AGS/Outline:Specialcommitteesinintereste OUTLINE

SPECIAL NEGOTIATING COMMITTEES UNDER DELAWARE LAW

A. Gilchrist Sparks, III

and S. Mark Hurd

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I.THE LEGAL EFFECT OF using A SPECIAL negotiating COMMITTEE

A.Historical Origins

The use and importance of special committees increased with the Delaware Supreme Court’s suggestion in Weinberger v. UOP, Inc., 457 A.2d 701, 709 n.7 (Del. 1983), that the court might have had an “entirely different” view of the unfairness of the interested merger successfully challenged in that case if the merger had been negotiated with the controlling stockholder by a committee of independent directors.
The courts initially were split regarding the effect an independent special negotiating committee’s approval had on judicial review of an interested transaction. Some courts ruled that approval by a special committee led to application of the business judgment rule, while others concluded that such approval only shifted the burden of proof on the issue of entire fairness from defendants to the plaintiff. CompareIn re Trans World Airlines, Inc. Shareholders Litig., C.A. No. 9844, slip op. at 15-16 (Del. Ch. Oct. 21, 1988) (business judgment rule applies) withCitron v. E.I. du Pont de Nemours & Co., 584 A.2d 490, 500-02 (Del. Ch. 1990) (business judgment rule inapplicable but burden shifts and characterizing use of special committee as “strong evidence of fairness”). The difference may be significant. Were the business judgment rule applicable, a court would not review the substance of a transaction unless the plaintiff could rebut the business judgment rule presumptions that the directors acted in good faith, loyally and with due care. On the other hand, if entire fairness is the issue, and even if the burden of proof is shifted, plaintiff may proceed directly to seek to prove that the transaction is not substantively fair.

B.Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994)

In Kahn v. Lynch, the Delaware Supreme Court resolved the split. The court held that “[e]ntire fairness remains the proper focus of judicial analysis” of a merger transaction involving a controlling stockholder, but also concluded that approval by an independent special committee may shift the burden of proof to the party challenging the merger. Id. at 1116.
The court also cautioned that the mere existence of a special negotiating committee is not sufficient to shift the burden of proof. Rather, there must be “careful judicial scrutiny of a special committee’s real bargaining power before shifting the burden of proof on the issue of entire fairness.” Id. at 1117. The court noted with approval a two-part test formulated by the Court of Chancery for evaluating the propriety of shifting the burden:

a.The majority stockholder must not dictate the terms of the merger.

b.The special committee must have real bargaining power that it can exercise with the majority stockholder on an arm’s-length basis.

C.Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997)

In Kahn v. Tremont, the Delaware Supreme Court confirmed that the entire fairness standard of review governs all transactions, not just going-private transactions, involving a majority stockholder, at least where a majority of the subsidiary board is not independent. A plaintiff challenging a transaction with a controlling stockholder that was negotiated by independent directors who exercised real bargaining power will be required to prove the transaction was unfair. Seeid. at 428-29.
The court’s opinion stresses the importance of selecting independent and motivated directors for service on a special committee. In concluding defendants were not entitled to shift the burden of proof, the court noted that two of the three committee members “abdicated their responsibility” to the third, an individual who provided consulting services to an entity affiliated with the controlling stockholder. Id. at 429. The court also observed that the committee had retained counsel recommended by the corporation’s general counsel and that the committee’s financial advisor had lucrative past dealings with the controlling stockholder, further undermining the independence and integrity of the committee process. Seeid.

D.Although the use of a special committee in certain circumstances will not lead to application of the business judgment rule and despite the potential pitfalls, special committees remain a valuable and important tool of corporate governance. As Chancellor Chandlerrecently noted, “there is a strong role under Delaware law for meaningful independent director committees.” In re Digex, Inc. Shareholders Litig., Consol. C.A. No. 18336, slip op. at 72 (Del. Ch. Dec. 13, 2000, revised Jan. 19, 2001).

