1. Chapter 11: Sale of Control for a Premium
by Shu Lu
Summary
In this chapter, we will catch the glimpse of the inside of the selling company. More specifically, we will
discuss the intricate relationship between controlling shareholders and minority shareholders.
An alpha of a coyote pack in the wild world has a lofty position. Likewise, controlling shareholders have
special privileges in selling companies. They can control the merger by manipulating the board. By this
means, they are more flexible to cope with the risk arrangement. What is more, they are expected to
receive the premium, which reflects the true value of controlling blocks in terms of money. By contrary,
minority shareholders are less lucky. They are omegas in tribes. Even though the interests of minority
shareholders adheres to those of controlling shareholders, a minority shareholder barely get chance to
make his voice or to exert influence on the company.
Such is human nature, that individual has an unresisted incentive to maximize his own interests, even if
sometimes his gain causes others’ loss. In the cases of selling companies, people are afraid that
controlling shareholders might trample company and minority shareholders using their superiority. As a
result, the judicial review intrudes into the conflict between the controlling shareholders and minority
shareholders. It is never an easy job, because, like labyrinth, most M&A cases are full of inexplicable
details and odd plots, however, the eternal theme is greed. Before we set out to dive in the judicial review
of controlling shareholders, we should establish some fundamental principles:
• Even though a controlling shareholder has a fiduciary duty to both the corporation and the minority
stockholders, it has no duty of self-sacrifice in favor of minority shareholders.
• The premium paid for controlling blocks of share should be taken for granted, provided that a
controlling shareholder does not divest the benefits and interests of corporation or minority
shareholders.
• Altruism is not available in the business society.
Now, let us begin at our old friend “fiduciary duty ”. We know that officer and directors have to abide by
fiduciary duty rule, whereas shareholders were traditionally not subject to the same fiduciary duty rules.
With the time going by, courts said, no! We have to magnify the fiduciary duty into controlling
shareholders in order to protect the corporation and minority shareholders’ interests. For example, if a
shareholder disagrees with an ongoing merger, he has the right to seek to either appraisal action or a
fiduciary duty action.
The following cases relevant to minority shareholders will elaborate the above fundament principles to
you. And then we will spend a little time skimming through the Revlon case and Unocal case which, as
precedents, determines how to distribute the premium is fair.
Perlman v. Feldmann
219 F.2d 173 (2D CIR. 1955)
In this case, minority shareholders of Newport (derivative suit) sued Feldmann, a controlling
shareholder, alleging that the compensation that Feldmann received by selling his stock
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2. comprised the Newport’s asset : the power to control the distribution of the company’s product
during the war. The court stood for the plaintiff, viewing that Feldmann misappropriated the
corporation opportunity and should share his premium with the minority shareholders.
Feldmann was the majority shareholder and the chairman of board of directors in the Newport
Steel Corporation (Newport). During the Korean War, there was a severe shortage of steel
supply. As a result, the power of controlling Newport was very valuable. Feldmann, taking
advantage of the shortage, sold his controlling interests to Wilport Company (Wilport) for a
premium price. Newport minority stockholders (plaintiffs) brought a derivative suit against
Feldmann seeking accounting for and restitution of Feldmann’s gains in the sale. The plaintiffs
contended that the premium Wilport paid included a corporate asset—the ability to control
production of steel in a time when the supply was very low. They argued that this power was
held in trust for Newport by Feldmann as its fiduciary, because Feldmann did not account for the
non-participating minority stockholders for that share of their profit which is attributable to the
sale.
The appellant court stood for the minority shareholders (plaintiff), stating that in this case the
majority shareholder may violate his fiduciary duty, where he sold the controlling block of share
and shifted the dominion of distribution of product. The case was remanded to the district court
for determination of the questions below, the value of defendant’s stock with the appurtenant
control over the corporation’s output of steel.
The buyer, Wilport, was a purchasing syndicate, comprised many end-users of steel. The
primitive motive of Wilport was buying more steel from Newport by acquiring the preponderant
control power in the Board of Newport. The reason behind it is, during the Korean war, that the
government restricted the cap price of steel and steel shortage made such control power precious
and unique.
The plaintiff worried about Newport losing its advantage as long as Wilport sneaked into the
Board of Newport and then was able to select prospective purchasers. The plaintiff asserted that
Newport should have continued taking advantage of steel shortage by carrying out the
“Feldmann Plan” or building up patronage in the geographical area. Selling the controlling
block of share to actual customers impaired Newport’s superiority of acquiring additional
benefit, more specially, betrayed the Newport’s interests.
