Procedure Matters: Protecting Minority Stockholders in Conflict Transactions
June 22, 2010
This article discusses the recent Delaware case, In re John Q. Hammons Hotels Inc. Stockholder Litigation, which provides guidance as to what procedural protections are required in order to help avoid entire fairness review in certain conflict situations in which the majority stockholder is on both sides of the transaction.
Courts generally evaluate corporate actions using the business judgment rule, under which the court will give deference to those actions that can be attributed to a rational business purpose. However, if the board of directors or the majority stockholder has an interest in the transaction in which they would receive material benefits to the exclusion or detriment of the minority stockholders, then their actions are subject to court review under the more exacting “entire fairness” test. The concept of entire fairness includes an evaluation of fair dealing and fair price based on all aspects of the transaction, and the defendants must prove that the transaction was objectively or intrinsically fair to the minority stockholders.
For example, if the majority stockholder is on both sides of the transaction, such as a “squeeze-out” merger, then the burden will be on the majority stockholder to prove the entire fairness of the transaction. The majority stockholder may shift this burden back to the plaintiffs if it proves that there was a special independent committee of directors and if a majority of the minority stockholders approved the transaction. If the defendant can show that adequate procedures were in place to protect the interests of the minority stockholders, then the more deferential business judgment standard of review may apply. However, as the Hammons case demonstrates, a transaction may be subject to entire fairness review at the threshold if the procedural protections for the minority stockholders are inadequate or insufficient.
In The Hammons case, the majority stockholder negotiated a merger transaction with an unrelated third party acquirer in which the majority stockholder received certain benefits to the exclusion of the minority stockholders, including a continuing equity interest in the surviving entity and a line of credit. Since the majority stockholder’s interest in the proposed transaction was not identical to those of the minority stockholders, the corporation’s board of directors formed a special committee to negotiate the transaction on behalf of the minority owners. The special committee retained its own legal counsel and financial advisor.
A deal was reached with the third party seeking to acquire the corporation after significant negotiations and multiple offers. The merger agreement included a requirement that a majority of the unaffiliated stockholders approve the transaction, unless the special committee waived that requirement. The corporation sent a proxy statement to its stockholders, and the transaction was approved by a majority of the minority stockholders who voted on the matter.
Several of the minority stockholders filed suit and brought breach of fiduciary duty claims against the majority stockholder and the board of directors. The plaintiffs claimed that the majority stockholder breached his fiduciary duty by negotiating benefits for himself that were not extended to the minority stockholders, and that the directors breached their duties because they allowed the transaction to be negotiated through a deficient process and because they approved the transaction.
The court in Hammons denied motions for summary judgment, holding that the entire fairness standard of review, not the business judgment standard, applied. The court ruled that the vote of the minority stockholders was insufficient for two reasons:
The special committee could waive the condition requiring the vote of the minority stockholders.
The vote only required a vote of a majority of the minority stockholders voting on the transaction, rather than a majority of all minority stockholders.
According to the court, a vote of a majority of the minority stockholders serves as a check on the special committee and provides the minority stockholders with the opportunity to disapprove of the special committee’s work and stop a transaction they believe is not in their best interests.
The court stated that in order for the directors and the majority stockholder to receive the benefit of the business judgment rule (and in addition to having a disinterested special committee), the majority of the minority vote requirement must be a non-waivable condition to closing the transaction. Such a condition should increase the likelihood that the parties negotiating the deal will ensure it is fair to the minority shareholders, which in turn, should mitigate the chances of the minority stockholders blocking the transaction. The court also stated that the majority of the minority condition also ensures that the minority shareholders realize the importance of their vote and its impact on the proposed transaction.
An important lesson from Hammons is that, in order to avoid entire fairness review in a merger or sale transaction where the majority stockholder may receive different or greater consideration than the minority stockholders, the transaction must be:
Recommended by a disinterested and independent special committee, and
Approved by stockholders in a non-waivable vote of the majority of all the minority stockholders.
By ensuring that these procedures are followed, and assuming full and proper disclosures were made to the minority stockholders, directors and the majority stockholder are more likely to receive the benefit of the deferential business judgment standard of review if the transaction is ever challenged in court.