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.