Corporations Law: Changes in Control outline

Changes in Corporate Control Study Guide

I. Hostile Transactions

Should management’s efforts to block a hostile takeover be reviewed under business judgment rule or a stricter form of review? On one hand, whether a particular takeover bid is the best deal for a shareholder seems to fall under the business judgment rule. On the other hand, management does not want to be replaced so there is a duty of loyalty issue.

Cheff v. Mathes (Del. 1964)

• Primary Purpose Test:

• If the board was motivated by a sincere belief that the buying out of the dissident stockholder was necessary to maintain what the board believed to be proper business practices, the board will not be held liable.
• On the other hand, if the board acted solely or primarily because of the desire to perpetuate themselves in office, the use of corporate funds for such purposes is improper.

• The directors are of necessity confronted with a conflict of interest, and an objective decision is difficult. Hence, the burden should be on the directors to justify such a purchase as one primarily in the corporate interest.
• This burden can be satisfied with a showing of good faith and reasonable investigation.

Unocal Corp. v. Mesa Petroleum Co. (Del. 1985)

• The court reiterates the test from Cheff:

• The directors must show they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed because of another person’s stock ownership.
• They satisfy this burden by showing good faith and reasonable investigation.
• Such proof is materially enhanced, as here, by approval of a board compromised of a majority of outside directors.

• Once you pass the reasonable belief test, are there any limits to what you can do?
• The court adds an element of proportionality. For a defensive measure to come within the ambit of the business judgment rule, it must be reasonable in relation to the threat posed.
• The court lists factors that a company can take into account including the inadequacy of the price, illegality of the offer, the impact on “constituencies” other than shareholders, the risk of nonconsumation, and the quality of the securities being offered in the exchange.
• After passing these tests, the board’s decision is entitled to deference under the business judgment rule.

Paramount Communications, Inc. v. Time Incorporated (Del. 1990)

• Unocal review applies to all actions taken after a hostile takeover attempt has emerged that are found to be defensive in character.
• Did the Paramount offer pose a threat?
  • In Unocal there were problems with price and coercion. Here, there was no coercion, because no shareholders are left out of this deal as they were in Unocal. So the only issue can be price, but this price is so high!
  • However, the court stated that Time had an interest in preserving its long term corporate strategy.
  • Price and coercion are not the only factors. It is an open-ended analysis and the board can consider many other factors.
• Is the Warner tender offer proportional to the threat posed?
  -This step requires an evaluation of the importance of the corporate objective threatened; alternative methods for protecting that objective; impacts of the “defensive” action and other relevant factors.
  • The objective - the realization of the company’s major strategic plan - is reasonably seen as of unquestionably great importance by the board.
  • Moreover, the defensive step taken was effective but not “overly broad”. The board did only what was necessary to carry forward a preexisting transaction in altered form. It did not prevent Paramount from making an offer for Time-Warner or from changing the conditions of its offer.
  • However, management actions that are coercive in nature or force upon shareholders a management-sponsored alternative to a hostile offer may be struck down as unreasonable and non-proportional responses.
• The court concludes that the revised merger agreement was reasonable in relation to the specific threat posed by the Paramount offer.
• The court emphasizes the importance of the business judgment rule.

II. Friendly Transactions:

Friendly transactions still pose conflict of interest for target management, who may have approved the transaction because the acquirer promised them benefits after the transaction.

Friendly transactions are policed in the first instance by the requirement that any form of acquisition receive target shareholder approval.

However, management actions may limit the effectiveness of shareholder approval. For example, management may contractually agree with one bidder to neither solicit nor cooperate with a competitive bidder (a no-shop clause). Management may also assist a favored bidder by providing them an advantage, such as a termination fee or a stock or asset lock-up.

Case:  Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. (Del. 1986)

• Revlon extends the Unocal intermediate standard from target company defensive tactics to target company tactics that are designed to facilitate a friendly bid.
• The Revlon board’s decision authorization permitting management to negotiate a merger or buyout with a third party was a recognition that the company was for sale.
• The duty of the board had thus changed from the preservation of Revlon as a corporate entity to the maximization of the company’s value at a sale for the stockholders’ benefit.
• This significantly altered the board’s responsibilities under the Unocal standard. The whole question of defensive measures became moot.
• “The directors’ role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company.”
• The lock-up and no-shop and termination fee clauses are not per se illegal under Delaware law. But they have to be used to induce bidders into the auction, not end the auction and foreclose further bidding.
• In this case, the court decided that the board ended the auction to avoid personal liability to the note holders. No good faith and business judgment is lost. Unocal then requires a higher fairness review, which is very hard to meet if it gets to this point.

