This issue of the Debevoise & Plimpton Special Committee Report surveys corporate transactions announced during the period from January through June 2022 that used special committees to manage conflicts and key Delaware judicial decisions during this period ruling on the effectiveness of such committees.
Of the nine special committee transactions surveyed in this issue, four were acquisitions by private equity funds managed by sponsors with preexisting control investments in the target company (another two transactions had other private equity or hedge fund involvement). Although each of those four transactions used special committees, the members of which were wholly independent of the controlling stockholder, to negotiate and ultimately approve the transaction on behalf of the target company, none used the second MFW prong of requiring approval of the transaction by holders of a majority of the stock held by unaffiliated stockholders. This middle ground may be indicative of private equity firms' general tendency, in weighing the trade-off between greater protection against post-closing stockholder claims versus lesser control over the outcome of the transaction, to put a higher value on control than other types of controlling investors.
Below, we discuss this control versus litigation risk mitigation dynamic in the context of an allcash sale of a private equity controlled company in light of "liquidity conflict" claims. These claims, while still relatively rare, have become more common over the past few years.
Liquidity Conflicts: A Case for Special Committees?
While special committees are standard practice in transactions where a controlling stockholder stands on both sides of a sale transaction, sales to third parties in which the controller receives the same type and amount of per share consideration as other target stockholders do not generally present the kinds of conflicts that would justify a special committee process. Some plaintiffs, however, have argued that, even in these situations, the large size of the controller's interest in the company may create a conflict — sometimes called a "liquidity conflict" — where the sale of the company was driven, in whole or in part, by the controller's particular need or desire for the liquidity that would result from the sale.
For example, in its 2011 decision in N.J. Carpenters Pension Fund v. infoGROUP, Inc., the Delaware Court of Chancery declined to dismiss a fiduciary duty claim based on allegations that infoGROUP's largest stockholder forced a sale of the company at an inopportune time and at an unfair price in order to satisfy his personal liquidity needs. 1 Unsurprisingly, this decision emboldened plaintiffs to press liquidity conflict claims in the context of private equity sponsor-controlled companies, given that the private equity business model is based on a limited investment time horizon.
For the most part, Delaware courts have been unsympathetic to claims that the relative size of private equity sponsors' investments usually makes a whole-company sale the most efficient exit strategy, or that the timing of a sale resulted primarily from the liquidity requirements of the sponsor of the fund, at least in the absence of evidence that the private equity sponsor failed to seek to maximize value in the sale transaction.2 Even if the sale is deemed to provide the sponsor with a non-ratable benefit — given the sponsor's limited ability to liquidate its investment in the existing public market as compared to smaller stockholders — where the sponsor receives the same pro rata consideration as all other stockholders, Delaware courts have found a strong inference of fairness. For Delaware courts to find a disabling conflict, the pressure on the controlling stockholder to sell quickly must be unusually high, such as the "very narrow circumstances" where the controlling stockholder forces a "fire sale" to meet some "exigent need." 3
Nonetheless, the recent opinion by the Delaware Court of Chancery in Manti Holdings, LLC et al. v. The Carlyle Group, Inc. et al. 4 indicates that the liquidity conflict specter continues to lurk in Delaware case law. In Manti, the court declined to dismiss fiduciary duty claims arising from a portfolio company sale. The court found sufficient facts to sustain a claim against the private equity sponsor and its affiliated directors based on an alleged liquidity conflict, in no small part based on a statement by a sponsor board representative to the effect that he was under pressure to sell the company because it was one of the last remaining investments in the applicable fund, and that the sponsor needed to monetize and close that fund in short order. In this case, the sponsor had an additional conflict: it held preferred stock entitling it to receive the bulk of the sale consideration before common stockholders received anything, thus arguably making the sponsor indifferent to the possibility that waiting to sell the company could result in a materially higher price. Those facts, along with a board process that allegedly excluded a dissenting minority board member, gave rise to a reasonable inference that the sponsor derived a unique benefit from the timing of the sale not shared with other common stockholders, and that the sponsor-designated directors, as dual fiduciaries, had acted disloyally in connection with the sale. As a result, the court held that the sale was subject to the test of entire fairness.
A conflicted controller can avoid the exacting standard of entire fairness by requiring a transaction to be approved both by a special committee of independent directors and by holders of a majority of the stock held by the company's unaffiliated stockholders.5 Should a private equity investor controlling a company with minority public stockholders use a special committee — whether or not coupled with a majority-of-the-minority approval condition — in order to avoid liquidity conflict claims? In most cases, probably not. Absent other conflicts, the mere desire of a controller to achieve liquidity through an entire company sale generally would not present a level of litigation risk that would lead most controllers to cede control of a sale process to a special committee.
