Exelon (NYSE: EXC) has launched an exchange offer for all of the outstanding shares of NRG Energy, Inc. (NYSE: NRG). Exelon is offering 0.485 of its common shares for each NRG share. The exchange offer follows a proposal made by Exelon to the NRG board on October 17. At that time, the exchange offer represented a 37% premium over NRG’s share price, albeit well below NRG’s 12-month high of $45 a share. NRG’s shares closed yesterday, November 12, at $21.60. Based upon yesterday’s closing price of Exelon ($50.57), the deal currently has a value of $24.53 per NRG share, down from a value of $26.43 on October 17.
Concurrently with its launch of the exchange offer, Exelon filed a complaint in the Delaware Chancery Court against NRG and its board of directors, seeking declaratory and injunctive relief. The basis for Exelon’s action is NRG’s rejection of Exelon’s October 17, 2008 deal proposal. NRG rejected the proposal by its letter dated November 9, 2008.
Exelon is miffed at the time NRG took to evaluate Exelon’s offer and reject it—20 whole days! It asserts by its complaint ((no. CA 4155) assigned to Vice Chancellor Lamb) that it has received “positive feedback” on its proposal “from a number of sources, including a number of NRG’s stockholders.” Complaint ¶ 3.
Exelon initiated discussions over a transaction with NRG on September 26, 2008, which was followed on September 30, 2008 by a meeting among the principals in New York. Apparently impatient at the slow pace of discussions, Exelon elected to make a formal proposal on October 19, 2008 and to publicly disclose it. Notwithstanding several attempts to engage in substantive discussions over the proposal with NRG, so Exelon asserts, NRG refused to do so. The rejection of Exelon’s proposal came in the form of NRG’s letter of November 9.
NRG has a somewhat different take on the matter, as detailed in its rejection letter. For present purposes, it is enough to note that NRG’s view is that Exelon’s proposal is “opportunistically timed” and “grossly undervalues NRG on both an absolute basis and relative to Exelon’s share value…” NRG’s CEO and Chairman point out to Exelon that, based upon the proposed fixed exchange ratio of 0.485, “NRG stockholders would own 17% of the combined company while contributing 30% of a combined company recurring cash flow in 2008.”
And, for good measure, Messrs. Crane and Cosgrove of NRG object to Exelon’s negotiating style, eschewing “private negotiation” and pursuing NRG “in a highly public and preemptive manner…” Since the proposal is for an exchange offer, Messrs. Crane and Cosgrove point out, for good measure, certain “risks and concerns” concerning Exelon as a company and as an investment by NRG’s stockholders.
Exelon’s Complaint.
By its complaint, Exelon asserts these claims:
· That NRG’s board’s rejection of Exelon’s proposal represents a breach of the board’s fiduciary duties to NRG stockholders, and will cause irreparable harm to Exelon and to NRG’s stockholders;
· The adoption of any defensive measure by the NRG board (including, for example, a poison pill) would itself be a breach of the NRG board’s fiduciary duties to NRG’s stockholders; and
· The NRG board’s anticipated refusal to render Section 203 of Delaware’s General Corporation Law (Delaware’s business combination statute) inapplicable to the Exelon proposal itself is a breach of the board’s fiduciary duties to NRG’s stockholders.
Exelon seeks, by way of relief, an order from the Chancery Court declaring that the board of directors of NRG has breached its fiduciary duties in rejecting Exelon’s proposal; declaring that the board’s failure to declare Section 203 inapplicable to the Exelon proposal is a breach of its fiduciary duties; compelling NRG to approve Exelon’s proposal for purposes of Section 203; declaring that the adoption of any measure which would thwart or frustrate Exelon’s proposal would be a breach of the board’s fiduciary duties; and enjoining NRG and its officers and agents from adopting any measure that would interfere or frustrate Exelon’s proposal.
The first question is whether Exelon has standing to assert fiduciary duty breaches against the NRG board. Generally companies such as NRG owe no fiduciary duties to takeover prospectors, and that would be true here, but for the fact that Exelon owns 500 shares of NRG common stock. While nominal, that should be sufficient to confer standing upon Exelon to assert its fiduciary duty claims against the NRG board:
“Delaware courts have shown considerable latitude in entertaining fiduciary duty litigation brought by stockholders who are also themselves bidders for control. The only consistent limitation placed on those persons is that they also be stockholders at all relevant times and, thus, among those to whom a duty was owed, even if they only own one share. Of course, this rule is not based on the economic significance of such a bidder’s investment, which often is immaterial. Instead, it is based on a purely legal or equitable notion that limits to those having a relationship with the corporation the right to sue over its internal affairs.”
Omnicare, Inc. v. NCS Healthcare, Inc. 809 A.2d 1163, 1172 (Del. Ch. 2002) (footnote omitted).
So standing should not be a barrier to the assertion by Exelon of its claims, but ripeness should be. Exelon’s claims are wildly premature. Undoubtedly they have been brought to open one front in what undoubtedly will be a long campaign between Exelon and NRG. The campaign includes not only Exelon’s exchange offer and this lawsuit, but also its threatened proxy contest for NRG’s scheduled 2009 annual meeting (May 14, 2009) at which Exelon has announced that it will seek to expand the size of NRG’s board such that the directors to be elected at that meeting will constitute not less than 50% of the NRG board, and will nominate candidates to fill the newly created vacancies.
That the campaign will be a long one is virtually assured by the nature of Exelon and NRG, heavily regulated power companies. Among other approvals for the deal listed by Exelon in its S-4 preliminary offering prospectus are approvals from the Federal Energy Regulatory Commission, the Nuclear Regulatory Commission, the Pennsylvania Public Utilities Commissions, the New York Public Service Commission, the California Energy Commission, the California Public Utilities Commission, and the Public Utility Commission of Texas.
