PNB Holding: Majority-of-the-Minority Clarified
In a recent decision, captioned In re PNB Holding Co. Shareholders Litigation, the Delaware Court of Chancery provided important guidance with respect to, among other things, the possibility of using (and the proper standard for calculating) a fully-informed, non-coerced vote of a majority of disinterested stockholders (a “majority-of-the-minority”) in order to invoke the substantive protections of the business judgment rule outside of the context in which a controlling stockholder is on both sides of a merger transaction.
The PNB Holding Facts
The case involved PNB Holding Company, a Delaware corporation and bank holding company (the “Company”), headquartered in Livingston County, Illinois. Although initially a community bank confined to the town of Pontiac, the Company embarked on an expansion plan in the mid-1990s. After suffering initial setbacks, the Company eventually established a foothold in a nearby growing county and began to reap rewards from its expansion. Following that success, the Company’s board considered other strategic alternatives, including the possibility of merging with a similar sized bank, acquiring smaller banks, converting to an S corporation, or continuing to operate under its current business plan.
Eventually, the Company’s board decided to convert the Company to an S corporation. Because the Company had too many stockholders to qualify as an S corporation, however, the Company needed to engage in a transaction to reduce the number of stockholders. To accomplish that goal, the Company’s board formed an S Corporation Conversion Committee (the “Committee”), which retained Prairie Capital Services, Inc. (“Prairie Capital”), an independent investment banker, to determine the “fair value” of the Company’s capital stock.
Based on Prairie Capital’s advice, the Committee recommended, and the Company’s board ultimately approved, a merger transaction to cash out a sufficient number of stockholders, at a price of $41.00 per share, in order to permit the Company to qualify as an S corporation (the “Merger”). Any stockholder who owned at least 2,000 shares of stock and was one of the largest 68 stockholders, as of May 2, 2003, would remain a stockholder of the Company, while all other stockholders would be cashed out. Importantly, all of the directors held a sufficient number of shares (either personally or through trusts) such that they would remain stockholders of the Company following the Merger.
The Merger was approved by 92.6% of the shares that were voted in person or by proxy at the meeting. Only 48.8% of the departing stockholders, however, voted in favor of the Merger. Of the balance of the stockholders who were not eligible to remain as stockholders of the Company, 37.3% failed to return a proxy, 6.2% perfected a demand for appraisal rights, 4.3% voted against the Merger, and 3.4% abstained. Following consummation of the Merger, the number of stockholders of record was reduced from approximately 360 to 69. All of the Company’s executive officers and directors, and certain of their family members, remained stockholders in the Company.
The PNB Holding Decision
Several stockholders dissented from the Merger and perfected their appraisal rights, while several other stockholders accepted the Merger consideration, but commenced an action in the Delaware Court of Chancery alleging that the Company’s directors breached their fiduciary duties by approving a merger that was unfair to the minority stockholders. The actions were consolidated into an equitable/appraisal action, “rest[ing] on the notion that the $41.00 per share paid in the Merger was unfair.”
With respect to the equitable claim, the Court first considered the plaintiffs’ contentions that the Merger was subject to the entire fairness standard of review. The plaintiffs argued that the Company’s board should be “considered as a monolith and that given the board’s voting power and board control, the Merger should be analyzed as if it were a squeeze-out merger proposed by a controlling stockholder.” In Kahn v. Lynch Communications Systems, Inc., the Delaware Supreme Court held that the entire fairness standard of review applied ab initio in certain special circumstances, e.g., a negotiated going private transaction with a controlling stockholder or a merger of two companies under the common control of one controlling stockholder. In those circumstances in which a controlling stockholder is on both sides of a negotiated transaction, the Delaware Supreme Court has found that the approval of the transaction by disinterested directors (e.g., by a special committee) or by a majority of disinterested stockholders would only shift the burden of proving entire fairness, but would not invoke the substantive protections of the business judgment rule.
