In its recent decision in In Re Books-A-Million, Inc. Stockholders Litigation (“BAM”), the Delaware Court of Chancery addressed a basis for challenging a shift from entire fairness review to the business judgment rule that the Delaware Supreme Court did not contemplate in Kahn v. M&F Worldwide (“MFW”).
Prior to the Delaware Supreme Court’s ruling in MFW, mergers in which a controlling stockholder purchased a corporation’s remaining shares were subject to Entire Fairness review, even where such deals were facilitated by independent committees. Independent committees bore the burden of proving that they bargained at “arms-length,” uninfluenced by the controlling stockholder.
In MFW, the Supreme Court noted that although Entire Fairness review is the default standard for reviewing controlling stockholder squeeze-out merger transactions, it is not the appropriate standard in every merger of this type. The Court held that when the controlling stockholder sufficiently removes itself from the outcome of the merger, the Business Judgment Rule, not Entire Fairness, is the operative standard of review unless the transaction is “so extreme as to constitute waste and thereby support an inference of subjective bad faith.”
Pursuant to the Court’s holding in MFW, Entire Fairness review gives way to the Business Judgment Rule if a controlling stockholder satisfies six elements: (1) the controller approval of the transaction is conditioned on approval by a special committee and the vote of a majority of the minority stockholders; (2) the special committee is independent; (3) the special committee is free to reject the transaction; (4) the duty of care to negotiate a fair price is met; (5) the stockholder vote is informed and; (6) the stockholder vote is not coerced. Compliance with all six elements results in the grant of a motion to dismiss a complaint challenging the transaction.
In BAM, plaintiffs, minority stockholders in Books-A-Million (the “Company”), alleged that the Company’s directors, controlling stockholders, and certain officers breached their fiduciary duties in approving a squeeze-out merger proposed by the Company’s controlling stockholder (the “Merger”). The Merger was structured to comport with the MFW standard. Plaintiffs argued, among other things, that the independent committee created to assess the Merger (the “Committee”) breached its fiduciary duties when it accepted the controlling stockholder’s bid over a “substantially superior offer” from a third party.
In BAM, the Court of Chancery faced the issue of whether plaintiffs pleaded sufficient facts to establish that the Merger did not satisfy the MFW framework, so as to prevent a shift from application of the Entire Fairness standard to the Business Judgment Rule. After analyzing each of the six elements discussed in MFW, the court determined that “[t]he plaintiffs’ complaint ha[d] not pled grounds to take the transaction outside of the [MFW] framework” and that “the business judgment rule applie[d].”
The BAM decision is significant in that the court was forced to address a challenge to MFW that was not explicitly contemplated by the Supreme Court when it decided MFW. In attacking the second MFW element , i.e., the special committee’s independence, plaintiffs argued that two members of the Committee “approved the Merger in bad faith, thereby displaying a lack of independence in fact.” To support their claim, plaintiffs alleged that the Committee’s acceptance of the controlling stockholder’s offer, rather than a third party’s offer at $0.96 more per share, was irrational. Plaintiffs suggested that by accepting the controlling stockholder’s offer, the Committee did not act independently, but rather “disloyally favored the interests of the [controlling stockholder].” Plaintiffs argue that because the Committee recommended the lower bid, it contravened its duty to advance the best interest of the stockholders, and thus acted with subjective bad faith.
In MFW, the Supreme Court found that when special committee members are shown to be independent, there is no basis to infer subjective bad faith by the special committee. Citing this language, the court in BAM found that “the difficult route of pleading subjective bad faith is [a] theoretically viable means of attacking the [MFW] framework.” To support this finding the court noted that under Delaware law, “pleading facts sufficient to support an inference of subjective bad faith is one of the traditional ways that a plaintiff can establish disloyalty sufficient to rebut the Business judgement rule.”
The court ultimately determined that plaintiffs failed to sufficiently plead that the Committee acted with subjective bad faith in approving the Merger, and that the Merger satisfied the MFW standard. The court stated that in order to find that the Committee acted with subjective bad faith, it must determine that the Committee acted with “intent to harm” or engaged in an “intentional dereliction of duty.”
Addressing plaintiffs’ arguments, the Court stated that a recommendation by the Committee that the merger proceed at a lower price did not necessarily give rise to an inference of subjective bad faith. The Court cited Mendel v. Caroll for the proposition that directors can not dilute the shares of a controlling block to secure control of a company. Such a dilution is permissible, however, if directors act with a good faith belief that the dilution is necessary to prevent the controlling stockholder from using its power to the disadvantage of minority shareholders.
Here, the court was unconvinced that the controlling stockholder in the Company attempted to exploit its control the the detriment of minority stockholders. The Court noted that the market affords different discount rates depending on the shares the acquirer already has in the company. Generally, when a prospective buyer has a substantial ownership interest in a company, its offer to purchase additional equity in such company comes with a higher discount rate, and thus, a lower purchase price. The inverse is true for prospective buyers with little or no ownership interest in a company.
In BAM, the court reasoned that because the prospective third party buyer sought to purchase control of the company, its price included a control premium. The controlling stockholder’s offer did not require a control premium as it, unlike the third party offeror, sought to purchase a minority stake in the Company. Thus, the court held that, although lower, the controlling stockholder’s offer rationally reflected the value of the interest it sought to purchase and, therefore, that it was not improper for the Committee to recommend the sale to the Anderson family. Moreover, the court noted that the solicitation of a third party offer by the committee was a legitimate exercise in assessing the value of the Anderson offer.
After determining that plaintiffs failed to plead subjective bad faith by the committee, and thus failed to prevent a shift to entire fairness, the court applied the business judgment rule. In so doing, the court found that the merger provided the stockholders a 90% premium over the trading price of BAM stock. Moreover, the court noted that the transaction was approved by a majority vote of fully informed stockholders. Thus, the court found that the business judgment rule applied and dismissed the complaint challenging the Merger.
Lindsay is a second year student at Widener University Delaware Law School and a Staff Member on the Delaware Journal of Corporate Law.
Suggested Citation: Lindsay Killian, Rebutting Fairness in Business: A Look at In Re Books-A-Million, Del. J. Corp. L (Nov. 27, 2016), www.djcl.org/blog.