Court of Chancery Issues Significant Decision on Special Committee Process
On December 21, 2005, the Court of Chancery rendered a decision in In re Tele-Communications, Inc. Shareholders Litig., C.A. No. 16470, Chandler, C. (Del. Ch. Dec. 21, 2005), denying defendants' motion for summary judgment on several claims challenging the merger of Tele-Communications, Inc. 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 successfully shift the burden of proving entire fairness, especially where that committee is confronted with the challenging task of considering a transaction providing a premium to a class or series of high-vote stock over a class or series of low-vote stock.
At issue in TCI was the treatment of two series of common stock: Series A TCI Group Common Stock (the "Series A shares") and Series B TCI Group Common Stock (the "Series B shares"). The Series A shares were entitled to one vote per share, while the Series B shares were entitled to ten votes per share. Otherwise, the Series A shares and the Series B shares had identical terms. When discussions began between TCI and AT&T concerning a proposed merger, John Malone, TCI's Chairman and Chief Executive Officer, insisted that in order to obtain his consent and approval of the transaction as a TCI stockholder, the Series B shares would need to receive a premium of ten percent over the Series A shares. Malone owned a majority of the Series B shares and controlled 47% of the total voting power of the TCI shares. Malone and four other TCI directors, collectively constituting a majority of the nine member TCI Board, owned 84% of all of the outstanding Series B shares.
The TCI Board formed a special committee to consider the proposed merger. The special committee was comprised of two members: Paul A. Gould, an owner of a significantly larger number of Series B shares than Series A shares, and John W. Gallivan. Before the special committee's deliberations commenced, the TCI Board approved a plan to reasonably compensate the committee members for their service, but did not specify either an amount or a formula for determining the compensation. The special committee met four times over a five day period. The special committee did not hire its own independent financial advisors or legal counsel, but relied on TCI's financial and legal advisors. TCI's financial advisor informed the special committee of precedent transactions where high-vote stock had received a premium to low-vote stock, but noted that those transactions were "less common" than transactions where no premium was paid. TCI's financial advisor also opined on the fairness of the merger consideration to each of the Series A shares and the Series B shares, respectively.
After receiving that advice, the special committee recommended the merger to the full TCI Board and it was approved. Several months later, TCI stockholders overwhelmingly approved the merger. Immediately prior to the stockholder approval, the special committee members were each paid $1 million for their committee service. As a result of their ownership of the Series B shares, a majority of the directors received, in the aggregate, $376 million more than they would have received if no premium had been paid and the shares were treated equally. Malone obtained the highest benefit from the premium, receiving in excess of $100 million more than he would have received if there were no premium, while the director obtaining the lowest benefit from the premium received in excess of $500,000 more than he would have received if there were no premium.
Plaintiff stockholders brought several claims challenging the merger. In rejecting defendants' motion for summary judgment on certain of those claims, the Court concluded, among other things, that the relevant standard of review was entire fairness. Citing FLS Holdings[2] and Reader's Digest,[3] 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." 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.
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. The Chancellor determined that defendants failed to prove that the special committee was truly independent, fully informed and had the freedom to negotiate at arm's length, finding 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 proceeded to examine the special committee process under the entire fairness standard. The Chancellor concluded that, based on the current record, the defendants had failed to demonstrate 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 Choice of Directors. 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 Lack of a Clear Mandate. 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 Choice of Advisors. 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 Diligence of Research and Analysis of Pricing. 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 Nature of the Fairness Analysis. 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."
- Result is Lack of Arm's Length Bargaining. All of the above factors led to a flawed special committee process that created an "inhospitable" environment for arm's length bargaining. 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.
The TCI decision reiterates the importance of designing and implementing an effective special committee process where a transaction is likely to be adjudicated under the entire fairness standard, highlighting, in particular, the importance of choosing disinterested and independent directors to serve on a special committee. A board of directors forming a special committee should: (i) carefully choose independent committee members who are not tainted by interest, (ii) establish the compensation of committee members in advance, (iii) provide the special committee with a clear mandate, (iv) allow and encourage the special committee to hire independent financial advisors and legal counsel, and 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. 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 receives all relevant information reasonably available to it to evaluate the fairness of that premium and 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.
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Notes
1 John F. Grossbauer is a partner and Michael K. Reilly is an associate 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.
2 In re FLS Holdings, Inc. S'holders Litig., 1993 WL 104562 (Del. Ch. Apr. 21, 1993).
3 Levco Alternative Fund Ltd. v. Reader's Digest Ass'n, Inc., 2002 WL 1859064 (Del. Aug. 13, 2002).