SPECIAL NEGOTIATING COMMITTEES

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1 SPECIAL NEGOTIATING COMMITTEES If, When, Who and How A Guide for the General Counsel January 2012 Mark D. Gerstein mark.gerstein@lw.com Bradley C. Faris bradley.faris@lw.com Latham & Watkins LLP Although this article may provide information concerning potential legal issues, it is not a substitute for legal advice from qualified counsel. This article is not created nor designed to address the unique facts or circumstances that may arise in any specific instance. You should not, nor are you authorized to, rely on this content as a source of legal advice. This article does not create any attorney-client relationship between you and Latham & Watkins. Latham & Watkins operates as a limited liability partnership worldwide with affiliated limited liability partnerships conducting the practice in the United Kingdom, France and Italy and affiliated partnerships conducting the practice in Hong Kong, Japan and Singapore. Latham & Watkins practices in Saudi Arabia in association with the Law Office of Mohammed Al-Sheikh. Copyright 2012 Latham & Watkins. All Rights Reserved.

2 SPECIAL NEGOTIATING COMMITTEES: IF, WHEN, WHO AND HOW A GUIDE FOR THE GENERAL COUNSEL INTRODUCTION In our experience, the general counsel s participation and support is an essential element in managing the legal and business risks associated with conflict of interest transactions. The general counsel is frequently the first legal decision-maker to be advised of or identify the potential conflict transaction and, due to his or her familiarity with the business, social and other dynamics among directors and management of the corporation, is often in the best position, working with outside counsel, to facilitate a pragmatic and effective process to mitigate the conflict. At the same time, the general counsel will often be placed in a difficult position, balancing the demands of the board, independent directors often constituted as a special negotiating committee management and a dominant or controlling shareholder. The continued recovery in economic and financial markets, as well as enhanced availability of acquisition financing, has facilitated a general increase in public M&A activity, including going private transactions with dominant or controlling shareholders and private equity sponsors. Going private transactions in this context frequently raise conflict of interest concerns, carrying heightened risk. Indeed, a board that fails to adequately address independence and conflicts issues, including, when appropriate, by forming a special negotiating committee, 1 risks litigation, the ability to complete the transaction on the terms agreed to by the parties, and the prospect of personal liability. In turn, the Delaware courts frequently find themselves scrutinizing board processes in connection with going private transactions with dominant or controlling shareholders and private equity sponsors. 2 The tenor and substance of those decisions reflect deep concern in the Delaware courts over the incentives affecting and motives of all of the players in going private transactions, and the impact of those issues on the business outcomes of the transactions; one court has noted in particular the tendency of control to result in odd behavior by even disinterested directors. 3 In recent decisions, the courts have focused heavily on the proper standard of review applicable to controlling shareholder transactions, and Mark D. Gerstein, Partner and Global Co-Chair, Mergers & Acquisitions Group, Latham & Watkins LLP, Chicago and New York, and Bradley C. Faris, Partner, Mergers & Acquisitions Group, Latham & Watkins LLP, Chicago. The authors wish to acknowledge the assistance of Timothy FitzSimons and Zachary Judd, partners in the Mergers & Acquisitions Group, Latham & Watkins LLP, Chicago, and Eric Swibel, an associate in the Chicago office of Latham & Watkins LLP. 1 Although more frequently referred to as a special committee, we use the term special negotiating committee from time to time to distinguish from a special litigation committee, which is established in connection with shareholder derivative actions. 2 See, e.g., In re Cox Commc ns, Inc. S holders Litig., 879 A.2d 605 (Del. Ch. 2005); In re Loral Space & Commc ns Inc., 2008 WL , at *20-21 (Del. Ch. Sept. 19, 2008); In re CNX Gas Corp. S holders Litig., 4 A.3d 397 (Del. Ch. 2010); In re Del Monte Foods Co. S holders Litig., 2011 Del. Ch. LEXIS 30 (Del. Ch. Feb. 14, 2011). 3 In re S. Peru Copper Corp. Shareholder Litig., C.A. No. 961-CS, slip op. at 33 (Del. Ch. Oct. 14, 2011); see also, e.g., In re Netsmart Techs., Inc. S holders Litig., 2007 Del. Ch. LEXIS 35 (Mar. 14, 2007) and In re SS&C Techs., Inc. S holders Litig., 2006 Del. Ch. LEXIS 201 (Del. Ch. Nov. 29, 2006). 2

3 on establishing the appropriate relationship between the standard of review and procedural protections. Although the Delaware Supreme Court will have the last word, recent decisions from the Delaware Chancery Court signal a possible change in approach to these issues. This paper seeks to guide the general counsel as he or she navigates the conflict of interest transaction. Our goal is to provide a general overview of the key issues the general counsel will face in this process and practice-oriented approaches to addressing these concerns. Because more than 50% of United States public corporations and 63% of Fortune 500 corporations are incorporated in Delaware, 4 and Delaware is generally considered to have the most well developed law in this area, we look to Delaware law for purposes of this paper. ESSENTIAL LEGAL BACKGROUND The Business Judgment Rule The traditional business judgment rule the deferential standard known well to every general counsel 5 generally does not apply to the following conflict transactions: transactions in which a majority of the board has financial or other interests adverse to the corporation; 6 transactions in which an individual director or a minority of the board have financial or other interests adverse to the corporation, if the interested director or directors are viewed to control or dominate the board as a whole; 7 transactions in which a majority of the directors receive a special or personal benefit, if material, that may be incidental to an arms length transaction; 8 and transactions with a controlling shareholder. 9 4 State of Delaware, Department of State: Division of Corporations, Why Choose Delaware as Your Corporate Home?, at (last accessed March 21, 2011). 5 The business judgment rule is the presumption under Delaware law that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in honest belief that the action taken was in the best interests of the company. Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984) See Paramount Commc ns Inc. v. QVC Network Inc., 637 A.2d 34, 42 n.9 (Del. 1994). See Cinerama, Inc. v. Technicolor ( Technicolor II ), 663 A.2d 1156, 1168 (Del. 1995). See Cede & Co. v. Technicolor ( Technicolor I ), 634 A.2d 345, 362 (Del. 1993). See Kahn v. Lynch Communication Sys., Inc. ( Lynch I ), 638 A.2d 1110, 1115 (Del. 1994). Note that a shareholder may be viewed as controlling at less than 50% ownership if the shareholder exercises control over the business affairs of the corporation. See id. at (citing Ivanhoe Partners v. Newmont Min. Corp., 535 A.2d 1334, 1344 (Del. 1987)); see also In re Loral Space & Commc ns Inc., 2008 WL , at *20-21 (Del. Ch. Sept. 19, 2008) (finding a shareholder s control of 36% of votes and affiliation with a majority of directors to constitute a control position and dominant role sufficient for the court to treat it as a controlling stockholder); In re Cysive, 3

