Special Committee Must Be Formed “Ab Initio” to Cleanse a Transaction With a Majority-Conflicted Board

The Delaware Chancery Court recently held that, for a transaction involving a majority-conflicted board to be entitled to business judgment review (rather than the entire fairness standard), the special committee that approved the transaction must have been sufficiently constituted and authorized ab initio (i.e., “from the beginning”). Salladay v. Lev (Del. Ch. Feb. 27, 2020). In doing so, Vice Chancellor Sam Glasscock III borrowed from the framework used to cleanse a controlling stockholder transaction under Kahn v. M&F Worldwide Corp. (MFW), 88 A.3d 624 (Del. 2014). Under MFW, a controlling stockholder transaction is entitled to business judgment review if the controller conditions the transaction ab initio on both the approval of an independent special committee and the uncoerced, informed vote of a majority of the minority stockholders.

According to Vice Chancellor Glasscock, the same rationale for imposing MFW’s ab initio requirement applies to a transaction “where there is no controlling stockholders but the board is conflicted.” In either context, “[t]he acquirer—as well as any interested directors—must know from the transaction’s inception that they cannot bypass the special committee.”

A former stockholder of Intersections, Inc. brought fiduciary duty claims against three directors (one of whom was also the CEO) claiming that they approved a take-private acquisition of the company at an unfair price and influenced the transaction to divert merger consideration to themselves. The plaintiff argued that the entire fairness standard of review should apply because at least half of the directors (three of the six-member board) were conflicted because they rolled over significant portions of their equity in the merger. The defendant directors contended that business judgment review should apply and the claims should be dismissed because the transaction had been approved by an independent special committee and a majority of the disinterested stockholders.

The Court ruled that the special committee was not properly constituted from the merger’s inception in a way that could invoke business judgment review and denied the defendants’ motion to dismiss. The Court found that the complaint adequately pleaded that substantive economic negotiations occurred before the special committee was formed, which “deprived the Committee of the full negotiating power sufficient to invoke the business judgement rule.”

A potential acquirer expressed interest in the company and began discussions with the conflicted directors and members of company management about a possible transaction. According to the complaint, at one meeting, the company’s CEO/board chair suggested to the potential acquirer that the company’s board may be receptive to an offer in the range of $3.50 to $4.00 per share. Just over a week later, the board formed the special committee of three independent and disinterested directors and determined to condition its approval of the transaction on the favorable recommendation by the special committee. The acquirer made an initial offer of $3.50 per share. After a few weeks of negotiations, the acquirer increased its offer to $3.68 per share. Upon recommendation from the special committee, the board approved the transaction at that price. Based on the facts alleged, Vice Chancellor Glasscock held that it was conceivable that discussions that preceded the special committee’s formation essentially formed a price collar that set the stage for future economic negotiations. In that situation, a “’bare knuckle contest over price’ is unlikely, and the existence of the committee is insufficient to replicate an arms-length transaction.” Thus, entire fairness review applied.

The Court also refused to invoke business judgment review under Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015), which applies when a conflicted transaction not involving a controlling stockholder is approved by a fully informed, uncoerced vote of a majority of the disinterested stockholders. Corwin cleansing was not available because the complaint adequately pleaded material misstatements and omissions in the merger proxy statement. In particular, the Court took issue with (1) potentially coercive disclosure in the proxy suggesting that a change of control of the company could occur if the stockholders rejected the transaction and (2) insufficient disclosure about the special committee’s financial advisors, including the fact that one adviser abruptly resigned days after being engaged.

In light of this decision, companies and advisers working on conflicted transactions should formalize the creation and authorization of the special committee as early as possible in the deal process and certainly before any economic terms are negotiated. They should also make sure that board and committee meeting minutes reflect the committee’s formation and actions. Finally, they should ensure that disclosures about the transaction are clear and complete so a stockholder vote will be considered fully informed.