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Fairness in Delaware Freezeout Transactions: How Two Discrepant Legal Standards Affect Valuations

Authors:
  • Sutter Securities Financial Services, San Francisco

Abstract

This article discusses the differing legal standards that were applied in Delaware courts to one-step and two-step mergers.
LITIGATION SERVICES - Freezeout Transactions
proved and “fair price” includes all el-
ements of value3(see discussion of En-
tire Fairness below).
“Entire Fairness” (“fair dealing
plus fair price”) review is friendlier to
minority shareholder plaintiffs than
the “Business Judgment Rule” review,
which the Chancery Court has held to
be the appropriate standard for the
newer freezeout tender offers. The
combined effect of two 2001 decisions,
one by the Supreme Court in Unocal
Exploration4and the other by the
Court of Chancery in Siliconix,5was to
make it possible for a control share-
holder to avoid the negotiated freeze-
out’s Entire Fairness standard by
choosing the two-step freezeout ten-
der offer. The Supreme Court has not
yet ruled on whether controllers who
use this new format get to avoid entire
fairness scrutiny. The Supreme Court,
in fact, “has never had an occasion to
rule on the issue of what equitable
standard of review applies in a tender
offer freezeout.”6Nevertheless,
transaction planners and controllers,
relying on the Court of Chancery’s de-
cisions, are increasingly availing
themselves of this newer form of
freezeout.
The Business Judgment Rule is
considered “deferential” to corporate
management because, under this
standard, courts commonly defer to
directors’ and officers’ judgment.
When Business Judgment is applied,
the freezeout is reviewed only in terms
of “fair dealing,” not “fair price.” This
narrower scope makes it difficult for
plaintiffs to challenge the transaction.
Thus, the Business Judgment review
applied in the unilateral freezeout
tender offer is friendlier to the con-
troller. As a result, control sharehold-
ers are utilizing the freezeout tender
offer format with increasing frequen-
cy in order to "freeze out" minority
shareholders and achieve 100% own-
ership.
ENTIRE FAIRNESS IS THE
SETTLED AND EXCLUSIVE
STANDARD OF REVIEW FOR
NEGOTIATED FREEZEOUTS
In 1994, the Delaware Supreme Court
ruled in Lynch7that the stringent En-
tire Fairness test is the exclusive stan-
dard of review when a controller ac-
quires the minority’s shares through a
negotiated freezeout, because it views
these transactions as “presenting a
risk of self-dealing by controllers.8In-
deed, the Delaware Courts
...have long reviewed minority
shareholder challenges to such
pre-approved freeze outs
under the exacting “entire fair-
ness” standard [footnote omit-
ted], reasoning that conflicts of
interest faced by the controlled
corporation’s board of directors
(who approve the transaction
on the minority’s behalf), along
with the controlling sharehold-
er’s coercive capabilities, pre-
clude application of the more
deferential business judgment
form of review. 9
FVLE Issue 8 • August/September 2007 • www.valuationproducts.com • Page 11
Delaware courts are currently apply-
ing two discrepant legal standards of
fairness to freezeouts of minority
shareholders. This article addresses
their development and their impact
on fairness opinions and valuations.
CONTRASTING STANDARDS OF
FAIRNESS IN FREEZEOUTS
When control shareholders (“con-
trollers”) take a company private by
acquiring all the shares held by mi-
nority public shareholders, the trans-
action is described as a freezeout.1
The two common formats for control
shareholders of Delaware corpora-
tions to effectuate a freezeout are (a)
the traditional one-step negotiated
long-form merger (“negotiated
freezeouts”) and (b) the newer two-
step freezeout structured as a tender
offer followed by a short-form merger
(“freezeout tender offers”), which
began being used in 2001.
