A Hot Winter in Delaware's Courts: Recent Developments in Delaware Corporate Law

Introduction

In recent months, Delaware's Supreme Court and Court of Chancery have issued opinions in four cases that will significantly impact the way in which practitioners advise their corporate clients on several significant issues.  First, in In re Pure Resources, Inc. Shareholders Litigation, Vice Chancellor Strine issued an opinion in which he addressed the perceived doctrinal disunity characterizing Delaware's current practice of reviewing negotiated merger transactions with controlling shareholders with greater scrutiny than a transaction that accomplishes the same result but by way of a first-step tender offer followed by a "short-form" merger under 8 Del. C. § 253.  Roughly a month later, the Court of Chancery and the Supreme Court weighed in on the issue of how tightly parties to an acquisition transaction can "lock up" a preferred deal in In re NCS Healthcare, Inc. Shareholders Litigation.  Next, in early January, the Supreme Court issued an opinion in MM Companies, Inc. v. Liquid Audio, Inc. clarifying the standard of review that the courts should apply in reviewing defensive measures that adversely affect the shareholder franchise.  Finally the Court of Chancery's opinion in Biondi v. Scrushy should be mandatory reading for all attorneys that advise special committees of boards of directors as part of their practice.  This article will discuss the Courts' opinions in these four cases and will attempt to place the import of these decisions in the appropriate context. 

In re Pure Resources, Inc. Shareholders Litigation: How to Tame the "800 Pound Gorilla."

In October of 2002, Vice Chancellor Strine issued an opinion in the Pure Resources litigation in which he thoroughly examined "an aspect of Delaware law fraught with doctrinal tension:  what equitable standard of fiduciary conduct applies when a controlling stockholder seeks to acquire the rest of the company's shares?"[1]  In conducting its analysis, the court examined and attempted to reconcile what it found to be conflicting doctrinal underpinnings in the Supreme Court's decisions in Kahn v. Lynch Communication Systems, Inc.,[2] which requires an application of the entire fairness test, and Solomon v. Pathe Communications Corp,[3] which exempts a transaction from that test in situations where the controlling stockholder makes a "voluntary" tender offer to purchase the minority's shares.  The court ultimately found that the more deferential Solomon line of authority applied where a controlling shareholder commenced a tender offer that had as its ultimate goal a "short form" merger.  He concluded that the law based on Solomon should give greater recognition to the "inherent coercion" with which the Supreme Court was concerned in Lynch.[4]  Important to practitioners is the Vice Chancellor's suggestion that the law should only find a controlling shareholder tender offer to be non-coercive where:  (1) it is subject to a non-waivable majority of the minority tender condition; (2) the controlling shareholder commits to a prompt § 253 merger at the same price if it reaches the 90% threshold; and (3) the controlling shareholder has not threatened retribution.[5]  While the language of Vice Chancellor Strine's opinion did not explicitly state that these conditions are required in all majority stockholder tender offers, practitioners are on notice that the roadmap for acquisition tender offers by controlling stockholders has probably changed. 

Unocal Corporation ("Unocal") owned 65.4% of the issued and outstanding stock of Pure Resources, Inc. ("Pure").  Pure was the product of a business combination between Titan Exploration, Inc. and a spin off of Unocal's operations.  The remaining 34.6% of Pure was held by management of Pure and the former stockholders of Titan. 

In the summer of 2001, Unocal explored the feasibility of acquiring the rest of Pure, but "the tragic events of that year and other mundane factors" derailed the process.[6]  In the spring of 2002, Pure began considering the creation of a "Royalty Trust," which would sell portions of certain mineral rights owned by Pure to third parties in order to reduce Pure's debt and give the company capital to expand. 

In August 2002, as a result of pressures generated by the Royalty Trust discussions, Unocal made an exchange offer directly to the stockholders of Pure pursuant to which the stockholders (other than Unocal) would receive 0.6527 shares of Unocal common stock for each outstanding share of Pure common stock tendered.  The offer also contained the following key features:  (1) a non-waivable majority of the minority tender provision, which included management of Pure as part of the minority, (2) a waivable condition that enough shares be tendered to enable Unocal to own 90% of the outstanding stock of Pure, thus allowing a short-form merger under Section 253 of the DGCL, and (3) a statement that Unocal intends to consummate the short-form merger as soon as practicable at the same exchange ratio.[7] 

The Pure Board established a Special Committee to respond to the Unocal offer, which had the authority to retain independent advisors, formulate a recommendation on the offer's advisability, and negotiate with Unocal to increase its bid.  The Committee met with Unocal and asked it to increase its offer, but was unsuccessful.  Based on the analysis and advice of its financial advisors, the Special Committee voted not to recommend the Unocal offer. Management also announced their personal intentions not to tender. 

