should build a record that demonstrates how the financing proposal will benefit the company (and the process) without compromising the investment bankers’ incentives.

IV. The Special Committee Process and Fairness Opinions: In re Tele-Communications, Inc. S’holders Litig. [56]

On December 21, 2005, the Court of Chancery rendered a decision in In re Tele-Communications, Inc. Shareholders Litigation denying defendants’ motion for summary judgment on several claims challenging the merger of Tele-Communications, Inc. (“TCI”) with AT&T Corp., consummated in March of 1999.  Among other things, the decision highlights the importance of designing and implementing an effective special committee process in order to accomplish a shift in the burden of proving entire fairness, especially where that committee is confronted with the challenging task of considering a transaction that envisions the payment of a premium to a class or series of high-vote stock over that to be paid to a class or series of low-vote stock.

A. Background facts

TCI stock consisted of two series:  Series A, which was entitled to one vote per share, and Series B, which was entitled to ten votes per share.[57]  When TCI and AT&T began discussions concerning a proposed merger, TCI’s chairman and CEO, John Malone, insisted that he would not approve a transaction as a TCI stockholder unless the Series B shares obtained a premium of 10% over the Series A shares.[58]  Malone owned a majority of the Series B shares and controlled 47% of the voting power of TCI. Malone and four other directors (five of the nine-member board) collectively owned 84% of the Series B shares.[59]

The TCI board formed a special committee to consider the AT&T merger.  The special committee consisted of Paul A. Gould, who owned significantly more Series B shares than Series A, and John W. Gallivan.[60]  The special committee members were promised compensation for their service on the special committee, but prior to beginning their work, neither an amount nor a formula for establishing the compensation was established.[61]  The special committee did not hire its own financial advisor or legal counsel, but relied on TCI’s financial and legal advisors.[62]  TCI’s financial advisor informed the special committee that transactions where high-vote stock received a premium to low-vote stock were “less common” than transactions where high-vote and low-vote stock received the same amount, but did not say how much “less common” such structures were.[63]  The special committee met four times over a five day period.[64]  The special committee voted to approve the merger, including the 10% premium to Series B stock,[65] and the merger was overwhelmingly approved by the shareholders.[66]  The special committee members each received $1 million for their service on the special committee.[67]  The directors who owned Series B shares received, in aggregate, $376 million more than they would have received had there been no premium.  John Malone in particular received a premium of $100 million for his Series B shares.[68]

Plaintiff stockholders brought several claims challenging the merger.  In rejecting defendants’ motion for summary judgment on certain of those claims, the Court initially concluded that the relevant standard of review was entire fairness.  Citing FLS Holdings[69] and Reader’s Digest,[70] the Court found that entire fairness should apply because “a clear and significant benefit . . . accrued primarily . . . to [] directors controlling [] a large vote of the corporation, at the expense of another class of shareholders to whom was owed a fiduciary duty.”[71]  In the alternative, the Court concluded that a majority of the TCI directors were interested in the transaction because they each received a material benefit from the Series B shares premium.[72]

B. The Holdings

After concluding that the transaction would be reviewed under the entire fairness standard, the Chancellor, drawing all reasonable inferences in favor of the plaintiffs for purposes of deciding the summary judgment motion, found that the creation and use of the special committee had failed to shift the burden of proof under that standard.[73]  The Chancellor determined that the record contained a genuine issue of material fact as to whether the special committee was truly independent, fully informed and vested with the freedom to negotiate at arm’s length.

On the question of independence, the Court stated that Gould’s holdings of Series B shares, which provided him with an additional $1.4 million as a result of the premium paid on the Series B shares, and the “suspiciously contingent compensation of the Special Committee…sufficiently impugn the independence of the Special Committee to prevent any burden shifting.”

The Court then examined the special committee process under the entire fairness standard.  The Chancellor concluded that it could not conclude on summary judgment that the merger was entirely fair because genuine issues of material fact remained relating to fair dealing and fair price. Accordingly, the Chancellor denied defendants’ motion for summary judgment.

