Landry's Restaurants, Inc. Going-Private Transaction: Stepping into the "Incoherence" of Delaware's Law of Controlling Party Buyouts

A. Background

Tilman J. Fertitta, Chairman of the Board, CEO, President, and 35% stockholder of Landry’s Restaurants, Inc., a Delaware corporation (the “Company”), is one tough negotiator. In January of this year Fertitta proposed taking the Company private at $23.50 per share. The Company responded by doing all of the right things: appointing a special committee of three independent directors to review the strategic alternatives available to the Company; evaluate Fertitta’s proposal and alternative proposals; negotiate, as appropriate, a deal with Fertitta or possibly others; and ultimately recommend to the Board “at the appropriate time” what to do.

The committee retained a slew of advisors, including separate counsel, King & Spalding (after vetting that firm and others), and financial advisor Cowen and Company, after vetting 24 candidates. During the course of its negotiations with Fertitta, the committee retained special Delaware and Nevada counsel (the Company operates a casino in Las Vegas). As a measure of the intensity of the work, the chair of the committee was paid, up front, $60,000, and the two other members of the committee were each paid $50,000.

This was played by the book.

Fertitta didn’t read the book. On April 4, 2008, he lowered his offer price of $23.50 to $21.00 per share, “a result of the credit market conditions worsening significantly” since the date of his initial offer, making it “far more costly” for him to obtain the debt financing required to consummate the deal. Proxy Statement at 23 (dated July 17, 2008). He also cited the continued decline in the economy and the risk of further deterioration in the credit markets. It probably also did not hurt that, even at the lowered price of $21 per share, his offer was 37% over the then trading price of the Company’s shares (symbol: LNY).

The negotiations were long and arduous, concluding with the June 16, 2008 definitive merger agreement.

The committee considered soliciting other interested parties to bid for the Company (Fertitta’s proposal of January 2008 had been publicly disclosed) but concluded against a pre-signing market check: “The special committee noted the risk that if a pre-signing market check were carried out Mr. Fertitta might withdraw his offer to acquire us, [and considered] the risk that no bidder would come forward in this process and the risk that this process could significantly disrupt us in our operations.” Proxy Statement at 27.

So the committee slogged on. K&S preliminarily addressed with Fertitta’s counsel, the Olshan Grundman firm, “adjusting” Fertitta’s severance (which is substantial) and “neutralizing” his voting rights in any vote on the merger. Olshan Grundman told K&S to forget it.

The negotiations came down to price and whether the merger would require, for approval, not only approval of a majority of the Company’s outstanding shares but also approval by a majority of the outstanding shares not held by Fertitta and its affiliates:

“After discussion, the special committee instructed K&S to advise Olshan that the special committee was not inclined to move forward with Mr. Fertitta’s proposed transaction unless Mr. Fertitta increased his offer price [from $21.00 per share] and the condition that the merger be approved by a majority of the disinterested shares. As instructed, K&S so advised Olshan that the special committee would not engage in further negotiations until Mr. Fertitta responded to the special committee’s request.” (Proxy Statement at 31.)

These requests were not only conveyed by committee counsel to Fertitta’s counsel, but also by the chair of the special committee to Fertitta himself.

Fertitta said no, and further advised the chair “that he would withdraw his offer to acquire us altogether if all outstanding issues in the proposed transaction were not resolved by June 13, 2008.”

The committee blinked, and the deal, set forth in the definitive merger agreement of June 16, 2008, is at $21 per share, and its approval will require the approval only of the holders of a majority of the outstanding shares, with Fertitta and the other members of management controlling some 40% of the outstanding shares.

B. Delaware’s Law of Interested-Party Buyouts

The opinions of Vice Chancellor Leo Strine are entertaining and informative. He likes to discourse. He has done so at length on Delaware’s law of a board’s duties when considering a transaction with a controlling shareholder. Specimens include his opinions in In Re Cox Communications, Inc. Shareholders Litigation (“Cox Communications”), 879 A. 2d 604 (2005); In Re Cysive, Inc. Shareholders Litigation (“Cysive”), 836 A. 2d 531 (2003); and In Re Pure Resources, Inc. Shareholders Litigation (“Pure Resources”), 808 A. 2d 421 (2002). He articulated the problem proposed by the “Lynch doctrine” (Kahn v. Lynch Communication Systems, Inc., 638 A. 2d 1110 (Del. 1994)) (“Lynch”) in Pure Resources:

“The Court [in the Lynch case] held that the stringent entire fairness form of review governed [an interested-party merger] regardless of whether: i) the target board was comprised of a majority of independent directors; ii) a special committee of the target’s independent directors was empowered to negotiate and veto the merger; and iii) the merger was made subject to approval by a majority of the disinterested target stockholders.”

