Corporate AlertMarch 2014
The Herrick Advantage
At the podium...
On April 10, Barbaros M. Karaahmet will participate in Thomson Reuters' inaugural M&A/Private Equity Forum in New York City. Barbaros and his co-panelists, will address legal, financial, and compliance issues currently affecting cross-border transactions. Click here for more information.
Earlier this month, the U.S. Supreme Court resolved the question of whether the whistleblower protection provisions of the Sarbanes-Oxley Act of 2002 ("SOX") protect employees of private contractors of publicly traded companies from retaliation for reporting potential fraud. In a 6-3 decision, the Court, citing a legislative mandate to safeguard investors in public companies, held that the whistleblower protections created by SOX extend not only to employees of public companies, but to employees of contractors and subcontractors of public companies, including accounting firms and investment advisers.
The case, Lawson v. FMR LLC, No. 12-3, slip op. (March 4, 2014), involved two employees employed by private firms contracted to advise and manage mutual funds. One plaintiff alleged that he was terminated after reporting inaccuracies in a draft registration statement his firm prepared on behalf of a client; the other plaintiff claimed that she was discharged for internally reporting improper accounting practices.
The relevant statute, Section 806 of SOX, affords a private right of action to whistleblowers, and provides that no public company, nor any officer, employee, contractor, subcontractor, or agent of such company, may discriminate "against an employee" because of whistleblowing activity. Before Lawson, it was unclear whether the term "employee" referred only to employees of the public company. The Court, in reversing a lower court's ruling, emphasized that expanding the applicability of whistleblower protections to employees of private contractors that provide services to public companies is consistent with Congress' desire to restore trust in public markets by ensuring that employees cannot be retaliated against for reporting irregularities or potential fraud.
Following the Lawson decision, private employers that perform services for public companies should review their anti-retaliation policies to ensure compliance with SOX. In particular, employers should be mindful of the broad range of whistleblowing activities protected by SOX, which includes internal reporting on a wide variety of potential fraud, whether or not related to securities fraud or specific SEC rule violations.
Delaware Court of Chancery Applies Entire Fairness Review to Merger and Allows Post-Closing Damages to Stockholders
In a summary judgment decision regarding a cash-out merger of minority stockholders by a controlling stockholder, the Delaware Court of Chancery recently held that the entire fairness review applied to the merger and that post-closing damages were available to the minority stockholders as a remedy for materially misleading disclosures in the merger proxy statement.
Here, although the board appointed a special committee and obtained approval from a majority of the minority stockholders, the Court applied the entire fairness review, and not the business judgment rule, in its review of the merger. The Court noted several deficiencies in the merger process that triggered the entire fairness review: the merger proxy statement contained incorrect information; the special chairman of the committee's independence was not clear; the fairness of the special committee's process was questionable; the merger was not arms' length; and there were triable issues of fact about the fiduciary duty of loyalty and good faith of the directors.
The special committee argued that its role in disclosing erroneous information in the proxy statement amounted to, at most, a breach of the duty of care, for which the members were exculpated pursuant to the company's charter, but the Court, in applying the entire fairness review, held that the duty of loyalty is central in interested transactions such as the one in question.
This decision puts directors and members of special committees on notice that while they may be exculpated in the event of a failure to meet a duty of care, a Court may look closely at the duty of loyalty and award post-closing damages where a controlling shareholder successfully completes a cash-out merger based, at least in part on inaccurate disclosures to the stockholders.
The Delaware Supreme Court recently affirmed a Delaware Court of Chancery ruling upholding the ouster of Eldon Klaassen, the CEO of Allegro Development Corporation, amid declining corporate financial performance.
In 2007 and 2008, Allegro sold a new class of Series A Preferred Stock to two outside investment funds (the "Series A Investors"). At the time of the transaction, the parties entered into a stockholders agreement governing, among other things, the appointment of directors to Allegro's board, which eventually consisted of two appointees of the Series A Investors, two outside directors, and Klaassen. Klaassen continued to own a majority of the common shares of Allegro.
