Entire Fairness Standard of Review Does Not Apply in Short-Form Mergers
From The Corporate Governance Advisor, Vol.9:6, November/December 2001
Copyright ©2001 Aspen Law & Business, a Division of Aspen Publishers, Inc.
A Wolters Kluwer Company.
Reprinted with permission. All rights reserved.
On July 25, 2001, the Delaware Supreme Court rendered its en banc decision in Glassman v. Unocal Exploration Corp. The decision had been eagerly awaited by Delaware practitioners, who hoped the decision would resolve a long-standing debate as to the appropriate standard of review to be applied in challenges to short-form mergers effected pursuant to Section 253 of the Delaware General Corporation Law (DGCL). By affirming the ruling of the Delaware Court of Chancery that the entire fairness standard does not apply in a short-form merger, the Supreme Court settled that debate. Nevertheless, the full implications of the decision await further case law development.
What Is the Standard of Review under Section 253?
Section 253 of the DGCL authorizes the board of directors of a Delaware corporation that owns 90 per-cent or more of each of the outstanding classes of stock of a subsidiary that are entitled to vote on a merger to merge the subsidiary into itself without any requirement for action to be taken by the board of directors of the subsidiary. Unocal Exploration involved a challenge to such a short-form merger of Unocal Exploration Corporation (UXC) with and into its 96 percent stockholder, a wholly owned subsidiary of Unocal Corporation (Unocal). Plaintiff-appellants contended that Unocal, an earth resources corporation primarily engaged in the exploration and production of crude oil and natural gas, timed the merger of UXC into Unocal to take advantage of a decrease in natural gas prices.
On appeal, plaintiff-appellants challenged the fairness of the merger, arguing that mergers effected under Section 253 should be reviewed under the entire fairness test the same standard that is typically applied to cashout mergers effected by controlling stockholders under the long-form merger statutes, Section 251 and Section 252 of the DGCL. Plaintiff-appellants based their argument on, among other things, the Supreme Court decisions in Weinberger v. UOP, Inc., Bershad v. Curtiss-Wright Corp., and Kahn v. Lynch Communications Systems, Inc., each of which were mergers under the Delaware long-form statute-but each of which seemingly supported, at least in some respect, the notion that the entire fairness standard of review should be applicable to short-form mergers.
For example, in Bershad, the Supreme Court specifically cited Section 253 when it identified statutory merger provisions that embodied fairness issues when it stated, "In parent-subsidiary merger transactions the issues are those of fairness-fair price and fair dealing. These flow from the statutory provisions permitting mergers." Moreover, in its 1994 decision in Kahn, the Supreme Court stated flatly that "[a] controlling or dominating shareholder standing on both sides of a transaction, as in a parent-subsidiary context, bears the burden of proving its entire fairness." Although the Court made no mention of Section 253 in this context, the statement is not, by its terms, limited to long-form mergers. Equally compelling, in plaintiff's view, was the language in the Kahn case stating that entire fairness review is "exclusive . . . in . . . interested cashout mergers by a controlling stockholder . . . ."
The Delaware Supreme Court rejected plaintiff-appellants' reading of these cases, relying instead on the approach enunciated long ago in Stauffer v. Standard Brands, Inc. In Stauffer, plaintiffs claimed that the board of directors of Standard Brands had breached its fiduciary duties to the minority stockholders by setting a grossly inadequate and unfair price for their stock. In affirming the Chancery Court decision to dismiss plaintiffs' com-plaint, the Stauffer Court reasoned that the unilateral right given to a parent by Section 253 meant that, absent inequitable action constituting "fraud or illegality" that renders the merger itself subject to attack, a minority stockholder's complaint in a short-form merger relates only to value-which issue can be adequately addressed in an appraisal proceeding. Appraisal is, therefore, normally the "only recourse" for a stockholder who believes he or she was unfairly cashed out in a short-form merger.
The fundamental principle underlying Stauffer (and, therefore, underlying Unocal Exploration) is that Section 253 creates an affirmative right in a 90 percent stockholder to eliminate minority stockholders' participation in the controlled corporation, rather than merely representing a truncated procedure for effecting a merger in such circumstances. This statutorily-created right "authorizes the elimination of minority stockholders by a summary process that does not involve the 'fair dealing' component of entire fairness." Accordingly, Section 253 "effectively circumscribe[s] the parent corporation's obligations to the minority in a short-form merger." As the Supreme Court explained:
Under settled principles, a parent corporation and its directors undertaking a short-form merger are self-dealing fiduciaries who should be required to establish entire fairness, including fair dealing and fair price. The problem is that §253 authorizes a summary procedure that is inconsistent with any reasonable notion of fair dealing . . . . The equitable claim plainly conflicts with the statute. If a corporate fiduciary follows the truncated process authorized by §253, it will not be able to establish the fair dealing prong of entire fairness . . . . In order to preserve its purpose, §253 must be construed to obviate the requirement to establish entire fairness.
