Much of the march of corporate governance law, as with civilization generally, is to restrain the excesses of the powerful. An illustration is Chancellor Chandler’s important decision in In Re John Q. Hammons Hotels Inc. Shareholder Litigation, 2009 WL 3165613 (October 2, 2009). The Chancellor’s decision is in response to cross motions for summary judgment, and comes some four years after the challenged merger closed on September 16, 2005. In the course of his decision, the Chancellor articulates standards for “majority of the minority” stockholder votes that in certain circumstances would permit the application of a business judgment rather than an entire fairness standard of review for interested-party mergers, applies strict standards to the disclosure of conflicts involving a special committee’s advisors, and applies a surprisingly expansive standard to an aiding and abetting claim against an unaffiliated buyer.
A. John Q. Hammons and His Eponymous Company
John Q. Hammons controlled John Q. Hammons Hotels, Inc. (the “Company”). The Company, an owner and manager of hotels, when public in 1994. It had two classes of stock, Class A and Class B. Hammons and his affiliates owned 5% of the Class A shares and all of the Class B shares, the latter of which had super voting rights. Through his stock holdings, Hammons controlled 75% of the voting power of the Company.
The hotels were owned and operated by a limited partnership of which the Company was the sole general partner. The Company owned a 28% interest in the limited partnership; Hammons owned the remaining the 72% interest (as a limited partner) in the partnership.
Hammons is obviously old school, regarding the trappings of corporate governance as a nuisance. Thus –
• He “disliked the procedural requirements associated with public stockholders and a board of directors, . . . (Slip Opinion at 6).
• He hired the Company’s President in 2001 “without consulting the Board . . .” Id.
• The Company had numerous related party transactions with Hammons: he owned a hotel management company that provided accounting and other administrative services to the Company; owned a 50% interest in the entity from which the Company leased its corporate headquarters; utilized the Company for administrative and other services for his outside business interests (for which he reimbursed the Company); utilized the services of Company employees in his personal enterprises; and owned real estate underlying one of the Company’s hotels that the Company leased from him.
• He threatened legal action against the Board to prevent it from pursuing the sale of certain hotels that the Board concluded were no longer “core assets” of the Company.
• He entered into a side agreement with a broker retained to sell one of the Company’s properties, which granted Hammons a right of first refusal, without disclosing the agreement to the Board.
B. Merger of the Company
Consistent with his style, in early 2004 Hammons informed the Board that he had begun discussions with a third party regarding a sale of the Company and/or his interest in the Company. Hammons’ hand-picked suitor offered $13 per share for all of the outstanding Class A shares. The deal included extensive agreements with Hammons to accommodate his desires to avoid taxation of the disposition of his interest in the Company, to provide him with financing to continue his development of hotels, and to grant to him, by distribution from the buyer, one of the Company’s premier properties.
The deal with the initial suitor eventually went away. The deal that was done, and is the subject of this litigation, was done with affiliates of Jonathan Eilian, an unaffiliated third party. Eilian eventually negotiated a deal whereby his acquisition vehicles would pay $24 in cash per share to the Class A stockholders and accommodate Hammons’ tax, line of credit, and property desires. The deal was negotiated by a special committee of the Company’s board, comprised of independent directors, who retained Lehman Brothers as its financial advisor and the Katten Muchin firm as its legal advisor.
C. Critical Facts
The special committee negotiated with Eilian a not uncommon protection for the minority stockholders, namely, that the deal be approved by a majority of the Class A shareholders of the Company other than Hammons and his affiliates, but, as it turns out, the agreement was deficient in two respects: the condition was to secure the approval of a majority of the Class A shares voting on the merger, and the condition was waivable by the special committee.
