June 23, 2020

Controllers: Dell Redemption Flunks MFW

Some companies just seem to be magnets for litigation, and Dell is definitely one of them.  The company’s latest visit to the Delaware Chancery Court, In re Dell Technologies Class V Stockholders Litigation, (Del. Ch.; 5/20), involved a challenge to Dell’s efforts to redeem a series of tracking stock that it originally issued in connection with its 2016 acquisition of EMC. Dell attempted to cleanse the transaction under MFW, but Vice Chancellor Laster concluded that its efforts did not pass muster.

The facts of the case are somewhat complicated.  At the time of Dell’s acquisition, EMC owned slightly less than 90% of a publicly traded company called VMWare, and as part of the consideration for that deal, Dell issued a new series of stock – Class V shares – designed to track VMWare’s performance. Dell subsequently decided to consolidate its VMWare ownership interest and began to consider possible alternatives to accomplish this objective. One alternative involved the negotiated redemption of the Class V shares, while another involving Dell’s exercise of its right to force their conversion into Dell’s Class C Shares.

In an effort to satisfy MFW’s requirements, Dell formed a special committee, and conditioned any redemption on the receipt of a favorable recommendation from that committee and a majority-of-the-minority vote. However, the committee’s authority did not extend to the exercise of Dell’s right to force conversion of the shares, and Dell took steps to prepare for that alternative as well.

Importantly, forced conversion was not a favorable option from the perspective of the Class V holders. The conversion ratio was based on each stock’s market price in the ten trading days leading up to Dell’s decision to force the conversion. That mechanism sparked concern that Dell could exploit the conversion right to its advantage, and allegedly caused the tracking shares to trade at a “Dell discount” to VMWare’s common stock.

The special committee negotiated the terms of a proposed redemption with Dell, and ultimately arrived at a deal that it recommended to the Class V holders.  Certain large Class V holders balked, and Dell then engaged in direct negotiations with those holders in which the special committee did not participate. After several months, the special committee came up with its own revised proposal at a higher price, but by that time, Dell and the large holders had reached their own deal – at a lower price than the special committee was proposing.

After the special committee learned of the agreement between Dell & the large Class V holders, it met for an hour and recommended Dell’s revised deal.  The plaintiffs sued, alleging that Dell’s board and its controlling shareholders breached their fiduciary duties, and contending that their actions should be evaluated under the entire fairness standard.  The defendants responded by asserting that the transaction complied with MFW’s requirements, and that their actions should be evaluated under the business judgment rule.

This Morris James blog on the case says that Vice Chancellor Laster held that the entire fairness standard should apply, both because of flaws in the transaction’s process, and due to its coercive features.  This excerpt reviews the Vice Chancellor’s assessment of the process:

Regarding the process, the Court explained that the committee’s mandate was too narrow because it failed to include authority over Dell’s exercise of the Conversion Right. The Court explained that, under MFW, a special committee must have power to prevent the controller from acting unilaterally via “alternative means for the controller’s desired end” or, stated somewhat differently, the “functional equivalent” thereof. Here, Dell allegedly had prepared for and threatened exercising the Conversion Right – an unattractive outcome for the Class V holders – as an alternative to the redemption.

Similarly, Dell’s decision to engage in direct negotiations with the large Class V holders failed to comply with MFW, which the Court explained requires “dual protections.” That is, the special committee “will act as the bargaining agent for the minority stockholders, with the minority stockholders rendering an up-or-down verdict on the committee’s work.”

The Court reasoned, “[t]hose roles are complements, not substitutes. A set of motivated stockholder volunteers cannot take over for the committee and serve both roles.” Under MFW, if a committee’s proposal is rejected by the minority stockholders, then “the committee must return to the bargaining table, continue to act in its fiduciary capacity, and seek to extract the best transaction available.”

The Vice Chancellor also reviewed Delaware case law on coercion, and concluded that the issue boiled down to whether “the fiduciary has taken action which causes stockholders to act – whether by voting or making an investment decision like tendering shares – for some reason other than the merits of the proposed transaction.” The blog says that VC Laster found that the plaintiffs adequately alleged that Dell’s potential exercise of the conversion right – along with public statements of its intent to do so if it couldn’t negotiate a redemption deal –  resulted in impermissible coercion:

The Court reasoned that the fear of a forced conversion could induce Class V stockholders to approve a proposed redemption for reasons other than the merits of the transaction. The situation, with a status quo freighted with so-called “Dell discount,” also supported a finding of coercion. Finally, Dell’s decisions to retain control over the Conversion Right undermined the committee’s bargaining power and ultimate recommendation. The circumstances supported an inference that the Committee approved the redemption not because it was fair, but because it was better than the alternative of a forced conversion.

The Vice Chancellor declined to dismiss the plaintiffs claims. He concluded that MFW’s requirements had not been satisfied and that the redemption should be subject to review under the entire fairness standard.

John Jenkins