Inside M&A

Crying Revlon: Delaware Courts Dismiss Claims in Morton's Restaurant Group Acquisition


Andrew B. Kratenstein

In In Re Morton’s Restaurant Group, Inc. Shareholders Litigation, Chancellor Strine dismissed all claims in an action arising out of the acquisition of Morton’s Group, Inc. (Morton’s). This case is another example of attempted misuse of the so-called Revlon “entire fairness” test by plaintiffs. It also is a reminder to boards and their advisors of the benefits of an extensive market check, as well as sharing the proceeds of the transaction ratably amongst all stockholders.

Morton’s owns and operates a chain of high-end steakhouses. Morton’s stock was listed on the New York Stock Exchange (NYSE) until 2012. A private equity fund called Castle Harlan, Inc. (Castle Harlan) owned 27.7 percent of Morton’s stock and placed two directors on the ten-director board, one of whom was the de facto board chairman. A third director was Morton’s Chief Executive Officer. The remaining seven directors qualified as independent under NYSE rules.

In January 2011, Castle Harlan suggested that Morton’s explore selling itself. The board agreed and conducted an extensive nine-month market check for a buyer. In December 2011, Morton’s entered into a merger agreement with wholly owned subsidiaries of Landry’s, Inc. (Landry’s). The merger price represented a 33 percent premium over Morton’s closing market price and a 41.9 percent premium over the weighted average price of the stock for the prior three-year period. All of the stockholders received the same consideration per share and, importantly, any control premium was shared ratably by all stockholders. The transaction was approved by 92 percent of the stockholders.

Former Morton’s stockholders sued, alleging that Castle Harlan had acted in its own self-interest and rushed Morton’s into a sale without regard to the shareholders’ long-term interests. Plaintiffs argued that the transaction should be subject to “entire fairness review” underRevlon, Inc. v. MacAndrews & Forbes Holdings, Inc. Specifically, plaintiffs claimed that: (1) Castle Harlan was a controlling stockholder with “unique liquidity need[s]” that forced a sale at an inadequate price and (2) the independent directors put Castle Harlan’s liquidity needs above their fiduciary duties to the stockholders. The plaintiffs also alleged that the buyer and the company’s two financial advisors aided and abetted the board’s breach of fiduciary duty by conspiring with the board to sell the company on the cheap.

Chancellor Strine held that all of these allegations failed. First, Chancellor Strine held that Castle Harlan, which owned 27.7 percent of the company’s stock and controlled only two of ten board seats, was not a controlling shareholder. Plaintiffs failed to allege any facts demonstrating that Castle Harlan exercised actual domination or control of the board. The complaint was devoid of allegations suggesting that the seven disinterested directors were not independent.

Second, Chancellor Strine held that, even if Castle Harlan was a controlling stockholder, plaintiffs “plead no facts supporting the rational inference that it is conceivable that Castle Harlan’s support for an extended market check involving an approach to over 100 bidders in a nine-month process reflected a crisis need for a fire sale.” In addition, the transaction proceeds were shared ratably across all shareholders, which qualified the transaction for “safe harbor” protection that “immunizes the transaction because it allows all stockholders to share in the benefits of the transaction equally with the large blockholder.”

Chancellor Strine also noted that he was “flummoxed” by the plaintiffs’ attack on the private equity firm “playbook” of taking a company private, working to improve its operations and profitability, then taking the company public, retaining a large non-majority stake in the company for several years and eventually being open to selling the entire company after a “thorough, non-hurried process in which it shares the control premium ratably with the company’s other investors.” Chancellor Strine noted that private equity firms typically hold their stock for far longer periods than typical stockholders and are entitled to “sell at a good price for the benefit of their investors.” Indeed, other shareholders should welcome “the idea that they will receive their ratable share of a control premium after a full and open sale process … that rewards them along with the private equity firm.”

Third, the complaint also failed to plead a viable damages claim. The plaintiffs argued that the board breached its fiduciary duties by allowing one of its financial advisors to provide financing for Landry’s bid. However, the board’s mergers and acquisitions committee allowed the financing because the buyer was having difficulty obtaining financing. The board also required the financial advisor to agree that it would: (a) recuse itself from further negotiations, (b) reduce its fee by $600,000 (to allow for a second financial advisor to render an independent opinion and run a go-shop) and (c) issue a fairness opinion on the consideration in the transaction. The company then used the fee reduction to hire a second financial advisor, who also rendered a fairness opinion and shopped the company to other bidders at a higher price.