Plaintiffs argued that the offer should be preliminarily enjoined because (i) the offer was not entirely fair, (ii) the offer was coercive, and (iii) the disclosures provided to the Pure stockholders in connection with the offer were inadequate and misleading.[8]  Specifically, plaintiffs argued "the structural power of Unocal over Pure and its Board, as well as Unocal's involvement in determining the scope of the Special Committee's authority, made the offer coercive."[9]  Plaintiffs further asserted that Unocal used its unique access to inside information from Pure to impose an inadequate bid at a time that was advantageous to Unocal, and then acted in its self-interest by preventing the Special Committee from obtaining the necessary authority to respond to the Offer.[10]  For these reasons, plaintiffs asserted that Unocal breached its fiduciary duties as a controlling stockholder and the Pure Board breached its duties by failing to take more proactive measures against Unocal.[11] 

Unocal, in its defense, asserted that the entire fairness standard did not apply to the offer, and instead the offer was valid under the standard set forth in Solomon v. Pathe Communications, which permits a controlling stockholder to make a tender offer at any price so long as the offer is not structurally coercive nor contains any misleading disclosures.[12]  Moreover, Unocal highlighted the negative recommendation from the Pure special committee, the fact that the tender was conditioned on a majority of the minority provision, and that it intended to complete a short-form merger at the same price as conclusive evidence that Pure's shareholders were not being coerced into tendering their shares to Unocal.[13] 

This opinion is, perhaps, most important to practitioners for its thorough and thoughtful analysis of the apparent discrepancy in the policies espoused in the Lynch and Solomon lines of cases.  The court began with the general observation that the Lynch line of cases, where a controlling stockholder negotiates a merger agreement with the target board to buy out the minority, "emphasizes the protection of minority stockholders against unfairness" while the Solomon line (tender offer, followed by a short-form merger) "facilitates the free flow of capital . . . so long as the consent of the sellers is not procured by inadequate or misleading information or by wrongful compulsion."[14]  The court's general observation on this distinction is worth quoting in its entirety. 

These strands appear to treat economically similar transactions as categorically different simply because the method by which the controlling stockholder proceeds varies.  This disparity in treatment persists even though the two basic methods (negotiated merger versus tender offer/short-form merger) pose similar threats to minority stockholders.  Indeed, it can be argued that the distinction in approach subjects the transaction that is more protective of minority stockholders when implemented with appropriate protective devices-a merger negotiated by an independent committee with the power to say no and conditioned on a majority of the minority vote-to more stringent review than the more dangerous form of a going private deal-an unnegotiated tender offer made by a majority stockholder.  The latter transaction is arguably less protective than a merger of the kind described, because the majority stockholder-offeror has access to inside information, and the offer requires disaggregated stockholders to decide whether to tender quickly, pressured by the risk of being squeezed out in a short-form merger at a different price later or being left as part of a much smaller public minority.  This disparity creates a possible incoherence in our law.[15]

The court then launched into a detailed discussion of both lines of authority.  The Vice Chancellor began with Lynch and its holding that when a controlling stockholder attempts to acquire the remaining shares by way of a negotiated merger pursuant to 8 Del. C. § 251, the entire fairness standard of review applies regardless of whether:  (1) the target board was comprised of a majority of independent directors; (2) the target appointed a special committee of independent directors with the authority to negotiate and veto the merger, or (3) the merger was made subject to approval by a majority of the disinterested stockholders of the target.[16] 

It was the policy driving the Supreme Court's decision in Lynch that had an impact on the litigation before the Court of Chancery.  In colorful, but effective terms, the Vice Chancellor described that policy. 

The Supreme Court concluded that even a gauntlet of protective barriers like those would be insufficient protection because of (what I will term) the "inherent coercion" that exists when a controlling stockholder announces its desire to buy the minority's shares.  In colloquial terms, the Supreme Court saw the controlling stockholder as the 800-pound gorilla whose urgent hunger for the rest of the bananas is likely to frighten less powerful primates like putatively independent directors who might well have been hand-picked by the gorilla (and who at the very least owed their seats on the board to his support).

The Court also expressed concern that minority stockholders would fear retribution from the gorilla if they defeated the merger and he did not get his way.  This inherent coercion was felt to exist even when the controlling stockholder had not threatened to take any action adverse to the minority in the event that the merger was voted down and thus was viewed as undermining genuinely free choice by the minority stockholders.[17]

The Court then examined the Solomon line of cases and the policy behind them.  The Vice Chancellor described the "prototypical" transaction at issue in this line of cases as a tender offer by the controlling stockholder to the minority stockholders (often with a minimum tender condition that would allow it to reach the 90% ownership threshold for a short-form merger under § 253).[18]  This way of completing a transaction differs markedly from the negotiated merger approach because with the tender offer/short-form merger approach, neither stage requires the target board to take any action.[19] 

Another key difference identified by the court was in the type of coercion that might be exerted against the minority stockholders.  The court observed: 

In the tender offer context addressed by Solomon and its progeny, coercion is defined in the more traditional sense as a wrongful threat that has the effect of forcing stockholders to tender at the wrong price to avoid an even worse fate later on, a type of coercion I will call structural coercion.  The inherent coercion that Lynch found to exist when controlling stockholders seek to acquire the minority's stake is not even a cognizable concern for the common law of corporations if the tender offer method is employed.[20]

