Securities & Structured Finance Litigation Update – December 2021

Litigating Shareholder Actions After MFW and Dell

Controlling shareholders (“controllers”) who engage in self-interested transactions can be held liable for breaches of fiduciary duties owed to minority shareholders.  Such “controller” claims are generally evaluated according to Delaware’s stringent “entire fairness” standard.  The controller bears the burden of proving both “fair price” and “fair dealing”—that the challenged transaction was substantively and procedurally fair.  This is exacting and its application can result in significant liability for controllers, including exposure to shareholder class actions seeking large damages.  But the Delaware Supreme Court’s decision in Kahn v. M & F Worldwide Corp. (“MFW”), 88 A.3d 635 (Del. 2014) creates a “safe harbor” by which controllers can avoid fairness review and therefore minimize their liability.  This article discusses the MFW decision and recent cases applying it, including the Dell Class V litigation, in which a court denied a motion to dismiss based on MFW.

MFW:  In MFW, the Delaware Supreme court held that entire fairness review does not apply to controller transactions that are conditioned, from the outset, on the approval of both: (1) a fully empowered, disinterested, and independent special committee that represents the interests of minority shareholders; and (2) a fully informed and un-coerced “majority-of-the-minority” shareholder vote.  Id.  Delaware courts evaluate six conditions to determine whether MFW’s requirements are satisfied:

• The controlling stockholder must condition the transaction on both special committee approval and a majority-of-the-minority vote of stockholders;
• The special committee must be independent;
• The special committee must be empowered to freely select its own advisors and definitively say “no” to the transaction;
• The special committee must fulfill its duty of care in negotiating a fair price;
• The vote of the minority stockholders must be informed; and
• There must not be any coercion of the minority stockholders.

The goal of MFW is to protect minority shareholders by ensuring that the procedural safeguards of an independent special committee and majority-of-the-minority vote prevent controllers from engaging in unfair transactions that advantage themselves at the expense of minority shareholders.  As the Dell court explained: “MFW’s dual conditions create a potent tool to extract good value for the minority because from the start of negotiations the controlling stockholder knows that it cannot bypass the special committee’s ability to say ‘no.’”  In re Dell Techs. Inc. Class V Stockholders Litig. (“Dell”), 2020 WL 3096748, at *15 (Del. Ch. June 11, 2020).  If both of MFW’s conditions are met, the deferential business judgment rule applies, rather than the entire fairness test.  Under the business judgment rule, nearly all corporate actions aside from overt waste are permissible, so if the business judgment rule applies, the plaintiffs’ claims are generally dismissed. 

Getting Around MFW:  Although several controllers have successfully invoked MFW to obtain the protection of the business judgment rule,  more recent decisions illustrate the limits of MFW—and potential pitfalls for controlling shareholders seeking to escape entire fairness review.

In Dell, a class of investors for which Quinn Emanuel serves as co-lead counsel defeated the application of MFW.  Dell concerned a 2018 transaction in which Dell’s controlling shareholders redeemed a class of stock (“Class V” stock) held by minority shareholders for a mix of cash and another class of Dell stock (“Class C” stock).  To invoke MFW, Dell’s board appointed a special committee to negotiate on behalf of Class V shareholders and held a shareholder vote at which a majority of the minority shareholders voted to support the deal.  Class V investors challenged the transaction as unfair and alleged the deal price was too low and that the special committee was conflicted and ineffective.  The investors brought breach-of-fiduciary duty claims against Dell’s controlling shareholders (Michael Dell and Silver Lake Partners) and members of the special committee.  Defendants moved to dismiss under MFW.  Vice Chancellor Laster denied the motion.