What the Supreme Court Did Not Change
The Supreme Court was careful, however, to note specifically that Section 253 does not eliminate the parent corporation's fiduciary duty to disclose to the minority stockholders all information that is reasonably necessary in order to enable them to intelligently decide whether to exercise their appraisal rights.
The Court also reaffirmed the statements in Weinberger with respect to the scope of the matters that can be considered in an appraisal, stating that "fair value must be based on all relevant factors, including damages and elements of future value, where appropriate." Thus, the Court made clear that the types of factors that are often raised in an entire fairness claim, such as timing a merger to take advantage of a temporary depression in the stock price or other market fluctuations that affect the underlying value of the stock, may be considered in an appraisal proceeding.
Although the Supreme Court's decision makes clear that the entire fairness standard of review does not apply to short-form mergers in which the parent holds the requisite amount of subsidiary stock at the time that it determines to merge, its focus on the unilateral nature of this right suggests that a different result may apply in circumstances in which a parent corporation requires the assistance of the subsidiary's board of directors to reach the 90 percent threshold prior to consummating a short-form merger. For example, often times a cashout transaction involves a tender offer by the majority stockholder followed by a short-form merger, and the tender offeror may negotiate for a "top up option" to enable it to reach the 90 percent threshold required by Section 253.
Unocal Exploration does not resolve whether such "back-end" mergers, which are typically negotiated with the target board of directors as part of an overall transaction, allow a parent corporation to avoid the need to accept the burden of proving entire fairness. Indeed, Vice Chancellor Lamb acknowledged this concern in a footnote to his Chancery Court opinion in In re Unocal Exploration Corporation Shareholders Litigation in which he stated his belief that certain structures involving an ultimate merger under Section 253 might nevertheless implicate entire fairness review, including situations in which the short-form merger was the second step in a two-step acquisition approved by the board of the target corporation. Such transactions might well be viewed by a court as a unitary transaction requiring entire fairness review, with the merger viewed as the final step in a "conspiracy to establish an unlawful end by unlawful means."
The focus of the Supreme Court in Unocal Exploration on the rights of the majority stockholder also suggests that there may be circumstances in which a majority stockholder that crosses the 90 percent threshold through stock purchases may avoid entire fairness review of any subsequent merger. In In re Siliconix Shareholders Litigation, plaintiff brought an action to enjoin a controlling stockholder from proceeding with a tender offer, which was to be followed by a back-end merger, claiming that the price being offered was unfair. In denying plaintiff's request, the Chancery Court reiterated the well-established principle that a controlling shareholder extending an offer for minority-held shares in the controlled corporation is under no obligation to offer any particular price for the minority-held stock, absent evidence that material information about the offer has been withheld or misrepresented, or that the offer is coercive in some significant way, and held that the defendants could not be required to show the entire fairness of their tender offer.
Moreover, the Court held that the Siliconix board was under no duty to guide the minority stockholders in their decision to accept or reject the controlling shareholder's tender offer. When viewed together, Siliconix, coupled with Unocal Exploration, may offer majority stockholders a roadmap for accomplishing a cashout of the minority without assuming the heavy burden of proving entire fairness. Of course, the success of such a plan is wholly dependent on the majority stockholder's ability to convince a sufficient number of minority stockholders to tender their shares in order to achieve the 90 percent ownership level required by Section 253.
The resolution of the issue surrounding the appropriate standard of review under Section 253 not only brings a degree of certainty and definiteness that had been lacking in the context of short-form mergers, but also creates a bright-line rule for practitioners. This approach is consistent with one of the hallmarks of Delaware law -- that is, if a corporation and its board of directors adheres to the statutory requirements of the DGCL, their actions will be upheld by a Delaware court. The decision in Unocal Exploration may also reflect a renewed emphasis by the Supreme Court on the importance of predictability and certainty in the corporate arena, a subject that has received much recent attention.
1 Del. Supr. C. A. No. 12453, Berger, J. (July 25, 2001).
2 The entire fairness standard requires the directors to establish that the challenged transaction was the product of both fair dealing (how the transaction was timed, initiated, structured, negotiated, disclosed, and approved) and fair price (all elements of value). See, e.g., Weinberger v. UOP, Inc. Del. Supr. 457 A.2d 701 (1983).
3 Del. Supr., 457 A.2d 701 (1983).
4 Del. Supr., 535 A.2d 840 (1987).
5 Del. Supr., 638 A.2d 1110 (1994).
6 8 Del. C. §§ 251-253. Bershad, 535 A.2d at 845.
7 638 A.2d at 1115.
