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Directors Governance Center

December 7, 2015

Delaware Supreme Court Affirms Pleading-Stage Dismissal Under “MFW” Framework

On November 19, 2015, [1] the Delaware Supreme Court upheld the Court of Chancerys bench ruling in Swomley v. Schlecht( SynQor) [2] dismissing breach of fiduciary duty claims arising out of a controller-led buyout pursuant to the framework set forth by the Court of Chancerys 2013 opinion in In re MFW Shareholders Litigation [3] and the Delaware Supreme Courts 2014 affirmance in Kahn v. M&F Worldwide Corp. ( MFW). [4] Directors, officers, and their advisors should be aware of SynQorbecause it provides guidance on how to structure the process in a controller-led buyout to reap the benefits of the MFWframeworknamely, business judgment review and dismissal at the pleading stage. Prior to MFW, claims challenging a controller-led buyout were reviewed under the exacting entire fairness standard, whereas MFWapplies the more deferential business judgment rule, provided that the transaction is conditioned on approval by an empowered, disinterested, and independent committee of directors andan informed and un-coerced majority vote of the minority stockholders. SynQoris significant because it represents the first pleading-stage dismissal applying the MFWframework, thereby offering significant protection to directors and officers involved in controller-led buyouts.

The Court of Chancerys Decision

At issue in SynQorwas the 2014 management-led buyout of SynQor, Inc. (SynQor or the Company), a privately held Delaware corporation. The buyer group, consisting of SynQors senior management, owned approximately 46% of the Companys outstanding stock and was led by Dr. Martin Schlecht, who served as President and CEO of SynQor, and one of its three directors. In an effort to obtain the deferential business judgment review set out in MFW, the Companys board conditioned the transaction on both the approval of a special committeeconsisting of the Companys two other directors (the Special Committee)and a majority-of-the-minority vote of the disinterested stockholders.

Following the Special Committees review and approval, certain of the Companys minority stockholders (Plaintiffs) brought an action seeking to enjoin the transaction and obtain damages for breaches of fiduciary duties against Dr. Schlecht and the members of the Special Committee. Supplemental disclosures mooted Plaintiffs disclosure claims and the transaction closed following a 61% vote of the disinterested minority, after which Plaintiffs pressed their breach of fiduciary duty claims post-closing. The Company and directors moved to dismiss those claims under MFW. Plaintiffs countered that the MFWstandards had not been met and therefore the transaction must be evaluated for entire fairness on a developed record.

In a bench ruling, the Court of Chancery (Laster, V.C.) granted dismissal. The court began by reviewing the MFW criteria for application of business judgment review: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority. [5]

The court next concluded that, as a procedural matter, MFWcould be applied at the motion-to-dismiss stage given that the whole point of encouraging [the MFW] structure was to create a situation where defendants could effectively structure a transaction so that they could obtain a pleading-stage dismissal against breach of fiduciary duty claims. Thus, although defendants must establish the conditions necessary for application of the MFWframework, that can be done at the pleadings stage, so long as the structural conditions have been described in the complaint or in a public way suitable for judicial notice, such as board resolutions and a proxy statement.

Having determined that it could apply MFW at the motion-to-dismiss stage, the Court of Chancery analyzed each factor as follows in granting dismissal:*The controller conditioned the transaction on the approval of both a special committee and a majority or the minority stockholders. Plaintiffs alleged that the buyout was not conditioned ab initio on the requisite dual procedural cleansing mechanisms because (a) the buyer groups initial offer hedged on whether the minority-of-the-majority vote would be waivable; and (b) the disabling resolution applied to the board, not the controlling buyer group. The court rejected the former argument, reasoning that when the buyer group first proposed the buyout, and before any negotiations took place, the Companys board passed a resolution that it would not approve or recommend the proposed transaction (or any alternative) without a prior favorable recommendation from the Special Committee and would not consummate the transaction without the prior affirmative vote of the majority of the unaffiliated stockholders. As to Plaintiffs latter argument, the court noted the interesting question of whether the condition-based enforcement structure envisioned by MFW must necessarily apply specifically to the controller (and not just the board generally), but found that, even if that were true, the resolution adopted by SynQors board applied to the leader of the control group, Dr. Schlecht, through his position as a signatory board member.

