Delaware Judge Sides With Board on Merger Case

What happens when shareholders file a derivative lawsuit on behalf of a company against the board and management and then those same defendants agree to sell the company, knowing it will nullify the derivative suit?

That was the thorny question at the heart of a Delaware Chancery Court ruling in May involving a prolonged battle between shareholders and the board and management of Massey Mining. And the court—in a ruling authored by Vice Chancellor Leo J. Strine, recently nominated to be the courts next chancellor—sided with the board and management and decided not to block the acquisition. 

The case involved an elaborate set of corporate governance questions about the board's role in determining the fate of a company when the board members have been accused of wrongdoing. Shareholders also accused directors of not considering the potential windfall from the lawsuit against themselves when they priced the company for the sale. And once again the Delaware court system has found that directors have a considerable leeway to make important decisions, as long as they are made in good faith and are in the best interest of shareholders.

For Massey Energy, the trouble began in April 2010, when an explosion killed 29 coal miners at one of the company's 47 mines. That same month, shareholders, including several pension funds, filed a lawsuit in Delaware Chancery Court, alleging that Massey's directors and former chief executive, Don Blankenship, breached their fiduciary duties by disregarding federal mining safety regulations.

After the shareholder lawsuit was filed, Massey announced a pending sale to competitor Alpha Natural Resources. The move further enraged shareholders, and they filed a second class-action lawsuit in February 2011, alleging that the merger was an attempt by Massey's board and management to escape liability for the mine disaster. Delaware courts have held that when a company is acquired, shareholders of the seller no longer have the ability to continue a derivative suit against it, since they no longer have an interest in the seller and therefore can't bring a claim on its behalf. The shareholders also claimed that Massey did not properly value the pending derivative claims against its board.

On May 31, Strine denied shareholders' motion for a preliminary injunction to block the merger.

In his ruling, Strine said that he could find no real evidence that Massey's board deliberately breached its fiduciary duty. “[T]he record does not suggest that it is likely that the merger was inspired solely, or even in any material way, by a desire of the Massey directors to extinguish the derivative claims or to insulate themselves from liability,” he said.

“It probably will become more standard practice in analogous circumstances in the future, that directors get independent advice on how to think about these derivatives claim.”

—Steve Quinlivan,

Shareholder,

Leonard, Street and Deinard

One message to come out of Strine's ruling is that companies have a duty when considering a merger proposal to consider the value of the entire operation's assets, including the value of any litigation against it, says Kevin LaCroix, an executive vice president at Oakbridge Insurance Services and author of the D&O Diary blog. “To the extent to which boards are fulfilling their responsibilities to corporations and shareholders is going to be a matter of significant scrutiny,” says LaCroix. “That's critically important for any board facing a perspective merger opportunity.”

Yet Strine ruled that the question of whether Alpha paid fair value considering the derivative litigation against Massey's directors was immaterial, since the claims were too difficult to value and might be difficult to prove at trial. “It's just an incredibly difficult thing to do,” agrees Steve Quinlivan, a shareholder of law firm Leonard, Street and Deinard.

Of course, valuing pending lawsuits in preparation for sale of the company is commonplace. What is less common and creates an “unusual dynamic” is when the board has to value pending derivate litigation against itself, says LaCroix.

The court's decision, however, suggested that “not only was it in their expectations that they would [consider the litigation in the price], but if a board failed to do that they might be breaching their fiduciary duty of care,” says LaCroix. “That's probably the most concerning note for other boards of directors in considering a merger proposal.”

MASSEY OPINION

The following excerpt is from the opinion in In Re Massey Energy Company Derivative and Class Action Investigation.

The Balance of the Equities Weigh Against an Injunction Because the

Stockholders Are Empowered to Decide for Themselves Whether to Approve the

Merger

The difficulty of actually recovering a judgment on the Derivative Claims that

would be material in relation to Massey's overall value also weighs heavily on my mind

in assessing the balance of equities.

The Massey stockholders are well positioned to determine for themselves whether

to accept the Alpha Merger. They can turn it down, continue as Massey stockholders, and

enjoy or suffer as the case may be the outcome that comes from the status quo, including

the net benefits or costs that come from the regulatory and legal proceedings involving

the company—including from the outcome of the Derivative Claims. Or the Massey

stockholders can decide that a deal with Alpha at price that is a premium to the price at

which Massey was trading the day of the Upper Big Branch Disaster is, in a world of

risk, the better bet, especially given the chance to benefit if Alpha's management

approach enables the Massey coal reserves to be more safely and profitably extracted.

Because it is the Massey stockholders' capital at stake and not mine, I am chary to

substitute my judgment. The plaintiffs are institutional investors and could make their

case to turn down the Merger at the ballot box. They are not well positioned to have this

court risk the benefits the Alpha Merger promises to Massey stockholders by enjoining

the Merger, and taking that decision out of the stockholders' own hands.

Nor is their some cost-free way to an injunction. Alpha argues with considerable

force that it may well choose to sue former Massey fiduciaries if that is in its interest as

an acquiror. To enjoin the Merger unless Alpha transfers the rights to the Derivative

Claims to a litigation trust on behalf of the Massey stockholders would allow Alpha to

walk away. Whether Alpha would actually do so is, of course, unclear, but I find no

reason in equity to conclude that Alpha would not have a good faith basis for doing so.