The court then turned its attention to the question of "whether the mere fact that one type of transaction is a tender offer and the other is a negotiated merger is a sustainable basis for the divergent policy choices made in Lynch and Solomon?"[21]  In solving this puzzle, the court noted that "Delaware law has not regarded tender offers as involving a special transactional space, from which directors are altogether excluded from exercising substantial authority," and for this reason it was "important to ask why the tender offer method should be consequential in formulating the equitable standards of fiduciary conduct by which the courts review acquisition proposals made by controlling stockholders."[22]  The court queried whether the answer to the question above was that the tender offer method is inherently more protective of minority shareholders, and thus, less scrutiny was required as compared to negotiated mergers?[23]  The court ultimately found, however, that the coercive forces weighed equally and that formalistic distinction between the two types of transactions could not bear the weight of scrutiny.[24] 

The problem is that nothing about the tender offer method of corporate acquisition makes the 800-pound gorilla's retributive capabilities less daunting to minority stockholders.  Indeed, many commentators would argue that the tender offer form is more coercive than a merger vote.  In a merger vote, stockholders can vote no and still receive the transactional consideration if the merger prevails.  In a tender offer, however, a non-tendering shareholder individually faces an uncertain fate.[25]

The plaintiffs urged the court to find that the absence of a meaningful distinction between the effects the two types of transactions have on the minority shareholders indicated that the court should apply the entire fairness standard of Lynch to tender offers by controlling shareholders.  The court rejected the plaintiffs' invitation and found that: 

Instead, the preferable policy choice is to continue to adhere to the more flexible and less constraining Solomon approach, while giving some greater recognition to the inherent coercion and structural bias concerns that motivate the Lynch line of cases.

. . .

To the extent that my decision to adhere to Solomon causes some discordance between the treatment of similar transactions to persist, that lack of harmony is better addressed in the Lynch line, by affording greater liability-immunizing effect to protective devices such as majority of minority approval conditions and special committee negotiation and approval.[26]

In applying the Solomon standard to the case at bar, the court noted that "[i]n order to address the prisoner's dilemma problem [of inherent coercion], our law should consider an acquisition tender offer by a controlling stockholder non-coercive only when" (1) it is subject to a non-waivable majority of the minority tender condition; (2) the controlling stockholder promises to consummate a prompt short-from merger at the same price if it obtains 90% of the shares; and (3) the controlling stockholder has made no retributive threats.[27]  In addition, the court stated that the informational and timing advantages possessed by the controlling stockholder required some countervailing protection in order to afford the minority the opportunity to make an informed and voluntary tender decision.[28]  As such, the controlling stockholder "owes a duty to permit the independent directors on the target board both free rein and adequate time to react to the tender offer, by (at the very least) hiring their own advisors, providing the minority with a recommendation as to the advisability of the offer, and disclosing adequate information for the minority to make an informed decision."[29] 

When applying these principles to Unocal's offer, the court held that the offer was coercive because it included within the definition of the "minority" stockholders whose incentives to consummate the transaction were different from the general Pure stockholder, namely those stockholders who were Unocal directors and officers and those who were the management of Pure.[30]  The court noted, however, that the Offer would be non-coercive if it were amended to condition approval on a majority of Pure's unaffiliated stockholders.[31] 

The court also was faced with several significant issues related to the disclosures that were, or should have been, made to the Pure shareholders.  The plaintiffs argued that neither Unocal's S-4 issued in support of its tender offer nor the 14D-9 issued by Pure in reaction to the offer was materially complete or accurate.  Before addressing the plaintiffs' specific disclosure claims, the court made some general observations about the disclosure duties that surround transactions such as the one at issue.  The court began by noting that "[i]n circumstances such as these, the Pure stockholders are entitled to disclosure of all material facts pertinent to the decisions they are being asked to make."[32]  In this case, Pure's shareholders had two initial choices:  tender or not tender.  If they did not tender then they had a subsequent choice to make in the near future:  accept the § 253 merger consideration or seek appraisal.[33]  With these considerations in mind, the court found that: 

The S-4 and the 14D-9 must contain the information that "a reasonable investor would consider important in tendering his stock," including the information necessary to make a reasoned decision whether to seek appraisal in the event Unocal effects a prompt short-form merger.[34]

The plaintiffs had advanced a panoply of attacks on the disclosures by both Unocal and Pure, but it was the plaintiffs' argument that the 14D-9 should have included the substantive work of the bankers with which the court examined most closely.  The plaintiffs asserted that because the Pure stockholders were (1) left to their own devices to accept or reject the merger, and (2) faced with a decision on whether to pursue appraisal upon the consummation of the short-form merger, that they were entitled to "estimates and underlying analyses of value developed by the Special Committee's bankers."[35]  In response, the defendants argued that:  (1) the 14D-9 already contained a great deal of financial data regarding Pure's past and expected performance, (2) the bankers' opinions were included, (3) forcing the special committee to disclose the bankers' ranges of values could undermine its negotiation posture, and finally, (4) that Delaware law "indicates that a summary of the results of the actual valuation analyses conducted by an investment banker ordinarily need not be disclosed."[36]

The court noted that: 

