The synopsis describes the cutting edge issues we address regarding the deficiencies in the current state of the law regarding statutory demands by a shareholder for books and records of a corporation purusant to DGCL section 220.

This Article examines Section 220 of Delaware General Corporation Law (“DGCL”) which generally provides limited rights to shareholders seeking “books and records” of a corporation.  The Article presents an argument that encourages Delaware’s Legislature and courts to address the archaic nature of the phrase “books and records” by modernizing and making more meaningful the statute and case law which do not reflect the current world of electronically stored information (“ESI”) and the fact that nearly all information in today’s digital world is created and maintained exclusively in electronic form and is not reduced to “hard copy.”  While certain judicial decisions have reflected a reluctance to consider ESI in this context, no Delaware court has directly and authoritatively addressed the issue of whether ESI must be produced in connection with a proper Section 220 demand.  This Article provides persuasive reasoning why the Delaware Legislature and the Delaware courts should require the production of appropriate ESI in response to a proper Section 220 demand in order for Section 220 to maintain any practical usefulness.   

Among the reasons to attend, is the chance to hear Chancellor Strine discuss the recently promulgated Practice Guidelines for the Court of Chancery. Justice Ridgely of the Delaware Supreme Court will be featured on a legal ethics panel. Another panel is entitled: Corporate Law Updates via Blogs. One of the panelists is Doug Batey of Stoel Rives, author of the LLC Law Monitor blog, who describes the seminar in a post.

Issue Addressed

Whether the settlement of a derivative action that the Court considered fair should be approved despite the objections of the named plaintiffs. 

Short Answer

The Court explained that the settlement could still be approved even if the named plaintiffs objected to it but in light of the potential merits of the objectors’ arguments, the Court would approve the settlement provisionally – - unless the objectors posted a secured bond or letter of credit in the full amount of the settlement consideration of $13.25 million, at which time they could apply to the Court for approval to take over the case.

Several prior opinions in this case have been highlighted on these pages here.

Brief Background

This is the 7^th opinion by the Court of Chancery in this long running derivative action.  The case involves a derivative claim against a fund that was formed for senior employees of the Canadian Imperial Bank of Commerce to co-invest with the bank in private equity opportunities.  Shortly before trial in early 2011, a mediation resulted in a settlement that the named plaintiffs initially agreed to, but they subsequently joined with other objectors in opposing the settlement.

Legal Analysis

The Court reviewed the fundamentals of Delaware law applicable to this situation.  Namely, settlements of a derivative action require Court approval, and also require the Court to determine the intrinsic fairness of the settlement.  Although the Court does not perform its own evaluation of the case on the merits, it must apply its own business judgment in deciding whether the settlement is reasonable.

The Court emphasized that it was not necessary for the named plaintiffs to support the settlement in order for the Court to approve it.  The Court explained that by suing a representative capacity, “the named plaintiffs gave up the right to dictate the outcome of the action unilaterally.”  Moreover, the Court emphasized that “counsel in a derivative and/or class action may present a proposed settlement over the objections of the named plaintiffs.  The mere fact that the counsel takes a different view on the advisability of a settlement than the named clients, does not, in itself, constitute grounds for disqualification.” 

The Court recited the reasons why it believed that the settlement proposal was reasonable even if it was on the “low end” of reasonableness. 

The Court, however, recognized that it “is not infallible,” and wanted to allow for the possibility that the objectors may be right in their analysis that the potential damages could exceed $200 million, far more than the approximately $13 million value of the settlement.

The Court recited several quotations from law review articles and other decisions of several federal courts to address the competing interests which raise the concern, in general, that the interests of counsel for the class may diverge from the interests of their clients, and that the requirement of judicial approval for settlements in representative litigation must take those factors into account.  Moreover, the Court observed that there may be concern that the interests of the objectors to the settlement may also diverge from the interest of the company, or in this case the fund, against whom the claims were made.

Balancing of Risk

In order to balance the risk of losing the certainty of the settlement against the possibility that the settlement consideration may by inadequate, the Court fashioned a somewhat Solomonic remedy which provided that it would enter an order approving the settlement, as well as the counsel fees for the plaintiff – - unless the objectors or their counsel provided the Court within 60 days with a secured bond or letter of credit or similar security in the amount of the settlement consideration.  If the objectors pursue the case and ultimately recover less than the current settlement, the fund will have the right to execute on the security to collect the difference.  If however the objectors in the future were to receive more than the current cash settlement, they would be entitled to the benefits of the larger settlement.

