Frank v. Elgamal: Court of Chancery Finds Allegations of “Control Group” Sufficient to Invoke Entire Fairness Review of Merger
June 5, 2012
In Frank v. Elgamal, C.A. No. 6120-VCN (Del. Ch. Mar. 30, 2012), the Court of Chancery held that entire fairness review would apply to the merger of American Surgical Holdings, Inc. (“American Surgical”) with an unaffiliated private equity purchaser in which American Surgical’s minority stockholders were cashed out. Because the Court concluded that the plaintiff had adequately alleged the existence of a control group, the Court found that the merger would be subject to entire fairness review under the standard set forth in In re John Q. Hammons Hotels Inc. Shareholder Litigation., 2009 WL 3165613 (Del. Ch. Oct. 2, 2009).
The American Surgical board designated two directors as a special committee charged with negotiating the terms and conditions of any potential transaction involving the sale of the company. After conducting a strategic process, the company entered into a merger agreement with an unaffiliated private equity firm, Great Point Partners I, LP (“Great Point”). The plaintiff alleged that the company had received a proposal from a different private equity firm for a multi-million dollar investment that would have allowed the company to fund its expansion plans and allowed the company’s public stockholders to continue their investment in the company. However, this proposed investment was allegedly less lucrative than the Great Point merger proposal to the company’s alleged “control group,” which included two directors who also served as top managers of the company and two other managers. Accordingly, the plaintiff alleged that the control group pushed forward with the merger with Great Point’s affiliate, AH Holdings, Inc. (“Holdings”), and that the special committee acquiesced to the control group.
The merger was structured as a reverse-triangular merger, in which Holdings merged with American Surgical and American Surgical was the surviving entity. Under the terms of the merger agreement, each share of American Surgical common stock was converted into the right to receive $2.87 in cash. However, on the same day as the execution of the merger agreement, the members of the alleged control group entered into exchange agreements pursuant to which they would exchange, immediately prior to the merger, some of their American Surgical stock for shares of Holdings. As a result, while all other American Surgical stockholders would be cashed out through the merger, the members of the control group would retain an interest in the company. The members of the control group also entered into voting agreements, pursuant to which they agreed to vote all of their American Surgical common shares in favor of the merger. Finally, the members of the control group also each executed employment agreements with Holdings, which became effective with the merger.
In addressing the complaint’s breach of fiduciary duty claims, the Court primarily focused on whether the plaintiff had adequately alleged the existence of a control group. The Court began its analysis by noting that Delaware case law has recognized that a number of stockholders could together constitute a control group “where those shareholders are connected in some legally significant way—e.g., by contract, common ownership, agreement, or other arrangement—to work toward a shared goal.” If such a control group exists, it is accorded controlling stockholder status and each of its members owes fiduciary duties to the minority stockholders of the corporation.
Although none of the individuals in the alleged control group owned more than 30 percent of the company’s common stock, they collectively owned more than 70 percent of the common stock as of the record date for voting on the merger. Moreover, the complaint alleged that each member of the control group acted in concert and had contemporaneously entered into the voting agreements, the exchange agreements, and the employment agreements. The Court concluded that, for the purposes of a motion to dismiss, these allegations were sufficient to establish the existence of a control group. The Court noted that private equity purchasers often condition a transaction on the continued employment of key members of management and sometimes provide that those persons receive an equity stake in the company. The Court recognized that, in other circumstances, the Court of Chancery had found it permissible to structure a transaction in this way. However, the Court noted that where the complaint adequately alleges that the managers who will be given a continuing interest in the company are members of a control group, it is reasonable for the Court to infer that the managers/control group members are using their control to acquire unique benefits for themselves at the expense of the minority stockholders.
Having concluded that the existence of a control group was adequately alleged, the Court explained that the merger is analogous to the transaction at issue in Hammons. Following the reasoning of Hammons, the Court explained that, in such circumstances, the controlling stockholders and the minority are “competing” for portions of the consideration that the third-party acquiror is willing to pay. In Hammons, the Court of Chancery held that the business judgment rule would apply to such a situation only if the merger was subject to “robust procedural protections,” such as a nonwaivable vote of a majority of the minority stockholders and a recommendation by a disinterested and independent special committee. Because American Surgical had not conditioned the merger on approval by a majority of the minority stockholders, the Court found that the transaction would be subject to entire fairness review and therefore refused to grant American Surgical’s motion to dismiss.