March 17, 2006 | Posted By Sheppard Mullin

DELAWARE RULING QUESTIONS GENERALLY ACCEPTED MERGER PRACTICES

A recent Delaware Chancery Court decision raises questions about certain common merger practices. The opinion, In re TCI Shareholders Litigation, criticizes both:

  • the use of a contingent fee arrangement by an investment bank that issued a fairness opinion to a special committee; and
  • a special committee's use of investment bankers and legal counsel who had worked for the company.
The court found that these practices raised serious questions about the independence of the committee, and the quality of the advice it received.

While it is important to scrupulously maintain the independence of special committees, investment banker contingent fees and use by the special committee of counsel with prior ties to the company are standard M&A practices that prior court rulings have permitted. The court's unusually critical opinion of these practices in the TCI decision should be considered in light of the fact that the special committee's process as a whole was seriously flawed.

The court found multiple deficiencies in TCI's special committee process, including:

  • lack of a clear mandate;
  • committee members who were not disinterested;
  • failure of the committee to be fully informed;
  • failure of the committee to engage in arm's length negotiations; and
  • failure to fix the committee's compensation in advance.
In addition to the special committee's procedural shortcomings, a control premium was tendered to the owners of a higher vote class of stock, and this group of owners was composed largely of TCI board members and officers. Because TCI's officers and a majority of directors had personal interests that diverged from those of the holders of lower vote stock, the court determined that the special committee's actions were subject to the entire fairness standard of review instead of the more lenient business judgment rule.

Under the entire fairness standard, the defendant must prove the entire fairness of a transaction to the stockholders, including fair dealing and fair price. In certain circumstances, such as when a transaction is approved by a special committee comprised of disinterested directors, the burden of proving the entire fairness of a transaction may be shifted to the plaintiff. In the TCI opinion, the court concluded that the burden of proof should remain on the defendants, given the fact that one of the two members of the special committee had significant holdings of higher vote stock, plus the presence of the other procedural flaws listed above.

The court returned the case to the lower court for trial on whether the defendants had met their burden under the entire fairness standard. By imposing this higher standard, the court has brought into stark focus the importance of an independent special committee with independent advisors. The TCI court's negative opinion of investment banker contingent fees and counsel connected to the company, however, is unusual and should be viewed in the context of the case's particularly inflammatory circumstances.

A copy of the court's opinion is available by clicking here.

For further information, please contact Lauralee Gooch at (310) 228-3745 or Jeff Kaye at (213) 617-4164.