The Delaware Court of Chancery's recent decision, In re Southern Peru Copper Corp. Shareholder Derivative Litigation, C.A. No. 961-CS (Del. Ch. Oct. 14, 2011), provides a number of reminders and considerations for any board or committee that is involved in evaluating or negotiating a potential transaction. Though Southern Peru is an entire fairness case, its lessons are instructive in the context of any material transaction. Our major take-aways from the opinion are set forth below, followed by a brief summary.

Our Take-Aways

  1. If a special committee is formed, it should be broadly authorized to reject any proposal and consider alternatives to the proposed transaction and to negotiate all of the terms of the deal, as opposed to merely "evaluating" the proposed transaction. Chancellor Strine found that the Southern Peru special committee's mandate was too narrowly drawn, leading the special committee to presume that they were not free to consider alternatives to the proposed transaction. See Opinion at 63-65, 68-70.
  2. Special committee members should be able to properly represent the long-term interests of typical, unaffiliated shareholders. While Chancellor Strine did not find that the Southern Peru special committee members were interested in the transaction, he did find that one of the members had differing motivations due to the fact that he represented a founding shareholder that was seeking the sort of short-term liquidity that the proposal would provide. See Opinion at 65-67.
  3. In the case of transactions with controlling shareholders or other interested parties, the special committee's mandate is to vigorously represent the interests of the unaffiliated stakeholders. In various places, Chancellor Strine made findings reflecting that he did not believe this special committee understood its role to get the best possible deal for Southern Peru's shareholders or to reject the transaction. In one particularly pointed part of the opinion, Chancellor Strine found it odd that a special committee member was "comforted" by certain financial information that favored the proposal. See Opinion at 19-21.
  4. In analyzing a proposed transaction, directors and financial advisors should rely on robust assumptions that have defensible bases. Assumptions should not be selected in order to substantiate the fairness of the proposed transaction. Extreme caution should be taken before relying on any assumptions that are different than the assumptions used by the business in the ordinary course. Chancellor Strine found that the Southern Peru committee's financial analysis was unreliable in several respects, including that it (1) valued Southern Peru below the value derived from its publicly-traded share price and (2) used projected copper prices for valuing the target that were higher than those used in its ordinary course projections. See Opinion at 79-85.
  5. In analyzing the transaction, directors and financial advisors should use financial valuations that are favorable to their constituents to negotiate for the best price. The Southern Peru committee's financial advisor performed initial analysis indicating that Southern Peru was substantially overpaying for its acquisition target. Chancellor Strine found that the committee and its advisor retooled their analysis to make the transaction seem more acceptable, rather than using this initial analysis to bargain for a lower acquisition price. See Opinion at 70-79.
  6. If there is a lapse of time between the date the proposed transaction is initially approved and the date of the shareholder vote or closing, directors should evaluate (with the help of their advisors) whether there has been a change in economic conditions or financial data between that time. If there has been a material change, directors should consider whether such changes necessitate an updated fairness analysis and opinion. Chancellor Strine found that the Southern Peru directors had failed to re-examine the transaction after it was approved, despite the fact that rising copper prices led to significant industry changes and that the company's actual performance was differing substantially from the projected performance statistics employed in the valuation process. See Opinion at 88-93.
  7. Although Chancellor Strine was quite harsh on the special committee's conduct, it is notable that he granted summary judgment for the special committee under Southern Peru's "bad faith" exculpatory provision. Given the degree to which Chancellor Strine second-guessed the special committee's analysis and process, this holding may be important for LLCs, LPs, and other contractually-governed entities that have contractually replaced fiduciary duties with good faith standards. See Opinion at 43.
  8. The damage award is one of the largest damage awards ever entered in a breach of fiduciary case in Delaware, if not the largest. While this may embolden plaintiffs in the future, it is our view that the award was the product of unfortunate facts and testimony and the application of the highest standard under Delaware law.

Background of the Transaction

Grupo México, S.A.B. de C.V. owned 54 percent of the NYSE-listed mining company, Southern Peru Copper Corporation, and 99 percent of a privately-held Mexican mining company, Minera México, S.A. de C.V. In 2004, Grupo proposed that Southern Peru purchase its 99 percent interest in Minera for $3.1 billion in Southern Peru shares.

Because its controlling shareholder had an economic stake in both sides of the proposed transaction, Southern Peru formed a Special Committee of disinterested directors to evaluate the transaction. The Special Committee members were esteemed and well-educated businesspeople and attorneys, and although two of the members had been nominated to the Board of Directors by Grupo, Plaintiff did not contest their independence. The Special Committee also hired a team of advisors, including a law firm, an investment banking firm, and a mining consultant.

The Special Committee's financial advisor performed numerous analyses to determine the equity value of the privately held Minera, including a discounted cash-flow analysis, a contribution analysis, and a look-through analysis. However, only by employing "its most aggressive assumptions" could the financial advisor calculate a $3.05 billion value for Minera. By contrast, its "mid-range" assumptions calculated Minera's value at $1.7 billion, and other valuation techniques resulted in estimated values as low as $227 million. Thus, using reasonable valuation metrics in its "give-get" analysis, the transaction required Southern Peru to "give" Grupo $3.1 billion in stock in order to "get" a company worth $1.7 billion.

However, rather than advising Southern Peru not to pursue the transaction, the financial advisor engaged in analysis to devalue the "give" portion of the "give-get" analysis. Although the market value of Southern Peru stock could be easily determined by reference to its NYSE share price, the Special Committee's financial advisor instead calculated the value of this stock using various valuation techniques. Based on its "mid-range" assumptions, the financial advisor calculated that $3.1 billion in Southern Peru stock was actually worth only $2.06 billion. Rather than question this analysis or investigate why their stock was apparently so overvalued by the market, the Special Committee found "comfort" in this analysis because it substantiated the fairness of the transaction.

