In In re Primedia, Inc. Shareholders Litigation, 2013 WL 2169415 (Del. Ch. May 10, 2013), Vice Chancellor Laster of the Court of Chancery held that plaintiffs whose standing to pursue derivative insider trading claims had been extinguished by merger had standing to challenge directly the entire fairness of that merger based on a claim that the target board of directors failed to obtain sufficient value in the merger for the pending derivative claims.
In late 2005 and early 2006, two plaintiffs filed derivative complaints on behalf of Primedia, Inc. (“Primedia” or the “Company”) generally asserting that the members of the Company’s board of directors had breached their fiduciary duties by causing Primedia to sell assets and redeem preferred stock in a manner that benefitted certain affiliates of KKR, Primedia’s controlling stockholder. Primedia’s board formed a special litigation committee (the “SLC”) and authorized it to investigate plaintiffs’ allegations. While the SLC’s investigation was ongoing, plaintiffs amended their complaint to assert corporate opportunity claims against the KKR affiliates and indicated to the SLC their belief that the documents produced to plaintiffs during the SLC’s investigation would support an insider trading claim against the KKR affiliates under Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949).
The SLC ultimately resolved to recommend dismissal of the plaintiffs’ claims. With respect to the Brophy claim, the SLC’s view was that it was likely barred by the statute of limitations. It also found that the evidence supported the view that the KKR affiliates did not possess the requisite scienter to support such a claim.
On June 14, 2010, the Court of Chancery granted the SLC’s motion to dismiss the derivative complaint over plaintiffs’ objection. With respect to the Brophy claim in particular, the Court rejected the SLC’s view that no evidence supported a finding of scienter, and held that the elements of such a claim were likely well-pleaded and would survive a motion to dismiss. The Court nevertheless held that the SLC’s decision not to pursue the Brophy claim was reasonable, in reliance on Court of Chancery decisions that would limit the Company’s potential remedy for such a claim to harm actually suffered by the corporation (which the Court estimated at approximately $1.5 million) as opposed to full disgorgement of trading profits (which could have required a payment of up to $190 million from the KKR affiliates). Taking into account the risks associated with litigation, including the real risk of an adverse ruling on the statute of limitations defense, the Court determined that the SLC’s decision not to pursue the Brophy claim fell within a range of reasonableness.
The derivative plaintiffs appealed, and the Delaware Supreme Court reversed. Among other things, the Supreme Court clarified that full disgorgement of all profits obtained by an insider-trading fiduciary was an available remedy for a successful Brophy claim. Kahn v. Kohlberg Kravis Roberts & Co., 23 A.3d 831, 837-40 (Del. 2011).
While the appeal was pending, Primedia entered an agreement to be acquired by a third party by merger for approximately $316 million. While considering whether to approve the merger, the Primedia board considered whether the derivative claims had any value and concluded that for the reasons discussed in the SLC report and in light of the dismissal by the Court of Chancery, the claims had limited, if any, value. After the Supreme Court issued its ruling, the Primedia board met to discuss the Supreme Court’s opinion, and determined that it was not in the best interest of the Company to pursue the derivative claims. The merger was completed within a month after the Supreme Court’s decision. The derivative plaintiffs entered a stipulation dismissing their claims on the ground that the merger had deprived them of standing.
However, after the merger was announced but before it was completed, the same plaintiffs filed a putative class action in the Court of Chancery, in which they alleged, among other things, that the merger failed the test of entire fairness because the Primedia board failed to obtain any value for the Brophy claim against the KKR affiliates.
Defendants moved to dismiss. The Court denied the motion, relying primarily on Parnes v. Bally Entertainment Corp., 722 A.2d 1243 (Del. 1999), and In re Massey Energy Co., 2011 WL 2176479 (Del. Ch. May 31, 2011). The Court held that a plaintiff seeking to assert such a “failure to value” claim must first establish its standing to sue, which can be done by satisfying a three-part test. First, the underlying derivative claim either must have survived a motion to dismiss or must otherwise state a claim upon which relief can be granted. Second, the value of that claim must be material in the context of the merger. Finally, the plaintiff must adequately allege facts supporting an inference that the acquiror would not assert the underlying derivative claim and did not provide value for it in the merger price.
With respect to the first prong, the Court held (as it had during the Zapata hearing in the derivative action) that, while there were litigable issues related to laches and the statute of limitations that would need be addressed, the allegations of plaintiffs’ complaint easily stated a claim. The Court had previously dismissed plaintiffs’ Brophy claims at the request of the SLC, but it had done so based on its belief that the value of the Brophy claim was in the low seven-figure range. After the Supreme Court clarified on appeal that full disgorgement was a possible remedy for a fiduciary’s insider trading, the potential value of the plaintiffs’ claim increased substantially, to the point where it may have been material in the context of the merger, thereby satisfying the second element of the standing test. Finally, relying in part on case law suggesting that acquiring parties are typically interested in the value of the business they are acquiring, not derivative claims, the Court held that the complaint adequately alleged that the acquiror was unlikely to assert the derivative claims, and the third prong of the standing test was met.
The Court then moved on to the entire fairness claim, and held that the allegations of the complaint were sufficient to render it reasonably conceivable that the merger conferred a unique and material benefit on the KKR affiliates, the Company’s controlling stockholders, that was not shared with the Company’s minority stockholders. That is, before the merger, the KKR affiliates faced potential liability on the derivative Brophy claim, but all stockholders would benefit proportionately from any recovery. The merger eliminated all stockholders’ potential benefit from a recovery on the derivative claim, but also eliminated the KKR affiliates’ potential liability. Thus, the Court held that the merger had effectively diverted the minority stockholders’ ratable share of the potential derivative recovery (which the Court quantified at $80 million) to the KKR affiliates who controlled Primedia. Because the complaint adequately alleged that the KKR affiliates received a material benefit not shared with other stockholders, the Court determined that the transaction would be subject to entire fairness scrutiny. The Court therefore denied the defendants’ motion to dismiss.