Pure Resources, 808 A. 2d at 435.

One can shift the burden of persuasion by the use of one or more of these mechanisms to mimic arms-length negotiations (shifting the burden from the defendants to demonstrate the entire fairness of the transaction to the plaintiff to demonstrate the unfairness of the transaction), but the test remains the same: the deal must pass past a “fair dealing” and “fair price” entire fairness test:

“The concept of fairness has two basic aspects: fair dealing and fair price. The former embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained. The latter aspect of fairness relates to the economic and financial considerations of the proposed merger, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock. However, the test for fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness.”

Lynch, 638 A. 2d at 1115, quoting Weinberger v. UOP, Inc., 457 A. 2d 701, 711 (1983).

And the use of a special committee to negotiate the deal does not end the analysis to determine a burden shift. The court must examine the makeup of the committee, its advisors, and the negotiations it conducted to determine whether it had and in fact exercised “real bargaining power” with the controlling shareholder:

“The same policy rationale which requires judicial review of interested cash-out mergers exclusively for entire fairness also mandates careful judicial scrutiny of the special committee’s real bargaining power before shifting the burden of proof on the issue of entire fairness.”
Lynch, 638 A. 2d at 1117.

The practical effect of the Lynch doctrine is that it is virtually impossible for defendants to obtain dismissal of a complaint challenging an interested-party merger on the pleadings. Cox Communications, 879 A. 2d at 620; Cysive, 836 A. 2d at 548. As Vice Chancellor Strine observed in Cysive:

“Another factor is even more important, which is that the determination of whether the burden should shift under the Lynch doctrine is the kind of decision that can usually be only made after a trial or, at the earliest, on undisputed facts that have emerged from a discovery record developed before the filing of a motion for summary judgment.”

The doctrinal “incoherence” bemoaned by the Vice Chancellor is illustrated by Delaware’s law governing tender offers made by controlling stockholders. Under Delaware’s “doctrine of independent significance,” if one statutory door in Delaware corporate law is closed to a Delaware corporation, that does not mean, ipso facto, that another statutory door cannot be used to achieve the same result. Thus, while a merger with a controlling shareholder will entail an entire fairness review, a tender offer used to accomplish the same result is not subject to such a review.

This approach typically involves an all-shares, all-cash tender offer, which may be conditioned upon the offeror receiving sufficient tenders for it to obtain 90% of the target’s shares, thus enabling the controlling stockholder to consummate a short-form merger under Section 253 of the Delaware General Corporation law (to which the entire fairness doctrine does not apply – objecting stockholders in a short-form merger are limited to perfecting their dissenters’ rights, assuming the absence of fraud).

Because, under Delaware law, neither the tender offer nor the short-form merger requires any action by the target’s board of directors, Delaware’s courts do not impose any right of the stockholders to receive a particular price. (Under the SEC’s Rules 14e‑2 and 14d‑9, the target board does have to state and distribute its position on the tender offer and file a Schedule 14D‑9 with the SEC.) Interested-party tender offers under Delaware law are measured by whether there is “structural coercion” and whether there are materially false or misleading disclosures made to the stockholders in connection with the offer. Examples of “structural coercion” include a threat by the controlling stockholder to seek affirmatively to de-list the target’s shares after completion of the tender offer or a threat to do a back-end short-form merger involving a smaller payment or the use of junk bonds in payment of the back-end consideration. See the Vice Chancellor’s exposition in Pure Resources, 808 A. 2d at 437-439.

C. As Applied to Fertitta’s Proposal

Predictably, shortly after Fertitta made his buyout proposal in January 2008, five class action lawsuits were filed in the state courts in Harris County, Texas. Showing a bit more restraint, Delaware counsel delayed their filing until after a definitive merger agreement was signed and announced on June 16, 2008. The two Delaware actions have been consolidated as Stuart v. Landry’s Restaurants, Inc. et al. (Action Nos. 3856-VCL and 3860-VCL) to be heard before Vice Chancellor Lamb (like Vice Chancellor Strine, an alumnus of the Skadden firm).