So among those cheering this battle are Wall Street lawyers and bankers.
Thursday, November 13, 2008
Tuesday, November 11, 2008
CSX v. TCI; Oral Argument Before the Second Circuit (August 25, 2008)
The oral argument on the parties’ cross-appeals in this case was heard before judges Calabresi, Newman, and Winter on August 25, 2008. We are still awaiting the Court’s decision. As I reported in my post of September 15, 2008, the panel issued a summary order on September 15 affirming Judge Kaplan’s ruling not to enjoin the voting of CSX shares by TCI and 3G. The effect of that order was to seat four of the five nominees for the CSX board put forth by TCI and 3G. The panel’s explanation of its summary order, and its ruling on Judge Kaplan’s findings of liability and his entry of a permanent injunction restraining TCI and 3G from future violations of Section 13(d) of the Exchange Act will be addressed in its forthcoming opinion that fully disposes of the parties’ appeals.
I took the occasion over this past weekend to listen to a CD of the oral argument, as presented by Chris Landau of Kirkland & Ellis for TCI and 3G and by Rory Millson of Cravath for CSX. The argument was spirited, running for about an hour. The panel was clearly well prepared and peppered counsel with questions. Indeed, the exercise reinforced the observation that an effective litigator requires a steely determination and focus, since the last thing this panel allowed counsel to do was to complete a sentence. I am sure the transcript of the oral argument reads like Joyce’s Ulysses, with the beginning of a thought appearing on one page, the middle of the thought appearing many pages later, and the conclusion of the thought appearing somewhere near the end of the transcript.
While predicting the outcome of an appeal based upon a panel’s questions is hazardous, it struck this observer that Judge Winter had difficulty with CSX’s position and will therefore vote to overturn Judge Kaplan’s decision that, by entering into cash-settled equity swaps, TCI and 3G violated Section 13(d) of the Exchange Act. Judge Calabresi, who was the most active questioner (interrupter), and Judge Newman appeared more skeptical of TCI and 3G’s position, although by several of his questions Judge Calabresi expressed concern that Judge Kaplan’s findings of fact may not have been sufficient to serve as a predicate for a finding beneficial ownership by TCI and 3G in the CSX referenced shares.
By his questioning Judge Newman focused on the realities of the relationship between TCI and the banks. He directed Landau’s attention to the passage of Judge Kaplan’s decision where the Judge quotes from the SEC’s 1977 release adopting the beneficial ownership disclosure requirements:
“It therefore is not surprising that the SEC, at the very adoption of Rule 13d-3, stated that the determination of beneficial ownership under Rule 13d-3(a) requires
‘[a]n analysis of all relevant facts and circumstances in a particular situation … in order to identify each person possessing the requisite voting power or investment power. For example, for purposes of the rule, the mere possession of the legal right to vote securities under applicable state or other law … may not be determinative of who is a beneficial owner of such securities inasmuch as another person or persons may have the power whether legal, economic, or otherwise, to direct such voting.’”
Slip Opinion at 49-50 (citing to Exchange Act Release No. 34-13291) (footnote omitted, emphasis added).
What interested Judge Newman was the reference to “otherwise” in the quoted passage and what type of “otherwise” power the SEC was referring to. Given that counterparty banks are generally indifferent to the voting of any shares they may purchase to hedge their exposure to a swap, doesn’t the long party have “otherwise” power to direct the voting of such shares? In response Landau referred to the Division of Corporation Finance’s amicus letter to Judge Kaplan of June 4, 2008, in which the Division stated clearly that “economic incentives do not constitute a sufficient basis for establishing any such [voting or investment] powers.” Judge Newman appeared to dismiss the Division’s letter as not having the authority of an SEC release, such as the one he pressed Landau on. Judge Newman even posed this hypothetical to Millson, CSX’s counsel — what if TCI had asked Deutche Bank to vote the CSX shares and Deutche Bank had said, “Sure, we’ll vote with you.” (Apparently CSX did not have the opportunity to put that question to a representative of Deutche Bank.)
Millson, repeating the stance taken in CSX’s briefs, took the position that a long party who enters into a swap referencing more than 5% of an issuer’s shares, with the intent of exercising or influencing control of the issuer, is a beneficial owner of the referenced shares. The panel appeared clearly unreceptive to adopting this position. The panel pressed Millson on Judge Kaplan’s absence of any finding that TCI and 3G “influenced” the voting by its counterparties of their CSX shares. While Judge Kaplan concluded (Slip Opinion at 61) that there is “reason to believe that TCI was in a position to influence the counterparties, especially Deutche Bank, with respect to the exercise of their voting rights,” Millson had to concede that that was not a finding of influence.
Landau pressed the panel with TCI’s argument that Rule 13d-3 cannot extend beyond Section 13(d) of the Exchange Act and that a party must have “beneficial ownership” of shares before a reporting obligation under Section 13(d) arises. Judge Newman in particular appeared to have trouble with this claim, particularly in the context of the “plan or scheme” language of Rule 13d-(b), which extends “beneficial ownership” of shares to any “trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose or effect of … preventing the vesting of … beneficial ownership as part of a plan or scheme to evade the reporting requirements of Section 13(d) or 13(b) of the [Exchange] Act, …” (Emphasis added.) (The Division of Corporation Finance, in its amicus letter of June 4, 2008, stated its belief that Rule 13d‑3, “properly construed, is narrower in coverage than the statute.”) How, asked Judge Newman, can actual beneficial ownership be a predicate to a trigger for Section 13(d) reporting if the trigger includes arrangements or devices to “prevent” the vesting of beneficial ownership?