Because Morton’s has an exculpatory provision in its charter that immunizes directors for breaches of the duty of care, plaintiffs were required to plead that the directors breached their duties of loyalty or good faith. That claim failed because plaintiffs failed to plead any conflict of interest by Castle Harlan or any of its board members. “To the contrary, the complaint and the documents it incorporates illustrates that the board of Morton’s took great care to test the market in a very full way.” There were also no well-pleaded allegations of any collusion between the board and its financial advisors to generate an unfair price.

Based on the foregoing, Chancellor Strine dismissed all claims. The complaint was “an example of the now too common invocation of the iconic Revlon case in a circumstance where the key problem in Revlon—board resistance to a higher bidder based on a bias against that bidder—is entirely absent.” A board engaged in a sale process can thus protect itself and the transaction by conducting an extensive market check and by sharing the proceeds of the sale ratably amongst all stockholders.


Delaware Court of Chancery Upholds Forum Selection Bylaws


Andrew B. Kratenstein

In recent years, virtually every merger and acquisition (M&A) transaction of significant size involving a U.S. public company has been challenged in court. According to a recent study by Matthew D. Cain and Steven M. Davidoff, in 2013, shareholders challenged a record 97.5 percent of M&A transactions that targeted U.S. public companies where the value of the transaction was more than $100 million and the offer price was at least $5 per share. By contrast, in 2005, only 39.3 percent of such transactions generated a lawsuit. These statistics demonstrate a stark reality: Do a deal, get sued.

A company that pursues an M&A transaction should not only expect to be sued, but to be sued in multiple jurisdictions. Shareholders who wish to challenge the proposed terms of an M&A deal can sue in a state or federal court located in either the target company’s state of incorporation (often Delaware) or the location of the company’s headquarters. According to Cain and Davidoff, between 2005 and 2013, the average number of lawsuits brought per deal jumped from 2.2 to 6.9, and the percentage of deals subject to multi-jurisdiction litigation increased from 8.3 percent to 41.6 percent, reaching a peak of 53.0 percent in 2011.

In response to these trends—and concerns that multi-forum litigation concerning the same deal is inefficient and costly—more than 250 publicly traded corporations have adopted forum selection bylaws that require all shareholder litigation relating to corporate governance occur in the corporation’s state of incorporation. This strategy was suggested by Delaware Vice Chancellor Travis Laster in a 2010 opinion. However, a year later, in the first written opinion to address a forum selection bylaw, a California federal judge refused to enforce the bylaw because it was purportedly adopted without shareholder consent.

The tide turned on June 25, 2013, when Chancellor Leo E. Strine Jr. (who was recently confirmed to become the Chief Justice of the Delaware Supreme Court) issued his ruling in Boilermakers Local 154 Retirement Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013), which upheld forum selection bylaws adopted by Chevron Corporation (Chevron) and Federal Express (FedEx). The plaintiffs argued that the bylaws: (1) exceeded the boards’ authority under Section 109 of the Delaware General Corporation Law (DGCL) and (2) were contractually invalid because they were unilaterally adopted by the boards. Chancellor Strine rejected both arguments.

With respect to the boards’ statutory authority to adopt the bylaws, Chancellor Strine began with the statutory language of DGCL § 109(b). The statute states that the bylaws of a corporation “may contain any provision, not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs and its rights or powers or the rights or powers of its stockholders, directors, officers or employees.” Chancellor Strine held that the forum selection bylaws “easily meet these requirements” because they regulate (1) “the forum in which stockholders may bring suit, either directly or on behalf of the corporation in a derivative suit, to obtain redress for breaches of fiduciary duty by the board of directors and officers,” as well as (2) “the forum in which stockholders may bring claims arising under the DGCL or other internal affairs claims.” Thus, forum selection bylaws relate to the “business of the corporation[s],” the “conduct of [their] affairs” and regulate the “rights or powers of [their] stockholders.”

Chancellor Strine also held that forum selection bylaws are contractually valid and enforceable. He noted that the certificates of incorporation of both Chevron and FedEx authorize their boards to amend the companies’ respective bylaws. Thus, Chancellor Strine found that the stockholders had assented to the bylaw change:
[W]hen investors bought stock in Chevron and FedEx, they knew (i) that consistent with 8 Del. C. § 109(a), the certificates of incorporation gave the boards the power to adopt and amend bylaws unilaterally; (ii) that 8 Del. C. § 109(b) allows bylaws to regulate the business of the corporation, the conduct of its affairs and the rights or powers of its stockholders; and (iii) that board-adopted bylaws are binding on the stockholders.

Under that clear contractual framework, the stockholders assent to not having to assent to board-adopted bylaws. The plaintiff’s argument that stockholders must approve a forum selection bylaw for it to be contractually binding is an interpretation that contradicts the plain terms of the contractual framework chosen by stockholders who buy stock in Chevron and FedEx.
Accordingly, Chancellor Strine concluded that the bylaws were statutorily and contractually valid on their face.

