Entire Fairness Standard Applied When Controlling Stockholder Negotiated Economic Terms With a Minority Stockholder Before MFW Protections Were in Place

The Delaware Chancery Court recently held that a going-private transaction was not entitled to the deferential business judgment standard of review because the controlling stockholder failed to condition the transaction on special committee and minority stockholder approval before engaging in substantive economic discussions with a minority stockholder. In re HomeFed Corp. S’holder Litig., C.A. No. 2019-0592-AGB (Del. Ch. July 13, 2020).

In 2017, an independent director of HomeFed Corporation proposed to Jefferies Financial Group Inc., which owned 70% of HomeFed, a transaction whereby Jefferies would acquire the remaining shares of HomeFed by exchanging two of its shares for each share held by HomeFed’s minority stockholders. In December 2017, HomeFed’s board of directors formed a special committee to negotiate the proposed transaction with Jefferies. The board resolutions establishing the special committee provided that HomeFed’s officers were not to discuss a potential transaction with any other party unless the special committee approved or was present for the discussions.

In March 2018, the special committee “paused its process” (but was not formally dissolved) after Jefferies indicated that it was no longer interested in the deal. Nevertheless, over the next 11 months, Jefferies held repeated discussions about a potential transaction directly with HomeFed’s largest minority stockholder, Beck, Mack and Oliver, LLC (BMO), whose support was needed to obtain minority stockholder approval. In early February 2019, BMO informed Jefferies that it would support a 2-for-1 share exchange. Weeks later, Jefferies formally proposed such a transaction, conditioned on approval by a special committee and a majority of the minority stockholders (which was almost certain to be satisfied given that BMO had indicated its support). The special committee was “reauthorized” by the board and eventually approved the transaction in May 2019. The minority stockholders approved the transaction in July 2019, and the transaction closed the following month.

After the closing, certain former HomeFed minority stockholders filed breach of fiduciary duty claims against the special committee members and Jefferies in the Delaware Chancery Court. The defendants moved to dismiss the claims, arguing that the transaction should be evaluated under the business judgment standard of review. The Court disagreed, finding that it was reasonably conceivable that the transaction did not satisfy the “ab initio” requirement set forth in Kahn v. M&F Worldwide Corp. (MFW), 88 A.3d 724 (Del. 2014). Under MFW, a squeeze-out merger by a controlling stockholder is entitled to business judgment review (rather than the stringent entire fairness standard) only if the merger is conditioned ab initio on both (1) the approval of an independent, adequately empowered special committee that fulfills its duty of care and (2) the uncoerced, informed vote of a majority of the minority stockholders.

The Court held that, viewing the discussions as part of a single negotiation process, the fact that the original process had not been conditioned at the outset on satisfaction of the MFW conditions required application of entire fairness. The Court further ruled that even if the two different discussions were viewed as separate and distinct, the later negotiations were not protected by MFW because Jefferies had discussed key economic terms (e.g., the exchange ratio) with BMO before agreeing to the MFW dual protections. The Court found that these discussions were not merely “preliminary,” as Jefferies contended, and were detrimental because they “anchored the negotiations and undermined the Special Committee’s ability to bargain effectively as the minority stockholders’ agent.” To support this conclusion, the plaintiff stockholders noted that Jefferies cited the significant stockholder’s support for a deal at a 2-for-1 exchange ratio as a justification for rejecting a fixed-value counteroffer made by the special committee.

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, companies and advisers should be cautious about direct negotiations between a controlling stockholder and minority stockholder which could, depending on the facts and circumstances, interfere with a special committee’s effective functioning and
render MFW unavailable.