This is a continuation of an ongoing debate in Delaware corporate law, and one I confess to believing has often been answered in an intellectually unsatisfying manner.  Fearing stepping on the SEC's toes and worried about encouraging prolix disclosures, the Delaware courts have been reluctant to require informative, succinct disclosure of investment banker analyses in circumstances in which the banker's views about value have been cited as justifying the recommendation of the board.  But this reluctance has been accompanied by more than occasional acknowledgment of the utility of such information, an acknowledgment that is understandable given the substantial encouragement Delaware case law has given to the deployment of investment bankers by boards of directors addressing mergers and tender offers.[37]

The court then identified two Supreme Court opinions that it believed evinced the conflicting message regarding disclosures of this type.  It identified Skeen v. Jo-Ann Stores, Inc.[38] as espousing the view that "a summary of the bankers' analyses and conclusions was not material to a stockholder's decision whether to seek appraisal," and McMullin v Beran[39]as indicating that such information might well be material in these circumstances.[40] 

In resolving this issue, the court found that: 

it is time that this ambivalence be resolved in favor of a firm statement that stockholders are entitled to a fair summary of the substantive work performed by the investment bankers upon whose advice the recommendations of their board as to how to vote on a merger or tender rely. . . .  Moreover, courts must be candid in acknowledging that the disclosure of the banker's "fairness opinion" alone and without more, provides stockholders with nothing other than a conclusion, qualified by a gauze of protective language designed to insulate the banker from liability.[41]

The court ultimately held that the disclosures were inadequate in that they (i) failed to disclose any substantive portions of the work of the financial advisors that the Special Committee relied upon as a basis for their recommendation not to tender,[42] (ii) materially misstated the Pure Board's rejection of the Special Committee's request for broader authority,[43] and (iii) omitted any discussion of two of the motivating factors for the Offer--to eliminate the potential liability exposure certain Unocal designees on the Pure Board would face if Unocal began to compete with Pure in its core areas of operation and the importance of considerations of the Royalty Trust.[44]  In light of the inadequate disclosure and the lack of a majority of the unaffiliated minority condition, the court issued a preliminary injunction.[45] 

In re NCS Healthcare, Inc. Shareholders Litigation: Keep the Key to that Lock.

The 2002 contest between Genesis Health Ventures, Inc. ("Genesis") and Omnicare, Inc. ("Omnicare") to win the hand of NCS Healthcare, Inc. ("NCS") inspired several decisions in both the Court of Chancery and the Supreme Court of Delaware.[46] 

Beginning in late 1999, NCS began to see its financial prospects dwindling which led to a precipitous decline in the market price for its stock.  NCS quickly began to explore strategic alternatives that might turn around its fortunes.  Toward that end, in early 2000, NCS hired UBS Warburg L.L.C. to identify potential acquirers or investors.  A solicitation of over fifty potential mates turned up empty handed.  By the summer of 2001, though, NCS had invited Omnicare to talk to its bankers concerning a possible transaction.  At that time, Omnicare proposed a bankruptcy sale under Section 363 of the Bankruptcy Code.  Between the summer of 2001 and February 2002, Omnicare put forth several other iterations of its previous offer, but they all involved an asset sale in bankruptcy that would not likely provide any positive return to NCS' stockholders.  An outcome unacceptable to NCS. 

In January 2002, NCS invited Genesis to the dance.  Genesis executed a confidentiality agreement and began a due diligence review.  At this point, it is worth noting that Genesis and Omnicare have a bitter history, as Genesis had previously lost a bidding war to Omnicare for another entity.  For this reason, Genesis would insist on exclusivity agreements and lock-up provisions in any proposed transaction with NCS and would absolutely refuse to participate as a "stalking horse." 

Due to NCS' precarious financial condition, the board decided that it should appoint a special committee of independent directors to assist the company in upholding its fiduciary obligations not only to its shareholders, but also to other interested constituencies.  The special committee assumed control over the negotiations with Genesis.  In June 2002, Genesis proposed a transaction that would take place outside of bankruptcy, and although it would not provide a full recovery to noteholders, it would provide the shareholders with a modest return.  As discussions progressed, the terms continued to improve. 

On June 26, 2002, Genesis told NCS that it would only continue with discussions if NCS would enter into an exclusivity agreement.  Because the latest proposal from Genesis was clearly superior to the last offer by Omnicare, the special committee agreed to execute an exclusivity agreement with Genesis that provided for an initial 16-day exclusive negotiating period to be followed by an additional week if the parties were still negotiating.  The parties were, indeed, still negotiating, and extended the agreement for one week.  Because the parties were close to a deal, on July 26, 2002, they agreed to an additional extension until July 31st. 

By late July, Omnicare began to suspect that NCS was close to inking a deal with someone, and on July 26, 2002, faxed a letter to NCS outlining a proposed transaction.  This transaction offered full payment to NCS's noteholders as well as providing $3.00 per share in cash for NCS shareholders.  The offer was, however, subject to the completion of due diligence by Omnicare. Because of the exclusivity agreement, the overture fell on deaf ears.  The special committee did, however, use Omnicare's latest proposal as leverage to extract additional value from Genesis. 