Shortly after the Series A Investors purchased shares of Allegro, the company's financial performance began declining. The Series A Investors and, eventually the outside directors, became dissatisfied with Klaassen's performance as CEO. By mid-October 2012, all of the directors other than Klaassen decided among themselves to replace Klaassen as CEO at the regularly scheduled November board meeting. Without informing Klaassen, the four other directors held two preparatory conference calls ahead of the November board meeting and instructed outside counsel to prepare a resolution removing Klaassen as CEO. One of the outside directors asked Klaassen to have Allegro's general counsel attend the November board meeting on a pretext; the real reason for the general counsel's attendance was to implement Klaassen's termination as CEO.
At the November board meeting, Klaassen was removed as CEO. Initially, he offered to help his replacement learn about the industry and the company, and he began negotiating the terms of a consulting agreement with Allegro. However, in late 2012, Klaassen began expressing displeasure at his removal and brought suit in June 2013 seeking, among other things, a declaration that he was the lawful CEO of Allegro.
Klaassen argued that his removal as CEO was invalid for two reasons: (i) lack of advance notice of the plan to terminate him and (ii) the other directors' use of deception in carrying out the plan. The Court affirmed the Court of Chancery decision, holding that (i) there is no requirement under Delaware law that a director be given advance notice of specific agenda items to be addressed at regular board meetings (as opposed to special board meetings and in connection with actions by written consent) and (ii) even if certain conduct of the other directors was deceptive, Klaassen's removal was voidable, not void, and that he subsequently acquiesced in his removal. The Court also noted that the meetings held by the other four directors prior to the November 1st board meeting were not, as Klaassen contended, special meetings of the board, since no action was taken until the regularly scheduled November board meeting.
The Delaware Supreme Court's ruling should provide useful guidance as to notice and disclosure requirements in a situation where the board of directors is seeking the removal of a CEO or other officer who also sits on the board and may hold a significant amount of stock. Likewise, the Court's ruling drives home the principle that an officer who thinks he or she has been improperly removed should act promptly to seek to enforce any rights he or she may have.
Klaassen v. Allegro Development Corporation, No. 583, 2013, 2014 WL 996375 (Del. March 14, 2014)
Investment Bank Held Liable for Aiding and Abetting Directors' Breaches of Fiduciary Duty
The Delaware Court of Chancery recently held that RBC Capital Markets, LLC ("RBC") aided and abetted breaches of the duties of care and disclosure by the directors of Rural Metro Corporation ("Rural").
According to the court, RBC, which was seeking to obtain a lucrative role as a lender to Warburg Pincus, the potential private equity buyers of Rural's competitor Emergency Medical Services Corp. ("EMS"), was eager to be the adviser to Rural because it thought doing so would give it a leg up in its quest for financing fees in the EMS deal (n.b. RBC did not end up with a financing role on the EMS deal). Rural's board retained RBC, and RBC advised the Rural board to put the company in play.
The court noted that while RBC was seeking to facilitate the sale of Rural to Warburg Pincus, RBC failed to inform Rural's board that it was also lobbying Warburg for a role in financing Warburg's bid for EMS. The court noted that RBC was engaged in a "full court press" to convince Warburg to include RBC in its financing package. At the same time, RBC was lowering the valuation of Rural that it presented to Rural's board, and providing other materially misleading information to the board.
Finding the process faulty, the court held that the merger did not generate for stockholders the best value reasonably attainable, and that the board, based on information it received from RBC, was providing materially misleading information to the shareholders.
"RBC created the unreasonable process and informational gaps that led to the Board's breach of duty. At the outset, RBC knew that it was not disclosing its interest in obtaining a role financing the acquisition of EMS or how it intended to use the Rural process to capture the EMS financing business. . . . Most egregiously, RBC never disclosed to the [b]oard its continued interest in buy-side financing and plans to engage in last minute lobbying of Warburg."
This opinion continues a recent line of cases from Delaware courts addressing investment bankers' conflicts-of-interest in M&A deals.
In re Rural Metro Corporation Stockholders Litigation, No. 6350-VCL, 2014 WL 971718 (Del. Ch. Mar. 7, 2014).
