When all of the owners are not unanimously in support of a deal to alter an entity’s ownership, structure, or control, challenges will arise. There are important lessons for closely held businesses that arise from lawsuits challenging publicly traded corporate deals. Although federal and state securities laws provide a more structured framework governing publically traded company transactions, the fiduciary duties owed by majority owners, officers, and directors often impose parallel obligations for closely held entities.
Most savvy investors and business owners are aware of the recent rise in public company shareholder strike suits asserting claims against companies and boards of directors when the company announces a merger, going private transaction, or other business combination. The complaint allegations follow a boilerplate “check-the-box” style. Frequently, within days of an announcement of such a transaction, multiple plaintiffs’ firms engage in a race to the courthouse. The lawsuits typically raise three alleged defects with the transaction: flawed process, insufficient consideration, and inadequate disclosures.
While the targets of these attorney-driven suits have largely been publicly traded corporations that have deep pockets to cover plaintiffs attorneys’ fees as part of a settlement, the types of claims raised are similar to the avenues of attack for minority owners to use in challenging transactions proposed by directors and majority owners of privately held companies. Majority owners of close corporations nearing retirement who wish to either cash out their interest or pass it on to family members, or other new owners, should be cognizant of these issues and consider whether any dissenting minority owners are likely to challenge the proposed transaction. Typically, litigation challenging the process or the adequacy of the disclosures is driven by a motive to delay the deal in hopes of finding an alternative suitor, or, ultimately, to extract a higher price for the minority owners’ interests. Each of the three prime targets for challenge—process, price, and disclosures—will be addressed in turn in the closed corporation context.
Most jurisdictions have held that majority owners with a controlling interest in an entity owe fiduciary duties of care and loyalty to minority owners. Majority owners are required to act in good faith toward minority interests and are generally prohibited from using their control to their own advantage, without providing the minority owners with an equal opportunity to share in the benefits.
Common features of majority-driven transactions that are likely to draw litigation and scrutiny by the courts are efforts to squeeze-out or freeze-out dissenting minority owners. These actions can take the form of stripping minority owners of certain rights, terminating the employment of minority owners who work for the company, or taking actions that diminish or eliminate the minority’s interest in the corporation.
Some jurisdictions frown upon such actions, and apply a “reasonable expectations” standard under which it may be viewed as oppressive conduct to interfere with a minority’s objectively reasonable expectations in employment with the company, the opportunity to participate in the governance of the venture, or with the opportunity to receive a return on their investment. Other jurisdictions apply an “entire fairness” standard, in which the majority bears the burden of demonstrating that the process and ultimate price were fair to the minority.
Regardless of which test of fairness applies, courts have generally first required that minority owners rebut the business judgment rule presumption that the majority have acted in the best interest of the company on an informed and good-faith basis. The most persuasive tool for dissenting minority owners to use to rebut the business judgment rule are facts demonstrating that the majority owners engaged in self-dealing or had a material conflict of interest.
In Kahn v. M&F Worldwide Corporation, the Delaware courts concluded that the business judgment rule would apply to majority-controlled freeze-out mergers “if, but only if, (i) the controller conditions 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 acts with care; (v) the minority vote is informed; and (vi) there is no coercion of the minority.”
In light of Kahn, majority shareholders of a publicly traded company wishing to pursue a transaction which will eliminate the minority shareholders’ interests should consider forming an independent, special committee to consider the transaction and require a favorable vote by a majority of the minority in order to minimize the risk of protracted litigation and additional pay-outs once the transaction closes. Closely held entities that do not have the same types of formal special committee structures should still adopt procedures to demonstrate fairness.
Apart from the process used for vetting and approving the transaction, majority owners can take steps long before a transaction is contemplated that will minimize the risk of protracted litigation. For example, the owners of the business can adopt buy-sell agreements that protect each owner’s interest in the business and create a mutually agreeable protocol for a buyout. Another option is the creation of call and put rights, which provide a mechanism for requiring the minority owners to sell their interests or for the minority shareholders to require the majority to purchase their interests, respectively. Business owners should consult with counsel long before a significant change in ownership is contemplated in order to work out a process mutually agreeable to all stakeholders or, at a minimum, a process that will be demonstrably fair.
Some jurisdictions, such as Delaware, impose a duty to maximize value for shareholders in a change in control situation. Others do not create such an obligation and allow majority shareholders to consider a broader range of factors, other than price, in determining whether to adopt a particular transaction. In most cases, challenges to the consideration of a deal are difficult when each shareholder receives the same pro-rata amount and are more likely to be fatal when the majority receives extra compensation for their interests in the company.
A central factor to consider in analyzing a transaction is the valuation that supports a fairness opinion. A fairness opinion is a written document—typically in the form of a brief letter—issued by an independent financial advisor. It states the financial advisor’s view as to the fairness of the proposed transaction, from a financial point of view, and the consideration an owner will receive if the deal is consummated. The central tenet of a fairness opinion is a comparison of the price being offered to the “intrinsic” value of the enterprise—i.e., the value of the business if it were to maintain the status quo and continue to operate as a going concern.
