Significant 2017 Decisions Affecting Private M&A: Part 2
The first two of the decisions in part two of this three-part series are Delaware Court of Chancery fiduciary duty cases relating to controlling stockholders. The third decision concerns a takeover defense, and makes clear that under Delaware law, bylaws cannot require supermajority stockholder approval for removal of directors.
Frederick Hsu Living Trust v. ODN Holding Corp. (April 14, 2017)
Selling company assets in order to generate funds to satisfy an obligation to redeem preferred stock may violate a board’s fiduciary duties to residual claimants; fiduciary duties may require boards to commit an "efficient breach" of the redemption obligation.
In Frederick Hsu Living Trust, the Delaware Chancery Court refused to dismiss fiduciary duty claims against certain officers and directors of ODN Holding Corp. (the company) and its controlling venture capital fund for improperly favoring the fund's interests, to the detriment of other stockholders, in connection with the sale of substantially all of the company's businesses to generate cash to partially redeem preferred stock held by the fund.
The fund, Oak Hill Capital Partners, invested $150 million in the company in 2008 in connection with the purchase of Series A preferred stock. Following purchases of common stock of the company in 2009, Oak Hill became the controlling stockholder, and had the right to designate three members of the company's eight-member board of directors. The preferred stock contained a redemption right that was exercisable five years after the issuance date. The redemption right obligated the company, following exercise by Oak Hill, to redeem the preferred stock for an amount equal to the original issue price plus declared and unpaid dividends. If the funds legally available for redemption were insufficient to cover the redemption price, the company was obligated to redeem the maximum number of shares permissible. Thereafter, the company was obligated to "take all reasonable actions (as determined by the [board] in good faith and consistent with its fiduciary duties) to generate, as promptly as practicable, sufficient legally available funds to redeem all outstanding shares of [preferred stock], including by way of incurrence of indebtedness, issuance of equity, sale of assets ... or otherwise."
Prior to 2011, the company engaged in a growth strategy, including through acquisitions. In 2011, after Oak Hill determined that it would have to exercise its redemption right in order to get its capital back, the company changed its strategy and its management team. In 2012, the company sold two of its four lines of business for $15.4 million. The sold businesses included two companies that had been purchased in 2007 for $46.5 million. In May 2012, the compensation committee of the board approved bonus agreements for the CEO and two other officers, which provided for payments if the company achieved a "liquidity event," including redemption of at least $75 million of the preferred stock.
In August 2012, after the board had dropped to seven members, the board formed a special committee consisting of two nonmanagement directors unaffiliated with Oak Hill, which was tasked with evaluating alternatives for funding the redemptions and negotiating with Oak Hill. The company's attempts to obtain a bank loan were unsuccessful. After some back-and-forth with Oak Hill, the special committee approved using $45 million of the company's $50 million in funds to redeem a portion of the preferred stock, in return for an agreement by Oak Hill to forbear on any additional redemption payments until Dec. 31, 2013, which forbearance was cancellable by Oak Hill on 30 days' notice. The court described this forbearance as largely illusory, given that Oak Hill could not compel the company to make additional redemptions unless out of legally available funds, and it was unlikely such funds would become available before the end of the year.
In April 2014, the special committee approved the sale of another of the company's businesses for $40 million. The board used the proceeds to redeem additional shares of preferred stock. In December 2014, the company sold another portion of its remaining business, representing the majority of its remaining revenue, for $600,000, despite having paid $17 million for the business in 2010. In March 2016, Frederick Hsu, one of the founders of the company, brought an action for breach of fiduciary duty by directors and certain officers, breach of fiduciary duty by Oak Hill, unlawful redemptions, and various other claims.
Legal Principles Applicable to Breach of Duty of Loyalty
After dismissing the plaintiff's claims for unlawful redemptions because the company had sufficient funds under Section 160 of the Delaware General Corporation Law to make the redemptions, the court considered the plaintiff's breach of duty of loyalty claims.
The court held that in corporations with more than one class of stock, the directors' fiduciary duties run to the corporation and to "stockholders in the aggregate in their capacity as residual claimants, which means the undifferentiated equity as a collective, without regard to any special rights." The court noted that this is a presumptively long-term focus. However, that does not equate to a duty to ensure a corporation's perpetual existence, because there could be situations where continuing the corporation as a going concern could be value-destroying.