In reaching the decision that the defendants failed to demonstrate fair dealing and fair price, the Court found, based on a review of the evidence in a light most favorable to the plaintiffs, the following special committee process flaws:

• The special committee was tainted with an interested director.[74]  The TCI board selected Gould, who held Series B shares and gained an additional $1.4 million as result of the premium paid on those shares, to serve on the special committee.  There was no explanation for why the TCI board did not select, in place of Gould, one of the other directors, who held only Series A shares.  This flaw appears to be of primary importance to the Court’s decision and contributed to each of the other flaws in the committee process.
   

• The special committee did not have a clear mandate.[75]  Gallivan believed the special committee’s job was to represent the interests of the holders of the Series A shares, while Gould believed the special committee’s job was to protect the interests of all of the stockholders.
   

• The special committee should have retained its own advisors.[76]  The special committee did not retain separate legal and financial advisors, and chose to use the TCI advisors.  Moreover, the Court criticized the contingent nature of the fee paid to the financial advisor, which amounted to approximately $40 million, finding that such a fee created “a serious issue of material fact, as to whether [the financial advisor] could provide independent advice to the Special Committee.”  While the Court agreed with Malone’s assertion that TCI had no interest in paying such compensation absent a deal, “[a] special committee does have an interest in bearing the upfront cost of an independent and objective financial advisor.”  It is important to point out, however, that the advisors were hired to advise TCI in connection with the transaction, and a question arises as to whether the Chancellor’s concerns about the contingent nature of the fee would have been mitigated if a special committee comprised of clearly disinterested and independent directors hired independent advisors and agreed to a contingent fee that created appropriate incentives.
   

• The special committee did not conduct sufficient due diligence or analysis of the pricing[77].  The special committee lacked complete information about the premium at which the Series B shares historically traded.  The Court noted that the plaintiffs had presented evidence that showed that the Series B shares had traded at a 10% premium or more only for “a single five-trading day interval.”  The Court did not find it persuasive that the financial advisor supported the payment of the premium by reference to a call option agreement between Malone and TCI that allowed TCI to purchase Malone’s Series B shares for a 10% premium, expressing concern about the arm’s length nature of that transaction.  In addition, the special committee lacked complete information about the precedent transactions.  The Court stated that the special committee should have asked the financial advisor for more information about the precedent transactions, including information concerning the prevalence of the payment of a premium to high-vote stock over low-vote stock.  By contrast, the Court noted that the plaintiffs had presented evidence suggesting that a significantly higher number of precedent transactions provided no premium for high-vote stock.
   

• The fairness analysis and the fairness opinion did not provide the special committee with all of the relevant information.[78]  One of the most significant parts of the Court’s analysis for corporate practitioners was the Chancellor’s focus on the nature of the fairness opinion delivered by the financial advisor.  While the financial advisor did conduct a separate analysis of the fairness of the price to be paid to each class, the financial advisor’s opinion did not “discuss the effect of the [Series B shares] premium upon the [Series A] holders, i.e., whether the [] premium was fair to the [Series A] holders.”  The Court stated that the Reader’s Digest decision “appears to mandate exactly such an analysis: that the relative impact of a preference to one class be fair to the other class.”  The Court noted that the Reader’s Digest decision “mandated more than separate analyses that blindly ignore the preferences another class might be receiving, and with good intuitive reason: such a doctrine of separate analyses would have allowed a fairness opinion in our case even if the [Series B] holders enjoyed a 110% premium over the [Series A] holders, as long as the [Series A] holders enjoyed a thirty-seven percent premium over the market price.”  The Court found that the plaintiffs had “presented sufficient evidence of the historical [Series B shares] premium and comparable precedent high-vote stock premiums to demonstrate a triable issue with respect to the fairness of the [] premium to the [Series A] holders.”
   

• All of the above factors led to a flawed special committee process that created an “inhospitable” environment for arm’s length bargaining.[79]  The Court found that the unclear mandate, the unspecified compensation plan and the special committee’s lack of information regarding historical trading prices of the Series B shares and the precedent merger transactions were relevant to concluding that the process did not result in arm’s length bargaining.

