On Monday in City of Dearborn Police and Fire Revised Retirement System (Chapter 23) v. Brookfield Asset Management Inc., the Delaware Supreme Court reversed the Court of Chancery in a case challenging a squeeze-out merger. The Court of Chancery had dismissed on the basis of the MFW cleansing, ruling that an effective special committee and informed, disinterested stockholder vote had neutralized the conflict of interest in the controller-led buyout. But, the Supreme Court held that deficient disclosures in the proxy material surrounding conflicts of interest affecting the financial and legal advisors to the special committee impaired the stockholder vote, even though those conflicts were not themselves sufficiently serious as to constitute a breach of duty.
As we have discussed before, under the "business judgment rule" while Delaware courts do not second-guess corporate boards' actions in most cases, that deference does not apply when a corporate board, or someone upon whom they are beholden, has a conflict of interest. One of the most important types of these conflicted transactions are 'squeeze-outs,' i.e. transactions in which a controlling stockholder seeks to buy out the minority stockholders. Because of the conflict of interest this creates, Delaware courts review these transactions under the searching "entire fairness" standard of review. Delaware does, however, provide a mechanism for controllers interested in pursuing a squeeze-out to do so without losing the protection of the business judgment rule. This mechanism, called "MFW" cleansing, requires the controller to first set up an independent special committee to negotiate the transaction, and to condition the transaction on the fully-informed approval of the minority stockholders. If the special committee independently negotiates the transaction, and if the minority stockholders approve it, Delaware law regards this as effectively neutralizing the conflict of interest and will apply the business judgment rule, resulting in a pleading-stage dismissal of a lawsuit challenging the transaction.
But, if a plaintiff demonstrates that either of these procedural protections were flawed – that the special committee could not or did not perform its function of properly mimicking an independent board, or if the vote of the minority stockholders was not fully informed – then the business judgment rule does not apply and a court will review the transaction under the entire fairness standard.
City of Dearborn concerns just such a freeze-out merger transaction. A company owning 62% of the stock in a publicly-traded company proposed to buy out the minority stockholders. The controller set up a special committee, which hired its own advisors and negotiated, eventually agreeing to a transaction that valued the company at $3.3 billion. The special committee recommended the board approve the transaction, which it did, after which the company prepared a proxy statement to be sent to investors.
The plaintiff stockholders sued. The stockholders argued that the special committee could not act independently because of improper threats by the controlling company; or, in the alternative, that it failed to do so by improperly relying on legal and financial advisors whose relationships were too close to the controlling company. It also argued that the stockholder vote was uninformed, because of a number of things which they allege the company omitted or misstated in the proxy materials. The trial court disagreed and held both MFW protections were satisfied, and dismissed the case under the business judgment rule. The stockholders appealed and, on Monday, the Supreme Court reversed.
On this appeal, the Supreme Court agreed with the trial court that the special committee had functioned properly and was not coerced, but disagreed that the stockholder vote had been fully informed. In particular, it held that three pieces of information were missing or incorrectly described in the proxy materials, fatally undermining the disclosures. First, it characterized the proxy materials as failing to disclose that the special committee's financial advisor had a $470 million stake in the controlling company and its affiliates; second, as failing to disclose the special committee's legal advisor had both prior and ongoing representations of the controlling company; and third, as failing to adequately disclose the benefits the controlling company would reap from consolidation.
The Supreme Court held that, although the financial and legal advisors' relationships with the controller were not sufficiently close to make it wrongful for the special committee to retain them, the duty of disclosure is broader and requires candor about an advisor's conflicts which are not themselves disabling. Additionally, a description of the benefits from consolidation needed to be "clear and transparent." The company's disclosures fell short with respect to a change in management fees, which would net $130 million per year, as it disclosed only a formula, and significant additional research and work would have been necessary for a stockholder to replicate that calculation.
As a result of those deficiencies, the case was remanded back to the trial court, which will now – after discovery and trial – examine the transaction for its entire fairness. The directors may still prevail – with the operation of the special committee and the $3.3 billion price tag, the Court of Chancery may still hold that the transaction was 'entirely fair.' But, even if it does, the discovery and trial process may be expensive and time-consuming, emphasizing the importance of scrupulously adhering to the MFW framework in order to obtain pleading-stage dismissal.
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