4 In these types of transactions, the predicate of the business judgment rule that decisions made in good faith by informed, disinterested directors should not be second-guessed by Delaware courts generally does not apply and Delaware courts will scrutinize the transaction to ensure it is fair to the corporation and its shareholders. 10 The board may, however, by use of procedural safeguards, affect the manner in and standards by which the court reviews its conduct and the transaction. Entire Fairness In certain circumstances, Delaware courts will review the board s actions with respect to conflict transactions under the entire fairness standard, which is the strictest standard for review of board action under Delaware law. Accordingly, when a controlling stockholder stands on both sides of a transaction, the interested defendants are required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain. 11 Fundamentally, a transaction is entirely fair if it mimics a hypothetical arms length negotiated transaction. 12 The standard has two component parts fair dealing and fair price although the analysis is more fluid in practice and looks to all aspects of the transaction. 13 Although the general counsel must understand the entire fairness standard to advise the board and other constituents, the general counsel frequently has more opportunity to facilitate the process by which the parties reach a price the fair dealing prong than the price itself. 14 This Inc. S holders Litig., 836 A.2d 531, (Del. Ch. 2003) (chairman and CEO with approximately 40% of outstanding voting stock held to be a controlling shareholder). 10 We also discuss below circumstances in which the business judgment rule may still apply to a conflict transaction. See infra When to Form a Special Committee When Not to Form a Special Committee and The Unified Standard: Cox Communications & CNX Gas. 11 In re S. Peru Copper Corp. Shareholder Litig., C.A. No. 961-CS, slip op. at 46 (Del. Ch. Oct. 14, 2011) (citing In re Pure Res., Inc., S holders Litig., 808 A.2d 421, (Del. Ch. 2002); In re Cysive, Inc. S holders Litig., 836 A.2d 531, (Del. Ch. 2003), In re Cox Commc ns, Inc. S holders Litig., 879 A.2d 604, 617 (Del. Ch. 2005); In re CNX Gas Corp. S holders Litig., 4 A.3d 397, (Del. Ch. 2010)). 12 See, e.g., In re John Q. Hammons Hotels Inc. Shareholder Litig., 2011 Del. Ch. LEXIS 1, at *9 (Del. Ch. Jan. 14, 2011) ( Thus, the extensive arm s length negotiation with two active bidders for the period of nine months and the timing of the Merger demonstrates that the process was entirely fair. ). 13 See Monroe County Emps. Ret. Sys. v. Carlson, 2010 WL , at *2 (Del. Ch. June 7, 2010) ( The entire fairness test is not a bifurcated one; dealing and price must both be considered. ); Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983) ( The test of fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness. ); S. Muoio & Co. LLC v. Hallmark Entertainment Investments Co., 2011 Del. Ch. LEXIS 43, at *34 (Del. Ch. Mar. 9, 2011) ( These prongs are not independent and the Court does not focus on each of them individually. ). 14 Nonetheless, fair price is often the paramount consideration. Monroe County, 2010 WL , at *2. See also ebay Domestic Holdings, Inc. v. Newmark, 2010 Del. Ch. LEXIS 187, at *112 (Del. Ch. Sept. 9, 2010) ( Price, however, is the paramount consideration because the procedural aspects of the deal are circumstantial evidence of whether the price is fair. ) (citations omitted). 4

