Target and Buyer are energy companies with complementary businesses. Target distributes and operates on-site combined heat and power systems and natural gas powered cooling systems. Buyer designs, manufactures, and sells combined heat and power systems. Prior to the merger, the companies were affiliated; they shared co-founders, brothers John (businessman) and George (prominent engineer); co-CEOs (John and Ben); certain members of senior management, directors, and ownership; and office space. In 2014 and 2015, nearly 10 percent of Buyer’s total revenues came from sales of cogeneration parts and services to Target.
Discussions of a merger between the two companies began in early 2016. The initial discussions took place informally and included John, Ben, and outside counsel for both companies, as well as the management teams of both companies. These initial meetings were not disclosed to either company’s board of directors at the time that the meetings were ongoing. In March 2016, John and Ben informed the board of directors of each company of the merger discussions, leading each board to create a committee of independent directors to negotiate the merger.
Target and Buyer independent committees continued to meet discuss, evaluate, and negotiate the merger of Target and Buyer until October 31, 2016 when a merger agreement was negotiated. The agreement reflected the committees ultimately negotiated purchase price of $0.38 per share of Buyer, which the parties settled upon after discussing prices ranging from $0.29 to $0.41 per share. Each committee of independent directors recommended the merger to their respective boards of directors. Following these recommendations, each company’s board of directors unanimously approved the merger.
On November 1, 2016, the agreement of merger was executed by Target and Buyer, and, on November 2, 2016, Target and Buyer announced their plan of merger, upon the consummation of which Target would be a wholly owned subsidiary of Buyer.
At the time the merger was announced, co-founders John and George each had leadership roles in the companies. John was the co-CEO of both companies and served as director of each, while George was a technical advisor to Target and had previously served as chairperson of the board of directors for Target and on the board of directors for Buyer. The two brothers, together with their families, also beneficially owned or controlled more than 34 percent of Target stock and more than 23 percent of Buyer common stock. By virtue of their ownership interests in Target and Buyer, the brothers, with a small group of other major shareholders, had the ability to control various corporate decisions, including the two companies’ direction and policies, the election of directors, the content of the charter and bylaws and the outcome of any other matter requiring shareholders’ approval, including a merger.
The proxy statement issued to shareholders described the merger agreement negotiation process and the two companies’ overlapping leadership and ownership. Stockholders overwhelmingly voted in favor of the merger, and, on May 18, 2017, the merger was executed.
Minority Target Shareholders sued John and George in a Massachusetts federal district court claiming that they received less than they should from the merger because of John and George’s conflict of interest resulting from their controlling interest on both sides of the deal. In legalese they accused John and George, as controlling shareholders of both Target and Buyer, of breaching their fiduciary duty to Minority Target Shareholders.
John and George pushed back saying that Minority Target Shareholders’ allegations, even if true, did not state a claim against John and George for breach of their fiduciary duty to Target Minority Shareholders because John and George received the same price per share for their Target stock as the price received by the Minority Target Shareholders. The court agreed with John and George and dismissed Minority Target Shareholders’ claim.
The court noted that both sides agreed that John and George were controlling shareholders of Target and Buyer and that they owed a fiduciary duty to Minority Target Shareholders to treat them fairly in the merger. However, the court also noted that both sides conceded that John and George received the same price for their Target stock as the Minority Target Shareholders.
The court concluded that Target Minority Shareholders’ factual allegations were not enough to trigger application of Delaware’s entire fairness rule to this deal, which would in effect permit Target Minority Shareholders’ claim to proceed and require John and George to prove that the deal was fair to the Minority Target Shareholders. The entireness fairness rule would have applied had Minority Target Shareholders had also alleged, for example, that John and George had liquidity problems.
In that case, the burden would be on John and George to prove that their liquidity problems did not force them to agree to a deal that resulted in a price for the Target shares that was lower than it should be. Without the entire fairness rule, the court applied the usual business judgment rule which gave Target and Buyer’s boards the benefit of the doubt that the merger was made in good faith.
This case is referred to Vardakas v. American DG Energy INC., Civil No. 17-10247-LTS, United States District Court, D. Massachusetts, (November 16, 2018).
Comment. A controlling shareholder in a company has a fiduciary duty to treat minority shareholders fairly in a merger or acquisition. And, there is always a risk of a minority shareholder filing a claim against a controlling shareholder for treating the minority shareholder unfairly in a deal; especially when the company is a public company.
By John McCauley: I help people start, grow, buy and sell their businesses.
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