On July 28, 2002, NCS and Genesis entered into a merger agreement under which each share of NCS stock would be converted into Genesis stock valued at approximately $1.60 per NCS share.  The Merger Agreement also provided that the agreement could not be terminated prior to the NCS shareholders having the opportunity to vote on the transaction.  Relatedly, Genesis and NCS entered into voting agreements with two shareholders that had the effect of guaranteeing that 65% of the total NCS voting equity would be voted in favor of a transaction with Genesis.  NCS' board approved this merger agreement three days after Omnicare contacted NCS regarding a potential cash deal worth $3.00 per NCS share.  Undeterred, however, Omnicare ultimately commenced a tender offer for NCS shares at $3.50 per share. 

Two general "prongs" of litigation were spawned by these events.  The first was litigation instituted by Omnicare as a shareholder of, and bidder for, NCS generally alleging that NCS breached various fiduciary and statutory duties.  The second group of cases was those filed by other shareholders and ultimately consolidated into what will be called here the "shareholder action."  The shareholder action similarly alleged breaches of fiduciary duty related to the NCS-Genesis transaction. 

In the Court of Chancery, Omnicare's action ran into a procedural "snag" when the Court found that Omnicare did not have standing to pursue its fiduciary duty claims.[47]  In so ruling, the Court found that Omnicare, which had purchased its NCS shares on the day the merger was announced, was not an NCS shareholder at the relevant time-in the Court's view, the point at which the merger terms were approved by the NCS board.[48]  Thus, the Court found that the NCS board owed no duty to Omnicare at the time it agreed to the merger terms Omnicare was attacking.  The Court also found that Omnicare, solely in its status as a bidder, likewise, was without standing to pursue the fiduciary duty claims.[49] 

Although Omnicare was prevented from pursuing its fiduciary duty claims, the shareholder plaintiffs were not, and their motion for a preliminary injunction was allowed to proceed.  The shareholder plaintiffs argued that the NCS board had breached its fiduciary duties by "locking up" the allegedly inferior deal with Genesis in the face of the allegedly superior offer from Omnicare.  The plaintiffs claimed that the NCS board, by entering into the voting agreements and committing the transaction to a vote with a preordained conclusion, impermissibly "locked up" a deal with Genesis that it could not prevent even when the NCS board eventually recommended against the transaction.  Finally, the plaintiffs also argued that Revlon applied,[50] thus enhancing the duty of care and compelling the directors of NCS to seek the highest price available. 

The court addressed the Revlon argument first because if it does not apply, the defendants' actions would be judged under the more deferential business judgment standard.[51]  The court began by noting that a "stock-for-stock merger, pursuant to which the stockholders receive shares of an issuer without a controlling person or group, does not trigger Revlon duties because it does not result in a change of control."[52]  Here, the court found that not only did it not result in a change in control, but also the new transaction would eliminate the control block that could be exercised by two of the directors.[53]  The court was equally unpersuaded that NCS had begun an active bidding process.[54]  Thus, the court found that it would review the board's actions using the normal business judgment analysis.[55] 

After reviewing the record, the court found that the NCS directors "pursued a rational process, in good faith and without self-interest, and were adequately apprised of all material information reasonably necessary to their decision."[56]  The court was swayed by its conclusions that NCS was faced with the proverbial "a bird in the hand is better than two in the bush" dilemma because none of Omnicare's proposals prior to inking the deal with Genesis would be considered as favorable and that the NCS board was cognizant of that history.[57]  On this basis, the court ruled that the plaintiffs had failed to show a likelihood of success in showing that the defendants breached their duty of care.[58] 

The plaintiffs also argued that the voting agreements (in which two shareholders controlling 65% of the vote agreed to vote in favor of the transaction) combined with the requirement that the transaction be submitted to a shareholder vote pursuant to Section 251(c)[59] of the Delaware General Corporation Law impermissibly locked-up the transaction to the exclusion of all others.[60]  Specifically, the plaintiffs argued that these deal protection devices constituted "defensive reactions" as contemplated by Unocal[61]and that these "defensive devices were impermissibly preclusive, coercive and unreasonable.[62]  The court, however, did not buy this argument and found that "the plaintiffs have not succeeded in showing that the NCS board of directors acted unreasonably at the time it agreed to [the lock-up] provisions or that these provisions were improperly preclusive or coercive of stockholder action."[63] 

The shareholder plaintiffs' application for an interlocutory appeal was initially denied by the Supreme Court.  That order, however, was vacated and the appeal was accepted.  On December 10, 2002, the Supreme Court issued an Order encompassing its decision on the appeal and intends to issue a written opinion in due course.  In an infrequent split decision of 3-2, the Court reversed the Chancery Court's decision and found that: 

even if one assumes that the board of directors attempted to seek a transaction that would yield the highest value reasonably available to the stockholders, the deal protection measures must be reasonable in relation to the threat and neither preclusive nor coercive.  The action of the NCS board fails to meet those standards because, by approving the Voting Agreements, the NCS board assured shareholder approval, and by agreeing to a provision requiring that the merger be presented to the shareholders, the directors irrevocably locked up the merger.  In the absence of a fiduciary out clause, this mechanism precluded the directors from exercising their continuing fiduciary obligation to negotiate a sale of the company in the interest of the shareholders.

While we must await the Supreme Court's opinion for the full expression of its views, the language of the order makes it difficult to imagine a case in which deal protection devices that completely lock-up a transaction will be respected.  In this case, the situation seemed particularly egregious considering the wide disparity between the value of the ultimate offers and the fact that even with a negative recommendation from the board, they could not stop the "runaway train."

