Delaware Court of Chancery Applies Entire Fairness Review in Finding That Controlling Stockholders and Special Committee Members Breached Fiduciary Duties to Target Stockholders
By Lisa Stark and Frank Mazzucco
In FrontFour Capital Group LLC v. Taube, C.A. No. 2019-0100-KSJM (Del. Ch. Mar. 11, 2019), the Delaware Court of Chancery found that, due to their conduct in connection with two mergers of affiliated entities, controlling stockholders and special committee members breached their fiduciary duties to target stockholders under the entire fairness standard of review and failed to provide certain material disclosures to stockholders.
In June 2018, Brook and Seth Taube (the “Taube Brothers”) proposed to combine Medley Management, Inc. (“Medley Management”), an asset management firm that they founded and majority owned, with two affiliated business development corporations advised by Medley Management: Medley Capital Corporation (“Medley Capital”) and Sierra Income Corporation (“Sierra”). As part of the proposed mergers, Medley Management stockholders were to receive cash and stock representing a 100% premium to the company’s trading price, while Medley Capital stockholders were to receive only shares of Sierra stock providing no premium. Medley Management’s senior executives would receive lucrative employment contracts and inside directors of Medley Capital’s board would receive both compensation for their interests in Medley Management and enhanced compensation packages.
Following the announcement of the mergers, FrontFour Capital Group LLC and FrontFour Master Fund, Ltd. (collectively, “FrontFour”) filed an action. FrontFour’s complaint set forth three causes of action. First, FrontFour alleged that the Taube Brothers and Medley Capital’s special committee breached their fiduciary duties to FrontFour and Medley Capital stockholders in connection with the approval of the mergers. Second, FrontFour contended that Medley Capital’s public disclosures failed to provide several categories of information material to stockholders in voting on the mergers. Third, FrontFour alleged that Sierra had aided and abetted the other defendants’ breaches of fiduciary duty.
With regard to FrontFour’s first claim, the Court noted that entire fairness review is triggered “when the board labors under actual conflicts of interest,” such as when a controlling stockholder stands on both sides of a challenged transaction or when a controlling stockholder competes with the minority stockholders for consideration. In determining whether a minority stockholder (such as the Taube Brothers) exercises de facto control, the Court stated that a plaintiff may show either that (i) the stockholder “actually dominated and controlled the majority of the board generally”; or (ii) the stockholder “actually dominated and controlled the corporation, its board or the deciding committee with respect to the challenged transaction.” Here, the Court held that FrontFour had met its burden of proving that at least 50% of Medley Capital’s special committee members were not “independent” from the Taube Brothers when negotiating the mergers because they “willfully deferred to their authority.” Accordingly, the Court applied the entire fairness standard of review.
The Court held that the defendants failed to demonstrate that the mergers were the product of both fair dealing and fair price. With regard to fair dealing, Medley Capital’s board and special committee acquiesced to a deal timeline desired by Medley Management, declined to consider alternative transactions or inquire meaningfully as to the value of Medley Management, failed to conduct a pre-signing market check, and was unaware that approximately 30 confidentiality agreements contractually prohibited third parties from proposing an alternative transaction with Medley Capital. With respect to fair price, the Court found that “this is a case in which a deeply flawed process obscures the fair value of Medley Capital.”
The Court also evaluated FrontFour’s claim that the merger agreement’s deal protections failed enhanced scrutiny review. The Court found that “[d]ue to extreme process flaws that led to the Proposed Transactions, the deal protections are not within the range of reasonableness.” In sum, the Court found that the Taube Brothers and the Medley Capital special committee breached their fiduciary duties to FrontFour and other Medley Capital stockholders in connection with the approval of the mergers.
In its second claim, the Court agreed with FrontFour’s contention that the Medley Capital directors breached their fiduciary duty of disclosure in soliciting the stockholder vote on the merger by failing adequately to inform Medley Capital’s stockholders of the flawed process that led to the mergers, including the expressions of interest from third parties, which were not hidden from the special committee.
Finally, in its third claim, FrontFour contended that Sierra aided and abetted the other defendants’ breaches of fiduciary duty. According to the Court, to establish an aiding and abetting claim against Sierra in this instance, FrontFour would need to prove that Sierra “knowingly participated” in the other defendants’ breaches of fiduciary duty. Under a fact-intensive analysis, the Court concluded that FrontFour did not prove that Sierra knowingly participated in such breaches of fiduciary duty.
With regard to remedies, FrontFour sought relief through a curative shopping process. However, the Court stated that, under the Delaware Supreme Court’s 2014 decision in C&J Energy, a court cannot issue an injunction if such relief would “strip an innocent third party of its contractual rights” under a merger agreement, unless the party seeking the injunction proves that the third party aided and abetted a breach of fiduciary duty by the target directors. Given the Court’s findings that FrontFour failed to prove that Sierra aided and abetted in the other defendants’ breaches of fiduciary duty, the Court denied FrontFour’s request for affirmative injunctive relief. However, the Court held that Medley Capital’s stockholders were entitled to corrective disclosures and enjoined the mergers pending such disclosures.