*The Special Committee Was Independent. The court next rejected Plaintiffs allegations that the Special Committee members lacked independence because, among other things, they had historically been elected by Dr. Schlecht and had received a non-contingent $50,000 payment for their service on the Special Committee. The court reasoned that the trial court decision affirmed by the Delaware Supreme Court in MFW had looked to traditional independence and interestedness factors under this element, and the allegations pled by Plaintiffs had not traditionally been viewed as disqualifying conflicts under Delaware law.The court also considered, in part, Plaintiffs challenges to the sales price under this prong of the MFWanalysis. In footnote 14 of MFW, the Delaware Supreme Court had suggested that the complaint in that case would have survived a motion to dismiss under its newly announced standard, because the plaintiff there had pled facts as to the insufficiency of price that called into question the adequacy of the special committees negotiations. Seizing on that footnote, Plaintiffs in SynQor argued that the valuation accepted by the Special Committee was so deficient and artificially depressed that it raised a question as to whether the Special Committee negotiated in the best interest of the Companys disinterested stockholders. However, the court found no such inference, explaining that there were no allegations as to why the Special Committee members, who were not experts in valuation, should have called into question the nature of the valuation analysis.

*The Special Committee Was Empowered.The court quickly dispensed with the next element, determining that the Special Committee was empowered to, and did in fact, freely select its own financial and legal advisors, whom Plaintiffs failed to challenge. Further, pursuant to the boards resolution, the Special Committee was empowered to say no to the buyout, and Plaintiffs had not pled any facts suggesting otherwise.

*The Special Committee Met Its Duty of Care in Negotiating a Fair Price.Plaintiffs deficient valuation allegations resurfaced under the duty-of-care prong of the MFWanalysis but were again rejected by the court. The court explained that the [d]uty of care is measured by a gross negligence standard, which under Delaware case law is a stringent standard amounting to recklessness or even wanton conduct. While the court acknowledged that there were certainly potential bases to disagree with the [Special Committees] strategy or tactics in the negotiation, as well as the valuation methodology used by the Special Committees financial advisor, such allegations do not amount to gross negligence.

*The Minority Vote Was Informed.The court next analyzed the majority-of-the-minority vote and found it informed. The court emphasized that, although SynQor is a private company, [t]he stockholders were provided with a public-company-style proxy statement as well as supplemental disclosures distributed after the minority stockholders filed their complaint. Notwithstanding the legitimate questions as to the techniques used by the Special Committees financial advisor, the Companys disclosures provided a fair summary of the financial advisors workenough that the stockholders were in a position to know what they were getting or werent getting. Regarding other alleged omissions, including Dr. Schlechts compensation, the court determined that this information was immaterial to the stockholders vote in a cash-out transaction.

*The Minority Vote Was Not Coerced.Finally, Plaintiffs alleged that the vote was coerced by a retributive threat by the Company to refuse future opportunities for liquidity. Plaintiffs argued that, though the Company had not issued dividends in over a decade, the Companys directors had floated the idea of a dividend or stock repurchase in the years leading up to the proposed buyout and then took it off the table in the proxy statement. The court found that the boards actions were not coercive, explaining that coercion turns on whether [the stockholders] can vote down a deal and keep the status quo, even if the status quo happens to be unattractive, such as being locked into an illiquid instrument.

Implications of the Delaware Supreme Courts Decision

The Delaware Supreme Courts Order affirming SynQorconfirms that MFWreview can, and was principally intended to, apply at the pleading stage, and that it is available to both public and private companies.

The Order also confirms the tests that will be applied to the MFWfactors. Most importantly, in endorsing the Court of Chancerys strict adherence to the traditional, process-based tests of gross negligence and independence in evaluating the Special Committee on a motion to dismiss, the Order helps to close the door on the role of substantive price objections in defeating the application of MFW at the pleading stagea route which the Delaware Supreme Court appeared to have originally left open in footnote 14 of MFW. By upholding the dismissal of the claims in SynQor in the face of colorable valuation objections, the Delaware Supreme Court has indicated that, notwithstanding footnote 14 of MFW, routine price objections will not serve as a basis for withstanding dismissal in future MFWproceedings.

In sum, the SynQorprecedent should be a useful tool for directors, officers, and advisors interested in structuring a controller-led buyout so that the substantial benefits available under MFW can be realized: business judgment review and dismissal at the pleading stage.

[1] Swomley v. Schlecht, No. 180,2015, 2015 WL 7302260 (Del. Nov. 19, 2015).

[2] C.A. No. 9355-VCL (Del. Ch. Aug. 27, 2014) (TRANSCRIPT).

[3] 67 A.3d 496 (Del. Ch. 2013).

[4] 88 A.3d 635 (Del. 2014).

[5] Id. at 645.