Although he held that forum selection bylaws were facially valid, Chancellor Strine also held that plaintiffs are not precluded from challenging such bylaws, as applied to particular circumstances (a so-called “as-applied” challenge). In M/S Bremen v. Zapata Off-Shore Co., 407 U.S. 1, 15 (1972), the Supreme Court of the United States held that forum selections clauses in contracts are to be enforced unless the party challenging enforcement of the clause “could clearly show that enforcement would be unreasonable or unjust, or that the clause was invalid for such reasons as fraud or overreaching.” Chancellor Strine held that “forum selection bylaws will therefore be construed like any other contractual forum selection clause and are considered presumptively, but not necessarily, situationally enforceable.” A plaintiff may also argue that “the forum selection clause should not be enforced because the bylaw was being used for improper purposes inconsistent with the directors’ fiduciary duties.”

In the first decision to apply Boilermakers, a justice of the New York Supreme Court, Commercial Division followed Chancellor Strine’s lead in holding that a Delaware forum selection bylaw was enforceable (see Hemg Inc. v. Aspen University). This ruling is important because many companies are incorporated in Delaware but have their headquarters in New York, making New York a common alternative forum to Delaware.

The Boilermakers ruling also may encourage corporations to adopt bylaws requiring that shareholder disputes be arbitrated rather than litigated in court. A Maryland state court has upheld the validity of such a bylaw.

Whether such bylaws will continue to survive judicial scrutiny remains subject to debate, but the Boilermakers decision is unquestionably an important step in reducing the burden and expense of multi-forum litigation concerning M&A deals. The statistics already show that the percentage of mergers subject to multi-jurisdictional litigation dropped from 53.0 percent in 2011 to 41.6 percent in 2013, presumably due at least in part to the proliferation of forum selection bylaws after 2010 and Chancellor Strine’s decision upholding them in mid-2013.


Managing Risk - Captive Insurance Companies


Elizabeth Erickson | Kristen E. Hazel

In every mergers and acquisitions (M&A) transaction, a series of risk management choices must be made. These choices range from “bet the company” decisions to ordinary course insurance procurement decisions. Following an acquisition or a divestiture, risk management decisions must be made with regard to the newly constructed business enterprise. As an example, consider a global acquisition that results in a decentralized management structure. Over time, the businesses will begin to align from both an operational and a management perspective. The risk management team will look for opportunities to reduce insurance costs and to minimize loss exposures as operational and management decisions are made. A captive insurance arrangement can be an important tool for reducing those costs and minimizing those exposures. Captive insurance companies can offer a wide variety of coverage, ranging from standard risks—general and auto liability, property, certain types of employee benefits and workers compensation—to more exotic lines of coverage, such as terrorism and cyber risks. There are several forms of captive insurance arrangements each uniquely suited to particular fact patterns. The common denominator among the various forms of captive insurance is enhanced risk management, reduction of the cost of risk and, in the for-profit arena, potential tax benefits.

What is a captive insurance company?

First and foremost, a captive insurance company is an insurance company. The business of the company must be, predominantly, the underwriting of risks, management of claims and related activities, including investment activities. In conducting this business, the insurance company accepts risk of loss associated with a specific contingency. Second, the insurance company is “captive” in that it may be wholly owned within a related group of companies and insure only risks of that related group (of course, the captive may also insure unrelated parties).

A captive insurance company can be organized as a domestic corporation or as a foreign corporation. In either case, the company is licensed and regulated by the applicable jurisdiction’s insurance regulator. Typically, a captive insurance company is run by a professional insurance manager. Of course, the owner/policyholder’s risk management professionals will be involved on a daily basis, and these in-house professionals, not the management company, will make the captive’s business and strategic decisions.

What constitutes the business of insurance?

As a general principle, insurance is a contract that operates to protect the insured against an economic loss arising out of a particular contingency in exchange for a premium payment. The risk must arise as a result of an uncertain or fortuitous event and must relate to an economic loss. A good example of the type of risk often covered by captive insurers is workers’ compensation risk. In contrast, business risks, such as risks associated with defective products that must be replaced, do not typically have the requisite element of uncertainty or fortuity to be considered insurable risks.

How does the captive insurance company operate?

The insurance risk must be transferred to the captive insurance company, which must then have a sufficient pool of risks, such that the insured is not funding its own risk. In other words, once the risk is transferred to the insurance company and an actuarially determined premium is paid by the insured(s), the insurer has a sufficiently diversified risk pool, such that the premium payment cannot be more properly viewed as a deposit.