Under current Delaware law,
different standards of legal review for
fairness are applied to these two
forms even though their function—
taking a company private— is the
same.2Paradoxically, a controller who
undertakes the traditional long-form
freezeout and negotiates the merger
terms with the target's independent
directors is held to a higher standard
of fairness than when the controller
chooses to act unilaterally via a short-
form freezeout tender offer.
The standard for the negotiated
going-private transaction is a “strict
scrutiny” review for “fairness” called
“Entire Fairness.” This review is both
broad and exacting. The Court looks
at the fairness of the entire transaction
by assessing not only whether minor-
ity shareholders were dealt with fairly
— “fair dealing”— but also whether
they received a “fair price” for being
frozen out of their shareholdings.
“Fair dealing” involves how the trans-
action was timed, initiated, struc-
tured, negotiated, disclosed and ap-
Continued on next page
expert
TIP
Given Delaware’s prominence
in case law in the appraisal in-
dustry, an understanding of
“fairness” in freezeout trans-
actions could be important.
Fairness in Delaware Freezeout Transactions:
How Two Discrepant Legal Standards Affect Valuations
GILBERT E. MATTHEWS, CFA &
MICHELLE PATTERSON, JD, PhD
Sutter Securities Incorporated
San Francisco, CA
gil@suttersf.com
Page 12 • www.valuationproducts.com • August/September 2007 • FVLE Issue 8
LITIGATION SERVICES - Matthews and Peterson, continued
Moreover, in these freezeouts, the
controller is often able to take the
company private by voting its majori-
ty shares in favor of the merger with-
out any vote by the minority.
Under Entire Fairness, there is
an important shift in the ordinary liti-
gation process that works to the ad-
vantage of the minority shareholder
plaintiff. In most litigation, the plain-
tiffs bear the burden of proving their
case. In contrast, with Entire Fairness,
controller defendants have the burden
of showing that their transactions
were, in fact, fair. The law imposes
this burden because the controller is
seen as a conflicted, interested party.
Nevertheless, there is a way for the
controller to shift the burden back to
the plaintiff. There is an “established
equitable practice of allowing ratifica-
tion by disinterested directors … to
insulate a self-dealing transaction
from strict scrutiny for fairness [foot-
note omitted].10 If disinterested direc-
tors approve a corporate action, the
Courts usually allow the business ac-
tion to be reviewed under the deferen-
tial Business Judgment Rule. Howev-
er, because of the Courts’ concern re-
garding mergers by control parties,
even if disinterested director approval
is present, the review for fairness in
negotiated freezeouts remains the
broader Entire Fairness.
The courts, however, recognize
under Entire Fairness the potentially
minority-protective value of inde-
pendent director and shareholder rat-
ification, and afford the controller
who provides for these in its transac-
tion the benefit of being able to shift
the burden of proof back to the plain-
tiff. The controller must show that its
negotiated freezeout included either of
two procedural safeguards:
(a)a special committee of inde-
pendent directors of the sub-
sidiary with the ability to
block the transaction (inde-
pendent committee
approval) or
(b)a condition that an informed
majority of the minority
shareholders approve the
transaction (majority of the
minority approval).
Since a minority shareholder’s chal-
lenge remains under the Entire Fair-
ness standard, the Chancery Court
must undertake a comprehensive and
stringent review of price and dealing
with no possibility for an early dis-
missal of the case. Thus, a defending
controller cannot avail itself of the
Business Judgment Rule regardless of
what procedurally fair steps it follows
in its freezeout transaction.
