27 September 2021

Bear Market For Plaintiffs’ Liquidity-Based Conflict Allegations

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In M&A litigation, plaintiffs’ lawyers see actual or perceived conflicts of interest as gold.  Conflict allegations can take many forms and arise in a variety of contexts: for example, a board member of a target company who is offered employment by the would-be acquirer, or a controlling stockholder who sits on both sides of a transaction.  Another common example, and the focus of this post, is a board member or stockholder whose financial interests are alleged to diverge from other stockholders because of a need or desire to quickly liquidate holdings (referred to as a “liquidity-based conflict”).

As discussed below, two recent Delaware Court of Chancery decisions have addressed “liquidity-based” conflicts in differing contexts, but with similar results:  in each case, the alleged conflicts turned out to be fool’s gold.

Flannery v. Genomic Health

This recent decision from Vice Chancellor Slights concerned the 2019 merger in which Exact Sciences (“Exact”) acquired Genomic Health (“Genomic”) for a combination of cash and stock.  The plaintiff, a former Genomic stockholder, “pulled out all stops to implicate either entire fairness review or Revlon enhanced scrutiny in order to survive dismissal,” with one such “stop” involving allegations of a liquidity-based conflict.

Two brothers and their affiliated companies (the “Baker Brothers”) had at times held upwards of 45% voting control of Genomic, although at the time of the merger their voting control had declined to approximately 26%.  Under Delaware law, the highest standard of review – entire fairness – will apply, among other circumstances, where (i) “the plaintiff presents facts supporting a reasonable inference that a transaction involved a controlling stockholder” and (ii) the controller “engages in a conflicted transaction” either by standing on both sides of the transaction or “compet[ing] with the common stockholders for consideration.”

The plaintiff argued that the entire fairness standard of review should apply because the Baker Brothers’ minority stake was “potent” (which made them a “controller” despite their
less-than-majority voting control) in combination with their “unique desire” to exit their investment (i.e., a liquidity-based conflict).  As to the latter argument, the Court acknowledged that a “legally cognizable conflict” may arise “where the controller gets a ‘unique benefit’ by extracting something uniquely valuable to the controller, even if the controller nominally receives the same consideration as all other stockholders.”

The Court, however, did not credit the plaintiff’s “conclusory” argument that “the Baker Brothers’ [] supposed desire to exit their investment in Genomic supports an inference that they directed the Board to recommend the Merger at an unfair price.”  Recognizing that, as a general matter, controllers have interests identical to other stockholders — “to maximize the value of their shares” — the Court noted recent decisions holding that liquidity-based allegations will rise to an actionable conflict only where the transaction is alleged to be a “fire sale” where the seller agreed to a sale without taking the usual steps to maximize value.  A “mere desire to sell” cannot create an actionable conflict.

Because the “vague allegation that the Baker Brothers [] sought liquidity, without more, does not suffice,” the Court held that the Baker Brothers were not conflicted controllers and that “there is no basis to review the Merger for entire fairness.”  For this, among other reasons that led to business judgment rule deference and/or exculpation, the plaintiff’s complaint was dismissed.

Kihm v. Mott

This recent decision from Vice Chancellor Zurn likewise involved an attempt to obtain enhanced scrutiny of a merger transaction — in which GlaxoSmithKline acquired Tesaro Inc. (“Tesaro”) — based on allegations of liquidity-based conflicts.  Specifically, the plaintiff sought to portray a private equity sponsor and significant stockholder of the target, as well as its affiliated board member, as conflicted based upon their “unique interest in selling Tesaro before year-end 2018” in order to raise money for a new fund.  While superficially similar to the allegations in Genomic, the plaintiff’s attempted use of those allegations differed materially.

Unlike Genomic, this case involved a “cash-out” merger, meaning the target’s stockholders would receive only cash for their shares, as opposed to stock in the acquirer.
Cash-out mergers are “presumptively subject to at least enhanced scrutiny under Revlon” unless they have been “cleansed” pursuant to the Delaware Supreme Court’s Corwin decision.  Although not the focus of this post, in brief, “Corwin cleansing” affords business judgment rule deference to a cash-out merger where it has been ratified by a fully-informed, uncoerced vote by a majority of the target’s disinterested stockholders.

Notably, while the complaint included numerous allegations about the sponsor’s motivations, it did not assert that the sponsor was a controlling stockholder or otherwise allege “coercion.”  Instead, the plaintiff sought to evade Corwin on the grounds that the merger vote was uninformed.  This is where the sponsor’s purported conflict came into play.  Rather than asserting that the liquidity-based conflict on its own was debilitating, the plaintiff alleged that the company’s failure to disclose that conflict led to an uninformed vote.

Different approach; same result.  The Court commented that the plaintiff was seeking an “extraordinary inference” that the sponsor had an interest in “short-changing itself” with respect to the transaction price “in favor of liquidity due to its investment life cycle and business model.”  The allegations were insufficient to support such an inference.  Because the sponsor was not a controller, it “was not a fiduciary and did not have its own power to pressure or force Tesaro’s sale.”

Thus, whether the sponsor was conflicted was “not material on a standalone basis,” but rather such conflicts were relevant “only insofar as they inform” whether the sponsor’s board designee was conflicted.  In that regard, the Court found that the sponsor designee’s “dual fiduciary status” was adequately disclosed, and that, “[e]ven assuming [the sponsor] has divergent liquidity interests, those specific interests do not add to the total mix of stockholder information about [the sponsor] or the sale process.”

As in Genomic, there was no other basis for enhanced scrutiny and, in the absence of waste allegations, the motion to dismiss was granted.

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These are not the first decisions to view with skepticism allegations of liquidity-based conflicts.  Nonetheless, they are welcome news for private equity sponsors and other investment entities who, by the very nature of their businesses, often seek “liquidity” for their investments in a way that may differ from the common stockholder base.  Those business practices, without more, are unlikely to invite enhanced scrutiny in the context of post-closing merger litigation.