Is There a Right Way to Go Private? Finessing divided legal standards poses a challenge

Delaware courts traditionally have applied differing standards to review the propriety of a going-private deal involving a controlling stockholder. The standards fall into two major categories, each resulting from major cases decided in that state. This has led to a peculiar situation in which different transaction structures with the same functional result – taking a company private – can be challenged by plaintiffs and reviewed by the courts under divergent standards. With going-private deals forecast to increase because of the huge financial resources of private equity funds and the cost pressures on smaller public firms from Sarbanes-Oxley compliance, it’s advisable to analyze the effects of these different standards as well as efforts to harmonize them. Under one standard, unless there is coercion or faulty disclosure, courts have applied the business judgment rule – coupled with traditional common law fiduciary duty concepts – to review tender offers. This line emerged from the In re Siliconix Shareholders Litigation case decided by the Chancery Court in 2001. Under the other standard, the courts, regardless of the procedural safeguards used, traditionally have utilized the more stringent entire fairness standard – requiring fair price and fair dealing – to evaluate negotiated mergers. This standard was enunciated in the 1994 Kahn vs. Lynch Communications Systems Inc. decision. In a 2005 decision, In re Cox Communications Inc. Shareholders Litigation, Vice Chancellor Leo Strine took the opportunity to review the Lynch and Siliconix standards and propose revisions to each in an attempt to harmonize the two strands. His proposal to subject Lynch transactions to the lower business judgment rule if certain procedural safeguards are employed makes sense. But we believe he’s off the mark in proposing that Siliconix transactions be subject to entire fairness unless an independent special committee of the target approves the tender offer. The following discussion explores: * The current going-private landscape; * Delaware’s differing views of negotiated mergers and tender offers in Lynch and Siliconix; and * Strine’s proposed revision of these differing standards of review in Cox Communications Current Going-Private Landscape From January 2000 through December 2005, there were, on average, 80 going-private deals per year. In contrast, there were, on average, 247 completed IPOs per year during the same period. While the number of going-private deals fell from a high of 125 in 2003 to 60 in 2004, they subsequently increased to reach 105 deals in 2005. Conversely, the number of completed IPOs steadily declined from a high of 461 in 2000 to a low of 126 in 2005 (see exhibit on page 42). In short, current market conditions are creating an environment in which the number of companies entering the public market is approaching the number of participants leaving the public stage through going-private transactions. Directors and management of small- and mid-cap public companies continue to cite a similar litany of rationales for going private. These companies have limited analyst coverage and research, which adversely affect both their stock prices and trading volumes. Second, Sarbanes-Oxley continues to impose disproportionately increased compliance costs on smaller companies, e.g., internal compliance expenses, auditing fees, investor disclosure, and public relations costs. Third, directors and officers of public companies continue to be exposed to increased personal liability because of corporate scandals such as those at American International Group Inc., HealthSouth Corp., and Refco Securities. Finally, a continued stock market focus on short-term results restricts management’s ability to enact long-term strategies. These factors persuade management of many public companies to consider going private to reduce their financial and legal risks. Differing Treatment of Deals Various mechanisms are available for public companies to go private, e.g., reverse stock splits, asset dispositions, bankruptcy-related acquisitions, etc. However, negotiated mergers and tender offers remain the predominate structures. While the result of each of these structures is the same, the Delaware courts have applied different standards in reviewing their propriety when a controlling stockholder is key a factor in the deal. Negotiated Mergers In negotiated mergers, a controlling stockholder, management group, or third party will reach an agreement to merge the target into an acquisition subsidiary and pay public stockholders cash for their shares. This format requires board and stockholder approval in accordance with applicable Delaware statutes. In Kahn v. Lynch Communications Systems Inc., the Chancery Court held that “the exclusive standard of judicial review in examining the propriety of an interested cash-out merger by a controlling or dominating shareholder is entire fairness.” The court said: “The concept of fairness has two basic aspects: fair dealing and fair price. The former embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained. The latter aspect of fairness relates to the economic and financial considerations of the proposed merger, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock. However, the test for fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness.” The