* * *

Practical lessons from   for fiduciaries (and practitioners) to consider include the following:

• Special Committee Process and Design are Critical.  The TCI decision reaffirms the importance of designing and implementing an independent and effective special committee process where a transaction is likely to be adjudicated under the entire fairness standard.  In addition to the obvious need to appoint to a special committee only members who are not tainted by interest, the decision highlights the concomitant needs to: (i) establish the compensation of committee members in advance, (ii) provide the special committee with a clear mandate, (iii) allow and encourage the special committee to hire independent financial advisors and legal counsel; (iv) structure the advisors’ compensation so as to minimize their incentive to favor any particular deal, and (v) generally encourage a process that results in arm’s length bargaining.
   

• Extra Care is Required in Premium Consideration Deals.  Of particular importance to corporate practitioners, the TCI decision suggests that a special committee charged with considering a transaction that provides a premium to a high-vote stock over a low-vote stock should ensure that it demands and considers all information reasonably available to it and relevant to the fairness of the proposed premium and, in that regard, that it should request a fairness opinion focused on the low-vote stock in an effort to allow the special committee to evaluate not only the fairness of the merger consideration to each class or series separately, but also the fairness of the merger consideration to the low-vote stock in light of any premium paid on the high-vote stock.

We note that, as a practical matter, it may be difficult to obtain a fairness opinion from a financial advisor that addresses that issue.  Despite the Court’s decision in Reader’s Digest, financial advisors have remained reluctant to provide opinions comparing the value of consideration received by separate classes or series.  It remains to be seen whether the TCI decision will lead to a strong enough demand by special committees as to encourage financial advisors to offer such opinions more freely.  Notwithstanding this practical obstacle, however, the TCI decision leaves no doubt that special committees must focus on the differing treatment of classes and series of shares of stock and obtain all relevant information to evaluate that differing treatment.  Even if the special committee is unsuccessful in receiving the desired form of written fairness opinion, it should secure oral advice from the financial advisor sufficient to enable the special committee to make an informed decision about the fairness of the consideration.

V. Agreement to Submit Rights Plan to Stockholder Vote: Unisuper Ltd. v. News Corporation [80]

This case, although dealing only with a motion to dismiss, includes a succinct and clear examination of the ability of the board of directors to limit by contract its ability to take unilateral action in areas traditionally reserved to board judgment.

A. Background facts

Shareholders of News Corporation (“News Corp.” or the “Company”) brought this action against News Corp. and its directors, seeking to invalidate News Corp.’s extension of its poison pill rights plan and to prohibit any further extensions absent shareholder approval.  Defendants moved to dismiss on the grounds that the plaintiffs had failed to state a claim upon which relief could be granted. The Court granted in part and denied in part the motion to dismiss.

In April 2004, News Corp, which was then an Australian corporation, announced a reorganization that would include the reincorporation of News Corp. as a Delaware corporation.[81]  The reorganization was contingent on a shareholder vote of approval by each class of News Corp.’s shareholders, voting separately – thus, the public shareholders, voting as a class, could have prevented the reorganization by voting against it.[82]

In order to garner the necessary approval, News Corp. negotiated with certain shareholder organizations to obtain their support for their deal.  As part of these discussions, News Corp. agreed, among other things, that it would implement a board policy (the “Board Policy”) that would require the board to obtain shareholder approval within one year of adopting a poison pill, and further agreed that shareholder approval would be obtained before the Company rolled over any existing poison pill.

The terms of this policy were announced in a press release on October 6, 2004:

The Board has adopted a policy that if a shareholder rights plan is adopted by the Company following reincorporation, the plan would have a one-year sunset clause unless shareholder approval is obtained for an extension.  The policy also provides that if shareholder approval is not obtained, the Company will not adopt a successor shareholder rights plan having substantially the same terms and conditions.[83]

On October 6, the Board issued a letter to shareholders, reiterating that the board had established the Board Policy.  On October 26, 2004, the shareholders and option-holders voted to approve the reorganization.  Importantly, the policy on its face contained no limits on the board’s commitment to submit the extension of a rights plan to a shareholder vote.[84]