The Court recognized that even though this approach addresses the agency costs and the inherent problems with representative actions, through an auctioning process, it was imperfect because the objectors and their counsel would not be entitled to the entire amount of any increased recovery even though they were providing a bond for the entire amount of the settlement.

The Court conducts a careful weighing of the public policy concerns that are at work due to the different interests and different perspectives of the parties that are presenting a settlement of this type to it for approval.  The citations to various law review articles and federal court opinions provide a basis for deep thought about these issues that have a substantial impact on society.

Conclusion

In sum, the Court explained that it would approve the settlement and the fee request by the plaintiffs’ attorneys unless the objectors posted security and applied to take over the case within 60 days.  The Court then went on to explain the basis for approving the amount of fees requested by the plaintiffs, as well as a request for payment to the named plaintiffs for their substantial contributions to the case over several years.

LightLab Imaging, Inc. filed an action against the defendants relating to a technology dispute. In connection with a separate but substantially related action filed in Massachusetts, LightLab had filed in Delaware a motion to stay that Massachusetts action because the material facts in the dispute were not static.

The Court granted the motion to stay noting that:

[t]he court may exercise its discretion to grant a stay where ‘a controversy has not yet matured to a point where judicial action is appropriate.’ One factor indicating that a dispute is not ripe is where the ‘material facts’ of the dispute are not ‘static.’ Moreover, in deciding whether a claim is ripe for decision, Delaware courts look to ‘whether the interests of those who seek relief outweigh the interests of the court and of justice in postponing review until the question arises in some more concrete and final form.’

Noting that there was substantial overlap between the cases in Delaware and the Massachusetts litigation on appeal, the Court found that “LightLab sought to stay the [Massachusetts] litigation for substantially the same reasons that the defendants raise here – that is, that the material facts necessary to resolve the claims as to whether Axsun and Volcano have breached the Contract by supplying Volcano with a Laser are not yet static…. It was LightLab that desired the original stay, and at that time it knew of the issues that it now claims justify expedient action on the part of the defendants and the court.”  The Court also noted that LightLab (i) sought a stay of its counterclaims because the facts were still fluid and that it did not make sense to have a trial on that basis, (ii) failed to move to expedite its appeal in Massachusetts, and (iii) now seeks to have serial trials on issues that LightLab selects without any exigent circumstances.

Brief Overview: This opinion dealt with the esoteric issue of whether Microsoft Corporation had standing to bring derivative claims as a shareholder in, and on behalf of, Vadem, Ltd.–based on the law of the British Virgin Islands which applied because that is the law pursuant to which Vadem, Ltd. was formed.  As a result of the application of that country’s somewhat archaic law, Microsoft was first required to seek leave from the High Court of the British Virgin Islands before bringing a derivative suit on behalf of Vadem, Ltd.  Because it failed to do so, the Court dismissed those claims.  The Court regarded the remaining claims as time-barred.  The discussion of the cases that were time-barred was not especially noteworthy, and based on the recondite BVI law, this summary will make merely two passing notations that may be of more widespread interest.

Useful Rulings of Note in this Decision 

One of the defendants was a dissolved Delaware corporation but pursuant to DGCL Section 278, even though it was a defunct company, because it was dissolved less than 3 years before the initiation of the lawsuit, it continued as a “body corporate” for purposes of participating in the lawsuit.  Also, the Court observed that Court of Chancery Rule 44.1 allows the Court to consider “relevant material,” including an affidavit, in determining foreign law, and the determination by the Court will be treated as a ruling on the question of the law.

Issue Addressed

Whether the plaintiff satisfied the pre-suit demand requirements in her derivative claims against the trustees of the trust.

Short Answer

No, and therefore her complaint was dismissed.

Background

This case involved claims by a common stockholder of a Delaware statutory trust against the trustees of that trust, as well as claims against those entities that she alleges aided and abetted the breach.  The Court determined that the claims were derivative and in order to survive a motion to dismiss under Section 3816 of the Delaware Statutory Trust Act (“DSTA”), the Court explained that a plaintiff must plead particularized facts raising a reasonable doubt that the actions of the trustees were taken honestly and in good faith.  Because the Court determined that that standard was not met, the complaint was dismissed.

