Frank v. Elgamal, C.A. No. 6120-VCN (Del. Ch. March 30, 2012). See summary of prior Chancery decision in this matter highlighted on these pages.
Whether it was premature to rule on a fiduciary duty claim based on the entire fairness standard, at the motion to dismiss stage. Answer: Yes.
Summary of Holding
In this challenge to a merger in which a controlling group of stockholders received an interest in the surviving entity, the Court determined that the claims are subject to the entire fairness standard, rather than the business judgment rule, because appropriate procedural protections were not in place to protect the minority stockholders. The Court described the transaction involved here as similar to the merger involved in the Chancery case of In Re John Q. Hammons Hotels Inc. S’holdr Litig., 2009 WL 3165613, at *10 (Del. Ch. Oct. 2, 2009), and the Court applied the same standard of review as in that case.
[Note: This is one of 5 opinions issued within the last week or so by the same Vice Chancellor, with the average length of each case being about 30 to 40 pages long. Yet another example of how prolific the Court of Chancery is.]
This purported class action challenges a merger of American Surgical Holdings, Inc. with AH Merger Sub, Inc., a wholly-owned subsidiary of AH Holdings, Inc., which, in turn, is an affiliate of Great Point Partners, I LP. After the appointment of a Mergers and Acquisitions Committee, and months of negotiations between American Surgical and Great Point, a merger agreement was entered into and structured as a reverse triangular merger. Under the terms of the merger agreement, each share of American Surgical common stock was converted into a right to receive $2.87 in cash. The merger agreement also contained several defensive devices, including a termination fee, a matching rights provision, and a no-shop clause.
The Court referred to certain defendant directors of American Surgical and two key employees of American Surgical as representing the “Control Group.” In addition to the merger agreement, each member of the Control Group executed a stockholder voting agreement, an exchange agreement that allowed them to retain interest in the company following the merger, and employment agreements which became effective at the time of the merger.
The complaint alleges that the valuation opinions were flawed and that the comparable company analysis was not done properly, with the result being that the merger price was too low. The complaint also alleges that not all aspects of the fairness opinion were fairly disclosed to the shareholders, and that the Control Group, with its ongoing interest in the company, would benefit from the synergies of the merger, but this fact was not disclosed in the definitive proxy statement.
This suit was filed after the preliminary proxy statement was filed. The subsequent definitive proxy statement contained supplemental disclosures that mooted the disclosure claims in the complaint.
The complaint alleges that the Control Group, as controlling shareholders, violated their fiduciary duties of loyalty and care owed to the public shareholders of American Surgical by usurping the benefit for themselves of an ongoing interest in the company on terms that were unfair to the class. Count II alleges that the Control Group was unjustly enriched as a result of the merger. Court III alleges that the board breached their duty to ensure that the transaction was entirely fair even though they were standing on both sides of the transaction. Count IV alleges that the purchasing entities aided and abetted the breaches of fiduciary duty.
The remedy the complaint seeks is to certify this action as a class action, rescind the merger or, in the alternative, recover rescissory damages, have the defendant account for all the damages they caused the purported class, and to recover the costs of this action, including reasonable attorneys’ fees.
The defendants filed a joint motion to dismiss pursuant to Court of Chancery Rule 12(b)(6), arguing that the allegations are insufficient to rebut the presumptions of the business judgment rule.
The Court reviewed the Delaware standard for a motion to dismiss under Rule 12(b)(6), which is “reasonable conceivability,” (and is different than the federal standard under Rule 12(b)(6)). See Central Mortgage Co. v. Morgan Stanley Mortgage Capital Holdings, LLC, 27 A.3d 531, 537 (Del. 2011).