The court noted that holders of preferred stock have rights that are generally contractual in nature. Citing In re Trados Inc. Shareholder Litigation, the court noted that preferred stockholders are owed fiduciary duties "only when they do not invoke their special contractual rights and rely on a right shared equally with the common stock."1 The court noted that these principles apply, notwithstanding the contractual obligation of the company to redeem the preferred stock.
The court noted that the "fiduciary status of directors does not give them Houdini-like powers to escape from valid contracts." According to the court, if directors breach their fiduciary duties when entering into a contract, it may be possible to invalidate the contract on fiduciary duty grounds. But that is not so where a corporation is already bound by a valid contract (like the redemption obligations of the preferred stock). The board still has to act consistent with its fiduciary duties when taking action under valid contracts. In such a situation, "there remains room for fiduciary discretion because of the doctrine of efficient breach."
Contractual Redemption Right Does Not Foreclose Fiduciary Duty Claims
Applying these principles to the situation under consideration, the court noted that the plaintiff was not relying on an efficient breach argument, because the divestitures took place before the redemption right contractually arose. The court noted that the complaint asserted that the board acted disloyally by selling off businesses to raise cash before the contractual redemption right was exercised, and that the divested businesses would have generated greater long-term return for the undifferentiated equity. Moreover, the redemption provisions expressly noted that the company's obligation to generate sufficient cash to fund the redemption was subject to the board's fiduciary duties. The court noted that Oak Hill's contractual redemption right was not inconsistent with the plaintiff's fiduciary duty claims.
Entire Fairness is Standard of Review
The court then addressed the applicable standard of review. The court held that the allegations supported a reasonable inference that the directors acted to benefit Oak Hill, and thus entire fairness would apply. Of the nine directors who served on the board during the relevant period, the court found that the complaint adequately called into question the interests of seven of those directors, given that some were nominees of Oak Hill, one received a bonus that was tied to achieving $75 million in redemptions, and three outside directors took numerous steps that favored the interests of Oak Hill. Given that Oak Hill was a controlling stockholder, and used its power to its benefit in negotiations with the company over the redemption right, use of a special committee, without the protection of a majority-of-the-minority vote, was not sufficient to change the standard of review from entire fairness to business judgment.
Allegations Supported Reasonable Inference of Lack of Entire Fairness
The court held that the allegations supported a reasonable inference that the decision to generate funds to pay off Oak Hill by pursuing a de facto liquidation of the company was not entirely fair to the undifferentiated equity. The court found that the complaint supported a reasonable inference that it was not fair to the undifferentiated equity to change business strategy so as to stockpile cash to be available for the redemptions. According to the court, the company could have continued to grow its business, redeemed the preferred stock over time, and generated returns for its common stockholders. According to the court, the complaint also supported a reasonable inference that the company failed to obtain a fair price in the divestitures.
The decision is reminiscent of In re Trados, where a change-of-control transaction at the behest of the holders of preferred stock, who controlled the corporation, was similarly subject to an entire fairness standard of review. Both cases illustrate the risks to the board of pursuing exit transactions where the holders of common stock will receive little or no consideration.
Redemption provisions are a common feature of preferred stock instruments, particularly in private equity deals, and limit the down-side risk to the holders of the preferred stock. Frederick Hsu Living Trust highlights the risk that board action to generate funds to satisfy the redemption right may constitute a violation of the board's fiduciary duties. The risk of a duty-of-loyalty claim could be mitigated by providing in the terms of the preferred stock for a significant increase in the dividend rate following a failure of the corporation to redeem. The board would have to factor the economic implications of this in its assessment of whether it is in the best interests of the corporation and its residual claimants to sell assets to fund the redemption, or leave the preferred stock outstanding and accruing high dividends.
Another mitigation strategy would be to have the borrower be a limited liability company instead of a corporation. Board fiduciary duties can be substantially eliminated in limited liability companies, unlike in corporations.
Frederick Hsu Living Trust arguably also has some implications for drag-along rights, which, like redemption rights, are contractual rights that may be used to the benefit of controlling stockholders. In the wake of In re Trados, many practitioners advocated for the use of drag-along rights as a way of avoiding Trados-like fiduciary duty actions. The theory is that if the stockholders have the contractual ability to force a sale of the corporation through a drag-along right, the decision whether to sell is made by the stockholders and not the board, and thus the board's fiduciary duties are not implicated. In Frederick Hsu Living Trust, Vice Chancellor J. Travis Laster raised the possibility (in dictum) that a board may have a fiduciary duty to cause the corporation to breach its contractual obligations. Thus, to the extent that exercise of drag-along rights involves action by the corporation (as most drag-alongs do), Frederick Hsu Living Trust can be read as suggesting that boards may have a fiduciary duty to residual claimants to consider whether to cause the corporation not to comply with the drag-along procedures. Such an interpretation of a board's fiduciary duties would undermine the effectiveness of drag-alongs as solutions to the Trados problem.