It is hard to say where this will come out. If I had to read the tea leaves, I would guess that Judge Calabresi would opt for sending the case back to Judge Kaplan for further findings, Judge Newman would affirm, and Judge Winter would reverse.
Or the panel, with judges Calabresi and Newman in the majority, could affirm Judge Kaplan’s finding of violation on grounds suggested by Professor Coffee, as discussed in my post of August 23, 2008:
“The ‘voting power’ prong [of Rule 13d-3(a)] has, however, greater promise. Most swaps dealers do not vote the shares they buy to hedge their position for a variety of reasons: because they have no economic motive to vote, because they fear losing Schedule 13G eligibility, or because it is more profitable to lend their shares to short sellers. Those that do vote often divide their votes, voting both ways according to some formula or according to the recommendations of a proxy advisory firm. Thus, the repeated act of recalling shares just prior to the record date and relending the shares immediately afterward does distinguish Deutsche Bank in this case from the vast majority of swaps dealers. A narrower decision, written on this rationale, could find a violation [of Schedule 13(d)] without generally deeming the ‘long’ side of an equity swap to be the beneficial owner of the referenced shares held by the dealer.”
Coffee, “The Wreck of the CSX: Transparency and Derivatives,” NY Law Journal (July 17, 2008).
For my prior commentary on this case, see my posts of September 15, August 23, 13, and 1, July 30, 26, and 17, and June 24 and 23.
I took the occasion over this past weekend to listen to a CD of the oral argument, as presented by Chris Landau of Kirkland & Ellis for TCI and 3G and by Rory Millson of Cravath for CSX. The argument was spirited, running for about an hour. The panel was clearly well prepared and peppered counsel with questions. Indeed, the exercise reinforced the observation that an effective litigator requires a steely determination and focus, since the last thing this panel allowed counsel to do was to complete a sentence. I am sure the transcript of the oral argument reads like Joyce’s Ulysses, with the beginning of a thought appearing on one page, the middle of the thought appearing many pages later, and the conclusion of the thought appearing somewhere near the end of the transcript.
While predicting the outcome of an appeal based upon a panel’s questions is hazardous, it struck this observer that Judge Winter had difficulty with CSX’s position and will therefore vote to overturn Judge Kaplan’s decision that, by entering into cash-settled equity swaps, TCI and 3G violated Section 13(d) of the Exchange Act. Judge Calabresi, who was the most active questioner (interrupter), and Judge Newman appeared more skeptical of TCI and 3G’s position, although by several of his questions Judge Calabresi expressed concern that Judge Kaplan’s findings of fact may not have been sufficient to serve as a predicate for a finding beneficial ownership by TCI and 3G in the CSX referenced shares.
By his questioning Judge Newman focused on the realities of the relationship between TCI and the banks. He directed Landau’s attention to the passage of Judge Kaplan’s decision where the Judge quotes from the SEC’s 1977 release adopting the beneficial ownership disclosure requirements:
“It therefore is not surprising that the SEC, at the very adoption of Rule 13d-3, stated that the determination of beneficial ownership under Rule 13d-3(a) requires
‘[a]n analysis of all relevant facts and circumstances in a particular situation … in order to identify each person possessing the requisite voting power or investment power. For example, for purposes of the rule, the mere possession of the legal right to vote securities under applicable state or other law … may not be determinative of who is a beneficial owner of such securities inasmuch as another person or persons may have the power whether legal, economic, or otherwise, to direct such voting.’”
Slip Opinion at 49-50 (citing to Exchange Act Release No. 34-13291) (footnote omitted, emphasis added).
What interested Judge Newman was the reference to “otherwise” in the quoted passage and what type of “otherwise” power the SEC was referring to. Given that counterparty banks are generally indifferent to the voting of any shares they may purchase to hedge their exposure to a swap, doesn’t the long party have “otherwise” power to direct the voting of such shares? In response Landau referred to the Division of Corporation Finance’s amicus letter to Judge Kaplan of June 4, 2008, in which the Division stated clearly that “economic incentives do not constitute a sufficient basis for establishing any such [voting or investment] powers.” Judge Newman appeared to dismiss the Division’s letter as not having the authority of an SEC release, such as the one he pressed Landau on. Judge Newman even posed this hypothetical to Millson, CSX’s counsel — what if TCI had asked Deutche Bank to vote the CSX shares and Deutche Bank had said, “Sure, we’ll vote with you.” (Apparently CSX did not have the opportunity to put that question to a representative of Deutche Bank.)
Millson, repeating the stance taken in CSX’s briefs, took the position that a long party who enters into a swap referencing more than 5% of an issuer’s shares, with the intent of exercising or influencing control of the issuer, is a beneficial owner of the referenced shares. The panel appeared clearly unreceptive to adopting this position. The panel pressed Millson on Judge Kaplan’s absence of any finding that TCI and 3G “influenced” the voting by its counterparties of their CSX shares. While Judge Kaplan concluded (Slip Opinion at 61) that there is “reason to believe that TCI was in a position to influence the counterparties, especially Deutche Bank, with respect to the exercise of their voting rights,” Millson had to concede that that was not a finding of influence.
Landau pressed the panel with TCI’s argument that Rule 13d-3 cannot extend beyond Section 13(d) of the Exchange Act and that a party must have “beneficial ownership” of shares before a reporting obligation under Section 13(d) arises. Judge Newman in particular appeared to have trouble with this claim, particularly in the context of the “plan or scheme” language of Rule 13d-(b), which extends “beneficial ownership” of shares to any “trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose or effect of … preventing the vesting of … beneficial ownership as part of a plan or scheme to evade the reporting requirements of Section 13(d) or 13(b) of the [Exchange] Act, …” (Emphasis added.) (The Division of Corporation Finance, in its amicus letter of June 4, 2008, stated its belief that Rule 13d‑3, “properly construed, is narrower in coverage than the statute.”) How, asked Judge Newman, can actual beneficial ownership be a predicate to a trigger for Section 13(d) reporting if the trigger includes arrangements or devices to “prevent” the vesting of beneficial ownership?
