For the past decade or more, the Delaware Court of Chancery has applied a different standard of judicial review to certain minority freezeouts effected by means of a tender offer followed by a short-form merger, as opposed to those effected via a negotiated merger. These two transactional paths are functionally similar, in that either may result in the controlling stockholder acquiring the remainder of the stock from the minority and owning 100 percent of the target.
Nevertheless, while the Delaware courts have historically applied the onerous “entire-fairness” standard to negotiated mergers, the Court of Chancery has, in recent years, applied the far more deferential business- judgment standard to tender offers followed by short-form mergers, if they met certain conditions intended to insure that the minority stockholders are not coerced into accepting. That is, until the recent Delaware Chancery Court decision in In re CNX Gas.
Under the Delaware Supreme Court’s 1994 Kahn v. Lynch decision, a negotiated merger between a controlling stockholder and its subsidiary is reviewed for entire fairness, meaning that the transaction must have been effected at a fair price and by means of a fair process. While not insurmountable, entire fairness is the strictest standard that can be applied to board decisions and is generally fact-intensive to resolve. Thus, regardless of whether the transaction is ultimately validated or not, litigation costs associated with proving entire fairness are significant.
In a series of decisions, including that of Vice Chancellor Leo Strine in Pure Resources (2002), the Delaware Chancery Court declined to apply entire fairness in the tender-offer context if the tender offer is subject to a non-waivable majority-of-the-minority tender condition, the controlling stockholder commits to consummate a prompt short-form merger at the same price, the controlling stockholder makes full disclosure and no retributive threats and the independent directors on the target board have free rein and adequate time to react to the tender offer.
The CNX Gas decision also includes important commentary that the special committee must have authority comparable to that exercised by a board in a third-party transaction, including the power to deploy a rights plan.
Why the difference? Commentators generally point to two main sources for the distinction: Under Delaware law, while boards must approve mergers and recommend them to the stockholders, there is no specified board role in responding to tender offers or short-form mergers, and there generally is no duty for the controlling stockholders to offer a fair price to minority stockholders in a tender offer or a short-form merger. In a non-coercive tender offer, the stockholders are free not to tender, and in a short-form merger, the sole remedy is appraisal. In contrast, most negotiated parent/subsidiary mergers are effectively authorized by the vote of the parent alone, so once the subsidiary board authorizes the merger, the minority stockholders have no effective say.
The recent CNX Gas decision looks to a “unified standard” that would apply to all freezeouts. In a departure from prior Chancery Court decisions, Vice Chancellor J. Travis Laster adopts a standard suggested in dicta in Cox Communications (another Vice Chancellor Strine opinion issued years after Pure Resources) and holds that entire fairness should apply to freezeout tender offers unless the tender offer is negotiated and affirmatively recommended by a special committee of independent directors and conditioned on the affirmative tender of a majority of the minority shares.
The CNX Gas decision also includes important commentary that the special committee must have authority comparable to that exercised by a board in a third-party transaction, including the power to deploy a rights plan, and that the effectiveness of a majority-of-the-minority condition may be undermined by the inclusion of stockholders whose economic incentives materially differ from those of the other minority stockholders. Thus, CNX Gas effectively imports elements of entire fairness into the tender- offer context by requiring that the transaction be structured to simulate arm’s length board and shareholder approvals (meaning that there must be a fair process).
In the CNX Gas case, CONSOL Energy sought to acquire the remaining publicly held shares of its 83-plus-percent owned subsidiary, CNX Gas, via a tender offer followed by a short-form merger. CONSOL first entered into an agreement with T. Rowe Price, the holder of 37 percent of CNX Gas’s public float, to tender its shares to CONSOL, and then began a tender offer structured as required by Pure Resources, including a commitment to promptly complete a short-form merger at the same price.
CNX Gas formed a special committee to respond to the tender offer from CONSOL, but the committee’s authority was limited to engaging financial and legal advisors and preparing a Schedule 14D-9. The special committee was not formally authorized to negotiate with CONSOL or consider other alternatives, although it did attempt unsuccessfully to negotiate an increased price. The special committee did issue a Schedule 14D-9 that remained neutral with respect to the tender offer, but disclosed the opinion of its financial advisor that the offer was fair from a financial point of view.
Minority stockholders sued to enjoin the transaction, arguing that the tender offer did not meet the standard that was set in Pure Resources, and failed to satisfy entire-farness review. Vice Chancellor Laster, in response, applied the new “unified standard” and suggested a similar standard should apply to negotiated controlling stockholder mergers, while recognizing that to do so would require that the Delaware Supreme Court modify Kahn v. Lynch.
The CSX Gas Court applied the unified standard to CONSOL’s tender offer and found that entire fairness—not business judgment—should apply for a number of reasons. Most obviously, the special committee did not recommend the transaction and lacked the authority to negotiate or to implement a poison pill. Echoing concerns identified in the recent EMAK decisions (which discussed equitable concerns related to empty voting, where a stockholder’s voting interests are uncoupled from his or her economic interests), Vice Chancellor Laster also questioned the effectiveness of the majority-of-the-minority condition, because T. Rowe Price, which had agreed to tender, held a slightly higher percentage of CONSOL stock than CNX Gas stock. The Court observed that T. Rowe Price’s holdings arguably made it either indifferent to the tender offer or even incentivized it to favor its holdings in CONSOL. Determining that entire fairness applied and that the plaintiffs could seek money damages after the tender offer closed, the Court declined to issue a preliminary injunction.
In an interesting development after the CNX Gas decision, Vice Chancellor Laster approved a request for interlocutory appeal on the issue of the standard of review, but the Delaware Supreme Court declined to hear the appeal. So, for the time being, the law in this area remains unsettled, and controlling stockholders who are considering a freezeout must continue to weigh the risk of entire-fairness review against the transactional uncertainty introduced by empowering a special committee to negotiate the controlling stockholder’s proposal and even block any further acquisition of shares by it through the implementation of a poison pill.
Stephen P. Lamb is a partner in the corporate and litigation departments of Paul, Weiss, Rifkind, Wharton & Garrison LLP, and served as a vice chancellor of the Delaware Court of Chancery from 1997 to July 2009. Frances Mi, counsel in the corporate department of the firm, also contributed to the preparation of this article.