There are a number of methodologies that a financial advisor may use to estimate a company’s intrinsic value, principally an income approach and a market approach. An income approach attempts to estimate the intrinsic value of a business based upon the operating cash flows that the business can be expected to generate in the future, discounted to their present value equivalent (i.e., their value in today’s dollars, versus their nominal value in the future) at a rate of return that reflects the relative risk of those cash flows. The market approach is a valuation technique whereby the value of the target company is estimated based on the prices paid for the shares of “guideline” companies either in the public markets or in similar M&A transactions. These observations make it possible to estimate the value of shares in a closely held company that have no active market.
Specifically, the trading prices of the guideline companies are first converted into pricing multiples by dividing an observable market price by some measure of operating performance—e.g., sales, earnings, or EBITDA. A price to earnings or P/E, multiple, as well as an enterprise value to EBITDA (EV/EBITDA) multiple, are common and well-known pricing multiples that are often used. After analyzing the risk and return characteristics of the guideline companies relative to the target company, appropriate pricing multiples are selected and are applied to the corresponding operating results of the target company in order to estimate its value.
Once the relevant valuation approaches are selected by the financial advisor and are applied to estimate the value of the target company, the separate indications of value resulting from each approach are then reconciled by the financial advisor (based on the quantity and quality of information underlying each approach is) into a conclusion of a range of value for the business. This conclusion of value is then compared to the price being offered in the transaction. In the sale of a business, if the price being offered is within or above the concluded range of value, then the financial advisor will determine the price to be fair from a financial point of view. On the contrary, if the price is below the concluded range of value, the financial advisor will likely need to have a hard conversation with its client and their counsel.
Although the fairness opinion itself takes the form of a short letter, the intrinsic valuation underlying the financial advisor’s opinion is typically presented in a lengthier presentation in which the advisor describes its work, discusses the methodologies that were applied to value the business and the significant assumptions used therein, and provides supporting schedules showing details of major calculations and analyses. In conjunction with the opinion letter, it is this presentation that forms the basis of the financial advisor’s role in informing the company’s directors as to value, thereby helping them to demonstrate to the shareholders, and ultimately to the courts, that they have fulfilled their fiduciary duty of care in reviewing a transaction.
It is important for all of the constituents in a deal—including the majority shareholder (who may be acquiring the minority’s shares in a squeeze-out transaction or selling his or her shares alongside the minority in a change-of-control transaction), the minority owners, and the board or special committee members who are the recipients of a fairness opinion—to understand the limitations of a fairness opinion. Indeed, a fairness opinion only considers the price or consideration that is being offered in a given transaction, but does not speak to other, procedural aspects of fairness. For instance, a fairness opinion does not address the underlying business decision of the company, the board, or the special committee to proceed with the transaction (e.g., the process by which the deal is being approved) or the merits of the transaction relative to any alternative business strategies or transactions that may exist for the company (e.g., the process by which the company was, or wasn’t, marketed to potential bidders, as the case may be). In addition, a fairness opinion is not a declaration that the price being offered in a given deal is the “best” or highest price—only that it is a fair price in the context of the company’s underlying intrinsic value. Thus, a fairness opinion is only intended to be utilized as one input to consider in analyzing a potential transaction.
Despite these limitations, a fairness opinion can provide critical information to the members of a board of directors or special committee who are charged with reviewing a transaction and providing a recommendation to the company’s shareholders.
Majority owners of close corporations should ensure that minority owners are provided access to what courts call “material information”—that is, information a reasonable owner would consider important in deciding how to vote. The fairness opinion itself is often a core piece of the material information that should be provided to minority shareholders, though the complete set of underlying data relied upon by the financial advisors does not in all cases need to be provided.
In order to avoid protracted litigation over the amount of information provided, which for close corporations typically comes in the form of a breach of fiduciary duty action against the majority shareholders, business owners should generally consider providing a copy of the fairness opinion, any reasonably certain financial projections relied upon in the opinion, and a complete summary of the terms, conditions and processes associated with the transaction. In addition to these basic disclosures, counsel should be consulted to determine what additional information may be appropriate for disclosure, and majority owners should not interfere with any rights of access to information provided in the entity’s charter or provided by state statute.
The obligation to provide material information, however, does not require a business to disclose en masse any and all information that may simply be of casual interest to owners. For example, there is generally no obligation to disclose the majority shareholder’s underlying reason for acting, strategic alternatives which were not pursued, offers not pursued, or the complete set of underlying details for the fairness opinion.
Majority business owners who wish to pursue a transaction that will eliminate or significantly reduce the percentage stake of the minority owners should seek counsel early in the process, and work out a plan to obtain buy-in from the minority owners. Planning should include a realistic assessment of who may be likely to contest the transaction. It should also include setting forth a process for the approval of the transaction and provision of adequate disclosures to shield the majority from an action for breach of their fiduciary duties, including the potential provision of a fairness opinion from an independent financial advisor. Early consultation with counsel and financial advisors experienced in transactions which eliminate or diminish the minority’s stake in the entity is critical to obtain the best chances for a litigation free transaction.
Contact the authors:
William W. Jacobs – Thompson Hine – Bill.Jacobs@ThompsonHine.com
Anthony J. Rospert – Thompson Hine – Anthony.Rospert@ThompsonHine.com
Thomas M. Ritzert – Thompson Hine – Thomas.Ritzert@ThompsonHine.com