Delaware Vice Chancellor Strine Suggests Reform of Delaware Common Law Regarding Fully Negotiable Going-Private Transactions
by David J. Berger and John P. Stigi III

Introduction

The controlling stockholder of a public company makes an offer to buy all of the company’s shares at a premium over the market price. The offer is conditioned on an agreement to final terms with a special committee of independent directors. When the offer is announced publicly, a stockholder sues, attacking the sufficiency of the offer and challenging the conduct of the parties to the proposed deal—even though the deal is still negotiable and the special committee has barely begun its work. The special committee negotiates with the controlling stockholder, working hard to obtain an even greater premium for the benefit of the company’s public stockholders. Eventually, after the deal is reached, the plaintiff offers to settle, claiming that the pendency of the litigation contributed to the increase in the proposed consideration. Oh, and the plaintiff ’s lawyer wants a fee for the benefit “his” work provided to the public stockholders.

In In re Cox Communications, Inc. Shareholders Litigation,¹ Vice Chancellor Leo E. Strine Jr. faced this factual scenario in ruling on an objection to the stockholder plaintiff ’s application for an award of attorneys’ fees. Strine expressed irritation with the “premature, hastily-drafted, makeweight” complaint, which attacked “a fully negotiable proposal” by a controlling stockholder of Cox Communications to take the company private.² The problem for the defendant, the court recognized, is that under existing Delaware law, it is “impossible for a controlling stockholder ever to structure a [going-private] transaction in a manner that will enable it to obtain dismissal of a complaint challenging the transaction.”³ Thus, as Strine observed, this type of case “has settlement value, not necessarily because of its merits but because it cannot be dismissed.”⁴

Background

The Cox family founded Cox Communications and has continued to control the company since its public offering. In the summer of 2004, the Cox family decided to take the company private, and informed the board of directors that it was prepared to propose a buy-out of the remaining public shareholders at a price of $32 per share. The offer was explicitly conditioned upon approval of a special committee of independent directors. Within hours of the public announcement of the proposal, a number of plaintiffs’ law firms filed lawsuits alleging the $32 offer was too low.⁷

To evaluate and negotiate the proposal, the board established a special committee of independent directors. The special committee retained Goldman Sachs as its financial advisor and also hired independent legal counsel to assist in its negotiations with the Cox family. Eventually, following lengthy negotiations, the special committee agreed to a transaction whereby the Cox family would make an offer to acquire all of the outstanding shares for $34.75 per share—an increase in total consideration of approximately $675 million. The buy-out was explicitly conditioned upon, among other things, approval of a majority of the minority shareholders (the “Minority Approval Condition”).⁸

On a parallel track, the stockholder plaintiffs hired an individual financial expert to advise them during negotiations with the Cox family’s litigation counsel. While plaintiffs proposed that the family raise its offer to $37 per share, the special committee and the family were in negotiations that would lead to the $34.75 per share agreement. Eventually, counsel for the plaintiffs agreed that the $34.75 price accepted by the special committee was fair, accepted the other terms of the transaction, and agreed to settle their claims. After settlement, the family agreed not to oppose a request by plaintiffs’ counsel for payment of attorneys’ fees of up to $4.95 million. Certain Cox stockholders, however, did object to the fee request.⁹

The Court’s Ruling

Vice Chancellor Strine began his decision by stressing that the key principle of Delaware’s approach toward corporate law is the “empowerment of centralized management, in the form of boards of directors and the subordinate officers they choose, to make disinterested business decisions.”¹⁰ The court then discussed the seminal case of Kahn v. Lynch Communications, Inc.,¹¹ which sets forth the standard of review for goingprivate transactions where the controlling stockholder proposes a merger with minority stockholders. Specifically, Lynch provides that:

[A] merger with a controlling stockholder [is] always . . . subject to the entire fairness standard. Even if the transaction was 1) negotiated and approved by a special committee of independent directors; and 2) subject to approval by a majority of the disinterested shares . . . the best that could be achieved [by a controlling shareholder who was sued on the grounds that the transaction was unfair] was a shift of the burden of persuasion on the issue of fairness from the defendants to the plaintiffs.¹²

The vice chancellor noted that Lynch creates a procedural disadvantage for the corporate defendants in such a transaction because, regardless of the steps taken to ensure fairness to the minority shareholders, a case challenging the transaction still had settlement value. These cases cannot be dismissed at the pleading stage because a determination of whether the transaction is “fair” necessarily requires the terms to be fleshed out and the evidence to be evaluated.¹³ Indeed, although Lynch creates a strong incentive to use special negotiating committees to address mergers with controlling stockholders by providing that the use of a well-functioning special committee shifts the burden of persuasion from defendants to plaintiffs, this burden-shifting arrangement has significant limitations. Notably, because the Lynch standard does not offer any additional “liabilityinsulating” benefit for the use of a Minority Approval Condition, that important procedural protection has been less than prevalent.

