October 28, 2010
The Delaware Court of Chancery’s decision in eBay Domestic Holdings, Inc. v. Newmark, C.A. No. 3705-CC (Del. Ch. Sept. 9, 2010), provides important insight on the use—and possible limitations—of takeover defense mechanisms in the context of private, closely held corporations.
The litigation arose from a dispute among the stockholders of craigslist, Inc. craigslist is a private Delaware corporation that has only three stockholders: Craig Newmark (“Newmark”), James Buckmaster (“Buckmaster”) and eBay Domestic Holdings, Inc. (“eBay”). Newmark and Buckmaster—craigslist’s founder and CEO, respectively—collectively own a majority of craigslist’s shares and are the only two members of craigslist’s board of directors.
eBay acquired its shares of craigslist in 2004 when a stockholder named Philip Knowlton began to shop his shares to third parties. eBay hoped that purchasing Knowlton’s 28.4% interest in craigslist would ultimately lead to a deal whereby eBay would be able to acquire craigslist and capitalize on the monetization potential of craigslist.
In what ultimately would be a $32 million transaction, eBay paid $16 million for Knowlton’s shares and paid Newmark and Buckmaster $16 million collectively in exchange for certain minority investor protections. The purchase was memorialized in a stock purchase agreement (the “SPA”) and a stockholders’ agreement (the “Shareholders’ Agreement”). Among other protections, the Shareholders’ Agreement granted eBay the right to consent to certain corporate governance transactions, including any charter amendment that adversely affects eBay, and granted the parties rights of first refusal over each other’s shares. As would prove to be important, if eBay engaged in “Competitive Activity,” as defined in the Shareholders’ Agreement, it would lose both its consent rights over certain corporate governance transactions and its right of first refusal over Newmark’s and Buckmaster’s shares. At the same time, however, Newmark and Buckmaster would lose their right of first refusal over eBay’s shares, making eBay’s shares freely transferable.
After the transaction closed, craigslist reincorporated in Delaware. The Delaware charter provided for a three-person board of directors elected by cumulative voting, thus ensuring that eBay could use its 28.4% stake in craigslist to elect one of the three members of the craigslist board unilaterally. At the time that eBay purchased its craigslist stock, Newmark and Buckmaster had entered into a voting agreement ensuring that their shares would be voted in such a way that the remaining two members of craigslist’s board of directors would be elected by Newmark and Buckmaster, respectively.
The Court of Chancery’s opinion describes a relationship between two companies that “are, to put it mildly, different animals.” eBay “operates its business with an eye to maximizing revenues, profits, and market share.” craigslist, by contrast, “largely operates its business as a community service,” with nearly all of its classified advertisements being placed free of charge. Perhaps not surprisingly, the relationship between the stockholders quickly began to deteriorate.
In 2007, eBay launched a competing online classifieds website, called Kijiji, in the United States. craigslist sent eBay a notice of “Competitive Activity” within the meaning of the Shareholders’ Agreement, and after failing to cure, eBay lost both its consent rights over certain corporate governance transactions and its right of first refusal over Newmark’s and Buckmaster’s shares. Buckmaster and Newmark encouraged eBay to sell back its craigslist shares and began exploring ways to ensure that having a competitor as a large stockholder with the ability to elect a director would not harm craigslist.
After several months of consideration, Newmark and Buckmaster approved three measures that were the subject of the Court of Chancery’s post-trial opinion: (1) the implementation of a staggered board through amendments to the craigslist charter and bylaws (the “Staggered Board Amendments”) (thereby preventing eBay from utilizing cumulative voting to elect one of craigslist’s three directors unilaterally); (2) the adoption of a stockholder rights plan (the “Rights Plan”); and (3) an offer “to issue one new share of craigslist stock in exchange for every five shares on which a craigslist stockholder granted a right of first refusal in favor of craigslist” (the “ROFR Transaction”). Subsequently, eBay initiated the action at issue here, alleging that the three measures were approved in breach of the fiduciary duties that Newmark and Buckmaster owed to eBay in their capacities as directors and controlling stockholders.
The Court determined that the three measures approved by Newmark and Buckmaster were not “inextricably related” defensive actions such that all three would have to be analyzed collectively under the Unocal standard of review. With respect to the Staggered Board Amendments, the Court found that implementation of the staggered board structure was not a defensive measure taken for entrenchment purposes and, therefore, should not be reviewed under Unocal because, even without a staggered board, Newmark and Buckmaster would control a majority of the craigslist board by virtue of their voting agreement. The Court also determined that entire fairness review was not appropriate because eBay failed to rebut the presumption of the business judgment rule, rejecting eBay’s arguments that Newmark and Buckmaster were personally interested in the Staggered Board Amendments and approved the Staggered Board Amendments in bad faith. In particular, the Court was not persuaded that the Staggered Board Amendments should be reviewed for entire fairness on the ground that eBay was affected differently than Newmark and Buckmaster by the implementation of the staggered board structure. The Court therefore reviewed the Staggered Board Amendments under the business judgment rule standard and held that the Staggered Board Amendments were a reasonable response to a concern (one validated by evidence adduced at trial) that eBay would misuse confidential craigslist information it learned at board meetings to obtain a competitive advantage.
The other two measures challenged by eBay did not stand up under the Court’s review. With respect to the Rights Plan, the Court (utilizing the Unocal standard of review) held that potential changes in the craigslist corporate culture, standing alone, were not a threat to corporate policy or effectiveness sufficient to justify a defensive measure. Rather, the Court found that in order to protect “corporate culture” with a defensive measure such as a rights plan, there must be some evidence that the culture will “lead at some point to value for stockholders.” The Court found that in the absence of any “serious attempt” by Newmark and Buckmaster to prove that “the craigslist culture, which rejects any attempt to further monetize its services, translates into increased profitability for stockholders,” craigslist did not possess “a palpable, distinctive and advantageous culture that sufficiently promotes stockholder value to support the indefinite implementation of a poison pill.” The Rights Plan was therefore held invalid.
With respect to the ROFR Transaction, because the Court held that Newmark and Buckmaster stood on both sides of the ROFR Transaction and concomitant share issuance in the traditional sense, that measure was analyzed under the entire fairness standard. The Court held that the ROFR Transaction failed the “fair price” prong of the entire fairness test for at least two reasons. First, although each craigslist stockholder was offered one additional craigslist share in exchange for granting a right of first refusal over five craigslist shares, the Court found that “it actually costs eBay more to grant a right of first refusal over five of its craigslist shares than it actually costs [Newmark or Buckmaster] to do the same” because Newmark’s and Buckmaster’s shares were already encumbered (by a right of first refusal between Newmark and Buckmaster) and eBay’s shares were not. Thus, while Newmark and Buckmaster could receive an additional craigslist share in exchange for five already-encumbered shares, the Court found that eBay would have to provide more consideration in the form of five freely transferable shares to receive an additional craigslist share. Second, the Court held that the transaction put eBay in a situation where either choice it made would result in economic harm to eBay while simultaneously benefitting Newmark and Buckmaster. If eBay agreed to accept the ROFR Transaction, it would suffer an illiquidity discount by encumbering its then freely transferable shares. If eBay did not agree to the ROFR Transaction, its ownership interest in craigslist would be diluted. Having failed the “fair price” prong of the entire fairness test, the ROFR Transaction was found to be invalid.
As a remedy, the Court ordered rescission of the Rights Plan and the ROFR Transaction.