Notice that this case happened in federal circuit court about six decades ago. Thirty years later,
Easterbrook and Fischel voiced their disagreement with the out-dated disposition. They found
that the price of per share of Newport in the stock market proved to rise after the Feldmann had
sold his controlling block of share to Wilport. In addition, Wilport strengthened the market
position of Newport by appointing more experienced and competent managers replacing former
ones. All statistics manifested that the market refuted that Wilport deprived Newport of its
privilege of controlling steel supply. Therefore, the court, to some degree in this case, maybe
made an error.
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3. Mendel v. Carroll
651 A. 2d 297 (Del. Ch. 1994)
In this case, Mendel and other minority shareholder sought an unprecedented order requiring the
Board to grant a stock option to a third party, in order to dilute the voting power of the
controlling block held by the Carroll family. The court stood for the controlling shareholder,
denying the preliminary injunction.
The Carroll family, who is a controlling shareholder in Katy’s Industries, proposed purchasing
the outstanding stock from the minority shareholders at a $25.75. At the same time, Pensler, a
third party, presented an offer of $27.8 to purchase all outstanding shares. It was no doubt that a
minority shareholder prefers to accept the latter offer, however, the board under control of the
Carroll family denied the Pensler’s proposal, instead, accepting the Carroll family’s proposal.
The Carroll family owns between 48% and 52% of Katy’s voting stock. Neither did they intend
to sell their stock, nor to buy stock from other shareholders at the price as same as or above the
Pensler’s proposal. The minority shareholder stated that this case triggered Revlon duty, which
means when the break-up of a corporation is inevitable, the corporation’s board of directors
violate its duty of loyalty to the shareholders if its first consideration is not maximizing the
shareholders’ benefit when the company is eventually and inevitably sold.
The court found that the duty did not require the board to accept a third party’s offer at the
slightly higher than the price that had been offered by the controlling shareholder, the Carroll
family, simply because these two offers are fundamentally different. The Pensler’s offer included
purchase the Kay’s control and remaining part of corporation’s share at a single price, however,
the Carroll family only paid for the outstanding stock but not for the controlling power, which
they had already possessed. Moreover, there are no evidences to prove that $ 25.75 was an unfair
price. The court held that in this case the controlling shareholder neither trigger Revlon's duty
and nor have a duty to sacrifice themselves in order to maximize the minority shareholders’
interests.
Apart from the request of stock option of a third party, the plaintiff sought to prohibit the
distribution of $ 14 special dividend authorized by the whole board, but the court found that the
lack of evidence establish the fraud or gross abuse of discretion of the board.
In re Synthes, Inc. shareholder litigation
50 A.3d 1022(Del. Ch. 2012)
The Court of Chancery dismissed an amended class action complained that alleged that Mr.
Wyss, chairman and controlling shareholder of Synthes and its board of directors breached their
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4. fiduciary duties by refusing to consider the PE Club’s bid that would cashed out all the minority
shareholders, instead accepting the J&J’s bid for 65% stock and 35% cash at the price of CHF
159. The court held that Business Judgment Rule applied because Mr. Wyss received the same
consideration as the other shareholders.
Synthes is a global medical device company incorporated in Delaware, but its headquarter
locates in Switzerland. Mr. Wyss, who used to be a founder and CEO of Synthes, was the
Chairman of the Board and the alleged controlling stockholder as well. Not only did he own
38.5% of the Synthes’ stock, but controlled approximately 52% shares as well. A part of his
retirement plan is to divest his stockholdings in Synthes. He had to find the way to sell such large
block of stock without reducing the price of stock. The best option to deal with this dilemma was
selling all his stock to a sole buyer.
Search for competent buyer began in April 2010, after Mr. Wyss approved of the Board’ request.
The Board hired Credit Suises Securities (USA) LLC as its financial consultant and appointed an
independent director as the leader. The Board contacted nine logical strategic buyers, which have
sufficient financial ability to buy Synthes as a whole. Later, three potential strategic buyers sign
up the confidentiality agreement and then Synths opened up its door to these buyer in order to
fully disclose financial information by means of the due diligence.
J&J, one of three potential strategic buyers, is a well-known global manufacturer of healthcare.
It, definitely, has adequate financial resource to acquire Synthes. Finally, J&J turned out to be
the only strategic buyer. Although J&J submitted its first non-binding offer the price range of
CHF 145-150 per share with more than 60% of the consideration to be paid in form of J&J stock,
the Board kept seeking potential financial buyers.
Usually, as long as a strategic buyer acquires a target company, most managers and lots of
workers of the target company will be fired. However, a financial buyer tends to retain
everything because they are not interestsed in adjustment of target’s normal operation. Therefore,
most managers prefer financial bidders than strategic bidders.
A newly formed consortium (the “PE Club”) submitted a revised bid: all-cash purchase price of
CHF151. However, unlike J&J, the PE Club did not have such deep pocket. It required Wyss to
“ convert a substantial portion of his equity investment in Synthes into an equity investment in
the post-merger company. ” In other words, Wyss would remain as the a major investor in
Synthes. This bidding totally was not in accordance with Wyss’s ultimate goal.
