DealLawyers.com Blog

As I blogged yesterday, a recent Delaware Chancery Court decision – In re: Tele-communications, Inc. Shareholders Litigation, – has raised significant concerns regarding whether contingent fees for advising a special committee are appropriate – and the need for a relative fairness opinion when the transaction consideration is allocated amongst classes of capital stock. Below is more analysis on this important case from Kevin Miller of Alston & Bird:

Overview

Of most concern to financial advisors, Chancellor Chandler, on defendants’ motion for summary judgment (which requires that he view the facts in the light most favorable to, and making all reasonable inferences in favor of, the plaintiffs) concluded that:

1. the contingent compensation of the financial advisor (here, $40 million) created a serious issue of material fact as to whether the financial advisor could provide independent advice to the Special Committee; and

2. the Special Committee should have examined the fairness to the holders of low vote stock of the premium being paid to the holders of the high vote stock, apparently by obtaining an opinion as to the fairness of the high vote premium to the holders of the low vote stock.

In light of this decision, financial advisors to special committees should expect to receive requests that they agree to noncontingent fees and because there can be no guarantee that a transaction will ultimately be consummated, should expect the proposed noncontingent fees to be lower than the contingent fees financial advisors might otherwise expect to receive.

In addition, if the transaction consideration is allocated amongst classes of capital stock (other than by the terms of such securities or a preexisting contract or other obligation), financial advisors are also likely to receive requests to provide opinions regarding the fairness of such allocation to the holders of one or more classes of capital stock – an issue that financial advisors have historically viewed as being outside the proper scope of a fairness opinion. The latter issue may not be restricted to situations involving a special committee.

The Facts

The case arose in connection with the 1999 merger of TCI with a subsidiary of AT&T. While on its face an arms’-length transaction, the Board of TCI formed a Special Committee to evaluate the proposed transaction because of the potential conflicts faced by members of the board resulting from their ownership of different classes of TCI capital stock.

According to the opinion, TCI had issued two classes of tracking stock – one high vote, one low vote – with respect to each of three divisions, for a total of six classes of capital stock. The terms of the proposed merger included a 10% premium payable to the holders of the high vote stock of one division as compared to the consideration payable to the holders of the low vote stock of that division. Disclosure claims and claims challenging the fairness of the transaction were brought on behalf of the holders of the low vote stock of that division.

Since a majority of TCI’s directors owned substantial amounts of high vote stock and they stood to receive a significant benefit as a result of the 10% premium at the expense of the holders of low vote stock, the court applied an entire fairness test rather than the business judgment rule. Because of the deficiencies described below (drawing all reasonable inferences in favor of the plaintiffs), the establishment of a special committee failed to shift the burden of proof back to the plaintiffs at the summary judgment stage.

Entire Opinion Issues

With respect to the entire fairness of the 10% premium payable to holders of high vote stock, Chancellor Chandler concluded that:

1. The Special Committee lacked complete information regarding the premium at which high vote shares historically traded.

2. The Special Committee failed to ascertain the relative infrequency of high vote premiums in comparable transactions.

[Note: While the court acknowledged arguments that such premium may often be foregone to, among other things, avoid litigation and that, in this case, the largest holder of high vote stock had repeatedly made it clear that absent a 10% premium there would be no transaction, the court concluded that, reasonably construing the record in the light most favorable to the plaintiffs, the Special Committee was inadequately informed. Nevertheless, many commentators will criticize the court’s apparent focus on the historical relative trading prices of a liquid low vote stock and an illiquid high vote stock and the numerous precedent transactions in which holders of high vote stock had foregone a premium even though they may have been legally and economically entitled to one (e.g., the fact that holders of high vote stock may be willing to forego a control premium to avoid litigation is not much help or particularly relevant when negotiating with a large holder of high vote stock like John Malone who adamantly insists on extracting a premium to which he is legally entitled).]

3. While TCI’s financial advisor separately analyzed the fairness of the high vote exchange ratio to the holders of high vote stock and the fairness of the low vote stock exchange ratio to the holders of low vote stock, in Chancellor Chandler’s view the Delaware Supreme Court’s decision in Levco v. Reader’s Digest required an examination of the fairness of the premium paid for the high vote stock to the holders of low vote stock, apparently by obtaining an opinion as to the fairness of the high vote premium to the holders of the low vote stock.