It is hard to say where this will come out. If I had to read the tea leaves, I would guess that Judge Calabresi would opt for sending the case back to Judge Kaplan for further findings, Judge Newman would affirm, and Judge Winter would reverse.
Or the panel, with judges Calabresi and Newman in the majority, could affirm Judge Kaplan’s finding of violation on grounds suggested by Professor Coffee, as discussed in my post of August 23, 2008:
“The ‘voting power’ prong [of Rule 13d-3(a)] has, however, greater promise. Most swaps dealers do not vote the shares they buy to hedge their position for a variety of reasons: because they have no economic motive to vote, because they fear losing Schedule 13G eligibility, or because it is more profitable to lend their shares to short sellers. Those that do vote often divide their votes, voting both ways according to some formula or according to the recommendations of a proxy advisory firm. Thus, the repeated act of recalling shares just prior to the record date and relending the shares immediately afterward does distinguish Deutsche Bank in this case from the vast majority of swaps dealers. A narrower decision, written on this rationale, could find a violation [of Schedule 13(d)] without generally deeming the ‘long’ side of an equity swap to be the beneficial owner of the referenced shares held by the dealer.”
Coffee, “The Wreck of the CSX: Transparency and Derivatives,” NY Law Journal (July 17, 2008).
For my prior commentary on this case, see my posts of September 15, August 23, 13, and 1, July 30, 26, and 17, and June 24 and 23.
Thursday, November 6, 2008
Comet Systems, Inc. v. MIVA, Inc.; Are Change-of-Control Bonuses Properly Deductible in Calculating Earnout Payments?
Comet was merged into a subsidiary of MIVA. The merger consideration consisted, in part, of a potential $10 million earnout, which could be earned over 2004 and 2005. The earnout was based upon Comet’s performance relative to three performance goals. One of the goals was a function in part of cost, defined in the merger agreement as “Operating Costs Excluding Amortization and One-time, Non-recurring Expenses.”
In anticipation of a potential transaction, Comet had adopted a bonus plan providing for the award of bonuses solely in the event of an acquisition or similar transaction. Under the plan, Comet paid out bonuses in connection with the MIVA merger, from the merger proceeds. MIVA deducted the payments as a cost in calculating the earnout, resulting in a reduced earnout payment.
A. The Bonuses Were Not A Proper Deduction
Vice Chancellor Lamb, in his opinion of October 22, 2008 (2008 WL 4661829), had little difficulty siding with the former stockholders of Comet in concluding that the “cost” of the merger bonuses was not an “operating cost” as defined in the merger agreement.
Delaware follows the “objective” theory of contracts whereby a contract’s construction should be that which would be understood by an objective, reasonable third party. The contract terms themselves are controlling when they establish the parties’ common meaning so that a reasonable person in the position of either party would have no expectation inconsistent with the contract language. Slip Opinion at 10-11, quoting Eagle Industries, Inc. v. DeVilbiss Healthcare, Inc., 702 A.2d 1228, 1232 (Del. 1997). MIVA argued that the merger bonuses qualified as an “ordinary” cost of doing business because they contribute to employee retention during a sales process. Responded Vice Chancellor Lamb:
“But the fact than an expense qualifies as an ordinary cost of business does not preclude treatment of that expense as one-time and non-recurring. Black’s Law Dictionary defines a ‘one-time charge’ as ‘[a]n ordinary cost of business excluded from income calculations.’ Thus, simply qualifying a cost as ordinary is not sufficient to dispositively determine that the cost is not one-time and non-recurring.”
Slip Opinion at 11.
The Vice Chancellor’s explanation of earnouts is instructive:
“Earnouts are typically used where the buyer and seller cannot agree on a price because the seller is more optimistic about the future prospects of a business than is the buyer. As a result, charges and costs which occur as a result of the merger and are not expected to be representative of future costs in the business are reasonably excluded. The natural reading ‘one-time, non-recurring expenses’ is to exclude exactly such charges.”
Slip Opinion at 11-12 (footnotes omitted).
B. Time For Performance
MIVA delayed an earnout payment it calculated was due, from March 2005 until June 2006. It argued that because there was no time specified for payment of any earnout amount in the merger agreement, the Court should not award interest on the amount due to the delay in its payment.
A specific payment covenant was not necessary, ruled the Vice Chancellor, because in every contract there is implied a promise or duty to perform with reasonable expediency the thing agreed to be done, and a failure to do so is a breach of contract. Slip Opinion at 18, citing Williston On Contracts. Therefore, MIVA had a duty to make the earnout payment within a “reasonable” time in the absence of a contractual term to the contrary. MIVA therefore should have made the payment within 90 days of its determination, and accordingly the plaintiff stockholders were entitled to interest on the overdue payment, notwithstanding the silence of the merger agreement on the time for payment.
In anticipation of a potential transaction, Comet had adopted a bonus plan providing for the award of bonuses solely in the event of an acquisition or similar transaction. Under the plan, Comet paid out bonuses in connection with the MIVA merger, from the merger proceeds. MIVA deducted the payments as a cost in calculating the earnout, resulting in a reduced earnout payment.
A. The Bonuses Were Not A Proper Deduction
Vice Chancellor Lamb, in his opinion of October 22, 2008 (2008 WL 4661829), had little difficulty siding with the former stockholders of Comet in concluding that the “cost” of the merger bonuses was not an “operating cost” as defined in the merger agreement.