FREEZEOUT TENDER OFFERS
ARE SUBJECT TO BUSINESS
JUDGMENT RULE REVIEW IF
NONCOERCIVE AND IF
DISCLOSURE IS ADEQUATE
Freezeout tender offers have become
more popular since the Chancery
Court ruled that they will be re-
viewed under the Business Judgment
Rule rather than Entire Fairness un-
less the offer is coercive or material in-
formation is withheld (as discussed
below). The Supreme Court in Unocal
Exploration (2001) clarified the stan-
dard for review for short-form merg-
ers, ruling that for short-form merg-
ers, appraisal is the exclusive remedy
available to a minority stockholder
complaining of unfairness. The Court
of Chancery ruled in Siliconix that the
Business Judgment Rule applied to a
freezeout tender offer. The combined
effect of Unocal Exploration and Sili-
conix was to enable a control share-
holder to avoid the more exacting En-
tire Fairness standard applicable to a
negotiated transaction by using the
two-stage freeze-out process: a tender
offer for enough outstanding shares to
attain 90 percent ownership, followed
by a short-form merger.
Neither Entire Fairness Nor the
Business Judgment Rule Is Applica-
ble to Short-Form Mergers—Minori-
ty Shareholders’ Only Remedy is
Appraisal
Delaware General Corporate Law
§253 authorizes the corporate owner
of 90 percent or more of the voting
stock of a company to merge the sub-
sidiary into itself without any require-
ment that the subsidiary’s board of di-
rectors approve the merger (a “short-
form merger”).11 Unocal Exploration
held that Entire Fairness was not ap-
plicable to short-form mergers con-
ducted under §253. The Supreme
Court took note of the fact that a par-
ent corporation and its directors are
self-dealing fiduciaries who, under
settled principles, would be required
to establish Entire Fairness in a freeze-
out transaction, but said that §253, as
written by the Legislature, does not
hold them to do so. The Court ac-
knowledged that §253’s merger proce-
dure is inconsistent with customary
notions of fair dealing.
In a short-form merger, there is
no agreement of merger negoti-
ated by two companies; there is
only a unilateral act - a decision
by the parent company that its
90% owned subsidiary shall no
longer exist as a separate entity.
The minority stockholders re-
ceive no advance notice of the
merger; their directors do not
consider or approve it; and
there is no vote. 12
Because minority shareholders are not
entitled to an Entire Fairness judicial
review, they are not entitled to the eq-
uitable remedies that an Entire Fair-
ness review provides. The Court held
that “absent fraud or illegality, ap-
praisal is the exclusive remedy avail-
able to a minority stockholder who
objects to a short-form merger.”13
Business Judgment Rule, Not Entire
Fairness, Is the Standard for Nonco-
ercive Freezeout Tender Offers
Also in 2001, a Chancery Court case
provided the answer to the question
of what the standard of judicial re-
view for fairness would be if a con-
troller combined a tender offer with a
short-form merger to take a company
private — the tender offer freezeout.
Vice Chancellor Noble ruled that the
control shareholder could acquire mi-
nority shares in a tender offer without
the recommendation of the sub-
Continued on next page
FVLE Issue 8 • August/September 2007 • www.valuationproducts.com • Page 13
LITIGATION SERVICES - Matthews and Peterson, continued
sidiary’s board of directors. He con-
cluded that the controller had no duty
to demonstrate Entire Fairness unless
coercion or disclosure violations oc-
curred, and that the appropriate stan-
dard of review was Business Judg-
ment accompanied by the usual fidu-
ciary duties imposed on controlling
parties. However, Entire Fairness
would be invoked if the offer were
“coercive.”
Vice Chancellor Strine subse-
quently defined “coercive” in Pure Re-
sources (2002), ruling that a freezeout
tender offer would be deemed coer-
cive unless
(a) it was subject to a non-waivable
condition that no shares would
be accepted unless an informed
majority of the minority ten-
dered,
(b) the controller committed to a
prompt short-form merger at
the same price if it reached 90
percent ownership, and
(c) there were no threats of retribu-
tion if the offer was not accept-
ed.14
Strine later made clear in Cox (2005)
that a coercive tender offer could be
subject to Entire Fairness if the con-
troller did not conduct the transaction
in conformity with a high level of fi-
duciary duty. He said that a noncoer-
cive tender offer “requires the equiva-
lent of an informed, uncoerced major-
ity of the minority vote condition for a
controller to avoid entire fairness re-
view.”15
Strine also ruled in Pure that (a)
the target company should be allowed
and enabled to set up an independent
director committee, (b) the committee
should review the controller’s merger
terms and make a recommendation,
and (c) disclosure should include a
summary of the substantive work per-
formed by the financial advisor.16
Strine's ruling has resulted in in-
creased use of financial advisors in
this form of freezeout.
