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Gesoff v. IIC: Delaware Court Provides Additional Guidance for Special Committees and their Advisors

By Kevin Miller and Chris Rosselli

Kevin Miller (kevin.miller@alston.com) is a partner in the New York offi ce of Alston & Bird LLP. Chris Rosselli (chris.rosselli@alston.com) is an associate in the Atlanta offi ce of Alston & Bird LLP.

Delaware’s Court of Chancery recently issued another opinion offer-ing guidance for special committees and their advisors in related-party transactions echoing many of the themes recently emphasized in In re Tele-Communications, Inc.1 and a 2004 decision, In re Emerging Com-munications Inc.2 The latest decision, Gesoff v. IIC Industries, Inc.,3 involved a going-private transaction in which a British parent company acquired the publicly traded minority shares of its U.S. subsidiary, IIC Industries, Inc. In fi nding that the merger “was marked with grave examples of unfairness, and led to a plainly unfair price,”4 the court emphasized the following lessons for special committees in parent-subsidiary mergers:

• A special committee should have a clear and unambiguous mandate to negotiate vigorously on behalf of the minority stockholders;

• The negotiation between a special committee and a controlling stockholder should resemble an arm’s-length negotiation between unrelated parties;

• The advisors of a special committee must be competent, independent and loyal; and

• Whenever possible, a special committee should be comprised of more than one member.

In addition, the court’s opinion provides important guidance for invest-ment banks and their counsel on appropriate valuation methodologies and additional guidance for directors regarding the exculpatory provisions of Section 102(b)(7) of the Delaware General Corporation Law.5

BackgroundThe going-private transaction at issue in Gesoff was initially structured

as a tender offer by parent for all of the issued and outstanding shares of IIC to be followed by a “short-form” merger to cash out any stockholders remaining after completion of the tender offer.6 In deference to the heightened judicial scrutiny applicable to going-private transactions under Delaware law, the board of directors of IIC formed a special committee to examine the tender offer and present a recommendation to the board

July/August 2006 Volume 10 No. 7

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IN THIS ISSUE:

Gesoff v. IIC: Delaware Court Provides Additional Guidance for Special Committees and their Advisors

By Kevin Miller and Chris Rosselli .................1

From the Managing Editor

It Just Goes to Show Ya, It’s Always Something… ..........................................2

Traps for the Unwary: Regulatory Considerations in Broker-Dealer Acquisitions

By Robert Boresta ......................................6

Protecting the Interests of an Executive When the Company is Sold

By Robert M. Fields ....................................9

Cross-Border M&A — A Checklist for US Companies Making Acquisitions in New Zealand

By David Quigg & John Horner ..................11

Corporate Governance Feature:Delaware Supreme Court Affirms Trial Decision in Disney Derivative Litigation

By Stephen F. Arcano ...........................................14

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© 2006 Thomson/West Legalworks Vol. 10 No. 7, 2006

of protections [is] insuffi cient.”9 Entire fairness has two aspects: fair dealing and fair price. Both the process of determining the terms of the merger and the consideration actually paid in the merger must be fair to the minority stockholders. It is not enough that the directors honestly believe in the fairness of the transaction. Rather, the merger must be objectively fair.

By establishing a properly functioning special committee to negotiate on behalf of the minority interest, boards of directors can not only establish fair dealing but they can also shift the bur-den of proof regarding entire fairness to the plaintiffs. However, merely forming a special committee, without more, will not be suffi cient for either purpose. As in In re Tele-Communications Inc. and In re Emerging Communications Inc., Gesoff confi rms that a special committee cannot assist a board of directors in establishing entire fairness or shifting the burden of proof if the committee is not independent, well-informed and empowered with the ability to negotiate the transaction.

Lessons for Special CommitteesMandate — The lack of a clear mandate was once again at

the heart of the court’s conclusion.10 The initial board resolution authorizing the formation of the special committee provided the committee only with the vague authority to “examine the Tender Offer and to prepare and present a recommendation … on the Company’s position on the Tender Offer.”11 When the transaction changed to a “long-form” merger with the corresponding increase in the potential for coercion of the minority stockholders, neither the special committee nor the boards of IIC or parent took any additional steps to ensure that the somewhat new transaction would be fair to the minority.12 In fact, the testimony of the special committee at trial revealed a deep confusion as to the distinction between the two forms of transaction, the resulting impact on the minority stockholders and the standards of judicial review.13 At no point was it clear whether the special committee held the critical power to say “no” to the merger.