Delaware follows the “objective” theory of contracts whereby a contract’s construction should be that which would be understood by an objective, reasonable third party. The contract terms themselves are controlling when they establish the parties’ common meaning so that a reasonable person in the position of either party would have no expectation inconsistent with the contract language. Slip Opinion at 10-11, quoting Eagle Industries, Inc. v. DeVilbiss Healthcare, Inc., 702 A.2d 1228, 1232 (Del. 1997). MIVA argued that the merger bonuses qualified as an “ordinary” cost of doing business because they contribute to employee retention during a sales process. Responded Vice Chancellor Lamb:
“But the fact than an expense qualifies as an ordinary cost of business does not preclude treatment of that expense as one-time and non-recurring. Black’s Law Dictionary defines a ‘one-time charge’ as ‘[a]n ordinary cost of business excluded from income calculations.’ Thus, simply qualifying a cost as ordinary is not sufficient to dispositively determine that the cost is not one-time and non-recurring.”
Slip Opinion at 11.
The Vice Chancellor’s explanation of earnouts is instructive:
“Earnouts are typically used where the buyer and seller cannot agree on a price because the seller is more optimistic about the future prospects of a business than is the buyer. As a result, charges and costs which occur as a result of the merger and are not expected to be representative of future costs in the business are reasonably excluded. The natural reading ‘one-time, non-recurring expenses’ is to exclude exactly such charges.”
Slip Opinion at 11-12 (footnotes omitted).
B. Time For Performance
MIVA delayed an earnout payment it calculated was due, from March 2005 until June 2006. It argued that because there was no time specified for payment of any earnout amount in the merger agreement, the Court should not award interest on the amount due to the delay in its payment.
A specific payment covenant was not necessary, ruled the Vice Chancellor, because in every contract there is implied a promise or duty to perform with reasonable expediency the thing agreed to be done, and a failure to do so is a breach of contract. Slip Opinion at 18, citing Williston On Contracts. Therefore, MIVA had a duty to make the earnout payment within a “reasonable” time in the absence of a contractual term to the contrary. MIVA therefore should have made the payment within 90 days of its determination, and accordingly the plaintiff stockholders were entitled to interest on the overdue payment, notwithstanding the silence of the merger agreement on the time for payment.
Wednesday, November 5, 2008
In re Loral Space and Communications Inc. Consolidated Litigation; How Not to Run a Special Committee
MHR Fund Management LLC, an eponymous hedge fund created by Mark H. Rachesky (the “MHR” of the fund, a former lieutenant of Carl Icahn) owned 36% of Loral Space and Communications Inc. (“Loral”), having obtained its position through Loral’s bankruptcy. MHR proposed investing an additional $300 million in Loral. To establish the fairness of the terms of the investment, Loral established a two person special committee to negotiate the deal. The effort turned out to be a miserable failure, as found by Vice Chancellor Strine in his opinion after trial. In re Loral Space and Communications Inc. Consolidated Litigation, 2008 WL 4293781 (September 19, 2008). The Vice Chancellor’s opinion offers a checklist for how not to run a special committee.
A. The Basics
Delaware statutory law, GCL §144, reflects the modern trend of not voiding interested director/officer contracts if certain conditions are satisfied, including —
(i) That the material facts as to the director’s or officer’s relationship or interest are disclosed or known to the board or any committee thereof, and the board or committee, in good faith, authorizes the contract or transaction by the affirmative votes of a majority of disinterested directors, even if the number of disinterested directors be less than a quorum, or
(ii) The contract or transaction is fair as to the corporation as of the time it is authorized, approved or ratified by the board or a committee thereof.
Delaware’s common or “judge-made” law applies the “entire fairness standard” to interested party contracts or arrangements “where a majority of the board is interested or lacks independence from the interested party.” Slip Opinion at 46, note 109.
The entire fairness standard requires a court to consider two factors — fair dealing and fair price. “Fair dealing” involves a fact intensive inquiry and “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.” Slip Opinion at 49 (citing Weinberger v. UOP, Inc. 457 A.2d 701, 711 (Del. 1983)).
The fair price inquiry focuses upon whether the price and the terms of the transaction were the best terms reasonably available.
The use of a special committee of the board, comprised of directors independent of the “interested” party, to negotiate and approve an interested-party transaction, can be a device to shift the burden of persuasion on the issue of fairness from the interested parties to the plaintiff. In re Cysive Shareholders Litigation, 836 A.2d 531, 547-51 (Del. Ch. 2003).
To be effective, a special committee must function “as an effective proxy for arms-length bargaining, such that a fair outcome equivalent to a market-tested deal” is reached. Slip Opinion at 49. To be effective a special committee should be composed of competent and motivated directors independent of the interested party, assisted by competent financial and legal advisors.
B. The Loral Special Committee
Effective it was not.
Composition. First, it failed the composition test. It consisted of only two directors, a chairman — John D. Harkey, Jr. — whom Vice Chancellor Strine concluded was affiliated with MHR, and director Arthur L. Simon, whom the Vice Chancellor found to be ineffectual. Harkey was listed by MHR as one of its “selected investment advisors,” and had long business and social ties with Rachesky, MHR’s founder and managing director. Harkey also solicited investments in his own company from MHR during his service on the Special Committee! Moreover, during the Special Committee’s deliberations, Harkey copied MHR on internal Committee communications, “including its fallback position on a key negotiating point.” Slip Opinion at 50.
Serving as a director on a public company’s board of directors can be hazardous to one’s reputation. No individual should consent to doing so without realizing that his or her behavior may be put under a microscope. Vice Chancellor Strine’s treatment of Committee member Simon illustrates these admonitions. His treatment of Simon is withering. Simon “brought the scientific concept of inertia to the Special Committee by generally remaining at rest until set into motion by the Committee’s advisors.” Slip Opinion at 50.