Vice Chancellor Strine observed that the “incentive system that Lynch created for plaintiffs’ lawyers is its most problematic feature.”¹⁴ In contrast to any other type of transaction, under Lynch it was impossible “to structure a merger with a controlling shareholder in a way that permitted the defendants to obtain a dismissal of [a case challenging the fairness of the transaction] on the pleadings.”¹⁵ Again, under the analysis set forth in Lynch, financial fairness is always a debatable issue and plaintiffs therefore always have a “colorable position.”¹⁶ Accordingly, it makes more sense for defendants to pay to settle the case, rather than fight the litigation and face steep discovery costs if the litigation goes forward.

The court sharply criticized the practices of the plaintiffs’ bar with respect to the going-private process, noting that litigation under Lynch “never seems to involve actual litigation conflict” when it begins with a complaint attacking a negotiable proposal.¹⁷ Strine described the typical process of a transaction, in which the plaintiffs file complaints the day the proposal is announced, even though their claims are not yet ripe—at this point there is merely an opening proposal subject to negotiation—as plaintiffs’ counsel surely recognize. Thereafter, the special committee and controlling shareholders engage in real negotiations over the terms and structure of a deal while, on a second track, defendants’ attorneys negotiate with plaintiffs’ counsel. Once the price the special committee will accept is established, defense counsel makes its final and best offer to plaintiffs’ counsel, which inevitably accepts the offer subject to confirmatory discovery. The court commented on the “shocking” inability of the plaintiffs here to identify a single instance in a case of this kind where a plaintiff ’s lawyer refused to settle once a special committee and the controlling shareholder had agreed upon a price.¹⁸

The court also commented on alternative structures for going-private transactions. First was the Lynch structure, used in the Cox Communications transaction, where a controlling stockholder makes a merger proposal to the minority shareholders and events proceed as discussed above. An alternative route is where a controlling stockholder instead makes a tender offer to acquire the rest of the company’s shares. This structure is known as a “Siliconix deal,” after the case In re Siliconix Inc. Shareholders Litigation.¹⁹

The Siliconix route—typically a front-end tender offer designed to allow the controlling stockholder to obtain ninety percent of the shares, combined with a back-end short-form merger to acquire the remaining ten percent—involves less negotiation and litigation than the Lynch model. In a tender offer scenario, courts assume the minority requires less protection. Thus, “[s]o long as the controller did not actually coerce the minority stockholders or commit a disclosure violation,” the transaction can proceed. Although Siliconix transactions generally are not subject to the “entire fairness” standard, they do create difficulties for both stockholders and buyers, in part because the controlling shareholder does not always reach the ninety percent threshold necessary to do a short-form merger.²⁰

Strine also set forth a proposed reconciliation of the disparate Lynch and Siliconix lines of authority, as he seemed to find no coherent reason to have different standards of review for two transactions designed to achieve the same end result. Under his proposal, a controlling stockholder would not be required to prove entire fairness if “1) the tender offer was recommended by an independent special committee; 2) the tender offer was structurally non-coercive . . .; and 3) there was a disclosure of all material facts.”²³

Finally, Strine reviewed in detail the fee application submitted by plaintiffs’ counsel, and substantially lowered the amount awarded. In particular, the court ruled that “no risk premium should be awarded in fee applications of this kind, when a plaintiff suing on a proposal settles at the same level as the special committee.”²⁴

Significance of Cox Communications

Vice Chancellor Strine has become one of the country’s most respected judicial authorities on corporate governance law and litigation. His views on these issues carry great weight, both with his brethren on the Delaware courts and with courts outside the state. That alone makes the opinion noteworthy in several respects.

Will the Delaware Supreme Court or legislature respond to Strine’s proposal for reform?

