In the case of In re Southern Peru Copper Corporation Shareholder Derivative Litigation, C.A. No. 961-CS (Del. Ch. Oct. 14, 2011), read opinion here, [read revised opinion of Dec. 20, 2011 here], the Delaware Court of Chancery explained in more than 100 pages why the directors of a company breached their fiduciary duties in connection with a stock transaction, and why the Court imposed damages of over $1.2 billion, not including interest. The revised opinion of December 20, 2011, linked above, modified the amount of the judgment to about $1.3 billion which with interest is expected to total about $2 billion. In connection with the amended judgment, at a hearing, the Court awarded attorneys’ fees in this derivative action in the amount of $285 million–which is expected to increase to about $300 million based on the total increased judgment. A post on the hearing granting attorneys’ fees is available on these pages here.
The following summary was prepared by Kevin F. Brady of Connolly Bove Lodge & Hutz LLP.
In 2004, Grupo México, S.A.B. de C.V. was the controlling stockholder of Southern Peru Copper Corporation. In February 2004, Grupo Mexico proposed that Southern Peru buy its 99.15% stake in Minera México, S.A. de C.V., a Mexican mining company. At the time, Grupo Mexico was Southern Peru’s majority stockholder owning 54.17% of Southern Peru’s outstanding capital stock (with voting rights for 63.08% of Southern Peru). Grupo Mexico initially proposed that Southern Peru purchase its equity interest in Minera with 72.3 million shares of newly-issued Southern Peru stock valued at approximately $3 billion.
The Special Committee
In response to Grupo Mexico’s proposal, on February 12, 2004, the Board of Southern Peru formed a four-person Special Committee of very experienced independent directors to evaluate the transaction. The Special Committee was instructed that its “duty and sole purpose” was “to evaluate the [Merger] in such manner as the Special Committee deems to be desirable and in the best interests of the stockholders of [Southern Peru]. The Special Committee was authorized to retain legal and financial advisors “at Southern Peru’s expense on such terms as the Special Committee deemed appropriate.” The Special Committee hired experienced U.S. legal counsel, an experienced financial advisor in Goldman Sachs, and specialized mining consultants. Importantly, the Special Committee did not get the power to negotiate, nor was it authorized to explore other alternatives.
The Special Committee then asked Grupo Mexico for a “price term” to properly evaluate the transaction. On May 7, 2004, Grupo Mexico responded with a term sheet containing more specific details as well as an increase in its asking price from $3.05 billion to $3.147 billion in market-tested Southern Peru stock. Goldman did a “give/get” analysis of Grupo Mexico’s proposal and in the end Goldman’s valuation was significantly less than Grupo Mexico’s. Goldman valuation was that Southern Peru would “give” stock with a market price of $3.1 billion to Grupo Mexico and would “get” in return an asset worth about $1.7 billion. After that, as the Court noted, “the Special Committee began to devalue the ‘give’ in order to make the ‘get’ look closer in value.” The Special Committee made a counterproposal offering that Southern Peru would acquire Minera by issuing 52 million shares of Southern Peru stock with a then-current market value of $2.095 billion. The Special Committee also proposed a fixed exchange ratio that would set the number of shares of Southern Peru shares issued in the merger instead of the floating one initially proposed. Grupo Mexico rejected that offer and countered with a proposal in excess of 80 million shares (approx. $3.1 billion). After more negotiations, on August 21, 2004, Grupo Mexico proposed 67 million shares ($2.76 billion market value on August 21 which rose to $3.06 billion by September 8, 2004).
On September 23, 2004, the Special Committee responded with a proposal which contained, among other things: (i) an offer of a fixed purchase price of 64 million shares of Southern Peru ($2.95 billion market value); (ii) a 20% collar around the purchase price, which gave both the Special Committee and Grupo Mexico the right to walk away from the Merger if Southern Peru’s stock price went outside of the collar before the stockholder vote; (iii) a voting provision requiring that a majority of the minority stockholders vote in favor of the Merger; and (iv) a cap on Minera’s net debt, which Southern Peru was going to absorb in the Merger, at $1.105 billion at closing.
A Deal is Reached and Litigation Starts
The parties eventually arrived at an agreement which included, among other things, the following terms: (i) 67.2 million shares (valued at $3.08 billion on October 13, 2004); (ii) a $1 billion cap on Minera’s debt; and (iii) a special dividend of $100 million to be paid by Grupo Mexico which had the effect of decreasing the value of Southern Peru’s stock. The Special Committee dropped its demand for a collar and a majority of minority vote but they did get a supermajority vote of all outstanding stock. The Special Committee and the Board approved the merger in October 2004, and on March 28, 2005, more than 90% of the stockholders of Southern Peru voted to approve the merger. At the time of the closing, 67.2 million shares of Southern Peru had a market value of $3.75 billion which was significantly higher than the initial asking price of $3.1 billion. Even with this significant increase in value, Goldman did not update its fairness analysis between October 2004 and March 2005.
A derivative action was filed in late 2004 and the first hurdle for the Court and the parties was the standard of review. Consistent with Delaware Supreme Court precedent in Kahn v. Tremont, the parties agreed that the appropriate standard of review of the merger at issue was entire fairness, irrespective of the use of a Special Committee. Thus, the Court proceeded to analyze the merger through the two basic aspects of the fairness ― process and price.
