01 April 2021

Delaware Court of Chancery Will Evaluate Third-Party Sales of Controlled Companies Under the Enhanced Scrutiny Standard of Review

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The Delaware Court of Chancery recently held that a stockholder plaintiff pleaded facts sufficient to support a reasonable inference that a target company’s board of directors could have achieved a higher deal price had the company’s financial advisor not, unbeknownst to the board, tipped the buyer about the price of another bid during the sale process.

Firefighters’ Pension System of the City of Kansas City, Missouri Trust v. Presidio, Inc. (Del. Ch. Jan. 29, 2021). In the Presidio opinion, Vice Chancellor J. Travis Laster confirmed that the intermediate enhanced scrutiny standard of review — as articulated in the Delaware Supreme Court’s 1986 Revlon decision — will apply to future sales of controlled companies to third parties.

In December 2019, Presidio, Inc. (the company) merged with an affiliate of London-based private equity firm BC Partners Advisors L.P. (BCP). The company’s stockholders, including a controlling stockholder that controlled 42% of the voting power and was entitled to appoint five of the company’s nine directors, received $16.60 per share in cash.

The sale process began in May 2019, when the company’s controlling stockholder and its financial advisor met with each of BCP and private equity firm Clayton Dubilier & Rice, LLC (CD&R) in connection with exploring a potential sale of the company. In July 2019, BCP offered to acquire the company for $15.60 per share. The company’s board countered with a price of $16.25 per share plus a robust go-shop provision. BCP increased its offer to $16.00 per share and agreed to the go-shop, which was memorialized in a merger agreement entered into on August 14, 2019. The $16.00 deal price valued the company at $2.1 billion and represented a roughly 20% premium over the company’s trading price.

The go-shop began immediately and the company’s financial advisor contacted 52 potential buyers, including CD&R. On September 23, 2019, CD&R offered to acquire the company for $16.50 per share, although indicating that its offer price “could potentially increase” after completing additional confirmatory diligence. Under the merger agreement with BCP, the company’s CEO would roll over two-thirds of his equity and run the company post-closing; CD&R’s offer, in contrast, did not contemplate an equity roll-over or post-merger employment for the CEO.

CD&R qualified as an “Excluded Party” under the company’s original merger agreement with BCP, meaning the company (1) could continue to negotiate with CD&R for 10 days and (2) would be subject to a lower break-up fee of $18 million if it terminated the merger agreement for a deal with CD&R (rather than $40 million for non-Excluded Parties). Unbeknownst to the company’s board, the company’s financial advisor allegedly informed BCP about the specific price of CD&R’s bid. Based on this tip, BCP immediately raised its offer to $16.60 per share conditioned on a flat termination fee of $40 million applying to a deal with any competing bidder (whether or not it qualifies as an Excluded Party). BCP insisted that the company respond to its increased offer within 24 hours. The company’s board instructed the financial advisor to ask CD&R to increase its offer and push for a response in less than 24 hours (eight days sooner than CD&R’s deadline to negotiate under the merger agreement). CD&R met the deadline and responded that it could raise its bid to at least $17.00 per share but noted that it would likely exit the sale process if the company increased the termination fee. Having concerns about CD&R’s offer, and still unaware of the financial advisor’s tip to BCP, the board accepted BCP’s offer and entered into a revised merger agreement. The company publicly announced the revised merger agreement and CD&R did, in fact, walk away from the process, foreclosing a bidding war. The company’s stockholders approved the merger by more than 85% of the vote and the deal closed on December 19, 2019. Thereafter, a former stockholder sued, arguing that (1) the CEO, board, and controller breached their fiduciary duties by approving the amended merger agreement and failing to disclose all material information to stockholders and (2) the company’s financial adviser and BCP aided and abetted those breaches. The complaint alleged that the company’s CEO, controlling stockholder, and financial advisor tilted the sale process in BCP’s favor out of self-interest: the CEO due to the promise of post-closing compensation and employment; the controlling stockholder because it was eager to unload its investment in the company quickly; and the financial advisor to further its lucrative relationships with BCP, the controlling stockholder, and the CEO.