Lynch court went on to clarify that the controlling stockholder has “[t]he initial burden of establishing entire fairness…However, an approval of the deal by an independent committee of directors or an informed majority of minority shareholders shifts the burden of proof on the issue of fairness from the controlling or dominating shareholder to the challenging shareholder-plaintiff.” It’s important to note that procedural safeguards like approval by an independent committee or an informed majority of the minority stockholders merely shifts the burden of persuasion to the plaintiff to prove that the deal was not entirely fair. Such safeguards do not lower the standard of review to the business judgment rule, which would, in effect, remove the fair price component of the entire fairness test. “All in all, the [Lynch] court was convinced that the powers and influence possessed by controlling stockholders were so formidable and daunting to independent directors and minority stockholders that the protective devices like special committees and majority of minority conditions (even when used in combination with the statutory appraisal remedy) were not trustworthy enough to obviate the need for an entire fairness review,” the Chancery Court noted in a later decision. Tender Offers In a tender offer, a controlling stockholder, management group, or third party will mount a bid to purchase all of a company’s outstanding public shares directly from the shareholders with the goal of obtaining at least 90% of the total. Once that threshold is reached, the acquirer can effect a short-form merger and cash out the remaining stockholders, i.e., those who haven’t tendered. According to the Siliconix decision, Delaware courts should not apply the entire fairness standard to tender offers involving a controlling stockholder unless the offer is coercive or contains disclosure violations. Accordingly, the default standard for such transactions is the business judgment rule, coupled with traditional common law fiduciary duty concepts. While the Siliconix court did not specify the factors for determining whether a tender offer is coercive, Strine in a 2002 ruling on In re Pure Resources Inc. Shareholders Litigation articulated that an tender offer by a controlling stockholder would not be considered coercive only when: * It is subject to a non-waiveable majority of the minority tender condition; * The controlling stockholder promises to consummate a prompt . . . [short-form] merger at the same price if it obtains more than 90% of the shares; and * The controlling stockholder has made no “retributive threats.” It’s interesting to note that in both Siliconix and Pure Resources, the respective courts specifically rejected the idea that the entire fairness test be applied to tender offers. The court in Siliconix noted that “as long as the tender offer is pursued properly, the free choice of the minority shareholders to reject the tender offer provides sufficient protection.” In particular, the court noted that the controlling stockholder is under no obligation to offer any particular price for the minority-held stock. Similarly, Strine acknowledged in Pure Resources that as long as the tender offer is non-coercive and the independent directors of the target are permitted to make an informed recommendation and provide fair disclosure, “the law should be chary about superimposing the full fiduciary requirement of entire fairness on top of the statutory tender offer process.” The court in Siliconix acknowledged that it may seem strange that a tender offer is given less scrutiny than a merger. From the standpoint of the stockholder, there is little substantive difference between a tender offer followed by a back-end merger and a one-step merger. However, Vice Chancellor John W. Noble, who wrote the Siliconix decision, identified two simple concepts for this difference in judicial approach. First, accepting or rejecting a tender offer is a decision to be made by the individual stockholder. Second, in negotiated mergers, the target company evaluates the decision to enter into the merger agreement with the controlling stockholder but does not confront a comparable decision in a tender. The target of the tender offer is the stockholder, not the corporation. From a statutory perspective, the legislature has imposed specific duties on directors of corporations reaching merger agreements, but has chosen not to impose comparable statutory duties on directors in tender offers. Strine is not as sanguine about this discrepancy. Cox Communications Decision The Cox Communications case arose from challenges to the efforts of the Cox family, which owned about 74% of Cox Communications Inc., to take the cable TV giant private during the summer of 2004 in a negotiated merger. The initial claims in the case principally contested the value offered for the public’s shares. However, these claims were settled by the parties and the remaining issue heard by the court was an objection to the award of stipulated attorney fees. In the context of describing why he was slashing the fees awarded to the plaintiffs’ counsel, Strine reviewed “the non-coincidental relationship between the premature filing of cases like this and the [entire fairness] standard of review articulated in…Lynch.” On Aug. 1, 2004, the Cox family presented the Cox Communications board with its