The Court described the transaction involved here as similar to the merger involved in the Chancery case of In Re John Q. Hammons Hotels Inc. S’holdr Litig., 2009 WL 3165613, at *10 (Del. Ch. Oct. 2, 2009). That is, where as in this case a corporation with a controlling stockholder merges with an unaffiliated company, the minority stockholders of the controlled corporation are cashed-out, and the controlling stockholder receives a minority interest in the surviving company. In that situation, the controlling stockholder does not “stand on both sides” of the merger and therefore the Delaware Supreme Court decision in Kahn v. Lynch Communications Systems, Inc., 638 A.2d 1110 (Del. 1994), does not mandate that the entire fairness standard apply, notwithstanding any procedural protections that were used.
The Court added that 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.” Hammons, at *12. (emphasis in original.) The Court emphasized, however, that if a transaction is not conditioned on “robust procedural protections,” then the entire fairness is the appropriate standard of review. In this case, because the merger was not conditioned on “robust procedural protections,” the merger will be reviewed for entire fairness.
The Court reiterated the settled principle of Delaware law that when a control group exists, it is accorded controlling shareholder status, which means that its members owe fiduciary duties to the minority shareholders of the corporation. See Dubroff v. Wren Holdings, LLC, 2011 WL 5137175, at *7 (“Dubroff II”) (Del. Ch. Oct. 28, 2011).
As in the Hammons case, in this case the controlling stockholder entered into a merger with an unaffiliated company, and in the merger, the minority stockholders were cashed-out while the controlling stockholder retained the ability to participate in the future profits of the corporation and its future growth. The Court in Hammons determined that even when an independent and disinterested special committee negotiates on behalf of a minority, a merger will still be subject to entire fairness review unless it is conditioned on “robust procedural protections.” Without these protections, it is reasonable to infer that the controlling stockholder might “agree to a lower sale price in order to secure a greater profit from its investment in the surviving entity.” See Hammons at *12.
There were no robust procedural protections in this case, such as “non-waivable vote of the majority of all the minority stockholders.” Where, as here, the entire fairness standard applies, “controlling stockholders can never escape entire fairness review, but they may shift the burden of persuasion by showing “that the transaction was approved by an independent board majority (or in the alternative, a special committee of independent directors).” See In Re Southern Peru Copper Corp S’holder Deriv. Litig., 2011 WL 6440761, at *20 (Del. Ch. Oct. 14, 2011, revised Dec. 20, 2011).
The determination of whether a defendant has met the burden of entire fairness will normally be impossible by examining only the documents the Court is free to consider on a motion to dismiss. See footnote 74. See generally footnote 75 which is an expansive discussion of the Court’s awareness of transactions, that are not prohibited by Delaware law, which involve a private equity fund purchasing companies with the condition that critical members of management continue on in employment in the new company. The Court cited as a decision excepting such structure the Chancery opinion in the case of In Re OPENLANE, Inc., S’holders Litig., 2011 WL 4599662, at *5 (Del. Ch. Sept. 30, 2011).
Because the merger will be reviewed for entire fairness, the motion to dismiss Count I was denied. Although the claim for unjust enrichment in Court II appeared to be duplicative of the breach of fiduciary duty claim, Delaware law permits a plaintiff to simultaneously assert two equitable claims even if they overlap. See MCG Capital Corp. v. Maginn, 2010 WL 1782271, at *25 n.147 (Del. Ch. May 5, 2010). Although a plaintiff can only receive one recovery, at this early procedural juncture, the Court allowed both claims to proceed and denied the motion to dismiss that claim.
The Court also refused to dismiss Court III which alleged a breach of fiduciary duty to ensure that the merger was fair to the minority shareholders and that those shareholders were provided with all material information with which to seek an appraisal. Even though the charter included an exculpatory provision under DGCL Section 102(b)(7), the defendants recognized that this early stage in the case was not the appropriate time to address the impact of the exculpatory provision under Section 102(b)(7), which would need to be decided at trial or after further summary disposition. Therefore, Court III will proceed to trial. However, the Court granted the motion to dismiss Count IV regarding the aiding and abetting claim.