After engaging in this analysis, the Special Committee made a counterproposal to Grupo, offering to acquire Minera for 52 million shares of Southern Peru stock, worth $2.1 billion at the time of the counteroffer. However, the Special Committee's counteroffer was based on a fixed number of shares, rather than a fixed aggregate price. Grupo and the Special Committee exchanged a number of counteroffers in terms of a fixed number of shares. The parties ultimately reached a deal at 67 million shares, which had a market value of $3.56 billion when the deal was reached. The parties also agreed that two-thirds of shareholders would need to approve the transaction.

However, this two-thirds requirement was easily satisfied due to another deal negotiated by Grupo and Harold Handelsman, a member of the Special Committee. Handelsman needed Grupo's approval to acquire registration rights for the Southern Peru shares held by Cerro Trading Co., Inc., a company represented by Handelsman that owned 14 percent of Southern Peru's stock. Thus, on the same day that the Special Committee approved the Minera transaction, Grupo granted Cerro registration rights for its Southern Peru units in exchange for Cerro's pledge to vote in favor of the Minera transaction. Because Grupo and Cerro together owned more than two-thirds of Southern Peru's stock, the Minera transaction vote became a foregone conclusion. Grupo entered into a similar deal with Phelps Dodge, another large Southern Peru shareholder.

The Minera transaction was approved and, by the time it closed, Southern Peru's stock price had risen 21.7 percent, thanks to rising copper prices. Because the transaction was based on a fixed number of shares, Southern Peru paid — in cash value — 21.7 percent more for Minera than it had agreed to pay. The Special Committee did not ask its financial advisor to update its fairness analysis to account for the rising price of Southern Peru stock.

The Chancery Court's Analysis

The parties agreed that the entire fairness standard applied to the court's review of the transaction: "where . . . a controlling stockholder stands on both sides of a transaction, the [self-]interested defendants are required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain." The court explained that entire fairness involves two aspects — fair process and fair price — but "what ultimately matters most is that the price was a fair one."

The burden of persuasion usually rests with defendants under entire fairness review, but a defendant may shift the burden to a plaintiff by establishing that the transaction was approved by a majority of independent directors, a special committee of independent directors, or (in some circumstances) an "informed vote of a majority of the minority shareholders." However, in order to receive this burden shift, the special committee must have been "well functioning" and "effective," an analysis the court criticized for "overlap[ping]" with the underlying analysis of the fairness of the transaction. Because the Southern Peru Special Committee was not "well functioning," the self-interested defendants did not receive the marginal benefit of a burden shift. Nor did the burden shift because of the vote, since it was pre-determined by the Grupo's ancillary dealings and not "well-informed" due to omissions in the proxy statement. In particular, the proxy "obscured" and "did not disclose" details regarding the financial advisor's computations and initial determinations that Minera was worth far less than the price paid. Grupo also participated in road shows "with information that made the total mix of information available to stockholders materially misleading."

The court began its entire fairness analysis by criticizing Southern Peru for limiting its authorization of its Special Committee to "evaluating" the transaction. Although the Special Committee did negotiate against Grupo, the paradigm set by Southern Peru caused the Special Committee to "accept[] that only one type of transaction was on the table, a purchase of Minera by Southern Peru." The court explained that "the Special Committee was trapped in the controlled mindset, where the only options to be considered are those proposed by the controlling stockholder." Further, such a mindset prevented the Special Committee from asking Grupo, "If Minera is so attractive, why are you seeking to reduce your ownership interest in it?" Given that Minera was in economic distress at the time of its sale, this was a critical inquiry that the Special Committee failed to perform.

In this "altered state of a controlled mindset," the Special Committee "blithely" discarded the initial valuations performed by its financial advisor and instead adopted valuations that questionably downplayed the market value of Southern Peru stock. The financial advisor "helped its client rationalize the one strategic option available within the controlled mindset that pervaded the Special Committee's process."

The court next criticized the selection of Handelsman for the Special Committee. Although the court found no evidence that Handelsman acted in bad faith, it found the that Handelsman was "not ideal" because he had an unusual incentive to consummate a transaction and — given that he was angling to liquidate Cerro's shares — was less concerned with the long-term health of Southern Peru.

The court also criticized the Special Committee's decision to change the negotiations to a fixed number of shares, especially given that it and its financial advisor "believed that copper prices were going steeply higher." Although the Special Committee attempted to prove its negotiating prowess by pointing to other negotiation victories, the court was less than impressed. For instance, the court pointed out that the Special Committee unsuccessfully attempted to get a "majority of minority" vote to approve the deal, instead settling for the two-thirds majority, which Grupo was able to easily seal with its Cerro and Phelps Dodge deals.

Finally, in light of changing market conditions and updated EBITDA information following the approval of the transaction, the court criticized the Special Committee's failure to update its analysis prior to closing the deal.

Based on the foregoing criticisms, the court held that the transaction did not satisfy entire fairness scrutiny. Taking advantage of its "broad discretion to fashion equitable and monetary relief under the entire fairness standard," the court calculated damages as the difference between the "entirely fair" price and the price that Southern Peru ultimately paid for Minera. Using "defendant-friendly assumptions," the court employed various valuation techniques and calculated the value of Minera as $2.4 billion as of the transaction date. The court subtracted this amount from the value of the shares Southern Peru paid to acquire Minera to arrive at a damage calculation of $1.263 billion and ordered Grupo to return sufficient shares of stock to Southern Peru to satisfy this damages award.

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