After consulting its advisor, the Board found the PE Club’s bidder was more appealing because it
was all cash. Not surprised, Mr. Wyss opposed the PE Club’s bid since the only thing he could
get was one illiquid block of stock in the private post-merger entity. As a controlling shareholder,
Mr. Wyss caused the Board to cease consideration of the PE Club’s bid. In fact, Synths used the
PE Club’s bid as leverage to push the J &J to raise its’ bid.
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5. Eventually, the J&J agreed to increase its offer to CHF 159 per share, with a consideration mix of
65% shock and 35% cash. All shareholders, including Mr. Wyss, would receive the same per
share Merger consideration.
In April 2011, the boards of both companies separately met and approved the Merger Agreement
which implied an equity value of $ 21.3 billion, representing a 26% premium to Synthes’s
average 30- day trading price during the month preceding the announcement. After the
shareholder’s approval and regulatory review, the Merger closed in June 2012. The PE Club did
not raise its bid again.
The plaintiff filed suit alleging breach of fiduciary duty claims against Wyss and the Board. The
plaintiff argued that the Merger was subject to entire fairness review because Wyss had a
personal motive to divest his stock as soon as possible, which was opposite to the best interests
of Synths and minority shareholders. Moreover, the plaintiff alleged that the Merger should be
examined by Revlon test.
The court rejected all above complaints. First, the the entire fairness review, The court held that
the business judgment rule applies in a merger resulting from he open and deliberative sale
process when a controlling stockholder shares the control premium ratably with the minority
stockholders, because the controlling shareholders has intensive motive to maximize the price of
the per share. The court observed that “there is a good deal of utility to make sure that when
controlling stockholders afford the minority pro rate treatment, they know they that they have
docked within the safe harbor created by the business judgment rule.” Pro rata treatment is
considered fair. Second, the court held that the plaintiff failed to plead fact to suggest that Wyss
reduced the price of the Synthes in order to meet his anxious financial need. Actually, the
premium of J&J bid was higher than which of PE Club’s Bid and the procedure of the merger
lasted for over 2 years. Further, the court held reject the minority shareholders’ claim that Mr.
Wyss and the directors of board deprived their opportunity to sell out all of their stock for cash,
because the Delaware Court does not require that the controlling shareholder sacrifice his
individual’s interests for the best interests of the minority shareholders. The court emphasized
that the minority misguided view of the duties of a controlling shareholders under Delaware law.
The court rejected the Revlon and Unocal claims as well.
So far, we have gone through all the cases in this Chapter. You probably have realized that the
Revlon case and Unocal case are triggers in judicial review, so let us to run over those milestone
cases in order to clarify some significant principles of “the breach of the board’s duty”.
Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.
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6. 506 A.2d 173 (Del. 1986)
This case is relevant to the breach of the board’s duty of loyalty, when the break-up of the
company is inevitable and eventual. Briefly, as long as the board fully knows that the company
certainly would be taken over, their duties change from protecting the company as a vital entity
to magnifying the shareholder’s interests.
Pantry Pride, Inc. (Pantry Pride) sought to acquire Revlon, Inc. (Revlon) and offered $45 per
share. Revlon determined the price to be inadequate and declined the offer. Despite defensive
efforts by Revlon, including an offer to exchange up to 10 million shares of Revlon stock for an
equivalent number of Senior Subordinated Notes (Notes) of $47.50 principal at 11.75 percent
interestss, Pantry Pride remained committed to the acquisition of Revlon.
Pantry Pride raised its offer to $50 per share and then to $53 per share. Meanwhile, Revlon was
in negotiations with Forstmann Little & Co. (Forstmann) and agreed to a leveraged buyout by
Forstmann, subject to Forstmann obtaining adequate financing. Under the agreement, Revlon
stockholders would receive $56 per share and Forstmann would assume Revlon’s debts,
including what amounted to a waiver of the Notes covenants.
Upon the announcement of that agreement, the market value of the Notes began to drop
dramatically and the Notes holders threatened suit against Revlon. At about the same time,
Pantry Pride raised its offer again, this time to $56.25 per share. Upon hearing this, Forstmann
raised its offer under the proposed agreement to $57.25 per share, depending on two conditions.
First, a lock-up option giving Forstmann the exclusive option to acquire part of Revlon for $100-
$175 million below the purported value if another entity acquired 40 percent of Revlon shares.
Second, a “no-shop” provision, which constituted a promise by Revlon to deal exclusively with
Forstmann. In return, Forstmann agreed to support the par value of the Notes, even though their
market value had significantly declined. The Revlon board of directors approved the agreement
with Forstmann.
