Recently, in In Re BGC Partners, Inc. Derivative Litigation (“BGC”), the Delaware Court of Chancery ruled in favor of the defendants while applying the “entire fairness” standard of review in evaluating a merger transaction. This marks the second time in 2022 where the court has determined that a transaction was “entirely fair,” and with the insight gleaned from these cases, we present below some pointers for how boards of directors, controlling shareholders and management should design and execute deal processes to minimize exposure when the entire fairness standard applies.
The Entire Fairness Standard
When a transaction involves self-dealing by a controlling shareholder, the applicable standard of judicial review is entire fairness1, as opposed to the more deferential business judgment rule. Entire fairness means: (1) fair dealing (or fair process), which “embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained” and (2) fair price, which “relates to the economic and financial considerations of the proposed merger, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock.”2
Historically, defense verdicts are rare when the entire fairness standard is employed, however, on April 27, 2022, Elon Musk was handed a victory in a Delaware Chancery Court case stemming from Tesla’s 2016 acquisition of SolarCity. Tesla stockholders had claimed that the acquisition was the product of breaches of fiduciary duties and other wrongdoing and sued Mr. Musk and others. Mr. Musk owned approximately 22% of Tesla’s common stock at the time of the acquisition, his brother sat on the Tesla board and, in addition to his leadership positions at Tesla, was the Chairman of the SolarCity board of directors and his cousin was its chief executive officer.3 Despite finding that “the process employed by the Tesla board to negotiate and ultimately recommend the acquisition was far from perfect,” the court held (without determining whether the entire fairness standard was actually applicable to the case) in favor of Musk, describing the transaction as “entirely fair in the truest sense of the word.”4 The court was satisfied that Tesla’s board meaningfully vetted the acquisition through due diligence and with the advice of first rate legal and financial advisors and that Musk did not stand in the board’s way. Moreover and “if not more important”, the court found that the price paid by Tesla was fair.
BGC was a derivative action challenging the acquisition by BGC Partners Inc. of Berkeley Point Financial LLC (“Berkeley Point”), a real estate brokerage and lender, from an affiliate of Cantor Fitzgerald (“Cantor”). Because BGC Partners, Berkeley Point and Cantor shared the same controlling stockholder, Howard Lutnick, the court applied the entire fairness standard. The plaintiffs argued that Lutnick (who owned a 54% ownership interest in Berkeley Point and a 23% ownership interest in BGC Partners) had a financial incentive to cause BGC Partners to overpay for Berkeley Point (as opposed to the typical claim that target shareholders were underpaid). The court ruled in favor of the defendants, finding that the transaction was entirely fair to BGC Partners and its minority stockholders. The court acknowledged that the process was marred in several respects but that these weaknesses did not render the process unfair in light of certain procedural strengths. In fact, the record demonstrated that “the Special Committee undertook good faith, arm’s length negotiations with the guidance of independent advisors that resulted in a deal with a favorable structure and a fair price.”5
Tips for Designing and Executing an Effective Deal Process in Conflicted Transactions
Delaware courts have held that “perfection is not possible or expected” when executing a deal process, but “evidence of fair dealing or not has significant probative value to demonstrate the fairness of the price obtained.”6 So what should companies keep in mind in designing deal processes in the context of conflicted transactions when the entire fairness standard might apply? Companies can reduce the risk of expensive and time-consuming litigation by adopting “objectively evident procedural protections” and “deal techniques that provide protection to stockholders that are substantially equivalent to arm’s length bargaining.”7 Some such procedural protections are listed below.
- Empower a special committee. Delaware courts have stated that the deferential business judgment rule is the standard of review that should govern conflicted merger transactions where the merger is conditioned at the outset upon both the approval of an independent, adequately empowered special committee that fulfils its duty of care and the uncoerced, informed vote of a majority of the disinterested, or unaffiliated, stockholders.8 The court lauded Tesla for conditioning the merger on the vote of the unaffiliated stockholders but was surprised that it failed to provide shareholders with the “paramount” procedural protection afforded by forming a special committee.