II.WHEN A SPECIAL COMMITTEE SHOULD BE USED

A.Interested Transactions Involving A Controlling Stockholder

Special negotiating committees are useful not only as a means to attempt to minimize the risk of a successful class action challenge to any going-private transaction, but also may be used in any transaction between a majority or controlling stockholder and the corporation.
Although a board is not legally required to use a special committee to negotiate an interested transaction, seeSmith v. VanGorkom, 488 A.2d 858, 876 (Del. 1985), the Court of Chancery has observed that the failure to use a special committee or other procedural safeguard “evidences the absence of fair dealing.” Seagraves v. Urstadt Property Co., C.A. No. 10307, slip op. at 11 (Del. Ch. Apr. 1, 1996).

B.Interested Transactions Not Involving A Controlling Stockholder

Special committees with decision-making authority:

In transactions not involving a controlling stockholder in which a majority of the directors are not both disinterested and independent, but which are not required to be decided by the full board, a special committee should be given final and binding authority with respect to the transaction. In such circumstances, the transaction will be subject to the highly deferential business judgment review.

Special committees with recommending authority:

Certain transactions, including mergers, must be acted upon by the full board of directors. If the transaction does not involve a majority stockholder but a majority of the directors have a conflict of interest, it is nonetheless possible to receive the protections of the business judgment rule if a properly functioning special committee recommends the merger transaction and the full board, after informing itself, simply adopts the special committee’s recommendation. SeeIn re Western Nat’l Corp. Shareholders Litig., Consol. C.A. No. 15927, slip op. at 67-68 (Del. Ch. May 22, 2000).

III.WHEN a special committee should not be used

A.A Majority Of The Board Is Disinterested And Independent

It may not be advisable to use a special committee to evaluate a transaction in which one or more directors is interested if a majority of the board is disinterested and independent, since action by that board should be judged by the business judgment rule standard, at least if the transaction is not with a majority stockholder.

In Puma v. Marriott, 283 A.2d 693 (Del. Ch. 1971), plaintiff challenged the corporation’s acquisition of all the stock of six corporations principally owned by members of the Marriott family, which held approximately 46% of the corporation’s common stock. The acquisition was authorized by unanimous resolution of the corporation’s five outside directors, who constituted a majority of the corporation’s nine person Board. The court held the business judgment rule applied because there was no showing of domination of the outside directors, no showing that would impugn the integrity and good faith of the outside directors and no showing the transaction’s terms were dictated by the Marriott family. Id. at 695. However, if there is doubt regarding disinterestedness and independence of a majority of the directors, the committee process may be advisable.

B.Short-Form Mergers

In circumstances where the controlling stockholder holds more than 90% of the corporation’s stock and can effect a short-form merger, there is no duty of fair dealing. SeeIn re Unocal Exploration Corp. Shareholders Litig., C.A. No. 12453, slip op. (Del. Ch. June 13, 2000). In such circumstances, therefore, the potential benefits of using the special committee process generally will be outweighed by the related costs.

IV.MEMBERSHIP OF THE SPECIAL COMMITTEE

A.Independent And Disinterested Directors

The independence requirement helps assure that each special committee member’s decision is “based on the corporate merits of the subject before the board rather than extraneous considerations or influences.” Aronson v. Lewis, 473 A.2d 805, 816 (Del. 1984).
The Delaware Supreme Court has held that “[t]o disqualify a director, for [business judgment] rule rebuttal purposes, there must be evidence of disloyalty.” Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 363 (Del. 1993), modified, 636 A.2d 956 (1994). The analysis is essentially one of fact. Id. at 364. Examples of disloyalty which might preclude a director from being deemed an independent special committee member include:
A perceived motive of entrenchment. SeePolk v. Good, 507 A.2d 531, 536-37 (Del. 1986).
An “actual financial interest” in the transaction. SeeIn re Grace Energy Corp. Shareholders Litig., C.A. No. 12464, slip op. at 10 (Del. Ch. June 26, 1992), appeal refused, 610 A.2d 725 (Del. 1992).

(1)Receipt of directors’ fees does not affect a director’s independence. SeeGrobow v. Perot, 539 A.2d 180, 188 (Del. 1988).

