Earlier this year, in a highly anticipated decision involving online dating service provider Match Group (Match), the Delaware Supreme Court ruled that the path to business judgment review for any self-interested controlling stockholder transaction — and not just for full “squeeze-out” mergers — requires compliance with the legal framework the Supreme Court endorsed in Kahn v. M&F Worldwide Corp. (MFW). This year also marks the 10th anniversary of MFW, which now has been applied in more than 20 cases.
The Match decision and today's body of MFW jurisprudence provide important guidance for directors in fulfilling their fiduciary duties when confronted with a conflicted controller transaction — an increasingly frequent occurrence as the law has evolved on what constitutes corporate control. More than ever, directors need to consider carefully the best way to approach such transactions to ensure fairness and mitigate litigation risk.
Background
A hallmark of Delaware corporate law is that its courts evaluate fiduciary conduct by applying common law standards of review that vary in their level of judicial scrutiny depending on the circumstances. The default standard of review is the business judgment rule. In simple terms, this rule presumes that directors make decisions on an informed and independent basis, with due care, in good faith and free of material conflicts of interests. If a stockholder fails to allege facts sufficient to rebut one or more of these presumptions, a court will not second-guess a board decision unless it was irrational. Thus, with only rare exceptions, when the business judgment rule applies, a stockholder challenge to fiduciary conduct will be dismissed at the outset of a case.
At the other end of the spectrum, the most onerous standard of review under Delaware law is the entire fairness standard. This test places the burden on defendants to prove that the challenged transaction was entirely fair, taking into account holistically both process (fair dealing) and financial (fair price) considerations. One situation that triggers entire fairness review is when a controlling stockholder stands on both sides of a transaction and receives a non-ratable benefit, i.e., a benefit not shared proportionately with other stockholders.
When the entire fairness standard applies in this situation, defendants may shift the burden of proof to the plaintiff to prove the unfairness of the transaction if it was approved by either one of two protective measures:
- A fully-empowered and well-functioning committee of independent directors, or
- The informed and uncoerced vote of a majority of the minority stockholders.
Nonetheless, because proving entire fairness is fact-intensive, a case involving a conflicted controller transaction historically had to go to trial unless it could be settled first — until, that is, MFW came along.
The MFW Decision
In 2014, in its seminal MFW decision, the Delaware Supreme Court endorsed a framework to provide defendants an off-ramp from litigation at the pleadings stage in a context where the conflict between a controller and minority stockholders is acute — a merger where a majority stockholder cashes out the minority stockholders to acquire all the shares of the company. Specifically, the Supreme Court held that a squeeze-out merger would be subject to business judgment review if the transaction was conditioned ab initio (from the start) on satisfying both of the protective measures mentioned above: approval of a fully-empowered committee of independent directors that satisfies its duty of care and the fully informed, uncoerced vote of a majority of the minority stockholders (MoM vote).
The rationale for the MFW dual-protection framework is to replicate arms' length negotiations in a conflicted controller transaction by having a special committee serve as the bargaining agent for minority stockholders, who ultimately render an up-or-down verdict on the committee's work. Critically, the framework requires the controller to disable itself before any substantive economic negotiations begin and for the controller and the special committee to bargain under the pressure of achieving a result acceptable to a majority of the minority stockholders. Employed properly, MFW's dual protections remove the controller from standing on both sides of the transaction.
Many practitioners viewed the MFW framework as a promising development to mitigate litigation risk in planning and implementing conflicted controller transactions. Indeed, use of the MFW framework expanded to include many forms of transactions other than squeeze-out mergers where controllers stood to receive non-ratable benefits, including third-party mergers, share reclassifications, stock redemptions and a spin-off transaction. The rate of achieving pleadings-stage dismissals from employing MFW, however, has been relatively low.
Over the past 10 years, Delaware courts have analyzed compliance with the MFW framework in at least 23 cases. Reliance on the MFW framework in those cases resulted in only nine dismissals, for a dismissal rate of approximately 39%. In the remaining 14 cases, the Court of Chancery declined motions to dismiss (and one for summary judgment) in 10 cases and the Delaware Supreme Court reversed dismissal motions granted by the Court of Chancery in four cases.
The grounds for noncompliance with the MFW framework in the 14 cases that survived dismissal can be grouped into three categories. (Note: The deficiencies identified below are not final determinations; rather, they reflect that sufficient allegations were alleged to state claims for relief. Because several cases involved multiple deficiencies, the figures below exceed the 14-case count):
- Failing to employ the dual protections ab initio (eight cases) where an MoM vote was not imposed up-front as a condition of the transaction (four cases) or where the controller engaged in substantive economic negotiations before an independent committee was empowered to negotiate exclusively on behalf of the company (four cases).
- Deficiencies concerning the independent committee prong of MFW (five cases) where committee directors were deemed non-independent (four cases) and/or where the committee was not fully empowered and/or undermined by the controller (three cases).
- Deficiencies concerning the MoM vote prong of MFW (seven cases) where the proxy seeking stockholder approval of the transaction omitted material information and/or contained materially misleading information.
