Note on Kahn v. Lynch Communication Systems, Inc.
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In Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994) public shareholders of Lynch Communication Systems, Inc. ("Lynch") challenged the fairness of a cash–out merger of Lynch into its controlling shareholder, Alcatel U.S.A. Corporation ("Alcatel").
Alcatel offered to acquire Alactel in a merger, in which the 57% of Lynch shares not owned by Alcatel would receive $14 cash per share. Lynch's Board of Directors appointed a committee of disinterested directors (the "Independent Committee"), consisting of Kertz, Wineman and Beringer (the chair), and authorized it to negotiate the cash merger offer with Alcatel.
After consulting independent investment advisors, the Independent Committee concluded that $14 was inadequate. Independent legal counsel suggested that the Independent Committee review alternatives to a cash–out merger with Alcatel, including a "white knight" third party acquiror, a repurchase of Alcatel's shares, or the adoption of a shareholder rights plan.
The Independent Committee, made a a counteroffer at a price of $17 per share. Alcatel responded with an offer of $15 per share. When the Independent Committee rejected a price of $15, Alcatel raised its offer to $15.25 per share. The Independent Committee also rejected this offer. Alcatel then made its final offer of $15.50 per share.
At the Independent Committee's meeting (on November 24, 1986) to consider Alcatel's final offer, Beringer reported that Alcatel was "ready to proceed with an unfriendly tender at a lower price" if the $15.50 per share price was not accepted. Beringer also reported that the alternatives to a cash–out merger had been investigated but were impracticable. After meeting with its financial and legal advisors, the Independent Committee voted unanimously to recommend that the Lynch board of directors approve Alcatel's $15.50 cash per share price for a merger with Alcatel. The Lynch board met later that day. With Alcatel's nominees abstaining, it approved the merger.
After a trial, the Court of Chancery concluded that Alcatel had not breached its fiduciary duties, and entered judgment in favor of the defendants. On appeal, the Delaware Supreme Court held that the Court of Chancery had applied the wrong standard of review, and reversed and remanded:
A controlling or dominating shareholder standing on both sides of a transaction, as in a parent–subsidiary context, bears the burden of proving its entire fairness. Weinberger v. UOP, Inc., Del.Supr., 457 A.2d 701, 710 (1983). * * * The concept of fairness has two basic aspects: fair dealing and fair price. * * * However, the test for fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness.
The logical question raised by this Court's holding in Weinberger was what type of evidence would be reliable to demonstrate entire fairness. That question was not only anticipated but also initially addressed in the Weinberger opinion. This Court suggested that the result
could have been entirely different if UOP had appointed an independent negotiating committee of its outside directors to deal with Signal at arm's length,
fairness in this context can be equated to conduct by a theoretical, wholly independent, board of directors.
Id. [at 709–10 n. 7.] Accordingly, this Court stated,
a showing that the action taken was as though each of the contending parties had in fact exerted its bargaining power against the other at arm's length is strong evidence that the transaction meets the test of fairness.
In this case, the Vice Chancellor noted that the Court of Chancery has expressed "differing views" regarding the effect that an approval of a cash–out merger by a special committee of disinterested directors has upon the controlling or dominating shareholder's burden of demonstrating entire fairness. One view is that such approval shifts to the plaintiff the burden of proving that the transaction was unfair. The other view is that such an approval renders the business judgment rule the applicable standard of judicial review.
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Entire fairness remains the proper focus of judicial analysis in examining an interested merger, irrespective of whether the burden of proof remains upon or is shifted away from the controlling or dominating shareholder, because the unchanging nature of the underlying "interested" transaction requires careful scrutiny. The policy rationale for the exclusive application of the entire fairness standard to interested merger transactions has been stated as follows: parent subsidiary mergers, unlike stock options, are proposed by a party that controls, and will continue to control, the corporation, whether or not the minority stockholders vote to approve or reject the transaction. The controlling stockholder relationship has the potential to influence, however subtly, the vote of [ratifying] minority stockholders in a manner that is not likely to occur in a transaction with a noncontrolling party. Even where no coercion is intended, shareholders voting on a parent subsidiary merger might perceive that their disapproval could risk retaliation of some kind by the controlling stockholder. For example, the controlling stockholder might decide to stop dividend payments or to effect a subsequent cash out merger at a less favorable price, for which the remedy would be time consuming and costly litigation. At the very least, the potential for that perception, and its possible impact upon a shareholder vote, could never be fully eliminated. Consequently, in a merger between the corporation and its controlling stockholder—even one negotiated by disinterested, independent directors—no court could be certain whether the transaction terms fully approximate what truly independent parties would have achieved in an arm's length negotiation. Given that uncertainty, a court might well conclude that even minority shareholders who have ratified a ... merger need procedural protections beyond those afforded by full disclosure of all material facts. One way to provide such protections would be to adhere to the more stringent entire fairness standard of judicial review.
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The same policy rationale which requires judicial review of interested cash–out mergers exclusively for entire fairness also mandates careful judicial scrutiny of a special committee's real bargaining power before shifting the burden of proof on the issue of entire fairness. A recent decision from the Court of Chancery articulated a two–part test for determining whether burden shifting is appropriate in an interested merger transaction:
The mere existence of an independent special committee ... does not itself shift the burden. At least two factors are required. First, the majority shareholder must not dictate the terms of the merger. Second, the special committee must have real bargaining power that it can exercise with the majority shareholder on an arms length basis.
