A transaction involving a controlling stockholder on both sides of the deal presents a clear conflict of interest that will result in heightened scrutiny under the “entire fairness” standard of review if later challenged. However, there is not always a conflict when the controller stands on just one side of the table, as seller, and is receiving additional consideration that the other stockholders will not receive. A recent decision provides a helpful roadmap for directors and controlling stockholders (who also have fiduciary duties to the minority) when navigating sales of such companies where there are heightened litigation risks due to the presence of actual and perceived conflicts of interest. Particularly for VC- and PE-backed sales involving a controller, the ruling provides helpful new guidance on the type of side deals between the controller and the buyer that may result in a disabling conflict, and on how to apply the procedural devices established in Kahn v. M&F Worldwide Corp. to “cleanse” a potential conflict.
In In re Martha Stewart Living Omnimedia, the court reiterated that even in deals where the controller does not stand on both sides of a transaction, “entire fairness” will apply when the controller receives disparate consideration that improperly diverts deal consideration away from the stockholders. The court also held that in these one-sided deals, the transaction can be structured in advance to comply with the Delaware Supreme Court’s seminal decision in M&F Worldwide to cleanse a potential conflict. In M&F Worldwide, the Court held that if the transaction is conditioned at the outset on both (1) the approval of an independent special committee and (2) the approval of a majority of the minority stockholders, the business judgment rule, and not “entire fairness” will apply on a motion to dismiss. This was important because, previously, conflicted transactions could not usually be dismissed at the pleading stage because of the necessary fact-finding that was required to determine whether the deal was entirely fair. Applying Kahn, the court in Martha Stewart held that even if the transaction was conflicted, business judgment review similarly could apply if the transaction employed the dual-protections in M&F Worldwide.
In the case, former stockholders of Martha Stewart Living Omnimedia, Inc., brought breach of fiduciary duty claims against controlling stockholder Martha Stewart, and aiding and abetting claims against third-party buyer Sequential Brands Group following Sequential’s purchase of MSLO in December 2015. The complaint alleged that Stewart breached her fiduciary duties to the minority stockholders by leveraging her position as an 89% stockholder to secure greater consideration for herself that would have otherwise been paid as deal consideration to all stockholders, including the minority. The court dismissed the claims against Stewart, noting that her side deals did not create an actual conflict. It further held that even if the transaction was conflicted, business judgment review would apply.
Post-Merger Employment Agreement Did Not Create a Conflict
In the case, the plaintiffs alleged that Stewart improperly negotiated side deals with the buyer that improperly diverted merger consideration away from the stockholders in the form of registration rights and an employment agreement that, among other things, promised Stewart an annual salary, bonus and a percentage of licensing revenues in exchange for continued employment and promotion of Martha Stewart branded products. The court held that even if Stewart did not stand on both sides of the transaction, “entire fairness” will apply if the controller used her leverage to improperly divert special consideration to the controller that would otherwise be paid to the stockholders. Here, the court found that Stewart’s side deals did not represent an improper diversion of consideration because Sequential had good reason to want to incentivize the company’s namesake and founder to commit her time, energy and talent to the brand. It further noted that Stewart had had substantially similar arrangements with Martha Stewart Living prior to the merger, and that the timing of the Stewart negotiations did not suggest a diversion at all since Sequential actually ended up increasing its offer from $5.75 per share to $6.15 per share after the side deals with Stewart were negotiated.
M&F Worldwide Extends to One-Sided Deals Subject to Strict Compliance
- Minority Vote Condition is Implemented Before the Actual Conflict
The court also agreed with Stewart that M&F Worldwide can apply to one-sided controller transactions so long as the dual protections of a special committee and majority-of-minority vote were present at the “outset” of the conflict. The plaintiffs had alleged that the majority of the minority condition was not effective because it was implemented too late, after negotiations with the buyer had already commenced. The court disagreed, holding that in the context of a one-sided controller deal, the procedural protections need not be in place at the start of transaction discussions with the buyer (as in a two-sided controller transaction), but rather should be in place at the point when a conflict actually emerges – usually before the controller sits down to negotiate separately with the buyer for disparate consideration. Here, the court found that the majority of the minority condition was timely as the proxy made it clear that Sequential had already “locked” this condition into the deal process and found that a draft of the merger agreement contained the condition on the day Stewart began negotiations with Sequential regarding her side deals.
- Special Committee is Independent, Fully Empowered and Informed
Although the plaintiffs eventually dropped all claims against the special committee, they alleged that the protection afforded by the special committee was ineffective for purposes of M&F Worldwide because the directors had loyalties to Stewart. The complaint also alleged that the special committee did not have an effective mandate since at the start of negotiations, it was only authorized to hire legal and financial advisors. The court easily dismissed these allegations.
It held that the plaintiffs’ allegations regarding the special committee’s were conclusory and did not provide the needed specificity to rebut a presumption of independence. The court did not find it reasonably conceivable that the four special committee members were not independent based on allegations that one director served as the CEO of a company that sold products designed by Stewart, another director was employed by a media company that carried Martha Stewart programming, another director served as the CEO of a tennis association and Stewart was a tennis enthusiast, and a fourth director was a former consultant for one of Martha Stewart’s accounts.
The court further held that the special committee had a sufficiently broad mandate, and that the committee was empowered in a timely manner. The court found that the independent committee had the power to negotiate with the buyer on behalf of the board and to say “no” to the transaction, and that this mandate was in place before negotiations began even though the committee was initially only empowered to hire advisors. This aspect of the ruling highlights the need to ensure that the transaction committee is independent, formed in a timely manner and given a broad mandate prior to the start of negotiations to hire advisors, negotiate the deal and approve or reject the deal in its independent judgment.
This decision underscores the importance of carefully attending to conflicts when structuring employment agreements and other side deals with controlling stockholders including founders and key employees when those deals could potentially divert consideration away from the minority stockholders. In the context of a VC-backed sale where the founders are “controlling stockholders” (i.e. hold a majority stake or otherwise exercise control) and are getting special employment arrangements, or when there are VCs that are controlling stockholders that are getting interests that diverge from the common, there are particularly heightened litigation risks. While such special arrangements do not necessarily pose a conflict that would trigger “entire fairness,” as was the case here, the decision illustrates the potential benefits (pleading-stage dismissal) of structuring a deal to eliminate the delays, expenses and other risks associated with discovery and protracted litigation. At the same time, it also emphasizes the need to strictly comply with the requirements of M&F Worldwide and subsequent decisions, including by paying specific attention to the sequencing of various deal processes, as described above.
It is worth mentioning that as a procedural matter, the court drew facts from both the plaintiffs’ complaint and the company’s proxy statement, noting that the documents contradicted one another in significant and potentially dispositive ways. Citing prior cases, the court noted that when a proxy is “integral” to the complaint because it is the “source for merger-related facts,” it should be incorporated by reference into the complaint and considered as true in resolving the dispute. This emphasizes the need, in any M&A transaction, to ensure that the background to the merger section of the proxy or information statement is carefully crafted to disclose all necessary facts regarding conflicts, mitigation, deal sequencing and process, as these disclosure documents are often the primary source of facts for plaintiffs’ counsel and the court at the motion to dismiss stage.