Analysis

The Court conducted the same analysis to determine whether a claim is direct or derivative as would be done in a case involving a corporation.  Thus, the Court compared Court of Chancery Rule 23.1(a) with Section 3816(c) of Title 12 of the Delaware Code, which is the counterpart in the DSTA to the pre-suit demand requirement in Rule 23.1.  See Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004), in which the Delaware Supreme Court articulated the test for assessing whether a claim asserts a direct or derivative harm.

The Court explained that the standard used to determine demand futility when a plaintiff sues on behalf of a statutory trust are the same as those applied to derivative suits by corporate stockholders.  Where a plaintiff challenges a conscious business decision by the board, the Aronson test applies.  In order to survive a motion to dismiss, the plaintiff must successfully plead demand futility by alleging particularized facts that raise a reasonable doubt that:  (1) “The directors are disinterested and independent [or] (2) The challenged transaction was otherwise the product of a valid exercise of business judgment.”  See footnotes 76 through 80.  The plaintiff in this case sought to rely on the second prong of Aronson which, as the Court explained, is a “heavy burden.”

As applied to the facts of this case, in order to succeed, the plaintiff in this case was required to plead facts amounting to corporate waste.  As regular readers are aware, the valid waste claim must establish that:  “A transfer of corporate assets that serves no corporate purpose or for which no consideration at all is received,” has taken place.

The Court provided citations to authority to explain how difficult it was to succeed on such a claim and, predictably perhaps, the Court held that the allegations in this case fell short. 

The Court referred to a decision by former Chancellor Chandler in which he quipped that a waste claim in the context of the second prong of Aronson may be akin to a search for the Loch Ness monster, and: “like the cameras of many a tourist in Scotland, the allegations of the plaintiff here are not sufficiently focused to bring the fabled beast within our ken.”  See footnotes 95 and 96.  Footnote 100 refers to a case that underscores the point by explaining that it is not sufficient that a plaintiff regards a decision as “unwise, foolish or even stupid” because those descriptions are not legally significant nor are they legally sufficient to successfully plead a waste claim.

Issue Addressed: Whether the Court should enjoin a hostile bid based on the disclosure of information in violation of the parties’ confidentiality agreement. Short Answer: Yes.

Background

This 138-page decision was issued after the close of the markets on Friday afternoon and generated several articles over the weekend in the trade press, business publications, mainstream media and by legal commentators. So much so, that a summary even now, on the next business day, would add little to what has already been said. Still more, Martin Marietta announced today that they would appeal to the Delaware Supreme Court. For a sample of the stories, see, e.g., here and here.

Nonetheless, in a nutshell, Vulcan and Martin Marietta had been flirting with each other regarding a possible combination for about a decade. Their most recent courtship was reignited in 2010. They signed a confidentiality agreement that contemplated an amicable business combination but at some point, Martin Marietta disclosed that information as part of a hostile bid.

Analysis

The Court emphasized that its decision was based entirely on contract law and its reasoning did not rely on any fiduciary principles. Professor Steven Davidoff provides an insightful analysis and encourages a reading of the tome for its perspective on the minutiae of how deals are made–or sought to be made. Professor Davidoff’s overview of the case does it justice. Perhaps we will provide a more comprehensive summary later, as well as noteworthy details regarding the embryonic appeal as it develops.

Supplement: Eduardo Gallardo of Gibson Dunn provides an overview of the case here.

UPDATE:  As Tom Hals of Reuters reports, the Delaware Supreme Court has granted an expedited appeal and scheduled oral argument on May 31, which is one day prior to the  Vulcan shareholders meeting.

Issue Addressed

In this appraisal proceeding pursuant to 8 Del. C. § 262, the post-trial issue addressed by the Court was whether the “fair value” of the company was worth more than the $40 million acquisition price. 

Short Answer

In an unusual twist, the Court found that the “fair value” of the company for appraisal purposes was only $34 million – - $6 million less than the cash acquisition price.

Background

This appraisal action was pursued by minority shareholders which included the founder and former CEO of the company, who voted in favor of the merger as a director, but later voted against it as a shareholder.  The case was filed in January 2010 and the trial was held in July 2011, followed by extensive post-trial briefing and oral argument.  Petitioners contended that the fair value of the company was $55 million.  By comparison, the respondent company claimed that the company was only worth $33 million, even though the cash acquisition price was $40 million.  The major difference between the valuations by the experts for each of the parties was twofold:  (1) whether cash flow projections for new planned facilities should be included in the valuations; and (2) “the appropriate small company size premium to be applied to the Company’s cost of equity.”  The Court explained that those two areas of dispute accounted for most of the differences between the parties’ respective valuations.