MM Companies, Inc. v. Liquid Audio, Inc.: Introducing Unocal with a Twist of Blasius.

This expedited appeal to Delaware's Supreme Court challenged the Court of Chancery's bench ruling permitting an incumbent board of directors to adopt certain defensive measures changing the size of Liquid Audio, Inc.'s ("Liquid Audio") board.[64]  The Supreme Court, however, found that the record reflected that the defensive actions were taken for the primary purpose of impeding the full effectuation of the shareholder vote in an impending election for successor directors, reversed the decision of the trial court, and remanded the matter for further proceedings. 

Liquid Audio is a publicly traded company primarily engaged in the business of providing software and services for the digital transmission of music over the internet.  Plaintiff MM Companies, Inc. ("MM") is a publicly traded company that (as part of a group) holds approximately 7% of Liquid Audio's common stock.  For more than a year, MM's efforts to enter into a transaction that would give it control over Liquid Audio had been rejected as inadequate.  Ultimately, in June 2002, MM began to solicit proxies for a shareholder meeting scheduled for July 1, 2002.  In addition to proposing two nominees for the board, MM's proxy statement included a proposal to increase the size of the board by four (from five to nine) and to fill those positions with its nominees.  If successful, this proposal would have resulted in MM's nominees controlling a majority of the board.  However, the board expansion proposal required the vote of 66 2/3 % of Liquid Audio's outstanding stock.  On June 13, 2002, however, Liquid Audio announced that it had entered into a stock-for-stock merger transaction with Alliance Entertainment Corp. ("Alliance"), and postponed the annual meeting. MM then filed suit under Section 211 of the DGCL to force Liquid Audio to hold its annual meeting.  The Court of Chancery heard that case and ordered Liquid Audio to hold its annual meeting in late September 2002. 

In August of 2002, it became increasingly apparent that MM's two nominees would be elected to the board at the annual meeting.  On August 23, 2002, Liquid Audio announced that the board had amended the bylaws to increase the size of the board to seven members (from five) and announced the appointment of two directors to fill those newly created directorships.  At the annual meeting, MM's nominees were elected, but its board expansion proposal failed to achieve the necessary level of support.  After the meeting, MM amended an earlier suit to allege that the expansion of the board, its timing, and the appointment of the two new directors violated the principles of both Blasius[65]and Unocal[66] because the actions frustrated MM's attempt to gain a "substantial presence" on the board for at least another year. 

The Court of Chancery, in a bench ruling, ruled in favor of the defendants by finding that the expansion of the board did not violate Delaware law under either Blasius or Unocal.  It rejected the Blasius claim by finding that the addition of new directors "did not impact the shareholder vote or the shareholder choices in any way."  The court rejected the Unocal claims by finding that the board expansion was not coercive or preclusive, that the shareholders consistently faced the same choices, and that there was no showing that the board's actions fell outside a range of reasonable responses.  The plaintiff appealed. 

The Supreme Court began its analysis by examining a core factual finding by the trial court that Liquid Audio's actions were "for the primary purpose of diminishing the influence of MM's nominees if they were elected at the annual meeting."[67]  The court then turned its attention to a short "primer" on corporate governance principles such as the importance of the shareholder franchise and the allocation of power between directors and the shareholders they represent.[68]  The Supreme Court next discussed in detail how (and why) the "compelling justification" standard of Blasius applies where directors act for the primary purpose of impeding or interfering with the effectiveness of a shareholder vote.[69] 

The "heart" of the court's decision, however, is its discussion of how the enhanced standards of judicial review of both Blasius and Unocal are not mutually exclusive as both address the inherent conflicts of interest that arise when a board acts to prevent shareholders from effectively exercising their right to vote.  This is so because: 

[b]oth standards recognize the inherent conflicts of interest that arise when a board of directors acts to prevent shareholders from effectively exercising their right to vote either contrary to the will of the incumbent board members generally or to replace the incumbent board members in a contested election.[70]

With this doctrinal backdrop in place, the Supreme Court noted that its earlier decision in Stroud v. Grace[71] had "acknowledged that board action interfering with the exercise of the shareholder franchise often arises during a hostile contest for control" and that, accordingly, "such action necessarily invoke[s] both Unocal and Blasius."[72]  The court went on to find that: 

This case presents a paragon of when the compelling justification standard of Blasius must be applied within Unocal's requirement that any defensive measure be proportionate and reasonable in relation to the threat posed.  The Unocal standard of review applies because the Liquid Audio board's action was a "defensive measure taken in response to some threat to corporate policy and effectiveness which touches upon issues of control."  The compelling justification standard of Blasius also had to be applied within an application of the Unocal standard to that specific defensive measure because the primary purpose of the Board's action was to interfere with or impede the effective exercise of the shareholder franchise in a contested election for directors.[73]

After completing its analysis of applicable precedent, the court found that because Liquid Audio acted with the primary purpose of thwarting the effective exercise of the shareholder franchise, "the incumbent board of directors had the burden of demonstrating a compelling justification for that action to withstand enhanced judicial scrutiny within the Unocal standard of reasonableness and proportionality."[74] 