5 role is essential. A process that satisfies the fair dealing standard is itself strong evidence of the fairness of the transaction. 15 For these reasons, we focus heavily on process in this paper. Fair Dealing Fair dealing focuses upon the process by which the board considers, negotiates and approves the transaction. 16 Delaware courts will scrutinize the following process points, among others: Timing How and when the transaction was initiated, including whether the timing of the transaction was financially disadvantageous to the shareholders. Delaware courts will also scrutinize whether the board or special committee had adequate time to evaluate and respond to the transaction. 17 Mandate Whether the special committee received a broad grant of authority, including the express power to negotiate and explore other strategic alternatives. 18 Disclosure Whether the interested parties disclosed to the board or special committee all material information related to the transaction and the corporation, including up-to-date internal management projections, asset valuations and other information about the corporation s prospects. 19 However, fair dealing does not typically require disclosure of the interested party s highest or reservation price or valuation analyses prepared for the interested party by its advisors See Monroe County, 2010 WL , at *2 ( Delaware law focuses on fair dealing in controlling shareholder transactions primarily because a fair price is more likely to follow fair dealing. ); Rosenblatt v. Getty Oil Co., 493 A.2d 929, 928 n.7 (Del. 1985) (An independent bargaining structure, while not conclusive, is strong evidence of the fairness of the merger ratio. ). See also Seagraves v. Urstadt Property Co., 1996 Del. Ch. LEXIS 36, at *15 (Del. Ch. Apr. 1, 1996) ( A board is not legally required to utilize an independent negotiating committee or obtaining [sic] an investment banker fairness opinion. However, where a board does employ one or more of those procedural safeguards, that will be viewed as persuasive evidence that the minority stockholders were treated fairly. (citations omitted)). 16 In re S. Peru Copper Corp. Shareholder Litig., C.A. No. 961-CS, slip op. at 47 (Del. Ch. Oct. 14, 2011). 17 See Weinberger, 457 A.2d at 711; In re John Q. Hammons Hotels Inc. S holder Litig., 2011 Del. Ch. LEXIS 1, at *9. 18 See In re S. Peru Copper Corp. Shareholder Litig., C.A. No. 961-CS, slip op. at 12 (Del. Ch. Oct. 14, 2011); id. at 69 ( Even if the practical reality is that the controlling stockholder has the power to reject any alternate proposal it does not support, the special committee still benefits from a full exploration of its options. ). 19 See Emerging Commc ns, 2004 Del. Ch. LEXIS 70, at *129 (failure to provide most-recent financial projections, without more, was enough to render the Special Committee ineffective as a bargaining agent for the minority stockholders ). 20 See Kahn v. Tremont Corp., 1996 Del. Ch. LEXIS 40, *51-56 (Del. Ch. Mar. 21, 1996), rev d on other grounds, 694 A.2d 422 (Del. 1997), for a discussion of the duty of disclosure in negotiations with a special committee. Although the Delaware Supreme Court disagreed with the Court of Chancery s characterization of the basis for not disclosing certain information as a form of privilege, the court recognized that the duty of disclosure could be limited by the normal standards of arms-length bargaining. 5

6 Structure Whether the transaction is viewed as coercive to the shareholders or is otherwise structured to unfairly favor the interested party. For instance, a two-step merger that offers cash in the first step and debt or other securities in the second step could be viewed as coercive and unfair. Negotiations Whether the process served as a surrogate for the energetic, informed and aggressive negotiation that one would reasonably expect from an arm s-length adversary. 21 This will often involve an evaluation of whether the board or special committee was reasonably informed, including by consultation with independent and able financial and legal advisors, and whether the committee was adequately empowered to bargain independently. 22 Delaware courts also examine the behavior of the interested party in negotiations, and particularly whether the interested party acted in good faith. In this regard, threats by the interested party that are viewed as coercive will adversely affect a court s assessment of the credibility of the negotiating process. 23 Approval How the board evaluated and approved the transaction, including scrutiny of the quality and depth of the board s deliberations. A court s inquiry will focus on how the special committee actually negotiated the deal, looking back at the substance, and efficacy, of the special committee s negotiations, rather than just...the composition and mandate of the special committee. 24 Fair Price Fair price relates to the economic and financial considerations relied upon when valuing the transaction. In particular, courts consider the corporation s assets, market value, future prospects, earnings, and other factors that affect the intrinsic value of the transaction. 25 A fair price is not necessarily the highest price that the interested party would be willing to pay. 26 However, a price within a range of reasonable prices may not be viewed as entirely fair, if a higher price could have been obtained in an arms length transaction. As an evidentiary matter, a Delaware court is likely to consider a range of valuation metrics, including analyses based on comparable transactions, comparable companies, discounted cash flows, net asset value and 21 In re Trans World Airlines, Inc. S holders Litig., 1988 Del. Ch. LEXIS 139, at *21 (Del. Ch. Oct. 21, 1988). See also Weinberger, 457 A.2d at 709 n.7 ( [A] showing that the action taken was as though each of the contending parties had in fact exerted its bargaining power against the other at arm s length is strong evidence that the transaction meets the test of fairness. ) See In re CNX Gas Corp. S holders Litig., 4 A.3d at 413 n.8. See, e.g., Lynch I, 638 A.2d at In re S. Peru Copper Corp. Shareholder Litig., C.A. No. 961-CS, slip op. at 50 (Del. Ch. Oct. 14, 2011). See Tremont Corp., 694 A.2d at 431. See Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1134, 1143 (Del. Ch. 1994), aff d Technicolor II, 663 A.2d

