Corporate Governance Group. Client Alert DELAWARE COURT APPLIES ENTIRE FAIRNESS ANALYSIS TO CORPORATE TRANSACTIONS WITH CONTROLLING SHAREHOLDER

Transcription

1 June 17, 2010 Client Alert Bei j i n g Fr a n k f u r t Ho n g Ko n g Lo n d o n Lo s An g e l e s Mu n i c h Ne w Yo r k Si n g a p o r e To k y o Wa s h i n g t o n, DC DELAWARE COURT APPLIES ENTIRE FAIRNESS ANALYSIS TO CORPORATE TRANSACTIONS WITH CONTROLLING SHAREHOLDER Also determines that independent director not an adequate counterweight to permit burden shifting In Gentile v. Rossette, 1 the Delaware Court of Chancery recently reaffirmed the duty of a board of directors to establish the entire fairness of both the process and price of a transaction likely to benefit a controlling shareholder. Vice Chancellor Noble s opinion demonstrates that the board of directors of even a relatively small corporation in financially dire straits, when approving a transaction between the company and a controlling shareholder, will find its actions subject to strict judicial scrutiny. On the other hand, the decision also points out that a director who approves a transaction found not to be entirely fair will not be held personally liable for damages, at least so long as the director acts loyally and in good faith and the corporation s charter contains appropriate exculpatory language for duty of care violations. Background In March 2000, the two-member board of directors of SinglePoint Financial, Inc., consisting of Douglas Bachelor and David Rossette, authorized the conversion of much of the debt owing to Rossette into SinglePoint common stock at a rate of $.05 per share. SinglePoint, a Delaware corporation formed to provide technology and computer services to financial service firms, had generated little revenue during its software development years and relied primarily on Rossette for capital. The board approved the debt conversion to relieve SinglePoint s balance sheet of the staggering debt owing to Rossette and, hopefully, to facilitate future business, the possibility of other investment, and, perhaps, even a sale of the entity. Please feel free to discuss any aspect of this Client Alert with your regular Milbank contacts or with any of the members of our Corporate Governance Group, whose names and contact information are provided at the end of this alert. In addition, if you would like copies of our other Client Alerts, please visit our website at and choose the Client Alerts & Newsletters link under Newsroom/Events. This Client Alert is a source of general information for clients and friends of Milbank, Tweed, Hadley & McCloy LLP. Its content should not be construed as legal advice, and readers should not act upon the information in this Client Alert without consulting counsel Milbank, Tweed, Hadley & McCloy LLP. All rights reserved. Attorney Advertising, prior results do not guarantee a similar outcome. 1 C.A. No VCN (Del. Ch. May 28, 2010).

2 As a result of the debt conversion, Rossette saw his already-majority equity stake rise from 61% to 95%. The conversion rate of $.05 per share contrasted sharply with relatively contemporaneous transactions in Company shares, including the $.50 per share rate negotiated by Rossette just several months prior in an earlier debt conversion and the $.75 per share exercise price used in connection with recent grants under the Company s stock option plan. Rossette, who received a fairness opinion from The Harman Group supporting the conversion rate, claimed that Bachelor had negotiated him up from his initial offer of $.01 per share. Despite the debt conversion, by June 2000 Rossette saw no prospect for SinglePoint to sustain itself and encouraged merger discussions with Cofiniti, Inc., a privately-owned competitor. The board negotiated a term sheet with Cofiniti, which contemplated a merger in which SinglePoint shareholders would receive Cofiniti shares in exchange for their shares. For this purpose, the term sheet valued Cofiniti stock at $5.00 per share and SinglePoint stock at $2.46 per share. In addition, the term sheet recognized that Cofiniti would accept responsibility for the immediate payment of SinglePoint s remaining debt to Rossette. At the last moment, however, Cofiniti took advantage of the superior bargaining position it enjoyed due to SinglePoint s weakened state by insisting that Rossette both accept deferred payment of his debt and continue to personally guarantee other SinglePoint obligations. To mollify Rosette s frustration with these new terms and preserve the transaction, Cofiniti offered Rossette a put option that would give him the right to sell his Cofiniti shares received in the merger after one year or upon the realization of other certain other benchmarks to Cofiniti at a price of $5 per share. No other SinglePoint shareholder was offered a comparable opportunity. The merger was consummated in October 2000 with Rosette s support, but within several months Cofiniti filed for bankruptcy and the shares issued in the merger became worthless. Thereafter, the former minority shareholders of SinglePoint sued Rossette and Bachelor, alleging breach of fiduciary duty in connection with their approval, in their capacity as directors, of both the debt conversion and the put option. In this connection, the plaintiffs argued not only that the transactions were unfair to them, but that the burden of establishing the fairness of the transactions rested with the defendant directors. The Court ruled in favor of the defendants in connection with the put option, but sided with the plaintiffs with respect to the debt conversion. Damages, however, were assessed against only Rosette. The Debt Conversion The Court s Analysis The Court began by noting that Rossette s orchestration of the debt conversion for his benefit was a classic example of self-dealing by a controlling shareholder, demanding an entire fairness analysis. The defendants argued, however, that it should be the plaintiffs burden to prove unfairness because Bachelor, as one member of a two-person board, was independent and received no benefit from that transaction. They also argued that SinglePoint was a small company with very limited resources and that expectations must be adjusted to accommodate that reality. 2