Case:  Mills Acquisition Co. v. Macmillan, Inc. (Del. 1989)

• Revlon was triggered when Macmillan put the company up for sale and started taking bids.
• Under Revlon, the board’s duties are altered and the sole responsibility of the directors is to achieve the best price for the shareholders.
• After triggering Revlon, the court goes through a two-step inquiry.
  • If directors favored one bidder, the court determines whether the directors believed that target shareholders’ interests were advanced by the favoritism.
  • If directors were properly motivated, then, as in Unocal, the court looks to proportionality: Was the benefit provided to the favored bidder “reasonable in relation to the advantage sought to be achieved?” In other words, did the directors get a good deal?
• Throughout the auction process, Evans and Riley provided advantages to KKR at the expense of Maxwell. These advantages included confidential information, a “tip” on Maxwell’s bid, a no-shop clause, and a crown jewel lock-up.
• The lock-up and no-shop clauses are not per se illegal, but can only be used for the benefit of the shareholders by improving the bids or inducing more bidders into the auction. Neither of those benefits occurred in this case.
• Evans and Riley violated their duties of loyalty. The rest of the board violated their duties of care. They were aware of the conflicts of Evans and Riley, they improperly delegated auction oversight, and they did not seek out all reasonably available information.

Case:  Paramount Communications, Inc. v. QVC Network, Inc. (Del. 1994)

• Paramount wanted to merge with Viacom. QVC made a hostile bid, but Paramount gave Viacom advantages as its favored bidder (no-shop, termination fee, etc.)
• Paramount argues that Revlon does not attach because a breakup of the corporate entity is required.
• The court says that Revlon is triggered when a board enters into a merger transaction that will cause a change in corporate control, initiates an active bidding process seeking to sell the corporation, or makes a breakup of the corporate entity inevitable.
• The court held that there was a sale or change of control in this case, because the majority of the corporation’s voting stock was transferred from the fluid market into the hands of a single person or a cohesive group acting together.
  • It matters because it shifts all the voting powers from the diffuse group to the single person or controlling group.
• Under Unocal, Revlon, and Macmillan, the board’s actions fail the enhanced judicial scrutiny.

Case:  Omnicare, Inc. v. NCS Healthcare, Inc. (Del. 2003)(en Banc)

• The board does not have unbridled discretion to defeat any perceived threat to a merger by protecting it with any draconian means available.
• Therefore, in applying enhanced judicial scrutiny to defensive tactics designed to protect a merger agreement, a court must first determine whether the actions taken were preclusive or coercive before its focus shifts to the “range of reasonableness” in making a proportionality determination.
• In this case, the defensive measures were preclusive and coercive in the sense that they made it “mathematically impossible” and “realistically unattainable” for the Omnicare transaction or any other proposal to succeed, no matter how superior the proposal.
• The deal protection devices were designed to coerce the consummation of the Genesis merger and preclude the consideration of any superior transaction.

III. Sale of Control:

Here, a conflict arises over the distribution of the premium paid for control.
-If a controlling shareholder sells her shares at a premium, do minority shareholders have a right to a portion of the premium?

Case:  Perlman v. Feldmann (2nd Cir. 1955)

• Feldmann (dominant stockholder, president, chairman of board) sold his shares for $20 each, even though the market price had not exceeded $12 and the book value was $17.03.
• The minority shareholders, as plaintiffs, contend that the consideration paid for the stock included compensation for the sale of a corporate asset. This power was the ability to control the allocation of the corporate product in a time of short supply, through control of the board of directors.
• Court views this as a misappropriation of a corporate opportunity case. The corporation could have used its market position to finance improvements in its exitsing plants or acquire new ones, or build up patronage in its geographical area for when steel becomes more abundant.
• The Court states that here we have no fraud, no misuse of confidential information, no outright looting of a helpless corporation. However, “the actions of the defendants in siphoning off for personal gain corporate advantages to be derived from a favorable market situation do not betoken the necessary undivided loyalty owed by the fiduciary to his principal."
• When the sale necessarily results in a sacrifice of this element of corporate good will and result in unusual profit to the fiduciary who has caused the sacrifice, he should have to account for his gains.
• To the extent that the price received by Feldmann included such a bonus, he is accountable to the minority shareholder plaintiffs.

The current state of the law allows the controlling shareholders to sell control at a premium without an obligation to allow minority shareholders to participate and/or otherwise share in the premium.  This is subject to a number of exceptions. (see: Mendel v. Carroll)

1. “Looting” theory - controlling shareholder cannot sell his shares if he knows the purchaser will do harm to the company.
2. Theft of corporate opportunity
3. Sale of office - selling your stock, but in reality selling your directorship by agreeing to resign and then elect the purchaser’s candidate.

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