Everyone knows that mergers need to be approved by the board and shareholders of the target company. If you are an acquirer looking to buy a company, you will want to structure the deal so a majority of your target’s shareholders give you a thumbs-up. In typical acquisitions, this is not a meaningful barrier to consummating the deal. After the target’s board and their advisors have evaluated the deal (including by potentially soliciting other bids) and carefully determined that it is in the best interests of shareholders, the target shareholders themselves are almost always very happy to come along for the ride and cash out at a premium.
While the shareholder approval requirement very rarely stops deals from going through, it does create significant administrative burdens (i.e., drafting and mailing proxies, holding a shareholder meeting). The requirement also means that deals close more slowly than they otherwise would.
But what if you are a potential acquirer and you already own a large majority of the target company’s stock? Do you still need to seek shareholder approval?
Under some circumstances, controlling shareholders can dispense with target company stockholder approval by carrying out a “short-form merger.” In this article, I’ll explain how short-form mergers work in Delaware. Then I’ll explain some litigation risks associated with short-form mergers and insurance coverage implications.
Short-Form Mergers Under Delaware Law
Section 253 of the Delaware General Corporation Law (DGCL) sets the ground rules for short-form mergers. Under the law, a parent corporation can merge with a subsidiary corporation without going through certain formalities. To do so, the parent corporation must own “at least 90% of the outstanding shares of each class of the stock” of the subsidiary corporation. The only relevant corporate action is that the board of directors of the parent corporation must (1) adopt a resolution approving a certificate of merger, and (2) furnish the minority shareholders a notice advising that the merger has occurred and that they are entitled to seek appraisal (more on this later). The merger can be completed without a vote from the minority shareholders.
It's easy to understand why this legal mechanism exists. If a controlling shareholder has a dominant controlling stake in a subsidiary corporation, it would be inefficient to force the controlling parent to go through a lengthy formal shareholder approval process.
But, efficiency gains notwithstanding, what prevents the parent from jamming a very low acquisition price down the throats of minority shareholders? Can the minority shareholders sue? I’m glad you asked.
Short-Form Litigation Risks
Recognizing the potential for abusively low offer prices from controlling shareholders, the DGCL provides appraisal rights to minority shareholders in short-form mergers. This means that, if minority shareholders ask, the Court of Chancery will conduct proceedings to determine the “fair value” of the target corporation. If the “fair price” determined by the judge is greater than the merger price, the controlling parent has to pony up the difference to the minority shareholders.
There are a couple of things to unpack here. First, the Delaware courts have left open the possibility of short-form merger litigation based on “fraud or illegality.” What does this mean? The key Delaware cases don’t say, and I’m not aware of any successful shareholder litigation predicated on this theory.
At a high level, it seems the Delaware courts have left open the possibility of damages—on top of appraisal—for egregious behavior. If, for example, a majority shareholder sought to fraudulently and artificially drive down the target corporation’s valuation to diminish the worth of minority shareholders’ interests and then pursued a short-form merger at a bargain basement price, maybe the Delaware courts would perk up. But it doesn’t look like any such fact patterns have made it to the Delaware Court of Chancery recently.
Second, when it sends the required short-form merger notice, the parent corporation has a fiduciary duty of “full disclosure” to the minority shareholders. If this duty is violated, the minority shareholders have remedies in court. As the Delaware Supreme Court explained in a riveting 2009 opinion, if minority shareholders can demonstrate that material information was omitted from the short-form merger notice, the controlling parent will be required to disclose the omitted material information.
Also, plaintiffs can sue on behalf of all minority shareholders, without any opt-in requirement.
Finally, minority shareholders can take the benefit of the merger—the original price tendered for their shares—and also bring “quasi appraisal” litigation claiming that they did not receive a fair price. This structure is more favorable to plaintiffs than standard appraisal actions, which require shareholders to meet a variety of procedural requirements.
Insurance Considerations
As we have seen, the litigation risks to short-form mergers are significantly lower than the risks to traditional merger transactions. However, any time the courts create an opening for plaintiffs, creative lawyers are happy to walk through the door. Disclosure obligations—and claims that disclosure was deficient—and appraisal or quasi-appraisal proceedings should be top of mind for controlling shareholders pursuing short-form mergers. The specter of claims alleging “fraud or illegality” also remains.
In the world of traditional mergers and acquisitions, target companies routinely purchase tail policies for directors and officers. This ensures that if the target company’s directors and officers are sued after the target company is acquired, ceases to exist, and stops buying D&O insurance, insurance coverage is still available to protect individual balance sheets. (Check out this article to learn more about M&A D&O tail policies more generally.)
The case for a tail policy may be somewhat less compelling in the short-form merger context. First, litigation risks are simply lower in short-form world. Also, depending on the facts and circumstances, appraisal actions may not be covered by a D&O policy. However, you might be able to get coverage for short-form merger litigation alleging that directors breached their fiduciary duty of disclosure or claiming that they engaged in securities fraud.
In the end, the pressure to buy a tail policy is relaxed compared to normal M&A. As a result, in some cases, you may be comfortable relying on the controlling parent’s balance sheet. Still, if you are planning a short-form merger, you should ask your insurance advisor for guidance on risk transfer options available in the market. No matter the context, it is never fun to face down securities litigation or a regulatory enforcement matter without the benefit of a good insurance policy behind you.
