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S. Muoio & Co. LLC v. Hallmark Entertainment Investments Co., et al.: Court of Chancery Upholds Recapitalization as Entirely Fair

April 28, 2011

In S. Muoio & Co. LLC v. Hallmark Entertainment Investments Co., et al., C.A. No. 4729-CC (Del. Ch. Mar. 9, 2011), the Court of Chancery held that a recapitalization of Crown Media Holdings, Inc. ("Crown") by its controlling stockholder and primary debtholder, Hallmark Cards, Inc. and its affiliates (collectively "Hallmark"), was entirely fair. The Court closely examined the special committee process at issue, and its post-trial opinion demonstrates the benefits of a properly functioning special committee.

Hallmark first proposed a recapitalization of Crown on May 28, 2009. At that time, Crown owed Hallmark over $1.1 billion in debt and the debt service on Crown's obligations had risen to $100 million a year. Crown's cash flows, however, were insufficient to pay the interest or principal on the debt, which matured in 2011. To allow Crown to operate despite its debt load, Hallmark and Crown had in prior years negotiated waiver and standstill agreements that enabled Crown to defer payment on the debts and avoid an event of default and potential bankruptcy.

Upon receiving the recapitalization proposal, Crown's board of directors formed a special committee consisting of three independent directors of Crown (the "Special Committee"). The authorizing resolutions empowered the Special Committee to consider Hallmark's proposal as well as such other matters as the Special Committee deemed advisable. Following its establishment, the Special Committee retained Richards, Layton, & Finger, P.A., as its legal advisor and Morgan Stanley as its primary financial advisor; at a later stage in the process, the Special Committee also retained Houlihan Lokey to render an opinion as to the fairness of the recapitalization.

In consultation with Morgan Stanley, the Special Committee considered all available options, including a third-party refinancing, a third-party sale, simply rejecting Hallmark's proposal in favor of the status quo, or negotiating the recapitalization with Hallmark. After extensive due diligence, Morgan Stanley advised the Special Committee that Crown's value did not exceed the value of its debt and that Crown was unlikely to be able to meet its debt obligations as they matured. In light of these facts, the Special Committee determined that the status quo (i.e., expecting Hallmark to grant further extensions to Crown to repay its debt) was unsustainable and that Crown faced serious insolvency risks. Thus, the Special Committee decided not to seek further debt extensions from Hallmark. Additionally, while the Special Committee remained open to the possibility of a third-party refinancing or sale, it considered both events unlikely, given Crown's financial situation, prior extensive sale efforts and the advice of its financial advisors.

The Special Committee's initial response to Hallmark's proposal was to ask Hallmark to take Crown private at a price fair to the minority stockholders, however Hallmark rejected that alternative. In response, the Special Committee then submitted a counterproposal to the recapitalization. Following months of negotiation, Crown and Hallmark announced the approval of a non-binding term sheet and nearly a month later the parties entered into a formal agreement providing for the terms of the recapitalization. The recapitalization agreed to by the parties significantly improved on the terms of Hallmark's initial proposal. Notable terms of the recapitalization included Hallmark exchanging its $1.1 billion in debt for $315 million in new debt and $185 in preferred stock, Hallmark's guarantee of a new revolver for Crown, and a standstill agreement limiting Hallmark's ability to purchase or sell Crown stock (and, importantly, restricting its ability to effect a short-form merger). As the Court noted in its analysis of the transaction, the Special Committee had negotiated for a lower amount of debt with lower interests rates and longer maturities than Hallmark had originally proposed. The Court also noted that the Special Committee achieved one of its important goals when Hallmark agreed to reduce Crown's debt level to $500 million. This reduction meant that Crown's minority stockholders' equity would have value to the extent Crown was worth more than $500 million, instead of the pre-recapitalization level of $1.1 billion.

Plaintiff S. Muoio & Co. LLC ("Muoio"), a Crown stockholder, filed suit on July 13, 2009, seeking to enjoin the recapitalization. The parties agreed to stay the litigation while the Special Committee considered Hallmark's proposal. After the Special Committee approved the recapitalization agreement with Hallmark, Muoio filed an amended complaint seeking rescission of the recapitalization. Muoio alleged that the recapitalization process was flawed, including claims that (i) Hallmark dominated the Special Committee process; (ii) the chair of Special Committee was not independent; (iii) the Special Committee's mandate was too narrow; and (iv) the recapitalization was timed to disadvantage Crown's minority stockholders. Muoio further alleged that the recapitalization significantly undervalued Crown and therefore improperly transferred wealth and voting power from Crown's minority stockholders to Hallmark.

