Picture this: your company is about to enter into a transaction, but the controlling stockholder stands on one side of what you—the board—are required to approve, either because they are literally standing on the other side of the chess board or simply because they are getting a little extra something that others—that is, your minority shareholders—are not getting. As a board member, this could be a legal minefield if you are not careful.
Delaware courts have handed down some lessons—some hard, some helpful—and you probably have received lots of memos and briefs from your lawyers on these topics, but with all on your plate, who has time to read and digest, and most importantly remember, all that, right? putting myself in your shoes, I therefore prepared a handy-daddy cheat sheet that just highlights what you need to remember to ask about in these high-stakes situations so you don’t end up breaking a sweat (or the law). Caution: This is not legal advice and is simply meant as a starting point. So, let’s dig in:
- The Minefield—Do a Little Digging
Remember two things: Firstly, a controlling stockholder is not simply someone that holds more than 50%. It is now established law that someone who can direct the big decisions of the Company is also considered a controlling stockholder even if their ownership is less than 50%. The conflict situations in question are not just your controlling stockholder buying out the company or quite literally standing there as the opposite party to your transaction.1 Secondly, the conflict situations are not limited to scenarios where your controlling stockholder is literally on the other side; it also applies when that stockholder is getting something others are not getting.2
Now what? Once you have determined that the transaction is in fact a controlling stockholder transaction, make sure it meets “entire fairness” standards. That means that you the board must be ready to show to the court that both the procedure you followed in negotiating and finalizing the transaction and the price were fair to the company. This means you actually will go through a trial and will need to present iron-clad evidence to a judge to convince him/her that you met these prongs. So, naturally, you ask: Is there a way to avoid litigation? The answer is yes!
- Your Board’s Secret Weapon—Only If you do it right
Story Time: In re MFW Shareholders Litigation
Think of MFW like a masterclass in getting it right. The controlling stockholder, MacAndrews & Forbes, wanted to buy out minority shareholders. The board, knowing the stakes, formed a special committee of independent directors to negotiate the deal. Not only that, but they also made sure the deal wouldn’t fly unless a majority of the minority shareholders gave it a thumbs-up.
What They Did Right: By setting up a truly independent committee and requiring minority approval, the board earned the court’s trust. Instead of facing the dreaded “entire fairness” standard (which is like trying to prove your innocence with both hands tied), they got the more relaxed business judgment rule.
- Special Committee—Not a show but a real negotiating power
Remember three things regarding your special committee:
- Firstly,what makes it special is its independence, true independence. Remember when Elon Musk got that jaw-dropping $55 billion pay package? Well, Tesla’s board probably wishes they handled that differently. In Tornetta v. Musk, the court took a magnifying glass to the board’s so-called independence. Turns out, several directors had cozy ties with Elon—think yacht clubs, fishing together every Sunday and pretty much buying your house because someone, i.e., your controlling stockholder, gave you most of your business on other deals.
- Secondly, make sure all the members are independent, i.e., free from any personal or financial ties to the controlling stockholder. Remember that even one conflicted director can unravel the whole deal. In re Match Group, Inc. Derivative Litigation, where the controlling stockholder was getting benefits that other stockholders were not, only one of the directors on the special committee was found not to be independent and that alone deprived the board from the benefits of going through the trouble of installing a special committee.
- Thirdly, your special committee must have toothand can’t just act at the pleasure of the controlling stockholder. In Firefighters’ Pension System of City of Kansas City v. Foundation Building Materials, Inc., the court held that the special committee was formed too late, only acted “when prompted” by the controlling stockholder and was otherwise quite dormant.
In short, make sure your special committee is an independent negotiating agent—pick directors with zero ties to the controlling stockholder. Form the special committee early on and give them full power to pick independent advisors, negotiate transaction and have the power to say no.
