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Corporate transactions: planning insights from Delaware Chancery

Current financial turmoil may be expected to foster derivative actions seeking to hold corporate management responsible for financial loss.

We see deals involving potential claims of self-interest initiated by major stockholders in an effort to buttress their companies.

honig-stephenI suspect that many corporate attorneys, in structuring related party transactions, are not sufficiently rigorous in enforcing all of the best procedural and disclosure steps.

An August Chancery Court decision (In Re Coty Inc. Stockholder Litigation, C.A. No. 2019-0336-ABG) reminds corporate practitioners how closely Delaware examines the fiduciary duty of directors and controlling shareholders in such instances.

The Coty tender

Prior to fall 2016, cosmetics conglomerate Coty was controlled by an offshore group of companies designated JAB. In October of that year, Coty made a huge acquisition of the Procter & Gamble beauty business, JAB thereby losing voting control as its ownership slipped to 36 percent. (JAB later raised its stake to 40 percent.)

Prior to 2019, Coty underwent a substantial change in management and, it turned out, in profitability that exceeding projected earnings. Five days after the announcement of financial results, JAB launched a tender for Coty common at $11.65 per share, seeking to reach between 47 and 60 percent ownership.

Tender price was in excess of recent trading averages and 21 percent over the most recent close, albeit well below $21.53 (Coty’s 52-week trading high). The tender expired on April 25, having attracted 75 percent of all public shares, more than twice the number of shares needed to reach 60 percent; thus, each tendering shareholder in fact sold only approximately 44 percent of shares tendered.

Tendered shares were accepted on April 30, and eight days later Coty announced third quarter earnings above analyst expectations. By May 17, the stock bumped up 25 percent from its April 30 close, from $10.82 to $13.50 (almost $2 per share above tender price, providing a “profit” to JAB approaching $300 million).

Given deal timing and the large JAB profit, it is no surprise that shareholders brought derivative class actions, claiming defects in pricing and tender process. Claims were asserted against directors and against JAB as controlling Coty shareholder. All defendants moved to dismiss. All defendants failed.

What did JAB and Coty do wrong?

Coty promptly responded to the tender in standard fashion: immediately naming a special “committee” of independent directors, which immediately hired a national law firm and a financial advisory firm.

The committee “determined that each member of the Committee does not have any material interest in, or in connection with, the Offer that is different from the interests of the Company’s stockholders generally.”

The committee spent a month examining the transaction, negotiated with JAB, and successfully negotiated a stockholders agreement protecting Coty minority shareholders by promising inter alia prompt elections of independent directors.

The committee then announced support of the tender, the Coty board accepted that recommendation, and JAB promptly filed its SEC 14-D and closed the transaction.

The manner in which Chancery rejected every defense argument to dismiss each count of the complaint constitutes the learning in this case.

The ‘Coty’ decision

We start with the constitution of the committee. It is typical that committee independence is attacked in derivative suits, but here the successful attack on the committee was premised on its own self-assertion.

The assertion by the committee that its members had interests identical to the public shareholders was insufficient process and disclosure, as it did not assure independence from the tender offeror, but only that the impact of the tender would fall equally on them personally.

The committee next was faulted for negotiating the tender price only on one occasion, implicitly seeming to evidence a lack of resolve. I suspect more importantly was the committee’s failure to insist on the timing of the tender as a material omission of fact and indeed a nonstarter.

While the tender was announced in the safe period after an earnings report, the committee had been advised by its financial firm that the tender was made at a “highly complex time” in that the new management, following the P&G acquisition, had not yet completed a strategic plan or financial projections.

The financial advisers had noted that Coty strategic planning would be finished perhaps as early as May, only a couple of months hence. The JAB timetable suggested a shoe-horning of the tender between the earnings announcement and the release of a strategic plan, which would certainly be optimistic.

Further, the 14-D lacked specific information regarding the professional history and relationships of outside directors and members of the committee itself. That information was available on the company website and partly disclosed in the proxy statement.

However, the 14-D expressly stated that it did not incorporate information on the website nor the portions of the proxy statement addressing “the Special Committee members’ biographical information.” Those carve-outs likely heightened the court’s suspicion that the tender was structured with an eye toward form but not full substantive disclosure.

The capper may have been the allegation, taken as true for purposes of evaluating the defendants’ motions to dismiss, that after the closing, JAB failed to fill the contractually promised independent director slots as provided in the protective stockholder agreement.

It is alleged that three directors were added, all with strong ties to JAB.

The complaint contains allegations against JAB as Coty’s de facto controlling shareholder. Claims against JAB for noncompliance with the stockholders agreement by failing to name new independent directors are pleaded as breach of contract. Allegations based on breach of fiduciary duty are asserted against the controlling shareholder under substantial Delaware precedent.

Chancery noted at the start of its “analysis” that, as conceded by the defendants, the tender was subject to review under the “entire fairness” standard. (The standard imposes something of a fiduciary duty on a controlling equity holder, without using that nomenclature, as it requires in cases of self-dealing that the shareholder must demonstrate fairness both in price and in the authorization process).

During the course of the entire 41-page decision there is no question raised as to the basis for asserting liability of JAB for breach of duty as de facto controller of Coty. The allegation that JAB “opportunistically timed and priced the Tender Offer so that it undervalued Coty and structured it in a coercive manner” was treated without discussion as properly pleaded.

Of interest also was Chancery’s close analysis of the claim that directors affiliated with JAB could not be liable for breach of duty because they recused themselves from acting on approving the tender. Chancery stated that the statutory exculpation from director breaches of duty, permitted in Coty’s certificate of incorporation under Delaware statute, was never available to directors who acted to the benefit of a controlling party or in bad faith. Exculpation seems reserved to errors by the pure of heart.

Avoiding liability by non-involvement is a very narrowly defined defense. Abstention must be total. It has long been understood that merely not sitting on a special committee and recusing oneself from voting is not enough.

In Coty, the recommendation statement made clear that the JAB-related directors may not have voted, but they participated in key meetings before the vote, discussed with the board the reason for making the tender, and suggested that the tender showed support for the Coty management team. In acting on a motion to dismiss a claim, without development of factual findings, Chancery refused to conclude that non-voting JAB-related directors avoided liability.

Lastly, Chancery dealt with the defense argument that stockholders who remained invested in the company post-tender by definition could not be harmed, and thus class action claims should be dismissed. Someone who held one share or 1 percent of Coty stock before the tender held that same one share or 1 percent afterward.

The court agreed with the defendants that a stockholder owes fiduciary duties if it either owns over 50 percent of the voting power or, if less, exercises control over company business affairs. But the fact that a shareholder can be treated as a controlling person in both instances does not speak to the harm potentially suffered by minority equity holders when control flips from de facto to absolute mathematical control.

Chancery held that gaining absolute voting power usually results in the minority suffering a loss for which it should be compensated by payment of the value of a control premium.

Indeed, an absolute majority controls without need for discussion board membership, mergers, cash-outs of minority, charter amendments, and the very nature of the corporation. The recommendation statement itself noted this loss of premium value as a deal negative.

Conclusion

While Coty involves a public entity, its principles also apply to private company transactions. Entire fairness, in dealing with cases involving self-interest, is a very fine legal screen.

I suspect that many corporate attorneys, in structuring related party transactions, are not sufficiently rigorous in enforcing all of the best procedural and disclosure steps. While this laxity can be understood given the cost of assiduous compliance in a private company with modest economics, the risk of lack of rigor is obvious.

“Close enough” may be sufficient with horseshoes and hand-grenades, but it seems not in Delaware Chancery.

Stephen M. Honig practices at Duane Morris in Boston.

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