In several recent decisions, the Delaware Court of Chancery addressed a number of issues relating to mergers and acquisitions and debt and equity financings. In In re Orchard Enterprises, Inc. Stockholder Litig., the Delaware Court of Chancery held that the entire fairness standard of review applied to plaintiffs’ challenge of a going-private merger by a controller, even though the merger had been conditioned on approval by both a majority-of-the-minority of the company’s stockholders and a special committee. In Lehman Brothers Holdings, Inc. v. Spanish Broadcasting Sys. Inc., the Court of Chancery found plaintiffs Lehman Brothers Holdings Inc. and T. Rowe Price High Yield Fund, Inc. acquiesced to defendant’s failure to pay dividends under the preferred stock designation governing their investment. These cases and more are discussed below, along with some amendments to the General Corporation Law of the State of Delaware (the “DGCL”), which create two new mechanisms to cure an overissue of stock and other defective corporate acts. These DGCL amendments, which were approved in August 2013, become effective on April 1, 2014.
Chancery Court Addresses Application of MFW to a Squeeze-Out Merger by a Private Equity Fund
In In re Orchard Enterprises, Inc. Stockholder Litig., C.A. No. 7840-VL (Del. Ch. Feb. 28. 2014), the Delaware Court of Chancery held that the entire fairness standard of review applied to plaintiffs’ challenge of a going-private merger of Orchard Enterprises, Inc. (“Orchard”) by its controller, Dimensional Associates, LLC (“Dimensional”), even though the merger had been conditioned on approval by both a majority-of-the-minority of Orchard common stockholders and a special committee. The Court stressed that the use of a special committee and a majority-of-the-minority vote as procedural protections could only take a self-dealing transaction out of entire fairness review under In re MFW S'holders Litig., 67 A.3d 496 (Del Ch. 2013), if the controller agreed to the procedural protections upfront, before any negotiations began. In this case, Dimensional only agreed to the majority-of-the-minority vote after negotiations had started and as a way to gain a price concession from the special committee.
Moreover, the Court held that the defendants would bear the burden of proving entire fairness at trial because the procedural protections used (majority-of-the majority vote and the special committee) were each flawed. In particular, the Court was able to determine, on this motion for summary judgment, that at least one of defendants’ proxy statement disclosures was materially misleading—Orchard’s proxy statement soliciting votes on the merger erroneously stated that the merger triggered the liquidation preference of the Series A Preferred Stock held by Dimensional. Accordingly, the majority-of-the-minority vote to which Dimensional eventually agreed was insufficient to obtain a pre-trial determination shifting the burden of proof because Dimensional failed to establish as a matter of law that the vote was fully informed.
In addition, to obtain burden shifting, based on the use of a special committee, the members of the committee must be disinterested and independent. Here, plaintiffs raised factual issues about the independence of at least one of the members of the special committee. In this case, the chair of the special committee had strong social ties to Dimensional’s founder, Joseph Samberg. Further, the Court found that the plaintiffs raised litigable issues for trial whether the special committee also was infirm because it ignored the advice of Orchard’s CFO and others in determining how to value Dimensional’s Series A Preferred Stock, ultimately choosing to value it on a basis (liquidation value) that was inappropriate and which favored Dimensional to the detriment of the common stockholders.
The Court also determined that it could not determine that the merger price of $2.05 was fair to Orchard’s common stockholders, given the Court of Chancery had previously determined that the appraised fair value of the common stock was $4.67 per share for purposes of a statutory appraisal proceeding. The Court noted that Delaware Supreme Court precedent “establishes that the fair price and fair value standards call for equivalent economic inquiries.” Nonetheless, the Court found that the unitary entire fairness test is “flexible enough to accommodate the reality that ―[t]he value of a corporation is not a point on a line, but a range of reasonable values.” Accordingly, whether the merger was entirely fair would be determined at trial.
Chancery Court Declines To Enter a Partial Judgment to Stop the Accrual of Interest in a Statutory Appraisal Action
In Huff Fund Investment Partnership v. CKx, Inc., C.A. No. 6844-VCG (Del. Ch. Feb. 12, 2014), a statutory appraisal action, the Delaware Court of Chancery rejected respondent’s request for the Court to enter a partial judgment in favor of petitioner in an amount which represented respondent’s expert’s base case scenario for valuing the company and thereby stop the accrual of interest on the amount of the partial judgment.
This action involved an appraisal of the statutory “fair value” of plaintiff’s shares of CKx, Inc. (“Ckx”), which was acquired by Apollo Management in 2011. Thereafter, petitioner filed this appraisal action in the Delaware Court of Chancery. In November 2013, the Court issued an opinion in the action, which held that the merger price was the best indicator of the fair value of the petitioner’s shares. Subsequently, the Court permitted the parties to supplement the record with additional arguments regarding whether the merger price included synergies that should be excluded from a calculation of the fair value of petitioner’s shares, and whether the merger price failed to account for opportunities that should be included in the court’s determination of fair value. On November 27, 2013, the respondents requested the Court to order the petitioner to accept an unconditional tender of $3.63 per share, which represents respondents’ expert’s base case scenario for valuing CKx, plus accrued interest.
