Delaware Court of Chancery Applies Business Judgment Rule

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday August 23, 2013 at 9:30 am
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Editor’s Note: The following post comes to us from Alan Stone, partner in the Litigation & Arbitration Group at Milbank, Tweed, Hadley & McCloy LLP, and is based on a Milbank client alert by Mr. Stone & David Schwartz. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

In Southeastern Pennsylvania Transportation Authority v. Ernst Volgenau, et al [1] (the “SRA” decision), Vice Chancellor Noble continued a recent trend in Delaware case law involving acquisitions of companies with a controlling stockholder—if robust procedural protections are properly used (such as the recommendation of an empowered, disinterested special committee and the transaction is conditioned on a non-waivable vote of the majority of all minority target stockholders), the standard of judicial review applicable to such a transaction will be the deferential business judgment rule. Accordingly, when a target company is acquired by a third party unaffiliated with the target’s controlling stockholder, the target company can avoid “judicial review under the entire fairness standard and, perhaps in most instances, the burdens of trial.”

Only a few weeks ago, in a precedent setting decision, Chancellor Strine held that the standard of judicial review applicable to going private mergers with controlling stockholders (i.e., transactions in which the buyer is affiliated with or is the controlling stockholder) should also be the deferential business judgment rule if certain similar robust procedural protections were properly employed. [2]

Despite the obvious incentives resulting from these recent cases involving target companies with controlling stockholders, we believe that it still remains unclear how frequently both of these robust procedural protections will be both employed by target company boards given the risks associated with a majority-of-the-minority approval. For example, some target companies may still choose to simply implement only an independent, empowered special committee as its procedural protection, taking sufficient comfort in the fact that such action should shift the burden of proof under the entire fairness standard from the defendant to the plaintiff.

Background

SRA International, Inc., a “leading provider of technology solutions and professional services, primarily to the federal government”, agreed to be acquired by Providence Equity Partners LLC. As part of the transaction, in exchange for his Class B common stock, “the controlling stockholder received a minority interest in the merged entity, a non-recourse note…and…$31.25 per share in cash”, while minority stockholders received $31.25 per share in cash in exchange for their Class A common stock.

A special committee of the board of directors of SRA was constituted to negotiate the Providence transaction and the committee was empowered to engage its owns advisors as well as to evaluate, review and consider any other potential third-party interests. Before agreeing to a deal with Providence, the special committee conducted a pre- signing market check during which strategic and financial buyers were contacted, which process culminated in a multi-round bidding contest between Providence and another entity, with Providence eventually prevailing with its “best and final offer” of $31.25 (a 52.8% premium to the “unaffected share price”). The Providence merger agreement (i) contained a go-shop provision, pursuant to which the financial advisor to the special committee contacted approximately 50 potential buyers and (ii) was conditioned on a non-waivable condition of the vote of a majority of all minority target stockholders, which condition was satisfied when 81.3% of SRA’s minority stockholders voted to approve the Providence transaction.

Despite these procedural safeguards, the defendants alleged, among other things, that the controlling stockholder engaged in self-dealing because he was allegedly on “both sides” of the transactions and that the SRA directors breached their fiduciary duties in approving the Providence merger by conducting an inadequate sale process.

The Court’s Analysis

The Court noted that the crux of this decision was whether the “robust procedural protections” that were used entitled the merger to be reviewed under the “deferential business judgment rule instead of the exacting entire fairness standard.”

In short, because the Court determined that Providence was a third party buyer unaffiliated with SRA’s controlling stockholder, the Court, citing the Hammons [3] decision, held that a “transaction involving a third party and a company with a controller stockholder is entitled to review under the business judgment rule if the transaction is…(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 differentiated this decision from the recent MFW case because, in this instance, Providence was deemed to be unaffiliated with SRA’s controlling stockholder, whereas in the MFW decision, the buyer was the controlling stockholder.

Because of the various procedural protections noted above, the Court determined that the applicable standard of review would be the business judgment rule. The Court noted that because there was no dispute of material fact that (i) the “merger-related decisions of the directors” of SRA were “attributable to a rational business purpose and that the buyer was an arms’ length bidder,” as the controlling stockholder was determined to not “stand on both sides of the merger”, (ii) the SRA special committee was disinterested and independent and (iii) the controlling stockholder and the minority stockholders received “equal” consideration in the merger, the Court granted all of the defendants’ motions for summary judgment on all claims.

Conclusion

While not precedent setting like the recent MFW decision, the SRA decision continues the recent rulings by Delaware courts relating to the acquisitions of target companies with controlling stockholders. Deal makers now know with certainty that, regardless of whether a buyer is or is not affiliated with the target’s controlling stockholder, if both procedural protections are used (i.e., a special committee and majority-of-the-minority vote), a Court will apply the deferential business judgment rule.

Again, it remains unclear how frequently this approach may be employed by target companies given the risks associated with a majority-of-the-minority approval. Moreover, as previously noted in the MFW decision, these decisions should not be read as overturning existing, “inconsistent” precedent that suggests that a controlling stockholder does not owe “the same equitable obligations when it seeks to acquire the rest of a corporation’s equity by a tender offer, rather than by a statutory merger.” A controlling stockholder could, therefore, still determine to structure its transaction as a tender offer rather than follow the approach set forth in the these decisions.

Endnotes:

[1] C.A. No. 6354-VCN (August 5, 2013).
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[2] See In re MFW Shareholders Litigation, 67 A.3d 496 (Del. Ch. 2013), as well as our prior Client Alert entitled, “Deferential Business Judgment Rule Can Apply to Going Private Transactions with Controlling Stockholders”, dated June 3, 2013.
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[3] See In re John Q. Hammons Hotels Inc. Shareholder Litigation, 2009 WL 3165613 (Del. Ch. Oct. 2, 2009).
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