(2)Moreover, the Supreme Court has explained that the mere existence of some immaterial “self-interest, standing alone and without evidence of disloyalty,” does not rebut the presumption of the business judgment rule. Cede, 634 A.2d at 364.

The burden of proof may not shift where special committee members have received “significant payments” for services rendered to entities controlled by the interested controlling stockholder. In re MAXXAM, Inc./Federated Dev. Shareholders Litig., 659 A.2d 760, 774 (Del. Ch. 1995) (court had “serious questions” about independence). Even past relationships, if they create a reason to doubt current independence, may prevent application of burden shifting. SeeKahn v. Tremont Corp., 694 A.2d at 429 (noting committee member’s “long and personally beneficial relationship” with controlling stockholder).
To the extent possible, the interested party should not be involved in selecting the members of the special committee, seeIn re Fort Howard Corp. Shareholders Litig., C.A. No. 9991, slip op. at 30 (Del. Ch. Aug. 8, 1988), and should not select who will serve as the chairman of the committee.

B.Committees Of One

The Court of Chancery has explained that it will give special scrutiny to the independence and process employed by a special negotiating committee when there is only one member on the committee. In Kahn v. Dairy Mart Convenience Stores, Inc., C.A. No. 12489, slip op. (Del. Ch. Mar. 29, 1996), for example, the board appointed a special committee with two directors, one of whom was at the time a paid consultant for the corporation. The existence of that paid position raised a material fact regarding the director’s independence. Therefore, “the only procedural protection effectively afforded the minority was a special negotiating committee ... of one,” which called for “careful judicial scrutiny.” Id. at 14. The court noted that in such a case both the director and “the process employed” must be “above reproach for the director defendants to receive the procedural benefits of using an independent committee.” Id. at 15. SeeKahn v. Tremont Corp., 694 A.2d at 430 (describing a de facto committee of one as “a tenuous role”); cf.Lewis v. Fuqua, 502 A.2d 962, 967 (Del. Ch. 1985) (“If a single member [special litigation] committee is to be used, the member should, like Caesar’s wife, be above reproach.”).

V.FORMATION OF THE SPECIAL COMMITTEE

A.Scope Of Authorizing Resolution

Must Not Be Unduly Limited

In Kahn v. Tremont Corp., C.A. No. 12339, slip op. at 9 (Del. Ch. Apr. 22, 1994), the Court of Chancery ruled that “a special committee of allegedly disinterested directors can only be afforded dignity when the Court is content that the committee was truly independent in fact (and not unduly limited by the resolution establishing it as to it as to its powers), energetic, informed and well motivated.” Thus, the special committee must have sufficiently broad authority and access to relevant information. CompareIn re Republic American Corp. Litig., Consol. C.A. No. 10112, slip op. at 5-6 (Del. Ch. Apr. 4, 1989), aff’d, 586 A.2d 1202 (Del. 1990) (special committee’s assignment of “merely passing upon the fairness of the price” was “too narrow” to permit burden shifting); Rabkin v. Olin Corp., Consol. C.A. No. 7547, slip op. at 15 (Del. Ch. Apr. 17, 1990).

The Power To Say No

In In re First Boston, Inc. Shareholders Litig., Cons. C.A. No. 10338, slip op. at 15 (Del. Ch. June 7, 1990), the court noted that the special committee was “unable to shop the buyout groups [sic] proposal with any likely effect” and was so advised by its financial advisors. The court concluded that

the special committee could only see its options as limited. It retained, however, the critical power: the power to say no. It is that power and the recognition of the responsibility it implies by committees of disinterested directors, that gives utility to the device of special board committees in cha[n]ge of control transactions.

Id. (emphasis added). The court also noted that a special committee’s power to say no may be the only form of leverage against a controlling fiduciary because the power to say no will “force the fiduciary to choose among the options of implementing a frank self-dealing transaction at a price that knowledgeable directors have disapproved, to improve the terms of the transaction or abandon the transaction.” Id. at 16; see alsoKahn v. Lynch, 638 A.2d at 1119-20. Publicized examples of committees effectively using the power to say “no” include Life Technologies’ response to Dexter and Foamex’s response to Trace.