IMPACT OF FAIRNESS
STANDARDS ON
VALUATIONS
When a controller proposes a
going-private transaction, inde-
pendent directors customarily re-
tain financial advisors to value the
minority shares and to render fair-
ness opinions, thereby assisting the
directors in carrying out their fidu-
ciary duties. Delaware courts have
recognized the value to independ-
ent directors and shareholders of
fairness opinions and their under-
lying valuations. Indeed, the
courts view the obtaining of these
opinions as evidence of the directors’
fulfillment of their obligations.
The financial advisor must con-
sider the format of a Delaware freeze-
out that is being valued because the
standard of fairness that will be ap-
plied affects the value of the minority
shares. The remedy available to mi-
nority shareholders who believe that
the price offered is inadequate also
impacts fairness.
Fairness Opinions and Valuations in
Negotiated Freezeouts
As discussed above, a negotiated
freezeout is subject to Entire Fairness.
The remedy for minority shareholders
as a class is to receive "fair price,"
which the Supreme Court defined in
Weinberger as “all relevant factors: as-
sets, market value, earnings, future
prospects, and any other elements
that affect the intrinsic or inherent
value of a company’s stock.”17 This
decision enabled the valuator to use
forward-looking valuation methods
in Delaware courts, and to use valua-
tion approaches generally used by
practitioners rather than the outmod-
ed Delaware Block Method.
The valuation for a fairness
opinion in a negotiated freezeout is
similar to the analysis that a valuator
undertakes for an arms’-length trans-
action with a third party with one ex-
ception. The exception is that the val-
uator should not apply a control pre-
mium to the minority shares because
the controller already has control.
The control premium to be excluded
is an amount that a buyer would pay
for an entire company in excess of its
going-concern value as an independ-
ent business. The valuator should in-
clude a premium over market (the re-
ciprocal of a minority discount) to the
extent that it reflects the elimination
of discounts for minority interest and
lack of marketability.
Even if the procedures followed
by the controller and the independent
directors have succeeded in shifting
the burden of proof to plaintiffs, the
Court of Chancery will, in its Entire
Fairness review, consider the fairness
of the price. If there is a class action
challenging fairness, all minority
shareholders included in the class will
receive the benefit of any award above
the transaction price; in contrast, an
award in an appraisal action is paid
only to dissenting shareholders, not to
the other minority shareholders.
Fairness Opinions and Valuations
in Freezeout Tender Offers
A noncoercive freezeout tender offer
consists of two steps: a tender offer for
a majority of the minority shares and
a short-form merger if the controller
attains 90 percent ownership. Since
the Business Judgment Rule applies to
the tender offer, minority sharehold-
ers cannot receive a court review of
the fairness of the price. Each share-
holder has the opportunity to decide
whether to tender, based on available
Continued on next page
information. Pure provides that the
independent directors should (a) be
given “both free rein and adequate
time to react to the tender offer, by (at
the very least) hiring their own advi-
sors,” (b) make a recommendation to
minority shareholders, and (c) “disc-
los[e] adequate information for the
minority to make an informed judg-
ment.”18 For an informed recommen-
dation, the directors who retain a fi-
nancial advisor should ask for an
opinion as to the fairness of the pro-
posed transaction, and should dis-
close the advisor’s recommendation,
and the basis for it, to the minority
shareholders.
