In re John Q. Hammons Hotels Inc. Shareholder Litigation, No. 758-CC (Del. Ch. Oct. 2, 2009), read opinion here. A prior decision in this case by the Court of Chancery was highlighted here.
Kevin Brady, a highly respected Delaware litigator, prepared this synopsis.
This dispute arose out of the merger involving John Q. Hammons Hotels (“JQH”) pursuant to which the holders of Class A common stock received $24 per share in cash. Plaintiffs’ alleged that: (i) the controlling shareholder breached his fiduciary duty by negotiating benefits for himself that the minority stockholders did not receive; (ii) the directors breached their fiduciary duties by permitting a deficient process and subsequent approval of the merger; (iii) the acquisition vehicle aided and abetted the breaches of fiduciary duties: and (iv) the company’s proxy statement contained misstatements and omissions regarding the activities of the special committee process and certain conflicts with the company’s financial advisors.
On cross-motions for summary judgment, the Court concluded that Kahn v. Lynch Communications Systems did not mandate the application of entire fairness standard of review in this transaction notwithstanding procedural protections like a special committee or a minority of the majority vote requirement. Tthe use of sufficient procedural protections for the minority stockholders could have resulted in the application of the business judgment standard, but the procedures used here were insufficient. As a result, the Court determined that the applicable standard of review would be “entire fairness.”
JQH was a Delaware corporation that owned and managed a multitude of hotels. John Q. Hammons (“Hammons”), JQH’s Chairman, CEO and controlling shareholder (he owned 5% of the Company’s Class A common stock and all of the Class B common stock) with over 75% of the total vote in JQH, which in turn controlled John Q. Hammons Hotels, LP (“JQHLP”). Defendants JQH Acquisition, LLC (“Acquisition”) and JQH Merger Corporation (“Merger Sub”) were formed for purposes of the merger described below. Jonathan Eilian (“Eilian”), not a defendant, was the principal of Acquisition, which wholly owned Merger Sub. Plaintiffs were owners of Class A stock of JQH, which was publicly traded (as opposed to Class B stock).
Potential Transactions with Barceló and Eilian
In 2004, Hammons entered into discussions with third parties regarding a sale of JQH or at least his interest in JQH. By October, Barceló Crestline Corporation (“Barceló”) entered into an agreement with Hammons for $13 per share for all outstanding Class A common stock. The deal was structured in a way that benefited Hammons’ in a number of ways, most especially from a tax standpoint.
The Board recognized that Hammons’ interests may not have been identical to those of the other JQH shareholders, so the Board formed appointed three independent directors to a special committee to evaluate and negotiate a proposed transaction on behalf of the unaffiliated stockholders and make a recommendation to the Board. Katten Muchin Rosenman, LL” (“Katten Muchin”) was the special committee’s legal advisor, and Lehman Brothers (“Lehman”) was its financial advisor.
After Barceló’s public announcement, Eilian told the special committee that he was interested in entering into a possible transaction with JQH. In December 2004, Eilian submitted a proposal to the special committee whereby he would acquire Hammons’ interest in JQH and to make a tender offer for the remaining shareholders at a price to be determined later. After some back and forth with escalating offers from both Barceló and Eilian, exclusivity with Barceló was not renewed and negotiations proceeded with Eilian.
In January 2005, Eilian made an offer whereby he would acquire all outstanding Class A stock for $24 per share. Hammons then informed the special committee that he wanted to negotiate with Eilian. On June 3, 2005, Eilian confirmed his offer of $24 per share of outstanding Class A stock. Lehman advised that the $24 per share offer was fair to the minority shareholders from a financial point of view and that “the allocation of the consideration between Hammons and the unaffiliated stockholders was reasonable.” The Special Committee approved the merger agreement and the Board voted to approve the merger and the transaction agreements.
The merger was contingent upon approval of a majority of Class A stockholders voting on the transaction unless the special committee waived that requirement. The Merger Agreement included a $20 million termination fee and a “no shop” clause. Along with the merger agreement, Hammons and Acquisition entered into a number of other agreements “designed to provide Hammons financing to continue his hotel development activities without triggering the tax liability associated with an equity or asset sale. . . . In order to achieve his tax goals, Hammons had to have an ownership interest in the surviving LP and continue to have capital at risk.”