3 The Court rejected both of these arguments, noting that Bachelor had neither experience as a director nor any firm basis for determining what a fair conversion price would have been. More important, perhaps, he had no help and received no independent legal or financial guidance in assessing the terms of the debt conversion. While a fairness opinion that inspired confidence might have bolstered Bachelor s capacity to validate the transaction, the Court noted that the Harman Group analysis was not completed in time for Bachelor s approval of the debt conversion, the Harman Group did not receive complete and accurate financial records from SinglePoint and Bachelor never met with Harman Group representatives to review their opinion. Because the Harman Group s effort did not materially aid Bachelor; certainly, it did not enable him to be an independent counterweight to the objectives of the controlling shareholder, the Court placed the burden of justifying the fairness of the debt conversion on the defendant directors. Next, the Court applied an entire fairness analysis, with its two familiar components fair dealing and fair price to the debt conversion. With respect to the fairness of the process, the Court observed that Rossette essentially set the conversion rate with limited or no pushback from Bachelor, who was in no position to bargain effectively on behalf of the minority stockholders. The Court further noted that [a]lthough the Company s financial condition may have afforded Bachelor little leverage, the lack of any independent assistance legal or financial precluded a material effort on behalf of the constituency he represented. Thus, for the same reasons underpinning the Court s conclusion that Bachelor, as the second director, could not cleanse the taint of Rossette s self-interested conduct, the Court ruled that the process leading to the debt conversion was unfair. As for the fairness of the price utilized in the debt conversion, the Court reviewed both expert testimony and recent transactions in SinglePoint shares in determining that the value of the shares ranged from a low of $.10 per share to a high of $.75 per share. Based on this analysis, the Court ultimately decided on a fair value of $.40 per share, leading it to the conclusion that the price component of the Debt Conversion also was not fair. After determining that the damages suffered by the minority shareholders as a result of this unfair transaction were $309,000, the Court turned to the question whether either defendant should be held personally liable for these damages: In the case of Bachelor, Article 7 of SinglePoint s Certificate of Incorporation would exculpate him from liability for monetary damages caused by his breach of fiduciary duty as long as he acted neither disloyally nor in bad faith. 2 The Court reasoned that Bachelor is entitled to the protection of this exculpatory provision inasmuch as [h]e received no personal benefit from the Debt Conversion and as the holder of the largest block of Company stock other than Rossette, its dilutive effects affected him more than anyone else. At most, the Court declared, Bachelor breached his fiduciary duty of care because [h]is ability to discharge his duties effectively was crimped by his lack of experience as a director and the lack of resources to advise himself separately and independently of Rossette. However, because Bachelor otherwise acted loyally and in good faith, he may not be held liable for any money damages. 2 This provision was included in SinglePoint s Certificate of Incorporation consistent with Section 102(b)(7) of the Delaware General Corporation Law. 3

