In the recent post-trial decision, In re Southern Peru Copper Corporation Shareholder Derivative Litigation, Chancellor Strine of the Delaware Court of Chancery awarded damages in a derivative action after finding that the process by which a transaction with a controlling stockholder was negotiated and approved was not fair and did not result in the payment of a fair price, as a result of which the defendants had breached their fiduciary duty of loyalty.

Background

In February 2004, Grupo México, S.A.B. de C.V. ("Grupo Mexico"), the majority stockholder of Southern Peru Copper Corporation, a NYSE-listed mining company ("Southern Peru"), proposed that Southern Peru purchase its 99.15% stake in Minera México, S.A. de C.V. ("Minera"), a privately held Mexican mining company, in exchange for approximately $3.1 billion of shares of Southern Peru. At the time, Grupo Mexico owned 54.17% of the outstanding stock of Southern Peru and held 63.08% of its outstanding voting power. Two other large stockholders each held approximately 14% of Southern Peru's outstanding common stock.

In response to the Grupo Mexico proposal, Southern Peru created a special committee of four directors (the "Special Committee") to "evaluate" the proposed acquisition. The Special Committee retained legal counsel and a financial advisor that are well-known and reputable as well as a mining consultant. The financial advisor's initial analyses of the controlling stockholder's proposal focused on the "give" (the $3.1 billion price proposed by Grupo Mexico) and the "get" (Minera, which, based on the financial advisor's DCF, contribution and sum-of-the parts analyses, was valued on a standalone basis at no more than $1.7 billion). In later analyses, the Special Committee and its financial advisor selectively revised assumptions underlying the financial analyses of Minera and shifted the focus to the "relative value" of the two companies rather than Minera's standalone value, which had the effect of narrowing, but not eliminating, the valuation gap.

During the process, the Special Committee attempted to negotiate a lower purchase price of approximately $2.1 billion (a fact that was not disclosed to stockholders), and also asked Grupo Mexico for a collar on the number of shares to be issued in the transaction. It also proposed that the transaction be subject to the approval of the majority of the minority stockholders. The Special Committee won minor concessions from Grupo Mexico in negotiations, but agreed to drop the requests for the collar and the majority-of-the-minority condition. The Special Committee also became comfortable with a higher price based on the relative valuation of the two companies and approved the acquisition of Grupo Mexico's stake in Minera using a fixed exchange ratio that valued the transaction at approximately $3.146 billion using the market price of Southern Peru's stock. By the closing date, more than five months after the Special Committee's approval, Southern Peru's stock had increased 21.7% and the shares issued to Grupo Mexico had a market value of $3.75 billion.

The plaintiff brought a derivative suit challenging the transaction. On December 21, 2010, the court dismissed the members of the Special Committee from the case, leaving Grupo Mexico and its seven affiliated directors as defendants.

Standard of Review

As this case involved a controlling stockholder on both sides of the transaction, both parties and the court agreed that the appropriate standard of review was entire fairness, which requires proving that the deal reflected both a fair process and a fair price. As Chancellor Strine said (citing Weinberger v. UPO, Inc.), "Where, as here, a controlling stockholder stands on both sides of a transaction, the interested defendants are 'required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain.'" Although the court noted that having a fair price is usually the more important of the two factors, it does not bifurcate the analysis in this case because the two factors are intertwined, and the court "'determines entire fairness based on all aspects of the entire transaction.'"

Defendants typically have the burden of proof, but may shift it to the plaintiffs by showing that the transaction was approved either by (i) an independent board majority or a special committee of independent directors or (ii) an informed vote of the majority of the minority stockholders.