In reviewing the trial court's analysis, the Supreme Court found that the Court of Chancery properly looked, under Unocal, to see whether Liquid Audio's actions were either preclusive or coercive.[75]  If not, the court ruled, a reviewing court's attention should shift to examining the reasonableness of the response to the threat posed.[76]  In this regard, the court found that: 

When the primary purpose of a board of directors' defensive measure is to interfere with or impede the effective exercise of the shareholder franchise in a contested election for directors, the board must first demonstrate a compelling justification for such action as a condition precedent to any judicial consideration of reasonableness and proportionately. [sic][77]

Applying this standard, the Court found that "[s]ince the Director Defendants did not demonstrate a compelling justification for that defensive action, the bylaw amendment that expanded the size of the Liquid Audio board, and permitted the appointment of two new members on the eve of a contested election, should have been invalidated by the Court of Chancery."[78] 

The Liquid Audio opinion is significant because it potentially represents a substantial expansion of the Blasius compelling justification doctrine.  Traditionally, Blasius had been applied to invalidate actions that directly impacted the outcome of a shareholder vote.  For example, Blasius itself involved board action that made it impossible for the consent solicitation at issue there to achieve its stated objective of achieving board control.[79]  In contrast, Liquid Audio's board expansion did not prevent MM from succeeding in its efforts to elect two directors, and would not have prevented MM from achieving board control had the board expansion proposal succeeded.[80]  Nevertheless, because the board's action in adding two members was taken for what the Chancery Court found was the primary purpose of reducing the MM directors' ability to influence board decisions or to achieve control upon the resignation of one or more of the holdover directors, the Supreme Court found Blasius applicable.  If read broadly, therefore, the Liquid Audio opinion could result in a significant expansion of Blasius into challenges to any actions taken by incumbent directors in the face of a proxy contest involving board structure, such as the creation of committees that exclude the insurgent directors, or any other action that impedes the insurgents' ability to achieve their stated objectives.  The full impact of the Liquid Audio decision thus awaits further case law development. 

Biondi v. Scrushy: The Tale of a Special Committee. 

In mid-January of this year, Vice Chancellor Strine issued an opinion that merits the special attention of practitioners who advise special committees of boards of directors as part of their practice.  In this case, the court refused to grant the almost automatic stay of litigation that is generally granted during the pendency of the committee investigatory process because it found that the uncontested facts made "it clear that [the] court will never be able to defer to a decision by the [special committee] to terminate these actions."[81] 

This matter was before the court on the motion of the Special Litigation Committee ("SLC") of HealthSouth Corporation ("HealthSouth") to stay certain derivative actions that had been filed on its behalf.  The motion was premised on two alternative grounds:  (1) the Delaware derivative actions should be stayed under the Delaware Supreme Court's McWane[82] decision in deference to first-filed actions in Alabama, or (2) the actions should be stayed, pursuant to Zapata[83] and its progeny, in order to permit the SLC to conduct and complete its investigation of the derivative claims. 

HealthSouth, a health care corporation operating hospitals and other health care facilities, receives a large portion of its revenue through providing services that are ultimately paid for by the federal government under programs such as Medicare and Medicaid.  Moreover, private insurance companies are also influenced in their reimbursement policies by the reimbursement policies established by the government insurance programs.  Thus, any change in the federal government's reimbursement policies could have a profound effect on the fortunes of HealthSouth.  The complaints alleged that as early as the summer of 2001, HealthSouth and certain of its key officers and directors possessed early knowledge that the Centers for Medicare and Medicaid Services ("CMS") was planning on implementing a change in the way Medicare reimbursed providers for certain medical procedures and that this proposed change would have a materially negative effect on HealthSouth's earnings.  The complaints allege that the defendants, despite this advanced knowledge, kept that information to themselves, continued to issue "rosy" earning projections, and worst of all, traded in HealthSouth stock based on material non-public information. 

A year later, in August 2002, HealthSouth announced the change in Medicare reimbursement policy and its expected effect on the company's earnings - an annual reduction in HealthSouth's earnings before interest, taxes, depreciation, and amortization by $175 million.  The market's reaction to this news was swift and harsh as HealthSouth's shares lost 50% of their value within two days of the announcement.  As is wont to happen with such events, after the announcement, HealthSouth and certain of its officers and directors (in various combinations) were sued in both the state and federal courts in Alabama and in Delaware's Court of Chancery. 

