In re Orchard Enterprises: Distinguishing MFW, Court of Chancery Rules That Defendants Must Prove Entire Fairness of Squeeze-Out Merger Notwithstanding Special Committee Negotiation and Majority of the Minority Stockholder Approval
June 12, 2014
In In re Orchard Enterprises, Inc., Consol. C.A. No. 7840-VCL, 2014 WL 811579 (Del. Ch. Feb. 28, 2014), the Court of Chancery, by Vice Chancellor Laster, on cross motions for summary judgment, held, among other things, that the entire fairness standard of review will apply at trial to fiduciary duty claims challenging a squeeze-out merger, with the burden of persuasion on the defendants, notwithstanding that the merger was negotiated by a special committee and approved by a majority of the minority stockholders.
The action arose from a 2010 squeeze-out merger by Dimensional Associates, LLC, then the controlling stockholder of The Orchard Enterprises, Inc., a Delaware corporation (“Orchard”), in which Dimensional paid minority stockholders $2.05 per share. After the Court of Chancery held in an appraisal action that the fair value of Orchard’s common stock at the time of the merger was $4.67 per share, former minority stockholders sued Dimensional and Orchard’s former directors for breach of fiduciary duty and disclosure violations.
In response to a 2009 going-private proposal by Dimensional, the Orchard board formed a special committee with the exclusive power and authority to (i) negotiate with Dimensional, (ii) terminate consideration of Dimensional’s proposal, (iii) solicit interest from third parties, and (iv) retain independent advisors. After preliminary negotiations, the special committee concluded that it would recommend a transaction with Dimensional on three conditions: a price in the range of $2.05 to $2.15 per share (subject to confirmation by the committee’s financial advisor that such a price would be fair), approval by a majority of the minority stockholders, and a go-shop period. Dimensional countered with $2.00 per share with a go-shop period, but without a majority-of-the-minority approval condition. After further negotiations and advice from its financial advisor, the special committee accepted an offer of $2.05 per share with a go-shop period and a majority-of-the-minority approval condition. The merger was approved by the stockholders (including a majority of the minority) in July 2010.
In considering plaintiffs’ disclosure claims, the Court granted summary judgment in plaintiffs’ favor on their disclosure claim that the proxy materials materially misstated whether the merger triggered a preferred stock liquidation preference (an issue resolved in the negative in the earlier appraisal action). One of the inaccurate disclosures relating to the liquidation preference appeared in the notice of meeting as part of the summary of a proposed amendment to the certificate of incorporation that was sought in connection with the merger. Because this summary is one of the few items required to be included in the notice of meeting pursuant to the General Corporation Law of the State of Delaware, the Court held that the misstatement was per se material.
The Court then addressed the appropriate standard of review for plaintiffs’ breach of fiduciary duty claims. Referring to the Court’s decision in In re MFW Shareholders Litigation, 67 A.3d 496 (Del. Ch. 2013) (which was affirmed on appeal after the Orchard decision was issued), the Court explained that if “a controller agrees up front, before any negotiations begin, that the controller will not proceed with the proposed transaction without both (i) the affirmative recommendation of a sufficiently authorized board committee composed of independent and disinterested directors and (ii) the affirmative vote of a majority of the shares owned by stockholders who are not affiliated with the controller, then the controller has sufficiently disabled itself such that it no longer stands on both sides of the transaction, thereby making the business judgment rule the operative standard of review.” But, the Court continued, if “a controller agrees to use only one of the protections, or does not agree to both protections up front, then the most that the controller can achieve is a shift in the burden of proof such that the plaintiff challenging the transaction must prove unfairness.” If a pretrial determination regarding burden shifting cannot be made, the defendants will bear the burden at trial of proving entire fairness.
The Court first held that entire fairness, not business judgment, was the appropriate standard of review because Dimensional “did not agree up front, before any negotiations began,” that it would not proceed without a qualified special committee and a majority-of-the-minority condition. The Court next held that the approval of the merger by a majority of the minority was not sufficient to shift the burden of proving entire fairness to plaintiffs before trial because Dimensional did not prove as a matter of law that the stockholder vote was fully informed (due to at least one misstatement that was material as a matter of law and the potential for evidence at trial to show that other disclosures were materially false or misleading). The Court further held that the use of the special committee also was not sufficient to shift the entire fairness burden to plaintiffs before trial because (i) at minimum, the members of the special committee must be independent and disinterested, and triable issues of fact existed as to the independence of the chairman of the special committee from Dimensional, and (ii) plaintiffs “pointed to evidence which raises litigable questions about the Special Committee’s negotiation process.”
The Court declined to determine on summary judgment whether the merger was entirely fair, as fact issues precluded that determination. The Court noted that, although the disclosure violation “provides some evidence of unfairness,” at trial “a single disclosure problem may not be outcome-determinative.” In addition, while the appraisal decision, which valued Orchard’s common stock at more than two times the merger price, “is certainly evidence of financial unfairness,” the merger price nevertheless may fall within a range of fairness for purposes of the entire fairness determination. As a result, the Court held that the action would proceed to trial with the burden on defendants to prove that the merger was entirely fair. The Court noted, however, that if defendants could prove at trial that one or both of the special committee or the majority-of-the-minority vote “was effective, it will ‘significantly influence’ the determination of fairness and any potential remedy.”
With respect to potential remedies, the Court held that (i) Section 102(b)(7) exculpation could not support a summary dismissal of facially independent and disinterested directors because, in an entire fairness case involving a controlling stockholder, it was not possible to rule as a matter of law that plaintiffs’ claims solely implicated the duty of care and not the duty of loyalty; (ii) rescissory damages (i.e., “the monetary equivalent of rescission”) are one appropriate measure of damages for a squeeze-out merger and could be imposed in this action “if the merger is found not to be entirely fair and if one or more of the defendants are found to have violated their fiduciary duty of loyalty”; (iii) a “quasi-appraisal” remedy (i.e., “the quantum of money equivalent to what a stockholder would have received in an appraisal”) is one possible remedy for breaches of the duty of disclosure and thus one form of possible remedy in this action if defendants fail to prove that the merger was entirely fair; and (iv) under certain circumstances, “Delaware law continues to recognize the possibility of a post-closing award of damages as a remedy for a breach of the fiduciary duty of disclosure.”