Lesson. Authorizing resolutions should clearly set forth the committee’s duties to minority stockholders, empower the committee to select its own legal and fi nancial advisors, and, ideally, vest the committee with the power to say “no” if it is not satisfi ed that the transaction is in the best interests of the minority. The committee also should be able to articulate the extent of its authority because “no mandate, however clear, is suffi cient if the [committee] does not understand its considerable powers.”14

Advisors — The confusion of the special committee partly resulted from a lack of competent and independent advisors. The attorney advising the special committee was none other than the long-time outside counsel to IIC who had previously advised parent on its approach to the proposed transaction. Even if the special committee’s counsel were independent, the court found that the “ramshackle way in which the merger between IIC and [parent] was organized [raised], to say the least, very serious doubts about [counsel’s] familiarity and competence to give a client advice about Delaware fi duciary duty law.”15 The committee, however, accepted the selection of counsel without any independent investigation of his qualifi cations or consideration of any alternatives.16

of directors and stockholders of IIC. Contemporaneously with the formation of the committee, parent selected legal and fi nancial advisors for the committee and, with their assistance or acquiescence, coordinated the process by which the price to be paid in the tender offer would be agreed upon with the committee. The negotiations proceeded in accordance with the pre-arranged plan, and, on September 10, 2001, parent and the special committee agreed on a price of $10.50 per share (a fi gure well below the $13 maximum price previously authorized by parent’s board of directors based on prices it was paying in the market for IIC shares).

Commencement of the tender offer was understandably delayed by the events of September 11, 2001. Nevertheless, despite three extensions of the tender offer, parent failed to acquire suffi cient shares in the tender to effect a “short-form” merger. Consequently, in January 2002, parent determined to effect an alternative “long-form” merger in which the shares held by the public minority would be converted into the right to receive the same price paid in the tender offer. Unlike the “short-form” merger contemplated after the tender offer (which would not have required any action by the board of IIC or a vote of IIC’s stockholders), the new structure required the approval and recommendation of IIC’s board of directors and the approval of IIC’s stockholders, both of which were controlled by parent. Despite the change in structure and the delay since the tender offer was fi rst recommended, the special committee did not conduct any new research, obtain a new fairness opinion or otherwise approach parent to press for a higher price. Rather, the committee approved and recommended the “long-form” merger, apparently in reliance on its previous analysis and assertions by parent that IIC faced a number of challenges in the coming year as a result of, among other things, fallout from the terrorist attacks and concerns about the strength of various currencies.7 Shortly after formal approval of the “long-form” merger by the special committee, the IIC board approved the proposed merger and, on March 27, 2002, parent approved the merger at a meeting of IIC’s stockholders.

Following the merger, plaintiff stockholders sought ap-praisal for their shares and fi led a class action on behalf of the subsidiary’s public stockholders alleging that the transaction failed to satisfy the entire fairness test applicable to going-private and certain other related-party transactions under Delaware law. The court held in favor of plaintiffs and determined the fair value of IIC shares at the time of the merger to be $14.30, a fi gure signifi cantly in excess of the $10.50 per share paid in the offer and the “long-form” merger.8

Standard of Review and Burden of ProofDelaware courts apply an entire fairness standard of review

when evaluating statutory “long-form” mergers between a parent corporation and its subsidiary. Courts have held that the normal deference afforded boards of directors under the business judg-ment rule is not appropriate in a merger where the self-interested controlling stockholder has the power to impose unfair terms on the minority. “Entire fairness review, in other words, serves to protect the minority stockholders where the law’s normal range

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The committee faced similar problems with respect to the independence of its fi nancial advisors. Parent began cultivating a relationship with the fi nancial advisor to the special committee at least three months before the committee’s offi cial formation. In fact, parent provided the fi nancial advisor with the opportunity to “pitch” the special committee even before the committee of-fi cially existed, and the committee appointed its fi nancial advisor without interviewing any other candidates. As evidence of the fi nancial advisor’s dubious loyalties, the court noted that during the negotiation of the tender offer price, the fi nancial advisor provided parent with confi dential information and analyses.

Lesson. The legal and fi nancial advisors to the special com-mittee must be knowledgeable and independent. The committee should be active in the selection of its advisors and should be proactive in investigating the qualifi cations of its advisors and the extent and implications of current and prior relationships between its advisors and the controlling stockholder.17 “At a minimum, the special committee should have control over its own sources of information and should have the uncompromised loyalty of its advisors throughout the process.”18

Process — The negotiation of the merger consideration was non-existent. Instead, the committee appeared to assume that the prior negotiation of the tender offer price and parent’s assertion regarding the impact of intervening events (principally the events of September 11, 2001), without further investigation or examination, was suffi cient. Unfortunately, the negotiation of the tender offer price was largely a sham, which proceeded almost exactly in line with a pre-arranged script that was established between parent and the advisors to the special committee prior to the committee’s formation.19 The resulting tender offer price of $10.50 per share was well below the $13 per share maximum that was initially authorized by the board of directors of parent. During the four-and-one-half months following the agreement on the tender offer price, the special committee failed to undertake any additional steps to inform itself, such as undertaking any new investigation or analyses or obtaining a new fairness opinion, before agreeing to recommend the “long-form” merger.