Analysis

The Court began its analysis with the basics, and described the fundamental purpose of an appraisal action as a limited legislative remedy intended to provide stockholders who dissent from a merger asserting the inadequacy of the offering price, with “an independent judicial determination of the fair value of their shares.”  See footnote 10.  The DGCL entitles petitioners to their pro rata share of the “fair value” of the companies in question as of the merger date.  See 8 Del. C. § 262(h) (acknowledging that the fair value of the shares is “exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation, together with interest, if any, to be paid upon the amount determined to be the fair value”).

Determination of Fair Value

In connection with the broad discretion given to the Court to determine fair value, it takes into account all relevant factors known or ascertainable “as of the merger date that illuminates the future prospects of the company.”  However, the Court must determine the fair value of the company as a going concern which requires the Court to “exclude any synergistic value, that is, the amount of any value that the selling company’s shareholders would receive because the buyer intends to operate the subject company, not as a stand-alone going concern, but as part of a larger enterprise, from which synergistic gains can be extracted.”

Both sides in an appraisal proceeding have the burden of proving their respective valuations by a preponderance of the evidence, and the Court may consider “proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in Court.”  Acceptable techniques that have been recognized in Delaware include “the DCF approach and the comparable transactions approach.”  The Court will use its own independent judgment to determine the fair value of the shares if neither party satisfies its burden.  See footnotes 15 through 19. 

Relevance of Fiduciary Duty Claims

The Court noted in footnote 26 that where a company relies on the merger price as evidence of fair value, allegations of breach of fiduciary duty or other improper actions during the sales process are relevant to whether the merger price is credible evidence of fair value.  However, where evidence of fair value is supplied by expert analyses, allegations of improper conduct by the Company’s fiduciaries are relevant only to the extent that they relate to some assumption or input to the expert’s valuation, affecting in turn the credibility of the challenged valuation.  See also footnote 27 (citing Cede & Co. v. Technicolor, Inc., 2003 WL 23700218, at *7 (Del. Ch. Dec. 31, 2003) aff’d in part rev’d in part, 884 A.2d 26 (Del. 2005) (referring to Chancery decision holding that when management projections are made in the ordinary course of business, they are generally deemed reliable)).

Each of the parties’ experts relied primarily on their DCF analyses to value the Company and the Court spent considerable time focusing on the “disputed inputs and assumptions” regarding the projected cash flows, capital structure and costs of capital for the Company.

Value as of the Date of Merger

The Court determined that the projected new facility in Georgia was too speculative to be included in the valuation of the Company as of the merger date, based on Delaware appraisal law which provides that “the corporation must be valued as a going concern based on the “operative reality” of the Company as of “the time of the merger” and the Court is limited to factors known or knowable as of the merger date that relate to future prospects of the Company, but should avoid including speculative costs or revenues.  See footnotes 35 and 36.  The Court distinguished the decision in Delaware of Open MRI Radiology Associates, P.A. v. Kessler, 898 A.2d 290, 315 (Del. Ch. 2006), which included in an appraisal valuation certain proposed new facilities which the Court likened to a Starbucks or McDonald’s as part of a standardized business model – - which was substantially different from the business model involved in the instant case.

Capital Structure

The Court spent a substantial part of the opinion addressing the weighted average cost of capital (WACC), in order to discount the cash flow projections for the company.

The Court determined that the approach taken by the expert for the petitioner was inappropriate, in part, because the capital structure applied by the expert for the petitioner arose directly out of the expectation of the merger.  The Court of Chancery has previously rejected the proposition that changes to a company’s capital structure in relation to a merger should be included in an appraisal.  The Court cited to a case at footnote 54 in which it had previously refused to include debt incurred as part of the merger in the company’s capital structure because to do so would contravene the valuation statute’s command to appraise shares “exclusive of any element of value arising from the accomplishments or expectation of the merger.”  Instead, in that cited case, the Court determined that because the Company had no debt before the merger and because the petitioner had introduced no evidence of non-speculative plans to incur significant debt, (that is not due to the accomplishment of the merger), it was inappropriate to include the actual additional debt for purposes of an appraisal.  Thus, the Court determined in this case that the correct capital structure for an appraisal of Just Care is that “theoretical capital structure it would have maintained as a going concern.”