“The record reveals that Simon was confused about the status of key issues at several points throughout the process. Although Simon lacked any conflicting ties to MHR, he demonstrated neither the knowledge nor the inclination to prod Harkey and the Special Committee’s advisors toward an effective and aggressive strategy to ensure Loral got a fair deal.”
Slip Opinion at 51.
The Vice Chancellor quotes emails from Simon exclaiming “what is happening???” and “I am wondering where we are headed.” Slip Opinion at 35-36. And here’s the coup de grace:
“Later in the process, Simon went camping on a remote lake with no electricity for a one-month period beginning in late August. Simon took a six-mile boat trip for ‘a couple telephone meetings’ during that time, but his involvement was clearly limited. Simon’s emails and his role while he was camping at the lake are consistent with the impression that Simon gave at trial—someone who realized that he had responsibilities as a Special Committee member but who was content to simply show up by telephone at meetings when the Special Committee’s advisors called for one. As a result, Simon was often unaware of or perplexed by the state of the negotiations.”
Slip Opinion at 36 (footnote omitted).
Advisors. The Special Committee was appointed by the Loral board on April 7, 2006. It did nothing until holding its first meeting on May 15, 2006, at which time it selected King & Spalding as its legal advisor. MHR’s financial advisor was Deutsche Bank. Despite its considering larger financial advisors, referred to by the Vice Chancellor as those in the “bulge bracket,” the Committee ultimately settled on North Point Advisors LLC, a small investment bank with whom Harkey had worked in the past. Mistake. North Point, observed Vice Chancellor Strine, “was outgunned and outwitted,” and “not qualified to swim in the deep end.” Slip Opinion at 51.
The day after its first meeting, held May 15, 2006, the Special Committee received from MHR its letter of intent of proposed terms for a $300 million convertible preferred stock investment. North Point had no experience in the satellite industry, Loral’s business. It had little if any experience with the type of convertible preferred equity financing MHR proposed. North Point’s principal, David Jacquin, a former Cravath M&A attorney, advised the Committee that he would work with a former colleague experienced with this type of equity investment, but in fact never sought out his help.
The Special Committee agreed to the basic terms of the proposed MHR convertible preferred equity financing on June 7, 2006, only 11 days after North Point was hired. North Point did not conduct any market check:
“After that [the June 7, 2006 meeting], North Point remained inactive, claiming to make two phone calls to gauge interest, but never undertaking or seeking the mandate to undertake the kind of market search that an effective investment bank would have. Indeed, North Point seemed to lean on MHR’s bank, Deutsche Bank, as providing a reasonable basis for being so passive and not seeking to engender market competition.”
Slip Opinion at 52 (footnote omitted).
Other failings cited by the Vice Chancellor in North Point’s performance included its slanting its presentation to make the MHR financing appear fairer than it was, and not assisting the Committee in exercising the leverage it had on several occasions to strike a better deal for Loral and its non-MHR stockholders.
While King & Spalding escapes the severe criticism leveled by the Vice Chancellor at North Point, it is not left unscathed. “Regrettably,” the Vice Chancellor observed, “the ineffectiveness of North Point was not overcome by the presence of transactional lawyers with a large strategic view of their role as counsel.” While the firm is well respected, it did not help the Committee “overcome the lack of any strategic thinking by either North Point or the Special Committee itself.” Slip Opinion at 53.
Limited Mandate. Repeatedly throughout his opinion the Vice Chancellor returns to two critical failings by the Special Committee, besides its composition and its selection of a financial advisor, namely, its limited mandate and its failure to conduct a market check of the terms proposed by MHR for the convertible preferred financing.
The Special Committee was remiss in accepting MHR’s mandate “that it [Loral] had to get $300 million in equity financing and get it quick.” Slip Opinion at 54. What the Committee should have done was consider a broader mandate, including the possibility of a sale of the entire company (given that $300 million in equity financing represented more than half of the then market capitalization of Loral). Loral’s other investment banker, Morgan Stanley, even suggested early on alternative routes to meeting its capital needs, including a combination of equity and debt financing, but that option was rejected by the Special Committee as not consistent with its mandate (dictated by MHR). Nor did the Committee ever seriously consider an equity offering made to all of Loral stockholders, with a backstop provided by MHR (whereby it would take up any equity securities not purchased by the other Loral stockholders). In summary:
“A Special Committee that was formed in early April [2006] and did not hire a financial advisor until May 23, used a month and a half to do nothing. Then it cut the key economic terms of a deal 11 days later with no market check. Then, when things dragged on another three months, it never used the time to widen its perspective and market test its assumptions.”
Slip Opinion at 55.
Fair Price. Having found that the composition of the Special Committee and its advisors were not up to the task of negotiating effectively with Loral’s controlling stockholder, MHR, and that the Committee did not follow a fair process in negotiating the $300 million convertible preferred stock investment by MHR, Vice Chancellor Strine wasted little time in concluding that the terms of the investment were not fair to Loral. The terms found unfair including the following:
• The MHR convertible preferred carried a 7.5% dividend, which exceeded the 5.0% median of even the comparables North Point explored;
• The 12% conversion premium (to Loral’s closing price the day before the date the deal was signed on October 17, 2006) was substantially smaller than the 19.8% median conversion price of the North Point and Morgan Stanley comps;
• The preferred stock called for dividends to be paid in kind (that is, in additional shares of preferred stock) for the first five years, which was inconsistent with market practices, which usually allow the issuer to pay in cash or PIK at its option;
• The Special Committee awarded MHR a placement fee of $6.75 million even though, as observed by the Vice Chancellor, “nothing was placed…” (Slip Opinion at 66); and
• MHR extracted “incredibly broad class voting rights for itself” in the Certificate of Designation, effectively granting MHR “an iron grip on Loral and the ability to extract a control premium for itself in any future Change of Control…” (Slip Opinion at 66, 67 (footnote omitted)).
