What is Independence?
Delaware's Chancellor upholds the sale of a corporation to its largest shareholder, even though five of eight directors had interests in the deal
From The Daily Deal, Vol.2, No.95, June 23, 2000
Copyright ©2000 The Deal LLC
Reprinted with permission. All rights reserved.
Late last month, Chancellor William B. Chandler III provided additional guidance to Delaware corporations in structuring and obtaining approval of strategic investments and acquisitions. In 'In re Western National Corp. Shareholders Litigation,' Chandler granted summary judgment to defendants on a challenge to the acquisition of Western National by its 46% stockholder, American General Corp. The opinion is noteworthy for its application of the business judgment rule to the transaction, despite the presence of the 46% stockholder and the arguable interest in the merger of five of the eight members of the Western National board.
Western National's board decided the company required additional capital, but, for business reasons having to do with its credit standing as an insurer, debt financing was not an option. At that point, the board appointed a special committee consisting of three clearly disinterested directors to consider strategic alternatives.
The committee retained its own financial and legal advisers (who were recommended by management). Ultimately, the committee decided a sale of Western National was the optimal choice and, in the course of its activities, approached American General. American General indicated it would be interested in purchasing the company, but it would not sell its 46% stake. Left with one potential buyer, the committee and its advisers then negotiated, at arm's length, a merger agreement with American General.
Rebuffing the plaintiff's challenge, Chandler found that American General did not owe fiduciary duties to the remaining Western National stockholders because it did not exercise "actual control over the business and affairs of the corporation." (Emphasis in original).
The court's findings hinged on two key components—a standstill agreement that limited American General to two nominees on the eight-member board and the fact that American General had not used its nomination right to appoint managers "to play the part of provincial governors."
While Chandler found that a majority stockholder is always a fiduciary, he also cited Vice Chancellor Carolyn Berger's decision in DiNardo v. Renzi, which found that even a majority stockholder may be unable to exercise control if appropriate stockholder agreements are in place. Chandler's analysis suggests that a majority stockholder that has entered into a standstill of the type American General executed may be able, at a minimum, to shift the burden of proving unfairness to a plaintiff challenging a transaction between the stockholder and the corporation, despite its fiduciary status. Chandler further found the special committee's negotiation and approval of the merger agreement would be reviewed under the business judgment rule, despite evidence of a "mild" interest on the part of five of eight Western National board members. In so doing, he distinguished Kahn v. Lynch Communications Systems Inc. In Kahn, the Delaware Supreme Court held that, when a corporation merges with a majority stockholder, approval by a properly functioning special committee shifts the burden of proving unfairness to the plaintiff but does not justify invoking the business judgment rule.
Chandler found the threat of retaliation by a spurned majority stockholder underlying the Kahn holding was not present because the standstill agreement limited American General's ability to control corporate policy. But Chandler did not address the fact that the standstill was scheduled to expire in a little over a year after the merger agreement was executed. (It is unclear whether Chandler would have reached the same result if the standstill agreement were set to expire a short time—say, three months—following the execution of the merger agreement.)
Instead, the court relied on Puma v. Marriott, where transactions with a 46% stockholder, approved by disinterested directors constituting a majority of the entire board, were reviewed under the business judgment rule. Chandler also noted the merger had been approved by a majority of Western National's unaffiliated stockholders and wondered why informed stockholder ratification should not be dispositive of challenges such as this one.
Western National's treatment of committee approval provides some comfort to counsel who worried that, after Kahn, special committee approval of an interested transaction would justify invocation of the business judgment rule only where the committee consists of a majority of the whole board, rather than a majority of the disinterested directors. The Chancellor confirmed his view of the effect of disinterested director approval two days later in Cooke v. Oolie, in which he stated that fully informed approval of a self-dealing transaction by truly independent directors invokes the "safe harbor" of Delaware General Corporation Law Sec. 144(a)(i) and justifies application of the business judgment rule to the challenged decision in all cases, except when the interested party is a majority stockholder.
The Western National decision emphasizes the procedural and substantive advantages of having independent directors on public company boards of directors. It also suggests that contractual restrictions on the ability of a significant investor to exercise control may determine the outcome in any challenge to a transaction between a corporation and an investor, at least if the investor owns less than a numerical majority of the voting power.