Background
The Plaintiffs alleged that the Transaction was unfair to them, in part because the controlling shareholder would be “rolling” a portion of his equity holdings and would not be entirely cashed out of his interest in the Company. The complaint asserted that the Company’s board of directors, breached their fiduciary duties and violated the Company’s charter.
The Court of Chancery granted the Company’s motions to dismiss, finding that the Transaction complied with the framework established by Kahn v. M & F Worldwide Corp.,88 A.3d 635 (Del. 2014) (“MFW”). MFW provides in part that the business judgment standard of review governs squeeze-out mergers between a controlling stockholder and its subsidiary only where the merger is conditioned ab initio upon both the approval of an independent, adequately-empowered special committee that fulfills its duty of care; and the uncoerced, informed vote of a majority of minority stockholders.
The Plaintiffs in Inovalon appealed, asserting that the Transaction did not satisfy the MFW framework because: (i) “substantive economic negotiations” occurred prior to the formation of the special committee, which violated the ab initio requirement; and (ii) the vote of the minority stockholders was not informed because the Proxy omitted material information.
The focus of the Court’s opinion is the analysis of the Plaintiffs’ second claim, which the Court addressed after summarizing the relevant factual and procedural background of the case. The Court applied a materiality standard and emphasized that due to the “central role played by investment banks in evaluation, exploration, selection, and implementation of strategic alternatives,” Delaware courts require “full disclosure of investment banker compensation and potential conflicts.” The Court also noted that “special committee’s advisor’s conflicts are uniquely important considerations for minority stockholders” since it is imperative for the stockholders to be able to understand what factors might influence the advisor’s analytical efforts and opinions.
Analysis
The Court first examined the Plaintiff’s claim that the Proxy failed to adequately disclose the management incentive plan (“MIP”) term sheet, which outlined a proposed equity incentive program for certain employees, including the Founder and CEO (the “CEO”), in the post-Transaction entity. The Court held that the Proxy adequately disclosed the existence of equity incentives for certain employees and the controlling stockholder’s continued role as CEO in the post-Transaction entity, and that the MIP term sheet was not a concrete future business plan but a proposal subject to change and negotiation. The Court also noted that the Proxy contained the form of rollover agreement that revealed that the CEO was rolling over $700 million in equity, that the stockholders were reasonably informed of the MIP, and that the Proxy “explicitly stated that [the CEO] would continue as CEO in the post-Transaction entity.” This ultimately led the Court to hold that “although the exact terms of the MIP were not disclosed in the Proxy, the stockholders were reasonably informed of the existence of equity incentives that would be provided to certain employees, including the CEO, who would continue in the post-Transaction entity.”
Disclosure of Advisor Conflicts. The Court then addressed the Plaintiffs’ claim that the Proxy failed to adequately disclose the nature and extent of conflicts of interest on the part of the advisors to the special committee. The Court held that the Proxy was materially deficient in its disclosure of two advisor’s concurrent and prior representations of the buyer and members of the private equity consortium, and that these conflicts were relevant to the stockholders’ assessment of the advisors’ objectivity and the effectiveness of the market outreach process.
The Court also rejected the Court of Chancery’s summary dismissal of these claims stating that the due care analysis “did not sufficiently address all of the disclosure issues—some of which arose after the advisors’ retention.” The Court held that that since “there is no hard and fast rule that requires financial advisors to always disclose the specific amount of their fees from a counterparty in a transaction,” the analysis is subject to the materiality standard. Further, the materiality standard required an assessment of the conflicts “from the viewpoint of the ‘reasonable’ stockholder, not from a directors’ subjective perspective” and that the Proxy created a misleading impression as to the scale and significance of the advisors’ conflicts.
Finally, the Court addressed the Plaintiffs’ claim that the Proxy overstated one advisor’s role in the market outreach process, which was actually conducted by the second advisor. The Court held that the Proxy suggested that the first advisor had at least an oversight role in the process, while the meeting minutes of the special committee and the board of directors indicated that the advisor’s role was more of an “analytical and supervisory one.”
The Court stated that the Proxy’s suggestions of a more active role for the first advisor took on added significance in a scenario where the second advisor, as the lead advisor, also faced conflicts of interest. While the Court did not find it necessary to “pile on’ another basis for reversal” it concluded that the description of the advisor’s role in the market outreach efforts “do not sit comfortably” within the evidence provided.
Notably, the Court cautioned that “[b]oards, committees, and their advisors should take care in accurately describing the events and the various roles played by board and committee members and their retained advisors.”
Takeaway
Inovalon ruling should serve as a cautionary tale for companies, board of directors, and financial advisors—particularly for those engaging in transactions with controllers where the protections afforded by MFW are intended. The ruling highlights the importance of ensuring that external stockholder communications accurately reflect the internal reality of the company, that representations to minority stockholders align with board minutes, and that approval of a transaction that requires minority shareholder approval is predicated on a fully informed vote.
Client Alert 2024-105