In response to the suits, the HealthSouth Board created the SLC by a series of resolutions the court found "confusing."[84]  The basic charge to the SLC was to "investigate, review and analyze" the matters giving rise to the litigation.[85]  Moreover, the SLC was given the traditional powers to "consider and determine whether or not prosecution or continuation of such claims and actions is in the best interests of the Company and its shareholders, and what action the Company should take with respect" to the litigation.[86]  The board, however, limited this broad charge by further resolving that nothing in its empowerment of the SLC was: 

intended to moot or waive the Company's planned motions to dismiss or stay the Tucker Action [in Alabama's state court] for lack of standing and/or failure to state a claim upon which relief may be granted and failure to comply with the requirements of Rules 12(b)(6) and 23.1, Alabama Rules of Civil Procedure; provided, however, that the Committee should have full power and discretion to recommend that any Company motion or pleading be changed, withdrawn, or supplemented by additional or substituted pleadings or motions of the Committee or the Company, or both, as shall be deemed appropriate . . . .[87]

To further confuse matters, the board also resolved that the SLC's determinations "shall be final, shall not be subject to review by the Board of Directors and shall in all respects be binding upon the Company . . . ."[88] 

The complaint in this action attacked the charge given to the SLC because it prevented the committee from having the full authority to direct HealthSouth's reaction to the litigation (as Zapata arguably requires and as is usually the case in special litigation committee matters) and would not allow the SLC to prevent the board from seeking the dismissal of the actions over the SLC's recommendations otherwise.  In a move that the court found to be "a day late and a dollar short," on the eve that the SLC filed its reply brief, the board amended its charge to give the SLC the freedom to direct HealthSouth's response to the litigation as it saw fit.[89] 

The court continued by describing what it called the "Strange Early Days of the HealthSouth SLC."[90]  The court notes that the obvious purpose for "forming a special litigation committee is to promote confidence in the integrity of corporate decision making."[91] 

Critical to the accomplishment of [this] objective[], however, is the proper composition and empowerment of the committee.  If a special litigation committee is comprised of directors with compromising ties to the key officials who are suspected of malfeasance, if the committee is not fully empowered to act for the company without approval by the full board, or if the committee behaves in a manner inconsistent with the duty to carefully and open-mindedly investigate the alleged wrongdoing, its ability to instill confidence is, at best, compromised and, at worst, inutile.[92]

The court first expressed its alarm at the initial composition of the SLC.  The SLC was initially composed of an existing director, Larry D. Striplin, Jr., and a newly appointed director, Jon Hanson.  The court found this selection "somewhat surprising" since both of them serve on the board of the National Football Foundation and College Hall of Fame, Inc. (with Hanson as its chairman) with Richard Scrushy, chairman of HealthSouth.[93]  Moreover, one of that organization's key awards is named for HealthSouth.  Finally, the court found that "[c]ontributing to the disquiet is the long-standing personal ties between Striplin and Scrushy, who are both large contributors to college sports programs in Alabama.  Indeed, a stadium at a college in Alabama is named Scrushy-Striplin Field."[94]  Ultimately, Striplin resigned from the committee and a new director, Robert P. May, was elected to the board and appointed to the committee.[95] 

According to the court, the SLC's credibility was "undercut" from the very beginning because on the very day that the board appointed the SLC, the company hired an outside law firm to investigate the very same conduct that the SLC was charged with investigating.[96]  Less than a week later, HealthSouth's new CEO (successor to Mr. Scrushy) issued a press release that stated: 

I want to make it clear that Richard M. Scrushy had absolutely no knowledge about any changes in Medicare reimbursement rules until August 6, 2002, and none of us had any knowledge whatsoever that a possible rule change would have a material, financial impact on our company until August 15, 2002.[97]

The court found this press release "rather unusual, coming from the CEO of the company that had just chosen to form the SLC to investigate, among other things, the very question of whether" certain officers and directors improperly traded on material non-public information.[98]  The final "eyebrow-raising" event identified by the court was the October 30, 2002, press release titled "HEALTHSOUTH Chairman Richard Scrushy Cleared By Outside Investigation Of Advance Knowledge Of Medicare Rule Change Prior To Stock Transactions."[99]  Even though the outside law firm hired to investigate the allegations was not working with the SLC, the press release contained the following quote from the SLC chairman May: 

This thorough outside review conducted by Fulbright & Jaworski puts to rest any question whether Mr. Scrushy had any inkling or knowledge of the Medicare reimbursement rule change or its impact prior to his stock transactions in May and July 2002.[100]

After denying the SLC's motion to stay in favor of a prior-filed action in the Alabama state courts, the court turned to the issue of whether the action before it should be stayed until the SLC completed its investigation.  While it is "hornbook" law that a reasonable stay will generally be granted in order to allow a special committee to complete its task,[101] "the general rule that a stay should issue is subject to exception in an atypical case when, based on the undisputed facts in the stay motion record, the committee's later decision to terminate the litigation could not command respect under Zapata."[102] 

In weighing the relative "taint" of each of the "eyebrow raising" events described above, the court noted that most of them, standing alone, were not enough to corrupt the process so much that the court would never be able to defer to the committee's judgment.  When all the items were added together, the Vice Chancellor asked whether the combined weight would have "broken the camel's back?"[103]  Unfortunately, we do not know because the court found one fact was so egregious that it, alone, warranted denying the stay - the public announcement by the SLC's chairman, before the SLC process had really begun in earnest, that the Fulbright & Jaworski report vindicated the alleged wrongdoers that the SLC was to be investigating.[104]  Because of this fact, "[e]ven if the SLC later issues a report in favor of dismissal that reads well and that appears to be factually supported, there will always linger a reasonable doubt that its investigation was designed to paper a decision that had already been made."[105]  For that reason, the court also denied the SLC's motion to stay the action while the committee completed its investigation.

Notes