C. Remedy
Perhaps the most notable feature of Vice Chancellor Strine’s opinion is the remedy he crafted. He found that the terms of the $300 million convertible preferred stock were not fair to Loral. Exercising his equitable powers, he “reformed” the securities purchase agreement pursuant to which the preferred stock was issued to MHR to replace the preferred stock issued thereunder with non-voting common stock! To calculate the number of non-voting common shares to be issued to MHR, the Vice Chancellor took the $300 million investment (minus the $6.75 million placement fee), and divided the difference by $30.85, the mean between $34.78 (MHR’s contemporaneous valuation of Loral’s stock at the time of the deal), and $26.92 (Loral’s trading price at the time of the deal). Thus, in lieu of the convertible preferred stock Loral issued to MHR MHR will, instead, receive 9,505,673 Loral non-voting common shares.
MHR howled to the Vice Chancellor that he had no such power. The Vice Chancellor of course disagreed, relying upon Delaware Supreme Court precedent that the Court of Chancery has broad remedial power to address breaches of the duty of loyalty. See Slip Opinion at 75 and notes 160 and 161 (citations).
Certainly if MHR appeals Vice Chancellor Strine’s decision, the equitable remedy he crafted will be a central focus of the appeal.
A. The Basics
Delaware statutory law, GCL §144, reflects the modern trend of not voiding interested director/officer contracts if certain conditions are satisfied, including —
(i) That the material facts as to the director’s or officer’s relationship or interest are disclosed or known to the board or any committee thereof, and the board or committee, in good faith, authorizes the contract or transaction by the affirmative votes of a majority of disinterested directors, even if the number of disinterested directors be less than a quorum, or
(ii) The contract or transaction is fair as to the corporation as of the time it is authorized, approved or ratified by the board or a committee thereof.
Delaware’s common or “judge-made” law applies the “entire fairness standard” to interested party contracts or arrangements “where a majority of the board is interested or lacks independence from the interested party.” Slip Opinion at 46, note 109.
The entire fairness standard requires a court to consider two factors — fair dealing and fair price. “Fair dealing” involves a fact intensive inquiry and “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.” Slip Opinion at 49 (citing Weinberger v. UOP, Inc. 457 A.2d 701, 711 (Del. 1983)).
The fair price inquiry focuses upon whether the price and the terms of the transaction were the best terms reasonably available.
The use of a special committee of the board, comprised of directors independent of the “interested” party, to negotiate and approve an interested-party transaction, can be a device to shift the burden of persuasion on the issue of fairness from the interested parties to the plaintiff. In re Cysive Shareholders Litigation, 836 A.2d 531, 547-51 (Del. Ch. 2003).
To be effective, a special committee must function “as an effective proxy for arms-length bargaining, such that a fair outcome equivalent to a market-tested deal” is reached. Slip Opinion at 49. To be effective a special committee should be composed of competent and motivated directors independent of the interested party, assisted by competent financial and legal advisors.
B. The Loral Special Committee
Effective it was not.
Composition. First, it failed the composition test. It consisted of only two directors, a chairman — John D. Harkey, Jr. — whom Vice Chancellor Strine concluded was affiliated with MHR, and director Arthur L. Simon, whom the Vice Chancellor found to be ineffectual. Harkey was listed by MHR as one of its “selected investment advisors,” and had long business and social ties with Rachesky, MHR’s founder and managing director. Harkey also solicited investments in his own company from MHR during his service on the Special Committee! Moreover, during the Special Committee’s deliberations, Harkey copied MHR on internal Committee communications, “including its fallback position on a key negotiating point.” Slip Opinion at 50.
Serving as a director on a public company’s board of directors can be hazardous to one’s reputation. No individual should consent to doing so without realizing that his or her behavior may be put under a microscope. Vice Chancellor Strine’s treatment of Committee member Simon illustrates these admonitions. His treatment of Simon is withering. Simon “brought the scientific concept of inertia to the Special Committee by generally remaining at rest until set into motion by the Committee’s advisors.” Slip Opinion at 50.
“The record reveals that Simon was confused about the status of key issues at several points throughout the process. Although Simon lacked any conflicting ties to MHR, he demonstrated neither the knowledge nor the inclination to prod Harkey and the Special Committee’s advisors toward an effective and aggressive strategy to ensure Loral got a fair deal.”
Slip Opinion at 51.
The Vice Chancellor quotes emails from Simon exclaiming “what is happening???” and “I am wondering where we are headed.” Slip Opinion at 35-36. And here’s the coup de grace:
“Later in the process, Simon went camping on a remote lake with no electricity for a one-month period beginning in late August. Simon took a six-mile boat trip for ‘a couple telephone meetings’ during that time, but his involvement was clearly limited. Simon’s emails and his role while he was camping at the lake are consistent with the impression that Simon gave at trial—someone who realized that he had responsibilities as a Special Committee member but who was content to simply show up by telephone at meetings when the Special Committee’s advisors called for one. As a result, Simon was often unaware of or perplexed by the state of the negotiations.”
Slip Opinion at 36 (footnote omitted).
Advisors. The Special Committee was appointed by the Loral board on April 7, 2006. It did nothing until holding its first meeting on May 15, 2006, at which time it selected King & Spalding as its legal advisor. MHR’s financial advisor was Deutsche Bank. Despite its considering larger financial advisors, referred to by the Vice Chancellor as those in the “bulge bracket,” the Committee ultimately settled on North Point Advisors LLC, a small investment bank with whom Harkey had worked in the past. Mistake. North Point, observed Vice Chancellor Strine, “was outgunned and outwitted,” and “not qualified to swim in the deep end.” Slip Opinion at 51.