Delaware Court of Chancery Assesses Whether a Control Group Existed During Distinct Periods Throughout the Course of a Merger Transaction
In a recent Delaware Court of Chancery case, a plaintiff sued the board of directors and two key employees of American Surgical Holdings, Inc. (the "Company"), in connection with the Company's merger with an affiliate of Great Point Partners I, LP. The plaintiff claimed, among other things, that a group of stockholders, which the Court referred to as the Rollover Group, who together held a majority of the Company's stock, breached its fiduciary duties by foisting an unfair transaction, in terms of process and price, upon the other stockholders, and that the unfair transaction deprived the minority stockholders of the true value of the Company. The defendants moved for summary judgment disputing whether the Rollover Group was a control group. The Court analyzed, among other things, the application of the entire fairness review in a transaction involving a control group.
The existence of a controlling stockholder may affect the Court's standard of review of the business decisions of a company's board of directors. A stockholder is said to control a corporation where "it owns a majority interest in or exercises control over the business affairs of the corporation." A group of stockholders, none of whom individually qualifies as a controlling stockholder, may collectively be considered a control group that is analogous, for standard of review purposes, to a controlling stockholder. Allegations of mere parallel interests, without more, are insufficient to establish that the individual stockholders constituted a control group. The Court explained that the stockholders must be connected in some legally significant way (by contract, common ownership, agreement or other arrangement) to work together toward a shared goal.
Here, the Court assessed whether the Rollover Group constituted a control group in two distinct periods of time: first, during the period when the board of directors decided to sell the Company, including when a special committee took over the sale process; and second, during the period surrounding the selection of the options presented by the buyer. The Court concluded that the Rollover Group was not a control group when the board decided to sell the Company because its decision to sell was not conditioned on any terms from the Rollover Group. However, the Court was unable to reach the same conclusion regarding the selection of options presented by the buyer. According to the Court, a reasonable inference could be drawn that the Rollover Group was connected in a legally significant way and that the Rollover Group may have exercised its control to select the option most favorable to their self-interests.
Thus, to implicate the entire fairness standard of review, the Court found that it was the plaintiff's burden to first establish that there was a control group, and then only after satisfying that burden, would the plaintiff have an opportunity to prove that the defendant failed to satisfy the entire fairness standard. The fact-specific existence of a control group dictates whether the Court applies the entire fairness standard, and, according to the Court, whether a control group exists or not may change over the course of a transaction.
Richard Frank v. Zak W. Elgamal, et. al., C.A. No. 6120-VCN (Del. Ch. Mar. 10, 2014).
Roadmap for Controlling Stockholders to Avoid Entire Fairness Review
In another case regarding the entire fairness standard of review of board actions, the Delaware Supreme Court recently determined that controlling stockholders of Delaware corporations could avoid the entire fairness standard of review when structuring a going-private transaction, provided (i) the controlling stockholders condition the transaction from the outset on the approval of both a special committee and a majority of the minority stockholders; (ii) the special committee is independent, empowered to freely select its own advisors and to say no definitively and meet its duty of care in negotiating a fair price; and (iii) the vote of the minority is informed and uncoerced.
In this case, investor Ronald Perelman led a going-private transaction of M&F Worldwide Corp., a company he controlled. Although the plaintiff-minority shareholders of M&F Worldwide alleged that the transaction was unfair, they did not dispute that shareholders who voted for the deal were "fully informed and uncoerced" and "failed to allege any failure of disclosure or any act of coercion." Furthermore, M&F's board took the above stated measures. The Court, finding that Perelman acted as if he were an outside buyer, therefore concluded that Perelman's buyout of M&F Worldwide was not subject to the heightened entire fairness review.
This decision provides a clear roadmap for future controlling stockholders interested in going-private transactions.
Kahn v. M&F Worldwide Corp., No. 334, 2013, slip op. (Del. Mar. 14, 2014)
For more information on the issues in this alert, or corporate matters generally, please contact:
Daniel Etna at +1 212 592 1557 or [email protected]
Copyright © 2014 Herrick, Feinstein LLP. Corporate Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.