intention to offer $32 per share in a merger to acquire all of the public shares. The proposal specifically required the approval of a special committee of independent directors who would respond to and negotiate with the family. Following public announcement of the family’s proposal on August 2, the special committee began negotiating the merger with the family while 13 plaintiffs’ groups filed suit contending that the offer was too low. The decision later described them as “premature, hastily drafted, makeweight complaints” and said they contained other “strained accusations of wrongdoing.” The court added that it’s typical for shareholder plaintiffs to challenge a going-private deal before a controlling stockholder executes a merger agreement with the target company. Accordingly, defense counsel will attempt a two-track settlement effort to resolve both the proposed merger and the plaintiffs’ challenges at the same time. On Oct. 18, 2004, the family and the special committee reached an agreement on the merger with the family agreeing to pay $34.75 per share for the public’s outstanding shares and Cox’s board approved the increased offer the same day. Also on that day, the plaintiffs and the family reached an agreement to settle in exchange for the family’s recognition that “the efforts of the plaintiffs’ counsel in this action were causal factors that led to the family increasing its bid to $34.75, and agreeing that … [the merger be subject to a non-waivable majority of the minority approval condition].” Further, the family agreed not to oppose the plaintiffs’ requests for attorney fees of up to $4,950,000 and that any awarded fees would be paid directly by the family. The resulting decision grew out of a challenge to the stipulated attorney fees by an objecting stockholder. In reducing the award of attorney fees from the agreed amount of $4,950,000 to $1,275,000, Strine outlined how Lynch makes it impossible for a controlling stockholder ever to structure a deal in a manner that will enable it to obtain a dismissal of a complaint challenging a transaction. Thus, each case under the Lynch standard has a settlement value not necessarily because of its merits, but because it cannot be dismissed. Consequences of the Lynch Standard As previously discussed, the underlying proposition of Lynch is that “regardless of the procedural protections employed, a merger with a controlling stockholder would always be subject to the entire fairness standard.” Even if the deal is approved by a special committee of disinterested directors and subject to approval by a majority of the disinterested stockholders, the most that could be achieved would be to shift the burden of persuasion on the issue of fairness from the defendants to the plaintiffs. Strine acknowledged that “Lynch created a strong incentive for the use of special negotiating committees in addressing mergers with controlling stockholders.” “Independent directors have…aggressively undertaken the burdens of acting as a guarantor of the minority’s interest…” by in-depth examination of the underlying economics and the retention of experienced financial and legal advisers, he pointed out. However, the Lynch decision has made the use of a majority of the minority approval condition less prevalent because of the absence of any standard of review on the benefit for using that voting structure. Strine observed that the inclusion of a majority of the minority approval condition in a negotiated merger only minimally reduced the legal risk of plaintiffs’ challenges by simply shifting the initial burden of proof to the plaintiffs. Instead, he noted that the condition created substantial deal risk for the controlling stockholder because of the possibility that the minority stockholders would vote against the deal. Accordingly, a controlling stockholder was likely to accept this provision only at the request of the special committee or to settle a shareholder suit. As a practical matter, the effect of Lynch was to generate the use of special committees alone. However, in Strine’s view, the most problematic feature of Lynch is the incentive system it created for plaintiffs’ lawyers. The entire fairness standard provides incentives to plaintiffs, target companies, and controlling stockholders to settle “non-meritorious, premature suits” that result in the plaintiffs’ attorneys collecting their fees, the target companies avoiding disruptive litigation, and controlling stockholders gaining a greater certainty of closing. Reformation of the Lynch Standard In response to these consequences, Strine proposed in the Cox decision to reform the Lynch standard to enhance protections for minority stockholders and ensure the integrity of the litigation process. He suggested that in a going-private merger with a controlling stockholder, the business judgment rule, rather than the entire fairness standard, should apply if the deal includes both approval by a majority of the disinterested directors and a majority of the disinterested stockholders. In addition, a controlling stockholder or the directors of the target should be able to have the plaintiffs’ complaint dismissed unless: “the plaintiffs plead particularized facts that the special committee was not independent or was not effective because of its own breach of fiduciary duty or wrongdoing by the controller (e.g., fraud on the committee); or the approval