Chancery Court Awards $1.263 Billion in Derivative Action

In a recent decision that may be a cautionary tale to Delaware corporations, the Court of Chancery of the State of Delaware awarded $1.263 billion to mining company Southern Peru Copper Corporation in a shareholder derivative action. In In re Southern Peru Copper Corporation Shareholder Derivative Litigation, Delaware Chancellor Leo E. Strine Jr. held that, notwithstanding independent review and approval of a merger by a special committee comprised of top flight legal and financial advisors, a merger involving Southern Peru and its controlling shareholder, was unfair to the company.

The plaintiffs challenged a transaction between Southern Peru and its controlling shareholder in which Southern Peru purchased from this shareholder another mining company, Minera Mexico, S.A. In holding that the transaction was not entirely fair to Southern Peru, Chancellor Strine ordered the controlling shareholder (Grupo Mexico, S.A.B. de C.V) to return sufficient shares to Southern Peru to remedy the harm.

The decision will interest practitioners for Chancellor Strine’s rigorous scrutiny of the challenged transaction. The conclusion that the committee “fell victim to a controlled mindset” and allowed an interested party “to dictate the terms and structure of the Merger,” suggests that the court will not accept form over substance.

“Although directors are free in some situations to act on the belief that the market is wrong, they are not free to believe that they can in fact get $3.1 billion in cash for their own stock but then use that stock to acquire something that they know is worth far less than $3.1 billion in cash,” said the court. “In plain terms, the special committee turned the ‘gold’ it was holding in trust into ‘silver.’”

Special Committee Process Followed
Grupo controlled Southern Peru because it owned more than 50 percent of Southern Peru’s outstanding capital stock and controlled more than 63 percent of its shareholder voting power. Grupo also owned more than 99 percent of Minera, which it proposed to sell to Southern Peru for approximately $3.1 billion in Southern Peru’s publicly traded stock.

Because of Grupo’s status as its controlling shareholder, Southern Peru followed certain procedural steps designed to ensure that any transaction was a fair one. It appointed a special committee of disinterested directors to evaluate the transaction.

The special committee in turn retained high profile legal and financial advisors. The special committee also retained mining consultants to advise the financial advisors concerning technical aspects of mining valuation. The special committee obtained a fairness opinion, and the transaction required approval by a supermajority of the shareholders.

The Special Committee’s “Controlled Mindset”
Although the special committee was properly structured, it was ultimately ineffective. When the financial advisor evaluated the proposed transaction, it initially concluded that the selling price was roughly $1 billion too low.

Rather than reject the deal or negotiate for a lower price, however, the special committee instead began using discounted cash-flow valuation techniques to compare the “relative valuation” of the two companies. The court viewed this as a misguided effort to justify a transaction at or near the controlling shareholder’s proposed price.

The core problem, as the court saw it, was that the special committee conceived its role narrowly—to “evaluate” the transaction proposed by Grupo. Thus, said the court, “the special committee fell victim to a controlled mindset and allowed Grupo . . . to dictate the terms and structure of the Merger.” By failing to look at other alternatives, the special committee failed to generate a real market check and gave up its negotiating leverage.

Committee Member’s Interest Compromises Effectiveness
One of the members of the special committee represented a large shareholder, Cerro Trading Company, Inc., which held 11.4 million unregistered founder’s shares in Southern Peru, which equaled 14.2 percent of the common stock.

Cerro wanted to register its shares because otherwise SEC Rule 144 barred it from selling more than 1 percent of its holdings in any quarter. Because Grupo controlled Southern Peru, Grupo also controlled whether the company would take the steps necessary to allow Cerro to register its shares. At the same time that the special committee was negotiating the Minera transaction with Grupo, Cerro was negotiating with Grupo to register its shares.

It was not clear who proposed tying these two events together, but it was clear that the term sheets for the Minera deal included registration rights for Cerro. The court had “little doubt” that Cerro’s predicament “compromised [its representative’s] effectiveness.” Interestingly, the court declined to find that the compromised director acted in bad faith or breached his duty of loyalty to the company.

Defendants Retain the Burden of Persuasion
Delaware law generally imposes on the defendants the burden of proving a self-interested transaction is entirely fair. The defendants can shift the burden of persuasion to the plaintiff by showing that the transaction was approved either by an effective special committee or by an informed vote of a majority of the minority shareholders.

Chancellor Strine declined to shift the burden of persuasion to the plaintiffs because he found that the Southern Peru special committee was ineffective. In addition, the transaction was not conditioned on approval by a majority of the minority shareholders. Chancellor Strine also held, however, that he would have ruled the same way regardless of who carried the burden of persuasion, and mused in dictum over the practical implications of the burden shift.

The problem, explained Strine, is that “there is no way to decide whether the defendant is entitled to a burden shift without taking into consideration the substantive decisions of the special committee, a fact-intensive exercise that overlaps with the examination of fairness itself.” As a result, there is no reliable pretrial determination of who will carry the burden of persuasion at trial, and ultimately the burden matters only when the “judge is . . . in equipoise.” Strine adds, “When a standard of review does not function as such, it is not clear what utility it has, and it adds costs and complication to the already expensive and difficult process of complex civil litigation.”

Committee “Just Went Through the Motions”
Ultimately, the court concluded that the transaction was not fair to the company and the price it paid was too high. Relative valuation techniques are not “alchemy,” said the court, and cannot be used to “turn a sub-optimal deal into a fair one.”

“To me, the decision is a pretty standard application of the entire fairness test,” says Stephen C. Norman, Wilmington, DE, chair of the Derivative Suits Subcommittee of the ABA Section of Litigation's Class Actions and Derivative Suits Committee. Entire fairness, notes Norman, includes both fair process and fair price. In this case, “not even the process was fair,” Norman says. They just went through the motions.”

Guidance to Future Special Committees
“This will put the focus on special committees,” says Norman. “Plaintiffs’ lawyers will be investigating closely what exactly special committees do. It will be important that special committees have the power to ‘Just Say NO,’ and that sometimes they actually do,” he says. Form suggests simply having a committee is sufficient, substance (and the Southern Peru decision) likely means, “There must be adversarial negotiations.”

The Southern Peru decision offers some clear takeaways for advising future special committees. Effective special committees must:

• Conceive their mandates broadly, and look at alternative transactions.
• Be prepared to reject altogether the interested party’s proposal.
• Consider changed circumstances, update financial analyses, and be prepared to change their recommendation.
• Consider making approval by a majority of the minority shareholders a condition of the transaction up front.
• “Counsel representing controlling shareholders have to be disciplined in advising clients to let the process work,” says Sean O’D. • Bosack, Milwaukee, cochair of the Corporate Governance Subcommittee of the Section of Litigation’s Corporate Counsel • Committee. “You cannot preordain the result and structure the process to justify that result.”

“Counsel representing controlling shareholders have to be disciplined in advising clients to let the process work,” says Sean O’D. Bosack, Milwaukee, cochair of the Corporate Governance Subcommittee of the Section of Litigation’s Corporate Counsel Committee. “You cannot preordain the result and structure the process to justify that result.”

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