8 Kahn, Del. Supr., 630 A.2d 1110.
9 Del. Supr., 187 A.2d 78 (1962). As the Supreme Court noted in its opinion, the vitality of Stauffer ebbed and flowed over the years. It was nearly completely overruled in the 1970s, see Singer v. Magnovox Co., Del. Supr., 380 A.2d 969 (1977); Roland International Corporation v. Najjar, Del. Supr., 407 A.2d 1032 (1979), but was revitalized in Weinberger, in which the Court announced it was returning to the "well-established principles" of Stauffer and its progeny "mandating a stockholder's recourse to the basic remedy of appraisal." Weinberger, 457 A.2d at 715. After Weinberger, in cases such as Rabkin v. Philip A. Hunt Chemical Corp., Del. Supr., 498 A.2d 1099 (1985), as well as Bershad and Kahn, the Supreme Court appeared once again to retreat from the principles enunciated in Stauffer, focusing in those cases on the fiduciary duties possessed by a controlling stockholder and the concomitant requirement that self-dealing transactions involving fiduciaries be reviewed under an entire fairness analysis. Neither Weinberger nor the Delaware Supreme Court cases following it, however, involved a short-form merger effected under Section 253.
10 Unocal Exploration, mem. op. at p.3.
11 Unocal Exploration, mem. op. at pp.13-14. It should be noted that Unocal did cause UXC to employ a special committee of the UXC board of directors to negotiate on behalf of the minority stockholders of UXC. According to both the Chancery Court and the Supreme Court, Unocal did so in large part because of its awareness of the divergence that had arisen in the law and "engaged in a process that it believed would pass muster under traditional entire fairness review." Unocal Exploration, mem. op. at p.3. Vice Chancellor Lamb found that the use of a special committee did not affect his analysis of the appropriate standard of review, because the committee was established and operated in good faith and was not a "sham designed to lull the public stockholders into believing that their interests have been protected." In re Unocal Exploration Corporation Shareholders Litigation, Del. Ch., C.A. No. 12453, V.C. Lamb (Apr. 7, 2000) mem. op. at p.29, quoting Iseman v. Liquid Air Corp., Del. Ch., C.A. Nos. 9694, 9833, Berger, V.C. (Oct. 23, 1989) (emphasis in original). The Supreme Court, however, failed to address this issue with specificity. In the authors' view, this silence should be taken as an acknowledgement by the Court of the uncertain nature of the law of short-form mergers prior to Unocal Exploration, rather than as an endorsement of a broader approach under which the Court will not apply standard fiduciary duty analysis where a board voluntarily assumes a role in a transaction where no board action is otherwise required. See, e.g., Freedman v. Restaurants Assocs. Indus., Inc., Del. Ch., C.A. No. 9212, C., Allen (Sept. 21, 1990), mem. op. at 19 ("Although management may have no general obligation to disclose its purposes or motivation, once it undertook to disclose its purpose in revising the offer, it had an obligation to do so truthfully and candidly.").
12 Unocal Exploration, mem. op. at p.14.
13 In re Unocal Exploration Corporation Shareholders Litigation, Del Ch., C.A. No. 12453, V. C. Lamb (Apr. 7, 2000), mem. op. at p.16 n.26.
14 Braasch v. Goldschmidt, Del. Ch., 199 A.2d 760, 764 (1964). So read, Unocal Exploration is consistent with the Delaware Supreme Court's earlier opinion in McMullin v. Beran, Del. Supr., 765 A.2d 910 (2000). In McMullin, the Supreme Court found that a controlling stockholder's decision to effect a sale of the subsidiary through a long-form merger requiring subsidiary board approval implicated the fiduciary duties of the subsidiary corporation's directors and the majority stockholder. In doing so, however, the Court specifically noted that the majority stockholder was free to sell its own subsidiary shares for whatever consideration may have been acceptable to it. McMullin, 765 A.2d at 920.
15 Del. Ch. C. A. No. 18700, V.C. Noble (June 21, 2001).
16 Former Chancellor Allen described this principle as follows:
As a general matter, those who must shape their conduct to conform to the dictates of statutory law should be able to satisfy such requirements by satisfying the literal demands of the law rather than being required to guess about the nature and extent of some broader or different restriction at the risk of an ex post facto determination of error. The utility of a literal approach to statutory construction is particularly apparent in the interpretation of the requirements of our corporation law-where both the statute itself and most transactions governed by it are carefully planned and result from a thoughtful and highly rational process.
See Speiser v. Baker, 525 A.2d 1001, 1008 (Del. Ch. 1987).
17 See William T. Allen, et al., "Function over Form: A Reassessment of Standards of Review in Delaware Corporation Law" 56 Bus. Law. 1287 (2001).
* Mr. Grossbauer is a partner, and Ms. Salomone is an associate, in the law firm of Potter Anderson & Corroon LLP, in Wilmington, DE. The views reflected herein are those of the authors and may not reflect those of Potter Anderson & Corroon LLP or any of its clients.