Prof. Paul L. Regan
On Monday, August 27, 2012 the Delaware Supreme Court issued a 110 page opinion in which the Court upheld the decision of Chancellor Leo E. Strine Jr. awarding a judgment of more than $2 billion in damages in a shareholder derivative action on behalf of Southern Copper Corporation (formerly Southern Peru Copper Corporation (“Southern Peru”)) against its controlling shareholder Grupo Mexico (“Grupo”) and the directors on the board of Southern Peru who were affiliated with Grupo. The $2 billion judgment, premised on a finding of a breach of the fiduciary of loyalty by Grupo and the Grupo affiliated directors on the board of Southern Pacific, is the largest award ever issued by a Delaware court.
The case arose out of a controlling shareholder conflict transaction completed in 2005, originally proposed by Grupo, in which Southern Peru paid Grupo $3.7 billion in newly issued Southern Peru shares to acquire Grupo’s 99% stake in Minera Mexico (“Minera”). Chancellor Strine found after trial that Grupo’s ownership stake in Minera was worth only $2.4 billion and that Southern Peru thus had overpaid Grupo by $1.3 billion. With pre-judgment and post-judgment interest added to the $1.3 billion in transaction damages, the final judgment against the defendants was $2.031 billion. The Supreme Court also affirmed the Chancellor’s decision to award 15% of this amount, or $304 million in attorneys’ fees, to counsel for the shareholder plaintiff, emphasizing under established Delaware precedent that the most important factor to consider on fee petitions in common fund cases is the size of the benefit obtained for the corporation or its shareholders.
Grupo owed fiduciary duties to Southern Peru and its minority stockholders as the company’s controlling stockholder. Grupo held 54% of Southern Peru stock, controlled 63% of its voting power and also had the right to nominate a majority of the Southern Peru board. At the time of the Minera transaction, 7 of the 13 members of the Grupo board were affiliated with Grupo. In a thorough and highly fact-intensive opinion, the Delaware Supreme Court sweepingly affirmed Chancellor Strine’s conclusion that Defendant Grupo and its affiliate directors failed to demonstrate the entire fairness of the Minera transaction to Southern Peru and its minority shareholders. Indeed, the valuation evidence showed that the transaction was demonstrably unfair in this regard and thus could not withstand the strict judicial scrutiny that is the standard of review for such conflicted fiduciary transactions.
The unprecedented size of the judgment in the case will certainly bring much attention to the decision, but there is really no new doctrinal ground plowed in this one. Of most interest to this writer, and likely to transaction planners and litigants alike, is the Supreme Court’s discussion of the burden shifting analysis that applies to conflict transactions involving controlling shareholders.
Long ago the Supreme Court in Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983) ruled that strict judicial scrutiny, comprised of the now familiar entire fairness analysis which places the burden on the defendant to show fair dealing and fair price, was the proper standard of review for parent-subsidiary merger transactions. In a transparent signal to transaction planners, the Weinberger Court suggested in a footnote that such conflict transactions could receive a more favorable welcome by the Delaware courts if a committee of the subsidiary’s independent directors were established to negotiate exclusively on behalf of the minority stockholders and thereby approximate an arm’s length transaction. Id. at 709 n.7. A decade later, in Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110 (Del. 1994) the Delaware Supreme Court clarified that the effective use of a special committee in a parent-subsidiary conflict transaction, though welcome, would not avoid the strict scrutiny standard of review applicable to such problematic transactions but would however earn the defendants a favorable shift in the ultimate burden of proof. That is, assuming that a truly independent committee was appointed and then functioned effectively by approximating an arm’s length transaction (the Kahn committee, though independent, failed to function effectively by caving to the controller’s demands at the end of the process), the ultimate burden of proof on the merits – within the strict scrutiny standard of review – would shift thereby requiring the shareholder plaintiff to prove unfairness. Kahn also clarified that such a shift in the burden of proof would apply if the controlling shareholder empowered the minority shareholders with a “veto” by conditioning the transaction on an informed and approving vote of a majority of the minority shareholders.
The Southern Peru case decided this week directly addresses some important practical concerns that have remained since Lynch was decided nearly 20 years ago. Why would a controlling shareholder go to the trouble of a special committee process when the litigation pay-off is seemingly a mere modest shift in the burden of proof but an otherwise continuing application of the entire fairness test? Moreover, when cases go to trial in the Delaware Court of Chancery, don’t litigants need a trial strategy informed by what rules of law apply to their case? But the burden shifting that Lynch makes possible will not be known in most cases until after all the witnesses have testified and long after the parties have submitted their post-trial briefs in which they will still be arguing about who has the ultimate burden of proof in the case. Indeed the defendants in Southern Peru argued that such litigation uncertainty would dissuade corporations from forming independent committees in future transactions but the Supreme Court appropriately would have none of this flimsy claim.
Since Lynch was decided controlling shareholders planning a conflict transaction haven’t formed special committees for a modest shift in the burden of proof. They engage in such a process to win the day on the merits under the entire fairness analysis, irrespective of whether the burden of proof shifts from the defendants to prove fairness to the plaintiffs to prove unfairness. Planning for trial in an entire fairness case means first planning a transaction process that accords with the expectations that Weinberger, Lynch and their progeny have established. That means establishing a committee of genuinely independent directors to evaluate and/or negotiate a transaction with a controlling shareholder. Once constituted, the committee must then function effectively to the satisfaction of the reviewing Court, which in the context of a conflict transaction will be appropriately skeptical and untrusting (i.e., will apply strict scrutiny). Functioning effectively in turn means the committee must take on its responsibility as if it were engaging in an arm’s length negotiation and thus the committee must stand ready to reject any unacceptable proposals by the controlling shareholder and otherwise protect its independence from any influence or retributive threats (express or implied) of the self-interested controlling shareholder.
At the end of the day, the Supreme Court in Southern Peru unabashedly acknowledged that such genuine practical concerns might be raised by a burden shift that cannot be known before trial, but the Court clarified in such cases going forward that the burden of persuasion would remain “with the defendants throughout the trial to show the entire fairness of the interested transaction.” In this regard, the Supreme Court’s ruling is likely in keeping with the advice of counsel to controlling stockholders in such cases already, i.e., establish a special committee process that is unassailable but prepare for trial as if the burden of proof remains on the defendants. For transaction planners and litigation counsel alike, Southern Peru appropriately reinforces the practical reality that defendants in these cases need to protect the transaction with good process irrespective of whether they get the burden shift before, at or after trial.