On November 8, 2004, a potential hostile acquirer for News Corp. appeared on the scene.  In response, the News Corp. board adopted a poison pill and announced the adoption that same day.  It also announced that “going forward, it might or might not implement the Board Policy” depending on whether it deemed the policy “appropriate in light of the facts and circumstances existing at such time.”  One year later, the board extended the poison pill without a shareholder vote.[85]

Plaintiffs brought this action, alleging five counts:  breach of contract (count I); promissory estoppel (count II); fraud (count III); negligent misrepresentation and equitable fraud (count IV); breach of fiduciary duty (count V).  Plaintiffs sought relief in the form of a declaratory judgment declaring that the poison pill was invalid and enjoining defendants from extending the pill without shareholder approval.  Defendants moved to dismiss all counts.

B. The Holdings

The Court granted defendants’ motion with respect to counts III, IV and V, but denied the motion to dismiss with respect to counts I and II.

As to the breach of contract claim, plaintiffs alleged both a written and oral contract.  The written contract, according to plaintiffs, arose from the press release and letter to shareholders.  Defendants conceded that there was an agreement in the press release and letter to shareholders, but argued that the Board Policy was not irrevocable and that, under Delaware law, a board policy is non-binding and revocable by the board at any time.[86]  Plaintiffs argued that the provision of the Board Policy purporting to prevent the board from “rolling over” the poison pill from year to year was sufficient to establish it as an irrevocable contract.  The Court, although expressing great skepticism, found that the complaint sufficiently alleged the existence of a written contract, but that the terms of the alleged contract were ambiguous.  It thus denied defendants motion to dismiss the contract claim, stating that “both sides should have the opportunity to present evidence and make legal arguments concerning the proper interpretation of the agreement.”[87]

Defendants also argued that even if the contract did exist, it was unenforceable as a matter of law under Section 141(a) of the Delaware General Corporation Law (the “DGCL”) which charges a board of directors with the obligation to manage the business and affairs of a Delaware corporation absent a contrary charter provision.  Thus, the defendants argued that the contract, which purports to limit the board’s ability to manage the business and affairs of the corporation, is invalid because it is not in the corporation’s charter

The Court rejected that argument noting, among other things, that any contract a board enters into could be deemed to limit the board’s power and thus be invalid.[88]  The Court reasoned that Section 141(a) does not prohibit a board from entering into a contract that limits its powers, but merely prohibits a board from “ceding that power to outside groups or individuals.”[89]  The Court found that the “fact that the alleged contract in this case gives power to the shareholders saves it from invalidation under Section 141(a).  The alleged contract with ACSI did not cede power over poison pills to an outside group; rather, it ceded that power to shareholders.”[90]  The Court reasoned that, although Delaware law empowers the board to manage the business and affairs of the corporation, “when shareholders … exercise control over the business and affairs of the corporation the board must give way.  This is because the board’s power – which is that of an agent’s with regard to its principal – derives from the shareholders, who are the ultimate holders of power under Delaware law.”[91]

The Court also rejected the defendants argument that the Delaware Supreme Court decisions in QVC,[92] Quickturn[93] and Omnicare[94] supported the view that the contract is unenforceable as a matter of law.  In particular, the Court noted that those cases were different because they “invalidated contracts the board used in order to take power out of shareholders’ hands.”[95]

Defendants’ sought permission to appeal the Court’s decision to deny the motion to dismiss and the Court granted the request and issued a certification opinion.[96]  In that opinion, the Court expounded on and explained its agency analysis in Unisuper I, stating:  “although [Unisuper I] employed agency law principles to illustrate by analogy the gap filling nature of fiduciary duties, it did so in an effort pointedly to reject defendants’ effort to invoke the board’s fiduciary duties as a muzzle to silence shareholders.”[97]  The Chancellor also provided several examples of transactions that, in his opinion, would be negatively affected if defendants’ view of unenforceability were to be adopted.  One example was in the settlement context. Settlement agreements frequently commit the company to corporate governance “improvements” sought by representatives of the shareholders as remedies, such as commitments to restructure committees or to adopt certain policies or by-laws.[98]  If these contracts are deemed “unenforceable” under section 141, what incentive would shareholder-plaintiffs have to settle any dispute?

