Posts from 2011

Court Of Chancery Explains Class Certification Rules

In re Lawson Software Inc. Shareholder Litigation, C.A. 6443-VCN (May 27, 2011)

This decision explains in a clear way how the class certification process is to work and when the members of the class should receive more direct notice of the class action.

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Chancery Decisions Highlight Importance of Independent and Disinterested Directors in Company Sale Transactions

Lewis H. Lazarus
This article was originally published in the Delaware Business Court Insider | May 25, 2011
 
Two recent decisions from the Court of Chancery — In re Orchid Cellmark Inc. Shareholders Litigation and In re Answers Corp. Shareholders Litigation — illustrate how parties may reduce deal risk by ensuring that the directors responsible for managing a sale process are disinterested and independent.  At the same time, while the court in both cases rejected challenges to the transactions based on allegedly excessive deal protection terms, the court also signaled that providing much more than the parties did in Orchid may break the court’s proverbial back.

Independence and Disinterest

The court decided each of these cases following an expedited preliminary injunction hearing at which the plaintiffs sought to enjoin the transactions based in part on an allegedly inadequate sales process.  In this Revlon Inc. v. MacAndrews & Forbes Holdings Inc. context, the court is called upon "to assess carefully the adequacy of the sales process employed by a board of directors."  A primary inquiry in assessing a transaction is whether the directors responsible for the negotiations are independent and disinterested.

In Orchid, the court noted that five out of the six directors were independent. Its board formed a special committee to negotiate the transaction.  That committee included two independent directors and a third newly elected director who had been nominated by the company’s largest shareholder.  In addition to the independence of the special committee, the court also found no reason to doubt the independence or credentials of the special committee’s financial adviser.

Likewise, in Answers, although the plaintiffs raised questions about the independence of two of the directors, the court found that those directors did not lead the negotiations.  Moreover, four out of the seven directors who approved the transaction were disinterested and independent.  Finally, the court held that the company’s financial adviser’s independence and qualifications were not seriously challenged.  The independence of the directors and their advisers were significant factors in the court’s decision in both cases to uphold the reasonableness of the boards’ decision making.

Deal Protection Terms

The court noted that deal protection terms such as termination fees, expense reimbursements, and no-talk and no solicitation clauses are standard.  The issue is whether cumulatively they are impermissibly coercive or preclusive of alternative transactions.  In Answers, the court observed that the break-up fee of 4.4 percent of equity value was at the upper end of the "conventionally accepted" range.

However, the court stated that this is not atypical in a smaller transaction.  The court also rejected the plaintiffs’ challenge that the court should measure the break-up fee in reference to enterprise value on the ground that "Our law has evolved by relating the break-up fee to equity value."

In Orchid, the parties' deal protection included not only standard no-shop and termination provisions, but also a top-up option, matching rights and an agreement to pull the company’s poison pill, but only as to the buyer.  The court held that top-up options are standard in two-step tender offer deals.  As to the termination fee, the court found it appropriate in reference to the equity value of the target and again rejected the plaintiffs' effort to measure the termination fee in reference to enterprise value.  The court also recognized that the matching and informational rights might have a deterrent effect on a hypothetical bidder, but it found those provided in the merger documents would not preclude a serious bidder from stepping forward.

The court also found that the selective pulling of the pill was not impermissibly preclusive of alternative bids.  The court reasoned that the merger agreement enables the board to redeem the pill if it terminates the merger agreement.  Termination is permitted if the board receives a superior offer and withdraws its recommendation that the stockholders tender their shares.  The court observed that the termination fee that would be owed if the board terminates the merger agreement for a bidder who makes a superior offer and then pulls the pill would be no greater than if the company accepts a superior offer or terminates the merger agreement for some other reason.

Finally, because "a sophisticated and serious bidder would understand that the board would likely eventually be required by Delaware law to pull the pill in response to a Superior Offer," the court ruled that the deterrent effect of these provisions likely was minimal.

In so holding, the court stated that deal protection measures evolve and cautioned that at some point incremental protection may prove too much:

"Deal protection measures evolve.  Not surprisingly, we do not have a bright line test to help us all understand when too much is recognized as too much.  Moreover, it is not merely a matter of measuring one deal protection device; one must address the sum of all devices.  Because of that, one of these days some judge is going to say 'no more' and when the drafting lawyer looks back, she will be challenged to figure out how or why the incremental change mattered.  It will be yet another instance of the straw and the poor camel's back.  At some point, aggressive deal protection devices — amalgamated as they are — run the risk of being deemed so burdensome and costly as to render the 'fiduciary out' illusory."

