Chancery Court Clarifies the Cleansing Power of an Uncoerced and Fully Informed Disinterested Majority Stockholder Vote
By: Annette Becker and Will Smith
In In re Merge Healthcare Inc. Stockholders Litigation, No. 11388-VCG (Del. Ch. Ct. January 30, 2017), the Delaware Court of Chancery granted the defendant directors’ motion to dismiss brought against the plaintiff stockholders, holding that the cleansing effect of an uncoerced and fully informed vote of a majority of disinterested shares shields company directors from liability for alleged fiduciary violations as to an improper merger price and process. The Court found that the business judgment rule applied on review as opposed to the entire fairness standard.
This case arises from IBM’s acquisition of Merge Healthcare, Inc. (“Merge”) in late 2015. The Merge directors, including key stockholder and board chairman Michael Ferro, negotiated the IBM deal over the spring and summer of 2015. The Merge board entered into the merger agreement with IBM on August 6, 2015. On October 13, 2015, nearly 80% of the outstanding Merge shares were voted to approve the sale to IBM. The merger value was just over $1 billion with a deal price of $7.13 per share, representing a 31.8% premium to the Merge closing share price. The merger provided employment and transition agreements for management, including for one defendant director. The plaintiffs, owners of Merge common stock, brought an initial post-closing class action suit for damages on August 13, 2015; it was later consolidated with other Delaware actions, amended, and re-filed on February 8, 2016.
The plaintiffs claimed: (1) the directors breached their duty of care because the board engaged in an unfair merger process and accepted a depressed sales price; and (2) the directors breached their duty of disclosure because the board disseminated incomplete information in bad faith to secure stockholder consent to the merger. More specifically, the plaintiffs alleged that board chairman Ferro consummated the merger in pursuit of personal gain—to liquidate his Merge holdings and obtain a personal consulting fee due on completion of a merger valued at $1 billion or more. They also alleged that the board prepared a materially inadequate proxy to mislead stockholders into foregoing appraisal rights and voting for the merger.
The plaintiffs also argued that the merger should be subject to the entire fairness standard of review because a majority of the board was conflicted. They claimed that Ferro was a controlling stockholder because he personally controlled 26% of Merge shares, and due to his overlapping business relationships with the board, all but one director was beholden to him. The plaintiffs sought a quasi-appraisal remedy and compensatory damages for these injuries.
The defendants moved to dismiss the case for failure to state a claim, relying on the cleansing effect of the stockholders’ vote ratifying the merger transaction. The Court agreed, vindicating the defendants’ reliance on the cleansing power of a disinterested majority stockholder vote.
Importantly, the Court rejected the plaintiffs’ reading of the Delaware Supreme Court’s cleansing doctrine. The plaintiffs argued that a well-pled entire fairness case bars cleansing under Corwin v. KKR Financial Holdings LLC, 125 A.3d 304, 313–14 (Del. 2015). The Court reached a different conclusion, relying on the Chancery Court’s exposition of the cleansing doctrine in Larkin v. Shah, 2016 WL 4485447 (Del. Ch. Aug. 25, 2016). Under Larkin, the trigger for entire fairness is not “the mere presence” of a controlling stockholder “per se,” but when a controlling stockholder engages in a conflicted transaction, by sitting on both sides of the deal or competing with common stockholders for consideration. In such conflicted transactions, the Court writes, coercion is “deemed inherently present” and cannot be cleansed by a stockholder vote. But without a controlling stockholder pursuing personal gain, cleansing remains available and the business judgment rule applies, even if individual directors face conflicts that would ordinarily warrant entire fairness review.
Applying the Larkin rule, the Court found that the plaintiffs failed to rebut the cleansing vote in their complaint. The plaintiffs failed to plead facts sufficient to show Ferro extracted personal benefits, even assuming that he was a controlling stockholder. Nothing in his behavior evinced an interest adverse to the stockholders, and in fact Ferro waived the $15 million consulting fee owed to him by Merge to secure a higher purchase price from IBM. In addition, the plaintiffs failed to plead sufficiently that the director’s disclosures were materially misleading in some regard, leading to an uninformed vote. The plaintiffs not only argued new facts in their response brief concerning the nature of the board’s alleged informational misstatements, but also those facts contradicted the nature of the board’s misstatements pled originally in their complaint. Furthermore, the proxy disclosed projections for revenue, gross profit, EBITDA, EBIT, net income, earnings per share, and UFCF, the key inputs of the financial advisor’s merger analysis, and Ferro’s waiver of his $15 million consulting fee. The Court found these disclosures adequate and not misleading.
Under the Court’s analysis, the plaintiffs failed to plead adequately both coercion by a controlling stockholder and dissemination of materially misleading information by the board. Therefore, the business judgment rule applied to the board’s decision to approve the merger, not the entire fairness standard, because the cleansing stockholder vote was disinterested, uncoerced, and fully informed.
In re Merge Healthcare Inc. Stockholders Litigation, No. 11388-VCG (Del. Ch. Ct. January 30, 2017)