Following Delaware Supreme Court precedent set forth in Kahn v. Tremont Corp., the court determined that the burden of proof remained with the defendants, despite the Special Committee's existence and its approval of the transaction, because it found that the Special Committee was not "well-functioning" and failed to effectively play the role of a third-party with negotiating power. Chancellor Strine noted several problems with this approach, notably that the burden of proof has to be determined during the trial and is enmeshed in the substantive merits, which makes it harder to use the standard of review as the framework through which the court evaluates the evidence and trial testimony and through which litigants determine how best to prepare their case for trial. However, despite these problems, he felt constrained by precedent to evaluate the effectiveness of the special committee before awarding a burden shift. Additionally, the court concluded that although the transaction was ultimately approved by a majority of the stockholders excluding Grupo Mexico and the other two large stockholders, this "after-the-fact vote result" was not enough to shift the burden of proof, as this can occur only if the transaction has been conditioned "up-front" on the approval of a majority of the disinterested, informed stockholders. He also found that the minority stockholders were not fully informed because of both missing and "less than materially clear" disclosure in the proxy statement.

Analysis

The court concluded that the transaction was unfair, and that Grupo Mexico and its affiliated directors breached their duties of loyalty, for a number of reasons, including the following:

  • The Special Committee's Mandate, Mindset and Membership: The court discussed the importance of the mandate given to a special committee and criticized the fact that the Special Committee was empowered only to "evaluate" the transaction Grupo Mexico proposed and that it was not empowered to investigate alternatives, even if, as the court recognized, Grupo Mexico ultimately would have rejected them. The court found that the narrow mandate caused the Special Committee to have a "blinkered perspective" and a "controlled mindset" that drove it to try to rationalize the Grupo Mexico asking price "rather than aggressively testing the assumption that the [acquisition of Minera] was a good idea in the first place." Further, the court criticized the Special Committee for ignoring the proven cash value of Southern Peru's publicly-traded stock and turning to aggressive assumptions and a relative value analysis in an attempt to "equalize" the values of the two companies. The court noted that even if the Special Committee felt that the market was incorrectly valuing Southern Peru's stock, "a reasonable third-party buyer would only go behind the market if it thought the fundamental values were on its side." The court was unwilling to believe testimony from the Special Committee members that rationalized their actions, in part because there was no "contemporaneous record," such as minutes of Special Committee meetings, to corroborate it.

Additionally, the court found that a member of the Special Committee who was a key negotiator of the transaction was not ideally situated to negotiate for the minority stockholders because he was also representing a large stockholder more interested in achieving near-term liquidity for its Southern Peru shares than in maximizing the long-term value of Southern Peru itself. This Special Committee member participated in negotiating the substantive terms of the Minera transaction while concurrently negotiating with Grupo Mexico on behalf of the other large stockholder for registration rights to facilitate the sale of its Southern Peru stock. In exchange for registration rights, the stockholder agreed to vote in favor of the Minera acquisition if the Special Committee recommended it, and against it if the Special Committee either recommended against the transaction or withdrew its recommendation in favor of it. In discussing its earlier dismissal of all the special committee members as defendants, the court affirmed its view that, although it believed that this member was influenced by the large stockholder's desire for liquidity, it did not equate a legitimate concern of a stockholder for liquidity into a "self-dealing interest," and could not find that this member had "acted in bad faith to purposely accept an unfair deal." Accordingly, the court continued to be unpersuaded that this member could be labeled with the state of mind required to expose him to liability given the exculpatory provisions of Southern Peru's certificate of incorporation.

  • Stale Fairness Analysis: Although the Special Committee negotiated for and received the ability to change its recommendation that the Southern Peru stockholders approve the transaction, and knew that the vote of a large stockholder was tied to its recommendation, the court found that there was no evidence to suggest that the Special Committee or its financial advisor made any effort to update their fairness analysis, despite the fact that Southern Peru had significantly exceeded the projections used as the basis for the fairness analysis and that its stock price had been steadily rising in the months leading up to the stockholder vote. The court saw this failure on the part of the Special Committee, particularly when coupled with the fixed exchange ratio and lack of a collar, as additional evidence of its "controlled mindset," and concluded that this failure, "taken together with the negotiation process and the terms of the [Minera acquisition], was a regrettable and important lapse."

Damages

The court crafted the damages award to equal an amount that "approximates the difference between the price that the Special Committee would have approved had the transaction been entirely fair" and the actual price of the transaction. The court granted simple interest at the statutory rate since the date of the closing of the transaction and noted that Grupo Mexico could satisfy the award by returning to Southern Peru the appropriate number of shares.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.