Octogenarian pornographer and libertine Hugh Hefner wants to take Playboy Enterprises, Inc. private. According to PEI's press release, Hefner sent a letter to the board of directors proposing to acquire all outstanding shares of PEI common stock "not currently owned by Hefner for $5.50 per share in cash," which would come to about $123 million. "n the proposal letter, Hefner advises the board of directors that ... Hefner is not interested in any sale or merger of PEI, selling Hefner's shares to any third party or entering into discussions with any other financial sponsor for a transaction of the nature proposed in the letter."
The board responded by announcing that, if the proposal goes forward, the board will "form a special committee of independent directors to consider the proposal. The committee would retain independent financial advisors and legal counsel to assist it in its work."
The parent company of Penthouse has announced that it will make a counter-offer tomorrow.
The Shareholders Foundation, Inc., which describes itself as an investor advocacy group which does research related to shareholder issues and informs investors of securities class actions, settlements, judgments, and other legal related news to the stock/financial market, won the predictable race to the courthouse. They've already filed "a lawsuit has been filed in Delaware State Court on behalf of current investors in Playboy Enterprises,who purchased their PLA shares before July 12, 2010, over alleged breaches of fiduciary duty by certain members of the Playboy Enterprises board of directors and others, including Hugh Hefner, arising out of the attempt to sell Playboy Enterprises, Inc. too cheaply. Since nothing of any moment has happened yet, this is all about some plaintiff law firm getting its foot in the door to be lead counsel in an eventual suit. Which makes me proud to be a lawyer.
Bids of this sort put the board of directors in a difficult bind. They also raise an issue of Delaware law that's currently in the news.
More precisely, cases of this sort raise two distinct but closely related issues:
- What are Hefner's fiduciary duties as a controlling shareholder? If he goes forward with the proposal, he has an obligation to deal fairly with the minority shareholders and to pay a fair price for their shares. If Penthouse does make a higher competing bod, however, does Hefner have a duty to sell his shares to Penthouse?
- What are the board of directors' duties when faced with a freeze out offer from a controlling shareholder, especially when there is a higher competing bid?
Only rarely do you get cases that starkly present the question of shareholder duties qua shareholder duties without any intervening issue of director duties. Delaware Chancellor Allen's decision in Mendel v. Carroll is about as clear an example of such a case as one can ever expect to get. The Carroll Family collectively controlled Katy Industries, Inc., owning at various times 48 to 52% of the stock. Even when they did not have an outright majority, their status as the largest shareholder ensured that they had effective control.
The Carroll family proposed a freeze out merger that would have cashed out the minority shareholders at about $26 per share. The board set up a special committee comprised of independent directors to consider the offer. A competing offer was made by a group organized by a fellow named Sanford Pensler at about $28 per share. The Carroll Family withdrew their merger proposal, but also announced they had no interest in selling their shares. Their opposition to the Pensler proposal effectively precluded it from going forward. Minority shareholders sued, alleging both that the Carroll Family violated its fiduciary duties and that the board of directors violated its fiduciary duties.
If Carroll Family directors had voted on the proposal, the Carroll Family would have been on both sides of the deal. Because the board used a special committee of independent directors to make the decision, however, thereby keeping the Carroll Family out of the board's decisionmaking process, there are no complicating issues of whether any member of the Carroll Family had director duties. Instead, we have two distinct issues: (1) did the directors violate their fiduciary duties by failing to act against the majority shareholders' interests; (2) did the majority shareholder violate its fiduciary duty to the minority?
As to the board's duties, plaintiff argued that the originally proposed freeze out merger amounted to a shift in control. Under Delaware law governing corporate takeovers, where such a shift in control occurs the board of directors has a fiduciary duty to maximize immediate shareholder value. The Carroll Family proposal was only $26, Pensler offered $28. The Pensler deal therefore was the better deal and the board had a duty to take it. The board responded by arguing that the Carroll Family would not sell their shares. If the family will not go along, a deal cannot be done. Consequently, the board's duty to the shareholders is limited to getting the best deal possible given the Carroll Family's intransigence. Plaintiff replied that the board was obligated under these circumstances to act against the majority shareholders' interest. Plaintiff suggested the board sell additional shares to the Pensler group, thereby diluting the Carroll Family holdings to the point at which they no longer had control.
Chancellor Allen left open the possibility that a board might sometimes be required to act against the majority's interest. Because the board also owes fiduciary duties to the majority, however, he limited this possibility to cases in which the majority shareholder is overreaching and trying to injure the minority. On the facts, this was not such a case. Allen pointed out that the plaintiff's argument broke down at several points. First, because the Carroll Family already had effective control at all relevant times, nothing they did amounted to a shift of control, and the takeover precedents were irrelevant. Second, Allen also took issue with the proposition that $28 was a better deal for the shareholders than $26. The Carroll Family already had control. Their offer thus would not include a control premium. The Pensler group was trying to buy control. The fact that they were only willing to pay a $2 control premium suggests that they might be low balling the shareholders. Of course, Allen did not need to decide whether $28 from Pensler was in fact better or worse for the shareholders than $26 from the Carroll Family. In the absence of a showing that the board acted from conflicted interests, he properly left that issue to the board.