The Dell court found that nearly all of MFW’s requirements were not met, notwithstanding the appointment of the special committee and the shareholder vote.  First, the special committee was not empowered within the meaning of MFW because Dell had reserved the right to resort to back-up transactions—including a forcible conversion of Class V stock into Class C stock—if the proposed deal failed, and had not given the special committee authority to prevent such a “Plan B.”  Id. at *17.  Second, the controllers “bypassed the Special Committee and negotiated directly with [shareholders],” which deprived the special committee of the power to function.  Id.  Third, the controllers “created a coercive situation by threatening” to resort to back-up options if the deal failed, such as a forcible conversion of Class V shares into Class C shares.  By doing so, [Defendants] both undermined the Special Committee’s ability to bargain effectively and the ability of the stockholders to vote down the deal.”  Id. at *31  Fourth, the special committee was conflicted, including because one of its members (David Dorman) belonged to the same highly exclusive golf clubs—Augusta National and San Francisco Golf Club—as the managing partner of Silver Lake Partners.  Id. at *36.  Fifth, the shareholder vote was not informed, because the controllers failed to disclose material information, including prior valuations of Dell that were far lower than the valuation used in the deal.  Id. at *39-41. 

Dell shows that courts may look beyond the formal imposition of a special committee and a majority-of-the-minority vote where a controller has merely paid lip service to MFW without fastidiously observing its requirements.  Beyond Dell, other recent Delaware court decisions also illustrate the scope and limits of MFW’s protections for controlling shareholders.

Ab Initio Requirement:  The controllers must appoint a special committee ab initio—before the transaction begins.  But exactly what “ab initio” means—i.e., when MFW’s requirements kick in—has been the subject of frequent litigation.  The Delaware Supreme Court’s decision in Flood v. Synutra Int’l, Inc., 195 A.3d 754, 762 (Del. 2018) is instructive.  There, the plaintiffs argued that the controller had failed to qualify for MFW’s protections because the controller sent a letter to minority shareholders proposing to take a company (Synutra) private before appointing a special committee.  Liang Zhang and affiliates controlled 63.5% of Synutra.  Zhang sent a letter proposing to take Synutra private by acquiring the remainder of its stock.  One week later, the board formed a special committee, but did not discuss the proposal.  Two weeks after the initial offer, Zhang sent a second letter, this time with MFW conditions.  Price negotiations did not begin until seven months after the second letter.  Minority shareholders challenged the transaction, claiming that the first letter should have contained MFW conditions.  The Delaware Supreme Court disagreed and held that MFW applied because its twin conditions were put in place “before any substantive economic negotiations” occurred.  Id. at 762.  Flood confirms that not every corporate action by a controller triggers the imposition of MFW’s requirements.  But later cases make clear that controllers must be careful not to begin any “substantive economic negotiations” before appointing a special committee, or else they risk losing the protections of the business judgment rule.  Compare Olenik v. Lodzinski, 208 A.3d 704, 717 (Del. 2019) (ab initio requirement not satisfied where controlling shareholder engaged in months of discussions about the valuation of a merger target before appointing special committee).

Work-a-Day Transactions:  Delaware courts have also clarified that MFW does not only apply to “bet-the-company” transactions.  If MFW’s conditions are not satisfied, even more routine decisions may be subject to entire fairness review.  In Tornetta v. Musk, 250 A.3d 793 (Del. Ch. 2019), the court addressed the issue of whether the compensation plan for Tesla CEO Elon Musk was subject to entire fairness review or the business judgment rule.  The court found that because MFW’s conditions had not been satisfied, entire fairness review governed, even though the challenged decision was not a “transformational” transaction such as a merger or share redemption.  Id. at 800.

What Makes a “Controlling” Shareholder?  Courts applying MFW have sometimes applied “entire fairness” review even to shareholders that control less than a majority of the voting shares of a company.  In In re Tesla Motors, Inc. Stockholder Litig., 2020 WL 553902, at *4 (Del. Ch. Feb. 4, 2020), minority shareholders challenged Tesla’s acquisition of another company, Solar City, and sued Musk.  He argued that he was not a controlling shareholder because he owned only 22% of the voting shares. The court rejected this argument and concluded that a “minority blockholder can, as a matter of law, be a controlling stockholder through a combination of potential voting power and management control such that the stockholder could be deemed to have effective control of the board without actually owning a majority of the stock.”  Id.