A final point worth noting is that unlike the board in In re Trados, the board in Frederick Hsu Living Trust used a special committee as a procedural protection for the holders of common stock. The court in Frederick Hsu Living Trust noted that both an effective special committee and a majority-of-the-minority vote were required under the facts of the case in order to invoke the business judgment standard of review. A special committee on its own can have the more modest potential benefit of merely flipping the burden of proving lack of entire fairness to the plaintiff. A majority-of-the-minority vote will in many cases not be practicable, given that the holders of common stock can be expected to vote against any liquidation event that will result in them not receiving any consideration. As a result, it will generally not be possible to avoid an entire fairness standard of review in the types of situation presented by In re Trados and Frederick Hsu Living Trust.
Buttonwood Tree Value Partners LP v. R.L. Polk & Co. Inc. (July 24, 2017)
Actions of family members that acted as a controlling group, and directors allied with them, were subject to entire fairness review when the company they controlled conducted a self-tender offer in which tendering stockholders received less than nontendering stockholders received approximately two years later in a cash-out merger.
Buttonwood Tree Value Partners involved claims by minority stockholders against an alleged control group of family members and the directors representing them for breach of their fiduciary duties of care and loyalty in connection with a self-tender offer by R.L. Polk & Co. (the company). Members of the Polk family, which controlled the company since its founding in 1870, held more than 90 percent of the stock of the company at the time the company commenced a self-tender in March 2011 to purchase company shares at $810 per share (the self-tender). In October 2012, 15 months after the self-tender offer expired, the company engaged a financial adviser to explore a sale. The company was sold to IHS Inc. in June 2013 for $2,675 per share. The company declared a special dividend of $240 per share and two extraordinary dividends of $25 per share in 2012 prior to the sale to IHS. The plaintiffs were minority stockholders that sold shares in the self-tender and as a result, they argued, forwent extraordinary dividends amounting to more than one-third of the tender offer price they received, and merger consideration that was three times the self-tender price received. The Chancery Court ruled at the motion-to-dismiss stage that the claim relating to the members of the Polk family forming a control group could proceed at the pleading stage because it was reasonably conceivable that the Polk family controlled the company and engineered and stood on both sides of the self-tender. As a result, the court would analyze the claim under the entire fairness standard and found that the complaint adequately pled facts alleging that the transaction was not entirely fair to the plaintiffs.
R.L. Polk is a consumer marketing information company that collects and interprets data to help customers make informed decisions. Its assets included Carfax Inc., a provider of vehicle history reports. The company described itself as being minority-held, although approximately 9 percent of its outstanding shares of common stock were publicly held. The company's board of directors included three members of the Polk family — Stephen Polk (the company's chairman, CEO and president), Nancy K. Polk (Stephen Polk's sister-in-law) and Katherine Polk Osborne (Stephen Polk's niece) — along with four other members who were not Polk family members.
Starting in 2008, the board explored a number of strategic options for the company beginning with a self-tender at $850 per share, a price that was supported by an oral fairness opinion delivered by Stout Risius Ross Inc., a firm that renders valuation and financial opinions. The board eventually postponed this initial self-tender offer indefinitely as a result of economic uncertainties and the decline of the automotive industry. Following the 2008 self-tender postponement, the board explored a number of other possible corporate restructuring transactions, including a conversion of the company to subchapter S status and a short-form merger (examination of which was delegated to a committee of non-Polk directors). Throughout 2010 and 2011, the company and its counsel, Honigman Miller Schwartz & Cohn LLP, undertook significant work related to these corporate restructuring transactions, which the plaintiffs allege were a ruse to justify the elimination of minority stockholders prior to a more lucrative sale to a third party, but ultimately did not enact any corporate restructuring. In December 2010, Honigman prepared and delivered a legal memorandum to the board regarding a potential sale of the company.
At a March 9, 2011, board meeting, Stephen Polk informed the board that "the Polk family was no longer interested in pursuing a short-form merger" and that company management was instead interested in buying back shares of minority stockholders and various Polk family members. The board engaged SRR, which first delivered an oral fairness opinion and then a written fairness opinion stating that the proposed price for the self-tender, $810 per share, was fair from a financial point of view. The court noted that the company's stock traded in the $600 to $650 per share range prior to the self-tender. The company launched the self-tender on March 31, 2011, with an expiration of May 16, 2011.
