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Delaware Clarifies Application of Business Judgment Rule and Entire Fairness to Change of Control Transactions Involving Companies with Controlling StockholdersOctober 26, 2009
The Delaware Court of Chancery, in In re John Q. Hammons Inc., Shareholder Litigation, C.A. No. 758-CC (Del. Ch. Oct. 2, 2009), recently issued a decision clarifying the application of the business judgment rule and the entire fairness standard of review to change of control transactions involving companies with controlling stockholders. In order for the board of a target company with a controlling stockholder to receive the protections of the business judgment rule rather than the heightened scrutiny of entire fairness, the court held that the transaction must be (i) recommended to the minority stockholders by a disinterested special committee of the board of directors and (ii) subject to a non-waivable vote of the majority of all minority stockholders.
The case involved the acquisition of John Q. Hammons Hotels, Inc. (the “Company”), a publicly traded company controlled by John Q. Hammons (“Hammons”), by an acquisition vehicle owned by Jonathan Eilian (“Eilian”), an unrelated third party. Hammons was Chairman of the board of directors and controlled approximately 76% of the vote of the Company through his ownership of all of the Class B common stock and a small percentage of the Class A common stock. Hammons discussed a sale of the Company with various third parties and a special committee of disinterested directors was formed to evaluate the offers. The committee retained legal and financial advisors and adopted guidelines to ensure that stockholders could communicate with the committee, that interested purchasers would have equal access to information and to ensure that the committee and its advisors were fully informed of the merits of each proposal. After months of negotiations with several parties, the board approved the transaction with Eilian. Holders of the publicly traded Class A common stock were to receive cash consideration at a substantial premium for their shares. Hammons negotiated a preferred interest in the surviving partnership with a large liquidation preference, a $300 million line of credit and ownership of one of the Company’s marquee properties as consideration for his stock and certain other assets. The merger agreement required, as a condition of the merger, a majority vote of the minority stockholders actually voting, but which was waivable by the special committee; facts that would be key to the court’s analysis.
The plaintiffs alleged that the transaction was a minority “squeeze-out” merger and that Hammons used his controlling position to extract a disproportionate amount of the consideration for himself. They argued that the transaction should be scrutinized under the more exacting entire fairness standard since Hammons effectively stood on both sides of the deal. In contrast, the board argued that the transaction was fair to the minority stockholders and should be reviewed under the business judgment rule.
Entire Fairness vs. Business Judgment Rule
In order for a transaction to withstand the heightened scrutiny of entire fairness, the burden of proof lies with the board of directors to prove that the transaction involved (1) fair price and (2) fair dealing. The business judgment rule is a more deferential standard of review that requires the plaintiffs to rebut the presumption that the board properly discharged its fiduciary duties of care and loyalty when it evaluated and approved the transaction.
The court rejected the plaintiffs’ contention that Hammons stood on both sides of the transaction and ruled that the structure of the transaction did not automatically necessitate the application of the entire fairness standard of review. The court emphasized that “the controlling stockholder in this case did not make the offer to the minority stockholders; an unrelated third party did.” Although Hammons retained an equity stake in the surviving entity and received other consideration that differed from the minority stockholders’ consideration, the court held that “business judgment would be the applicable standard of review if the transaction were (1) recommended by a disinterested and independent special committee and (2) approved by stockholders in a non-waivable vote of the majority of all the minority stockholders.” The court emphasized that such “robust procedural protections” are necessary to protect the minority stockholders and must be “pre-conditions to the transaction.”
However, due to “deficiencies in the specific procedures” related to the majority of the minority vote in this case, the court applied entire fairness rather than the business judgment rule. The fact that the vote of the minority stockholders was waivable by the special committee and did not require an affirmative vote of the majority of all of the minority stockholders negated the effectiveness of the procedures. Even though the special committee chose not to waive the vote and the transaction was approved by a majority of all of the minority stockholders, the deficiencies in the procedures were not “cured” according to the court. The court noted that the business judgment rule could have been applied to this case if the proper procedures to protect the minority stockholders had been conditions precedent to the transaction.
In light of the court’s ruling, deal lawyers advising on change of control transactions involving companies with controlling stockholders should consider the use of a special committee and a non-waivable vote of a majority of all minority stockholders to avoid the application of the entire fairness standard of review. Of course, these provisions should not be automatically incorporated into every deal involving companies with controlling stockholders without particular analysis as to their effect on the outcome of the transaction. For certain transactions, such as where a majority of the minority vote may provide “hold up” power to certain stockholders who might seek to resist or vote down the transaction, not providing a majority of the minority vote and instead facing the plaintiffs on a potential entire fairness claim may provide greater deal certainty and an alternative approach to completing the transaction.
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