* * *

The following practice points can be drawn from the Court’s decisions:

• Committing to a Vote:  The decision indicates that there may be circumstances where a Delaware court will enforce a binding contract to submit the extension of a rights plan to a stockholder vote despite arguments relating to Section 141(a) and the board ’s fiduciary duties.  In addition, the decision suggests that there may be other types of contracts pursuant to which a board commits itself to submit a matter to a stockholder vote that the court will enforce.
   

• Proving the Contract:  In the order certifying the interlocutory appeal, the Court highlighted the fact that its earlier opinion expressed “great skepticism” with respect to whether a binding contract was actually entered into between the stockholders and News Corp.[99]  In the future, one may reasonably expect that a Delaware court will scrutinize closely any alleged contract in a similar setting, and the burden of proving the existence of such a contract might be significant.
   

• Carve-Outs Are Critical:  The Court made it clear that News Corp. could have included a fiduciary duty carve-out in the Board Policy.  The inclusion of such a carve-out would have ensured that the board of directors had sufficient flexibility to address hostile situations without the need to submit the rights plan to a stockholder vote.[100]
   

• A Retreat from Agency:  In the order certifying the interlocutory appeal, the Court of Chancery significantly qualified its reliance on agency principles.[101]  Practitioners should not, therefore, read the Court of Chancery’s decision as unqualified support for an argument that a board of directors, as agents, must always submit to the will of its stockholders, as principals, without regard to the board’s fiduciary duties or the requirements of Section 141(a).  The Court made it clear that it was not creating a new paradigm for understanding Delaware law, but simply utilized agency principles in response to the attempted use of fiduciary duty principles “as a sword for directors to use against shareholders as a group.”[102]

VI. “Pulling the MAE” or “Pulling the Recommendation”: Frontier Oil Corp. v. Holly Corp. [103]

This case provides some guidance as to the meaning of “material adverse effect” clauses found in most public company merger agreements as well as firmly answering the question surrounding a board’s duty to continue to evaluate its recommendation of a transaction at all times prior to the stockholder vote on the merger.

A. Background Facts

Frontier and Holly were both mid-sized petroleum refiners.  In late 2002 and early 2003, Frontier and Holly began serious merger negotiations.  By March 3, 2003, the parties had agreed upon the basic terms of a merger.  For each share of Holly common stock, its shareholders would receive one share of Frontier and $11.11 in cash.  Neither party had the benefit of any price protections or collars in the merger agreement.[104]

During March 2003, the parties proceeded with due diligence.  In that process, Holly learned about an oil rig that had been operated on the Beverly Hills High School campus.  While currently operated by Venoco, Inc., the rig had been sold to Venoco by Wainoco Oil & Gas Company (“Wainoco”), a Frontier subsidiary.  According to an article from the Los Angeles Times, Erin Brockovich was investigating a potential law suit against Wainoco alleging that the oil operations had released air contaminants resulting in an increased incidence of various cancers among Beverly Hills High School students and staff.[105]  Frontier expressed to Holly its belief its exposure was limited because, among other things, of the fact that the property in question was held by a subsidiary, Wainoco, and not by Frontier itself, and because of the terms of the Wainoco transfer of the property to Venoco.[106]

Holly’s board met and considered the implications of the potential litigation and Frontier’s response to it and determined not to approve the merger agreement until certain modifications were made to address Holly’s concerns.  Essentially, the merger agreement was modified to the effect that, if the litigation was deemed to be a material adverse effect, then Holly would have an out under the closing conditions.  The merger agreement, with these modifications, was signed.[107]

Two things happened after the signing of the merger and before the close.  First, litigation was in fact filed relating to the alleged Beverly Hills High School “cancer cluster.”  Second, an investigation of the lease of the Beverly Hills High School property revealed that Frontier’s corporate separateness defense would be essentially meaningless, as it now appeared that Frontier would have a direct obligation to pay at least some of the damages and costs that might be incurred in the litigation.[108]

The merger agreement contained a “fiduciary out” provision that provided Holly’s board with the ability to withdraw or withhold its recommendation of the merger and back out of the deal if it deemed that proceeding with the deal was not “consistent with its fiduciary duties.”[109]  Holly indicated that it would not proceed with the transaction unless the deal was restructured to address the lawsuits.  The parties negotiated for several months, but were unable to agree upon any alternative structures.