As an illustration of why principals should restrain their deal analysis in public, the record in this case included Eilian’s description, in an email sent during the negotiations, of his observation that Hammons practiced a “liberal” mixing of private and personal expenses and competitive interests; and, in one of his early letters to the special committee, his recognition of the “perceived conflicts of interest with the controlling Class B shareholder [Hammons]” as one explanation for the underperformance of the Company’s shares. Further, in an early presentation of his proposal for acquiring the Company, Eilian cited “unique issues of [the] controlling shareholder” as one source of the Company’s trading discount. Slip Opinion at 45. (Prior to merger rumors, the Company’s shares traded in the $4 to $7 range. It went public at $16.50 per share in 1994).
Two facts of interest here turned out to be relevant to the plaintiffs’ claims of nondisclosure: Katten Muchin represented the lender that provided the financing for Eilian to do the deal, and Lehman sought to play a role in Eilian’s planned refinancing of the Company’s debt. Neither alleged conflict was disclosed in the Company’s proxy statement, although Katten Muchin did secure a waiver from the special committee for its joint representation of the board and the buyer’s lender (the deal team and the loan team at Katten Muchin were separate). (Lehman did not get Eilian’s business, and asserted that the group at Lehman that solicited Eilian’s business was different from the group that worked for the Company.)
D. The Stockholder Vote
In a special meeting of stockholders held September 15, 2005, 72% of the outstanding Class A shares voted to approve the merger (with 89% of the Class A shares that voted voting to approve the merger).
E. Standard of Review: Entire Fairness or Business Judgment?
This was the threshold issue the Chancellor confronted in considering the cross motions for summary judgment. Looming over the decision was the Delaware Supreme Court’s decision in Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994), which mandates the application of an entire fairness standard of review to an interested cash-out merger by a controlling or dominating shareholder. The Chancellor concluded that Lynch did not mandate entire fairness review here because the buyer, Jonathan Eilian, “had no prior relationship with the Company or with Hammons” Slip Opinion at 25. No matter that Hammons secured separate benefits for himself from Eilian:
“The rights Hammons retained after the Merger – the 2% interest in the surviving LP, the preferred interest with a $335 million liquidation preference, and various other contractual rights and obligations – do not change that Eilian made an offer to the minority stockholders, who were represented by the disinterested and independent special committee. Put simply, this case is not one in which Hammons stood ‘on both sides of the transaction.’”
Slip Opinion at 25 (citing Lynch).
So the Chancellor moves on to a business judgment standard of review, correct? Incorrect. While Lynch does not mandate entire fairness review, the Chancellor nevertheless applied that standard of review here because of “deficiencies” in the procedures employed by the special committee in this deal. How so?
“In this case – which, again, I have determined is not governed by Lynch – business judgment would be the applicable standard of review if the transaction were (1) recommended by a disinterested and independent special committee, and (2) approved by stockholders in a non-waivable vote of the majority of all the minority stockholders.”
Slip Opinion at 29 (footnote omitted).
In an important footnote to this observation, the Chancellor emphasizes that the special committee cannot be just any special committee:
“Rather, the committee must be given sufficient authority and opportunity to bargain on behalf of the minority stockholders, including the ability to hire independent legal and financial advisors. Moreover, neither special committee approval nor a stockholder vote would be effective if the controlling stockholder engaged in threats, coercion, or fraud.”
Id. at 29 n. 38.
But why not apply the business judgment standard given that Hammons did not stand “on both sides” over the transaction? Because, observed the Chancellor, Hammons, by reason of his blocking position as controlling shareholder, and bargaining power, competed with the minority stockholders “for portions of the consideration Eilian was willing to pay to acquire” the Company. Id. at 30. Because of this fact, it was imperative that there be “robust procedural protections in place to ensure that the minority stockholders have sufficient bargaining power and the ability to make an informed choice of whether to accept the third-party’s offer for their shares.” Id.
F. The Chancellor’s Categorical Voting Rules
In explaining his conclusion that, to assure business judgment review (at least in interested party mergers not controlled by Lynch), namely, that the majority-of-the-minority vote be of all minority shares, and that the condition be non-waivable, even by the special committee, the Chancellor displays an appreciation for the pressures confronting special committees:
“To give maximum effect to these procedural protections, they must be preconditions to the transaction. In other words, the lack of such requirements cannot be ‘cured’ by the fact that they would have been satisfied if they were in place. This increases the likelihood that those seeking the approval of the minority stockholders will propose a transaction that they believe will generate the support of an actual majority of the minority stockholders. Moreover, a clear explanation of the pre-conditions to the Merger is necessary to ensure that the minority stockholders are aware of the importance of their votes and their ability to block a transaction they do not believe is fair.”