The Court found respondents’ request contrary to Section 262(h) of the DGCL, which provides for the accrual of interest at 5% over the Federal Reserve discount rate on the amount determined by the Court to be fair value from the effective date of the merger through the date of payment absent “good cause shown”. The Court explained that it could only depart from the statutory standard set forth in Section 262(h) under the “good cause” exception if there had been a demonstration of bad faith or vexatious litigation. Here, respondent was simply attempting to end-run the General Assembly’s determination as to the proper balance of the competing interests of appraisal petitioners, who have been cashed out of their investment and respondents, against whom too large an interest award may operate as a penalty.
Chancery Court Finds Lehman Acquiesced to Nonpayment of Dividends and Breach of Debt Covenants in Preferred Stock Designation
In Lehman Brothers Holdings, Inc. v. Spanish Broadcasting Sys. Inc., C.A. No. 8321-VCG (Del. Ch. Feb. 25, 2014), the Court of Chancery found that plaintiffs Lehman Brothers Holdings Inc. (“Lehman”) and T. Rowe Price High Yield Fund, Inc. (“T. Rowe”) acquiesced to defendant corporation’s failure to pay dividends owed to them under the preferred stock designation governing their preferred stock investment and therefore that plaintiffs could not recover monetary damages for that failure or related breaches of debt restrictions in the designation which became operative upon a default in dividend payments. In so finding, the Court avoided a substantive determination of what it meant for dividends to be “in arrears and unpaid … for four (4) consecutive quarterly dividend periods” under the certificate of designation, a disputed issue.
Plaintiffs Lehman and T. Rowe owned a respective 38% and 14% interest in the Series B preferred stock of Spanish Broadcasting System, Inc. (“SBS”), a Delaware corporation that owns and operates Spanish-language radio and television stations in the United States. Under the Series B Preferred Designation, plaintiffs were entitled to dividends, accruing at an annual rate of 10.75% of their liquidation preference, payable quarterly in arrears. If “at any time, dividends on the outstanding Series B Preferred Stock are in arrears and unpaid (and in the case of dividends payable after October 15, 2008, are not paid in cash) for four (4) consecutive quarterly dividend periods, ” then a Voting Rights Triggering Event (or “VRTE”) occurred under Section 9(b) of the Series B Preferred Designation. Upon the occurrence of a VRTE, the holders of Series B Preferred Stock became entitled to elect two directors, and SBS was prohibited from incurring additional debt absent payment of the dividend arrearages or obtainment of a waiver from the Series B preferred holders.
In April 2009, SBS publicly announced that it was suspending dividend payments on the Series B Preferred due to a liquidity crisis. Subsequently, SBS declared one dividend per year, payable on April 15 each year, and declined to pay dividends for the three quarters in between. In 2011 and 2012, SBS publically announced that it planned to incur additional debt to address a variety of liquidity issues. Plaintiffs did not notify SBS that they believed a VRTE event had occurred or that the incurrence of additional debt violated the Series B Preferred Designation.
In this action, the plaintiffs allege that dividends had been in arrears for four consecutive quarters by no later than July 2010, giving rise to a VRTE. SBS disagreed, arguing that a VRTE occurs, under Section 9(b) of the Series B Preferred Designation, only if the company fails to make at least one of four consecutive quarterly dividend payments in any given year. SBS subsequently moved to dismiss that action, and Plaintiffs moved for partial summary judgment. During a May 2013 hearing on those motions, the Court found that Section 9(b) was ambiguous on its face and reserved judgment on the summary judgment motions pending additional briefing.
The Court’s Analysis
In this decision, the Court resolved summary judgment in SBS’s favor by the application of the doctrine of acquiescence and determined that it need not address the substantive arguments the parties raised regarding the interpretation of Section 9(b) of the Designation, which it previously found to be ambiguous. Specifically, the Court found that plaintiffs acquiesced to any breach of Section 9(b) or the debt covenants under the designation. According to the court, in purchasing the Series B preferred stock, the salient feature of which was the payment of quarterly dividends, plaintiffs should have known that they had not received all quarterly dividend payments, commencing in May 2009.
Nonetheless, neither of the plaintiffs pursued its resulting right to seats on the company’s board or otherwise acknowledged the VRTE. Further, the Court found that the plaintiffs had either actual notice that SBS intended to take on additional debt by virtue of the company’s public filings or imputed notice. As to imputing plaintiffs with notice of the violation, the Court found that it was reasonable to assume that plaintiffs would be monitoring SBS’s activities by reason of their significant investment. The result of plaintiffs’ silence was SBS’s reasonable, foreseeable and detrimental reliance. According to the Court, if plaintiffs had notified SBS of their objections to the incurrence of additional debt, SBS could have, at a time prior to incurring any damages, chosen its own course, including attempting to obtain a waiver or refraining from incurring arrearages that would trigger a VRTE under plaintiffs’ interpretation of Section 9(b).