- Obtain unaffiliated stockholder approval. Among the most important procedural protections under Delaware law is the approval of a conflicted transaction by a majority of the unaffiliated stockholders. This approval “serves as a complement to, and a check on, the special committee.”9 The Tesla court identified the fact that the board conditioned the acquisition on the approval of a majority of disinterested stockholders as a process strength, stating that “as one of the most extolled and powerful protections afforded Delaware stockholders, such approval is compelling evidence that the price was fair.”10
- When empaneling a special committee, quality counts. Courts will carefully examine the composition and functioning of a special committee. Special committee members should, thus, be independent, inquisitive and diligent. The independence of committee members will be evaluated in light of financial connections to the conflicted controller as well as personal, social and other ones.11 Committee members should be highly engaged in the deal, and the committee as a whole should serve as a true check against conflicts of interest. The committee should be empowered to say “no” to a transaction that is not in the best interests of the company and its unaffiliated shareholders, and the special committee should engage in hard-nosed negotiating before approving a transaction. In BGC, the court found that the committee members, “each engaged and diligent—bargained with [the seller]” and “obtained meaningful concessions.”12 This overcame certain procedural weaknesses related to the level of involvement of the controlling stockholder in the selection of the committee.
- Importance of special committee’s advisors. Delaware courts view special committees’ financial and legal advisors (and how they were selected) as a critical factor in assessing the reliability and independence of the process employed by the special committee.13 The ability of a special committee to choose its own advisors is critical in assessing whether a special committee has any real authority. The special committee should, by board resolution, be empowered to engage financial, legal and other independent advisors to aid it in evaluating the transaction and to determine the compensation of such advisors. In BGC, there was some question as to whether Lutnick tainted the process by suggesting the committee engage certain legal and financial advisors. While this was seen by the court as a flaw in the process, the court found that the advisors were in fact independent. There was no evidence that the advisors were beholden to the controlling stockholder. In addition, the special committee had good reasons (other than Lutnick’s suggestion) to select the advisors that they hired, having had favorable past experiences with them. Also, it was important to the court that the advisors understood their roles and advocated on the special committee’s behalf. The court pointed to evidence that the financial advisors worked tirelessly on the committee’s behalf and “bargained hard” for the special committee against Cantor, for instance by pressing them for (and obtaining) due diligence documents that Cantor had been reluctant to provide—due diligence documents that permitted the special committee to negotiate with Cantor on a fully informed basis.
- Avoid interference by conflicted controller. The plaintiffs in BGC made much of the fact that Lutnick selected William Moran as one of the special committee’s co-chairs and then spoke to Moran about the selection of certain specific legal and financial advisors to the committee. This was viewed by the court as a significant procedural weakness. Lutnick should have had no role in the selection of the committee’s co-chairs or its advisors. Fortunately for the defendants, the composition and conduct of the special committee and the quality of the work performed by the advisors overcame this weakness. While Lutnick had a hand in selecting the co-chair, the court was unable to conclude that he was beholden to Lutnick or had a “controlled mindset.” Additionally, Lutnick was not present at the meeting where the special committee voted to designate the co-chairmen and did not dictate the special committee’s membership more broadly. In addition, he recused himself from the special committee’s deliberations after it was fully empowered.
- Engage in hard-nose negotiations and get meaningful concessions. As mentioned above, the selection of Moran by the controlling stockholder as one of the co-chairs was viewed as problematic by the court. This flaw in the process was largely excused by the hard-nosed manner in which Moran negotiated with Cantor. Delaware courts have stated that the “[m]ost important aspect of fair dealing is the committee bargaining hard” with its counterparty. When it came to substantive negotiations, the court found that the supposedly conflicted co-chair “pushed back firmly,” even telling the financial advisors to “go at [the negotiation with Cantor] hard” and to “negotiate from…a zealous or aggressive standpoint on behalf of the independent directors and the independent shareholders.” Moran did not hesitate to tell Lutnick that Cantor’s proposals did not satisfy BGC Partner’s objectives and signaled a willingness to end negotiations with Cantor. The court stated that the special committee and its advisors worked very hard to obtain meaningful concessions on price and ended up negotiating a structure that was in line with BGC Partner’s preferred structure.
