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This Dechert memo reviews the Delaware Supreme Court’s recent decision in Morris v. Spectra Energy Partners, (Del. Sup.; 1/21), which adopted the test established by the Chancery in In Re Primedia S’holders Litig. (Del. Ch.; 5/13) for determining when shareholders whose derivative claims have been extinguished by a merger have standing to bring a direct claim challenging the merger based on the seller board’s failure to obtain sufficient value for a material derivative claim.

Under the Primedia test, a court must consider three things: First, was the underlying claim viable enough to survive a motion to dismiss? Second, was its value material in context of the merger? And third, was the buyer unwilling to pursue the claim? The Chancery Court applied the Primedia test to the claims in Spectra Energy, and held that the equity holders did not have standing to pursue a direct claim.

The Chancery Court dismissed the case because it determined that the amounts involved were not material to the overall consideration paid in the merger.  In reaching that conclusion, the Court applied two discounts to determine the value of the derivative claim.  First, it applied an 83% discount based on the size of the public equity holders beneficial interest in the derivative claim.  Second, it applied a further 75% discount to the value of the claims based on the likelihood of their success on the claim.

The Supreme Court adopted the Primedia test, but held that the Chancery Court had erred in determining that the claim was immaterial. This excerpt from the memo reviews the Court’s reasoning:

The Delaware Supreme Court recognized that the Chancery Court has the authority to dismiss a direct shareholder claim for lack of standing if the claim is “meritless” or “immaterial.” Nevertheless, in this case, the Delaware Supreme Court held that the Chancery Court erred in finding the underlying derivative claim was “meritless” or “immaterial” for two reasons.

First, the Delaware Supreme Court emphasized that “the court must accept [Plaintiff’s] factual allegations as true and draw all reasonable inferences in his favor.” In other words, “if it is reasonably conceivable that the plaintiff could recover the damages claimed in the complaint, the court must accept that allegation as true for purposes of the motion to dismiss for lack of standing.” The Delaware Supreme Court therefore held that, apart from making this threshold determination about plaintiff’s allegations, a trial court may not apply “a further litigation risk discount at the pleading stage . . . on a motion to dismiss for lack of standing.” Accordingly, the Delaware Supreme Court found that it was error for the Chancery Court to apply a 75% litigation risk discount based on the court’s assessment of Plaintiff’s chances of success at 25%.

Second, the Delaware Supreme Court clarified that the Chancery Court must assess the materiality of the claim based on a consistent comparison of the claim to the value of the merger consideration. And so, it was error for the Chancery Court to compare, on the one hand, the value of the claims to a
limited group of equity holders, to the entity’s total equity value as determined by the merger. Materiality should instead be calculated by comparing the value of the claim to the subset of affected equity holders to the specific consideration those equity holders received in the merger, or by comparing the total value of the claim to the entity as a whole to the total consideration provided in the merger.

The Court concluded that if the derivative claim was discounted to an amount representing the public equity holders interest in the potential recovery, the Chancery Court should have compared that interest to the public equity holders interest in the merger consideration to assess its materiality. Applying that standard, the Court held that the claim was material and that the plaintiff had standing to pursue it.

– John Jenkins