On November 26, 2014, the Delaware Court of Chancery denied a motion to dismiss a complaint challenging a going-private transaction where the company’s CEO, Chairman and 17.5% stockholder was leading the buyout group. In his decision in the case, In Re Zhongpin Inc. Stockholders Litigation, Vice Chancellor Noble concluded that the complaint pled sufficient facts to raise an inference that the CEO, Xianfu Zhu, was a controlling stockholder, and as a result, the deferential business judgment rule standard of review did not apply. Instead, the far more exacting entire fairness standard governed, which in turn led the Court to deny the motion.
This is the fourth recent decision to address when a less-than 50% stockholder can be considered a controller, an issue that determines whether the alleged controller owes fiduciary duties to other stockholders and the standard of review the Court will apply in evaluating the challenged transaction. The decision therefore provides important guidance for directors and their advisors in structuring transactions involving large stockholders.
The company, Zhongpin Inc., a Delaware corporation headquartered in China, announced in March 2012 that Zhu proposed to purchase all the outstanding shares he did not own for $13.50 per share in cash. The CEO informed the board at that time that he did not intend to sell his stake to a third party. The board formed a special committee to address the proposal, which was comprised of the three non-employee members of the five-person Zhongpin board. The special committee retained independent financial and legal advisors and ultimately determined to enter into a merger agreement with the CEO-led group and recommended that stockholders approve the transaction. The merger agreement included a non-waiveable requirement that a majority of the minority stockholders approve the transaction; a 60-day go-shop that permitted the company in that period to solicit superior proposals; and the right on the part of the company to terminate the agreement for any reason during the go-shop period with no termination fee.
- Meaningful stock ownership, even if far less than 50%, coupled with unusually significant managerial and operational authority, may be sufficient to plead control.
In finding that the complaint pled control, the Court recognized that there is no “absolute percentage of voting power” required. Rather, the test is whether the stockholder’s combined voting, managerial or other power permit control of the corporation. Here, while acknowledging that most 17% stockholders are not controllers, and that a less-than 50% owner is “presumptively not a controlling stockholder,” the Court found that the complaint pled both “latent” and “active” control.
The complaint alleged latent control, or control via stock ownership, because (according to the company’s Report on Form 10-K) Zhu’s stockholdings allowed him to “exercise significant influence over” the company, including “shareholder approvals for the election of directors…the selection of senior management, the amount of dividend payments, if any…mergers and acquisitions, and amendments to [the company’s] By-laws.” Again citing the 10-K, the complaint also alleged that Zhu’s stock ownership could be a “possible impediment” to a third party acquisition – an allegation buttressed by the fact that the company received no bids during the go-shop period. The Court also found that the complaint alleged “active” control over the company’s daily operations. Relying yet again on the 10-K, the Court cited the company’s statements that it “rel[ies] substantially” on Zhu to manage operations and that his departure could have a “material adverse effect” on the company. The Court concluded that Zhu’s level of control was “significantly more than would be expected” of a CEO and 17.5% stockholder.
This is the fourth recent decision to address when a less-than 50% stockholder nonetheless may be a controller. In In Re: Crimson Exploration Inc. Stockholder Litigation (Oct. 24, 2014), the court expressed skepticism about (but did not decide) whether a 33.7% stockholder “actually exercised control over” the company’s board. In so holding, however, the court affirmed that mere allegations of a close working relationship between management and a large stockholder do not plead control, particularly given that a large stockholder “would suffer the most from a low merger price.” In In re Sanchez Energy Derivative Litigation (Nov. 25, 2014) and In re KKR Financial Holdings LLC Shareholder Litigation (Oct. 14, 2014), the Chancery Court likewise rejected allegations of minority stockholder control over the board with respect to the challenged transaction based on supposed control over management and operations of the company. Given that some level of stockholder influence on or control of management existed in all the cases, it is somewhat difficult to reconcile the outcome in these decisions with Zhongpin. One possible explanation is that Zhu’s control over the corporation was so substantial, and relatively greater than the power exercised by the alleged controllers in the other recent cases noted above, that, at the pleading stage, it sufficed to survive a motion to dismiss.
- A controlling stockholder transaction will not receive deferential business judgment review under M&F Worldwide unless there is approval by a majority-of-the-minority stockholders and an independent board committee from the outset of the transaction.
In Kahn v. M&F Worldwide Corp. (Mar. 14, 2014), which was decided after the Zhongpin transaction closed, the Delaware Supreme Court held that in going-private mergers where there is a controlling stockholder, the use of both a truly independent special committee and a majority-of-the-minority stockholder vote may allow for judicial review under the deferential business judgment standard. Here, both of these structural devices were in place, but the transaction was not conditioned on both sets of approvals from the outset. Rather, the majority-of-the-minority provision was included “at the tail end” of the process after the $13.50/share price had been agreed upon. As a result, entire fairness applied. The decision reinforces the importance of structuring controlling stockholder transactions from the outset to include minority protection devices in order to maximize the chances of obtaining deferential business judgment rule review in controlling stockholder transactions, assuming the committee and the controller are willing to agree to such provisions.
