Earlier this year, the Delaware Court of Chancery held that a conflicted transaction, even if not involving a controlling stockholder, could only be “cleansed” through the use of a special committee that was formed ab initio (i.e., from the outset). Accordingly, if boards of directors wish to form special committees of disinterested and independent directors to insulate themselves from fiduciary liability and invoke business judgment review in connection with M&A or other transactions, they must form those committees before any substantive economic negotiations have occurred.
Under Delaware law, courts will evaluate a disinterested and independent board of directors’ actions under business judgment review, a broadly deferential standard. However, if the majority of a board is conflicted, courts will increase their scrutiny and apply entire fairness review. Under entire fairness review, the board has the burden of showing the transaction was entirely fair to the company and its stockholders.
Nonetheless, Delaware courts have recognized two methods by which such a conflicted transaction without a controlling stockholder can potentially be “cleansed,” and thus reinvoke business judgment review: (1) approval by a fully informed, uncoerced vote of disinterested stockholders as noted under Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015), or (2) approval by a fully-empowered special committee consisting solely of disinterested and independent directors as noted under In re Trados Inc. S’Holder Litig., 73 A.3d 17 (Del. Ch. 2013).
Salladay v. Lev
On February 27, 2020, the Delaware Court of Chancery issued a decision expanding the formation requirements for a special committee. In Salladay v. Lev, C.A. No. 2019-0048-SG, 2020 Del. Ch. LEXIS 78 (Del. Ch. Feb. 27, 2020) (“Salladay“), the Court of Chancery held that a special committee can cleanse a conflicted, non-controller transaction only if the special committee is established ab initio (i.e., from the outset), before any substantive economic discussions have occurred.
In Salladay, the complaint alleged that interested directors improperly influenced the transaction process, resulting in the company being sold at an unfairly depressed price. Specifically, it alleged that the target company’s conflicted CEO and board chairman met with a representative of the acquirer, and disclosed that the board would be receptive to an acquisition offer of $3.50 to $4.00 per share. About a week later, the board established a special committee and conditioned the transaction on the committee’s approval. The acquirer made an initial offer of $3.50 per share, and after negotiations raised it to $3.68 per share. The special committee ultimately recommended approval of the transaction at the increased price of $3.68 per share.
In finding that the board’s use of a special committee did not cleanse the transaction, the Salladay court held that a special committee in a conflicted, non-controller transaction must be sufficiently constituted and authorized ab initio, consistent with the ab initio requirements established by Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW“) for conflicted transactions with a controlling stockholder. In MFW, the Delaware Supreme Court rationalized the ab initio requirements as providing protections for the interests of minority stockholders. A controlling stockholder must know, from inception, that it cannot bypass the special committee.
The Court of Chancery held that the same concerns apply in a conflicted transaction without a controlling stockholder. The price negotiations in any conflicted transaction must replicate an arms-length transaction to invoke business judgment review. Even in a non-control setting, commencing negotiations prior to the special committee’s constitution may begin to shape the transaction in a way that even a fully-empowered committee will later struggle to overcome. Like the controlling stockholder in an MFW scenario, the acquirer and any interested directors in a non-MFW scenario must know they cannot bypass the special committee.
Applying the ab initio requirement to the Salladay transaction, the Court of Chancery found it conceivable that the discussions among the conflicted CEO and board chairman and the acquirer essentially formed a price collar which set the field of play for economic negotiations to come. Notably, the initial offer was at the precise bottom of the range suggested by the CEO, and the special committee was not empowered until after the point at which it could act to replicate an arms-length transaction.
In light of Salladay, any company seeking to use a special committee to cleanse a conflicted transaction must be wary of the ab initio requirement. Unless the Delaware courts reach a contrary conclusion in the future, boards of directors wishing to utilize special committees to trigger business judgment review of transactions must be sure to form those committees before any economic negotiations take place.
If you have any questions concerning the impact of this ruling on any transaction that you are contemplating, please contact your Seward & Kissel relationship attorney.