7 stock price performance, among others. 27 A court may, in the face of perceived deficiencies in financial analyses conducted by the special committee s financial advisor, conduct its own inquiry as to fair value. 28 In addition to the valuation metrics noted above, the structure of a transaction (including the existence of a pre- or post-signing market-check ), while not directly related to the consideration offered, may be viewed as evidence of fairness. 29 In Fort Howard Corp., for instance, the court viewed the availability of a permissive 30 trading day post-signing market check and the fact that no competing offers were made during that period as sufficient evidence of the fairness of the price to overcome a number of procedural defects in the special committee process. 30 In the end, however, the price itself is often the paramount consideration. 31 The Traditional Impact of a Properly Functioning Special Negotiating Committee or Approval by a Majority of Disinterested Shareholders In litigation challenging a transaction subject to entire fairness review, the board initially has the burden to prove that the transaction is entirely fair. This burden shifts to the party challenging the transaction (that is, to prove that the transaction is not entirely fair) if the transaction is approved by an informed and properly functioning special committee of independent and disinterested directors Although no particular valuation metric is required, the committee and its financial advisor should ensure that the choice of methodology does not create the appearance that the analysis may be outcome-driven. See, e.g., In re S. Peru Copper Corp. Shareholder Litig., C.A. No. 961-CS, slip op. at 70 (Del. Ch. Oct. 14, 2011) Id. at 39, 100. Sole reliance on an investment banking firm s fairness opinion is a pale substitute for the dependable information that a canvas of the relevant market can provide. In re Amsted Indus. Inc. Litig., Cons., 1988 Del. Ch. LEXIS 116, at *21 (Del. Ch. Aug. 24, 1988). 30 See In re Fort Howard Corp. S holders Litig., 1988 Del. Ch. LEXIS 110 (Del. Ch. Aug. 8, 1988). See also In re Pennaco Energy, Inc. S'holders Litig., 787 A.2d 691, (Del. Ch. 2001) (fact that no higher bid comes forward during post-agreement market check period is evidence that the directors obtained the highest and best transaction reasonably available). In a transaction involving the sale of corporate control, the special committee and the board are obligated to seek the best value reasonably available to the shareholders. See Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986). More recently, courts have been less willing to forgive procedural defects, notwithstanding the availability of a post-signing market check. See, e.g., In re Del Monte Foods Co. S holders Litig., 2011 Del. Ch. LEXIS 30, at *56-57, * Monroe County, 2010 WL , at *2; see In re S. Peru Copper Corp. Shareholder Litig., C.A. No. 961-CS, slip op. at 48 (Del. Ch. Oct. 14, 2011) ( [W]hat ultimately matters most is that the price was a fair one. ). 32 See Lynch I, 638 A.2d at 1117; see also In re John Q. Hammons Hotels Inc. S holder Litig., 2011 Del. Ch. LEXIS 1, at *7 ( Here... plaintiffs bear the ultimate burden to show the transaction was unfair given the undisputed evidence that the transaction was approved by an independent and disinterested special committee of directors. ); S. Muoio & Co. LLC v. Hallmark Entertainment Investments Co., 2011 Del. Ch. LEXIS 43, at *35 (Del. Ch. Mar. 9, 2011); see also In re S. Peru Copper Corp. Shareholder Litig., C.A. No. 961-CS, slip op. at 53 (Del. Ch. Oct. 14, 2011) ( [Kahn v. Tremont Corp., 694 A.2d 422, 429 (Del. 1997)] implies that there is no way to decide whether the defendant is entitled to a burden shift without taking into consideration the substantive decisions of the special committee, a fact-intensive exercise that overlaps with the examination of fairness itself. ). 7

8 Approval of a conflict transaction by an informed majority of disinterested shareholders may also shift the burden of proving entire fairness to the party challenging the transaction. Disinterested shareholder approval does not by itself cure defects in the underlying process or the price obtained, however, as Delaware courts still examine the fairness of the underlying transaction. 33 For this reason, practitioners do not typically rely on disinterested shareholder approval alone to protect a board seeking to navigate a conflict transaction successfully. Establishment of a special committee can also demonstrate the good faith of the interested directors, enhancing the prospects of their conduct being exculpated from liability. 34 Even if the procedural effect of a special committee process that merely shifts the burden of proof in litigation appears to be somewhat limited, the practical benefits are significant. A process that shifts the burden in litigation constitutes strong evidence that the transaction satisfies the fair dealing component of entire fairness. Indeed, the authors are not aware of any reported decision where the burden was effectively shifted as a result of a special committee process in which a Delaware court subsequently determined the transaction was not entirely fair. As a result, the settlement value of litigation and the risk of personal liability for directors falls dramatically if the burden of proof is shifted to the party challenging the transaction. The Evolving Standard Applicable to Unilateral Tender Offers by Controlling Shareholders Delaware courts have applied different standards of review depending on whether the controlling shareholder freeze-out is structured as a negotiated merger or a unilateral tender offer. Negotiated mergers have been reviewed under the entire fairness standard. In contrast, courts have applied the business judgment rule to unilateral tender offers, albeit under an evolving set of procedures referred to as the Siliconix structure. 35 Under Siliconix, the entire fairness standard would not apply to a going private tender offer by a controlling shareholder so long as (i) the offer is subject to a non-waivable condition that a majority of the disinterested shareholders tender their shares, (ii) the controlling shareholder commits to complete a short form merger at the same price if more than 90% of the outstanding shares are tendered in the offer and (iii) the controlling shareholder does not make retributive threats to the special committee or the minority shareholders. 36 The Siliconix framework gained acceptance in Delaware, even though the framework of Lynch does not on its face exclude tender offers, and the Delaware Supreme Court has not addressed the question of whether tender offers fall outside of Lynch s burden-shifting regime ). 35 See Lynch I, 638 A.2d at In re S. Peru Copper Corp. Shareholder Litig., C.A. No. 961-CS, slip op. at 44 n.67 (Del. Ch. Oct. 14, See In re Siliconix Inc., S holders Litig., 2001 Del. Ch. LEXIS 83 (Del. Ch. June 19, 2001). The Siliconix structure is subject to the federal tender offer rules under Section 14(d) of the Securities Exchange Act of 1934, as amended. Among other things, these rules require the controlling shareholder to pay the highest and best price to all holders tendering in the offer. 36 See In re Pure Resources, Inc., S holders Litig., 808 A.2d 421, 445 (Del. Ch. 2002). 8