Together, these two cases demonstrate the value of a disinterested and independent decision-making body running a sale process.  Also, while the court rejected claims that the deal protection at issue was preclusive or coercive, the court also cautioned that counsel must be careful not to make an alternative transaction too burdensome or costly, lest any fiduciary out be deemed illusory.  Counsel should carefully evaluate the context of each transaction in determining appropriate deal protection, lest an added straw of protection is found to be the one that breaks the court’s proverbial back.

Lewis H. Lazarus (llazarus@morrisjames.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group.  His practice is primarily in the Delaware Court of Chancery in disputes, often expedited, involving managers and stakeholders of Delaware business organizations.  The views expressed herein are his alone and not those of his firm or any of the firm's clients.
 

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Court Of Chancery Explains Revlon Application In Mixed Consideration Offers

In re Smurfit-Stone Container Corp. Shareholder Litigation, C.A. 6164-VCP (May 20, 2011, revised May 24, 2011)

When does the Revlon doctrine apply when a takeover offer involves a mix of cash and stock?  After all, at least one Supreme Court decision suggests that if the stockholders will continue as part of a mix of all minority stockholders in the acquiring company, they may still be able to get a control premimum later and so Revlon does not apply.  This decision explains that even when the stockholders are being asked to take stock for some but not all of their shares that they still will lose the ability to get a control premimum for those shares to the extent they are sold for cash. Hence, Revlon applies and the board is required to get the best price possible for the stockholders in that transaction.

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Delaware's Complex Civil Litigation Court: One Year Later

Edward M. McNally
This article was originally published in the Delaware Business Court Insider | May 18, 2011

On May 1, 2010, the Delaware Superior Court established a specialized "division" within that court to handle business disputes, known as the "Complex Civil Litigation Division" (or "CCLD"). The CCLD complements the Court of Chancery by offering a specialized business court to handle cases for monetary damages where jurisdiction would not exist in the Court of Chancery. Three specially assigned judges handle the cases assigned to the CCLD. Now that a year has passed, it is time to review the work of the CCLD and to assess its future. The CCLD is off to a good start, but remains an underutilized resource for businesses faced with civil litigation.

For a number of years, civil litigation involving business disputes has been plagued by inefficiency, escalating costs and delay. Three areas in particular caused much of the trouble with business litigation. First, discovery of electronically stored information caused litigation costs to escalate even beyond the amounts in dispute. Second, delays from crowded court dockets frustrated businesses with a problem to resolve. Third, discovery disputes over privileged communications and the testimony of expert witnesses that are often involved in business disputes also increased litigation costs and delays.

The CCLD addresses each of these areas of concern. It utilizes judges experienced in business disputes who, by a Case Management Order ("CMO") entered at the outset of litigation, keep the litigation on track to a fixed trial date. The CMO also controls the discovery process and the collateral disputes that otherwise often derail a case. Discovery of electronically stored information ("e-discovery") is subject to a set of guidelines that require litigants to cooperate in e-discovery and to reduce its costs. Other protocols are imposed to limit disputes over the discovery of privileged communications and expert witnesses, with the goal of further reducing litigation costs.

None of these special aspects of the CCLD are groundbreaking innovations. The Federal Rules of Civil Procedure, for example, require case management conferences and court orders establishing pretrial and trial schedules. Those rules also were recently amended to better control e-discovery and expert witness discovery. Federal Rule of Evidence 502 also was added to better control attorney-client privilege disputes. The CCLD has freely borrowed from these innovations of the federal courts.

Moreover, the CCLD for the most part has chosen to characterize its special procedures as guidelines for litigants to adopt or modify as they choose by their own agreements. Thus, the parties may opt out of the expert witness, e-discovery and privileged communication guidelines of the CCLD if they wish. The court has made it clear that it will accept any reasonable proposal the parties choose.

Now that the CCLD has been in place for one year, it makes sense to see if its new procedures for Delaware’s Superior Court have succeeded in resolving the problems confronting business litigation.

As the awareness of the CCLD has grown, business for the CCLD has picked up speed. To date, 49 substantial business disputes have been assigned to the CCLD and its three judges. Our review of the dockets of those 49 cases (together with our direct participation in 25 percent of these cases) leads us to conclude the CCLD is making progress, but is still an underutilized resource.

The 49 cases fall into four categories: (1) those matters diverted from the CCLD by voluntary settlement, bankruptcy stays or removal to federal court; (2) those matters just recently filed whose history is too short to be analyzed; (3) those matters subject to motions to dismiss; and (4) those matters being actually litigated. In our experience this breakdown is typical of business litigation. For example, the CCLD attracts many insurance coverage disputes that are usually resolved by determinations of the scope of an insurance policy, often in the context of a motion to dismiss. Full litigation including discovery is not common in those cases.