Note: Whether a Special Committee is generally obligated to obtain an opinion from its financial advisor with respect to the fairness of a high vote premium to the holders of low vote stock will be the subject of much debate, particularly as many financial advisors believe such normative conclusions to be outside the proper scope of a fairness opinion. The key language in the TCI opinion is: “the [financial advisor] opinion does not discuss the effect of the [high vote stock] premium upon the [low vote stock] holders, i.e., whether the [high vote stock] premium was fair to the [low vote stock] holders. Unfortunately for defendants, Levco appears to mandate exactly such an analysis: that the relative impact of the preference to one class be fair to the other….In other words, the [Special Committee in Levco] should have sought an opinion as to whether the transaction was fair to the disadvantaged class of shareholders…” Arguably all Levco actually says is that the Special Committee needed to focus on the specific impact upon the low vote shareholders of differential payment received by the high vote shareholders and that can be accomplished by reviewing a quantitative analysis well within the core competencies of a financial advisor, while leaving the normative judgment/conclusion as to the appropriateness of such allocation to the special committee and the board following a review of all relevant and reasonably available information, including, as appropriate, information on historical relative trading values and precedent transactions.

Special Committee Issues

Somewhat reminiscent of Emerging Communications, the opinion also describes a special committee process that in many respects serves as a guide on what not to do.

Among other things:

1. The Special Committee was comprised of two members, one of whom primarily held and benefited from the premium paid to the high vote stock, and did not include a third director who was economically disadvantaged by the payment of the premium to the holders of high vote stock.

2. The Special Committee members did not appear to have a clear and unambiguous mandate. One member thought the Special Committee’s assignment was to ensure that holders of the low vote stock received fair consideration and in particular to ensure that holders of low vote stock received consideration that was fair in relation to the consideration received by holders of high vote stock. The other member thought the Special Committee’s assignment was to look after the interests of all shareholders, not just the holders of high vote or low vote stock.

3. The Special Committee did not hire its own, separate advisors but instead relied upon the advice of TCI’s legal and financial advisors. Chancellor Chandler noted that this alone raised questions regarding the quality and independence of the counsel and advice received.

Note: It was in this context that Chancellor Chandler questioned the appropriateness of the financial advisor’s contingent fee. While he noted the defendants’ arguments that, from TCI’s perspective, it would not be advisable to incur a large financial advisory fee absent a successful transaction, he remained concerned that, from the Special Committee’s perspective, the “potentially misguided recommendations [of a contingently paid and possibly interested financial advisor] could result in higher costs to the Special Committee’s shareholder constituency in the event a deal was consummated.”

4. The amount or benchmarks for determining the compensation payable to the members of the Special Committee were not determined at the beginning of the process; only that the members of the Special Committee should be reasonably compensated. Instead the board approved payments of $1 million to each member of the Special Committee well after they had completed their duties. Chancellor Chandler concluded that “the uncertain, contingent, and potentially large nature of the payments, without any objective benchmarks or other measures, could have given [the members of the Special Committee] additional undisclosed financial interests in the transaction that might have affected their judgments.”

Disclosure Issues

On a more positive note, the TCI decision confirmed that Delaware law does not require merger proxies to contain a blow-by-blow description of a board’s/special committee’s deliberative process: “No Delaware decision has ever held that a more detailed description of a committee’s deliberations, either akin to the minutes of the committee, or a transcript of committee meetings, or some other description of the give and take and discussions of the committee must be disclosed in order to support a statement of “careful consideration.” Instead, the courts of Delaware have repeatedly stated that, in the context of disclosures, less disclosure is often more appropriate than more in order to avoid buying shareholders beneath a tome of impenetrable complexity and length.”

Here is the case citation: In re: Tele-communications, Inc. Shareholders Litigation, C.A. No. 16470 (December 21, 2005) – a copy of the opinion is posted in our “Fairness Opinion” and “Special Committee” Practice Areas, and that is where we will be posting the upcoming deluge of law firm memos…