- The risk of “inherent coercion” in a controlling stockholder transaction warrants entire fairness review even if there is no allegation that the controller actually attempted to coerce the company’s board or committee to approve the transaction.
The Court also found that the absence of any allegations in the complaint that Zhu attempted to use his voting or other power to force the committee to accept his proposal did not affect whether the entire fairness standard applied. The premise of the entire fairness standard is that controlling stockholders “possess such potent retributive capacity” that entire fairness review is appropriate regardless of whether an effective special committee approved the transaction. At most, the presence of an effective committee or an informed majority-of-the-minority vote affects the burden of proof but not the applicable standard that applies.
Interestingly, the Court does not appear expressly to find that the complaint pled control over the committee with respect to the challenged going-private transaction – the inquiry deemed to be the relevant one in Crimson and Sanchez. However, such a conclusion may be inferred from the Court’s discussion of Zhu’s voting and operational power coupled with facts suggesting that the committee was ineffective (as discussed below).
- The sales process, including the effectiveness of the committee in negotiating with the alleged controller and the sufficiency of a pre- or post-merger agreement market check or go-shop, will affect the Court’s assessment of entire fairness.
The Court concluded that the complaint adequately pled unfair dealing and unfair price. As for price, the Court cited allegations referring to Bloomberg data suggesting that the transaction did not compare favorably to comparable transactions and that the $13.50/share price represented a 42% discount to the three-year high for the stock. As for unfair dealing, the Court observed that the company’s 10-K stated that Zhu’s cooperation may be necessary to attract third party acquisition proposals and that Zhu expressed an unwillingness to sell to a third party. As a result, the Court appeared to find plausible the allegation that the committee had no real power to generate superior proposals, rendering the market check conducted prior to signing the merger agreement and the solicitation efforts in the go-shop period ineffective. The Court also cited the fact that while the committee authorized its financial advisor to negotiate with Zhu on price, the committee did not provide firm counteroffers and it approved the merger agreement without a fairness opinion.
Although not stated explicitly in the portion of the Court’s opinion addressing unfair dealing, elsewhere in the decision the Court cites additional facts that suggest it viewed critically the sales process conducted by the committee. These include the facts that: (i) a few weeks after providing the committee’s financial advisor with financial forecasts for 2012 through 2016 prepared by management and reviewed by Zhu, the committee received revised forecasts (also reviewed by Zhu) reflecting decreases in projected revenues, profits and gross margins; (ii) Zhu never increased his initial acquisition price; (iii) during the pre-signing market check, when another bidder expressed interest in an acquisition at $15/share conditioned on Zhu’s participation, Zhu refused and threatened to withdraw his acquisition proposal if a deal was not signed promptly; and (iv) soon thereafter the committee’s financial advisor resigned.
The Court’s discussion of these allegations, and the picture they paint of a potentially ineffective committee, suggests that these considerations factored into its determination that the complaint pled unfair dealing. Particularly noteworthy is the fact that management provided downward revised projections to the committee within a few weeks of having provided an earlier set of data. As was the case in In re Rural/Metro Corp. Shareholders Litigation (Mar. 7, 2014), Chen v. Howard-Anderson (Apr. 8, 2014) and In re Orchard Enterprises, Inc. Stockholder Litigation (Feb. 28, 2014), Delaware courts will look quite skeptically at conduct suggesting that a participant in a merger transaction, whether management, a board or board committee, or an advisor, is manipulating financial projections or data in order to achieve a personally beneficial outcome to the detriment of stockholders.
- A Section 102(b)(7) exculpation provision will not be a basis for dismissing claims against directors where entire fairness applies.
The Court rejected the directors’ argument that the claims should be dismissed against them based on the company’s charter exculpation provision, which precludes claims for monetary damages arising from due care breaches against the directors. Although not stated explicitly, the Court appeared to conclude that the duty of loyalty potentially always is implicated whenever a complaint sufficiently pleads that directors “negotiated or facilitated” a transaction with a controlling stockholder that allegedly was unfair to the minority and the controlling stockholder used its power “over the corporate machinery” to bring about that transaction. That is the result, according to the Court, even in the absence of allegations of “specific wrongdoing by disinterested directors.”
Given this holding, it is difficult to understate the significance of the determination of whether a large stockholder is a controller. A finding of control makes it far more likely, if not certain (in the absence of satisfying the M&F Worldwide criteria) that stringent entire fairness review applies and that the directors will not prevail on a motion to dismiss based on a Section 102(b)(7) charter provision.