The defendants moved to dismiss, arguing that in the absence of a conflicted controlling stockholder the business judgment rule applied. For this, the defendants pointed to Corwin v. KKR Fin. Holdings LLC (Del. 2015) and argued that the merger was approved by a fully informed, uncoerced majority of the disinterested stockholders. The Court found that Corwin cleansing was not available to lower the standard of review because, among other things, the merger proxy statement failed to disclose the financial advisor’s tip to BCP which rendered the stockholder vote not fully informed.

The Court also considered arguments regarding the impact of the controller’s alleged conflict of interest, and the resulting impact on the standard of review. The plaintiff argued that the controlling stockholder “faced a liquidity-driven conflict” because it (1) held its investment in the company for twice as long as planned, (2) demonstrated its desire for liquidity by selling more than 21,000,000 shares in four secondary offerings, (3) would be able to appoint only four — rather than five — directors at the company’s next annual meeting, and (4) acted in accordance with its desire to liquidate by swiftly accepting BCP’s revised offer rather than allowing a bidding war with CD&R to unfold. In response, the defendants pointed to the Delaware Court of Chancery’s decision in In Re Synthes, Inc. S’holder Litig. (Del. Ch. 2012), where the Court found that a desire for liquidity could rise to the level of a disabling conflict of interest only in the context of a “crisis” or “fire sale” where the controller agrees to a sale to satisfy an “exigent need” for immediate cash. Thus, the Synthes court determined that the controller was not conflicted when the company engaged in a merger in which all of the company’s stockholders received the same consideration and applied business judgment review to the merger. Synthes, however, represented a departure from the Delaware Supreme Court’s 2000 decision in McMullin v. Beran, where the Supreme Court applied enhanced scrutiny to a controlling stockholder’s decision to sell a controlled subsidiary even though the controlling stockholder received the same consideration as all other stockholders. The McMullin court reasoned that the duty to maximize stockholder value pursuant to Revlon was “implicated” in the context of evaluating a proposal for the sale of a company to a third party at the behest of the controlling stockholder.

In Presidio, Vice Chancellor Laster followed McMullin, reasoning that the same standard of review should apply to the actions of a controlling stockholder as would apply to a board when either undertakes a sale of the company. He also rejected the argument that Synthes conflicted with Corwin in that Synthes would allow business judgment deference without the critical step of approval of the transaction by a fully informed, uncoerced stockholder vote. Finally, Vice Chancellor Laster explained that enhanced scrutiny review would enable a plaintiff to challenge — and a court to review — situations where a sale process is tainted by self-interest, as was reasonably conceivable in this case.

The Court evaluated the Presidio merger under the enhanced scrutiny standard of review and held that the complaint’s allegations supported a reasonable inference that the sale process fell outside the range of reasonableness. This was primarily due to the financial advisor’s undisclosed tip to BCP which the Court characterized as “cast[ing] a dim light on the sale process.” Specifically, the Court found it reasonably conceivable at the pleading stage that (1) the financial advisor and CEO tilted the sale process in BCP’s favor based on self-interest and (2) the board failed to provide active and direct oversight of the financial advisor, including by not requiring disclosure of or investigating actual or potential conflicts of interest until after the merger agreement was signed. The dismissal was granted in part, however, to parties that were exculpated from liability under the Company’s charter (i.e., directors, other than the CEO against whom a cognizable duty of loyalty claim had been pled) and the controller (as to whom the complaint failed to allege gross negligence). The remainder of the case and the aiding and abetting claims will thus continue. Presidio is a must-read for those interested in the standard of review applicable to corporate mergers, and is a reminder that the appearance or existence of undisclosed conflicts of interest are substantial fodder for stockholder plaintiffs.