9 In the absence of firm guidance from the Delaware Supreme Court, the Delaware Chancery Courts have molded the Siliconix framework on a case-by-case basis, generating an everevolving body of case law. 37 Most recently, Cox Communications and CNX Gas have gone one step further, contemplating a unified approach to freeze-out transactions that would eliminate the dichotomy in the standards of review applicable to negotiated mergers and tender offers. Until the Delaware Supreme Court has adopted or refused to adopt the unified standard, uncertainty regarding use of both a special committee and a majority of the minority approach will prevail. The Delaware Supreme Court declined the opportunity to provide definitive guidance on the appropriate standard or standards of review by declining an interlocutory appeal from the Chancery Court that ruled in CNX Gas. Cox Communications and CNX Gas contemplate the opportunity for controlling shareholders to obtain business judgment rule review for both mergers and tender offers. In Cox Communications, 38 Vice Chancellor Strine first suggested that the business judgment rule could (and should) apply to a conflict transaction approved both by a special committee of disinterested directors and an informed majority of disinterested shareholders. Vice Chancellor Strine argued that the dual approval structure would most closely replicate the process by which an arms length merger is approved under Section 251 of the Delaware General Corporation Law. Vice Chancellor Strine also argued that special committee approval of a going private tender offer in the Siliconix structure could (and should) be a condition to the protection of the business judgment rule accordingly, in Vice Chancellor Strine s view, a Siliconix-style tender offer that is not approved by a special committee should be subject to entire fairness review. A more recent decision by Vice Chancellor Laster, In re CNX Gas Corporation Shareholders Litigation, 39 further developed and applied the unified standard for reviewing controlling shareholder freeze-out transactions. Building on Cox Communications, CNX Gas applied the unified standard that provides for business judgment rule deference to freeze-outs that are both: (1) negotiated and recommended by a special committee, and (2) approved by a majority of the minority shareholders. 40 CNX Gas involved the acquisition of CNX Gas Corporation ( CNX ) by CONSOL Energy, Inc. ( CONSOL ). Prior to the acquisition, CONSOL owned 83.5% of CNX s common stock and its representatives controlled the CNX board. In September 2009, CONSOL initially approached T. Rowe Price, which managed funds that owned 6.3% of CNX s common stock (as well as partially overlapping funds that owned 6.5% of CONSOL s common stock), about acquiring the CNX shares held by the T. Rowe Price funds. In March 2010, T. Rowe Price reached an agreement to tender its CNX shares in a proposed CONSOL tender offer to be made for all publicly held shares at $38.25 per share in cash. 37 See, e.g., In re Cox Commc ns, Inc. S holders Litig., 879 A.2d 604; In re Pure Res., Inc. S holders Litig., 808 A.2d 421 (Del. Ch. 2002); In re CNX Gas Corp. S holders Litig., 4 A.3d In re Cox Commc ns, Inc. S holders Litig., 879 A.2d A.3d 397 (Del. Ch. 2010). See generally id. 9

10 After the announcement of T. Rowe Price s agreement, CNX s board approved the formation of a special committee consisting solely of John Pipski, CNX s lone independent director. The CNX board granted Pipski authority to prepare a Schedule 14D-9, hire legal and financial advisors, and make a recommendation as to the fairness of the transaction. Importantly, the special committee was not given authority to negotiate the terms of the tender offer, adopt a poison pill, or consider other strategic alternatives. CONSOL commenced its tender offer to acquire all publicly held shares of CNX in April 2010, subject to a non-waivable condition that a majority of CNX s outstanding minority shares be tendered excluding shares owned by the officers and directors of CONSOL or CNX, but including shares held by T. Rowe Price. Since T. Rowe Price had already agreed to tender its shares (which represented approximately 37% of the minority shares), the holders of only approximately 13% of CNX s other minority shares needed to tender to satisfy the majority of the minority condition. Nearly a month after the CNX board formed the special committee and one day prior to the filing of the CNX Schedule 14D-9, the board retroactively authorized the special committee to negotiate with CONSOL. The special committee s financial advisor opined that $38.25 was financially fair to CNX s minority shareholders. Nevertheless, Pipski and his advisors sought to negotiate a higher price, but were unsuccessful. The special committee determined not to recommend acceptance or rejection of the offer and to remain neutral because CONSOL had set the offer price during negotiations with T. Rowe Price, without input from the special committee or other minority shareholders, and because CONSOL had been unwilling to negotiate despite statements by CONSOL s management suggesting CNX s stock was worth more than $38.25 per share. The Schedule 14D-9 further identified the CNX board s refusal to give the special committee the full power of the board as an additional reason for neutrality. Applying the unified standard, the court first noted that the special committee did not affirmatively recommend the transaction, so the first prong of the standard was not met. The court offered dicta regarding the scope of authority appropriate (or perhaps required) for a properly constituted special committee, noting that the special committee was not initially empowered to negotiate with the controlling shareholder and did not otherwise have the full authority of the board with respect to the offer, including the ability to adopt a poison pill or pursue alternatives. Moreover, the court explained that, even though it might have been futile for the special committee to pursue alternatives without the controlling shareholder s approval, that judgment should have been left to the special committee, rather than CNX s conflicted board. Turning to the second prong, the court found that the majority of the minority condition was ineffective because T. Rowe Price s shares were counted as part of the minority for purposes of satisfying the condition, when T. Rowe Price funds had an economic interest on both sides of the transaction due to the significant ownership in CONSOL as well as CNX. Accordingly, the court in effect treated T. Rowe Price as conflicted and, therefore, not part of the relevant minority. 10