Two of the 14 cases where dismissal motions were denied for failing to condition the transaction up-front on an MoM vote were negotiated before the Supreme Court's MFW decision in 2014 and likely would have come out differently if they had been negotiated after that decision was issued. But even if those cases are not taken into account, the dismissal rate still would be less than 50%.
The Match Decision
The Match case arose out of the 2020 separation of Match Group from its controlling stockholder, IAC/InterActive Corporation (IAC), in a reverse spin-off transaction. Adopting the MFW framework, IAC conditioned the transaction from the start upon the two required MFW protections and obtained the approval of a separation committee and a majority of the minority stockholders.
Plaintiffs — minority stockholders of Match — brought claims asserting that MFW did not apply because the separation committee was not fully independent. The Court of Chancery dismissed the complaint after finding that the transaction fully complied with the MFW requirements. Significantly, the trial court determined that the independent committee prong of the MFW framework was satisfied even though plaintiffs sufficiently alleged that one of the three directors on the separation committee lacked independence from IAC, reasoning that the allegedly non-independent director did not dominate or infect the proper functioning of the committee, which was comprised of a majority of independent directors.
On appeal, after oral argument, the Delaware Supreme Court made an unusual request for supplemental briefing on an issue the trial court had not considered or been asked to consider, namely whether the Court of Chancery's judgment should be affirmed if the spin-off transaction was approved by either the separation committee or a majority of the minority stockholder vote. This request prompted speculation that the Supreme Court might endorse a more lenient standard to obtain dismissal of conflicted controller transactions outside the context of squeeze-out mergers.
The Supreme Court ultimately declined to do so. It instead confirmed that entire fairness remains the presumptive standard of review in any action challenging a transaction where the controller stands on both sides and receives a non-ratable benefit and that defendants must satisfy both prongs of the MFW framework in this situation to obtain business judgment review of the transaction. The Supreme Court reached this conclusion based on a careful review of Delaware precedents spanning over 40 years and reaffirmed that using only one of the two protective measures will shift the burden of proving entire fairness to the plaintiff, but will not alter the standard of review.
The Supreme Court's decision included a second significant ruling. Specifically, the court clarified that MFW's requirement for an independent committee mandates that the committee be “wholly” independent, not merely majority independent. In reaching this conclusion, the Supreme Court distinguished contexts not involving a controlling stockholder, where majority independence on a committee (or the board itself) is permissible, stating:
“To apply the business judgment rule when a controlling stockholder transacts with the corporation and receives a non-ratable benefit, however, the inherently coercive presence of the controlling stockholder requires it to irrevocably and publicly disable itself from using its control to dictate the outcome of negotiations to ensure an arm's-length outcome. A controlling stockholder's influence is not disabled when the special committee is staffed with members loyal to the controlling stockholder. We stated in MFW that the special committee must be independent, not that only a majority of the committee must be independent.”
Because the Match plaintiffs adequately alleged facts supporting a reasonable inference that one of the three members of the separation committee was not independent of IAC, the case could not be dismissed at the pleadings stage under the MFW framework.
Lessons from MFW and Match
For directors confronted with the prospect of a conflicted controller transaction governed by Delaware law, three lessons stand out from the Match decision and 10 years of MFW jurisprudence.
First, the entire fairness standard will apply to any form of transaction where a controlling stockholder stands on both sides and receives a non-ratable benefit. Thus, if a controller refuses to condition such a transaction on satisfying both MFW protective measures — whether because of execution risk, expense, lack of confidence in deriving a litigation benefit or for any other reason — the directors must consider carefully how to ensure that the transaction will pass the test of entire fairness. The surest way, if feasible, is to empower an independent and properly advised committee with the exclusive authority to negotiate with the controller to ensure arm's-length bargaining. That device by itself will not secure a pleadings-stage dismissal, but it will go a long way toward establishing a record of fairness essential to prevail in a litigation challenge.
Second, it is critical to vet directors thoroughly to determine their suitability to serve on an independent committee under Delaware law, which takes into account personal and business affiliations in a factually nuanced manner. An independence determination under stock exchanges rules — which are more mechanical than Delaware law standards and which focus on conflicts with management rather than with a controller — will not satisfy the requirements of Delaware law. Nor can the vetting process be limited to the information provided in a typical director questionnaire. Inquiry instead must be made in a more bespoke fashion to develop and assess the full picture of each director's relationship with the controller. There is no room for error. As Match makes clear, all committee membersmust be independent. If determining the independence of a potential committee candidate is a borderline call, prudence suggests going with a smaller committee.
Third, for those situations where the controller is amenable to conditioning a transaction on the MFW framework, special care must be paid to ensure transparency in the negotiation process. In recent years, disclosure violations have become the primary cause for denying MFW-based dismissal motions and just this year the Delaware Supreme Court twice reversed dismissals where the proxy failed to disclose information concerning potential conflicts of interests pertaining to the committees' financial and/or legal advisors. Although every proxy statement reflects an amalgamation of judgment calls open to second-guessing, special care should be given to ensure disclosure of all material information bearing on potential conflicts of interest concerning the process by which a transaction with a conflicted controlling stockholder was negotiated.