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Delaware Upholds Business Judgment Review for Controlling Stockholder Mergers If Minority Is Protected

On Friday, March 14th, the Delaware Supreme Court held that controlling stockholder mergers should be subject to deferential business judgment review, rather than the more stringent entire fairness standard, where minority shareholders are adequately protected from the outset by conditioning the merger on approval by an independent Special Committee and an informed, uncoerced vote of a majority of the minority stockholders.  The decision, Kahn v. M&F Worldwide Corp., is significant because it confirms that the business judgment rule should apply in these cases and specifies the steps corporate counsel should take in a controlling shareholder merger to ensure the easiest path through the gauntlet of litigation that typically surrounds such transactions.  The court's en banc decision upholds a Court of Chancery ruling issued last May by former Chancellor Strine, who was appointed as Chief Justice of the Delaware Supreme Court after the case was argued.

Delaware courts have long held that, where a corporate transaction involving self-dealing by a controlling shareholder is challenged, the controlling shareholder bears the burden of proving the entire fairness of the transaction to the corporation and the other shareholders.  Over the years, however, the Delaware Supreme Court has created exceptions to this general rule.  Approval by (1) an independent committee of directors, or (2) an informed majority of minority shareholders, shifts the burden of proof on the issue of fairness from the controlling or dominating shareholder to the challenging shareholder-plaintiff.  But what standard of review should be applied if both of these procedural safeguards have been adopted as conditions for a merger between a controlling shareholder and its subsidiary?

That is the question that the Delaware courts confronted in the Kahn case.  Investor Ron Perelman sought to take M&F Worldwide (MFW) private by having his company MacAndrews & Forbes Holdings, Inc., which already owned 43% of MFW, acquire the remaining shares of MFW.  From the outset, MacAndrews & Forbes conditioned the merger on approval by an independent special committee and a majority vote of stockholders unaffiliated with MacAndrews & Forbes.  Moreover, the merger took place at a 47% premium over MFW's stock price before Perelman's offer.  The merger was nevertheless challenged by MFW shareholders who claimed it was unfair.  The Delaware Court of Chancery held that, in light of the safeguards adopted to protect minority shareholders, the transaction should be reviewed under the deferential business judgment rule, rather than the entire fairness standard.  The court then granted summary judgment in favor of the defendants.

On appeal, the Delaware Supreme Court upheld the Court of Chancery's application of the business judgment rule in this situation and affirmed its summary judgment.  As summarized by the Delaware Supreme Court:

"[I]n controller buyouts, the business judgment standard of review will be applied if and only if:  (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority."

The high court reasoned that these protections prevent the controlling shareholder from using its power to dictate the outcome of negotiations and the shareholder vote, and thereby serve to replicate the conditions of a third-party, arm's-length merger.

While the Kahn decision will make it easier for corporate counsel to deal with shareholder suits challenging controlling stockholder mergers, it will not necessarily avoid the burdens of document production, depositions, and other discovery.  The Delaware Supreme Court noted that even under the new business judgment standard the Kahn complaint would have survived a motion to dismiss, requiring discovery on all of the elements of the new standard.  Nor will the new standard apply if the case goes to trial.  The court ruled that, where the defendants cannot show on summary judgment that the elements of the business judgment standard were met, the case should be tried under the entire fairness standard; "unless both procedural protections for the minority stockholders are established prior to trial, the ultimate judicial scrutiny of controller buyouts will continue to be the entire fairness standard of review."

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Chip Phinney