In considering the plaintiffs’ argument that the Merger should be subject to the rule of Kahn v. Lynch, the Court found that the officers and directors were not a “controlling stockholder group.” The Court noted that, under Delaware law, a controlling stockholder exists either where the stockholder (i) owns more than 50% of the voting power of the corporation, or (ii) exercises control over the business and affairs of the corporation. Taken as a whole, the officers and directors owned only 33.5% of the voting power of the corporation. Furthermore, the evidence failed to show that the officers, directors, and their respective families operated as a unified controlling bloc. Rather, Vice Chancellor Leo Strine, Jr. observed that there were no voting agreements in place between any of the members of the purportedly controlling block (consisting of directors, officers, spouses, children and parents), and that each individual “had the right to, and every incentive to, act in his or her own self-interest as a stockholder.” Importantly, of the approximately 20 people that comprised the “supposed controlling stockholder group,” the largest block held by any one holder was 10.6%. Thus, the Court reasoned as follows:
- Glomming share-owning directors together into one undifferentiated mass with a single hypothetical brain would result in an unprincipled Frankensteinian version of the already debatable 800-pound gorilla theory of the controlling stockholder that animates the Lynch line of reasoning.
The Court, therefore, held that the facts of PNB Holding did not fit within the Kahn v. Lynch line of jurisprudence.
Although concluding that the defendant directors were not controlling stockholders, the Court concluded that the defendant directors were subject to a conflict of interest that was sufficient to invoke the application of the entire fairness standard of review. Each of the defendant directors personally benefited to the extent that departing stockholders were underpaid. Furthermore, each of the defendant directors had a material interest in the Merger, which had the effect of yielding an economic benefit that was not shared equally by all of the stockholders of the corporation. In addition, and unlike in the context of determining whether a controlling stockholder group existed, the Court found that the family ties between the directors and the non-director stockholders were relevant. Importantly, several of the directors apparently transferred shares of the Company’s stock to family members in order to ensure that they remained stockholders of the Company after the Merger. The Court found that fact to be “indicative of the importance they ascribed to continued ownership in” the Company.
Having found that the Merger was subject to the entire fairness standard of review, the Vice Chancellor addressed the potential “cleansing” effect of approval by (i) independent and disinterested directors (e.g., a fully-functioning special committee), or (ii) a fully-informed, non-coerced vote of a “majority-of-the-minority.” With respect to the former, Vice Chancellor Strine stated as follows:
In my view, the rule of Lynch would not preclude business judgment rule protection for a merger of this kind so long as the transaction was approved by a board majority consisting of directors who would be cashed-out or a special committee of such directors negotiated and approved the transaction.
Although the defendant directors created the Committee to investigate the feasibility of the conversion of the Company to an S corporation, the Committee was not comprised of disinterested directors. As a result, the Committee did not operate to invoke the substantive protections of the business judgment rule.
The Court also noted that the substantive protections of the business judgment rule could be invoked if the Merger was approved by a “majority-of-the-minority.” The Court found, however, that the Company failed, as a mathematical matter, to obtain the approval of a vote of a “majority-of-the-minority.” In that regard, the Court rejected the defendant directors’ contention that only those stockholders who returned a proxy should be included in calculating whether a transaction had been approved by an informed, non-coerced “majority-of-the-minority.” Clarifying a previously unresolved aspect of Delaware law, the Court held that Delaware law requires a vote of a majority of all of the minority shares entitled to vote.
Equally important, Vice Chancellor Strine indicated that, outside of the Kahn v. Lynch context, the approval of a majority of the disinterested stockholders may be sufficient to invoke the protections of the business judgment rule, even if the challenged transaction is not subject to a non-waivable “majority-of-the-minority” condition. The Vice Chancellor stated as follows:
- Under Delaware law, however, the mere fact that an interested transaction was not made expressly subject to a non-waivable majority-of-the-minority vote condition has not made the attainment of so-called ‘ratification effect’ impossible. Rather, outside the Lynch context, proof that an informed, non-coerced majority of the disinterested stockholders approved an interested transaction has the effect of invoking business judgment rule protection for the transaction and, as a practical matter, insulating the transaction from revocation and its proponents from liability.