In a simple example, assume Company A procures general liability insurance for Company A and its affiliates from a commercial insurer. The policy provides for a deductible or self-retention and covers claims up to a specified policy limit. Company A wants to procure a supplemental policy to cover the deductible, but it finds commercial insurance to be too costly. To solve this problem, Company A could organize a captive insurance company to fund for this risk. Each affiliate would be an insured under the captive insurance policy, and the captive insurer would accept each affiliate’s risk in exchange for an actuarially determined insurance premium. Following the insurance transaction, the captive insurer bears the risks funded by the pooled premiums of the insureds, and, with respect to the insured risk, the insureds are financially protected.

Of course, there are a number of steps that Company A would need to take to implement this strategy: hire a management company, prepare a feasibility study, engage legal counsel, form an entity, apply for an insurance license, engage an actuary to determine a premium and allocation among the participating members of the Company A affiliates and to determine the captive insurer’s loss reserve (an estimate of the value of claims not paid), and establish internal policies and guidelines for implementation and maintenance of the captive insurance company. The captive insurance industry offers numerous resources to accomplish these tasks.

Once funded and operational, the captive insurance company will permit the owner(s) to centralize certain risk management decisions and, over time, the overall loss experience may improve. Moreover, by centralizing and managing risk, the combined businesses or, in the case of a divestiture, the newly rationalized business can devote more resources to the business itself.

What are the tax benefits of a captive insurance company?

The business driver for a captive insurance company is, at its core, risk management—loss mitigation and improved claims handling. An additional potential benefit of a captive insurance company lies in the U.S. federal income tax treatment of such a company. From a tax perspective, the captive insurance company must: (i) take on insurance risk; (ii) exhibit risk shifting and risk distribution; and (iii) constitute insurance in the commonly accepted sense. Where all three factors are present, the captive is treated as an insurance company for U.S. federal income tax purposes. Within a U.S. group of companies, the insureds’ premium payments would be deductible by the insureds and includible in income by the insurer. Thus, the deduction and inclusion should net to zero. The tax benefit arises from an additional deduction available only to insurers. Under the insurance rules applicable to captive insurers, the captive insurer is able to deduct an actuarially determined, discounted insurance loss reserve currently. This deduction provides a timing benefit to the group; rather than defer the deduction until the claim is paid, the captive insurance company is able to take the deduction currently. If the captive insurance company is organized outside the United States, the loss reserve becomes available through application of anti-deferral rules. Deemed income under the anti-deferral rules is reduced by the deductible loss reserve.

Of course, maintaining insurance company tax status is important. If the captive fails to qualify as an insurance company for U.S. federal income tax purposes, the foregoing tax treatment would be lost—the premiums no longer would be deductible by the insureds, and the loss reserve may be recaptured. In addition, special challenges are present in the M&A context. Specifically, a post-acquisition structure may contain multiple captive insurance companies if both the acquirer and target had captive arrangements in place prior to the transaction. Merging captives can be difficult, and the combination transaction must be carefully structured to avoid unintended tax consequences. An alternative to combining the captives, putting one or more of the captives into run-off, presents equally challenging tax issues. There, generally, are ways to structure around the tax issues, but careful coordination between the risk management and tax teams is advisable.

Are there tax detriments?

Many states impose a premium tax and/or a direct-placement or self-procurement tax. The premium tax is generally levied on gross premiums received by the insurer. The direct-placement tax is imposed on the insured. The direct-placement tax is levied when an insured procures insurance from a non-admitted carrier. For example, if an Ohio insured procures insurance from a Vermont captive insurer, the insured would be liable for the Ohio self-procurement tax because the Vermont captive insurer would be treated as a non-admitted carrier.

An additional tax in the form of a federal excise tax arises when insurance or reinsurance is procured from a non-U.S. insurer without tax treaty protection (e.g., an insurance or reinsurance company organized under the laws of Bermuda). The excise tax rate on insurance transactions is 4 percent of premiums paid and 1 percent of premiums paid on reinsurance transactions.

Operating the Captive Insurance Company

Captive insurance companies have been around for decades, and they have withstood countless challenges by the Internal Revenue Service (IRS). Nonetheless, continued challenges can be expected. Best practices for maintaining the insurance company include:

  • Contemporaneous documentation of the business purposes and business strategy for the captive insurance company;
  • Adequate capitalization to ensure that the captive insurance company can withstand losses by using actuarial analyses and maintaining adequate corporate capital;
  • Respect the corporate formalities of the captive insurance company; hold regular board meetings to address substantive issues, maintain books and records, and maintain independence in making risk management decisions; and
  • Undertake periodic internal audits with corporate, legal and tax counsel

If contacted by the IRS, don’t go it alone. The industry is rich with resources to help.