Delaware Chancery Court Addresses Standard for Evaluating Controlling Stockholder Tender Offers

June 4, 2010

In a recent ruling with important implications for parties structuring minority freeze-out transactions, Vice Chancellor Travis Laster of the Delaware Court of Chancery embraced a unified standard for reviewing such transactions, regardless of whether they are effected by means of a negotiated merger or a unilateral tender offer.  In In re CNX Gas Corp. Shareholders Litig., C.A. No. 5377-VCL (Del. Ch. May 25, 2010), V.C. Laster held that a proposed two-step freeze-out transaction — a unilateral tender offer followed by a short-form merger — is subject to the strict entire fairness standard, rather than the deferential business judgment rule, unless the tender offer is both (1) recommended by a special committee of independent directors with the authority to negotiate with the controlling stockholder, and (2) subject to a majority-of-the-minority tender condition.  V.C. Laster concluded that, because the Special Committee of CNX Gas had not recommended that stockholders tender, the transaction should be reviewed for entire fairness.

The CNX Gas case arose out of a unilateral tender offer launched in April 2010 by CNX Gas Corporation’s controlling stockholder, CONSOL Energy, Inc.  CONSOL owned directly or indirectly approximately 83.5% of CNX Gas’s outstanding shares.  The tender offer was subject to a majority-of-the-minority condition.  However, prior to launching the tender offer CONSOL had conducted successful negotiations with CNX Gas’s largest minority stockholder, who owned approximately 37% of the public float and agreed to tender such shares in the tender offer.   

In response to the tender offer, the CNX Gas Board created a Special Committee comprised of its sole independent director to review and evaluate the tender offer.  However, the CNX Gas Board did not grant the Special Committee authority to explore other alternative proposals, or (at least initially) to negotiate a better price with CONSOL.  The Special Committee specifically asked for authority to consider alternatives and, after retaining legal and financial advisors, the Special Committee requested that its authority be expanded to include "the full powers and authority of the board of directors" with respect to the tender offer.  The CNX Gas Board declined these requests on the basis that CONSOL was unwilling to sell its CNX Gas shares. Notwithstanding its lack of authority, the Special Committee unsuccessfully sought to negotiate a higher price with CONSOL.  (The CNX Gas board subsequently ratified the Special Committee’s efforts at negotiation by granting the Special Committee such authority after the fact).  The Special Committee announced in the Schedule 14D-9 that it would remain neutral with regards to the tender offer.  Minority stockholders filed suit in Delaware Chancery Court seeking to enjoin the tender offer.  Interestingly, the Special Committee’s financial advisor had indicated that it would be able to opine that CONSOL’s offer was fair from a financial point of view to holders of CNX Gas common stock other than CONSOL.  But the Special Committee and its advisors believed that CONSOL was not paying the highest price it was prepared to pay. 

In order to adjudicate the claims before him, V.C. Laster first had to determine what standards govern a unilateral tender offer launched by a controlling stockholder seeking to consummate a short-form merger.  As noted by the Court, Delaware law has applied a different standard of review depending on how a controlling stockholder freeze-out is structured.  The Delaware Supreme Court’s 1994 decision in Kahn v. Lynch Communications Systems established that a merger negotiated between a target company and its controlling stockholder should be reviewed for entire fairness both as to the negotiation process and the final agreed-upon price.[1]  Subsequent rulings by the Delaware Court of Chancery, however, held that a controlling stockholder could avoid the entire fairness review of a negotiated merger by launching a unilateral tender offer with the intention of subsequently consummating a short-form merger.[2]  In re Siliconix Inc. Shareholders Litigation, decided in 2001, held that a tender offer is not subject to entire fairness review if it is non-coercive and without disclosure violations.[3]  A year later, V.C. Strine, in In re Pure Resources, Inc. Shareholders Litigation, expanded on Siliconix (while noting that his decision was "tentative and incomplete") holding that a tender offer by a controlling stockholder should be deemed non-coercive only if (1) it is subject to a non-waivable majority-of-the-minority tender condition; (2) the offeror promises to complete a short form merger at the completion of the offer at the same price if it obtains more than 90% of the shares; and (3) "the controlling stockholder has made no retributive threats."[4]  Pure Resources also held that the controlling stockholder must allow the special committee of the target board "both free reign and adequate time to react to the tender offer[.]"[5] 

In 2005, V.C. Strine suggested in dicta in In re Cox Communications, Inc. Shareholders Litig. that the divergent doctrines for freeze-out mergers and tender offers should be scrapped in favor of a unified approach for controlling stockholder freeze-out transactions.[6]  Under the unified approach, "the business judgment rule [would] apply to any freeze-out transaction that [was] structured to mirror both elements of an arms’ length merger, viz. approval by disinterested directors and approval by disinterested stockholders."[7]   

In CNX Gas, V.C. Laster largely adopted the unified approach suggested by V.C. Strine in Cox Communications and applied it to CONSOL’s tender offer.  Under the standard set forth in CNX Gas, in order to obtain the deference of the business judgment rule, a tender offer as the first step in a minority squeeze-out must be both (1) recommended by a special committee of independent directors with the authority to negotiate with the controlling stockholder and (2) subject to a majority-of-the-minority tender condition.     

Applying this rule to the facts of the CNX Gas case, V.C. Laster held that entire fairness review was triggered because the Special Committee of the CNX Gas Board declined to recommend that the minority stockholders tender their shares.  Though this fact alone was found to be sufficient to warrant entire fairness review, V.C. Laster also found that the CONSOL tender offer also did not pass muster under the unified standard because the Special Committee "was not provided with authority comparable to what a board would possess in a third party transaction."  The Court’s opinion suggests that under the unified standard a special committee must, at a minimum, be given full authority to explore strategic alternatives, file litigation against the controlling stockholder and implement a rights plan.  Moreover, V.C. Laster questioned whether the majority-of-the-minority condition was sufficient in this case, given CNX Gas’s largest stockholder’s private negotiation with CONSOL preceding the tender offer, and such stockholder’s significant stake in CONSOL stock.     

The unified approach of CNX Gas, as applied to tender offers, conflicts with the recent Cox Radio decision, which was decided on May 6, 2010.  Cox Radio approved a class action settlement over objectors who argued that the tender offer should be subject to entire fairness; Cox Radio rejected their claims, citing In re Pure Resources for the proposition that a two-step freeze-out is not subject to entire fairness if it is subject to a non-waivable majority-of-the-minority condition, the controlling stockholder makes no retributive threats, and the special committee is free to evaluate the tender offer and make a recommendation to minority stockholders.   

Although many practitioners have been expecting — and hoping for — movement towards a unified standard for freeze-out transactions by controlling stockholders, the CNX Gas decision will create uncertainty and debate in the near term on the subject as it relates to controlling stockholder tender offers.  This is particularly true in light of the Chancery Court’s decision in Cox Radio, which predates CNX Gas by less than a month.  Resolution by the Delaware Supreme Court of the conflicting standards sponsored by these decisions would be welcomed by practitioners and participants in freeze-out transactions.  And assuming that V.C. Laster’s unified standard were to become the prevailing position, boards, special committees and their advisors will be left to grapple with the Court’s suggestion that in order to avoid entire fairness a special committee must have the authority that a board would have in a third party transaction — a suggestion that would be highly unappealing to a controlling stockholder, particularly to one that may have already paid a premium to acquire such controlling stake.