The Delaware Supreme Court, on Oct. 9, upheld the Chancery Court’s dismissal of a buyout/squeeze-out related lawsuit. In the process, it issued an opinion that indicates that the room for activist investors to use litigation or the threat of litigation to derail controlling shareholder transactions may be quite small, and that literalism about the Latin expression ab initio cannot expand it.
The case, Flood v. Synutra International, involved a lawsuit by a non-controlling shareholder, Arthur Flood, against controlling shareholder (“controller”) Liang Zhang and affiliated entities, who and which together controlled more than 63% of the equity of Synutra, a company that produces and distributes baby formula.
In January 2016, Zhang proposed to take Synutra private by buying up all the shares that he did not already own or control. This is a much-litigated situation, and the Delaware courts indicated, in the celebrated case of Kahn v M&F Worldwide [known as the MFW case] on similar facts, that they were at least in certain key procedural respects solicitous of the rights of the minority shareholders being squeezed out in such a matter.
Two Levels of Judicial Scrutiny
Simplifying a bit, there are two distinct levels of judicial scrutiny that a deal to take a company private in such circumstances can face, “business judgment” or “entire fairness.” If a court decides that a transaction or question is a matter of business judgment than it will generally presume the board acted in an informed manner and in good faith. But if the “entire fairness” standard comes into play, deference is out the window, the board and controller will have to prove both that the decision was made by a fair process and that a fair price has been offered to the non-controlling shareholders.
From the point of view of an activist investor, the very possibility that some such lawsuits may get past dismissal, and the board will be forced to meet the entire-fairness test, helps set the value of non-controlling shares. It gives the stockholders who might be squeezed out in such a situation a chance to squeeze back.
In MFW, Delaware laid out a two-part test that controlling shareholders and the controlled board must meet in order to earn the deference of the business judgment rule (aka the “safe harbor.”) The offer must be approved by an “empowered, independent committee” that acts with care, and it must win a majority-of-the-minority vote—a majority of the noncontrolling shareholders.
A Question of Timing
The Flood case didn’t involve the interpretation of either of those prongs, specifically. It involved the question of timing. The court in MFW said that it must be clear ab initio (from the start) that the contemplated deal will only proceed on those conditions. The plaintiff in Flood argued that this meant that the controller must include those two conditions in its first offer. In this case Zhang had not done so.
The state’s Supreme Court has now rejected what it regards as an overly literal understanding of the “start” of a negotiation. It says that the controller, the stockholder in Zhang’s position here, must accept those two conditions “before there has been any economic horse trading,” but that doesn’t require that these conditions be laid out and accepted at the very first overture.
Poetry and Prose
In a bit of poetic imagery, the court’s opinion observes that if one says that one enjoys the “beginning of fall” one is clearly referring to “those few weeks in late September and early October when the weather gets chilly and the leaves start to change color,” not solely the day of the autumnal equinox.
Less poetically, but more to the legal point, the Supreme Court found that the intense scrutiny of “entire fairness” is not called for so long as the two MFW protections are in place “at the germination stage of the Special Committee process, when it is selecting its advisors, establishing its method of proceeding, beginning its due diligence, and has not commenced substantive economic negotiations with the controller.”
One of the Justices, Karen L.Valihura, dissented from this decision, saying that the creation of a new “when the negotiations begin” test will create new “factual inquiries” that will in turn “defeat the purpose of what should be more of a bright line and narrow pathway” toward the safe harbor.