Delaware Court Sends a Message To Controlling Shareholders: Ruling in the Digex Case Warns About Treatment Of Minority Owners in Takeover Offers

Companies with publicly traded subsidiaries or hefty investments in other public firms have received a judicially delivered wake-up call on how to treat minority shareholders in fielding takeover offers. A recent decision by the Delaware Court of Chancery, say m&a attorneys, carries the implied warning that corporations have their legal house in order before selling IPOs of subsidiaries or taking substantial interests in other firms. The ruling was handed down last December in a complex deal involving the acquisition of Intermedia Communications Inc. by WorldCom Inc. The case reached the court because minority shareholders of Intermedia’s subsidiary, Digex Inc., were miffed that the highly successful web hosting and applications firm is to remain a publicly traded company. According to the complaint, WorldCom, by acquiring financially troubled Intermedia, actually was getting control of Digex on the cheap and denying minority shareholders a chance to sell for a heavy premium. The decision did not disturb the controlling shareholder’s authority to bypass an auction in selling a sub. But based on the somewhat unique issues in the case, m&a attorneys say there are two key messages from the ruling: *It’s a good idea to have the carved-out or affiliated company opt out of coverage of state “freeze-out” laws early, or well in advance of any takeover situation; and *If a special committee of directors is set up to represent minority shareholders, it should not be ignored or treated rudely. Terry Bridges of the Atlanta-based law firm of Troutman Sanders called the freeze-out statutes, the best known of which is Section 203 of the Delaware takeover law, a “trap for the unwary” if the controlled or affiliated companies don’t waive them. “Appointing a special committee is like letting the genie out of the bottle,” says William Lawlor of Dechert in Philadelphia. “Make sure that the result is something you can live with.” Digex holdersget some stock Although the decision by Chancellor William B. Chandler III did not stop the WorldCom/Intermedia merger as sought by the dissident stockholders, his opinion, covering more than 90 pages, was closely interpreted by the m&a bar as a warning flair of what might happen in future cases. In particular, Chandler was highly critical of how the Digex board, at WorldCom’s request, was compelled to waive the applicability of Section 203 as part of the merger. He suggested that the plaintiffs had a good chance of winning on this issue if the case went to trial. Ultimately, the trial was headed off when the three companies and the dissidents reached a settlement agreement in February. In what lawyers believe is the first arrangement of its type, the terms called for a small amount of WorldCom stock to be paid to Digex stockholders, although Digex would remain a public company. Under Section 203, an acquirer is barred from completely absorbing a target company incorporated in Delaware for a three-year period unless the deal is approved by the target’s board, i.e., a friendly deal, or the purchaser obtains at least an 85% interest. Similar statutes exist in many other states, although the threshold varies. However, Delaware and most other states allow their companies to waive applicability of the statute, which, the attorneys say, often is done by controlled or affiliated concerns. Digex was a notable exception, but the lawyers suggest that there might be others that should review their bylaws and make necessary changes. Digex was taken public in 1999 by Intermedia, which retains a 52% equity interest and 94% voting control. Chandler’s ruling was the second major Delaware decision in two years on takeover action involving publicly traded subsidiaries. Together, they affirm that a dominant shareholder calls all the shots in offering a controlled sub in the m&a market. In a 1999 ruling, Chancellor Myron T. Steele (later elevated to the Delaware Supreme Court) dismissed a shareholder suit challenging as too low the $57.75-a-share price paid by Lyondell Chemical Co. for ARCO Chemical Co., which was 82% owned by Atlantic Richfield Co. Steele rejected the plaintiffs’ assertion that Atlantic Richfield was required to hold an auction for ARCO Chemical. He said that an auction was required only if an acquisition resulted in a change of control, and the sale of a company with a dominant shareholder did not represent a change of control in the legal sense. Cutting down the wiggle room Chandler came to a similar conclusion on the special status of a controlling shareholder in the Digex case by rejecting the plaintiffs’ assertion that they were denied the ability to sell their shares at a premium. But he was far less tolerant of how the defendants handled the other issues – in particular, the waiver of Section 203. As a result of the waiver, WorldCom gained maximum flexibility in its relationship with Digex. WorldCom may subsequently acquire full control, or it may not. Chandler referred to this as a “belt and suspenders” approach. In the process, the chancellor said, Digex shareholders surrendered “bargaining leverage.” He went to rake the defendants for cavalier treatment of the special committee, composed of two independent Digex directors. The judge noted that they opposed the waiver, which was approved by the votes of four “interested” Digex directors who also serve on the Intermedia board, and that the special committee also questioned how WorldCom shifted its acquisition focus during negotiations from Digex to WorldCom. Under the settlement, WorldCom will divert $165 million worth of stock from the total price – valued initially at $6 billion in shares and assumption of liabilities – to Digex shareholders. The agreement also affirms the waiver of Section 203 and sets up business relationships between WorldCom and Digex. Equity carve-outs like Digex are the most visible formats for owning publicly traded subsidiaries. But as corporate structures grow more complex and layered, there are other mechanisms. One is when a restructuring company sells a business to another public company for stock of the buyer. Another is when a well-heeled large company invests in a smaller, younger concern to finance its development and the investee later goes public. Bridges says that the parties in divestiture and investment situations often sign standstill agreements that may limit the ability of the corporate shareholder to increase its investment, mount an acquisition offer, or sell its holdings before giving the investee right of first refusal. He advises that waivers of Section 203 and other freeze-out provisions should be part of the standstill agreements.