Introduction
On December 21, 2005, the Delaware Court of Chancery issued its decision in In re Tele-Communications, Inc. S'holders, Litig., Civ. A. No. 16470 (Del. Ch. Dec. 21, 2005) ("TCI"). TCI involved the sale of TCI to AT&T, in which the holders of the higher-voting Class B common stock ("TCOMB") received a 10% premium over the consideration received by the holders of the Class A common stock ("TCOMA"). TCI's board of directors had established a special committee of directors to review the transaction in light of the significant conflicts of certain board members, notably their ownership of TCOMB shares. The Court denied summary judgment to TCI's board of directors, finding the special committee process flawed and certain public disclosures surrounding the special committee's work misleading.
The TCI opinion serves as a reminder that Delaware courts will carefully scrutinize a special committee process to ensure that the committee is truly disinterested, understands its mandate, and performs its role with care. TCI also contains guidance for companies and their financial advisors when addressing the fairness of merger consideration paid in respect of multiple classes of stock. The TCI opinion contains several valuable lessons:
- If a board delegates matters to a special committee, the committee members must be selected carefully. Committee members cannot have interests that conflict with the interests of the constituency they represent.
- Boards should consider whether compensation paid to special committee members taints the special committee process or otherwise gives the appearance of impropriety or undue influence. The form, timing, amount and disclosure of special committee compensation should be defined and analyzed with great care; "uncertain, contingent, and potentially large . . . payments, without any objective benchmarks or other measures" may affect the judgment of a special committee.
- The mandate of the special committee must be clear. The mandate should be in writing and clearly identify the class of shareholders or other constituency on whose behalf the special committee is acting. A special committee must have the freedom to negotiate, and must actually negotiate, on behalf of the constituency it represents.
- Absent extraordinary circumstances, a special committee acting in an "interested" merger transaction, or a transaction involving a controlling shareholder, should retain its own financial and legal advisors. Retention of these advisors may be critical in a later challenge to the special committee's decision.
- A special committee must perform its role on an informed basis. Outside counsel and financial advisors are an important means by which a committee can inform itself, especially on an accelerated timetable. Special committee members should meet as frequently as necessary, not act in a rushed or hurried time frame, make sure they follow up (with management or the advisors) on areas of uncertainty and take all reasonable steps to make themselves comfortable with their decisions.
- Where fairness of the price being paid to a class of shares is at issue, boards should pay particular attention to the impact upon that class of a preference, if any, being given to another class of shares and whether any fairness opinion being relied upon by the board adequately addresses that issue.
Background Facts
In mid-1998, TCI's board began discussions with AT&T about a merger between TCI and an AT&T subsidiary. TCI had six series of tracking stock, including the TCOMA and TCOMB shares. Each share of TCOMB was entitled to 10 votes; each share of TCOMA was entitled to 1 vote. Eight-four percent of the TCOMB shares were held by five members of the nine-member TCI board.
TCI's Chairman and Chief Executive Officer, John Malone, controlled 47% of TCI's total voting power. From the outset, Malone made clear that he would not consent to any merger unless the TCOMB shares received a 10% premium over the TCOMA shares.
TCI's board established a two-person special committee of "disinterested" directors to review the potential transaction. One committee member owned approximately 73,000 TCOMA shares; the other committee member owned approximately 88,000 TCOMA shares and 246,000 TCOMB shares. At an early meeting, Malone suggested that the committee members be reasonably compensated for their efforts, but no further decision was made as to the amount of such compensation.
The special committee met a total of four times. The special committee did not retain its own financial or legal advisors, but instead used TCI's advisors. With respect to the 10% premium for the TCOMB shares, the special committee was advised by counsel to TCI's investment bank that there were precedents for higher-voting stock receiving a premium to lower-voting stock, but those transactions were "less common" than transactions in which all shares were compensated equally, regardless of voting power. Although the special committee received a fairness opinion that the merger consideration being paid for the TCOMA shares was fair to the TCOMA shareholders, that opinion did not opine on the fairness to the TCOMA shareholders of the premium paid to the TCOMB shareholders.
The special committee voted unanimously to recommend the merger to the full board, which approved the merger. The merger consideration represented a premium of 37% over TCOMA's market price and a premium of 52% over TCOMB's market price. This translated into a 10% premium for the TCOMB shares over the price received by the TCOMA shares. The different exchange ratios paid for the TCOMA and TCOMB shares resulted in the directors receiving $220 million more than if the TCOMB and TCOMA shares had received the same weighted exchange ratio.
