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Exiting the closely held company

by contributors Greg Hidalgo and Soren Lindstrom, K&L Gates | Published May 22, 2012 at 12:55 PM

Exit activity stormed into 2011 on a wave of momentum, but the options vanished abruptly by midyear as activity retreated across all channels. Private equity funds will undoubtedly feel some pressure to exit investments in 2012. They have been slow to return capital to their investors since the downturn, and the exit overhang has grown to nearly $2 trillion globally. Similarly, scores of privately held businesses are looking for signs of improved market conditions and ways to exit to obtain some long-awaited liquidity.

As boards of directors consider the sale of controlled companies, they should bear in mind that the Delaware Court of Chancery in a number of recent cases has continued to apply the more rigorous entire fairness standard of review (fair process and fair price) in its analysis of M&A transactions involving a company with a controlling shareholder, rather than applying the more director-friendly business judgment rule, sometimes resulting in costly judgments. As the guidance provided in these cases indicates, however, costly judgments do not have to be the outcome in controlling shareholder transactions. If a board of directors structures and manages a sale transaction properly, then the transaction is more likely to either (i) be subject to review under the more deferential business judgment rule, or (ii) if the entire fairness standard of review applies, at least shift the burden of proof as to entire fairness from the target company to the plaintiff.

The Delaware Court of Chancery's decision in In re John Q. Hammons Hotels Inc. Shareholder Litigation (Oct. 2, 2009, Jan. 14, 2011) is instructive for parties seeking to structure a sale transaction with a controlling shareholder that does not stand on both sides of the transaction so that the transaction will be subject to the more director-friendly business judgment rule rather than the entire fairness standard of review. According to the Delaware Court of Chancery, the business judgment rule would be the appropriate standard of review if there were "robust procedural protections" in place to ensure that the minority shareholders have sufficient bargaining power and the ability to make an informed choice of whether to accept the third party's offer. The Delaware Court of Chancery went on to state that adequate procedural protections would exist if the merger agreement (i) is recommended by an independent and disinterested special committee and (ii) includes a nonwaivable condition that the merger must be approved by a majority of all outstanding shares held by the minority shareholders.

In the most recent decision in this line of cases, In re Southern Peru Copper Corporation Shareholder Derivative Litigation (Oct. 14, 2011), the Delaware Court of Chancery found that the process undertaken and the price paid by Southern Peru, a NYSE-listed company, for the purchase of Minera, a privately held company, from Southern Peru's controlling shareholder Grupo México SAB de CV was not entirely fair and that the controlling shareholder defendants had breached their fiduciary duty of loyalty. The court awarded the plaintiffs over $1.2 billion in damages. Under Delaware law, the burden of showing that the sale transaction being challenged is entirely fair rests initially with the defendant directors, which may be shifted to the plaintiffs by showing that the transaction was either approved by an effective special committee of independent directors or by an informed vote of the majority of the minority shareholders. The court in Southern Peru found that the defendants failed to establish the basis for a shift of the burden of persuasion.

These cases highlight the following guidance for boards of directors to more effectively protect these transactions against costly judgments:

The board should thoroughly understand the entire fairness standard of review. In a nutshell, entire fairness is an extremely rigorous standard of judicial review in which the court inserts itself into the boardroom and effectively second-guesses every business decision with respect to a particular transaction, both as to process ("fair dealing") and price ("fair price").

The board should form a special committee of disinterested and independent directors. The interests of the directors on the special committee and of the minority shareholders must be aligned. When forming a special committee, the board should make broad inquiries into the disinterestedness and independence of directors who may be appointed to a special committee to ensure that such directors are (i) free of any potential conflicts, whether actual or apparent, such as personal and business relationships that would affect their ability to exercise independent judgment regarding the transaction and (ii) would not directly or indirectly receive benefits other than those received by the minority shareholders.

The scope of the board's mandate to the special committee should be explicit, taking into consideration the particular facts of the transaction. Ideally, the board should authorize the special committee to critically review, negotiate at arm's length, thoroughly evaluate (including the right to explore alternatives) and either recommend against or say no to the proposed sale transaction. Further, the special committee should have authority to engage, at the expense of the company, its own disinterested legal counsel, and financial and other advisers to assist the special committee in performing its obligations, and the officers of the company should be authorized and directed to provide assistance to the special committee as required by the committee. Boards sometimes limit the ability of the special committee to investigate alternative transactions in response to the expressed disinclination of the controlling shareholder, in which case, care should be taken, with the advice of legal counsel, to fully assess whether the particular facts warrant such an approach.

Surviving an entire fairness review requires a special committee to actively perform its mandate and meticulously document its process. The special committee must be actively engaged in evaluating and negotiating the proposed transaction, as well as in performing other aspects of its mandate. As articulated in In re Peru, the test for determining whether a special committee is "well functioning" requires a look at the substance, and efficacy, of the special committee's negotiations, rather than just a look at the composition and mandate of the special committee. In short, the special committee must seek to be fully informed and negotiate strongly for the best possible transaction for the minority shareholders. The actions and reasoning of the special committee should be fully documented in minutes of the meetings held by the special committee.

In order to ensure that the minority shareholders have sufficient bargaining power, special committees should aggressively seek to require that the transaction be conditioned on the approval of a majority of the outstanding shares held by the minority shareholders. No party, including the special committee, should have the right to waive this condition.

The minority shareholders must be fully informed. All relevant and material facts and information relating to the transaction, including any relationships, conflicts, available projections provided to the parties and financial advisers, financial information, transaction history and reasons why the special committee recommended the transaction to the minority shareholders, must be fully disclosed in the proxy statement or other solicitation materials so that the minority shareholders can make an informed decision about whether to approve the transaction.

The board and the special committee should be mindful of the importance of considering the advisability of their recommendation to shareholders, both as of the date on which the proxy statement is mailed to shareholders and also as of the date of the shareholders meeting, taking into consideration any changed circumstances. In some circumstances an updated fairness opinion from the target's financial adviser may be warranted. In In re Peru, Chancellor Leo E. Strine Jr. pointed out that the Southern Peru special committee "did not do any real thinking in the period between its approval of the Merger and the shareholder vote on the Merger" despite strong evidence that the bases for the special committee's original recommendation had changed.

Greg Hidalgo and Soren Lindstrom are corporate partners in the Dallas office of K&L Gates LLP.

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