11 CNX Gas can be viewed as an important step in the evolution of Delaware s fiduciary duties law, but the unified standard is not settled law. 41 Indeed, when faced with the familiar standard-of-review question just weeks before CNX Gas was decided, Vice Chancellor Parsons did not even mention the unified standard in Cox Radio. Instead, Vice Chancellor Parsons applied the prerequisites for business judgment review developed in Pure Resources. 42 If the unified standard is ultimately adopted by the Delaware Supreme Court, we anticipate that a controlling shareholder and the special committee would be permitted to in effect elect a standard of review through their choice of procedures i.e., they could choose business judgment rule review by employing a special committee and agreeing to a majority-ofthe-minority condition. 43 Alternatively, a controlling shareholder could retain more control over the process if it was willing to subject its process to traditional entire fairness review, all the while knowing that by incorporating one of the procedural safeguards, it could at least shift the burden. A controlling shareholder is likely to consider whether the benefits of qualifying under the unified standard outweigh the prospect of increased deal risk and increased transaction pricing created by the required procedural protections. The controlling shareholder will recognize that in order to qualify for business judgment review under the unified standard, the mere existence of protective devices is insufficient they must be effective. 44 By empowering a special committee with authority to take defensive measures, such as adoption of a poison pill (or perhaps even a dilutive issuance 45 ), the controlling shareholder surrenders its implicit threat of acquiring control directly from the shareholders if the special committee does not bargain fairly with the shareholder, which in our view could meaningfully 41 See Reis v. Hazelett Strip-Casting Corp., 28 A.3d 442, 460 (Del Ch. 2011) (citing CNX Gas for the proposition that [i]f the controlling stockholder permits the use of both [a duly empowered and properly functioning special committee and a condition that the transaction be conditioned on a correctly formulated majority-of-the-minority vote ], then the transaction could avoid entire fairness review ). 42 In re Cox Radio, Inc. S holders Litig., 2010 WL (Del. Ch. May 6, 2010) ( Pure Resources provides the standard applicable to the Transaction, as that case applies to tender offers made by controlling shareholders. ); see also In re Pure Res., Inc. S holders Litig., 808 A.2d 421 (Del. Ch. 2002). 43 See In re Cox Commc ns Inc. S holders Litig., 879 A.2d at 606 ( Lynch in its current form could be retained to govern any merger in which the controller refuses to use both of these techniques from the inception of the process, allowing for the controller to proceed, get appropriate burden-shifting credit for use of special committee or a Minority Approval Condition, but remain subject to the entire fairness standard. ); see also Reis v. Hazelett Strip-Casting Corp., No VCL, 2011 Del. Ch. Lexis 11, at *34 (Del. Ch. Jan. 21, 2011) (citing CNX Gas) ( If the controlling stockholder permits the use of both [a special committee and a majority-of-the-minority vote], then the transaction could avoid entire fairness review. ); S. Muoio & Co. LLC v. Hallmark Entertainment Investments Co., 2011 Del. Ch. LEXIS 43, at *35 n.73 (Del. Ch. Mar. 9, 2011) ( Here, as there was no majority of the minority vote, avoiding entire fairness review completely is not a possibility. ). 44 See In re CNX Gas, 4 A.3d at 413 ( [I]f a plaintiff can plead particularized facts sufficient to raise a litigable question about the effectiveness of one of the devices, then the transaction is subject to entire fairness review. ). 45 See Mendel v. Carol, 651 A.2d 297 (Del. Ch. 1994) (denying preliminary injunction where plaintiff asserted defendants breached their fiduciary duties by failing to grant an option to buy stock to dilute the voting power of an existing control block of stock). 11

12 affect the relative negotiating strength between the controlling shareholder and the special committee. By agreeing to a non-waivable requirement that a majority of the disinterested shareholders approve the transaction, the controlling shareholder also risks that minority shareholders vote against the transaction in the hopes of obtaining a second bite at the control premium apple. For this reason, the vote creates potential hold-up value for hedge funds and other short-term investors, including those that move into the stock post-announcement, to use a vote no threat or actual vote to create leverage for negotiation of a higher price. 46 We expect controlling shareholders will evaluate the particular circumstances of the proposed transaction and the expected relationship with, and dynamics of, their company s special committee. They will weigh, in a concededly rough calculus, the differential in expected costs of settlement obtained through adoption of a unified standard deal structure against the prospect of: (i) an overzealous special committee (or its advisors) using a broad grant of authority to effectively deprive the controlling shareholder of its control position and (ii) being held up by a relatively small proportion of shareholders. This analysis will require evaluation of both the company s shareholder profile and the expected market reception to the offered price. Of course, the decision as to deal structure and the authority of the special committee is not the controlling shareholder s or board s decision alone. Special committees may demand a broad grant of authority and a deal structure designed to obtain business judgment rule review, whether or not necessary or appropriate in the circumstances. Enhanced Scrutiny Under Revlon and Unocal/Unitrin Standards The board s or special committee s actions in going private transactions not involving a controlling shareholder, such as transactions with private equity buyers, will be subject to enhanced scrutiny under the Revlon and Unocal/Unitrin standards. In a transaction involving a sale of the company for cash or other sale of corporate control, as in the typical going private transaction with a private equity buyer, the Revlon standard requires the board to act reasonably to secure the best value reasonably available to shareholders. 47 This standard contemplates a judicial examination of the reasonableness of the board s actions, not the bare rationality 46 See LC Capital Master Fund, Ltd. v. James, 990 A.2d 435, 451 (Del. Ch. 2010); In re Lear Corp. S'holders Litig., 926 A.2d 94 (Del. Ch. Jun. 15, 2007). 47 See Revlon, Inc., 506 A.2d 173. See also Paramount Commc ns, Inc. v. QVC Network, Inc., 637 A.2d 34, 44 (Del. 1994) ( In the sale of control context, the directors must focus on one primary objective to secure the transaction offering the best value reasonably available for the stockholders and they must exercise their fiduciary duties to further that end. ). Recently, Vice Chancellor Laster found that Revlon duties also were triggered in a mixed stock/cash deal in which the public shareholders of a merger target were to receive approximately 50% of the merger consideration in cash and 50% of the merger consideration in the acquirer s stock, affording the shareholders a 15% equity interest in the post-transaction equity. Steinhardt v. Howard-Anderson, C.A. No VCL (Del. Ch. Jan. 24, 2011) (Transcript). Although Vice Chancellor Laster enjoined the proposed merger on disclosure rather than process grounds, he noted that [t]his is a situation where the stockholders are in the end stage in terms of their interest in [the target]. This is the only chance they have to have their fiduciaries bargain for a premium for their shares as the holders of equity interest in that entity. Id. at