The fact that Lynch transactions cannot defeat litigation at the pleadings stage clearly troubles the court. Under current law, each lawsuit has settlement value, regardless of the plaintiffs’ chances should they refuse to settle. In Cox, the court surmised that the reason plaintiffs always accept the special committee’s negotiated price is that a suit under Lynch is unlikely to succeed: “Given the special committee process, the Minority Approval Condition, and other factors, the plaintiffs candidly admit that they would have faced an uphill challenge.”²⁵ In proposing that the business judgment rule protect agreements with special committee and minority stockholder approval, the vice chancellor expects (rightly) that plaintiffs will be deterred from filing premature and pointless lawsuits.²⁶

It is unclear, of course, whether the Delaware Supreme Court or legislature will implement the proposed reform. As the vice chancellor recognized, the parties in Lynch never asked the court to consider whether “both special committee and an effective majority of the Minority Approval Condition should, as a tandem, justify invocation of the business judgment rule. . . . Therefore, it is arguable that the Supreme Court has never been asked to address the precise question that would be posed if a controller, from the inception of a transaction, made clear that its merger proposal was conditioned upon the use of both of these procedural protections, so as to most closely replicate the process by which an arms-length merger is approved.”²⁷

A warning to plaintiffs?

In the interim, however, plaintiffs are on notice that their fee requests will be scrutinized carefully and reduced significantly, limiting the economic incentive for bringing such suits. As Vice Chancellor Strine noted with disdain, plaintiffs filed “dashed-off complaints,” accomplished “little actual litigation work,” and submitted a legal bill reflecting “inefficient allocation between partners and associates.”²⁸ Plaintiffs no doubt can expect similar scrutiny from Strine and other Delaware chancellors in future such actions.

At the very least, observers may read the Cox decision to change the incentives for both attorneys and directors. Clearly, the possibility of eliminating litigation at the pleadings stage will make plaintiffs less inclined to file frivolous lawsuits. A more subtle result of the decision may be the increased use of Minority Approval Conditions in transactions involving interested directors. Minority stockholder approval serves to demonstrate the entire fairness of the transaction. However, because plaintiffs virtually always accept a special committee’s negotiated price, litigation has not reached the stage where minority shareholder approval is beneficial to directors. By suggesting that the addition of minority stockholder approval lead to application of the business judgment rule, Vice Chancellor Strine appears to have implicitly urged directors to involve stockholders when evaluating interested transactions.

Is the pendulum starting to swing back?

For the past several years, the trend of Delaware judicial decisions suggested that courts were raising the bar for director independence and good faith. For example, two years ago, in In re Oracle Corp. Derivative Litigation,²⁹ Vice Chancellor Strine evaluated an independent litigation committee established by the Oracle board of directors and ruled that the committee was not, in fact, independent: “By any measure this was a social atmosphere painted in too much vivid Stanford Cardinal red for the [Special Litigation Committee] members to have reasonably ignored it.”³⁰ Six months later, Vice Chancellor Strine addressed a corporate CEO’s fiduciary duty of loyalty in Hollinger Int’l, Inc. v. Black,³¹ and ruled that former Hollinger CEO Conrad Black had violated his duty of loyalty by misleading other directors about his interest in a newspaper company sale to a third party.³²

Beam v. Stewart³³ and In re Walt Disney Company Derivative Litigation³⁴ also suggested that Delaware courts were more closely scrutinizing director conduct. In Beam, Chancellor Chandler evaluated director independence in the context of the necessity of making pre-suit demand on a suit against directors of Martha Stewart Living Omnimedia. While the court ruled that a majority of the board’s directors were independent, Chancellor Chandler noted that the close personal friendship between Stewart and director Darla Moore may have compromised Moore’s independence. Had plaintiffs made “more detailed allegations about the closeness or nature of the friendship, details of the business and social interactions between the two, or allegations raising additional considerations,” the court would have ruled against Moore’s independence.³⁵ In Disney, Chancellor Chandler reviewed a duty of care lawsuit involving the Disney board’s decision to approve a $125 million settlement package for Michael Ovitz. In ruling that it appeared the board failed to exercise “any business judgment,” the court refused to apply the business judgment rule to dismiss the suit.³⁶ Commentators asserted that Disney signaled the willingness of Delaware courts to review the rationality of director decisions typically protected by the business judgment rule.³⁷ And indeed, Chancellor Chandler scrutinized the actions of Disney’s board and found them wanting, but not egregious enough to constitute a breach of the board’s fiduciary duties. ³⁸

Last year, while reviewing Oracle’s proposed takeover of PeopleSoft, Vice Chancellor Strine voiced his doubts about the wisdom of upholding a “poison pill” defense when a target’s shareholders approve of a takeover. Allowing the poison pill to prevent takeovers is another example of the deference that Delaware courts traditionally have granted directors. The vice chancellor noted that corporate law might benefit from tipping the balance toward shareholders when they disagree with directors about the fate of their company.³⁹