The Court noted that “fair dealing ‘embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained.” Fair price “relates to the economic and financial considerations of the proposed merger, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock.”
Entire Fairness and the Burden of Persuasion
Under the entire fairness standard, the controller cannot escape entire fairness review, but the controller may shift the burden of persuasion if (i) the controller shows that the transaction was approved either by an independent board majority (or in the alternative a Special Committee); or (ii) by an informed vote of the majority of the minority shareholders.
The Court then discussed in great detail what is required of a Special Committee ― is it just how the Special Committee was established or is it how the Special Committee functions? As the Court noted, “[a] close look at [Kahn v.] Tremont suggests that the inquiry must focus on how the special committee actually negotiated the deal ― was it ‘well functioning’ ― rather than just how the committee was set up. The test, therefore, seems to contemplate a look back at the substance, and efficacy, of the special committee’s negotiations, rather than just a look at the composition and mandate of the special committee.” At the end of the Court’s detailed discussion on burden of proof and burden shifting, the Court found that the burden of persuasion remained with the defendants because the Special Committee was not “well functioning.”
The Court rejected the defendants’ argument that since the Merger received super-majority support the burden should shift. The Court noted that there was no majority of the minority requirement and it was of little consequence for the stockholders to know that their vote is meaningful when in fact like here the transaction required a two-thirds vote which could be satisfied by Grupo Mexico and two large shareholders― Cerro and Phelps Dodge. The Court also rejected defendants attempt to shift the burden by arguing that the vote was fully informed based on material information left out of the Proxy Statement.
Negotiation and Approval of Merger Not Entirely Fair
The Court focused on the mandate for the Special Committee ― to “evaluate” a transaction suggested by the controller and the lack of their ability to do more than that. The Court found that the Special Committee was in essence controlled by the controller and allowed the controller to dictate the terms and structure of the merger. While the Special Committee did go further and actually negotiated with the controller, the Court noted that: “[t]he Special Committee did not insist on the right to look at alternatives; rather, it accepted that only one type of transaction was on the table, a purchase of Minera by Southern Peru. As we shall see, this acceptance influences my ultimate determination of fairness, as it took off the table other options that would have generated a real market check and also deprived the Special Committee of negotiating leverage to extract better terms.”
The Court also challenged the appropriateness of Harold Handelsman, a member of the Special Committee, because he was working with the controller on another deal. As the Court noted:
Handelsman may not have been solely focused on paying the best price in the Merger (even though all things being equal, Cerro, like any stockholder, would want the best possible price) because he had independent reasons for approving the Merger. That is, as between a Merger and no Merger at all, Handelsman had an interest in favoring the deal because it was clear from the outset that Grupo Mexico was using the prospect of causing Southern Peru to grant registration rights to Cerro (and Phelps Dodge) as an inducement to get them to agree to the Merger. Thus, Handelsman was not well-incentivized to take a hard-line position on what terms the Special Committee would be willing to accept, because as a stockholder over whom Grupo Mexico was exerting another form of pressure, he faced the temptation to find a way to make the deal work at a sub-optimal price if that would facilitate liquidity for his stockholding employer.
The Court also found that the Special Committee was focused on finding a way to make the terms of the merger proposed by Grupo Mexico make sense rather than determining if a merger was a good idea in the first place. In addition, the Special Committee and Goldman went to great lengths to justify the merger by equalizing the valuations of Minera but they couldn’t make it work so the Special Committee started “devaluing” Southern Peru and “topped up” the value of Minera. The Court found that the Special Committee “went backwards to accommodate Grupo Mexico’s asking price.” And any concessions that the Special Committee got, the Court characterized as “weak.” The final problem noted by the Court was that Goldman did not update its fairness opinion from the date the merger was approved by the Board until the date the stockholders voted to approve the merger, even though there was significant evidence that the bases for the fairness opinion in October 2004 had changed by March 2005.
The plaintiff sought “an equitable remedy that cancels or requires the defendants to return to Southern Peru the shares that Southern Peru issued in excess of Minera’s fair value”, or in the alternative, rescissory damages in the amount of the present market value of the excess number of shares that Grupo Mexico holds as a result of Southern Peru paying an unfair price in the Merger. The Court, in determining the appropriate valuation for the price the Special Committee should have paid, stated:
To calculate a fair price for remedy purposes, I will balance three values: (1) a standalone DCF value of Minera, calculated by applying the most aggressive discount rate used by Goldman in its DCF analyses (7.5%) and a long-term copper price of $1.10 per pound to the DCF model presented by the plaintiff’s expert, Beaulne; (2) the market value of the Special Committee’s 52 million share counteroffer made in July 2004, which was sized based on months of due diligence by Goldman about Minera’s standalone value, calculated as of the date on which the Special Committee approved the Merger; and (3) the equity value of Minera derived from a comparable companies analysis using the comparable companies identified by Goldman.
In the end, the Court awarded damages of $1.263 billion (noting that the record supported “a much larger award”) plus interest from the Merger date. Finally, the Court noted that “Grupo Mexico may satisfy the judgment by agreeing to return to Southern Peru such number of its shares as are necessary to satisfy this remedy.”
——————————————————————————————As expected, this case has generated substantial commentary. Among the more worthwhile reviews of the case is Kevin LaCroix’s post here on The D & O Diary.