[Rabkin v. Olin Corp., Del.Ch., C.A. No. 7547 (Consolidated), Chandler, V.C., 1990 WL 47648, slip op. at 14–15 (Apr. 17, 1990), reprinted in 16 Del.J.Corp.L. 851, 861–62 (1991), aff'd, Del.Supr., 586 A.2d 1202 (1990)(citations omitted.] This Court expressed its agreement with that statement by affirming the Court of Chancery decision in Olin on appeal.
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* * * The Court of Chancery gave credence to the testimony of Kertz, one of the members of the Independent Committee, to the effect that he did not believe that $15.50 was a fair price but that he voted in favor of the merger because he felt there was no alternative.
The Court of Chancery also found that Kertz understood Alcatel's position to be that it was ready to proceed with an unfriendly tender offer at a lower price if Lynch did not accept the $15.50 offer, and that Kertz perceived this to be a threat by Alcatel. The Court of Chancery concluded that Kertz ultimately decided that,
although $15.50 was not fair, a tender offer and merger at that price would be better for Lynch's stockholders than an unfriendly tender offer at a significantly lower price.
The Court of Chancery determined that "Kertz failed either to satisfy himself that the offered price was fair or oppose the merger."
* * * Beringer testified that at the time of the Committee's vote to recommend the $15.50 offer to the Lynch board, he thought
that under the circumstances, a price of $15.50 was fair and should be accepted
Kahn contends that these "circumstances" included those referenced in the minutes for the November 24, 1986 Independent Committee meeting:
Mr. Beringer added that Alcatel is 'ready to proceed with an unfriendly tender at a lower price' if the $15.50 per share price is not recommended to, and approved by, the Company's Board of Directors.
In his testimony at trial, Beringer verified, albeit reluctantly, the accuracy of the foregoing statement in the minutes:
[Alcatel] let us know that they were giving serious consideration to making an unfriendly tender.
The record reflects that Alcatel was "ready to proceed" with a hostile bid. This was a conclusion reached by Beringer, the Independent Committee's chairman and spokesman, based upon communications to him from Alcatel. Beringer testified that although there was no reference to a particular price for a hostile bid during his discussions with Alcatel, or even specific mention of a "lower" price, "the implication was clear to [him] that it probably would be at a lower price."8
According to the Court of Chancery, the Independent Committee rejected three lower offers for Lynch from Alcatel and then accepted the $15.50 offer "after being advised that [it] was fair and after considering the absence of alternatives." The Vice Chancellor expressly acknowledged the impracticability of Lynch's Independent Committee's alternatives to a merger with Alcatel: Lynch was not in a position to shop for other acquirors, since Alcatel could block any alternative transaction. Alcatel also made it clear that it was not interested in having its shares repurchased by Lynch. The Independent Committee decided that a stockholder rights plan was not viable because of the increased debt it would entail.
* * *
The Court of Chancery properly noted that limitations on the alternatives to Alcatel's offer did not mean that the Independent Committee should have agreed to a price that was unfair:
The power to say no is a significant power. It is the duty of directors serving on [an independent] committee to approve only a transaction that is in the best interests of the public shareholders, to say no to any transaction that is not fair to those shareholders and is not the best transaction available. It is not sufficient for such directors to achieve the best price that a fiduciary will pay if that price is not a fair price.
(Quoting In re First Boston, Inc. Shareholders Litig., Del.Ch., C.A. 10338 (Consolidated), Allen, C., 1990 WL 78836, slip op. at 15–16 (June 7, 1990)).
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A condition precedent to finding that the burden of proving entire fairness has shifted in an interested merger transaction is a careful judicial analysis of the factual circumstances of each case. Particular consideration must be given to evidence of whether the special committee was truly independent, fully informed, and had the freedom to negotiate at arm's length. [U]nless the controlling or dominating shareholder can demonstrate that it has not only formed an independent committee but also replicated a process
as though each of the contending parties had in fact exerted its bargaining power at arm's length,
the burden of proving entire fairness will not shift. Weinberger, 457 A.2d at 709–10 n. 7. See also Rosenblatt v. Getty Oil Co., Del.Supr., 493 A.2d 929, 937–38 (1985).
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The Court of Chancery's determination that the Independent Committee
appropriately simulated a third–party transaction, where negotiations are conducted at arm's–length and there is no compulsion to reach an agreement,
is not supported by the record. Under the circumstances present in the case sub judice, the Court of Chancery erred in shifting the burden of proof with regard to entire fairness to the contesting Lynch shareholder–plaintiff, Kahn. The record reflects that the ability of the Committee effectively to negotiate at arm's length was compromised by Alcatel's threats to proceed with a hostile tender offer if the $15.50 price was not approved by the Committee and the Lynch board. The fact that the Independent Committee rejected three initial offers, which were well below the Independent Committee's estimated valuation for Lynch and were not combined with an explicit threat that Alcatel was "ready to proceed" with a hostile bid, cannot alter the conclusion that any semblance of arm's length bargaining ended when the Independent Committee surrendered to the ultimatum that accompanied Alcatel's final offer.