There are easily imaginable circumstances in which Alpha would sue the former

fiduciaries of Massey to recover for judgments and other costs it will incur as Massey's

new owner, or even as leverage in dealings with former Massey fiduciaries over

obligations such as advancement. One could imagine circumstances in which the

principal value of the Derivative Claims Alpha has inherited against former Massey

fiduciaries is in reducing the costs to Alpha of honoring advancement and

indemnification obligations Massey owed to them. A judicial order enjoining the

Merger unless Alpha is willing to buy Massey in a deal in which it assumes the Disaster

Fall-Out liability, but does not acquire any of Massey's right to offset that liability by

seeking indemnification from Massey fiduciaries (i.e., the Derivative Claims), is an

injunction requiring Alpha to accept a different transaction than that which was

negotiated through an arms-length process. This is not a situation where the record bears

the inference that Alpha was somehow knowingly complicit in some breach of fiduciary

duty by the Massey Board; rather, the record indicates that Alpha was fended off by

Massey over an extended time period, was subjected to a competitive bargaining process,

and was pressed to pay a high value for Massey. To upset Alpha's expectations would

justifiably allow it to terminate the Merger Agreement.

In so concluding, I also take into account the plaintiffs' argument that I should put

the Merger on ice, and rush to hold a trial on the Derivative Claims before the Merger

Agreement's drop dead date of January 27, 2012. There are a variety of reasons why

that is neither practicable nor equitable. For one thing, it would seem to be extremely

disadvantageous to Massey as a stand-alone entity for Derivative Claims that seek to hold

fiduciaries liable to indemnify Massey if Massey is held liable to others to go forward

ahead of those direct claims. Even if one could, as I cannot in good conscience, put aside

that reality, there are also the questions of fairness to the defendants in addressing such

important Claims in an imprudently hasty manner and the costs to Massey stockholders

of not closing the Merger now. To delay the deal not only defers their receipt of the

Merger consideration, it also continues Massey under management the plaintiffs

themselves do not consider sound, and defers, and therefore endangers, the ability of

Alpha management to manage the Massey assets and to capitalize on potential synergies

for the benefit of all its post-Merger stockholders, including the current Massey

stockholders.

In my judgment, therefore, issuance of an injunction threatens more harm to

Massey stockholders than its potential benefits to them. Massey stockholders who are

persuaded that they will yield more value if the company remains independent and the

Derivative Claims proceed are free to take action even more formidable than a

preliminary injunction, by casting their ballots against the Merger and defeating it at the

polls.

Source: In Re Massey Energy Company Derivative and Class Action Investigation.

Strine's analysis reviewed all the actions that Massey's board took, LaCroix says. Did the board do everything to maximize shareholder value? Did it seek multiple bids? Did it negotiate hard to obtain a merger proposal? The answers to these questions were all highly relevant to support Strine's decision, he says.

The lesson for other boards is to always take into account whether the value of the pending lawsuit is material in the context of the overall merger transaction, LaCroix says.

Quinlivan also recommends that directors should record all of the varied conversations and judgments they make in board minutes, focusing on the strategic rationale of the deal. In Massey's case, it was about showing that the company's value had been battered due to the accident, might not recover, and that shareholders should take advantage of the remaining premium while they could. In this way, they were able to show that the directors were “focused on the strategic rationale of the deal and not their personal interest and liability,” Quinlivan says.

In a case that centered on analyzing the conflicts of interest of a seller that might be using a sale to excape litigation, Strine identified another instance of tangled interest in the case. In his ruling, he was critical of the law firm Cravath, Swaine & Moore for advising the Massey board in its consideration of the proposed merger, when the firm also served as defense counsel in the derivative suit. “It was therefore an awkward source of advice for the board in deciding what consideration, if any, to give to the derivative claims in negotiating a merger,” wrote Strine.

Strine said the “better practice” would have been if the board consulted independent counsel. Instead, its approach “fell short of the idea and might even arguably be characterized as a breach of the duty of care,” he wrote. 

The message from Strine is one that all companies and outside law firms can learn from. “I see this all the time in many different contexts, where the level of trust with their outside firm is so great that they turn to them for advice on many topics and almost consider them part of the management team of the company,” LaCroix says.  

The lesson for boards is to avoid any legal representation scenarios that could be perceived as having conflicts of interest. “It probably will become more standard practice in analogous circumstances in the future, that directors get independent advice on how to think about these derivatives claims,” Quinlivan says.

A parallel lawsuit was filed against Massey in the Supreme Court of West Virginia, but the court there said it did not have jurisdiction over the case. The ball is now in Alpha's court to decide whether to pursue the derivative suit or personal liability against Massey's board and management, a move that Strine did not encourage.

“Alpha has to deal with all of the disaster fall-out and Massey's unique approach to dealing with regulators,” Strine wrote. “This will almost certainly require Alpha to pay settlements, fines, and remediation costs. To the extent that the direct actions of Massey result in findings that Massey, as a corporation, consciously violated the law, Alpha has a rational incentive to shift as much of that liability to the former Massey directors and officers as can efficiently and realistically be achieved.”

Says LaCroix: “Clearly, if a company that faces a significant derivatives lawsuit is also entering into a merger transaction, they have to be careful about what their motivations are and seek independent counsel and make sure that the transaction is going forward on its own merit, something that's in the best interest of shareholders and not in service of any interest of the board.”