Pantry Pride brought suit, challenging the lock-up option and the no-shop provision. The
Delaware Court of Chancery found that the Revlon directors had breached their duty of loyalty
and enjoined the transfer of any assets, the lock-up option, and the no-shop provision. The
defendants appealed.
The Delaware Supreme Court confirmed the decision, holding the director of board of Revlon
should be committed into encouraging the potential buyers to raise their bids, rather than set up
look-up option and no-shop provision to end the auction when they fully knew that the breakup
of Revlon was inevitable. More specifically, the director of board of Revlon should put the
shareholders’ interests superior to their individual interests.
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7. When a board implements “anti-takeover measures,” the burden is on the directors to prove that
their actions were reasonable. However, the business judgment rule kicks in if directors prove a
good faith and reasonable investigation led to their decision.
In this case, the Revlon board’s initial defensive measures—its exchange offer for Notes—was
reasonable under the holding in Unocal Corporation v. Mesa Petroleum Co., 493 A.2d 946(Del.
1985), given the board’s determination that Pantry Pride’s offer was less than adequate. The
turning point is when Pantry Pride continually increased its offer, the court determines that it
became obvious that “the break-up of [Revlon] was inevitable.”
Since then, however, the duty of Revlon board was shifting from maintaining Revlon as a viable
corporate entity to maximizing the shareholders’ interests when the company was eventually and
inevitably sold. By granting the lock-up option to Forstmann that in turn guaranteed par value
for the Note holders threatening litigation against Revlon, it is apparent that the Revlon board of
directors had their own legal interestss in mind, rather than seek the best interests of the Revlon
shareholders.
The above facts established the breach of the board’s duty of loyalty and therefore the board is
no longer off the hook by being shielded under the business judgment rule. The lock-up option
should be enjoined and the Delaware Court of Chancery affirmed the decision.
Unocal Corporation v. Mesa Petroleum Co.
493 A.2d 946 (Del. 1985)
IIn this case, the board of Unocal attempted to exclude Mesa from the self-tender offer in order to defeat
Mesa’s two-tier cash tender offer. Mesa brought suit, challenging the Unocal’s exchange and exclusion
of Mesa. The Delaware Court of Chancery granted a preliminary injunction to Mesa, enjoining Unocal’s
exchange offer. Unocal appealed. The Delaware Supreme Court reversed the preliminary injunction,
holding that Unocal’s board’s selective tender offer was reasonable with respect to the threat issued by
Mesa.
The directors have to prove that they determined to purchases share with corporate fund against Mesa
under the good faith and reasonable investigations. As long as their conduct can constitute that they
exercise the duty of loyalty, their defense will success to attain the protection of the business judgment
rule.
Mesa Petroleum Co. owned 13% of Unocal Corporation’s stock. Mesa submitted a “two-tier” cash tender
offer for an additional 37% of Unocal stock at a price of $54 per share. The securities that Mesa offered
on the back end of the two-tiered tender offer were highly subordinated “junk bonds.” With the assistance
of outside financial experts, the Unocal board of directors determined that the Mesa offer was completely
inadequate as the value of Unocal stock. They felt that the stock of Unocal was at least worth $60 per
share, and the junk bonds were worth far less than $54 per share. To oppose the Mesa offer, the board of
the Unocal provides an alternative to Unocal’s shareholders, by adopting a selective exchange. Unocal
would self-tender its own shares to its stockholders for $72 per share. The Unocal board also determined
that Mesa would be excluded from the offer. The board approved this exclusion because if Mesa was able
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8. to tender the Unocal shares, Unocal would effectively subsidize Mesa’s attempts to buy Unocal stock at
$54 per share. In sum, the Unocal board’s goal was either to win out over Mesa’s $54 per share tender
offer, or, if the Mesa offer was still successful despite the exchange offer, to provide the Unocal
shareholders that remained with an adequate alternative to accepting the junk bonds from Mesa. In
addition, Unocal’s selective exchange offer was designed to protect its stockholders from Mesa’s tender
offer, and Mesa certainly would not qualify for the class of stockholders being protected from its own
offer. Accordingly, the selective exchange offer was reasonable in light of the threat posed to Unocal by
Mesa’s tender offer.
It is therefore upheld under the business judgment rule and the Delaware Court of Chancery is reversed.
Conclusion
Shareholders have the right to vote, sue and sell. Amongst these rights, for most shareholders,
sell is the ultimate measure to achieve their goal. Although the controlling shareholders,
naturally, have some special privileges, such as gaining special premium with regard to their
controlling of the companies, they have to abide by the fiduciary duty to companies and other
shareholders during the course of the transaction of their stocks. In other words, they are not
allowed to use their superiority to maximize their own best interests unless they can prove that
they do not deprive companies and minority shareholders of benefits and opportunities.
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