Private equity investors that control the boards of their portfolio companies have long assumed that they will also be able to control any arms-length sale of the public portfolio company to a third party, provided only that each stockholder of the company is treated the same way in such sale. However, recent decisions of the Delaware Court of Chancery call that assumption into question. These decisions suggest that the liquidity afforded a large stockholder in such a sale transaction may, in certain circumstances, constitute additional consideration not shared with the public stockholders and therefore, creates a conflict of interests that limits the ability of the private equity sponsor and its director appointees to control the sales process.
Under Delaware law, a transaction in which a controlling stockholder is treated differently from other stockholders is subject to the exacting test of “entire fairness.” Entire fairness requires the conflicted stockholder to prove that the deal was procedurally and substantively fair to the company’s minority stockholders. Such claims are almost impossible to get dismissed at an early stage of the litigation process and can be expensive to settle. The only potential escape from the entire fairness box is to give a fully empowered special committee of non-conflicted directors control over the sale process and to condition the transaction on the approval of a majority of the shares held by non-conflicted stockholders.
The conflict between a controlling stockholder and the minority public stockholders is obvious where the controlling stockholder proposes to take the company private or seeks to obtain a higher price for its shares than that paid to the public. In the first case, the controlling stockholder stands on both sides of the transaction; in the second case, it is competing with the public stockholders over the allocation of the overall purchase price. But a conflict has not generally been thought to exist in a transaction involving a sale to a third party buyer in which all stockholders are treated in the same way. However, in two recent decisions, the Delaware Court of Chancery has held that a large stockholder may also be conflicted if it has an urgent liquidity need or if the market for the company’s stock is not sufficiently robust to allow that stockholder to sell its entire stake into that market over a reasonable period of time.
In N.J. Carpenters Pension Fund v. infoGROUP (Del. Ch., Sept. 30, 2011) the Court of Chancery considered breach of fiduciary duty claims in connection with the all-cash sale of infoGROUP to CCMP Capital Advisors. Plaintiffs alleged that infoGROUP’s 37% stockholder, who was also a member of the company’s board, instigated the sale in order to satisfy his “desperate need for liquidity” and that the sale took place at a particularly inopportune time in light of a weak M&A market and the company’s improving prospects. The court refused to dismiss these claims, finding that the 37% stockholder’s need for liquidity was both material and not shared with the company’s other stockholders. The court held that in certain circumstances “liquidity is a benefit that may lead directors to breach their fiduciary duties.”
Similarly, In re Answers Corporation Shareholders Litigation (Del. Ch., April 11, 2012) involved the all-cash, third-party sale of Answers Corporation, a thinly traded Delaware public company, 30% of the stock of which was held by a financial sponsor. Following closing, former Answers stockholders brought suit against the company’s directors for breach of fiduciary duty and against the buyer for aiding and abetting such breach. Because the company’s charter exculpated directors from liability for duty of care claims, plaintiffs could recover damages only if they were able to prove that the directors breached their duty of loyalty. On a motion to dismiss, the court held allegations that a sale transaction provided the only way for the 30% stockholder to get liquidity and that such liquidity constituted a benefit not shared with the other stockholders (who had the practical ability to sell their shares on the limited public market) to be sufficient to state a claim for breach of loyalty against the directors appointed by the 30% stockholder. Citing the infoGROUP decision, the court held that the stockholder’s desire for liquidity could put those directors in a position where their interests conflicted with those of the public stockholders.
These two decisions should be contrasted with the outcome in In re CompuCom Systems, Inc Stockholders Litigation (Del. Ch. 2005). As with infoGROUP and Answers, CompuCom Systems was alleged to have been sold at a “fire sale price” so that its controlling stockholder could satisfy a “pressing need for cash” that resulted from the failure of the stockholder’s other investments. In the case of CompuCom, however, the court dismissed fiduciary duty claims on the grounds that the sales process had been managed by a special committee of outside directors, which had hired independent counsel and financial advisors and that had agreed to the sale transaction only at the end of a multiyear exploration of strategic alternatives. Thus, while the CompuCom controlling stockholder avoided liability, it did so only by surrendering control over the sales process.
It’s worth noting that the infoGROUP and Answers decisions involved motions to dismiss, and it is by no means clear that if matters were to be litigated to completion the defendants would be found liable for damages. However, these cases demonstrate that the Delaware courts are willing, as a legal matter, in the right circumstances, to view the mere size of the holdings of a controlling stockholder as putting that stockholder and its representatives on the subject company’s board in a conflict situation. At a minimum, the inability to get rid of such a claim at the motion to dismiss stage means that the litigation will be substantially more time-consuming to defend and more expensive to settle.
These decisions do not mean that all sale transactions involving a public portfolio company will be subject to an entire fairness review, or that a special committee must always be used in such cases to limit liability risks. Where the large stockholder has no immediate need to sell and the public market is sufficiently liquid to provide a viable exit mechanism in the ordinary course, the courts would have to go well beyond their recent holdings to impose liability based merely on the size of the controlling stockholder’s interest. On the other hand, in the case of a private equity stockholder that is near or past the end of the fund’s life, or a sponsor that needs an exit to support its pending fund-raising initiatives, or where the public market does not provide a realistic exit route for the sponsors in the ordinary course (but does for other stockholders), the stockholder and the company’s board need to take the potential conflict into account. In these circumstances, private equity firms may well wish to consider using the types of procedural protections—such as a special committee and potentially minority stockholder approval—that have been developed in the context of going private transactions to limit litigation risk. Even if the controlling stockholder is confident of being able to satisfy the strict standard of entire fairness—which may well be the case assuming the company is adequately shopped, all stockholders receive the same consideration, and there is no reason to believe the time of sale to be particularly inopportune—the benefit of limiting the litigation risk inherent in a duty of loyalty challenge may well outweigh the cost of giving up control over the sales process.