In the Beginning...
ATTORNEY: GUSTAVO F. BRUCKNER
POMERANTZ MONITOR JANUARY/FEBRUARY 2019
In its landmark 2014 decision, Kahn v. M&F Worldwide, known colloquially as MFW, the Delaware Supreme Court held that the deferential business judgment standard of review will apply to going private mergers with a controlling stockholder and its subsidiary if and only if the merger is conditioned “ab initio” —Latin for “from the beginning” — on two specific minority stockholder protective measures. Once a transaction has business judgment rule review, the Court will not inquire further as to sufficiency of price or terms absent egregious or reckless conduct by a Special Committee. Deals subject to the “entire fairness” standard of review have a significantly tougher time getting judicial approval than those subject to review under the business judgment rule.
These two conditions, which the controlling stockholder must agree to at the outset, are that the merger receive the approval of (1) an attentive Special Committee comprised of directors who are independent of the controlling stockholder, fully empowered to decline the transaction and retain its own financial and legal advisors, and satisfies its duty of care in negotiating fair price, and (2) a majority of the unaffiliated stockholders, who are uncoerced in their vote and fully informed. Delaware courts require that these conditions be agreed to “at the outset” to ensure that controlling shareholders not use the MFW conditions as “bargaining chips” during economic negotiations, essentially trading price for protection. Controllers are thus motivated to maximize their initial offer if they want the immediate benefit of business judgment review.
Until the MFW decision, transactions that involved a controlling stockholder were always subject to the heightened, entire fairness level of review, which shifts to the controlling stockholder the burden to show that the transaction is fair to the minority stockholders and functionally precluded dismissal of a complaint at the pleadings stage.
An interesting question arose in Flood v. Synutra: what constitutes the beginning? In January 2016, Liang Zhang, who controlled 63.5% of Synutra’s stock, wrote a letter to the Synutra board proposing to take the company private, but failed to include the MFW procedural prerequisites of Special Committee and majority of the minority approvals in the initial bid. One week after Zhang’s first letter, the Synutra board formed a Special Committee to evaluate the proposal and, one week after that, Zhang submitted a revised bid letter that included the MFW protections. The Special Committee declined to engage in any price negotiations until it had retained and received financial projections from its own investment bank, and such negotiations did not begin until seven months after Zhang’s second offer. Ultimately the board agreed to a deal.
Plaintiff Flood brought a lawsuit challenging the fairness of the price and asserting breach of fiduciary duties. Flood argued that because controller Zhang, who held 63.5% of the company’s stock, failed to propose inclusion of the MFW protections in his first offer (even though he did so shortly thereafter, before negotiations commenced), the transaction did not comply with MFW and still had to meet the “entire fairness” test.
The Delaware Supreme Court declined to adopt a “bright line” rule that the MFW procedures had to be a condition of the controller’s “first offer” or other initial communication with the target about a potential transaction. Rejecting this narrow reading of MFW, the Court clarified that the conditions need not be included in the initial overture but must be in place “at the beginning stage of the process of considering a going private proposal and before any negotiations commence between the Special Committee and the controller over the economic terms of the offer.” Thus, even if those protections were not included in the “first offer,” the key concern of MFW — “ensuring that controllers could not use the conditions as bargaining chips during economic negotiations”—would still be addressed if the protections were in place before any economic negotiations commenced. This more flexible approach incentivizes controlling stockholders to pre-commit to these conditions, which in turn benefits minority stockholders.