On Oct. 14, 2011, the Delaware Court of Chancery issued a 105-page post-trial opinion in In re Southern Peru Copper Corporation Shareholder Derivative Litigation, which involved a challenge to Southern Peru Copper Corp.’s purchase of Minera Mexico, S.A. de C.V. from Southern Peru’s controlling stockholder, Grupo Mexico, S.A.B. de C.V., for an implied value of $3.1 billion.
Chancellor Leo E. Strine Jr. applied the “entire fairness” standard, which applies to transactions with controlling stockholders and puts the burden of proof on the board of directors to show that both the transaction price and the process leading to the transaction were fair. The court:
- Concluded that the special committee formed to approve the transaction (advised by a global investment banking and securities firm) was independent and informed, but was nonetheless not “well functioning”
- Rejected the contention that the special committee process shifted the burden of proof back to the plaintiffs
- Found that the directors failed to establish fair process and fair price
- Awarded $1.3 billion in damages (the largest in the court’s history)
The defendants argued that the special committee process shifted the burden of proof back to the plaintiffs, but the Chancellor rejected the argument because he found that the committee was not “well functioning.” To start, the resolution creating the special committee did not expressly authorize it to negotiate or investigate alternatives, leaving it to evaluate the transaction as proposed by Grupo Mexico. Because of this, the court found its negotiations to be “stilted and influenced by its uncertainty about whether it was actually empowered to negotiate.”
Also troubling to the court was the fact that one of the special committee members was employed by a 14.2 percent stockholder who held “founders shares” in Southern Peru that needed to be registered. Grupo Mexico, as controlling stockholder of Southern Peru, controlled the decision to register those shares. The facts showed that while the special committee was negotiating the substantive terms of the transaction, that large stockholder was negotiating for registration rights.
This case is an example of why most cases settle once a court determines that “entire fairness” is to be the standard of review. Historically, it has proven to be a difficult standard for corporate defendants to meet because unlike application of the business judgment rule, in which the court focuses on whether a board is independent/disinterested and well-informed (and defers to its judgment if that is so), the entire fairness standard involves an inquiry into the actual substantive decisions of the board.
This case also stands as an example of why a special committee should be pristine – in both reality and perception. Here, the court second-guessed the decisions of the special committee because one of its members was employed by a large stockholder that wanted to monetize its investment, even though, according to the court, he “was not in any way in Grupo Mexico’s pocket” and he did not “purposefully tank the negotiations.” But that taint was enough to make the court uncomfortable with deferring to the special committee’s judgment, resulting in severe consequences for the defendants. That is why counsel must be diligent in promptly identifying and avoiding conflicts.
However, even if the special committee did not have a conflict problem, its decisions still would have been subjected to a substantive review. The court concluded that there is “no way” to determine whether a special committee is “well functioning” without “taking into consideration the substantive decisions of the special committee, a fact-intensive exercise that overlaps with the examination of fairness itself.” On this point, it’s not entirely clear that the court’s approach should be the law.
Though the case law applying the business judgment rule to a conflict-free and well-informed board does not use the phrase “well functioning,” it is a functionally equivalent determination. Once a court determines that a special committee is conflict-free, informed and well-qualified, burden shifting should be automatic, without substantive inquiry. The court can then take “into consideration the substantive decision of the special committee” – it has to under the “entire fairness” standard – but with the burden of proof on the plaintiffs, not defendants. This is an issue only the Delaware Supreme Court can conclusively resolve.
The court’s criticism of the resolution language forming and setting the mandate of the special committee also warrants discussion. Generally, “alternatives” refers to the exploration of transactions with other parties. Board resolutions creating special committees to review controlling-stockholder transactions often lack language granting power to pursue alternatives because it would be an act of futility as the controlling stockholder can veto any alternative.
The court concluded the resolution here precluded options that “would have generated a real market check and… deprived the special committee of negotiating leverage to extract better terms.” All of this emphasizes the need for resolutions with clear and broad mandates. Moreover, it may no longer be enough for the special committee to have full authority to hire independent financial advisors and legal counsel and to either approve, reject or “negotiate” with the controlling stockholder, as distinguished from exploring alternatives with other parties.
The claims against special committee members were dismissed prior to trial because Southern Peru had a Section 102(b)(7) exculpatory provision and the special committee members did not have a pecuniary interest in the transaction, nor was there any evidence they acted in bad faith. However, Grupo Mexico and its affiliated directors remained defendants and are now liable for the damage award. Presumably the individual defendants will seek indemnification from Grupo Mexico (not Southern Peru), but should they even be facing personal liability? These directors deferred to a special committee, three of four members of whom had no conflict problem. Should the law tag them with liability for being bystanders, simply because the court second-guessed the decisions of the special committee, all of whom face no liability? This too will likely be an issue for appeal.