- Due diligence. The quality of the due diligence effort undertaken in connection with a transaction is an important consideration in determining the overall fairness of the process. The due diligence process should be so robust as to ensure that the controlling stockholder discloses all of the material terms of the proposed transaction, all material facts relating to the use or value of the asset in question and all material facts which the controlling stockholder knows “relating to the market value of the subject matter of the proposed transaction.”14 In BGC, the court noted that the special committee devoted substantial time to its work, and “after months of due diligence, a deal was reached following arm’s length bargaining.” The court found that the special committee and its advisors, after significant follow-up with Cantor, was eventually successful in obtaining all the due diligence materials it needed, including materials that the record showed Cantor did not want to produce. The record also showed that the special committee met nine times during the three-month timeline of the deal and understood that it was “important to take the time it needed to digest the diligence items and better understand the strategic rationale” for the transaction and the value of the target. In the end, the court believed that the diligence conducted led to a reduction in the purchase price, which fell within what the court concluded was the “range of fairness.”
- Carefully document the special committee’s process. Board and special committee minutes should be detailed and reflect the careful consideration that was given to the proposed transaction and should highlight procedural strengths (e.g., that experts and special committee members are thoroughly vetted for independence and expertise, that due consideration is given to experts’ opinions and that the committee generally functions in an effective manner).
- Transaction timing. The BGC court stated that “the timing and initiation of a transaction can evidence a lack of fair dealing where it favors the controller to the minority’s detriment.”15 It is not evidence of fair dealing where a transaction party communicates its preferred timeline or slows a transaction to allow for careful consideration. But if, on the other hand, the record demonstrates that “the deal as timed, financially injured the minority shareholders or enabled [the controller] to receive value at the minority’s expense,”16 this could be an indication of unfairness.
The Tesla case is currently being appealed. Counsel for the plaintiff have argued that the trial court’s opinion “if allowed to stand, provides an all too easy roadmap for even the most conflicted transactions to sail through the entire fairness review.” Still, Tesla and BGC represent the latest thinking by the Delaware Court of Chancery on the application of the entire fairness standard in the context of conflicted transactions. These cases illustrate that the court will consider deal process infirmities in light of countervailing strengths and in light of whether the outcome ultimately obtained is fair. This is consistent with the court’s reasoning in Weinberger that “though the two aspects of entire fairness may be examined separately, the test for fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness.”17
1 Ams. Mining Corp. v. Theriault, 51 A.3d 1213, 1239 (Del. 2012)
2 Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983)
3 In Re Tesla Motors, Inc. Stockholder Litigation, 2022 WL 1237185
4 Id., at 128
5 In Re BGC Partners, Inc. Derivative Litigation, at 110
6 In Re Tesla Motors, Inc., at 82-83
7 Id., at 86
8 Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)
9 See In re John Q. Hammons Hotels, Inc. S’holder Litig., 2009 WL 3165613, at *12 (Del. Ch. Oct. 2, 2009)
10 In Re Tesla Motors, Inc., at 95-96, citing ACP Master, 2017 WL 3421142; see also Gesoff v. IIC Indus., Inc., 902 A.2d (Del. Ch. 2006)
11 It is worth noting that the independence standard under Delaware law is distinct from NASDAQ and NYSE independence tests. Delaware courts will consider directors’ independence under applicable stock exchange rules, but their ultimate analysis is more context specific and holistic.
12 In Re BGC Partners, Inc., at 3
13 Kahn v. Dairy Mart Convenience Stores, Inc., 1996 WL 159628, n.6 (Del. Ch. Mar. 29, 1996)
14 Kahn v. Tremont Corp., 1996 WL 145452 (Del. Ch. Mar. 21, 1996), at *16
15 In Re BGC Partners, Inc., at 52
16 Id., quoting Van de Walle v. Unimation, Inc. 1991 WL 29303 (Del. Ch. Mar. 7, 1991), at 1217 Weinberger, at 711
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