The additional fact in the Manti transaction that the sponsor held preferred rather than common stock does make it one in which having a special committee negotiate the transaction might have been a potentially meaningful protection. In the more garden variety liquidity conflict case, however, the sponsor still has alignment with the common stockholders in seeking the best price reasonably available and the sensitive issue — if indeed there is one — is the decision to sell in the first place. In any event, though, private equity sponsors and other controllers in this circumstance should be prepared to justify the sale process chosen, and should take care not to suggest that the timing or manner of the sale process is intended to confer some benefit on the controller that is not shared by the other stockholders
Recent Special Committee Decisions
"Serving as a director of a Delaware corporation is not a pro bono gig."
The prior issue of this Special Committee Report discussed a September 2021 decision of the Delaware Court of Chancery denying a motion for summary judgment brought by members of a special committee of a Delaware corporation on the basis of material questions of fact as to the independence of two of the three committee members. In the case of one of those members, the director's fees paid by the corporation over the prior eight years, which averaged $164,500 per year and which constituted his primary source of income, were found to raise questions as to his independence from the controller. In light of that case, it is worth noting that in January 2022, in a decision by Chancellor McCormick, the Delaware Court of Chancery held that a director's receipt of $140,000 in annual fees — which the court described as "not unusually excessive" — did not call into question the director's independence, even though it was his only source of income. In the words of the court, "serving as a director of a Delaware corporation is not a pro bono gig." Simons v. Brookfield Asset Management, Inc., et al., C.A. No. 2020-0841-KSJM (Del. Ch. Jan. 21, 2022).
Where a special committee was given the power to grant all corporate approvals in respect of a conflicted transaction, allowing a Section 203 waiver to be granted by the full board indicated that the special committee failed to function properly, thus rendering MFW inapplicable.
The founder, chairman and 20% stockholder of Highpower International proposed to take the company private at $4.80 per share. The transaction was conditioned on the approval of both a special committee of independent directors and a majority-of-the-minority stockholder approval. The special committee was given the exclusivity authority to grant any approvals of the board needed in furtherance of the transaction. After the founder proposed to expand the buyout group to include additional insiders, the expanded group sought a Section 203 waiver. The board granted that waiver, without any involvement by the special committee. The special committee ultimately approved the transaction at the originally proposed price, as did holders of 58% of the outstanding common stock held by unaffiliated stockholders. Following closing, former company stockholders brought fiduciary duty claims. Defendants moved to dismiss on the grounds that the requirements of MFW were met and the business judgment rule applied. The Delaware Court of Chancery held that "the special committee's failure to consider the Section 203 waiver as a committee, but instead allowing the board to waive it in the face of a clear delegation of authority to the special committee, creates a reasonable inference that the committee was not in fact functioning independently and did not fully discharge its obligations as set forth in the authorizing resolutions." Thus, the requirements of MFW were not satisfied, and the motion to dismiss was denied. Styslinger et al. v. Pan et al., C.A. No. 2020-0651-PAF (Del. Ch. Jan. 24, 2022; filed Feb. 7, 2022). Since Digex6 , Delaware courts have seen Section 203 approval as a key step—and a key leverage point for the target—in dealing with intricate interested stockholder situations, and this decision is consonant with that view.
Footnotes
1 C.A. No. 5334-VCN, 2011 Del. Ch. LEXIS 147 (Del. Ch. Sept. 30, 2011, revised Oct. 6, 2011); see also In re Answers Corp. S'holders Litig., C.A. No. 6170-VCN (Del. Ch. Apr. 11, 2012). The court in N.J. Carpenters cited the Delaware Supreme Court's opinion in McMullin v. Beran, 765 A.2d 910, 922-23 (Del. 2000), for the proposition that "Liquidity has been recognized as a benefit that may lead directors to breach their fiduciary duties."
2 See, e.g., In re Morton's Restaurant Group, Inc. S'holders Litig., 74 A.3d 656 (Del. Ch. 2013), and In re Crimson Exploration Inc. S'holder Litig., 2014 Del. Ch. LEXIS 213 (Del. Ch. Oct. 24, 2014). In each of these cases, the court dismissed claims based on the alleged liquidity conflict.
3 In re Synthes, Inc. S'holder Litig., 50 A.3d 1022 (Del. Ch. Aug 12, 2012).
4 C.A. No. 2020-0657-SG (Del. Ch. June 3, 2022).
5 Kahn v. M&F Worldwide Corp., 88 A. 3d 365 (Del. 2014).
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