Hammons was allocated a 2% interest in the cash flow distributions, preferred equity interest in the surviving LP and other rights and obligations. In addition, Hammons received $300 million in credit lines, as well as “(1) the Company’s Chateau Lake property in exchange for transferring certain assets and related liabilities to an Acquisition affiliate, (2) a right of first refusal to acquire hotels sold post-merger, and (3) an indemnification agreement for any tax liability from the surviving LP’s sale of any of its hotels during Hammons’s lifetime.”
At a special meeting of the shareholders on September 15, 2005, over 72% of Class A shareholders voted to approve the Merger. More than 89% of the Class A stockholders voted in favor of the transaction.
Allegations Regarding the Negotiation Process
Plaintiffs, Class A stockholders, raised various issues regarding the negotiation process, including:
• Hammons’ Ability to Block Transaction: Plaintiffs alleged that Hammons could threaten to walk away from any deal thereby leaving the plaintiffs with illiquid and undervalued stock. The result of Hammons’ power, as plaintiffs allege, was that “this threat relegated the special committee to a passive, tag-along role and forced them to be ‘friends of the deal’ in an effort to prevent Hammons from backing out of the deal.”
• Conflicts of Interest: Plaintiffs allege that because Katten Muchin advised the special committee and represented Eilian’s financing entity, iStar Financial Inc. (“iStar”), Katten Muchin had an incentive for the deal with Eilian to close. Likewise, Lehman sought from Eilian, but did not receive, the job of refinancing JQH’s debt. Further conflicts were alleged with the interactions between iStar and Lehman in the negotiations and those conflicts were not disclosed in the proxy materials.
The Litigation Starts
The action was filed in October of 2004. After discovery and an unsuccessful attempt at mediation, three sets of motions for summary judgment were filed:
• Director Defendants’ Motion for Summary Judgment: The directors basis for their motion was that “(1) plaintiffs cannot satisfy their burden to rebut the presumption of the business judgment rule, (2) the special committee members and the director defendants are shielded from monetary liability pursuant to the Company’s 8 Del. C. § 102(b)(7) exculpatory provision, and (3) there is no evidence to support the aiding and abetting claim.”
• Hammons’ Motion for Summary Judgment: Hammons’ alleged that “he took no part in the negotiations for the purchase of the minority’s shares and argues that he is entitled to summary judgment because plaintiffs cannot rebut the presumption of the business judgment rule and because even if entire fairness applies, Hammons acted fairly.”
• Plaintiffs’ Motion for Summary Judgment: Plaintiffs’ allege that “(1) entire fairness is the applicable standard of review, (2) the special committee process and stockholder vote were ineffective and the burden of persuasion at trial remains with defendants, (3) the challenged transactions were the result of unfair dealing, (4) certain defendants are liable for aiding and abetting Hammons’s breach, and (5) the only issue for trial is therefore fair price.”
Standard of Review – Entire Fairness or Business Judgment Rule
The Court noted that the threshold issue was whether the Court should apply the entire fairness standard or the business judgment rule in reviewing the merger. Alleging the merger to be a “minority squeeze-out transaction,” plaintiffs contended that Kahn v. Lynch Communication Systems Inc., 638 A.2d 1110 (Del. 1994), mandates that the Court apply the entire fairness standard of review. Defendants countered, alleging the business judgment standard of review was appropriate.
The Court rejected the plaintiffs’ argument stating that under Lynch, “‘the exclusive standard of judicial review in examining the propriety of an interested cash-out merger transaction by a controlling or dominating shareholder is entire fairness’ and that ‘[t]he initial burden of establishing entire fairness rests upon the party who stands on both sides of the transaction.’ Additionally, ‘approval of the transaction by an independent committee of directors or an informed majority of minority shareholders’ would shift the burden of proof on the issue of fairness to the plaintiff, but would not change that entire fairness was the standard of review.”
Hammons however, did not stand “on both sides of the transaction” and Hammons did not make the offer to the minority stockholders – an unrelated party, Elian, made the offer. Eilian negotiated separately with the minority shareholders, who were represented by the “disinterested and independent special committee,” and Hammons, “who had a right to sell (or refuse to sell) his shares . . . .” Thus, regardless of any procedural protections in place for the minority shareholders, “Lynch does not mandate that the entire fairness standard of review apply notwithstanding any procedural protections that were used [i.e., the special committee or the approval of the majority of the minority shares voting.].”
