Website: Wilson Sonsini Goodrich & Rosati - Delaware Court Applies Entire Fairness Standard of Review to a Sale of a Company to a Third Party When the Company Has a Controlling Stockholder

The Delaware Court of Chancery recently issued an interesting opinion that provides additional guidance for structuring transactions to acquire companies with controlling stockholders. In a case arising out of the sale of John Q. Hammons Hotels, Inc. (JQH), the court held that while the stringent entire fairness standard of review generally does not apply to companies with a controlling stockholder if the controlling stockholder was not on both sides of the transaction, the entire fairness standard may apply when the controlling stockholder and the minority stockholders are competing for the merger consideration. Because in this case the controlling stockholder was, in a sense, competing with the minority over how the merger consideration would be divided, the court held that the transaction must be, at a minimum, "(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."¹ While the plaintiffs conceded that the special committee was independent and disinterested, because the majority-of-the-minority condition was waivable and was based only on those voting (and not all minority stockholders), the court held that entire fairness applied (even though the condition was not waived and a majority of all of the minority stockholders did approve the transaction). The decision is significant because, among other reasons, it applies the entire fairness standard to a transaction in which the controlling stockholder did not stand on both sides of the transaction.

This case arose from the common fact pattern of an acquirer proposing to purchase a company that has a controlling stockholder.² What was somewhat unusual here was that the controlling stockholder received significant consideration different from that received by the minority stockholders. Here, the controlling stockholder was John Q. Hammons, who held approximately 76 percent of the voting power in JQH. The acquirer was Jonathan Eilian, a third-party real estate investor with whom, as emphasized by the court, Hammons had no prior relationship and whose offer was neither solicited by Hammons nor JQH.

Eilian approached JQH about a possible transaction in late 2004, when Hammons and a special committee of the JQH board were in the midst of negotiating a sale of the company to another third-party buyer, Barceló Crestline Corp. (Barceló). Over the next several months, Hammons and the special committee negotiated separately with each of Barceló and Eilian. Recognizing the need to obtain Hammons' consent to any merger, both investors agreed to provide consideration for Hammons' controlling interest that met his unique requirements, including ownership in the surviving entity for tax purposes and financial resources to continue to develop and manage hotels. The special committee, for its part, recognized its inability to broadly market JQH given Hammons' transactional veto power, and focused on obtaining the best price reasonably available to minority stockholders in any deal endorsed by Hammons.

Ultimately, the special committee rejected Barcel's offer of $13 per share for the minority shares, but accepted Eilian's subsequent, superior offer of $24 per share. Under Eilian's offer, Hammons received a 2 percent ownership interest in the cash-flow distributions and preferred equity of the surviving entity; a liquidation preference of $335 million associated with his preferred equity interest in the surviving entity; a $25 million short-term and $275 million long-term line of credit for hotel development; ownership of one of JQH's hotel properties; and various other contractual rights regarding the future development and management of hotels. In essence, Hammons converted his interest in JQH into an opportunity to benefit from any upside achieved by Eilian and to continue in the hotel business himself, without public investors, using assets and contractual rights that had belonged to JQH or had been exchanged for the assets of JQH. The minority stockholders of JQH, on the other hand, simply were cashed out.

In June 2005, the parties entered into a merger agreement that conditioned closing of the merger on approval by the majority of the minority stockholders who voted on the matter, or waiver of that condition by the special committee. In September 2005, the minority stockholders overwhelmingly approved the merger, which closed that month.

In their suit, the plaintiff stockholders alleged various breaches of fiduciary duty by Hammons (by dominating the negotiations and using his position of control to negotiate benefits for himself that were not shared with the minority stockholders) and the JQH directors (by allowing the merger to be negotiated through a deficient process), and contended that the merger was unfair to the minority stockholders, both from a procedural and a substantive standpoint. The primary issue before the court in its ruling on cross-motions for summary judgment was the appropriate standard of judicial review applicable to the transaction.

Under the Delaware Supreme Court's decision in Kahn v. Lynch,³ if a controlling stockholder stands on both sides of an acquisition transaction structured as a merger by acting as both a buyer and seller in the negotiations, the standard of review is entire fairness, under which the party with the evidential burden must prove that the transaction in question was both substantively fair (i.e., a fair price) and procedurally fair (i.e., a fair process that does not coerce the minority stockholders). The adoption of certain procedural protections for minority stockholders can shift the burden of entire fairness review in such mergers from the defendants to the plaintiffs, but cannot reduce the standard of review to the deferential and less stringent business judgment rule, under which courts typically do not second-guess board decisions absent a finding of a breach of the directors' duty of care or duty of loyalty.