Lesson. Although the negotiations between the special com-mittee and the controlling stockholder do not have to be a “death struggle … they should be vigorous and spirited, and provide evidence that the special committee and the parent are not collud-ing to injure the minority stockholders.”20 A process that relies on a special committee to establish fairness will not withstand judicial scrutiny if the parties do not conduct themselves in a manner consistent with a third-party, arm’s-length negotiation.

Composition — To make matters worse, the special commit-tee in Gesoff was comprised of a single independent director. The only other director of IIC who was independent and qualifi ed to serve on the special committee was too infi rm to fulfi ll the duties required by the supplemental appointment.21

Lesson. Whenever possible, the special committee should be composed of more than one member. The court acknowledged that a single-member committee is sometimes necessary when only one member of the board of directors is unaffi liated with the controlling stockholder. Such single-member committees, however, will be subject to a higher level of judicial scrutiny and must be above reproach.22

Lessons on ValuationHaving found that the process failed “at the very threshold to

establish fair dealing,”23 the court went on to fi nd that the price offered the minority stockholders was substantively unfair.24 After rejecting parts of the plaintiffs’ and the defendants’ valuation analyses, the court went on to establish a valuation of $14.30 per share. The court’s criticism of the plaintiffs’ and the defendants’ valuation methods will be of particular interest to investment bankers and their counsel.

The court refused to adopt the plaintiffs’ conclusion regard-ing fair value for numerous reasons, including:

• The valuation of plaintiffs’ real estate expert was based on documents that could not be produced at trial or were produced late and only in a foreign language, and the expert admitted that he had been engaged to do a “short version” valuation and had not been inside the properties;

• Without explanation, plaintiffs’ valuation expert initially relied on forecasts for the subsidiary that differed consider-ably from the forecasts produced by IIC’s management;

• Plaintiffs’ valuation expert used country-specific risk premia that were too low and also incorrectly applied control premia to a discounted cash flow analysis; and

• Plaintiffs’ valuation expert entirely discounted the existence of a small-stock risk premium in all circumstances.

The court was not entirely satisfi ed with the defendants’ con-clusion regarding fair value either, but used it as a starting point and made corrective adjustments, including the following:

• Noting the ambivalent attitude of Delaware courts to com-pany specific risk premiums due to their inherent subjectiv-ity, the court found that defendants’ expert inappropriately applied such premia in calculating the discount rates used to value all constituent parts of IIC’s business. The court held that the defendants had not carried the burden of proof regarding the appropriateness of company specific risk premia and adjusted the results of the defendants’ discounted cash flow analysis accordingly; and

• The court also criticized the application of a small com-pany risk premia (based on an Ibbotson Associates chart) because the Ibbotson chart relied solely on observations of the United States market, and defendants’ expert provided little or no support for using small company risk premia when valuing IIC’s businesses that operate entirely outside the United States. Consequently, after examining the relevant facts, the court held that small company risk premia should not be uniformly added to the weighted average cost of capital used to value IIC’s constituent parts and applied varying small company risk premia to the discount rates used to value some, but not all, of IIC’s constituent parts.

Good Faith and ExculpationThe court concluded its opinion by holding that the

exculpatory provisions of Section 102(b)(7) of the Delaware General Corporation Law allowed the sole member of the special

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committee to avoid personal liability.25 Section 102(b)(7) allows a Delaware corporation to limit or eliminate a director’s personal liability for breaches of its fi duciary duties as a director other than liabilities for breaches of the duty of loyalty; acts or omissions not in good faith or that involve intentional misconduct or knowing violations of law; or transactions in which the director derives an improper personal benefi t. As the sole member of the special committee in Gesoff was not personally confl icted, did not collude with parent and did not directly or indirectly benefi t from the transaction, the question as to whether the exculpatory provisions of IIC’s charter afforded a shield from liability turned on whether the sole member of the committee failed to act in good faith. In analyzing this issue, the court focused on whether the director knew, or should have known based on his knowledge and relevant expertise, that the merger consideration was unfair.26 The court concluded that the special committee did not act in bad faith, noting that the committee was unaware of the key facts that undermined the negotiation of the transaction: the committee did not participate in the pre-transaction orchestration; the committee did not know that its legal counsel was also advising parent on certain aspects of the transaction; and the committee did not know that its fi nancial advisor was communicating key facts and its valuation analyses to parent. The court found that, although the committee could have remedied the problems underlying the negotiation process through the greater exercise of due care, the resulting unfairness was the product of the manipulation of the process by parent and the confl icted advisors rather than the bad faith of the sole committee member. 27