As far as I can tell, Allen's analysis remains good law as to the Delaware duties of both the controlling shareholder and the target board.
As to issue # 2, new Delaware Vice Chancellor Laster's opinion in In re CNX Gas Corporation Shareholders Litigation, 2010 WL 2291842, Case No. 5377-VCL (Del. Ch. May 25, 2010), asserts that (as Charles Nathan explains):
Delaware courts historically have applied different standards of review depending on whether the controlling shareholder freeze-out is structured as a negotiated merger or a unilateral tender offer. Negotiated mergers have been reviewed under an entire fairness doctrine. In contrast, unilateral tender offers have been able to obtain the benefits of the business judgment rule, albeit under an evolving set of procedures.
Davidoff explains that:
Vice Chancellor Laster’s opinion upset what the world thought had been the standard set by Vice Chancellor Leo E. Strine Jr. in the Pure Resources opinion. In that opinion, Vice Chancellor Strine ruled that a court would not strictly review a “freeze-out” transaction if it complied with certain procedural requirements, including allowing for a special committee of independent directors to recommend for or against the offer. Vice Chancellor Laster modified the rule to require that the controlling shareholder receive “both the affirmative recommendation of a special committee and the approval of a majority of the unaffiliated stockholders”. In other words, the approval of the special committee is now required, whereas before the committee could recommend no, so long as it was allowed to do so. This substantially shifts the bargaining power to minority shareholders in freeze-out transactions.
Why does all this matter? Nathan explains:
The standard of review applicable to a transaction has important practical implications for the cost and uncertainty associated with the fiduciary duty lawsuits that regularly arise in controlling shareholder freeze-out transactions. Regardless of the real or perceived merits of these lawsuits, the standard of review that Delaware courts adopt impacts the stage at which a nonmeritorious lawsuit can be dismissed, as well as the substantive outcome if the case proceeds to trial.
Sophisticated transaction parties understand these dynamics and in structuring transactions subject to conflicts of interest seek to weigh (i) the potential under business judgment rule review to obtain dismissal of the lawsuit at an early stage, as well as the perceived benefits of the deferential standard at trial, which may reduce litigation-related costs and the risks of an adverse determination on the merits, against (ii) the cost and uncertainty of implementing the procedural protections that are required to achieve early dismissal or an advantaged procedural or substantive position at trial. Transaction parties evaluating these trade-offs generally consider the following practical issues:
- Entire fairness review, without burden shifting made available by appropriate procedural protections, carries substantial litigation risk for a controlling shareholder and all directors, and the prospect of personal liability for the conflicted directors.
- Affirmatively demonstrating entire fairness is factually intensive, making dismissal on the pleadings nearly impossible and greatly increasing the risk of protracted litigation and an adverse result.
- Shifting the burden of proof to the plaintiffs in an entire fairness case places a significant evidentiary burden on them and elevates their risks at trial, thereby frequently leading to a favorable settlement or trial outcome for the controlling shareholder.
- Burden shifting under the entire fairness doctrine rarely leads to pre-trial dismissal, however, adding to the settlement value for plaintiffs because defendants seek to avoid the costs of proceeding to a trial.
- Qualifying for business judgment rule review is far better for controlling shareholders than obtaining a burden shift under the entire fairness doctrine. It not only makes defense on the merits simpler, but also significantly increases the opportunity for a pre-trial dismissal, both of which contribute to optimize an inexpensive settlement.
Should Controlling Shareholders Seek the Benefits of the Unified Standard?
Understanding the implications of the standard of review, a controlling shareholder should consider whether the benefits of qualifying under the unified standard of CNX Gas outweigh the prospect of increased deal risk and increased transaction pricing created by the required procedural protections.
By empowering a special committee with authority to take defensive measures, such as adoption of a poison pill (or perhaps even a dilutive issuance), the controlling shareholder surrenders its implicit threat of acquiring control directly from the shareholders if the special committee does not bargain “fairly” with the shareholder, which in our view could meaningfully affect the relative negotiating strength between the controlling shareholder and the special committee.
By agreeing to a non-waivable requirement that a majority of the disinterested shareholders approve the transaction, the controlling shareholder also risks that minority shareholders vote against the transaction in the hopes of obtaining a second bite at the control premium “apple.” For this reason, the vote creates potential hold-up value for hedge funds and other short-term investors, including those that move into the stock post-announcement, to use a “vote no” threat or actual vote to create leverage for negotiation of a higher price.
We expect controlling shareholders will evaluate the particular circumstances of their proposed transaction and the relationship with the independent directors, as well as the expected dynamics of the special committee process. They will weigh, in a concededly rough calculus, the expected cost savings in litigation or settlement obtained through adoption of a unified standard structure against the prospect of: (i) an overzealous special committee (or its advisors) using a broad grant of authority to effectively deprive the controlling shareholder of its control position and (ii) being held up by a relatively small proportion of shareholders. This analysis will require evaluation of both the company’s shareholder profile and the expected market reception to the offered price. Of course, the decision as to deal structure and the authority of the special committee is not the controlling shareholder’s or board’s decision alone. We expect that future special committees may demand a broad grant of authority and a deal structure designed to obtain business judgment rule review, whether or not necessary or appropriate in the circumstances.