Beta

In discussing the cost of equity, the Court determined that neither side seriously contested the beta calculation of the other.  The Court found that the relevant beta was equal to 0.82.  Beta has been defined as follows: 

“Beta (β) of a stock or portfolio is a number describing the volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to. This benchmark is generally the overall financial market and is often estimated via the use of representative indices, such as the S&P 500.

An asset has a Beta of zero if its returns change independently of changes in the market’s returns. A positive beta means that the asset’s returns generally follow the market’s returns, in the sense that they both tend to be above their respective averages together, or both tend to be below their respective averages together. A negative beta means that the asset’s returns generally move opposite the market’s returns: one will tend to be above its average when the other is below its average.”

Equity Risk Premium

The Court’s discussion of this point also provides a practice tip regarding the Court’s current approach on this issue.

Regarding the equity risk premium, the Court determined that the supply side equity risk premium of 5.73% was the appropriate metric to be applied in valuing the Company.  The Court explained that despite the historical equity risk premium applied by the Court, “the academic community in recent years has gravitated toward greater support for utilizing the supply side equity risk premium.”  See Global GT L.P. v. Golden Telecom, Inc., 993 A.2d 497 (Del. Ch. 2010).  The Chancery decision in Global v. Golden was highlighted here, and the Supreme Court’s affirmance was summarized here.

The Court explained that in smaller companies, “an equity size premium” generally is added to the company’s cost of equity for the higher rate of return demanded by investors to compensate for the greater risk associated with small company equity.  Small company premiums are empirically estimated and both experts utilized the Ibbotson size premiums in performing their analysis.

No Liquidity Discount Allowed

The Court emphasized that: “Although a liquidity discount related to the marketability of a company’s shares is prohibited, that does not mean that the use of any input that is correlated with a company’s illiquidity is per se invalid.”  (emphasis in original.)  The reduced liquidity of smaller companies which results in their equity being riskier and investors demanding higher returns, increases the cost of capital and it is that type of liquidity circumstance that is captured in the Ibbotson size premium.  See footnotes 77 and 78.

That is, the liquidity effect that arises in connection with transactions between a company and its providers of capital, which is part of the value of a company as a going concern, and which impacts its ability to obtain financing and influences the overall risk and return profile, needs to be distinguished from the liquidity effect that is prohibited under Delaware appraisal law and relates to transactions between shareholders and other market participants.

Therefore, the Court explained that where the effect of the company’s illiquidity relates only to the ability of an investor to exit his investment by selling his shares in the market, such a transaction relates more to the structure of the market than to the company’s ability to generate profits.  As a result, such a discount rightly is excluded in an appraisal because it does not relate to the intrinsic value of the company.

By contrast, the liquidity effect at issue in this case relates to the ability of the company to obtain capital at a certain cost and this effect is related to the intrinsic value of the company as a going concern and should be included when calculating its cost of capital.

The Court rejected the adjustment by the expert for the petitioner because the Court explained that “small company size premiums regularly are applied in appraisal proceedings in Delaware” without the type of adjustment performed by the expert for the petitioner.  See D.R.E. 702 (an expert’s report must be based on reliable principles and methods).

Compounded Interest

The Court addressed the general rule that an award of interest is routinely made unless the petitioner brought the action in bad faith.  The Court rejected any argument of bad faith and awarded prejudgment interest to petitioners consistent with Section 262(h), on the value of the appraised shares.

Conclusion 

The Court ordered the parties to “cooperate to determine the amount of the interest award” based on a valuation of about $34 million.

Postscript

Although the amount of interest awarded was not computed as a final, total number, it was not obvious whether the shareholders would have been better off accepting the $40 million acquisition valuation of the Company – - or if the prejudgment interest at the statutory rate of “5% over the Federal Reserve Discount Rate” would put them in a better position than if they had accepted the original merger consideration and generated a return that was less than the amount of statutorily mandated prejudgment interest.

Supplement: Professor Stephen Bainbridge, a friend of this blog and Delaware’s favorite corporate law scholar, provides an insightful analysis of this case and also cites to related Delaware court decisions and relevant scholarship on the key topic addressed in this case.