The day after its first meeting, held May 15, 2006, the Special Committee received from MHR its letter of intent of proposed terms for a $300 million convertible preferred stock investment. North Point had no experience in the satellite industry, Loral’s business. It had little if any experience with the type of convertible preferred equity financing MHR proposed. North Point’s principal, David Jacquin, a former Cravath M&A attorney, advised the Committee that he would work with a former colleague experienced with this type of equity investment, but in fact never sought out his help.
The Special Committee agreed to the basic terms of the proposed MHR convertible preferred equity financing on June 7, 2006, only 11 days after North Point was hired. North Point did not conduct any market check:
“After that [the June 7, 2006 meeting], North Point remained inactive, claiming to make two phone calls to gauge interest, but never undertaking or seeking the mandate to undertake the kind of market search that an effective investment bank would have. Indeed, North Point seemed to lean on MHR’s bank, Deutsche Bank, as providing a reasonable basis for being so passive and not seeking to engender market competition.”
Slip Opinion at 52 (footnote omitted).
Other failings cited by the Vice Chancellor in North Point’s performance included its slanting its presentation to make the MHR financing appear fairer than it was, and not assisting the Committee in exercising the leverage it had on several occasions to strike a better deal for Loral and its non-MHR stockholders.
While King & Spalding escapes the severe criticism leveled by the Vice Chancellor at North Point, it is not left unscathed. “Regrettably,” the Vice Chancellor observed, “the ineffectiveness of North Point was not overcome by the presence of transactional lawyers with a large strategic view of their role as counsel.” While the firm is well respected, it did not help the Committee “overcome the lack of any strategic thinking by either North Point or the Special Committee itself.” Slip Opinion at 53.
Limited Mandate. Repeatedly throughout his opinion the Vice Chancellor returns to two critical failings by the Special Committee, besides its composition and its selection of a financial advisor, namely, its limited mandate and its failure to conduct a market check of the terms proposed by MHR for the convertible preferred financing.
The Special Committee was remiss in accepting MHR’s mandate “that it [Loral] had to get $300 million in equity financing and get it quick.” Slip Opinion at 54. What the Committee should have done was consider a broader mandate, including the possibility of a sale of the entire company (given that $300 million in equity financing represented more than half of the then market capitalization of Loral). Loral’s other investment banker, Morgan Stanley, even suggested early on alternative routes to meeting its capital needs, including a combination of equity and debt financing, but that option was rejected by the Special Committee as not consistent with its mandate (dictated by MHR). Nor did the Committee ever seriously consider an equity offering made to all of Loral stockholders, with a backstop provided by MHR (whereby it would take up any equity securities not purchased by the other Loral stockholders). In summary:
“A Special Committee that was formed in early April [2006] and did not hire a financial advisor until May 23, used a month and a half to do nothing. Then it cut the key economic terms of a deal 11 days later with no market check. Then, when things dragged on another three months, it never used the time to widen its perspective and market test its assumptions.”
Slip Opinion at 55.
Fair Price. Having found that the composition of the Special Committee and its advisors were not up to the task of negotiating effectively with Loral’s controlling stockholder, MHR, and that the Committee did not follow a fair process in negotiating the $300 million convertible preferred stock investment by MHR, Vice Chancellor Strine wasted little time in concluding that the terms of the investment were not fair to Loral. The terms found unfair including the following:
• The MHR convertible preferred carried a 7.5% dividend, which exceeded the 5.0% median of even the comparables North Point explored;
• The 12% conversion premium (to Loral’s closing price the day before the date the deal was signed on October 17, 2006) was substantially smaller than the 19.8% median conversion price of the North Point and Morgan Stanley comps;
• The preferred stock called for dividends to be paid in kind (that is, in additional shares of preferred stock) for the first five years, which was inconsistent with market practices, which usually allow the issuer to pay in cash or PIK at its option;
• The Special Committee awarded MHR a placement fee of $6.75 million even though, as observed by the Vice Chancellor, “nothing was placed…” (Slip Opinion at 66); and
• MHR extracted “incredibly broad class voting rights for itself” in the Certificate of Designation, effectively granting MHR “an iron grip on Loral and the ability to extract a control premium for itself in any future Change of Control…” (Slip Opinion at 66, 67 (footnote omitted)).
C. Remedy
Perhaps the most notable feature of Vice Chancellor Strine’s opinion is the remedy he crafted. He found that the terms of the $300 million convertible preferred stock were not fair to Loral. Exercising his equitable powers, he “reformed” the securities purchase agreement pursuant to which the preferred stock was issued to MHR to replace the preferred stock issued thereunder with non-voting common stock! To calculate the number of non-voting common shares to be issued to MHR, the Vice Chancellor took the $300 million investment (minus the $6.75 million placement fee), and divided the difference by $30.85, the mean between $34.78 (MHR’s contemporaneous valuation of Loral’s stock at the time of the deal), and $26.92 (Loral’s trading price at the time of the deal). Thus, in lieu of the convertible preferred stock Loral issued to MHR MHR will, instead, receive 9,505,673 Loral non-voting common shares.
MHR howled to the Vice Chancellor that he had no such power. The Vice Chancellor of course disagreed, relying upon Delaware Supreme Court precedent that the Court of Chancery has broad remedial power to address breaches of the duty of loyalty. See Slip Opinion at 75 and notes 160 and 161 (citations).
Certainly if MHR appeals Vice Chancellor Strine’s decision, the equitable remedy he crafted will be a central focus of the appeal.
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