The Court examined the recapitalization pursuant to the exacting entire fairness standard, requiring a review as to fair price and fair dealing. While the initial burden of establishing entire fairness rests with the party who stands on both sides of a transaction, the Court shifted the burden of proof to Muoio because the recapitalization had been negotiated and approved by an independent special committee.

After evaluating the actions of the Special Committee, the Court held that the recapitalization was the result of a fair process. The Court noted that the Special Committee met 29 times over a nine-month period to consider the recapitalization and potential alternatives. The Court disagreed with Muoio's allegations that Hallmark dominated the formation of the Special Committee by drafting the resolutions establishing and empowering the Special Committee and by suggesting possible counsel for the Special Committee. Instead, the Court pointed out that the Special Committee's counsel had completely redrafted the resolutions—which, significantly, provided the Special Committee with veto power over any transaction. The Court also found that the Special Committee selected its counsel based on the recommendation of one of its members, and not at Hallmark's behest.

The Court also rejected Muoio's challenge to the independence of the chairman of the Special Committee. Muoio had argued that the chairman lacked independence by virtue of (i) his charitable and civic service (which included serving on certain advisory boards with Hallmark executives and members of the Hall family, which controls Hallmark) and (ii) his fundraising efforts on behalf of the University of Kansas (which received funding from the Hall family). The Court declined to find that the chairman was not independent, noting, among other things, that he had received no salary from the University of Kansas and that he had never solicited the Hall family or Hallmark on the university's behalf. Further, the Court stated that "the individual committee members impressed me as directors willing to assume the task of the committee 'in a rigorous and independent manner.'"

Muoio further argued that the Special Committee was "hamstrung by its narrow mandate." The Court rejected this argument, noting that the Special Committee was broadly empowered to consider the recapitalization as well as other matters it deemed advisable. Further, the Court found that the Special Committee members viewed their mandate broadly and understood that they had the power and authority to negotiate with Hallmark, recommend or reject the recapitalization, and consider all alternatives.

In addition, the Court did not credit Muoio's allegation that Hallmark's recapitalization proposal was opportunistically timed. The Court noted that this "timing" theory was almost entirely based on Muoio's allegation that Crown had recently turned EBITDA-positive and was poised for substantial growth. The Court stated that if Crown was likely to experience a sudden and dramatic increase in value, either Hallmark or one of the sophisticated industry players that had recently examined Crown would have sought to capture this upside. Instead, despite the fact that Crown had been extensively shopped since 2005, no offer exceeding the value of Crown's debt had emerged.

In evaluating fair price of the recapitalization under the entire fairness standard, the Court stated that Crown's financial situation, which included serious liquidity issues, could not be ignored. The Court analogized this case to In re Vision Hardware Group, Inc. and In re Hanover Direct, Inc. Shareholder Litigation. In those cases, both of which involved the valuation of insolvent or nearly insolvent corporations, the Court recognized the reality that the value of a corporation's equity may approach zero as it approaches insolvency. In light of the economic problems facing Crown, the Court held that the recapitalization was entirely fair on its face.

Despite finding the recapitalization to be entirely fair, the Court nonetheless examined the parties' competing valuations. Muoio's expert witness proffered a valuation of Crown nearly three times higher than any other valuation. Further, Muoio's expert rejected his own comparable companies and comparable transactions analyses as absurdly low. In contrast, the defendants' experts utilized a variety of valuation techniques and considered valuations of Crown recently performed by potential acquirers. The Court held that the defendants' valuation analyses were more reliable because, among other reasons, the multiple methods of analysis served as a check on the reasonableness of each individual valuation technique.

The Court ultimately concluded that the recapitalization was entirely fair, and stated the Special Committee "reached the best deal possible through intense negotiations that were appropriately adversarial." Muoio filed an appeal of the decision on April 7, 2011.