B.Selection Of Independent Legal And Financial Advisors

The special committee should select its own independent legal and financial advisors. The Court of Chancery has noted that “no role is more critical with respect to protection of shareholder interests in these matters than that of the expert lawyers who guide sometimes inexperienced directors through the process.” In re Fort Howard, slip op. at 30. The special committee, not the interested party, should select the advisors. Seeid. at 30-31 (“A suspicious mind is made uneasy contemplating the possibilities when the interested CEO is so active in choosing his adversary”); see alsoKahn v. Tremont Corp., 694 A.2d at 429-30 (criticizing special committee’s selection of a financial advisor that, through an affiliate, had a significant business relationship with interested persons). To best simulate the dynamics of arm’s-length bargaining, the deliberations of the special committee and the advice of its independent financial and legal advisors should be kept confidential from the negotiators for the interested person. SeeRosenblatt v. Getty Oil Co., 493 A.2d 929, 938-39 (Del. 1985).

VI.DUTIES OF THE SPECIAL negotiating COMMITTEE

A.Duty To The Minority Stockholders

The special committee must understand its function is to negotiate both independently and, to the extent possible, as if at arm’s length. Accordingly, in In re First Boston, the Court of Chancery observed that:

When independent directors understand the nature of their mission ... to agree only to a transaction that is in the best interests of the public shareholders; to say no unless they conclude that they have achieved a fair transaction that is the best transaction available and where they pursue that goal independently, in good faith and diligently, their decision [will shift the entire fairness burden onto the party challenging the transaction].

Slip op. at 16. CompareIn re Trans World Airlines, C.A. No. 9844, slip op. at 18 (Del. Ch. Oct. 21, 1988) (burden not shifted where the special committee “did not supply an acceptable surrogate for the energetic, informed and aggressive negotiation that one would reasonably expect from an arm’s-length adversary”); Freedman v. Restaurant Assocs. Indus., Inc., C.A. No. 9212, slip op. at 17-18 (Del. Ch. Sept. 19, 1990, revised Sept. 21, 1990) (no burden shifting where “the management group could (and did) veto any action of the special committee that was not agreeable to the conflicted interests of the management”).

B.Duty To Be Informed

To receive the benefits of burden shifting, the special committee must be well informed. This fact has led plaintiffs to argue that the interested party failed to disclose material information to the special negotiating committee, leaving the burden on the defendant to prove that the transaction is entirely fair. SeeIn re Digex, slip op. at 69 (noting that interested directors “controlled the flow of all information” from potential acquiror to the special committee and prevented the committee from performing its function). In Kahn v. Tremont Corp., C.A. No. 12339, slip op. (Del. Ch. Mar. 21, 1996, revised Mar. 27, 1996), rev’d on other grounds, 694 A.2d 422 (Del. 1997), Chancellor Allen addressed the extent of a fiduciary’s obligation to disclose information to a special committee. Chancellor Allen opined that:

appreciation of the interests to be protected and the mutual gains to be achieved by the special committee process require the conclusion that there are some categories of information that while possibly material to the decision must be regarded as privileged from disclosure in order for a negotiation to occur at all.

Id. at 37. The court held the fiduciary was required to disclose:

all material information known to the fiduciary except that information that relates only to its consideration of the price at which it will buy or sell and how it would finance a purchase or invest the proceeds of a sale.

Id. at 39 (emphasis omitted). As a consequence, the interested party must disclose to the special committee (1) all material terms of the transaction, (2) “all material facts relating to the use or value of the assets in question to the beneficiary itself,” including alternative uses for the assets or hidden value, and (3) material facts relating to the market value of the subject matter of the transaction, including legal or technological changes that would affect value. Id. at 38-39.

Kahn argued against burden shifting because the special committee was not informed about advice received from the fiduciary’s financial advisor relating to the size of a potential discount on the price of the stock. The court ruled that such opinion information could be provided by any qualified broker, and that its disclosure would be inconsistent with the concept of arm’s-length negotiations.