The class action proceeded to summary judgment, where the critical issue became whether the court would apply the deferential business judgment standard or the searching entire fairness standard. The entire fairness standard encompasses two factually intensive, interlinked components: fair dealing and fair price. As a practical matter, the detailed factual inquiry required by the entire fairness standard almost ensures that a case will proceed past the pleading stage and often to trial. The result is costly litigation in which the defendants run the risk of an adverse judgment.
Whether entire fairness would apply to a disinterested third-party transaction where the controlling stockholder receives different consideration was an undecided issue under Delaware law. The plaintiffs in the Hammons case contended that the Delaware Supreme Court’s decision in Kahn v. Lynch Communications Systems, Inc. mandated the application of entire fairness. Lynch held that a controlling stockholder is required to prove entire fairness from the outset of the case in a transaction where the controlling stockholder effects a cash-out of the minority stockholders. Under Lynch, the use of an effective safeguard to mitigate the risk of overreaching by a controlling stockholder—the negotiation and approval of the transaction by a disinterested and independent special committee or the approval of the transaction by a majority of the disinterested shares—shifts the burden of proving entire fairness to the plaintiff but does not save the transaction from a searching judicial review.
The court distinguished the Hammons transaction from Lynch because the controlling stockholder wasn’t cashing out the minority—Eilian, an independent third-party, was. Thus, the policy considerations underlying Lynch were not fully implicated and the application of entire fairness was not mandated. Most importantly, the court noted that business judgment would be the applicable standard of review in a transaction involving a sale to a third party where a controlling stockholder receives consideration different from the minority stockholders if the transaction were both recommended by a well-functioning, disinterested, and independent special committee and approved by stockholders in a non-waivable vote of the majority of all the minority stockholders. The court reasoned that both of those procedural protections were necessary because, although the controlling stockholder was not on both sides of the transaction, the controlling stockholder and minority stockholders were competing for the total consideration that the third-party bidder was willing to pay.
Notwithstanding its new pronouncement of law, the court determined that the deficiencies in the specific procedures in Hammons were too great to permit the application of the business judgment standard. The majority-of the-minority vote was insufficient because it could be waived by the special committee and because it required only a majority of those minority stockholders who voted on the transaction. Beyond that, the court was unconvinced that the special committee functioned properly. Thus, the entire fairness standard applied and the court did not grant a motion for summary judgment as to the factual disputes over whether the fair price and fair dealing test was satisfied.
The court also refused to grant summary judgment on the disclosure claims. The court determined that there were triable issues of fact concerning the company’s failure to disclose two critical matters: the special committee’s financial advisor might underwrite a large security offering for Eilian after the completion of the transaction; and the special committee had waived a conflict regarding its legal advisor’s representation of the entity providing Eilian’s financing for the transaction. With respect to those claims, Hammons clarifies that disclosure claims may well survive the closing of the transaction if issues of loyalty are intertwined with the disclosure claims.
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.
Associates John P. DiTomo and Jeffrey M. Gorris contributed to the preparation of this article.
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