4 On the other hand, the Court determined that Rossette was not entitled to rely on the exculpatory provision in SinglePoint s Certificate of Incorporation. As a controlling shareholder who used his position to direct the Debt Conversion, with its unfair price and process, for his personal benefit, his liability was accompanied by, and indeed the result of, a breach of his fiduciary duty of loyalty. Thus, the [exculpatory provision] affords him no relief. 3 The Put Option Although the Court also subjected the put option to an entire fairness review in which the defendant directors bore the burden of proving fairness, the result was much different. Because the impetus for the adjustment came from Cofiniti s board and Rossette acquiesced in the revision only when he understood that the Merger would fail without his further cooperation, the Court reasoned that the put option was likely more advantageous to Cofiniti than to Rossette, and that any benefit accruing to Cofiniti came at Rossette s expense. Based on these facts, as well as the requirement that the Court review the put option within the context of merger negotiations and final transaction terms, the Court concluded that the inclusion of the Put Option as an element of the Merger transaction was entirely fair to the Company s shareholders. 4 Conclusion Gentile v. Rossette is a reminder that a board of directors must not shy away from its inherent duty to carefully structure and analyze transactions that have the likelihood of benefiting a controlling shareholder. Even with their companies facing financial calamity, directors must diligently consider both price and process, and obtain expert and independent financial and legal advise, when approving seemingly crucial transactions with a controlling shareholder. Nevertheless, directors of Delaware corporations can take comfort from the fact that, if the appropriate exculpatory provisions are available in their corporations certificates of incorporation, they will not be held monetarily liable for approving transactions that fail an entire fairness analysis so long as they act loyally and in good faith. 3 Plaintiffs also asked that Rosette be compelled to pay their attorneys fees, but the Court found that despite his breach of the duty of loyalty in connection with the debt conversion, Rossette s behavior did not rise to the level of bad faith necessary to justify a shifting of attorneys fees. 4 The Court was clearly skeptical of the $5.00 per share value attributed to Cofiniti s shares in the merger, noting that [a]lthough the right to sell Cofiniti back its stock for $5 per share in a year might seem like a sizeable benefit, it is clear that no one involved in the negotiations on either side believed that the Put Option had much, if any value. 4

5 Please feel free to discuss any aspect of this Client Alert with your regular Milbank contacts or with any of the members of our, whose names and contact information are provided below. Beijing Units 05-06, 15th Floor, Tower 2 China Central Place, 79 Jianguo Road, Chaoyang District Beijing , China Anthony Root aroot@milbank.com Edward Sun esun@milbank.com Frankfurt Taunusanlage Frankfurt am Main, Germany Norbert Rieger nrieger@milbank.com Hong Kong 3007 Alexandra House, 18 Chater Road Central, Hong Kong Anthony Root aroot@milbank.com Joshua Zimmerman jzimmerman@milbank.com London 10 Gresham Street London EC2V 7JD, England Stuart Harray sharray@milbank.com Thomas Siebens tsiebens@milbank.com Los Angeles 601 South Figueroa Street Los Angeles, CA Ken Baronsky kbaronsky@milbank.com Neil Wertlieb nwertlieb@milbank.com Munich Maximilianstrasse 15 (Maximilianhoefe) Munich, Germany Peter Nussbaum pnussbaum@milbank.com New York One Chase Manhattan Plaza New York, NY Scott Edelman sedelman@milbank.com Roland Hlawaty rhlawaty@milbank.com Thomas Janson tjanson@milbank.com Robert Reder rreder@milbank.com Alan Stone astone@milbank.com Douglas Tanner dtanner@milbank.com Singapore 30 Raffles Place, #14-00 Chevron House Singapore David Zemans dzemans@milbank.com Naomi Ishikawa nishikawa@milbank.com Tokyo 21F Midtown Tower, Akasaka, Minato-ku Tokyo Japan Darrel Holstein dholstein@milbank.com Washington, DC International Square Building, 1850 K Street Washington, DC Glenn Gerstell gerstell@milbank.com 5