Publications

3 Jan 2012

Delaware Court of Chancery awards US$1.2 B, issues guidance re controlling shareholders in M&A deals

Securities Litigation Alert

News and Insights from Austin

Robert W. Brownlie
John L. Reed
Courtney Stewart
Jennifer A. Lloyd

The Delaware Court of Chancery, in the recent decision In re Southern Peru Copper Corp. Shareholder Derivative Litigation, 30 A.3d 60, (Del. Ch. 2011), has awarded US$1.2 billion in damages (plus interest from the merger date to judgment and payment) after finding the controlling stockholder defendants had breached their fiduciary duty of loyalty in a stock-for-stock merger transaction.

The damages award reflects the court’s approximation of the difference between the price that should have been paid in a fair transaction and the actual price that was agreed to be paid in the transaction. On December 21, 2011, the court awarded $285 million in attorneys’ fees to plaintiffs’ counsel, which represented 15 percent of the total judgment after calculating interest.

In re Southern Peru provides a number of reminders for companies engaging in M&A transactions with their controlling stockholders.  This guidance should be considered to help minimize the total cost of the transaction by reducing litigation expense and the likelihood of an unfavorable verdict.

THE TRANSACTION

The case involved the acquisition of privately-held Minera Mexico by Southern Peru, a New York Stock Exchange listed company.  Both Southern Peru and Minera Mexico were controlled by the same large stockholder, Grupo Mexico, a holding company listed on the Mexican stock exchange (which held 54 percent of Southern Peru’s capital stock and 63.1 percent of the vote of Southern Peru and 99 percent of Minera Mexico).  Grupo Mexico proposed that Southern Peru buy its stake in Minera for 72.3 million shares of newly issued Southern Peru stock.  At the then-current market price of Southern Peru stock, this amounted to a valuation of Minera, which had no market-tested value, of US$3.1 billion.

Southern Peru appointed a special committee whose “duty and sole purpose” was to “evaluate” Grupo Mexico’s proposal.  The resolutions creating the special committee did not provide it with the express power to negotiate, nor did the resolutions authorize the special committee to explore other strategic alternatives.

The special committee retained financial and legal advisors.  The special committee’s financial advisor performed a number of valuation analyses (discounted cash flow, contribution analysis and sum-of-the-parts), which demonstrated that the equity value of Minera was more than US$1 billion short of the US$3.1 billion offer price proposed by Grupo Mexico.

The financial advisor then changed valuation metrics and performed a “relative valuation” to compare the intrinsic value of the Southern Peru shares to the intrinsic value of Minera in an “apples-to-apples” approach.  Although Southern Peru’s NYSE-listed stock had an actual market-tested value of US$3.1 billion, the financial advisor’s new analysis gave it a “fundamental” valuation of only US$2.06 billion.  This analysis tightened the gap between the give and the get.

Rather than question this analysis or investigate why their stock was apparently so overvalued by the market, the special committee found “comfort” in this analysis because it substantiated the fairness of the transaction.  The special committee and Grupo Mexico ultimately negotiated a transaction in which Southern Peru would acquire Minera for 67 million Southern Peru shares, which, at the time of the agreement, had a value of US$3.1 billion.

The transaction was approved and, by the time it closed, the stock price of Southern Peru had been rising steadily.  Because the transaction was based on a fixed number of shares, Southern Peru paid approximately 21.7 percent more for Minera at closing than it had originally agreed to pay.  Although the special committee could have changed its favorable recommendation before the deal closed, it did not ask its financial advisor to update the fairness opinion analysis to account for the rising price of Southern Peru stock.

KEY TAKEAWAYS

Give the special committee proper authority

The court was critical of the narrow wording of the special committee’s mandate to “evaluate” a transaction suggested by a majority stockholder.  The court highlighted that such a narrow mandate “trapped [the special committee] in [a] controlled mindset, where the only options to be considered are those proposed by the controlling stockholder” and that “[e]ven if the practical reality is that the controlling stockholder has the power to reject any alternate proposal it does not support, the special committee still benefits from a full exploration of its options.”

If a special committee is formed to negotiate with the controlling stockholder, it should be broadly authorized to reject any proposal and consider alternatives to the transaction, as opposed to merely “evaluating” the transaction.  A special committee should have sufficient time to work with counsel, investment bankers and other appropriate advisers to conduct a thorough analysis of the deal.  Where possible, a special committee, with the aid of a banker or advisor, should shop the deal to seek competing offers from others in the industry.

Are you straining to rationalize the deal?

The court concluded that the special committee went to great lengths to rationalize the transaction at the price proposed by Grupo Mexico by devaluing Southern Peru’s publicly traded share price and using projected copper prices for valuing Minera that were higher than those used in ordinary course projections.  The court found that this valuation methodology was results oriented and “undermine[s] the defendants’ argument that the process leading up to the Merger was fair and lend[s] credence to the plaintiff’s contention that the process leading up to the Merger was an exercise in rationalization.”

In analyzing a proposed transaction, directors should critically review the transaction instead of merely rationalizing it.  Do not make assumptions that serve largely to justify the proposed transaction.  If you find yourself reaching for justifications that are outside the way your company usually thinks, then take care.  You may be straying too far.

Keep evaluating the advisability of a transaction up to closing

The court found that the Southern Peru directors failed to re-examine the transaction after it was approved, despite the fact that rising copper prices led to significant industry changes and Southern Peru’s actual performance was substantially outpacing the projected performance statistics employed in the financial advisor’s fairness opinion.  The court noted this was a “regrettable and important lapse.”

If there is a distinct period of time between the date when the proposed transaction is initially approved and the date when shareholders vote to approve the transaction, directors (with the help of their financial advisors) should continue to re-evaluate the situation.  Has there been a change in economic conditions or financial data during that period?  If a material change has occurred, directors should consider whether such change necessitates an updated fairness opinion.

Ensure the interests of special committee members align with those of minority stockholders

The court noted that one of the Southern Peru special committee members was a poor representative of the minority stockholders because he had independent reasons for favoring the merger.  As the board representative for the second largest stockholder, which was in contemporaneous negotiations for registration rights for its shares in the company, he had an interest in favoring the deal because Grupo Mexico had from the outset linked the granting of the registration rights to the successful negotiation of the merger.  The court concluded that this director was “not well-incentivized to take a hard-line position” with Grupo Mexico or serve as the “defender of interests of minority shareholders in the dynamics of fast moving negotiations.”

Special committee members should be able to properly represent the minority stockholders.  Directors on the special committee should be disinterested in the transaction in the sense that they would not receive, directly or indirectly, benefits that are above and beyond those received by the minority stockholders.

Negotiating a deal means more than justifying it

In re Southern Peru illustrates that the process of negotiating a deal must involve more than merely justifying a price offered by the controlling stockholder.  Although the court was quite harsh on the special committee’s conduct, the court also granted summary judgment to the special committee under Southern Peru’s “bad faith” exculpatory charter provision.  This holding may be important for contractually governed entities that have replaced fiduciary duties with good faith standards.

For more information about this decision, please contact:

Robert W. Brownlie

John Reed

Courtney Stewart

Jennifer A. Lloyd