- Approval Of Minority Stockholders—Informed and Uncoerced
Remember three things here:
- Firstly,you must condition the approval of the transaction on this approval from the start before a price is negotiated (note the same principal applies for the approval of the special committee). Remember, you can’t go back and fix a broken process. Don’t be Elon.3
- Secondly, make sure your minority stockholders are fully informed. That means disclose, disclose, disclose. If the controlling stockholder is getting something other stockholders are not getting, disclose it. If the banker or lawyer that told your special committee that this transaction is a good idea or fair to the stockholders is otherwise cozy with the stockholder and have meaningful dollars coming to them because of the stockholder (not just on this deal but generally), disclose it.4Make sure your disclosure is clear and concise. Do not play cute.5
- Thirdly,make sure your minority stockholders are uncoerced. Don’t create a situation or structure that corners your minority stockholders into saying yes. You may be deemed to have created a situational coercion if you create such a terrible situation for the company that the stockholders do not really have any other option but to say yes.6 Also be careful that your structure is not deemed coercive, by asking that your minority stockholder votes for this, that and the other all together as a bundle; therefore, depriving them from a meaningful choice to say yes to one thing and no to the other.7
In short, be diligent, do your homework and disclose honestly. Remember that you get the benefit of “business judgment rule”—which means your actions will not go through judicial colonoscopy, even if your control stockholder does not act nice in the sandbox.8
2 In re Tesla Motors, Inc. Stockholder Litigation, the court applied the entire fairness standard to Tesla’s acquisition of SolarCity, even though Elon Musk wasn’t technically on the opposite side of the transaction. In Voigt v. Metcalf, the court held that entire fairness applied to a merger between two companies controlled by the same private equity firm because the firm’s control over both companies presented inherent conflicts, and the merger process wasn’t sufficiently independent. In re Ezcorp Inc. Consulting Agreement Derivative Litigation, the court applied entire fairness to a series of consulting agreements between EZCORP and its controlling stockholder’s affiliates, even though the controlling stockholder was not the direct recipient of the payments. In Firefighters’ Pension System of City of Kansas City v. Foundation Building Materials, Inc., which concerned the sale of a company by a private equity sponsor the court held that the early termination payment to the sponsor under a tax receivable agreement between it and the company provided the controlling stockholder (i.e., the private equity firm) a non-ratable benefit and was therefore subject to high scrutiny standards.
3After the court rejected Musk’s $55 billion compensation, he and Tesla tried to fix this hiccup by creating a new “independent committee” and soliciting a vote from the fully informed and uncoerced minority. Even if the company’s stockholders overwhelmingly approved the previously rescinded grant to Musk, the court denied Tesla’s motion to revise the previously nullified compensation package for a variety of reasons including that a conflicted controller transaction can only benefit from the MFW safe harbor if all is done before the process begins.
4 In re Match Group, Inc. Derivative Litigation, the court held the MFW safe harbor didn’t apply because the proxy statement did not fully inform stockholders of potential conflicts of interest relating to the special committees’ advisors. Similarly, in City of Dearborn Police & Fire Revised Retirement System v. Brookfield Asset Management Inc. (“Brookfield”), the court held that the disclosures were insufficient because the proxy statement did not disclose that one of the special committee’s bankers had worked on a transaction for the controller and that its affiliates collectively held substantial investments in entities affiliated with the controller. In City of Sarasota Firefighters’ Pension Fund v. Inovalon Holdings, Inc. (“Inovalon”), the court found that found that the amount of fees that were received by the special committee’s other financial advisor from the buyer in prior transactions should have been disclosed.
5 In Brookfield, the court found that the use of the word “may”—as in, we may have investments or may benefit from this deal—was misleading given that the banker and its affiliates had already invested hundreds of millions of dollars in the controlling stockholder. Similarly, in Inovalon, the court found that the use of the word “may” where the financial advisor was concurrently providing advisory services to one of the consortium members and receiving meaningful compensation for that was misleading and that the words “customary compensation” did not permit stockholders to compare the amount of fees received in the current transaction against those other prior transactions.
6 In re Saba Software, Inc. Stockholder Litigation, where the company faced a delisting from NASDAQ due to delayed reinstatement of financial statements, the transaction negotiated by the board and presented to the stockholders as the only viable option to avoid delisting was deemed to corner the stockholders between the rock and the hard place. They really did not have any other alternative.
7 In Sciabacucchi v. Liberty Broadband Corp., the deal had four components two of which were good for everyone and the other two were only good for the controller. All the four were cross-conditioned, which meant that the board used the value of the two good transactions for the minority stockholders as a carrot to hit them with the stick of the other two, which were just good for the controller.
8 In Smart Local Unions & Councils Pension Fund v. BridgeBio Pharma, Inc., the court rejected the plaintiff’s argument that the special committee did not meet its duty of care because it did not pursue more forcefully a transaction with a third party who had offered a higher price than the controller. Here, the controller did not want to sell to a third party or engage with the third party, but the special committee did engage in good faith with the third party and even encouraged the controller and the third party to negotiate.