The Court stated that the business judgment “would be the applicable standard of review if the transaction were (1) recommended by a disinterested and independent special committee, and (2) approved by stockholders in a non-waivable vote of the majority of all the minority stockholders.” However, in order to invoke the business judgment standard, “it is paramount – indeed, necessary . . . – that there be robust procedural protections in place to ensure that the minority stockholders have sufficient bargaining power and the ability to make an informed choice of whether to accept the third-party’s offer for their shares.”
Here the Court found that the procedure in place (where the special committee could waive the vote of the minority stockholders and required the approval of only the majority of the voting minority shareholders), were not sufficient. Importantly, the Court stated that the minority vote serves as a complement to, and a check on, the special committee. It also noted that “[a]n effective special committee, unlike disaggregate stockholders who face a collective action problem, has bargaining power to extract the highest price available for the minority stockholders. The majority of the minority vote, however, provides the stockholders an important opportunity to approve or disapprove of the work of the special committee and to stop a transaction they believe is not in their best interests. Thus, to provide sufficient protection to the minority stockholders, the majority of the minority vote must be nonwaivable, even by the special committee.”
Application of the Entire Fairness Standard: Fair Dealing and Fair Price
In determining the entire fairness “based on all aspects of the entire transaction,” the Court considers both fair dealing and fair price. While neither prong is considered in isolation, “[f]air dealing involves ‘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. . . .’” and “[f]air price involves questions of ‘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.’” The Court did note that while the special committee approval and the majority of the minority vote were not sufficient to invoke the business judgment standard of review that did not mean that the defendants per se would not be able to prevail on the issue of fair dealing.
Finding material factual issues as to the fairness of the price, including the actual value Hammons received and Lehman’s valuation thereof, the court denied the defendants’ motion for summary judgment. Likewise, there were material factual issues as to the fairness of the deal as there were questions about whether the special committee was coerced by Hammons or whether Hammons’ self-dealing negotiations depressed the value of the shares. Accordingly, the Court found that neither plaintiffs nor defendants were entitled to summary judgment on the issue of fair dealing.
Plaintiffs alleged four breaches of the duty of disclosure. First, plaintiffs allege that the proxy statement mischaracterized the special committee process by failing to disclose that it was a “subservient, deferential approach.” Under existing case law, directors are not required to engage in “self-flaggelation,” so the Court granted summary judgment in favor of defendants on this claim.
Second, plaintiffs alleged that the proxy failed to disclose the potential conflict that Lehman had with Eilian. Defendants’ motion was denied because the Court “has stressed the importance of disclosure of potential conflicts of interest of financial advisors.”
Third, plaintiffs asserted that Katten Muchin’s representation if iStar should have been disclosed. Even though this was disclosed to the special committee and measures were made to use different lawyers within Katten Muchin for iStar’s representation, the Court nonetheless held that this type of conflict must be disclosed to the shareholders. As the Court reasoned, “[t]his is particularly true, where, as here, the minority stockholders are relying on the special committee to negotiate on their behalf in a transaction where they will receive cash for their minority shares.” Thus the Court found that the defendants were not entitled to summary judgment on this claim.
Finally, plaintiffs alleged that it was a breach to not disclose a presentation to the special committee that Eilian made in 2004. In the presentation, Eilian provided a valuation of JQH’s shares under what defendants alleged was a hypothetical scenario. Because the Court could not conclude whether the scenario was hypothetical or tied to the merger and thus potentially material to a shareholder’s decision, the Court denied the defendants’ motion for summary judgment on this claim.
Aiding and Abetting Claim Survived
As to the acquisition vehicles, defendants’ motion for summary judgment on plaintiffs’ aiding and abetting a breach of fiduciary duty claim was denied. There were questions as to whether there was knowing participation by Eilian and whether Hammons’ conduct depressed the value of the stock. As a result, the Court found that the defendants were not entitled to summary judgment on this claim.
Postscript: The DealProfessor has provided an insightful review of this case here. The Harvard Law School Corporate Governance Blog provides an overview of the case here.