13 standard under the business judgment rule. 48 It is often noted that there is no single blueprint that a board must follow to fulfill its duties, 49 and Delaware courts have historically supported the use of a post-signing market check as reasonable under the circumstances so long as the terms are consistent with the Unocal/Unitrin standard described below. As illustrated by the Netsmart Technologies case, however, in which a post-signing market check for a micro-cap public company was found not to be a reliable way to test the market for strategic buyers, 50 the Revlon standard is not susceptible to rote application and requires the board or special committee to design a tailored process, relying upon the advice of outside advisors, 51 to secure the best value reasonably available. The Delaware Supreme Court reaffirmed the fact-specific nature of the Revlon inquiry in Lyondell Chemical Co. v. Ryan, noting that [t]here is only one Revlon duty to [get] the best price for the shareholders at a sale of the company. No court can tell directors exactly how to accomplish that goal, because they will be facing a unique combination of circumstances, many of which will be outside their control. 52 Provisions in a merger agreement that are intended to protect the deal no-shops, termination fees and the like are also subject to enhanced scrutiny under the Unocal/Unitrin standard. 53 The Unocal/Unitrin standard requires that the board had reasonable grounds for believing that a third party bid would constitute a threat to corporate policy and that the deal protection provisions agreed to by the board or special committee were reasonable in response to the perceived threat and not otherwise preclusive of a third party bid or coercive to shareholders. As with the Revlon standard, there are no bright lines against which Delaware courts will measure deal protection provisions, or safe harbors for board action. As emphasized in the Caremark Rx case, the Delaware court will consider a number of factors when evaluating the reasonableness of deal protection provisions, including, in that case: overall size of the termination fee, as well as its percentage value, the benefit to shareholders, including the premium that directors seek to protect, the absolute size of the transaction, as well as the relative size of the parties to the transaction, the degree to which a counterparty found such protection to be crucial to the deal, and the preclusive or coercive power of all deal protection devices included in the transaction, taken as a whole. 54 The opinion in particular should caution those who indiscriminately apply 3% as an acceptable termination fee without further analysis in the context of the transaction at hand and the likely interlopers See Netsmart Techs., 2007 Del. Ch. 35, at * See Barkan v. Amsted Indus., Inc., 567 A.2d 1279, 1286 (Del. 1989). See Netsmart Techs., 2007 Del. Ch. LEXIS 35, at *73. See In re Del Monte Foods Co. S holders Litig., 2011 Del. Ch. LEXIS 30, at *6 ( On this preliminary record, it appears that the Board sought in good faith to fulfill its fiduciary duties, but failed because it was misled by [its advisor]. ) Lyondell Chem. Co. v. Ryan, 970 A.2d 235 (Del. 2009) (quoting Revlon, 506 A.2d at 182). See Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003), applying UnocalCorp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985) standard of review for defensive devises to deal protection devices generally. 54 See La. Mun. Police Empls. Ret. Sys. v. Crawford, 2007 Del. Ch. LEXIS 27 (Del. Ch. Feb. 23, 2007). 13

14 WHEN TO FORM A SPECIAL NEGOTIATING COMMITTEE The general counsel is frequently the first legal decision-maker to be advised of or identify potential conflicts in transactions and to respond to questions from directors and management about the process to mitigate the conflict. Because the analysis is fact intensive, gathering all of the information that may indicate the presence of a conflict is typically the first task. The fact gathering process may be uncomfortable for directors and, as a result, the general counsel may wish to enlist the help of the chairman or lead outside director. We describe below what constitutes a conflict of interest and give examples of transactions for which a special committee is often formed. Identify and Analyze the Conflicts A conflict generally exists in any circumstance in which a director has a material interest in or with respect to a transaction that is adverse to the corporation or not shared equally with the shareholders. 55 A conflict must be material to result in heightened scrutiny. The existence of some immaterial self-interest, absent further evidence of disloyalty, is not alone sufficient to be viewed as a disabling conflict. 56 The most easily identifiable conflict exists in situations in which a director is on both sides of a transaction, as in a management buyout, or has a material financial interest adverse to the corporation, whether directly or indirectly via an entity that is doing business with the corporation. Examples of other possible conflicts of interest include: A director s family member or other close relative has a material interest in or with respect to a transaction. 57 The receipt of customary director s fees is not generally viewed as a material special benefit, but fees materially in excess of what is understood to be a usual and customary fee may constitute a conflict of interest. 58 In Emerging Communications, a director was found to have a conflict of interest where the director s fees paid to him were material in relation to his income, from which the court inferred a financial 55 See Aronson, 473 A.2d at 812. Such conflicts may be obtuse or indirect, yet nonetheless concern a court even where the court determines that the director relationship at issue does not render the director interested in the transaction. See In re S. Peru Copper Corp. Shareholder Litig., C.A. No. 961-CS, slip op. at 65 (Del. Ch. Oct. 14, 2011) See, e.g., Technicolor I, 634 A.2d at 363. See Chaffin v. GNI Group, Inc., 1999 Del. Ch. LEXIS 182, at *17-18 (Del. Ch. Sept. 3, 1999) (finding conflict of interest where approval of merger would result in substantial economic and career benefits to director s son). 58 See In re National Auto Credit, Inc. S holders Litig., 2003 Del. Ch. LEXIS 5, at *38-39 (Del. Ch. Jan. 10, 2003). Fees paid to a director who is a financial advisor in connection with a transaction have been held not to constitute a conflict of interest, but rather to align the interests of the director with the shareholders in attempting to maximize the value of the corporation. See Crescent/Mach I Partners, L.P. v. Turner, 2000 Del. Ch. LEXIS 145, at *39 (Del. Ch. Sept. 29, 2000). 14

