Lewis H. Lazarus, Morris James

Since the Delaware Supreme Court's 2015 Corwin v. KKR Financial Holdings decision, practitioners in merger transactions have been able to advise clients that a transaction otherwise subject to enhanced scrutiny could be subject to business judgment review if the transaction is approved by a majority of fully informed, noncoerced shareholders. A plaintiff nonetheless can avoid dismissal under this standard if it is able to allege a material misrepresentation or omission in the proxy statement and hence that any shareholder vote was not fully informed. Where the disclosures are adequate defendants can obtain dismissal at the motion to dismiss stage even if the narrative actually disclosed might be troubling. The idea is that where the disinterested shareholders approve the transaction on full information, there is no reason to subject the transaction to further scrutiny. This puts a premium on the quality of the disclosure. The recent case of Chester County Employees' Retirement Fund v. KCG Holdings, C. A. No. 2017-0421-KSJM (June 21, 2019), illustrates that a failure to provide full disclosure can be fatal to defendants' motions to dismiss asking the court to dismiss a challenge to a merger transaction at the pleadings stage.

Chester County involved a financial adviser, Jefferies LLC, who also was the seller's largest shareholder with a 24% stake. The buyer had several communications with Jefferies prior to notifying KCG Holdings Inc. of its interest in a potential acquisition. In those communications the plaintiff alleged that Jefferies disclosed confidential information about a potential restructuring of one of the company's significant assets, even though the board had not authorized that disclosure. Jefferies proposed that the company divest this asset post-closing. When the company's CEO first learned of the buyer's potential interest in acquiring the company at $18.50-$20 per share, the CEO's reaction was that management believed that the restructuring would result in the company having a stand-alone value 25% higher. Although the CEO continued to adhere to that view as discussions progressed, even when the buyer raised its bid to $20 per share, he nonetheless stated that he could support a transaction at $20.21 per share if the buyer would eliminate “closing risks, particularly personnel risks and the retention pool.” Shortly thereafter, the buyer agreed to a bonus compensation plan for KCG's top management of $13 million, or the amount equal to the difference between $20 and $21.50 per share. The plaintiff alleged that the CEO's reaction was that it was good news that the buyer had agreed to the bonus compensation even as the buyer rejected the company's counteroffer of $20.21 per share. The company eventually agreed to a transaction at $20 per share, subject to receipt of a fairness opinion. Prior to receipt of the fairness opinion, the company downwardly revised its financial projections, which caused the buyer's $20 bid to move from the bottom to the middle of the financial adviser's DCF range.

The plaintiff sued the director defendants for breach of fiduciary duty. The defendants move to dismiss on the ground that a majority of fully informed and uncoerced disinterested shareholders approved the transaction. The plaintiff argued that the vote was not fully informed, and that the transaction was subject to enhanced scrutiny. The court agreed, finding that the defendants failed to disclose the specific asset the company intended to divest, created a misleading impression that the divestiture proposal was '”vague or undeveloped,” and understated the potential value of the divestiture; failed to disclose the CEO's initial belief that $20.21 per share was too low a value, and explain his potential conflicts or how those conflicts may have affected his change of position; and the earlier projections which, in light of their having been prepared in the ordinary course, made them reasonably conceivable to be more reliable. For those reasons the court found the shareholder vote was not fully informed, the transaction was subject to enhanced scrutiny and denied the motion to dismiss.

Chester County illustrates that directors who authorize a merger transaction must ensure that disclosures are full and complete. In that circumstance a challenge to a merger transaction likely will be dismissed at the pleadings stage under Corwin. But where as here a plaintiff is able to allege material misrepresentations or omissions, a plaintiff's challenge is likely to survive a motion to dismiss with the claims subject to enhanced scrutiny and the company and defendants having to endure the costs of discovery.

Lewis H. Lazarus ([email protected]) is a partner at Morris James in Wilmington and chair of the corporate and commercial litigation group. His practice is primarily in the Delaware Court of Chancery in disputes, often expedited, involving managers and stakeholders of Delaware business organizations.