The right solution to the wrong problem: the status of controlling shareholders after In re John Q. Hammons Hotels Inc.

• Author: Klein, Benjamin
• Position: Delaware

INTRODUCTION

In re John Q. Hammons Hotels Inc. (1) (Hammons), a recent Delaware Chancery Court decision, announced new requirements that corporations with controlling shareholders must meet to ensure deferential "business judgment" review of acquisitions by third-party acquirors. Now these corporations must secure the "(1) recommend[ation of] a disinterested and independent special committee, and (2) approv[al] by stockholders in a non-waivable vote of the majority of all the minority stockholders." (2) If both of these prerequisites are not met, the exacting "entire fairness" standard of review will govern. Because the standard of review often determines the outcome of litigation, corporations with controlling shareholders will now have little choice but to follow the procedures set forth by the Hammons court. (3)

This Comment argues that the Hammons decision places unwarranted and costly procedural prerequisites on corporations with controlling shareholders. Part I summarizes the facts of Hammons and analyzes the legal rule promulgated by the decision. Part II argues that the Hammons ruling represents a departure from prior Delaware doctrine that suggested that, in the third-party merger context, approval by either a special committee or a majority of minority shareholders would trigger deferential business judgment review. Part III situates the Hammons decision within the current debate over the standard of review for control transactions. Many commentators have urged adoption of the Hammons rule in the freezeout context-that is, for transactions in which a controlling shareholder acquires the minority stake in a corporation. (4) Part III argues that Chancellor William Chandler misapplied this reform proposal to a third-party merger in Hammons, which does not pose the same concerns as those associated with a freezeout transaction.

1. FACTS OF HAMMONS

   In Hammons, Chancellor Chandler reviewed the merger of John Q Hammons Hotels Inc. (JQH) into a corporation indirectly owned by Jonathan Eilian, an independent third-party acquiror. JQH was controlled by John Hammons, the company's founder. (5) In early 2004, Hammons told the board of JQH that he was contemplating a sale of the company. The board responded by forming a special committee to evaluate the fairness of potential transactions to minority shareholders and to engage in negotiations on their behalf. The special committee evaluated a number of offers and ultimately approved the merger between JQH and Eilian. (6) The merger agreement was conditioned upon a majority of disinterested stockholders approving the transaction; however, this prerequisite could be waived upon the vote of the special committee. (7)

   At the outset of his opinion, Chancellor Chandler discussed which standard of review should apply. In Kahn v. Lynch Communication Systems, Inc., (8) the Delaware Supreme Court held that the exclusive standard of judicial review for freezeout mergers is entire fairness. (9) Chancellor Chandler distinguished the JQH merger from a freezeout merger, stating that "[u]nlike in Lynch, the controlling stockholder ... did not make the offer to the minority stockholders; an unrelated third-party did." (10) Because Hammons did not stand "on both sides of the transaction,"" entire fairness review was not mandated.

   Chancellor Chandler nevertheless decided to apply entire fairness review due to the potential for abuse of minority shareholders. Chancellor Chandler reasoned that entire fairness should apply because:

   Hammons and the minority stockholders were in a sense 'competing' for portions of the consideration Eilian was willing to pay[, and] Hammons, as a result of his controlling position, could effectively veto any transaction. In such a case it is paramount-indeed, necessary in order to invoke business judgment review-that there be robust procedural protections in place to ensure that the minority stockholders have sufficient bargaining power and the ability to make an informed choice of whether to accept the third-party's offer for their shares. (12) Chancellor Chandler then stated that a "recommend[ation] by a disinterested and independent special committee, and ... approv[al] by stockholders in a non-waivable vote of the majority of all the minority stockholders" (13) would provide sufficient procedural protections for minority shareholders, and thus the satisfaction of both of these conditions would result in the application of the business judgment rule. In the JQH merger, however, the majority-of-the-minority condition only required receipt of a majority of the disinterested shares actually voting and could be waived by the special committee. Thus, Chancellor Chandler held that entire fairness review applied. (14)

2. THE HAMMONS DECISION CONFLICTED WITH PRIOR DOCTRINE

   Delaware courts typically apply the deferential business judgment rule when reviewing corporate decisions. In situations involving a potential conflict of interest, however, they will employ the more stringent entire fairness standard, (15) Change-of-control transactions involving companies with controlling shareholders give rise to possible conflicts of interest. (16) As such, in some circumstances, the judiciary has required procedural protections for minority shareholders or has engaged in more exacting review of these transactions. Judges have recognized that freezeouts present special concerns of potential minority abuse because, in freezeout transactions, a controlling shareholder liquidates the minority position in order to gain total control of the corporation. Consequently, the judiciary has required heightened procedural safeguards in freezeout transactions. The Hammons decision extended these requirements to third-party mergers, which do not present the same concerns as those associated with freezeouts, thereby promulgating a new set of costly and unnecessary procedures that companies with a controlling shareholder must follow in order to engage in a merger.

   1. Divergence in the Delaware Freezeout Jurisprudence

      A brief examination of the evolution of Delaware law governing freezeout transactions is...