New Mechanisms to “Cure” An Overissue of Stock and Other “Defective” Corporate Acts Become Effective on April 1, 2014
Under the common law, a defective corporate act, i.e., an overissue or an election or appointment of directors or other corporate act that is defective for a failure to comply with the applicable provisions of the DGCL or the corporation’s organizational documents may be classified as either void or voidable. Void acts are considered ultra vires and cannot be validated under any circumstance whether under the equitable doctrine of ratification or otherwise. On the other hand, voidable acts may be validated by ratification (board and/ or stockholder approval of the acts). Under the common law, the distinction between void and voidable acts is unclear, leaving either no path or no clear path for a corporation to validate corporate actions that are ineffective for lack of authorization in some circumstances.
In the case of overissuances or other defects with stock issuances, corporations often opted to create new valid stock and then make an exchange offer to their putative stockholders—to exchange potentially void stock for valid stock. In some cases, where there was no realistic or certain “fix” for the defective corporate act, corporations petitioned the Delaware Court of Chancery for guidance. Recently, the Court of Chancery declined to take these cases on ripeness grounds. As a result of the uncertainty and the potential for a complete inability to cure defective corporate acts, corporations faced the possibility of being unable to enter into significant transactions or launch an IPO.
Effective on April 1, 2014, Delaware corporations will have two new mechanisms to validate corporate acts that are either void or voidable under the common law, because of some irregularity in their authorization. Under the first mechanism, embodied in new Section 204 of the DGCL, which creates essentially a statutory ratification procedure, corporations may validate defective corporate acts by board and/or stockholder approval.
Section 204 of the DGCL
In general, ratification under new Section 204 of the DGCL, requires board approval of the defective corporate act. Stockholders also must ratify the defective corporate act if a stockholder vote would have been required to authorize the defective corporate act either at the time of the defective corporate act or at the time of ratification. In addition, any defective corporate act resulting from a failure to comply with Section 203 of the DGCL must be submitted to stockholders for ratification, regardless of whether a stockholder vote would have been required at the time of the defective corporate act. Board quorum and voting thresholds are generally the then applicable thresholds unless a higher threshold was required at the time of the defective authorization, in which case the higher thresholds control.
In the event stockholder approval is required, notice must be given to all current holders of the corporation’s valid stock and putative stock, as well as the holders of valid and putative stock, as of the time of the defective corporate act, unless such holders cannot be determined from the corporation’s records. Except in limited cases, such as the ratification of an election of directors, the applicable stockholder quorum and voting requirements are the then applicable quorum and voting requirements for the approval of such defective act, unless the corporation’s organizational documents, other governance agreement or the DGCL in effect as of the time of the defective authorization would have required a larger vote for its approval or contained a higher quorum requirement, in which case the higher vote or quorum is generally required. However, in no case, shall the presence or approval of shares of any class or series of which no shares are then outstanding, or of any person that is no longer a stockholder, be required. Ratification of the election of a director generally requires the affirmative vote of the majority of shares present at the meeting and entitled to vote on the election of the director.
Once the applicable board and stockholder approvals are obtained, the corporation must file a certificate of validation with the Delaware Secretary of State if the act would have required a filing under Section 103 of the DGCL. In cases where stockholder approval was not required to cure the defective corporate act, notice must generally be given to all stockholders of the corporation whether putative or otherwise within 60 days after the date of adoption of the ratifying resolution by the board of directors. The notice must contain a copy of the ratifying resolution and a statement that any claim that the defective corporate act not be effective or be effective only on certain conditions, must be brought within 120 days from the validation effective time. Unless otherwise determined by the Court of Chancery in an action pursuant to new Section 205, ratification under Section 204 is retroactively effective as of the time of the defective corporate effect. Section 204 of the DGCL does not preempt or displace other means of ratifying or validating any act or transaction under the common law.
Section 205 of the DGCL
New Section 205 of the DGCL confers jurisdiction on the Court of Chancery to hear and determine the validity of any ratification effected pursuant to Section 204, the validity of any other corporate act or transaction (whether or not ratified pursuant to Section 204) and the validity of any stock or rights or options to acquire stock. Pursuant to Section 205, the Court of Chancery may, among other things, declare that a ratification in accordance with Section 204 is ineffective or is only effective at a time determined by the Court, validate any defective corporate act or putative stock, order the Secretary of State to accept a filing with an effective time determined by the Court, make such other orders regarding such matters as it deems proper under the circumstances. The Court of Chancery also possesses the ability to modify or waive any of the procedures set forth in Section 204.
The persons who may initiate an action pursuant to new Section 205 include a Delaware corporation, any member of the board of directors of a Delaware corporation, any record or beneficial holder of valid stock or putative stock, or any other person claiming to be substantially and adversely affected by a ratification pursuant to Section 204 of the DGCL. In general, any person challenging an act ratified under new Section 204 must bring that claim within 120 days of the date of validation of the act.