Of the cases actually going forward in the full litigation process, the large majority are subject to some form of CMO, including protocols on expert and privileged document discovery. Delays caused by discovery disputes seem to have been avoided, with savings in time and expense. Thus, as to those cases, the CCLD is working out as planned. Of course, a more complete review of how CCLD is working must await a significant number of CCLD cases going to trial or at least going through the full litigation process.

The mere existence of the CCLD protocols as guidelines also may be having a positive effect even if the parties to the litigation do not choose to explicitly adopt them. E-discovery is an example. The CCLD has a detailed set of "E-Discovery Plan Guidelines." Those guidelines require that the parties submit an "e-discovery" plan to the court, unless "the parties otherwise agree." The parties are reaching agreements on e-discovery and thus the guidelines are having their intended effect of reducing e-discovery costs.

Of course, as with anything new, there are some problems that the CCLD is working to address. Motions to dismiss a complaint sometimes delay assignment of a matter to the CCLD. If it was a defendant who requested assignment to the CCLD, that assignment was planned to occur after an answer to a complaint was filed. If there was no answer but instead a motion to dismiss, assignment was delayed in these cases. Motions to dismiss have also delayed entry of a CMO. That is understandable given that granting such a motion will save the court from entering a useless CMO. Such a delay in ultimate case disposition when a motion to dismiss is eventually denied is a problem in all civil litigation. The CCLD is expected to address these issues shortly.

Finally, the CCLD appears to be an underutilized resource as it passes its first-year anniversary. We are told that the CCLD judges are able to go to trial on almost any schedule the parties choose. While that capacity may not last forever, it is a big advantage to litigants. Given Delaware’s predominance as a corporate domicile where jurisdiction over Delaware entities is established, companies interested in efficient resolution of business disputes before specially-focused judges should more frequently file their claims in the CCLD. If businesses are serious about improving the efficiency and predictability of business litigation, they will choose the Delaware Superior Court’s CCLD more frequently. We are confident that as the CCLD’s reputation grows, its docket will grow as well.

Edward M. McNally (emcnally@morrisjames.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. He practices primarily in the Delaware Superior Court and Court of Chancery handling disputes involving contracts, business torts and managers and stakeholders of Delaware business organizations. The views expressed herein are his alone and not those of his firm or any of the firm’s clients.
 

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Court Of Chancery Denies Fruitless Inspection

Graulich v. Dell Inc., C.A. 5846-CC (May 16, 2011)

The Court denied a petition to inspect corporate records for the purpose of determining if a suit should be filed against the Board when the plaintiff lacked standing to file such a suit, the statute of limitations barred the claim, and the potential claim was already the subject of a settlement of a prior suit.  One has to wonder why this petition was ever filed.

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Court Of Chancery Accepts Deal Protection Terms

In re Orchid Cellmark Inc. Shareholders Litigation, C.A. 6373-VCN (May 12, 2011)

In another decision reviewing whether deal protection agreements are impermissibly preclusive, the Court noted: " one of these days some judge is going to say "no more"..."   This decision and its recent companion decision,  In Re Answers Corporation Shareholders Litigation, C.A. 6170-VCN (April 11, 2011),  list many deal protection measures that the Court has accepted.

Since the Delaware Supreme Court's split decision in Omnicare, Inc. v. NCS Healthcare Inc., 818 A.2d 914 (Del. 2003) rejecting a lock up agreement with the majority owner, the Delaware courts have not overturned such deal protection measures in merger agreements.  Maybe this decision is a warning.   After all, the Chancellor's recent decision in Air Products and Chemicals Inc. v. Airgas Inc., 16 A.3d 48 (Del. Ch. 2011)  also expressed some doubts that Delaware should be so protective of a Board's power to block a takeover.  We shall see.

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Superior Court Refuses to Permit "Pick Off" Of Class Representative

Stratton v. American Independent Insurance Company, C.A. 082-12-12 JRS CCLD ( May 11, 2011)

In this unusual fact pattern, a defendant paid the class representative the most the representative might have received for himself if the class claim were won and then argued the class action was moot.  The Court disagreed and did a careful analysis of why the class action could proceed despite the defense effort to "pick off" the class representative.

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The Viability of the Disclosure Only Settlement

This article was originally published in the Delaware Business Court Insider | May 11, 2011
 
For corporations facing stockholder litigation challenging a proposed business combination, negotiating a settlement in which the corporation agrees to provide additional disclosures without any increased consideration can be an efficient means of avoiding the risk of litigation.  The benefit created by the additional disclosures means the plaintiff’s lawyer can apply for a fee while the corporation and its directors get a release of all claims.

Some recent decisions of the Court of Chancery, however, have cast some doubt on the ability of a "disclosure only" settlement to serve as the sole consideration for a settlement or a substantial fee.  Practitioners on both sides should be aware of these developments when negotiating a settlement of litigation challenging transactions.