Delaware courts have taken a different approach when the offer to purchase in an acquisition transaction involving a target company with a controlling stockholder is made directly to minority stockholders through a tender offer. In that situation, the transaction can be reviewed under the business judgment rule, subject to the requirements that certain procedural safeguards similar to those required by Kahn v. Lynch are put in place and that the tender offer is not coercive.⁴

Commentators long have noted that Delaware's differing approach to mergers and tender offers involving conflicted controlling stockholders may lead to substantively similar transactions being subject to different levels of review depending on the deal structure. In more recent Delaware Court of Chancery opinions, the court has advocated for harmony in this area by moving towards the approach taken by the courts in respect of tender offers and adopting the business judgment standard of review for controlling stockholder mergers in which heightened procedural protections for minority stockholders (similar to those in Kahn v. Lynch) have been adopted.⁵

Because the Controlling Stockholder Was Not on Both Sides of the Transaction, Lynch Not Applicable

The plaintiffs in this case contended that Hammons stood on both sides of the merger because he would receive an ownership interest in the surviving entity as well as other contractual benefits not available to the minority stockholders, as discussed above. The court rejected this argument, emphasizing the fact that Eilian had negotiated separately with Hammons and with the special committee. Thus, Hammons was not in the position of negotiating on behalf of the minority stockholders, nor was the special committee negotiating directly with Hammons. Rather, the offer made to the minority stockholders came from an unaffiliated third party.

The court also declined the plaintiffs' invitation to apply the rule of Kahn v. Lynch in these factual circumstances and review the merger under an entire fairness standard whether or not Hammons stood on both sides of the transaction. To the contrary, the court held that the business judgment standard may be invoked when the controlling stockholder is not on both sides of the transaction and when the interests of the minority stockholders are adequately protected. Nonetheless, the court held that business judgment review was not automatic outside of the Kahn v. Lynch context, instead indicating that because Hammons was essentially competing with the minority stockholders for the portion of the merger consideration to be received, the merger still could be subject to entire fairness review until the defendants overcame the additional hurdle of demonstrating that the interests of the minority stockholders had been protected.

The court recognized that there are two procedural safeguards that can be adopted by a board in an effort to either shift the burden and/or provide for the business judgment standard of review: 1) recommendation by a disinterested and independent committee of the board of directors and 2) approval by stockholders in a non-waivable vote by a majority of all minority stockholders. The court then found that the JQH merger lacked the second safeguard because it was conditioned only on approval by a majority of the minority stockholders who voted, rather than all minority stockholders, and because the need for minority stockholder approval was waivable by the JQH special committee. As a result, the court determined that the merger was subject to entire fairness review.⁶

As Delaware law further evolves with regard to the standards applicable to controlling stockholder transactions, this area will continue to pose potential questions and pitfalls for boards attempting to negotiate and structure a transaction, creating a need to consult with legal advisors early on in any such process. While providing additional guidance in the area, Hammons still leaves unclear certain questions. For example, where is the line drawn between a controlling stockholder's involvement in a negotiating process and its receipt of consideration different from that received by the minority stockholders such that the controlling stockholder competes with the minority for the merger consideration and/or stands on both sides of a transaction?⁷ Nevertheless, Hammons provides some important practical guidance on these issues, including the following:

Please contact either of the authors, your regular Wilson Sonsini Goodrich & Rosati contact, or any member of our mergers and acquisitions practice or securities litigation department with any questions you may have about this important decision and the potential implications it could have on your business or the transactions in which you are involved.

¹ The defendants have filed an application for certification of an interlocutory appeal of the decision.

² These include situations in which stockholders do not have majority voting control but still hold significant equity stakes in the target company in question. See In re Cysive, Inc. Shareholders Litigation, 836 A.2d 531 (Del. Ch. 2003).

³ Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994).

⁴ See In re Pure Resources, Inc. Shareholders Litigation, 808 A.2d 421 (Del. Ch. 2002).

⁵ See In re Cox Communications, Inc. Shareholders Litigation, 879 A.2d 604 (Del. Ch. 2005).

⁶ Interestingly, the court rejected the defendants' argument that the business judgment standard was appropriate because a majority of all of the minority stockholders ultimately did approve the merger, noting that a failure to make the safeguards a precondition to a deal deprived them of their "maximum effect." In addition, the court criticized JQH's failure to disclose potential conflicts of interest faced by the special committee's legal and financial advisors.

⁷ In other words, the court did not explain what facts, such as the presence of a controlling stockholder alone, or Hammons' continuing interest in the surviving entity, were sufficient to overcome the presumption of business judgment in this case.