The United States has a problem of litigation. If a large M&A deal is announced, it is almost certain that a stockholder will challenge the deal in court. In 2014, 93% of all M&A deals valued over $100 million were challenged in court. This marked the fifth consecutive year in which more than 90% of all M&A deals valued over $100 million were challenged. This large amount of litigation has burdened the corporate world, and the Delaware Courts have started to take action to stop it.
In 2015, the Delaware Supreme Court issued its opinion in Corwin v. KKR Financial Holdings. The Corwin Rule has contributed to a high number of early dismissals of litigation challenging M&A transactions. This is being achieved by the Delaware courts’ growing deference to stockholder approval. On February 9 of this year, the Delaware courts have continued their expansive interpretation of the Corwin Rule in Volcano Stockholders Litigation.
The dynamics of M&A litigation
In the United States, litigation following M&A transactions is unavoidable. Several factors contribute to this situation. One reason is the fact that in the US, the losing party does not have to pay the other party’s attorney’s fees. This has the effect of encouraging frivolous lawsuits. Moreover, law firms that file such M&A litigation work on a contingency basis: when the litigation is successful, they receive a large chunk of money and when they fail, the plaintiff does not have to pay anything. As such, plaintiffs can try their luck without having anything to lose.
Usually, stockholders claim that the directors breached the fiduciary duties they owe to the corporation and its stockholders and that insufficient disclosures were made to the stockholders. The plaintiffs generally seek damages, additional disclosures by the corporation and most importantly, legal fees. This highlights how much of a business M&A litigation is: law firms are motivated by the legal fees and they actively search for stockholders so that they can litigate an M&A deal.
Almost all cases settle before going to trial, as there is pressure on both parties to settle. The company does not want to get into discovery because this is an expensive and time-consuming process. The plaintiff is being pressured by his lawyers to settle because they work on a contingency basis and it is not certain that they can win in court: the lawyers want to take the money and run. As an illustration: only one lawsuit proceeded to trial in 2014.
This proliferation of litigation following M&A transactions puts a heavy strain on the actors involved. Parties to the transaction (the corporations), stockholders and courts had to bear the costs of these lawsuits. This is why the courts stepped in.
The courts put a stop to it: Corwin
In Corwin v. KKR Financial Holdings LLC, the Delaware Supreme Court affirmed the dismissal of a stockholder’s action following a merger. The court held that when a merger has been subject to fully-informed, uncoerced approval by the disinterested stockholders, it is reviewable under the business judgment rule. The business judgment rule is a much less stringent standard of review than the enhanced scrutiny, which used to apply to such transactions. Under the business judgment rule, courts defer to the business judgment of the Board of Directors. To put it bluntly: the Board of Directors is given a lot of leeway as the court will not second-guess its decision. For the business judgment rule to apply to a merger transaction, several conditions have to be fulfilled:
- The transaction has been approved by a majority of fully informed, uncoerced and disinterested stockholders.
- The transaction does not involve a controlling stockholder (this has been held by the Delaware Court of Chancery and will likely be confirmed by the Delaware Supreme Court).
Corwin has had the effect of discouraging stockholder litigation after such transactions. Furthermore, since there has to be a fully-informed approval by the disinterested stockholders, focus has shifted to disclosing all material facts to stockholders. However, whether the disclosures that have been made were sufficient will become a new battleground.
Post-Corwin clarification: Volcano
After Corwin, some questions persisted. One of these questions was whether the application of the business judgment rule would be a rebuttable or an irrebuttable presumption. Volcano has made clear that it is the latter.
Secondly, Corwin was held in the context of a one-step merger. In this type of merger the stockholders vote to approve the merger agreement. A merger can also be effectuated in two steps. In this two-step merger, the acquirer reaches a merger agreement with the Board of Directors. Afterwards, he makes a tender offer, in which he buys the stock of the existing stockholders. After the tender offer, the acquirer hopes to have a majority of the stock, allowing him to approve the merger agreement. In Corwin, the merger was effectuated in one step: the stockholders voted to approve the deal, without there having been a tender offer. The question after Corwin was whether the stockholders tendering their stock in a two-step merger could be seen as an informed, uncoerced approval by a majority of the disinterested stockholders that triggers the application of the business judgment rule. This was a crucial question, since a lot of mergers are effectuated using a tender offer. There could be some discussion about this issue, since the stockholders do not actually vote on the transaction. The Court of Chancery held that the Corwin Rule also applies when a majority of the disinterested, uncoerced and informed stockholders tender their stock. This holding has now been affirmed by the Delaware Supreme Court.
What does the future hold?
Corwin and Volcano have made clear that the Delaware Courts will not second-guess the decision of the Board of Directors if it has been approved by a majority of disinterested, uncoerced and informed stockholders. Corwin, in combination with the Court of Chancery’s Trulia decision, has already had an effect on the frequency of M&A litigation. However, focus will shift from breach of fiduciary duties claims to claims related to the adequacy of the disclosures that were made. This trend can already be seen in practice. As such, it becomes crucial for the Board of Directors to ensure that the stockholders are adequately informed.
LL.M. Candidate, Class of 2017, Northwestern University Pritzker School of Law