Just prior to the shareholder vote, the board approved a payment of $1 million to each special committee member as compensation for their work.
TCI's shareholders overwhelmingly approved the merger. However, a class of TCOMA shareholders sued, claiming that the board breached its fiduciary duties by, inter alia, recommending a merger providing for the unequal treatment of TCOMA and TCOMB shares. The shareholders also claimed that the proxy statement disseminated in connection with the merger was misleading.
Highlights Of The Opinion
The Entire Fairness Test
The Court found that the entire fairness, not the business judgment, standard applied because the TCI directors owned significant amounts of TCOMB shares and had personal interests that significantly diverged from the interests of TCOMA shareholders. The Court found that there were genuine issues as to whether the special committee was fully informed, truly disinterested and had the freedom to negotiate on behalf of the TCOMA shares. The Court raised the following issues:
First, the Court noted that the special committee appeared confused about its mandate. One committee member believed his role was to represent the TCOMA shareholders while the other committee member believed his role was to look after all the shareholders' interests. Of particular concern was one committee member's belief that his role was not to negotiate but to determine fairness. According to the Court, the disagreement and misunderstanding over the special committee mandate "initiat[ed] a structural flaw that fissured throughout the process that followed."
Second, the Court questioned the choice of directors on the special committee. Of particular concern was that one committee member primarily held TCOMB shares and gained $1.4 million in value by virtue of the preferential treatment of the TCOMB shares. The Court questioned why another non management director who owned only TCOMA shares, and "lost" over $13 million in value by virtue of the TCOMB premium, was not selected to serve.
Third, the Court criticized the special committee's decision to use the legal and financial advisors already advising TCI instead of retaining its own advisors. Furthermore, because TCI's investment bank was compensated on a contingent basis (it received approximately $40 million upon consummation of the merger), the Court questioned whether the investment bank could provide independent advice to the special committee. (This aspect of the decision has led some to question whether contingent fee arrangements are prohibited per se; it is questionable whether the Court intended to go that far and its critique should be read in the context of both the flawed special committee process and its determination that the question raised triable issues of material fact.)
Fourth, the Court found that the special committee was inadequately informed because it failed to investigate the historical premiums at which the TCOMB shares had traded and was not sufficiently informed about precedent transactions involving higher-voting stock premiums. Although the investment bank's lawyer had indicated that such premiums were less common than equal treatment, the Court faulted the special committee for failing to ask "the lingering question . . . how less common are such high vote premiums than equal treatment?"
Fifth, the Court determined that, given the muddled special committee mandate, one committee member's $1.4 million premium windfall, the unspecified special committee compensation, and the special committee's lack of information regarding historical TCOMB trading prices and precedent transactions involving premiums for higher-voting stock, there was "an inhospitable clime for arm's length bargaining to blossom."
Finally, the Court questioned whether the price paid to the TCOMA shareholders was fair. While the price obtained by the TCOMA shareholders was significantly higher than TCOMA's market price, and within the range of the investment bank's valuations, the Court concluded that the price was arguably unfair in light of the premium received by the TCOMB holders. Tellingly, the fairness opinion "[did] not discuss the effect of the TCOMB premium upon the TCOMA holders, i.e., whether the TCOMB premium was fair to the TCOMA holders." According to the Court, if the investment bank's separate analyses were determinative, the TCOMB holders theoretically could have received a 110% premium, and the transaction still could have been "fair" to the TCOMA shareholders because those shareholders had received a 37% premium over the TCOMA market price. According to the Court, "entire fairness requires an examination of the fairness of such exorbitant premiums to the prices received by the TCOMA holders."
Failure To Disclose Special Committee Compensation
The proxy statement did not disclose the open-ended plan to compensate the special committee members, nor did it disclose the $1 million payment to each committee member. The Court noted that: "Compensation of Special Committee members that is contingent, ambiguous, or otherwise uncertain, raises a triable issue of material fact as to what each member anticipated in the event the Special Committee approved the transaction, and whether such anticipated reward was significant to the reasonable shareholder."
Conclusion
The TCI opinion reaffirms that a special committee process must be carefully designed and implemented if a board wishes to satisfy the high standard required under the entire fairness test. Furthermore, careful scrutiny must be given to any fairness opinion upon which the board relies in making judgments. TCI was issued after discovery on a full record and, unless settled, will now proceed to trial.
Published March 1, 2006.