Although the Court of Chancery has not recently issued a written opinion refusing to approve a "disclosure only" settlement, there is precedent for doing so — e.g., the Delaware Court of Chancery's 2006 opinion in In re SS & C Technologies Inc.  The issue most recently came to light in Scully v. Nighthawk Radiology Holdings Inc., a much discussed case in which the court appointed special counsel to report on whether the settlement in that case was collusive and improper.

There, the plaintiffs sought expedited proceedings to enjoin a merger between Nighthawk Radiology Holdings Inc. and another party based solely on claims of inadequate disclosures.  The court denied the motion, in part, because the court felt the disclosure claims were not meritorious and, indeed, would not support a "disclosure only" settlement.  The corporation then reached a "disclosure only" settlement with the plaintiffs in a parallel proceeding in Arizona and agreed to present the settlement for approval to that court.  The Court of Chancery viewed this as an attempt to avoid its earlier admonition that a disclosure only settlement would not be adequate consideration to support a release for defendants, and appointed special counsel to investigate the matter.

While the special counsel in Nighthawk ultimately concluded that no collusion was present, the healthy skepticism of "disclosure only" settlements expressed by the Court of Chancery should be noted. Courts appear to be scrutinizing closely "disclosure only" settlements as part of a Delaware court’s independent duty to ensure that a settlement is fair and reasonable — e.g., the Chancery Court's 2005 opinion In re Cox Communications Inc. Shareholders Litigation.  That skepticism is most clearly manifested in recent decisions analyzing fee requests in which disclosures were part of the benefit created.

For instance, on April 30's In re Sauer-Danfoss Inc. Shareholder Litigation, Consol, the Court of Chancery considered a request for $750,000 by plaintiffs’ attorneys who claimed they caused the corporation to issue corrective disclosures before the transaction was ultimately abandoned.  After first determining that the plaintiffs were entitled to credit for only one of the purported 11 additional disclosures, the court began its discussion of the fee to which the plaintiffs were entitled by noting that "all supplemental disclosures are not equal."  When quantifying the fee award for additional disclosures, the court "evaluates the qualitative importance of the disclosures obtained."  While one or two meaningful additional disclosures might merit an award of $500,000, prior precedent in contested fee cases reveals that less meaningful disclosures yield much lower awards.  With that in mind, the court awarded $80,000, in large part because the disclosures were not particularly meaningful and the plaintiffs had not actively litigated the case after filing, instead seeking to negotiate a settlement.

The court used three recent opinions to support its conclusion that an award of only $80,000 was sufficient under the circumstance. In the 2006 case In re Triarc Companies Shareholders Litigation, the court awarded $75,000 in fees and expenses for the additional disclosure that the chairman of the special committee thought the deal price was inadequate where the plaintiffs had done nothing after the disclosure mooted the claims in the amended complaint to create any benefit.

In the 2009 Chancery Court case In re BEA Systems Inc. Shareholders Litigation, the court awarded fees and expenses of $81,297 where supplemental disclosures were made before discovery, preliminary injunction briefing and hearing, but the injunction was denied.

Finally, in 2010's Brinckerhoff v. Texas Eastern Products Pipeline Co., the Chancery Court awarded fees and expenses of $80,000 to an objector to a settlement who settled his objection in exchange for additional disclosure from the corporation as Form 8-K.

The consistent thread throughout these opinions, including the recent Sauer-Danfoss decision, is that non-meaningful disclosures that were agreed to after little work by plaintiffs will not merit substantial fee awards.

What effect, then, does the court’s reluctance to award large fees for additional disclosures combined with the court’s criticism of "disclosure only" settlements have on class action and derivative litigation going forward?

First, it may provide a disincentive for plaintiffs firms to continue to file litigation in Delaware challenging transactions.  The data showing a decrease in the number of lawsuits filed in the Court of Chancery has been readily available for some time now.  While smaller fee awards and higher criticism of "disclosure only" settlements cannot be the sole basis for the decrease in filings in the Court of Chancery, it likely plays some role.

Second, the use of the "disclosure only" settlement may become a thing of the past due to the risk for both sides.  Plaintiffs may not be willing to enter into a "disclosure only" settlement because they know they are at risk they will not be awarded a substantial fee.  Defendants may not be willing to enter into a "disclosure only" settlement because they do not want to put at risk their global release if the settlement is rejected as unfair.

To be clear, there is nothing in the Court of Chancery’s current jurisprudence to suggest that a "disclosure only" settlement is per se impermissible.  What is clear, however, is that to the extent that the parties to stockholder litigation challenging a business combination believed they could settle a case for the relatively inexpensive cost of making additional information available to the stockholders, that path must be followed carefully while keeping in mind the authorities cited above.