The Court of Chancery ultimately concluded that the defendant directors failed to prove the entire fairness of the Merger. The Court awarded the appraisal claimants $52.34 per share and the claimants (who did not vote in favor of the Merger) damages in the amount of $11.34 per share (an amount representing the difference between the Merger consideration and the fair value). Claimants who voted in favor of the Merger were barred from recovery under the doctrine of acquiescence. Claimants who accepted the Merger consideration but did not approve the Merger were not similarly barred.
Lessons from PNB Holding
The PNB Holding decision contains several lessons for M&A practitioners, including the following:
•Existence of a Controlling Stockholder. The Court refused to find that a disparate group of directors who had a material conflict of interest with respect to the transaction should be grouped together as a controlling stockholder group. Moreover, the Court expressed skepticism with respect to the argument that family relations should always give rise to a conclusion that individuals should be deemed to be acting as a unified group with respect to their equity interests in a corporation.
- Invoking Business Judgment Rule Protection. Outside of the Kahn v. Lynch context, a fully-informed vote of a “majority-of-the-minority,” as a factual matter, and regardless of whether the merger transaction was conditioned on that vote, can invoke the protections of the business judgment rule and avoid entire fairness review. Similarly, the Court suggested that the negotiation and recommendation of a transaction by a committee of disinterested and independent directors should invoke the protections of the business judgment rule outside of the Kahn v. Lynch context.
- Majority of the Outstanding Minority. For the first time, the Court directly answered the oft-debated question of whether a vote of a “majority-of-the-minority” should be a vote of a majority of the outstanding voting power of the minority stockholders or merely a majority of voting power of the votes cast by the minority stockholders. The Court found that a vote of a “majority-of-the-minority” is effective to invoke the substantive protections of the business judgment rule (at least in the context at issue) only if the challenged transaction is approved by a majority of the outstanding voting power of the minority stockholders. In addition, the transaction need not be subject to a nonwaivable “majority-of-the-minority” condition in order to invoke the substantive protections of the business judgment rule.
- Adding Directors to Constitute a Special Committee. Because all of the directors had a material conflict of interest with respect to the Merger, it appeared to have been impossible for the Company to have formed a committee of independent directors that could have operated to invoke the substantive protections of the business judgment rule. The Court suggested, however, that additional directors could have been added to the Company’s board in order to form a special committee to protect the interests of the minority stockholders.
- Business Judgment in the Kahn v. Lynch Context. Vice Chancellor Strine questioned the well-settled rule of Kahn v. Lynch. The Vice Chancellor expressed his view that the business judgment rule protections should be available, even in the Kahn v. Lynch context, if the transaction is approved both by a fully-functioning special committee comprised of independent and disinterested directors and by a vote of a fully-informed, non-coerced “majority-of-the-minority.” The Court suggested, however, that in that context (and in contrast to a transaction not subject to Kahn v. Lynch) the transaction should be specifically conditioned upon the vote of a “majority-of-the-minority.” In dicta, the Vice Chancellor suggested that “the special rule of Lynch for mergers with controlling stockholders should, if anything, be curtailed to promote the use of special committees and majority-of-the-minority votes in effecting going private mergers so as to most effectively protect minority stockholders, by giving the proponents of such transactions the certainty of business judgment rule protection if they use that deal structure.”
The PNB Holding decision confirms that the substantive protections of the business judgment rule can be invoked, outside of the Kahn v. Lynch context, if a transaction is approved by independent and disinterested directors (e.g., by a fully-functioning special committee) or by fully-informed, non-coerced “majority-of-the-minority” stockholder approval. In addition, the Court found that, outside of the Kahn v. Lynch context, a transaction need not be conditioned upon a vote of a “majority-of-the-minority” in order for such a vote to be obtained and for the substantive protections of the business judgment rule to be invoked thereby. Finally, the Court answered the oft-debated question of how to calculate a vote of a “majority-of-the-minority” and concluded that such a vote (at least in the context before it) must be a vote of a majority of the outstanding voting power of the minority stockholders.
