In a long-awaited en banc decision, the Delaware Supreme Court has issued its most important ruling in years on the standard of review applicable to mergers when a controlling stockholder buys out the public. The decision, styled Americas Mining Corp. v. Theriault (Southern Peru), 51 A.3d 1213 (Del. 2012), constitutes the Delaware Supreme Court’s strong endorsement of the Court of Chancery’s trial ruling, and confirms that controlling-stockholder transactions present special risks for defendants and deal planners.
The appeal concerned a transaction in which Grupo México SAB, Southern Peru’s controlling shareholder, proposed selling one of its subsidiaries, Minera México S.A., a privately held company, to Southern Peru for $3.1 billion worth of Southern Peru’s listed stock. The transaction was thus plainly one in which the controlling stockholder (Grupo) would stand on both sides of the proposed transaction: It was directing one company it controlled to buy another company it controlled.
In recognition of the potential conflict, the Southern Peru board established a special committee of directors independent of Grupo. But, as the Delaware Court of Chancery found, the special committee’s mandate was defined narrowly, as its task was merely to “evaluate” the controller’s proposal — and not to assess whether the transaction was in the best interests of Southern Peru (let alone to consider strategic alternatives). The special committee “awkwardly” tried to negotiate with Grupo over the right price for Minera México, but the trial court held that the committee was operating in “a controlled mindset” that left the committee seeking “to justify a transaction at the level originally demanded by the controller.” Accordingly, Chancery ruled, the committee neither considered alternatives to the deal proposed by Grupo nor vigorously challenged Grupo’s terms.
The clinching evidence on the point was the committee’s valuation method. The special committee’s financial adviser performed a valuation of Minera to determine a fair price for an eventual purchase by Southern Peru. The adviser’s initial discounted cash flow analysis yielded a midrange valuation of about $1.7 billion — some $1.4 billion less than the price Grupo was asking that Southern Peru pay. The math made the Minera acquisition look like a bad deal for Southern Peru and a very good one for Minera (and thus Grupo, its near 100 percent owner).
But, the Court of Chancery found, instead of telling Grupo that it was not interested in what the numbers showed to be an unfavorable transaction, the special committee and its financial adviser changed their valuation method to make the proposed deal seem fairer. The facts, as found by the court, showed that the committee first determined that Southern Peru’s trading price exceeded the stock’s “intrinsic value,” and then adopted a “relative valuation” method on the basis that the two companies were in the same line of business. Ultimately, found the trial court, the special committee capitulated to Grupo’s demands, concluding a transaction for slightly more than $3 billion — roughly the same price Grupo had originally proposed.
‘ENTIRE FAIRNESS’ STANDARD
The Court of Chancery ruled that because Grupo controlled Southern Peru and stood on both sides of the transaction, the defendants would be subject to the “entire fairness” standard. Much of the doctrinal interest of the case rests in the court’s allocation of the burden of persuasion. The defendants argued that the burden should lie with the plaintiffs to show unfairness, because an independent committee approved the deal. The chancellor disagreed, holding that Delaware law contemplates a look back at the “substance, and efficacy” of the board’s procedural devices to determine whether a burden shift is warranted. Accordingly, the defense in an entire fairness case must demonstrate that an independent committee was “well functioning” before the burden may shift. And because this is a fact-intensive inquiry, the court may not be able to decide who bears the burden until after the trial.
The court went on to rule that any such burden-shift in the present case would be of limited significance, because the evidentiary standard was preponderance of the evidence, and the burden only mattered when the court was in equipoise about the facts — which the court here was not. The court concluded that Southern Peru had overpaid for Minera by roughly $1.3 billion and awarded that amount, plus interest at the statutory rate, for a total award of about $2 billion.
Noteworthy both for its doctrinal clarity and the sheer size of the award, the Chancery decision generated a prompt appeal. As appellants, the defendants argued that the court applied the entire fairness standard improperly — both by refusing to assign the burden until after trial and by failing to credit the special committee with a decisive burden shift. The Delaware Supreme Court disagreed. On the facts, the Supreme Court repeated the trial court’s findings nearly verbatim. On the law, the Supreme Court affirmed Chancery at every step.
The court explained that “when a transaction involving self-dealing by a controlling shareholder is challenged, the applicable standard of judicial review is entire fairness, with the defendants having the burden of persuasion.” The burden may be shifted when defendants use a special committee or obtain majority-of-the-minority approval of the transaction. But a special committee will only suffice to shift the burden when it “function[s] in a manner which indicates that the controlling shareholder did not dictate the terms of the transaction and that the committee exercised real bargaining power at an arms-length.”
The Supreme Court agreed with the Court of Chancery that this may require more than just “a look at the composition and mandate of the special committee” but rather a careful weighing of the evidence that may not happen until trial. Answering the defendants’ argument that such a rule would disincentivize the use of special committees, the Supreme Court noted that the benefits of the burden shift have always been understood to be “modest.” And it confirmed that “if the record does not permit a pretrial determination that the defendants are entitled to a burden shift, the burden of persuasion will remain with the defendants throughout the trial to demonstrate the entire fairness of the interested transaction.” Defendants in special-committee cases may still earn the burden shift pretrial and even seek summary judgment — but only if the pretrial evidence leaves no triable facts as to the proper functioning of the special committee and plaintiffs cannot proffer sufficient evidence to permit a finding in their favor on fairness.
Along the way, the Supreme Court restated the central premise of its 1994 decision in Kahn v. Lynch Communication Sys. Inc., 638 A.2d 1110 (Del. 1994), affirming that “[r]egardless of where the burden lies, when a controlling shareholder stands on both sides of the transaction, the conduct of the parties will be viewed under the more exacting standard of entire fairness as opposed to the more deferential business judgment standard.” This may be an important signal: Several recent Chancery decisions, along with considerable academic commentary, have suggested that when a controlling-stockholder transaction is both negotiated by a fully functioning special committee and approved by a majority of the public stockholders unaffiliated with the controller, the deferential business judgment rule should supply the standard of review.
But this issue remains to be argued again on clearer facts. The parties in Southern Peru agreed that the entire fairness standard governed, leading the Court of Chancery to conclude that there was “no need to consider whether room is open under [Delaware] law for use of the business judgment rule standard in a circumstance like this, if the transaction were conditioned upon the use of a combination of sufficiently protective procedural devices.” So a different standard of review remains theoretically possible when defendants combine multiple protective procedural measures.
What the decision makes clear, however, is that while a special committee standing alone can effect a burden shift, the benefits are only “modest” — and will only be available when the evidence establishes the effectiveness of the committee’s process. At the same time, the court re-emphasized that “any board process is materially enhanced when the decision is attributable to independent directors,” and the use of special committees is expected to remain customary in controlling-shareholder transactions.
William Savitt is a partner in the litigation department of New York-based Wachtell, Lipton, Rosen & Katz. He represents corporations and directors in litigation involving mergers and acquisitions, proxy contests, corporate-governance disputes, class actions involving allegations of breach of fiduciary duty, and enforcement actions relating to corporate transactions.