Peter B. Ladig (pladig@morrisjames.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group.  He represents both stockholders and directors in corporate litigation.  The majority of his practice is in the Delaware Court of Chancery, although he has extensive experience in the other state and federal courts in Delaware and has been involved in over 50 published decisions.  The views expressed herein are his alone and not those of his firm or any of the firm's clients.
 

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'Material Adverse Change' Clauses Protect Against Loss of Customers and Suppliers

Lewis H. Lazarus and Jason C. Jowers
This article was originally published in the Westlaw Journal Delaware-Corporate | May 4, 2011

In the article, Lewis H. Lazarus and Jason C. Jowers discuss the need for transactional and litigation attorneys who negotiate or litigate material adverse change clauses to focus on the particular language at issue as differences in phrasing could affect whether a seller is protected from a buyer's claim of breach.

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Ignoring Chancery Court's Guidance on How to Act in Merger Transactions Could Jeopardize Deals

Lewis H. Lazarus
This article was originally published in the Delaware Business Court Insider | May 04, 2011

The Delaware Court of Chancery, mindful of its role as a pre-eminent business court, works hard to communicate its expectations of officers and directors and their advisers.  That facilitates predictability.  Companies can be bought or sold with reduced risk that proposed transactions will be enjoined.  The corollary is that when advisers and their boards do not follow the rules, they put their clients’ transactions at risk.  Two recent cases illustrate that the Delaware Court of Chancery will not hesitate to enjoin a transaction where parties ignore clear guidance from prior opinions.

In its Feb. 14 decision in In re Del Monte Foods Co. Shareholders Litigation, the Court of Chancery enjoined a merger transaction from closing for 20 days and voided the deal protection terms that would have made a competing bid more expensive during that time period.  It did so because of conflicts of interest by the seller’s investment adviser.  The conflict arose because the seller’s investment adviser worked with the buyer to develop its merger proposal without telling the board, in apparent violation of a confidentiality agreement arising out of a previous failed effort to sell the company.  It then sought a role in providing buy-side financing.  All this while acting as financial adviser to the seller.

In enjoining the transaction the court relied on In re Toys "R" Us Inc. Shareholder Litigation, a 2005 case in which the court held that generally "it is advisable that investment banks representing sellers not create the appearance that they desire buy-side work, especially when it might be that they are more likely to be selected by some buyers for that lucrative role than by others."

Here the court found the investment adviser failed to disclose its conversations with prospective buyers or that it sought from the beginning to provide financing to the buyers.  This prevented the board from taking steps to protect the integrity of the process.  It also caused the seller to incur greater fees because once it was disclosed that the investment adviser sought to provide buy-side financing, the conflict required the board to obtain a new investment banker to opine on the fairness of the transaction.  Thus, while "the blame for what took place appears at this preliminary stage to lie with Barclays, the buck stops with the Board," the court said in Del Monte.

The remedy the court fashioned was unique — voiding the deal protection terms while enjoining the closing to permit a 20-day go-shop — but reflects the traditional equity power of the court to fashion a remedy tailored to the breach.  The court had no problem voiding the contractually bargained-for deal protection terms where the buyer knowingly participated in the board’s breach of fiduciary duty.  In so doing, the Del Monte court emphasized, "After Vice Chancellor [Leo] Strine’s comments about buy-side participation in Toys 'R' Us, investment banks were on notice."

Three weeks later, in its March 4 decision in In re Atheros Communications Inc. Shareholders Litigation, the Court of Chancery enjoined another transaction where the board failed to disclose the nature and amount of the investment adviser’s fee.  In Atheros the court found that stockholders voting on a proposed merger transaction would find it important to know that the investment adviser who rendered the fairness opinion upon which the board relied would receive 98 percent of its fixed fee only if a transaction closed.  The court was not troubled by the contingent fee per se, but rather by the fact that more than 50 times the portion that was otherwise due would be received only if a transaction closed.  As the court held, "the differential between compensation scenarios may fairly raise questions about the financial adviser’s objectivity and self-interest."

An additional factor justifying the court’s entry of injunctive relief was that the board did not disclose how soon in the process the seller’s CEO, who actively participated in negotiating the transaction price, knew that he would be staying on and receiving compensation from the buyer.  The court thus required additional disclosure on this point, finding that information that the CEO knew he would receive an offer of employment from the buyer at the same time he was negotiating the offer price would be important to a reasonable stockholder in deciding how to vote.

Both of these cases demonstrate the vitality of the court’s observation in Del Monte, cited in Atheros, that "because of the central role played by investment banks in the evaluation, exploration, selection, and implementation of strategic alternatives, this court has required full disclosure of investment banker compensation and potential conflicts."

That guidance means that practitioners and advisers would be well-served to avoid conflicts, to counsel their clients to avoid them, and to disclose such conflicts promptly.  Boards must also ensure that possible conflicts on the part of management who participate in the sale negotiations are properly managed by the board and fully disclosed.  As these cases demonstrate, it is the board’s responsibility to manage the sale process and failure to follow clear guidance from the case law imperils prompt closing of potential transactions.