15 incentive to agree to a going private transaction with the controlling shareholder, as opposed to a sale to a third party. 59 Stock ownership by a director or his or her employer does not alone constitute a conflict of interest. 60 However, stock ownership may be viewed to result in a conflict of interest in circumstances in which differential consideration is paid with respect to multiple classes of stock, or if the corporation buys back stock from a director or his or her employer. 61 Indemnification of directors is not typically viewed to create a conflict of interest. However, in the Caremark Rx case 62, the Delaware court noted that expanded indemnification provided by the buyer in a merger agreement could be important (and ostensibly constitute a conflict of interest) for directors subject to personal liability in connection with claims for backdating of executive stock options. A management director in an arms length transaction receives substantial change in control payments under existing agreements, particularly when alternative transactions being considered may not trigger such payments, or substantial payments in the transaction in exchange for future consulting services or a non-competition covenant. 63 Determine Whether to Form a Special Negotiating Committee If it is determined that a conflict exists, the next step is to evaluate whether a special committee should be formed with respect to the transaction. The board should make this decision after gathering all relevant information from management, the general counsel and outside counsel. While a board that fails to form a special committee in a transaction subject to entire fairness review will face significant additional litigation risk and the possibility of personal liability, 64 formation of a special committee is costly and the board should not initiate the process without a complete understanding of the procedures and potential pitfalls. The costs are substantial. The directors serving on a special committee will expend untold hours to complete the process and will typically receive additional fees for their efforts, and the committee will See Emerging Commc ns, 2004 Del. Ch. LEXIS 70, at *123. See Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 958 (Del. 1985). See Levco Alternative Fund Ltd. v. Reader s Digest Ass n, 2002 Del. LEXIS 488, at *5-6 (Del. 2002). See also In re FLS Holdings, Inc. S holders Litig., 19 Del. J. Corp. L. 270, 278 (Del. Ch. Apr. 2, 1993) See Crawford, 2007 Del. Ch. LEXIS 27. See Ryan v. Tad s Enterprises, Inc., 709 A.2d 682 (Del. Ch. 1996). See, e.g., Emerging Commc ns 2004 Del. Ch. LEXIS 70, at *

16 retain separate financial, legal and possibly other advisors at the corporation s expense. 65 Advisor costs can be substantial, as only advisors with a demonstrated ability to manage complex transactions will pass judicial muster. 66 Special committees may generate non-financial costs as well. For instance, arms length bargaining often leads to separate factions within the board and can have a lasting impact on the relationships among directors or with management. As a general rule, the board should form a special committee in any transaction in which a majority of the directors are conflicted. Also, the board should seriously consider forming a special committee even if a majority of the board is nominally independent and disinterested, if there is concern that the board will be viewed as controlled or dominated by the interested parties. Transactions with a controlling shareholder and management-led buyouts are the most frequent types of transactions in which special committees are formed. Transactions with a Controlling Shareholder Transactions involving a controlling shareholder involve conflicts in nearly every instance. The board should seriously consider forming a special committee in any significant transaction with a controlling shareholder or in which a controlling shareholder has a material interest adverse 67 to the corporation or its minority shareholders. 68 This is prudent even if the board of the controlled corporation consists of a majority of nominally independent and disinterested directors, due to the concern that these directors will be viewed as controlled or dominated by the controlling shareholder and its directors. A going private transaction that results in the freeze-out of the minority shareholders is the classic case in which to form a special committee. 69 The board should also seriously consider forming a special committee in 65 See In re John Q. Hammons Hotels Inc. Shareholder Litig., 2009 WL , at *12 n.38 (Del. Ch. Oct. 2, 2009) ( [I]t is not sufficient for the special committee to merely be disinterested and independent. Rather, the committee must be given sufficient authority and opportunity to bargain on behalf of the minority stockholders, including the ability to hire independent legal and financial advisers. ); In re Tele-Commc ns Inc. S holders Litig., 2005 WL , at *10 (Del. Ch. Jan. 10, 2005) (noting that the effectiveness of a Special Committee often lies in the quality of the advice its members receive from their legal and financial advisors ) See In re Loral Space & Commc ns Inc., 2008 WL , at *23 (Del. Ch. Sept. 19, 2008). See In re Loral Space & Commc ns Inc., 2008 WL , at *21 ( In determining whether a blockholder who has less than absolute voting control over the company is a controlling stockholder such that the entire fairness standard is invoked, the question is whether the blockholder, as a practical matter, possesses a combination of stock voting power and managerial authority that enables him to control the corporation, if he so wishes. ) (quoting In re Cysive S holders Litig., 836 A.2d 531, 553 (Del. Ch. 2003)). 68 We note that it is customary that the audit committee which is required to be composed of independent directors pursuant to Rule 10A-3(b)(1) under the Securities Exchange Act of 1934, as amended, and relevant stock exchange rules or some other committee of independent directors separately approve even insignificant transactions with a controlling shareholder. The controlling shareholder is required to deal fairly with the corporation in every transaction, including insignificant matters, but insignificant transactions are much less likely to result in litigation or personal liability. 69 We also note that, even though the business judgment rule may apply in the Siliconix structure, the board should form a special committee to review and make the recommendation to the minority shareholders with respect 16