The exclusive remedy available
to a minority shareholder who does
not tender and objects to the price of
the second-step short-form merger is
appraisal. In a Delaware appraisal, a
dissenting shareholder is entitled to
receive a pro rata share of the equity
value of the company as a going con-
cern, with no control premium and no
discount for lack of marketability or
minority interest. Certain factors that
would otherwise be relevant to a fair-
ness opinion, such as synergies, in-
creases in value attributable to the
transaction itself, reduction of exces-
sive salaries, and eliminating corpo-
rate waste, may not be included in an
appraisal valuation. In addition, liq-
uidation value may not be used as a
valuation method, even if liquidation
value is higher than going concern
value. Recent Delaware appraisal de-
cisions have favored discounted cash
flow, but they have often also used
guideline companies and guideline
acquisitions, with adjustments to
eliminate impermissible premiums
and discounts.19
Independent directors who ful-
fill their obligations as fiduciaries by
hiring their own advisor should ask
their financial advisor for guidance as
to the amount that minority share-
holders might receive if they request
appraisal. Since the appraisal remedy
is available, the value that a dissenting
shareholder would receive in an ap-
praisal represents a floor below which
a proposed freezeout price is not fair.
The valuator should use appropriate
valuation methods to determine the
amount that a Delaware court might
reasonably award to a dissenting
shareholder in an appraisal and dis-
cuss the valuation with the independ-
ent directors. This valuation will be
helpful to the independent directors
in discussions with the controller. Dis-
closure of the financial advisor’s valu-
ation conclusions, and a description of
inputs and methods used (with cus-
tomary caveats), should be helpful to
shareholders in deciding whether to
tender or to seek appraisal.
Fairness Opinions When Tender
Offer Might Not Achieve 90 Percent
Ownership
An issue not addressed in the recent
Delaware decisions is the impact of a
proposed freezeout tender offer on
minority shareholders if the controller
purchases a majority of the minority
shares but does not reach the 90 per-
cent ownership level required for a
short-form merger.20 In that situation,
non-tendering shareholders then
would be left with a thinner market
and with no assurance of being
bought out. If the valuator believes
that the proposed price is fair, the in-
dependent directors should be ad-
vised to consider negotiating for a 90
percent condition. When the con-
troller could complete the tender offer
without attaining the 90 percent
threshold, the valuator should consid-
er qualifying its opinion. Depending
on the valuator's conclusion, the fair-
ness opinion could state that the
transaction is fair, from a financial
point of view,21 to all minority share-
holders only if the 90 percent level is
reached, or that it is fair to sharehold-
ers who tender, with a negative opin-
ion (or no opinion) expressed to non-
tendering shareholders. F
Page 14 • www.valuationproducts.com • August/September 2007 • FVLE Issue 8
1“A freezeout is a transaction in which a controlling shareholder buys out the minority shareholders in a publicly traded
corporation, for cash or the controller's stock. Freezeouts are also known, with some occasional loss of precision, as
‘going private mergers,’ ‘squeezeouts,’ ‘parent-subsidiary mergers,’ ‘minority buyouts,’‘take outs,’ or ‘cash-out merg-
ers.’” Guhan Subramanian, “Fixing Freezeouts,” 115 Yale L.J. 2 (2005), p. 5. Our article does not address third-party
going-private transactions.
2See William T. Allen, Jack B. Jacobs, and Leo E. Strine, Jr., “Function Over Form: A Reassessment of Standards of
Review In Delaware Corporation Law,” Del. J. Corp. Law 859.
3Weinberger v. UOP, 457 A.2d 701 (Del. 1983) at 711.
4Glassman v. Unocal Exploration Corp., 777 A.2d 242 (Del. 2001). In the literature, this case is described either as
Glassman or as Unocal Exploration (as in this article).
5In re Siliconix Incorporated Shareholder Litigation, 2001 Del. Ch. LEXIS 83, 2001 WL 716787 (Del. Ch., June 19,
2001).