Lewis H. Lazarus (llazarus@morrisjames.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group.  His practice is primarily in the Delaware Court of Chancery in disputes, often expedited, involving managers and stakeholders of Delaware business organizations.  The views expressed herein are his alone and not those of his firm or any of the firm's clients.
 

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Court Of Chancery Sets Fee Guidelines

In Re Sauer-Danfoss Inc. Shareholders Litigation, C.A. 5162-VCL (April 29, 2011, revised May 3, 2011)

This will probably be the definitive decision on how to set the attorneys' fees in representative litigation where the benefit to the company and its stockholders is additional disclosures.  Not only does the decision explain how the Court will approach that issue, but it also contains a detailed table of fee awards in prior cases to serve as a guideline.

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Court Of Chancery Explains Step-Transaction Doctrine

Liberty Media Corporation v. The Bank of New York Mellon Trust Company, N.A. , C.A. 5702-VCL (April 29, 2011) affirmed, Del Supr September 21, 2011. Both Section 271 of the DGCL and many indentures provide that a corporation may not sell all or substantially all of its assets without stockholder approval.  For years, a recurring problem has been how to apply that law to a series of asset sales that when taken all together amount to a sale of almost all the company's assets.  This decision explains the so-called "step-transaction doctrine" under which such multiple sales may be aggregated to be considered one sale requiring stockholder approval. The short [and probably too simplistic answer] is that when the sales each have their own business justification, the Court will not aggregate them. Share

The Song of Preferred Stockholders: 'You Get What You Asked for, Not What You Need'

Edward M. McNally
This article was originally published in the Delaware Business Court Insider | April 27, 2011.

For a number of years, private equity investors bought preferred stock as their investment vehicle. That this stock was considered equity rather than debt made it particularly desirable for startup companies that need to conserve their borrowing capacity. For the investors, preferred stock also might have a favorable tax treatment on the inevitable day when it was redeemed by the issuing company. All the investor had to do was provide sufficient protection for itself by the rights given to its preferred stock by the issuer’s certificate of incorporation. Seems simple enough.

Yet even the most sophisticated equity investors have failed to get what they actually need to protect their investment. They have asked for literally dozens of different rights as preferred stockholders, only to find out later that they failed to get what they really needed to secure the return of their investment. While it is true that in some cases preferred stockholders are also owed the fiduciary duties owed to common stockholders, that is not good enough. After all, they are "preferred." Why have they failed to protect themselves?

There are two basic legal principles that affect the ability of preferred stockholders to protect their investment. First, it is settled Delaware law that preferred stockholder rights are based on their "contract," what the company’s certificate of incorporation provides for the preferred stock. The courts will not grant them rights they did not get in the certificate.

Two recent Delaware decisions illustrate this principle. On March 29. in Fletcher International Ltd. v. ION Geophysical Corporation, the Chancery Court said the preferred stockholder sought to protect its investment by bargaining for the right to consent to the sale of any stock by a company’s subsidiary. In that way the parent company’s most valuable assets, its subsidiaries, could not be diluted without the preferred stockholder’s approval. But when the parent company wanted to do a deal that the preferred stockholder did not approve, the parent company just formed a new subsidiary and sold that subsidiary’s stock itself. Because the certificate of incorporation only prohibited a stock sale by a subsidiary and not by the parent company, the court permitted the sale to go forward over the preferred stockholder’s objection. No amount of complaining about form over substance did the preferred stockholder any good. It still lost.

SV Investment Partners v. Thoughtworks Inc., a Nov. 10, 2010, Chancery Court decision, reached a similar disappointing result for the preferred investor. There, the preferred stock had the right to be redeemed out of "funds legally available" on the redemption date. On that date the company had a "surplus" — its assets were worth more than its debts. However, the court ruled that the preferred was not entitled to be redeemed. It reasoned that because the company had legitimate needs for its cash, those funds were not "legally available" for redemption. In short, the precise wording the preferred stockholders asked for in the certificate of incorporation did not get them what they needed to be redeemed.

Getting around this first legal principle of strictly limiting the preferred’s right is not as easy as just giving it the power to elect directors upon default. For then the second legal principle that affects preferred stockholder rights comes into play. Directors have a fiduciary duty to all stockholders, even if those directors have been appointed just by the preferred stockholders. Hence, in the Thoughtworks situation, even if the majority of the directors had been elected by the preferred stockholders, they well may have had a duty to not use its funds for redemption when other uses of cash were better for Thoughtworks.