The disclosures in the offer to purchase circulated in connection with the self-tender noted that the Polk family "owned or controlled 485,377 shares representing 90.5 percent of the total number of shares outstanding at the time of the Self-Tender." The offer to purchase disclosed that Polk family stockholders intended to tender approximately 10,000 shares in total, but that they might tender more or fewer shares. The offer to purchase further stated that the board did not consider other strategic options, including a merger or consolidation of the company, the sale or transfer of all or a substantial part of the company's assets, or a purchase of securities in a change-of-control transaction, as there were no firm offers for any such transaction. The offer to purchase stated that "the Polk family has not expressed interest in exploring any such transactions."
The plaintiffs' complaint included claims against (1) the Polk family directors and the other members of the Polk family who owned shares that were controlled by the Polk family directors, formed a part of the alleged control block, supported the Polk family directors or benefited from their actions (the Polk family class), (2) the non-Polk family directors, (3) the company and other entities formed in connection with the structuring options the company explored prior to the self-tender, and (4) the company's legal counsel and financial adviser for aiding and abetting. The claims against the company and the other entities formed by the company were dismissed at oral arguments. The court's decision addressed the claims with respect to the remaining defendant groups at the motion-to-dismiss stage. The claim against the non-Polk directors was dismissed because of a charter exculpatory provision and failure by the plaintiffs to adequately plead facts showing that the non-Polk directors were interested in the self-tender or not independent or acted in bad faith. The claims against the company's legal counsel and financial adviser were likewise dismissed because the court did not find it reasonably conceivable that SRR or Honigman knowingly provided substantial assistance to any fiduciary's breach of duty. The claims against the Polk family class, however, were allowed to proceed and the transactions in question subjected to an entire fairness review.
Analysis of Claim Against Polk Family and Polk Family Directors
Citing Kahn v. M&F Worldwide Corp., the court held that "[w]here a transaction involving self-dealing by a controlling stockholder is challenged, the applicable standard of judicial review is entire fairness."2 The defendants have the burden of proving that the transaction was entirely fair to the minority stockholders. The court held that "it was reasonably conceivable that, through its 90 percent ownership stake, the Polk family — including the Polk family directors — acted as a controlling stockholder such that entire fairness applies to [the] Self-Tender." In reaching that conclusion, the court first noted that "common familial relationships among holders of a majority of corporate voting power are not per se sufficient to establish a controlling group of stockholders." Here, however, there were a number of factors making it reasonably conceivable that the Polk family acted as a controlling block. In addition to the three Polk family members serving on the board, the offer to purchase contained numerous references to the "Polk family" as a single block and disclosed its shareholding as a collective block (i.e., 90.5 percent of the total number of shares outstanding). Most significant to the court was the allegation that Stephen Polk ended the discussions regarding the short-form merger the company was exploring prior to the self-tender by informing the board that "the Polk Family was no longer interested in pursuing a short-form merger as a way to restructure the Company." Based on these facts, the court held that it was reasonably conceivable that the Polk family class and the Polk directors "controlled the Company and engineered — and stood on both sides of — the Self-Tender." Accordingly, the entire fairness standard of review applied.
The court noted that the complaint alleged that the Polk family class and the Polk directors set a price for the self-tender through the use of a financial adviser that also worked for members of the Polk family (in connection with the aborted short-form merger). The complaint "further alleges that those who tendered forwent, as a result, extraordinary dividends amounting to over one-third of the sale price they received, together with merger consideration in an amount three times the Self-Tender price, within a period of around two years." The court held that these facts sufficiently alleged, at the pleading stage, that the transaction was not entirely fair to the plaintiffs. Accordingly, the court refused to dismiss the claims, including various disclosure-related claims, against the Polk family class and the Polk directors.
Buttonwood Tree Value Partners reinforces that the actions of controlling stockholders and related directors may be later scrutinized under an entire fairness standard of review when a series of transactions results in significantly different valuation outcomes for minority stockholders.
There are several potential structural protections that do not appear to have been employed in this case. Application of entire fairness as the applicable standard of review, and the resulting inability of the defendants to have the case dismissed at the pleadings stage, turned on the plaintiffs making the requisite showing that the Polk family class acted as a control block. The court noted that common familial relationships does not per se establish a controlling group of stockholders. The Polk family class could have established procedures, perhaps through the use of family trusts, to ward against the conclusion that they functioned as a control block. They could also have been mindful of not making public disclosures that indicated that they functioned as a control block.