One might view Cox Communications as a subtle shift of judicial scrutiny toward the excesses of the plaintiffs’ bar and away from strict scrutiny of director conduct and independence. Those concerned with Delaware’s close scrutiny of directors also may be encouraged by a recent speech given in London by Vice Chancellor Strine; he expressed his concerns about the Sarbanes-Oxley Act and told federal legislators to “stay in [their] lane” by leaving corporate governance to the states.⁴⁰ In addition, Strine criticized new standards requiring companies to have independent directors, arguing that such rules encourage isolated CEOs to be their company’s only strategic leader. These criticisms of Sarbanes-Oxley may signal increased deference given to corporate boards in the wake of post- Enron reforms.

Notes

1 Cons. C.A. No. 613-N (Del. Ch. June 6, 2005).

2 Id. at 1.

3 Id. at 2.

4 Id.

5 See id. at 3, 69, 71, 74.

6 Id. at 4.

7 Id. at 6-7.

8 Id. at 6.

9 Id. at 17-19; see also Elliot J. Weiss and John S. Beckerman, “File Early, Then Free Ride: How Delaware Law (Mis)Shapes Shareholder Class Actions,” 57 VAND. L. REV. 1797 (2004). Elliott Weiss, a corporate law professor at the University of Arizona School of Law, filed an objection on behalf of Franklin Funds, which owned 509,000 shares of Cox Communications. Professor Weiss has published numerous scholarly articles urging reform of Delaware law and encouraging better efficiency for shareholders. Weiss asserts that by allowing frivolous lawsuits to go forward, and thus creating settlement value for each suit, Delaware law allows plaintiffs’ lawyers to tax shareholders for no added value in return.

10 Cox Communications, slip op. at 19.

11 638 A.2d 1110 (Del. 1994).

12 Cox Communications, slip op. at 24.

13 See id. at 2, 35, 44, 46, and 51.

14 Id. at 30.

15 Id. at 31.

16 Id.

17 Id. at 53.

18 Id. at 34.

19 2001 WL 716787 (Del. Ch. June 19, 2001).

20 Cox Communications, slip op. at 38. Delaware courts have also explained that the lower standard of review reflects the reality that reaching the 90 percent threshold renders fraud unlikely. See Stauffer v. Standard Brands Inc., 187 A.2d 78, 80 (Del. 1962) (“[I]t is difficult to imagine a case under the short[-form] merger statute in which there could be such actual fraud as would entitle a minority to set aside the merger.”).

21 Cox Communications, slip op. at 4 (emphasis in original).

22 Id. at 29.

23 Id. at 80.

24 Id. at 3.

25 Id. at 71.

26 See id. at 5, 78, 79, 83, 84.

27 Id. at 84.

28 Id. at 73.

29 824 A.2d 917 (Del. Ch. 2003).

30 Id. at 947.

31 844 A.2d 1022 (Del. 2004).

32 Id.

33 833 A.2d 961 (Del. Ch. 2003).

34 825 A.2d 275 (Del. Ch. 2003).

35 Beam, 833 A.2d at 980.

36 Disney, 825 A.2d at 287.

37 See Stephen Bainbridge, “Substantive Due Care and the Business Judgment Rule in Corporate Fiduciary Duty Law,” Nov. 29, 2003, available at <www.professorbainbridge.com/2003/11/substantive_due.html>.

38 See In re The Walt Disney Company Derivative Litigation, C.A. No. 15452 (Del. Ch. Aug. 9, 2005).

39 David Bank, “How a Judge’s Ruling May Curb ‘Poison Pill’ as Takeover Defense,” WALL ST. J., Dec. 13, 2004, at B1.

40 Leo E. Strine, Jr., “The Delaware Way: How We Do Corporate Law and Some of the New Challenges We (and Europe) Face,” July 5, 2005 (speech). Strine also described Sarbanes-Oxley as an “odd tasting ‘jambalaya’ of ideas” and a “strange stew.”

About the Authors

David J. Berger (dberger@wsgr.com) and John P. Stigi (jstigi@wsgr.com) are partners in Wilson Sonsini Goodrich & Rosati’s securities and commercial litigation group, specializing in corporate governance litigation. The authors would like to thank Damien Weiss for his assistance in drafting this article.