Indeed, recent Delaware decisions have criticized directors elected by preferred stockholders who wrongly favor the preferred stock. Because of those decisions, I suspect that it is the desire to avoid assuming any fiduciary duty to other stockholders that causes some private equity investors to not seek board control even if they are not timely redeemed.

What then are the remedies of the poor preferred stockholder left to only the terms of his or her preferred stock "contract" in the face of ingenuous schemes to work around his or her rights?

To begin with, the reality is that most of the time preferred stock ends up with the preferences it asked for at the bargaining table. Even if redemption may be postponed beyond the redemption date, steeply accruing post-redemption date carrying charges cannot be ignored forever. The price to be paid is just too steep, particularly if the company is to be sold to a third party or go public. Moreover, private equity investors learn quickly. The loopholes validated by past decisions will close in the next deal. The information exchange is just too fast to permit a clever avoidance tactic to be used for very long.

Finally, as the Thoughtworks decision points out, there are multiple existing ways a preferred stockholder may protect his or her investment. Requiring that redemption be paid by a short-term note, drag-along rights or even a forced sale of the company may all protect preferred stockholders. The vigilant preferred investor will remain as "preferred" as he wants, so long as he knows what to ask for in advance. Careful drafting is the key to the desired result.

Edward M. McNally (emcnally@morrisjames.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. He practices primarily in the Delaware Superior Court and Court of Chancery handling disputes involving contracts, business torts and managers and stakeholders of Delaware business organizations. The views expressed herein are his alone and not those of his firm or any of the firm’s clients.
 

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Multi-Jurisdictional Litigation a Rich Vein of Issues for Chancery Court

Peter B. Ladig
This article was originally published in the Delaware Business Court Insider | April 20, 2011.

Settlements of multi-jurisdictional stockholder litigation challenging corporate transactions raise logistical and other issues for reviewing courts including the proper allocation of fees between and among competing plaintiffs.   Chancellor William B. Chandler III in In re Allion Healthcare Inc.  Shareholders Litigation recently addressed this problem and his opinion provides important guidance to practitioners.  Here, the problem was not the specter of a collusive settlement, as it was in the litigation arising out of the merger of Nighthawk Radiology Holdings Inc. (Nighthawk), previously reviewed in this space.

This time, the settlement was approved, but the counsel for plaintiffs in two different jurisdictions could not agree how to allocate the award of attorney fees between them, and required the intervention of the chancellor to resolve the dispute.  Not only is the chancellor’s analysis illuminating, he also used the opinion as an opportunity to suggest his preferred mechanism to address certain of the problems caused by multi-jurisdictional litigation.

On Oct. 18, 2009, Allion Healthcare Inc. (Allion) announced it had entered into an agreement contemplating a going-private merger transaction whereby Allion would merge with affiliates of private investment firm H.I.G. Capital LLC (HIG) and a group of Allion stockholders who together owned about 41 percent of Allion’s common stock. As a result of the merger, Allion’s unaffiliated stockholders would be cashed out for $6.60 per share.   In response to this announcement, lawsuits were filed in Delaware and other jurisdictions, including New York, alleging that the price to be paid in the merger was unfair and asserting claims of breach of fiduciary duty against Allion, its directors and HIG in connection with the merger.  The first lawsuit was filed in New York on Oct. 20, 2009. A week later, a lawsuit was filed in Delaware, followed by another lawsuit in Delaware filed by Steamfitters Local Union 449.

Defendants moved to stay the New York action in favor of the Delaware proceeding.  That motion was ultimately denied, but not before counsel for the plaintiffs in the Delaware action notified the Court of Chancery that the Delaware plaintiffs, New York plaintiffs and the defendants had reached an agreement for the defendants to supplement their proxy statement in exchange for the withdrawal of the motion for a preliminary injunction.

After the merger closed, the plaintiffs in New York and Delaware filed amended complaints.  Defendants filed motions to dismiss in both jurisdictions.  The motion to dismiss in New York was largely denied on Aug. 13, 2010, by which time the motion to dismiss in Delaware was fully briefed but not decided.

The parties to the Delaware proceeding began discussing settlement in August 2010, and informed the Court of Chancery in September that they had reached an agreement in principle to resolve the Delaware action.  The New York plaintiffs learned of the settlement of the Delaware action on the same day.  On Nov. 12, 2010, the parties to the Delaware action filed a stipulation of settlement providing for an additional $4 million to be paid to the unaffiliated stockholders of Allion.  The New York plaintiffs filed an emergency motion to intervene in the Delaware proceeding to either: (1) stay the action, (2) reject the proposed settlement, or (3) allow the New York plaintiffs to take discovery on the merits of the action and the proposed settlement.  The court denied that motion, finding that the New York plaintiffs were well aware of the settlement, and permitted the New York plaintiffs to object to the settlement at the hearing to approve the settlement.