Slip Opinion at 31-32.
G. Hammons’ Veto Power and Unfair Dealing
Plaintiffs argued that by reason of Hammons’ veto power over any deal, the special committee was by definition “coerced” into accepting any Hammons-approved deal because, absent any such approval, the Company’s shares would sink back to their pre-merger trading level ($4 to $7 per share). The Chancellor rejected this structural coercion claim, primarily because of the proposition that, at law, Hammons, as a controlling shareholder, had no obligation to sell his shares or to agree to any transaction that would have adverse tax implications for him:
“The mere possibility that the situation would return to the status quo, something Hammons could have chosen to do by never considering selling his shares, is not, standing alone, sufficient ‘coercion’ to render a special committee ineffective for purposes of evaluating fair dealing.”
Slip Opinion at 35.
H. Self-Dealing and Share Price Depression
The Chancellor concluded that a trial is necessary to resolve the parties’ claims on fair dealing. And, in what surprised this observer, the Chancellor concludes that the plaintiffs could prevail at trial on their claim of unfair dealing “if they were able to establish that the price of the minority shares was depressed as a result of Hammons’ improper self-dealing conduct.” Slip Opinion at 35. If the pre-merger price of the Class A shares was depressed by such conduct, “then the special committee and the stockholders could have been subject to improper coercion, meaning they would have been coerced into accepting any deal, whether fair or not, to avoid remaining as stockholders.”
I. Disclosure Claims
As noted above, the Chancellor concluded that the Company’s failure to include in its proxy statement the potential conflicts to which Katten Muchin and Lehman were subject precluded summary judgment on plaintiffs’ disclosure claims, thus necessitating that the claims be tried. In rejecting the defendants’ motion on these disclosure claims, the Chancellor places heavy reliance on the importance of disclosure of potential conflicts of interest to which advisors may be subject:
“This Court, however, has stressed the importance of disclosure of potential conflicts of interest of financial advisors. Such disclosure is particularly important where there was no public auction of the Company and ‘shareholders may be forced to place heavy weight upon the opinion of such an expert.’ It is imperative that stockholders be able to decide for themselves what weight to place on a conflict faced by the financial advisor.”
Slip Opinion at 40 (footnotes omitted).
Similar concerns apply to the disclosure of conflicts to which legal advisors may be subject:
“Again, the compensation and potential conflicts of interest of the special committee’s advisors are important facts that generally must be disclosed to stockholders before a vote. This is particularly true, where, as here, the minority stockholders are relying on the special committee to negotiate on their behalf in a transaction where they will receive cash for their minority shares. Although the waiver of the conflict by the special committee may have resolved any ethical violation, the special committee’s waiver of the conflict would likely be important to stockholders in evaluating the Merger and in assessing the efforts of the special committee and its advisors.”
Slip Opinion at 42.
J. Aiding and Abetting
An aiding and abetting claim requires, among other things, knowing participation in a breach of fiduciary duty by the alleged aider and abettor. In another surprise for this observer, the Chancellor concluded that, by reason of Eilian’s “awareness” of Hammons’ conflicts of interest and alleged improper self-dealing, he was not entitled to summary judgment on plaintiffs’ aiding and abetting claim: “There remains,” concluded the Chancellor, “a material issue of fact as to whether Eilian was aware that [the Company’s] stock price was depressed as a result of Hammons’ improper self-dealing.” Slip Opinion at 45.
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So this case is headed for trial. While the parties attempted mediation prior to the filing of their summary judgment motions, unsuccessfully, one would assume that settlement discussions may resume in earnest now that Chancellor has teed this case up for a full-blown trial.
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