Delaware Chancery Court Applies M&F Worldwide Six-Factor Test in Private Company Freeze-Out Merger and Grants Motion to Dismiss Claims Against Controlling Stockholders
In a bench ruling in Swomley v. Schlecht, C.A. No. 9355-VCL (Del. Ch. Aug. 27, 2014), the Delaware Chancery Court relied on the six-factor test set out in Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014), to dismiss a challenge to a private company freeze-out merger at the pleadings stage. As discussed in our March 25, 2014 update, the Delaware Supreme Court held in M&F Worldwide that a minority stockholder challenge to a controlling stockholder buyout would be reviewed under the business judgment standard, rather than the more rigorous entire fairness standard, in a transaction conditioned from the outset on approval by both a properly empowered special committee of independent directors and an informed, uncoerced majority of the minority vote.
The Swomley decision is notable for two reasons. First, the court granted the defendants’ motion to dismiss at the pleadings stage, before any discovery. The M&F Worldwide opinion had implied that cases applying the six-factor test would often survive such a motion. Second, the court applied the M&F Worldwide test, which had previously been applied only to public companies, to a challenged transaction involving a private company.
Background: Transaction Provides Dual Protections
Under M&F Worldwide, a challenged controlling stockholder buyout will be reviewed under the business judgment standard if (and only if) (1) the controlling stockholder conditions the transaction at the outset on the approval of both a special committee and a vote of a majority of the minority stockholders; (2) the special committee is independent; (3) the special committee is empowered to select its own advisors and to definitively say no to the transaction; (4) the special committee exercises its duty of care in negotiating a fair price; (5) the minority stockholder vote is informed; and (6) the minority stockholder vote is uncoerced. The Delaware Supreme Court concluded that a transactional structure meeting this test provided significant protection for minority stockholders, justifying application of the more lenient business judgment standard of review.
Swomley involved a cash-out merger of a privately held company, SynQor, in which the counterparty was a management group that owned approximately 46% of the outstanding stock. From the first SynQor board meeting to consider the transaction, the board resolved that any deal would require both approval of a special committee and a majority of the minority vote of disinterested stockholders, complying with the main prerequisite to application of the M&F Worldwide test. In the bench ruling, the court also noted that the minority stockholders were provided with a robust proxy statement, which was supplemented with additional disclosures after the case was filed. The transaction was approved by the special committee, and it ultimately received a favorable vote from holders of 61% of the minority shares.
Case Dismissed on Pleadings
As we noted in our March 25, 2014 update, the Delaware Supreme Court did not provide defendants with an unqualified win in M&F Worldwide. In a much-discussed admonishment, the court emphasized that “[i]f a plaintiff . . . can plead a reasonably conceivable set of facts showing that any or all of [the six factors] did not exist,” its complaint should survive a motion to dismiss and it should be permitted to conduct discovery. This raised concerns that controlling stockholder buyouts employing the dual protections of M&F Worldwide would nevertheless receive greater court scrutiny at the pleadings stage than other cases where the business judgment standard of review applies.
In Swomley, however, Vice Chancellor Laster observed that the whole point of M&F Worldwide was to incentivize controllers to meet the six-part test by holding out the possibility that breach of fiduciary duty claims relating to the transaction could be dismissed at the pleading stage. Accordingly, he granted defendants’ motion to dismiss, permitting defendants to avoid the costs of discovery. The court rejected plaintiffs’ argument that their complaint should not have to anticipate the defendants’ challenge under M&F Worldwide and plead around the six-factor test. Vice Chancellor Laster explained that, under M&F Worldwide, when a controlling stockholder buyout employs the dual protections structure, a plaintiff has the burden to attack the transaction by pleading facts that would undermine the elements of the M&F Worldwide test. In this case, where the transaction protections were described “in a public way suitable for judicial notice, such as board resolutions and proxy statement,” the court could dismiss based on the pleadings.
In dismissing the case, the court found that the plaintiffs had failed to plead facts sufficient to call into question any element of the six-factor test, finding that:
- the plaintiffs had not seriously called into question whether the dual protections structure had been properly employed in the transaction;
- the plaintiffs failed to allege any facts that, under a traditional analysis, called into question the independence or disinterestedness of the two-person special committee;
- the plaintiffs did not dispute that the special committee was empowered to “just say no,” since the transaction was clearly conditioned on the committee’s approval;
- while certain decisions of the committee relating to the negotiation of the deal price may have been debatable, the plaintiffs did not plead sufficient facts to support a breach of the duty of care since the duty is measured by a gross negligence standard (a high bar that essentially requires a showing of recklessness);
- the minority stockholder approval was sufficiently informed through a “public-company-style proxy statement,” and the plaintiffs’ disclosure allegations were not well pled; and
- the minority stockholders were not coerced because they could have voted the transaction down and returned to the status quo.
M&F Worldwide Applied to Private Company Transaction
Swomley was the first application of M&F Worldwide to a transaction involving a private company. The court dismissed this threshold question quickly, noting that Delaware generally does not distinguish between public companies and private companies. The court did allow that the private company context may be relevant as a factor in such a case but stated that this issue would not prevent application of the six-factor test.
Although Swomley extends the protection of the M&F Worldwide test to freeze-out mergers of private companies, many such companies will not have the governance structure or the resources to comply with the test. In particular:
- there may not be enough independent, disinterested directors to form a special committee;
- the controller may be unwilling to turn the decision over to the committee and a majority of the minority stockholders;
- even if the board can form a properly constituted independent committee, the company may not be able to afford independent advisors for the committee; and
- the company may not have the resources to prepare a public-company-style proxy statement of the type the court relied upon in Swomley.
Nevertheless, the Swomley decision is a good reminder that, although the risks of stockholder litigation in the context of a private company M&A transaction are lower as a practical matter, directors of private companies are generally held to the same standards as directors of public companies.
Bench Ruling Subject to Appeal
In the bench ruling transcript, plaintiffs’ counsel stated that he would raise questions regarding the ruling with the Delaware Supreme Court, indicating that plaintiffs will likely appeal the ruling. If the Swomley decision is appealed, the Delaware Supreme Court will have the final say on whether the motion to dismiss was properly granted under the M&F Worldwide six-part test.