A recent case from the Delaware Court of Chancery illustrates litigation risks that can arise in the context of a private equity buyout when managers holding a controlling share of a target company rollover equity into the new company while minority stockholders get cashed out. In Frank v. Elgamal, et. al, plaintiffs brought an action alleging the board of directors of American Surgical Holdings, Inc. breached their fiduciary duties by approving a sale to Great Point Partners, a private equity fund. The plaintiffs argued that a group of management stockholders with a controlling interest in the company led the board of directors to accept a deal that benefited management at the expense of the minority stockholders. The court denied the defendants' motion for summary judgment because it was unclear whether managers rolling over shares influenced the company to accept a deal that gave less cash to minority shareholders than an alternative transaction.
American Surgical began exploring a possible sale of the company in the summer of 2009 after receiving an expression of interest from Great Point Partners. The board formed an M&A committee and retained a financial advisor to solicit offers. By late 2009, three potential acquirers, including Great Point Partners, submitted non-binding indications of interest. After the board received those bids, it formed a special committee of independent, non-executive directors to oversee the negotiation process. The special committee decided to proceed to negotiate a merger with Great Point Partners.
In February of 2010, in the course of its diligence, Great Point Partners received notice of accounting problems with American Surgical's 2009 financial statements. Consequently, Great Point Partners sought to renegotiate the terms of the merger. Great Point Partners presented the company with three choices with varying mixes of cash and equity to be provided to the rollover stockholders. Significantly, the option that would have provided to the greatest ratio of cash to equity to the rollover stockholders provided slightly less overall consideration to the minority stockholders ($.04 per share) than if the rollover stockholders took more equity. The special committee and the board of directors ultimately chose the option that was the least favorable to the minority stockholders. This choice, combined with the evidence presented as to the special committee's decision-making process, led Vice Chancellor Noble to dismiss in part the defendants' motion for summary judgment.
In particular, the Court noted that it was not clear whether the special committee was informed of the three options and their varying levels of compensation for minority stockholders. One board member testified that the financial advisor told the special committee about the three options, but the minutes of the special committee meeting in which they adopted the new terms with Great Point Partners do not reflect any such discussion. This procedural defect, coupled with the fact that the management stockholders and the minority stockholders had a direct conflict of interest, led the Court to the conclusion that the "entire fairness" standard – under which the controlling stockholders have to prove that the transaction was fair to the minority stockholders – could apply to this transaction.
This case demonstrates that boards and their advisors should be vigilant about addressing any potential conflicts of interest between insider stockholders – such as managers rolling over their equity into the post-merger entity – and other stockholders. Failure to recognize that a given option deprives minority stockholders of even a few pennies per share of merger consideration can lead to a lawsuit in which the burden lies on the board of directors to prove that the merger price was entirely fair.
Frank v. Elgamal, C.A. No. 6120-VCN (Del. Ch. Mar. 10, 2014).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
