New Standard for Controlling Stockholder Buy--Out of Minority Stockholders
October 2002
New Standard for Controlling Stockholder Buy--Out of Minority Stockholders: Summary of Investment Banker’s Fairness Opinion Required
The Delaware Court of Chancery’s October 1, 2002, decision in In re Pure Resources, Inc. Shareholders Litigation contains new guidance for a controlling stockholder’s buy-out of minority stockholders in a Delaware corporation. In addition, the opinion requires a summary of the investment banker’s fairness opinion in the disclosure documents for such a transaction.
In Pure Resources, several stockholders of Pure Resources, Inc. sought a preliminary injunction from the Delaware Court of Chancery against Unocal Corporation’s unsolicited offer to exchange its common stock for the shares of Pure Resources common stock owned by the minority stockholders. Unocal owned 65 percent of Pure Resources common stock, and through a voting agreement had nominated and elected five out of Pure Resources’ eight directors.
In its opinion, the court reviewed the two different principles of Delaware law applicable to a controlling stockholder’s buy-out of minority stockholders. The first principle applies when a negotiated merger is used as the means to effect the buy out. The court observed that existing Delaware case law acknowledged that minority stockholders in this situation are subject to "inherent coercion"—a fear that the controlling stockholder will take retributive actions (e.g., stopping dividend payments or forcing a cash out merger at a lower price) if the minority does not acquiesce to the controlling stockholder’s plans—that influences the minority’s voting decision. The court noted that, to address this concern, current Delaware law (Kahn v. Lynch Communications Systems, Inc. and its progeny) subjected such a merger transaction to "entire fairness" review, even if the target board was composed of a majority of independent directors, the transaction had been negotiated with the procedural protection of a special committee and was subject to a "majority of the minority" vote condition. Entire fairness is a stringent test under Delaware law, requiring, in this context, that the controlling stockholder affirmatively prove both fair price and fair dealing.
The second principle applies when a tender or exchange offer, followed by a short-form merger, is used as the means to effect the buy-out. The court noted that while this transaction form also involves similar "inherent coercion" concerns as the merger structure, existing Delaware law (e.g., Solomon v. Pathe Communications Corp.) does not require that the transaction be reviewed under entire fairness. Instead, the transaction will not be considered coercive, and, thus, will be permissible, so long as the tender or exchange offer is subject to a non-waivable majority of the minority tender condition and the controlling stockholder promises to promptly effect a short-form merger on the same terms. The court, however, acknowledging that the same inherent coercion is present in the tender or exchange offer context, added a new third requirement that the controlling stockholder has not made any retributive threats.
Applying this second principle, the court preliminarily enjoined Unocal’s exchange offer. Unocal’s exchange offer had met the standard enunciated by the court with one exception. Unocal had incorrectly included, as part of the "minority" for purposes of the majority of the minority tender condition, Pure Resources stockholders that were affiliated with or otherwise aligned with Unocal. The court stated that once Unocal corrected how it defined the minority by excluding these stockholders, its exchange offer would be non-coercive and could proceed.
After Pure Resources, controlling stockholders should consider the use of a tender or exchange offer, rather than a negotiated merger, to effect a buy -out of minority stockholders in a Delaware corporation. The tender or exchange offer structure will avoid the heightened scrutiny of entire fairness.
The court also found that the Pure Resources’ Schedule 14D-9 omitted material information because it did not contain a summary of the analyses conducted by Credit Suisse First Boston and Petrie Parkman & Co., the financial advisors to Pure Resources. The court stated that the investment banking analysis was information that the Pure Resources minority stockholders would find material in deciding whether or not to tender into Unocal’s exchange offer. Accordingly, the court held that stockholders are entitled to a fair summary of the substantive work performed by the investment bankers. The court implied that such a summary could probably contain the basic valuation exercises undertaken by the investment bank, the key assumptions used and the range of values that were generated.
It is not clear at present whether Delaware courts will require a summary of investment banking analysis in all acquisitions of Delaware public corporations. The court’s opinion implies that the need to equalize the controlling stockholder’s informational advantage is a special consideration that may justify this additional disclosure in this context.
The Pure Resources decision is currently being appealed by the plaintiffs to the Delaware Supreme Court. We will keep you informed of the outcome of the appeal.