ConclusionSpecial committees can perform a critical role in going-private

transactions and certain related party transactions because of their ability to help establish the fair process prong of the entire fairness test and to shift the burden of proof regarding entire fairness. However, the mere establishment of a special committee is not enough to protect defendant directors. Courts will look through the form and substantively examine the structure and mandate of the committee, the independence of its advisors and the quality of the negotiation between the committee and the controlling stockholder.

Notes1. In re Tele-Communications, Inc. S’holders Litig., No. 16470, 2005

Del. Ch. LEXIS 206 (Del. Ch. Dec. 21, 2005).2. In re Emerging Communications Inc. S’holders Litig., No. 16415,

2004 Del. Ch. LEXIS 70 (Del. Ch. June 4, 2004).3. Gesoff v. IIC Industries, Inc., Nos. 19473 & 19600, 2006 Del. Ch.

WL 1458218 (Del. Ch. May 18, 2006).4. Id. at 1.5. Del. Code Ann. tit. 8, § 102(b)(7) (2005).6. Delaware law provides that a parent corporation that owns more

than 90% of each class of stock of its subsidiary otherwise entitled to vote on a merger may merge with the subsidiary without the approval of the board of directors or the stockholders of the subsidiary. Del. Code Ann. tit. 8, § 253. Such mergers are commonly referred to as “short-form” mergers. On the date the tender offer commenced, parent owned approximately 79% of the outstanding shares of IIC. Gesoff at 8.

7. “When asked during the trial why he felt no need for further information, given the events of September 11, 2001, [the

sole member of the special committee] explained that he was concerned that new information would refl ect a lower price for IIC than the merger price.” Id. at 9.

8. The primary defense appears to have been that even if the price per share offered in the tender offer was unfair on September 10, 2001, the date on which it was agreed with the committee, the tragic events of September 11, 2001, resulted in that price being more than fair on March 27, 2002, the effective date of the merger.

9. Gesoff at 10.10. Gesoff at 13.11. Id. at 4.12. Parent did hire a law fi rm to review the work of the legal counsel

to the special committee, but it appears that such review did not have any substantive impact on the special committee’s understanding of its role or the articulation of its mandate. Gesoff at 14.

13. Id.14. In this instance, the court was particularly concerned by the

committee’s inability to appropriately distinguish between the initially proposed tender offer and the ultimately consummated long-form merger. Id. at 11.

15. Id.16. To be fair, the special committee did ask the attorney about

confl icts of interest, to which the attorney replied that IIC and the special committee “were really on the same side of [the transaction], and looking to get the best price from [parent], and there was no confl ict,” a statement that the court found to be “frankly incredible.” Gesoff at 5 n. 40; Id. at 15.

17. In this instance, not only was the committee’s counsel also counsel to the parent company and the subsidiary, but, during the course of negotiations, the committee’s fi nancial advisor (who had been handpicked by the parent company) was sharing its fi nancial analyses with the parent company.

18. Gesoff at 12.19. In an email from the fi nance director of parent to the attorney who

would eventually be appointed counsel to the special committee, the fi nance director proposed that parent would initiate the process by making a lowish proposal to the board of directors of IIC. The board would respond by hiring the pre-selected fi nancial advisor who would recommend a bid that was a “bit higher.” Parent would meet this price, the fi nancial advisor would approve it, and parent would be free to make its tender offer for the shares of IIC. The attorney responded, “‘I just spoke to [the fi nancial advisor] and he confi rms that this is the process.’” Id at 5.

20. Id. at 12.21. Unfortunately, IIC’s second independent director passed away

before the merger was consummated. Id. at 4 n. 29.22. Id. at 11.23. Id. at 13.24. Interestingly, the court rejected, as insuffi ciently supported,

defendants’ argument that the events of September 11, 2001 had a material and adverse impact on the value of IIC’s non-U.S. businesses. Id. at 16-17.

25. Del. Code Ann. tit. 8, § 102(b)(7) (2005) (providing that a corporation’s certifi cate of incorporation may contain “[a] provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fi duciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director: (i) For any breach of the director’s duty of loyalty to the corporation or its