In August 2003, Frontier and Holly engaged in a phone conversation in which Frontier asked Holly, point-blank, if Holly intended to go through with the deal as originally negotiated (i.e., 1 share of Holly stock for 1 share of Frontier stock plus $11.11). Holly said no.[110]

The next day, Frontier filed this lawsuit, claiming an anticipatory breach of the agreement.

B. The Holdings

The Court first addressed whether Holly’s statements in the August 2003 phone call constituted a repudiation of the merger agreement sufficient to justify Frontier’s claim.  The Court found that Holly’s statements amounted only a statement that the board would no longer recommend the transaction, and not a repudiation of the merger agreement.  For example, Holly never suggested that it would not pay the termination fees and expenses provided for in the merger agreement.[111]

In determining that Holly did not repudiate the merger agreement, the Court expounded on a board of directors’ duty to continue to consider its decision to recommend that stockholders approve a merger agreement.  The Court found that:

The directors of Holly were under continuing fiduciary duties to the shareholders to evaluate the proposed transaction.  The Merger Agreement accommodated those duties by allowing, under certain circumstances, the board of directors to withdraw or change its recommendation to the shareholders that they vote for the Merger.  The presence of a “fiduciary out” does not preclude a finding of repudiation.  It does, however, establish a specific context in which the conduct of the players must be assessed.[112]

Further, the court stated:  “[r]evisiting the commitment to recommend the Merger was not merely something that the Merger Agreement allowed the Holly Board to do; it was the duty of the Holly Board to review the transaction to confirm that a favorable recommendation would continue to be consistent with its fiduciary duties.”[113]

The Court next addressed whether Frontier had breached the merger agreement by wrongfully declaring that Holly had repudiated and by filing this lawsuit.  Although the Court found Frontier had wrongfully claimed repudiation, and then failed to complete the transaction, constituting a breach of the merger agreement by Frontier, it nevertheless found that Holly had not suffered damages as a result, since Holly had already determined not to proceed with the merger agreement on other grounds (namely, the Brockovich lawsuit).[114]

Finally, the Court considered whether Frontier had breached its representation regarding the Brockovich litigation – i.e., whether that litigation constituted a material adverse effect under the merger agreement.  The Court found first that Holly bore the burden of showing that the Brockovich litigation constituted a material adverse effect under the merger agreement – essentially an outcome-determinative holding.[115]  Next, the Court concluded that Holly had not met that burden, applying the standard annunciated in In re IBP, Inc. S’holders Litig., that a material adverse effect means “the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner.”[116]  In so holding, the Court in Frontier demonstrated once again the heavy burden facing a party attempting to rely on a material adverse effect clause to justify termination of a merger agreement.

* * *

The following practice points can be drawn from the Court’s decision:

• Recommendations are Organic:  Since the inclusion in Section 251 (c) of the DGCL on the ability of merger agreements to require a board to convene and hold a meeting notwithstanding a change in its recommendation in favor of a transaction, there has been a debate whether the board’s duty to evaluate its recommendation could be limited in any meaningful way.  Frontier answers that question in the negative.  That is, the board must continue to monitor the facts relating to the advisability of a merger as they develop between the time of signing and the date of the meeting held to approve the transaction so as to fulfill its continuing fiduciary duty of disclosure.  This does not mean, however, that the merger agreement cannot impose consequences (such as a breakup fee) if the board in fact determines its recommendation must change.
   

• A Lawsuit Alone Will Not Likely Result in a MAE:  The Court’s decision in Frontier also confirms the approach taken in Tyson that sets a high standard for triggering a material adverse effect clause.  In Frontier, the Court found that the cost of defending even complex litigation is unlikely by itself to be material, and required proof of the ”probability of an [adverse] outcome on the merits”[117] in order to prove that the litigation in that case rose to the level of an MAE.

Notes