6Faith Stevelman Kahn, “Freezeout Doctrine: Going Private at the Intersection of the Market and the Law,” Business
Lawyer (forthcoming), pp. 24-5. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=952331
7Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994).
8F.S. Kahn, p. 24.
9Peter V. Letsou & Steven M. Haas, “The Dilemma That Never Should Have Been: Minority Freeze Outs in Delaware,”
Business Lawyer, Nov. 2005, p. 26.
10 F.S. Kahn, p. 23.
11 DEL. CODE ANN. tit. 8 §253.
12 Unocal Exploration at 247.
13Id. at 248.
14 In re Pure Resources, Inc. Shareholder Litigation, 808 A.2d 421 (Del. Ch. 2002) at 445.
15 In re Cox Communications, Inc. Shareholder Litigation, 879 A.2d 604 (Del. Ch. 2005) at 607.
16 Pure at 445.
17 Weinberger at 711.
18 Pure at 445.
19 For a discussion of Delaware appraisals, see Gilbert E. Matthews, “A Review of Valuations in Delaware Appraisal
Cases, 2004-2005,” Business Valuation Review, June 2006.
20 If the controller owns less than 80 percent, it could purchase a majority of the minority without reaching 90 percent.
21 “Fairness, from a financial point of view,” the customary language in fairness opinions, may equal or exceed the appli-
cable legal standard for fairness.
LITIGATION SERVICES - Matthews and Peterson, continued
ResearchGate has not been able to resolve any citations for this publication.
Article
Full-text available
Delaware's fiduciary doctrine governing going private transactions by controlling shareholders is presently in disarray. Controllers generally select between single step cash-out mergers and tender offers followed by short-form mergers to do these freezeouts, and they are subject to very different equitable standards depending on the format selected by the controller. Furthermore, the courts' longstanding commitment to applying strict scrutiny in the adjudication of freezeouts is in tension with the popular disfavor towards private class-action litigation. This disarray threatens minorities' interests in freezeouts and capital market values more generally. This Article reviews the foundations of freezeout doctrine and proposes that the Entire Fairness doctrine should apply as the standard of review in all freezeouts unless prior to accepting the controller's offer the target company's independent directors conducted an auction or market check to ascertain if better offers were available.
Article
One of the most profound transformations in Delaware corporation law since 1985 has been the development of new standards of judicial review, as well as novel applications of existing standards. Although the result of these developments has been positive, the developments have also, in some instances, become dysfunctional in the sense that their articulation and/or application has not adequately taken into account the policies underlying the standards and thus has failed to advance the core values of corporation law. In this Article, the authors explore these post-1985 doctrinal problems in five separate areas: (i) the review standard misapplied in duty of care cases; (ii) the improper linkage of the duty of care to entire fairness review; (iii) the failure of courts to defer to effective intra-corporate fairness procedures; (iv) the unnecessary linkage of the intermediate "reasonableness" standard of review to the business judgment and entire fairness standards; and (v) the "compelling justification" test and the unnecessary proliferation of review standards. The authors conclude that some doctrinal reformulation is needed in these areas to make the existing standards of review truly functional, i.e., adequately aligned with their underlying policy purpose so as to provide directors with incentives to act in order to advance corporate and shareholder interests, and simplified and rationalized to make the standards useful tools for judicial decisionmaking. The authors propose three basic reformulated review standards that would achieve these goals.
Unocal Exploration Corp., 777 A
  • Glassman
Glassman v. Unocal Exploration Corp., 777 A.2d 242 (Del. 2001). In the literature, this case is described either as Glassman or as Unocal Exploration (as in this article).
Lynch Communication Systems, Inc., 638 A.2d 1110 (Del
  • Kahn V
Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994).
For a discussion of Delaware appraisals, see Gilbert E. Matthews
For a discussion of Delaware appraisals, see Gilbert E. Matthews, "A Review of Valuations in Delaware Appraisal Cases, 2004-2005," Business Valuation Review, June 2006.