Kahn v. M&F Worldwide Corporation: a small but significant step forward in the war against frivolous shareholder lawsuits.

AuthorSharfman, Bernard S.
  1. INTRODUCTION II. THE LAW OF FREEZE-OUT MERGERS PRIOR TO MFW AND KAHN A. Entire Fairness 1. Fair Dealing 2. Fair Price 3. Non-Bifurcated Components III. THE STANDARD OF REVIEW AFTER KAHN A. The New Law IV. A ROADMAP FOR MEETING ENTIRE FAIRNESS IN A FREEZE-OUT MERGER A. Applying the Facts 1. The Controller Conditions the Procession of the Transaction on the Approval of Both a Special Committee and a Majority of the Minority Stockholders 2. The Special Committee Is Independent 3. The Special Committee is Empowered to Freely Select Its Own Advisors and to Say "No" Definitively 4. The Special Committee Meets Its Duty of Care in Negotiating a Fair Price 5. The Vote of the Minority is Informed; and 6. There Is No Coercion of the Minority B. Interpreting the Six Requirements V. THE RATIONALE FOR KAHN'S SIX REQUIREMENTS VI. WHERE DO WE GO FROM HERE? I. INTRODUCTION

    From time-to-time, a controlling shareholder will want to eliminate the minority shareholders by buying them out in a transaction called a freeze-out merger. (1) However, under Delaware corporate law, a freeze-out merger creates such a strong presumption of taint (2) that, for the last 30 years, the Delaware courts have required the decision to be reviewed under its highest level of scrutiny: entire fairness, i.e., fair dealing and fair price. (3) According to the Delaware Supreme Court, "[w]here a transaction involving self-dealing by a controlling stockholder is challenged, the applicable standard of judicial review is 'entire fairness,' with the defendants having the burden of persuasion." (4)

    Empirical evidence suggests that the entire fairness standard of review does provide the required benefits for minority shareholders in freeze-out mergers. Bates, Lemmon and Linck conclude that "[m]inority claimants in freeze-out offers receive an allocation of deal surplus at the bid announcement that exceeds their pro rata claim on the firm," suggesting "that minority claimants and their agents exercise significant bargaining power during freeze-out proposals." (5) Unfortunately, the application of the entire fairness standard of review in freeze-out mergers has also created unintended negative consequences. Because entire fairness makes it almost impossible for defendants to get the case dismissed prior to trial, (6) the standard has made it extremely tempting for plaintiffs' attorneys, in order to earn attorney's fees, to reflexively file a class action lawsuit in a freeze-out merger without regard to the claim's merits. (7) For example, in Kahn v. M&F Worldwide Corp.--the Delaware Supreme Court case that is the focus of this article--the initial lawsuit challenging the freeze-out merger was filed one day after the controlling shareholder announced its proposal to buy out the minority shareholders and several months prior to a board-approved transaction. (8) As will be subsequently discussed, the process of freeze-out merger litigation then proceeds in a very predictable manner, with the final result being a settlement that allegedly benefits no one except the plaintiffs' attorneys. (9)

    To help remedy this overabundance of frivolous lawsuits, the Delaware Supreme Court in Kahn provided the defendants the protections of the business judgment rule as long as the freeze-out transaction utilized the court's dual protection merger structure, i.e., the use of a special independent committee in negotiating the transaction on behalf of the minority shareholders and the approval of the transaction by an informed majority of minority shareholders. (10) By moving the standard of review to the business judgment rule, defendants now have the ability to seek dismissal of the suit prior to trial, thereby reducing, at least in theory, the pressure on defendants to seek a settlement automatically even if the suit is without merit.

    Unfortunately, the result is mostly aspirational because while the standard of review eventually shifts to the much more lenient business judgment rule, it does little to relieve the burden on defendants to show that the freeze-out merger ultimately meets the objective of an entire fairness standard of review: "fair price." (11) Each of the six requirements that the board and the controlling shareholder must meet may be subject to discovery. (12) The judicial review in total still requires a level of scrutiny, in terms of both process and discovery, that must be considered the functional equivalent of entire fairness. This does not mean, however, that Kahn is without significance. As subsequently discussed, Kahn may lay the foundation for a greater judicial attack on frivolous lawsuits in the context of freeze-out mergers if new approaches are allowed to enhance Kahn's dual-protection merger structure.

