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Pragmatic Effect of Recent Delaware Cases on Structuring Deals involving Large Stockholders

November 24, 2014

 

The level of judicial scrutiny of an M&A transaction is always a driver of deal structure and other deal terms. One question that has arisen over the years in Delaware deals involving large stockholders is whether the stockholder is a controlling stockholder such that the strict entire fairness analysis applies, instead of the more deferential business judgment rule standard. The answer can matter a great deal in determining the transaction structure, the requisite stockholder approval and other terms, which must be addressed at the outset and can be very difficult to fix after the fact.

Two recent decisions of the Delaware Court of Chancery offer direction on this topic. In re Crimson Exploration held that for large stockholders who held less than 50% of the outstanding capital stock of the target company, the factual analysis for determining the judicial standard of review turns on whether the stockholder “actually control[s] the board’s decisions about the challenged transaction”, and whether the stockholder actually “dominated” the board. In addition, the court will review whether the stockholder will receive a special benefit in the transaction separate and apart from what other stockholders will receive. In this case, the court found that the mere fact that the stockholder held over 30% of the target company’s capital stock and had designated a majority of the board and executive officers of the target company did not result in the stockholder actually controlling the board’s decisions with respect to the contemplated transaction. In addition, the fact that the large stockholder was also a large creditor and would receive a relatively modest debt pre-payment penalty and registration rights in the transaction was not viewed as sufficiently “unique benefits” to change the analysis. In re KKR Financial again applied the touchstone of “actual control” and held that, although the stockholder exercised total managerial control pursuant to a management agreement between the target and an affiliate of the stockholder, ultimate control over the transaction resided with the target company’s board, which the stockholder did not control through the management agreement.

By way of background, the Delaware courts have found a large stockholder to be a controller at levels as low as 35% (In re Cysive), 40.34% (In re Primedia), and 43.3% (Kahn v. Lynch). Conversely, stockholders holding as much as 44% (Superior Vision Services) or 46% (In re Western National) have been held to not be controlling stockholders.

As Crimson Exploration noted, entire fairness is not triggered only upon a large stockholder being deemed a controlling stockholder, but also requires a showing that the controller (1) stood on both sides of the transaction or (2) competed with the common (non-controlling) stockholders for consideration, such as the following:

Action That Could Trigger Entire Fairness

Case

Controller receives an equity stake in acquirer, a line of credit, and liquidation and other contractual rights

In re John Q. Hammons

Liquidity needs of controller manifestly drive controller to push for fire sale

In re infoGROUP

Controller receives more per share than other stockholders

Tele-Communications, Inc. and Delphi

Unique benefit received in the deal by the controller

In re Primedia, Inc.

Controller negotiates the merger for the target and rolls equity

In re LNR Property

The pragmatic effect of Crimson Exploration and KKR Financial is to offer guidance as to how to structure transactions with large stockholders that stand on both sides of the transaction or compete with the non-controlling stockholders for consideration:

  • Likely Controlling Stockholder.
    • Procedural protections should be implemented at the beginning of the transaction.

      • Failure to do so can be very difficult or costly to cure midstream, and may result in a flawed process that can put the deal at risk.

  • Consider using a special committee or a majority of the minority vote, so as to shift the burden of proof in entire fairness to the plaintiff as per Kahn v. Lynch

    • Alternatively, utilize both a special committee and a majority of the minority vote, so as to receive the protection of the business judgment rule under M&F Worldwide.

      • This requires assessing whether a majority of the minority vote would provide hold up power to hedge funds or activist investors.

  • If possible, limit the use of deal terms that were held to trigger entire fairness (see chart above).

    • Having the controller receive the same consideration as the common stockholders may insulate the deal against entire fairness as per the Synthes and Morton’s Restaurant Group decisions.

  • Likely Non-Controlling Stockholder.

    • Conversely, it can be just as damaging to the transaction to include procedural protections that are not necessary if there is no controller.

      • Special committees can significantly slow down deals (or, in some cases, result in deals never being reached) due to an inefficient sales process and/or the exclusion of certain directors. 

      • Majority of the minority votes may allow hedge funds or activist investors to hold the deal hostage.

        • If these procedural protections are not required, then including them typically does not facilitate signing or closing the deal.

    • While there is more flexibility to include specific terms for the large stockholder, caution is nevertheless required.

      • Understand why the large stockholder will receive different terms—what is the basis for that not being evidence of a controller?

As is typical in M&A transactions, the details matter—and with the controlling stockholder analysis, the details matter very much. Determining whether a large stockholder is or is not a controller at the outset of a deal allows the advisers to construct a thoughtful plan to maximize the chances of closing the transaction, and to minimize the probability that the deal will be held up in the courts.


This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Paul Scrivano, an O'Melveny partner licensed to practice law in New York and California, Noah Kornblith, an O'Melveny associate licensed to practice law in California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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