Another structural protection that does not appear to have been employed in connection with the self-tender is the use of a special committee of disinterested and independent directors with full authority to consider strategic alternatives, to employ legal counsel and financial advisers of its choice, and to negotiate at arms' length with the family stockholders. This is a bit surprising, given that the board appears to have formed a special committee in connection with consideration of a short-form merger and converting the company to subchapter S status. Under Kahn v. Lynch Communications Systems Inc.,3 an effectively functioning special committee will flip the burden of proving lack of entire fairness to the plaintiffs. Under Kahn v. M&F Worldwide Corp., both a special committee and a majority of the minority stockholder approval condition can result in business judgment as the applicable standard of review.
Frechter v. Zier, (Jan. 24, 2017)
Bylaw provisions of Delaware corporations requiring supermajority stockholder approval for removal of directors are invalid under Delaware law.
In Frechter v. Zier, the Court of Chancery found that a corporate bylaw provision that required a supermajority approval of the stockholders to remove a director was in violation of Section 141(k) of the DGCL.
On Jan. 7, 2016, defendant Nutrisystem Inc. announced that it had amended its bylaws to delete a provision allowing for the removal of directors only for cause. The court noted that Nutrisystem was presumably responding to a recent decision by the Delaware Court of Chancery finding that removal "for cause" provisions in bylaws of Delaware corporations without classified boards or cumulative voting were prohibited by Section 141(k) of the DGCL.4 Nutrisystem's amendment, however, left a provision in the bylaws requiring that a director may only be removed with the vote of 66 2/3 percent of the voting power of all of Nutrisystem's outstanding stock.
On Feb. 24, 2016, the plaintiff, a stockholder of Nutrisystem, filed a class action complaint against the company and its directors challenging the bylaw provision. In a decision on the defendants' motion to dismiss and the plaintiff's motion for summary judgment, the court reviewed the language of Section 141(k) of the DGCL, which provides that "[a]ny director or the entire board of directors may be removed, with or without cause, by the holders of a majority of the shares then entitled to vote at an election of directors." Based on the plain language of the statute, the court found the bylaw provision to be invalid.
The court then reviewed the defendants' contention that Section 141(k) is merely a permissive provision, in that it provides that holders of a majority of a company's shares "may" remove directors, but it does not prohibit bylaws from including a different requisite for director removal. The defendants pointed to other provisions of the DGCL that use "shall" or "must" language to argue that if there is a required vote for certain actions, the law uses mandatory language. The court disagreed with this reasoning, explaining that Section 141(k) provides that holders of a majority of shares may remove a director, but they are not required to do so; therefore mandatory language would not make sense. In addition, the court explained that the Nutrisystem bylaw does not allow holders of a majority of shares to remove directors, and is therefore inconsistent with the statute.
The court also noted the defendants' reading of Section 141(k) was inconsistent with the Vaalco Energy decision, where Vice Chancellor Laster found that the language in Section 141(k) providing that directors "may" be removed for cause prohibited bylaws requiring cause for removal. Therefore, the language in Section 141(k) providing that directors "may" be removed by a majority vote similarly prohibits bylaws that require some other threshold for removal.
Given both Vaalco Energy and Frechter, companies are encouraged to review their bylaws to ensure they do not include impermissible provisions limiting the removal of directors for cause or requiring a supermajority vote. While Vaalco Energy related to legacy bylaw language that was not removed when the company in that case declassified its board,5 Frechter involved bylaw language that appears to have been intended as a form of takeover defense that was unrelated to any board classification.6 Frechter provides clear guidance that this type of takeover defense is invalid. The Frechter court did not address whether it would have been valid if located in Nutrisystem's charter instead of its bylaws. Section 102(b)(4) of the DGCL, which permits charters to contain "[p]rovisions requiring for any corporate action, the vote of a larger portion of the stock or of any class or series thereof ... than is required by this chapter," appears to authorize such an approach.
See In re Vaalco Energy Inc. Shareholder Litigation, C.A. No. 11775-VCL (Del. Ch. Dec. 21, 2015). See also our summary of this decision located at https://www.apks.com/en/perspectives/publications/2017/01//-/media/files/perspectives/publications/2017/01/significant-2016-decisions-affecting-private-comp.pdf.