    This Commentary proceeds as follows. Part II describes Delaware law as it applies to freeze-out mergers prior to Kahn. Part III explains how Kahn has changed the law. Part IV describes how the Kahn court went about applying the new law to the facts of Kahn. Part V explains the rationale for the Kahn opinion: the deterrence of frivolous lawsuits. Part VI provides a recommendation on how the dual protection merger structure of Kahn can be modified to shift the balance of power between plaintiffs' attorneys and defendants, such that the threat of heightened judicial scrutiny and discovery is reduced without sacrificing the economic interests of minority shareholders.

  2. THE LAW OF FREEZE-OUT MERGERS PRIOR TO MFW AND KAHN

    Prior to the Chancery Court decision in In re MFW S'holders Litigation (13) (MFW), which Kahn essentially affirmed, the exclusive standard of review for freeze-out mergers was entire fairness. (14) Such a standard of review "is applied in the controller merger context as a substitute for the dual statutory protections of disinterested board and stockholder approval, because both protections are potentially undermined by the influence of the controller." (15) Like the Unocal test (16) or the Revlon duty, (17) the application of entire fairness is an exception to corporate law's default standard of review, the business judgment rule. (18) Entire fairness results if the presumption of the business judgment rule "is rebutted," i.e., when a court determines that a board decision is tainted with interest, a lack of independence, or a lack of due care (gross negligence; process due care only (19)) and an exculpation clause does not apply, (20) or when certain types of board decisions are presumed to lack fairness, such as when a controlling shareholder is dealing with the corporation. (21)

    The key difference between the two standards of review is that entire fairness requires a review of the result for "substantive fairness," with the burden of proof being on the defendants, (22) while the business judgment rule does not incorporate any type of substantive review and the burden of proof is on the plaintiffs. (23)

    1. Entire Fairness

    When the entire fairness standard applies,

    the board must present evidence of the cumulative manner by which it discharged all of its fiduciary duties. An entire fairness analysis then requires the [court] 'to consider carefully how the board of directors discharged all of its fiduciary duties with regard to each aspect of the non-bifurcated components of entire fairness: fair dealing and fair price.' (24) Moreover, "[n]ot even an honest belief that the transaction was entirely fair will be sufficient to establish entire fairness. Rather, the transaction itself must be objectively fair, independent of the board's beliefs." (25) However, "[a] determination that a transaction must be subjected to an entire fairness analysis is not an implication of liability." (26) Further determinations must also be made that the transaction was not entirely fair, an identification of whether the directors' duty of care or loyalty or both were breached, and the absence of affirmative defenses such as an exculpation clause that protects directors from liability for breaches in their duty of care. (27)

    1. Fair Dealing

      Fair dealing "embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained." (28) In addition, "[p]art of fair dealing is the obvious duty of candor .... Moreover, one possessing superior knowledge may not mislead any stockholder by use of corporate information to which the latter is not privy." (29) There are several prominent examples of a lack of fair dealing under the entire fairness standard of review. In Weinberger, two officers of the controlling shareholder, who were also directors of the target company's board, created a valuation memo. (30) For the memo, the officers used confidential information they obtained from the target company that was unfairly used by the controlling shareholder in its dealings with the target company's board of directors. (31) Moreover, the controlling shareholder structured the transaction to pressure the target board to make a decision quickly with minimal negotiations. (32) Finally, no one informed the shareholders on how the transaction was negotiated, or that the fairness opinion was put together in a rush. (33)

      In Kahn v. Lynch, because of the high pressure tactics of the controlling shareholder, the independent committee of directors was not able to exercise real bargaining power in an arms-length transaction, resulting in the independent committee agreeing to a price that was below fair value. (34) In Kahn v. Tremont Corp., the Special Committee created to negotiate on behalf of minority shareholders was tainted with a lack of independence in terms of both committee composition and the selection of both legal and financial advisors. (35) Finally, in Rabkin v. Philip A. Hunt Chemical Corporation, (36) an acquirer purchased majority control of a company on condition that it would to pay $25 per share to buy out the minority...

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