Entire Fairness Does Not Require Perfection
The Delaware Supreme Court recently held in In re Tesla Motors Stockholders’ Litigation, ___ A.3d ___, 2023 WL 3854008 (Del. Jun. 6, 2023) (“Tesla”), that an entire fairness analysis does not require perfection, so long as the acquisition itself was the result of fair dealing and fair price. Practitioners and boards engaging with a potentially conflicted transaction would be well served to study this opinion with care, particularly where the potential acquiror cannot (or chooses not to) employ a special committee of independent directors to handle negotiations.
In Tesla, the Supreme Court considered an appeal of former Vice Chancellor Joseph R. Slights III’s post-trial ruling that Tesla CEO and board member Elon Musk (a 22 percent owner of Tesla shares) did not cause Tesla to overpay for SolarCity, an entity founded by Musk’s cousins and in which Musk held a substantial investment. The ruling is particularly significant because the Court engaged with at least 11 flaws in Tesla’s process that had been identified by the Court of Chancery. Like the Court of Chancery, the Supreme Court held that various other positive factors amply outweighed those flaws and affirmed the lower court’s finding that the transaction satisfied entire fairness.
The flaws included that Tesla’s board was presumed conflicted, did not employ a special committee, and did not fully exclude Musk when analyzing the potential transaction, instead allowing Musk to have a voice in the selection of advisors and to participate in certain meetings. But ultimately, like the Court of Chancery, the Supreme Court held that substantial evidence demonstrated that Tesla’s acquisition of SolarCity was entirely fair, including because the negotiations were led by a highly credible, independent director; Tesla undertook substantial diligence on the matter and reduced its offer price as it received additional information; Tesla rejected a number of Musk’s requests concerning SolarCity; and, upon closing, Tesla was able to book a profit from the transaction. Further, both courts took meaningful note that the transaction included a majority-of-the-minority voting provision, and that Tesla stockholders voted overwhelmingly in favor of it.
In affirming the trial court ruling, the Delaware Supreme Court rejected the Appellants’ contention that 11 flaws in Tesla’s process—particularly the absence of a special committee of independent directors, conflicted board, and Musk’s presence during a critical board meeting regarding price—automatically required a ruling against Musk. The Court explained that while the use of a special committee and a favorable majority-of-the-minority vote would have entitled the transaction to the deferential business judgment standard of review under Kahn v. M & F Worldwide Corp. (“MFW”), the lack of such procedural protections did not require a finding of unfair process. Rather, the Court reiterated to boards and shareholders that even under Delaware’s demanding entire fairness standard, “a finding of perfection is not sine qua non in an entire fairness analysis.” “The paramount consideration . . . is whether the price was a fair one.”
The Delaware Supreme Court took particular note of the lower court’s finding that “the credible evidence produced at trial shows” that “the Tesla Board meaningfully vetted the Acquisition” and demonstrably “operated independently of Musk,” including insisting on “a walkaway right in the event of a SolarCity debt covenant breach;” that Musk “did not impede the Tesla Board’s pursuit of a fair price” or otherwise “exercise his purported control over the Tesla Board with respect to the acquisition;” and that the transaction included a majority-of-the-minority stockholder vote provision. Instead, the Tesla board invited Musk to join for certain strategic meetings because it believed that Musk’s “perspective[] regarding the solar industry and SolarCity, in particular, would be helpful.”
With respect to price, the Supreme Court recognized that “where there are process infirmities, the Court is obliged to study fair price even more carefully.” The Court also acknowledged the lower court’s determination that Musk presented the most persuasive evidence regarding SolarCity’s value and fairness of the price Tesla paid to acquire it. In contrast, Appellants had proffered only “incredible” testimony that SolarCity was insolvent (and not any other analysis regarding price).
It bears noting that the Delaware Supreme Court did agree with Appellants that the lower “court ‘failed to determine SolarCity’s value at the time the Acquisition closed’ and instead improperly compared SolarCity’s stock price from June 21, 2016 [the day Tesla’s Initial Offer to SolarCity was publicly announced] to its stock price right before the November 21, 2016 closing,” which had not yet factored in nonpublic information. Nevertheless, the Supreme Court ruled that this was not reversible error due to ample support in the record regarding the fairness of the price.
Key Takeaways
- After Tesla, it remains the case that, for controller buyouts or other conflicted transactions, boards should consider applying the MFW doctrine, so that they may benefit from the highly deferential business judgment standard of review, e.:
- (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority. Kahn v. M & F Worldwide Corp., 88 A.3d 635, 646 (Del. 2014).
- But if circumstances preclude utilizing a special committee or if MFW processes are not put in place, boards and advisors should be making real time decisions mindful of the likely application of the entire fairness standard if litigation follows. Indeed, as the Supreme Court observed, “[h]ere, the price of not utilizing a special committee was being subjected to entire fairness review—an expensive, risky, and ‘heavy lift’ in the litigation arena.”
- Of course, every circumstance will be unique, but process points that boards should consider include:
- Requiring a majority-of-the-minority voting provision.
- Tasking strong and careful independent directors to take the lead in negotiations.
- Taking affirmative steps that may show in the event of a challenge that the board operated independently of the controller. Such steps may include, depending on the circumstances, undertaking deep diligence over an extended time, rejecting requests from the controller, ensuring that the opportunity aligns with the company’s business plan, implementing a walkaway right in the event of certain financial breaches, employing independent advisors that closely study potential prices for negotiation, and revisiting whether an offer price should be adjusted in the face of additional information, among others.
This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.