Given the state of Delaware law, we know that it is highly unlikely that the Delaware action, assuming it is not stayed in deference to the Texas actions, will be resolved by a motion to dismiss, and therefore Fertitta and the Company’s board will have to establish the bona fides of the special committee’s bargaining, and Fertitta’s deal will have to pass the entire fairness test of Lynch.

How will this deal fare under an entire fairness review?

Certainly the Company’s special committee followed to the letter the form of vigorous bargaining with Fertitta, as made manifest by the 17-page exegesis of the history of the negotiations in the Company’s proxy statement. But the fruits of the committee’s negotiations are few, including such minor victories as an extension of the go-shop period from 30 to 45 days and Fertitta’s guaranty of certain payment obligations (not the merger consideration), including the payment of the reverse termination fee should he breach the merger agreement.
The committee failed in its two “deal” points presented to Fertitta: an increase in the offer price of $21 per share and that the merger receive the approval of a majority of the affiliated stockholders of the Company.

In light of the anomalies of Delaware’s law governing controlling party buyouts, one wonders why, in response to Fertitta’s rejection of the committee’s demand to increase the offer price of $21 per share, the committee did not say to Fertitta:

“OK, we meant it when we said we need a higher price and/or a condition to consummation of the merger that it be approved by a majority of our unaffiliated stockholders. So we’ve reached an impasse. You have an alternative – make an all-shares, all-cash tender for our outstanding shares (of which you own 35%) at $21 per share, and let the stockholders decide for themselves. If you are correct and the offer is fully priced, then you are likely to secure 90% or more of the shares, thus enabling you to do a short-form merger. We will state our position on your tender when we see its specifics.”

Even one of the “key” negotiating issues the committee claimed a victory on may be illusory. One issue that surfaced early and remained throughout the negotiations was whether to conform the definition of “material adverse effect” (“MAC”) in the merger agreement to the definition of such term in the lenders’ debt commitment letter to Fertitta. The Company’s proxy statement does not explain what the difference was, but presumably the MAC definition in the debt commitment letter was less deal protective than that requested by the committee. The Company reports a “victory” on this issue by reporting that the definition of MAC as finally negotiated “would be a definition that is customary for the type of transaction proposed by Mr. Fertitta instead of conforming to the definition in the debt commitment letter; …” Proxy Statement at 32.

So, for example, the definition of MAC in the merger agreement includes a MAC in general economic conditions or in the industries or markets in which the Company operates, but only in cases in which such changes do not affect the Company and its subsidiaries “to a materially disproportionate degree …” Presumably this qualification is not in the definition of MAC in the debt commitment letter. I say presumably because while the debt commitment letter is filed as an exhibit to the Company’s Schedule 13E‑3, that portion of it that defines MAC (contained in an exhibit to the debt commitment letter) is not filed with the document.

Because one of the closing conditions to Fertitta’s merger with the Company is compliance with certain conditions set forth in this unfiled exhibit to the debt commitment letter, it may be that the lenders’ out for any material adverse effect could excuse Fertitta from closing the deal if a MAC occurs within the meaning of the commitment letter.

What avenues are there for the litigation to be settled? Vice Chancellor Strine points the way, in his “essay” in Cox Communications (which involved a challenge to an attorney’s fee award!):

“But Lynch also created other unintended and unanticipated incentive effects which the objectors [to the fee request] point out. For starters, the absence of any additional standard of review-affecting benefit for a Minority Approval Condition [a condition that the merger receive the approval of a majority of the unaffiliated shares], has made the use of that independent, and functionally distinct, mechanism less prevalent. From a controller’s standpoint, accepting this condition from the inception of the negotiating process added an element of transactional risk without much liability-insulating compensation in exchange. Therefore, controllers were unlikely to accept a Minority Approval Condition as an initial requirement, and would, at most, agree to such a Condition at the insistence of a special committee and/or as a way to settle with the plaintiffs.”

Cox Communications, 879 A. 2d at 618 (emphasis added).

So what might we expect by way of settlement discussions between the Stuart plaintiffs and Fertitta? Other than the standard table pounding and invective, a settlement imposing upon the deal a Minority Approval Condition would be a way out of the dispute. It would allow plaintiffs to tout a significant structural improvement to the deal. For Fertitta it would achieve his objective of acquiring all of the Company at his price, $21 per share, assuming his fellow stockholders go along. The question is whether he is willing to assume the risk that his fellow stockholders will conclude, as the Company’s special committee concluded, that $21 per share is a fair price, under all of the circumstances, even if one has to hold one’s nose in reaching this conclusion.