of the minority stockholders was tainted by misdisclosure, or actual or structural coercion.” The court concluded that this revision would more closely replicate the elements of an arm’s-length merger by requiring the approval of both the independent directors and the minority stockholders to invoke the business judgment rule. In addition, controlling stockholders would have an incentive to utilize negotiated mergers with the knowledge that potential litigation could be dismissed at the pleadings stage. Impact on the Siliconix Standard Recognizing the “jarring doctrinal inconsistency” between the differing standards utilized to evaluate negotiated mergers and tender offers, Strine completed his analysis with a suggested revision of the Siliconix standard for reviewing tender offers involving controlling stockholders. “In the case of a tender offer by a controlling stockholder, the controlling stockholder could be relieved of the burden of proving entire fairness if: 1) the tender offer was recommended by an independent special committee; 2) the tender offer was structurally non-coercive in the manner articulated by Pure Resources; and 3) there was a disclosure of all the material facts.” Thus, the deal would be immune from challenge unless the plaintiffs pled particularized facts inferring that the special committee’s recommendation was tainted by a breach of fiduciary duty or there was a failure in disclosure. With this proposed strengthening of the standard of review in Siliconix transactions, together with Strine’s proposed alteration of the standard of review for Lynch transactions, there would no longer be a disparity of treatment between tender offers and mergers. In both cases, controlling stockholders would have a strong incentive to afford minority stockholders the dual protections of special committee review and a majority of the minority approval. Strine’s proposal to revise Lynch as it applies to going-private mergers makes sense for all of the reasons he articulates in Cox. But, while his proposed harmonization of the Lynch and Siliconix standards appears elegant at first glance, we believe his suggested revision of the Siliconix /Pure Resources standard of review – applying entire fairness unless a special committee recommends a tender offer – goes too far. As articulated by Noble in Siliconix, and acknowledged by Strine in Pure Resources, a controlling stockholder has no obligation to pay minority stockholders any particular price for their shares. The procedural limitations of non-coercion and adequate disclosure, as articulated in Siliconix and Pure Resources, largely apply the fair dealing prong of the entire fairness test to tender offers. That would include how the deal was timed, initiated, structured, negotiated, and disclosed, and how the approval of the stockholders was obtained. Thus, to impose the further requirement that a special committee of independent directors must recommend a tender offer to avoid the application of the entire fairness test is, in effect, to read a fair price requirement into tender offers. In light of existing procedural protections required to invoke the business judgment rule under Pure Resources, it’s unclear what additional procedural protections an independent special committee would provide. In addition, given that the target company board already is required to issue a recommendation on the tender offer under Rules14e-2 and 14d-9 of the Securities Exchange Act of 1934, it’s unclear how the involvement of a special committee strengthens the disclosure requirements of Siliconix. Thus, the special committee recommendation requirement could not fairly be considered a procedural requirement. At this point, the only facet left for the special committee to pass on is price. Therefore, to require the special committee to recommend the tender offer in order to avoid the application of the entire fairness test is to, in effect, impose the fair price provisions, and thus the entire fairness test, on tender offers. One may argue that this is appropriate. Treat tender offers and mergers the same. This point of view, however, ignores the well-articulated argument in Siliconix as to why tender offers are treated differently from mergers-namely, that the Delaware legislature has determined that directors must recommend a merger to stockholders, but has not required that they make any recommendation with respect to tender offers. In other words, no corporate action is required for a tender offer. And, it’s not appropriate for the courts to impose this requirement because the legislature has specifically determined that the target board need not act in a two-step tender. While Strine’s modification of the Siliconix standard for reviewing tender offers may logically “complete the circle” of his reformation of the Lynch standard for weighing mergers, the practical effect appears to impose a fair-price requirement on tenders. That proposition specifically has been rejected by Delaware courts this far. We believe the safeguards suggested in the Pure Resources ruling provide the correct balance between tender offers and mergers and that Strine’s refinement in the Cox decision goes too far. Christopher Hewitt is an M&A Partner in the Cleveland office of Jones Day and A. Guthrie Paterson is an Associate in the firm’s Los Angeles office. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com