United States: Entire Fairness and Fairness Opinions Applied to Multiple Classes of Equity

On December 21, 2005, Chancellor Chandler of the Delaware Court of Chancery issued an important opinion, In re Tele-Communications, Inc. Shareholders Litigation (No. 16470), of which members of special committees and their financial advisors should be aware. Although the Chancellor’s decision was in the context of a denial of a defendant’s motion for summary judgment, certain elements of the court’s findings call into question some well-established procedures used by Delaware M&A practitioners.

In March 1999, AT&T acquired Tele-Communications, Inc. (TCI). Prior to the acquisition, TCI was organized as three divisions (the TCI Group, the TCI Liberty Media Group and the TCI Ventures Group) and had two separate classes of stock (high- and low-vote) for each division intended to track their respective performances. John Malone, the Chairman and Chief Executive Officer of TCI, and other directors owned the majority of the shares comprising the high-vote stock of the TCI Group. At the outset of negotiations, Malone insisted that in order to receive his consent and approval of the AT&T transaction, the shares comprising the high-vote stock of the TCI Group receive a 10 percent premium over the shares comprising the low-vote stock of such division.

TCI engaged Donaldson, Lufkin & Jenrette (DLJ) as its financial advisor and, noting that several members of the TCI board would have significant financial and other conflicting interests in reviewing the transaction between TCI and AT&T, TCI’s board formed a special committee to negotiate the transaction. It should be noted the special committee used TCI’s advisors instead of retaining their own separate legal and financial advisors. After several meetings that included presentations from DLJ and TCI’s counsel, on June 23, 1998, the special committee voted unanimously to recommend the transaction to the board of directors of TCI. After discussion, the full board approved the transaction on the same date.

In connection with the special committee’s deliberations, DLJ delivered its opinion that the exchange ratio offered to holders of shares of each class of TCI stock was fair to the holders of each such class, from a financial point of view. DLJ did not opine as to the fairness of the exchange ratio to be received by holders of one class of stock as compared to the exchange ratio to be received by holders of another class, or what is commonly referred to as a "relative fairness" opinion.

The court determined the special committee members’ actions were subject to the entire fairness standard of review (instead of the business judgment rule) because TCI’s directors owned significant amounts of shares of the TCI Group’s high-vote stock (more than $300 million) and had personal interests that significantly diverged from those of holders of the low-vote stock. As an alternate basis to invoke the entire fairness standard, the court also found that a majority of the directors were interested in the transaction. Under Delaware law, the entire fairness standard requires defendants to prove the entire fairness of the subject transaction to TCI’s shareholders, which includes fair dealing and fair price. In certain instances under law, defendants are able to shift to the plaintiffs the burden of proving a particular transaction is entirely fair (for example, by having the transaction approved by a special committee comprised of disinterested directors).

The court concluded the burden of proving entire fairness in this case should not be shifted to the plaintiffs given the procedural posture of the case and the significant holdings of high-vote stock by one of the two members of the special committee as well as the "suspiciously contingent compensation" ($1 million) paid to members of the special committee and certain other potential procedural flaws and other matters, including:

• The special committee members’ alleged misunderstanding of their mandate;

• The special committee’s use of TCI’s advisors instead of retaining separate legal and financial advisors;

• The special committee’s lack of complete information regarding the premium at which the shares of the TCI Group high-vote stock historically traded compared to the low-vote stock;

• The special committee’s notification by TCI’s financial and legal advisors that transactions where holders of high-vote stock received a premium were, in fact, less common than transactions where holders of high-vote stock and low-vote stock received the same consideration; and

• The contingent nature of the bulk of DLJ’s compensation ($40 million) raised serious questions as to its impartiality.

In the present case, TCI’s directors not only held a greater number of shares of the TCI Group’s high-vote stock than low-vote stock, the high-vote stock was almost entirely owned by the board. Consequently, any premium granted exclusively to holders of shares of the TCI Group’s high-vote stock primarily benefited the TCI directors—and, the court implied, such premium would be granted at the expense of the holders of the low-vote stock. Citing a 2002 Delaware case, Levco Alternative Fund Ltd. v. Reader’s Digest Association, as precedent, under the entire fairness standard, the court concluded that the special committee should have requested a "relative fairness" opinion from its financial advisor (i.e., an opinion as to whether the transaction was fair to the holders of shares of the TCI Group’s low-vote stock in light of the preferential payment being made to holders of the high-vote stock).

Levco may be distinguishable from the facts at hand, however, for a number of reasons. In Levco, Reader’s Digest agreed to purchase 50 percent of Levco’s voting stock, and the holders of Levco’s non-voting stock objected to this sale because their equity interests were decreased by at least $100 million. Although Reader’s Digest formed a special committee, the committee did not evaluate the fairness of the transaction to the holders of non-voting stock, nor did the financial advisor render a fairness opinion to the holders of non-voting stock, as was done in TCI.

All in all, when viewing the evidence in the light most favorable to the plaintiffs, the court was unable to conclude the special committee discharged their obligations under the entire fairness standard. The court did not, however, fully examine the residual issues associated with its decision. Especially of interest is the court’s failure to distinguish different classes of common stock (e.g., high-vote and low-vote) from different classes of preferred stock, which is much more prevalent. Given that allocating consideration among different classes of capital stock could require a financial advisor to draw legal conclusions, financial advisors often refuse to deliver opinions in respect of such types of allocations.

Houlihan Lokey Howard & Zukin is one financial advisor we are aware of that presently will consider rendering "relative fairness" opinions in certain limited situations because, as Marjorie Bowen, the head of their opinion practice, stated, "There may be circumstances where it is appropriate in rendering a fairness opinion to examine how the consideration to be received is allocated amongst different groups or classes of security holders. For example, if a transaction provides insufficient value to meet a contractual obligation, or there is ambiguity as to how to compensate preferred holders given the structure of the transaction, that situation may be akin to a restructuring. Alternatively, transaction precedents and a thorough understanding of all rights and privileges of a holder or block of holders are key when considering the allocation of a transaction premium to a super-voting security."

If the reasoning behind the TCI decision is upheld after trial, M&A practitioners will have to reconsider certain long-standing practices in cases involving the entire fairness standard, and members of special committees and their financial advisors will be under greater scrutiny.

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