At the hearing, the court approved the settlement and awarded attorney fees and expenses of $1 million: $250,000 for the improved disclosures and $750,000 for the improved merger consideration.  The court allowed counsel for the plaintiffs the opportunity to create a fee-splitting solution.  They were unable to do so, and the court was required to resolve the issue.

Suggesting an Approach

Before addressing the merits of the issue before it, the court noted that the issue of fee-splitting is another practical problem caused by multi-jurisdictional litigation.  While discussing generally the other issues created by multi-forum litigation, in footnote 12 to the March 29 opinion in In re Allion Healthcare Inc. Shareholders Litigation, the chancellor suggested his solution:

"My personal preference, for what it’s worth," the chancellor wrote, "is for defense counsel to file motions in both (or however many) jurisdictions where plaintiffs have filed suit, explicitly asking the judges in each jurisdiction to confer with one another and agree upon where the case should go forward. In other words … my preference would be for defendants to ‘go into all the courts in which the matters are pending and file a common motion that would be in front of all of the judges that are implicated, asking those judges to please confer and agree upon, in the interest of comity and judicial efficiency, if nothing else, what jurisdiction is going to proceed and go forward and which jurisdictions are going to stand down and allow on jurisdiction to handle the matter….’ Judges in different jurisdictions might not always find common ground on how to move the litigation forward. Nevertheless, this would be, I think, one (if not the most) efficient and pragmatic method to deal with this increasing problem.  It is a method that has worked for me in every instance when it was tried."

This pragmatic solution is typical of the Court of Chancery’s approach to many issues, both procedural and substantive.  Indeed, the notion that the judges hearing related matters should collectively determine where the matter should go forward is similar in concept to the suggestion by the special counsel in Nighthawk that all courts hearing a related matter should be made aware of events in the other proceedings.  While some momentum appears to be building toward this type of disclosure, counsel representing defendants in a similar position would be wise to heed the suggestions in Allion and Nighthawk even before more definitive guidance emerges.

Counsel Fees

Turning to the merits of the fee dispute, the court found the analysis straightforward.  The court found that the disclosure portion of the fee was appropriately split equally between the New York and Delaware plaintiffs.  Although the New York plaintiffs may have argued later that the disclosures were inadequate to support a settlement, they still contributed to the benefit achieved by the disclosures by independently negotiating for them.

Unlike the disclosure portion of the fee, the court found that the efforts of the New York plaintiffs did not contribute to the benefit achieved by the increased merger consideration, and awarded all of the $750,000 increased consideration fee to the Delaware plaintiffs.

In Delaware, the filing of a meritorious action followed by a benefit conferred to a class creates a rebuttable presumption that the benefit was caused by the litigation.   When similar lawsuits are litigated in multiple fora, the presumption of a causal relationship between the litigation and the benefit achieved applies only to the Delaware litigation.   Affording the presumption to all actions would encourage placeholder filings in other jurisdictions, wasting judicial resources and making it more difficult to reach a settlement.

Here, the New York plaintiffs did not sign on to the settlement or otherwise support it.   Thus, the only way the New York plaintiffs could merit a fee is if the New York litigation somehow caused the Delaware settlement.  Here, counsel for the New York plaintiffs argued that even though it played no direct role in negotiation of the increase of the merger consideration, it created an "atmosphere" where the Delaware plaintiffs were able to negotiate a resolution.  The court rejected that argument for many of the same reasons it has been rejected before — the impact on the Delaware litigation was purely conjecture and in the absence of sufficient evidence to the contrary, a settlement achieved by counsel for Delaware plaintiffs should be attributed to them.  The court also rejected the New York plaintiff’s argument that the denial of the motion to dismiss in the New York action "moved" the case along to encourage settlement, finding that the evidence presented at the settlement hearing refuted this argument.

The chancellor’s decision in Allion, along with the report of the special counsel in Nighthawk, provide invaluable guidance to attorneys counseling directors and corporations involved in multi-jurisdictional litigation with a Delaware component.  Those who counsel these groups would be wise to review these issues carefully when advising them.

Peter B. Ladig (pladig@morrisjames.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group.   He represents both stockholders and directors in corporate litigation.  The majority of his practice is in the Delaware Court of Chancery, although he has extensive experience in the other state and federal courts in Delaware and has been involved in over 50 published decisions.  The views expressed herein are his alone and not those of his firm or any of the firm's clients.
 

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Court Of Chancery Enforces Scheduling Order

Encite LLC v Soni, C.A. 2476-CC (April 15, 2011)

When the Court of Chancery establishes discovery deadlines, it is not kidding.  The Court is consistently generous with lawyers who need more time and ask for it for a good reason and ahead of deadlines.  But when the lawyer fails to ask until the deadline has passed, the Court is not so kind and, as here, may deny the request.

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