 Michael K. Reilly and Roxanne L. Houtman practice law in the Wilmington, Delaware law firm of Potter Anderson & Corroon LLP. The views expressed are solely those of the authors and do not necessarily represent the views of the firm or its clients.
 2006 WL 2403999 (Del. Ch. Aug. 18, 2006).
 Prairie Capital determined that the fair value of the Company’s outstanding shares was $40.74 per share.
 The merger consideration represented a 12% premium over the Company’s book value and a 6% premium over market value.
 2006 WL 2403999, at *8.
 Some of the stockholders who accepted the Merger consideration also voted in favor of the Merger.
 2006 WL 2403999, at *8.
 638 A.2d 1110 (Del. 1994).
 2006 WL 2403999, at *10.
 The Court noted that this “second test exists to allow the law to impose fiduciary obligations on stockholders who, although lacking a clear majority, have such formidable voting and managerial power that they, as a practical matter, are no differently situated than if they had majority voting control.” Id. at *9.
 Plaintiffs maintained that the allegedly controlling group consisted of 20 individuals, all of whom were officers or directors of the Company, or were related to the officers or directors of the Company.
 2006 WL 2403999, at *10.
 The Vice Chancellor noted that “the sixty-eight remaining stockholders of [the Company] would gain the advantages of being stockholders in an S corporation. Any upside in [the Company’s] future would belong to [the remaining stockholders], exclusive of their departing brethren.” Id. at *11 (internal citation omitted).
 Following the reclassification, the defendant directors would be entitled to approximately 42% of the annual dividends. Id. at *13.
 Id. at *14 n.69.
 The Court reasoned that such a standard is in line with the vote required to approve a merger under Delaware law. Id. at *15 (“a vote of a ‘majority of the outstanding stock of the corporation entitled to vote’ is required for merger approval, and a failure to cast a ballot is a de facto no vote”) (citing 8 Del. C. § 251)). The Court also commented that a contrary holding required “an untenable assumption that those who did not return a proxy were members of a ‘silent affirmative majority of the minority.’” Id.
 Id. at *14 (internal citations omitted). Note, however, that the Vice Chancellor also recognized that with respect to going private transactions with controlling stockholders, there may be compelling justifications for requiring that a transaction be subject to an express, non-waivable condition that the “majority-of-the-minority” approve the transaction.
 2006 WL 2403999, at *21. See Clements v. Rogers, 790 A.2d 1222 (Del. Ch. 2001). Vice Chancellor Strine observed that, ordinarily, “[a]cceptance of the merger consideration is simply an abandonment of the appraisal right.…” 2006 WL 2403999, at *22.
 The Court noted, in particular, that “the idea that children and parents always see eye-to-eye is not a premise of our law. One can have a healthy family relationship and still feel free to vote one’s stock differently than a parent. Absent some reason to believe that the vote would work a serious injury on the close relative – for example, a vote that would ask a child to unseat her CEO father in favor of another director candidate, knowing that the loss of his seat would mean the loss of his job – the mere fact that relatives both own stock means little. Rather, what is critical is whether there is a reason to believe that the familial relationship, coupled with other important facts, is so thick that the stockholders should be treated as essentially a voting group.” Id. at *11 (citation omitted).
 See also In re Western Nat’l Corp. S’holders Litig., 2000 WL 710192 (Del. Ch. May 22, 2000) (finding that the business judgment rule standard of review applied to a transaction approved by a well-functioning independent special committee in the absence of a controlling stockholder.
 Id. at *14 (“But the PNB board all suffered the same conflict and made no attempt to add directors representing the stockholders to be cashed-out.”).
 See also In re Cox Communications, Inc. S’holders Litig., 879 A.2d 604 (Del. Ch. 2005).
 Id. at *14 n.69.