Flawed Special Committee Process Results in $1.26 Billion Judgment

The Delaware Chancery Court’s recent decision in In re Southern Peru Copper Corporation Shareholder Derivative Litigation¹ highlights the importance of special committees’ role in assuring that directors meet the rigorous “entire fairness” test when board conduct is challenged. The opinion offers directors valuable guidance to avoid costly errors.

Background

Grupo Mexico – which controlled 63% of the voting power of Southern Peru Copper Corporation (a NYSE-listed mining company) – wanted Southern Peru to acquire another Grupo Mexico subsidiary called Minera Mexico, a privately held entity engaged in mining operations in Mexico. Grupo Mexico’s asking price was $3.1 billion worth of Southern Peru’s publicly traded stock.

Southern Peru’s Board of Directors set up a Special Committee whose “duty and sole purpose” was to evaluate Grupo Mexico’s proposal and determine whether that transaction was in the best interests of Southern Peru’s stockholders. The authorizing resolutions did not explicitly give the Special Committee the authority to negotiate the terms proposed by Grupo Mexico or to explore alternative’s to Grupo Mexico’s proposal.²

The Special Committee retained Goldman Sachs as its financial advisor to determine the value of the Mexican mining company – the “get” Southern Peru would receive in exchange for its “give” of its publicly traded stock. Goldman Sachs’ initial analysis showed that Southern Peru would “give” stock with a market price of $3.1 billion but would “get” an asset worth only $1.7 billion.³

The Special Committee adopted a strategy so the values of the give/get would be more comparable. The Special Committee concluded that Southern Peru’s market price overvalued the company. Rather than taking advantage of this higher valuation multiple and using Southern Peru’s stock as cheap acquisition currency, Goldman Sachs was directed to use less favorable EBITDA multiples to conclude that the “real,” “intrinsic” or “fundamental” value of Southern Peru’s stock would be $2.06 billion, even though it had a market value of $3.19 billion at that time.⁴ The Special Committee also “topped up” Minera’s value by applying Southern Peru’s valuation multiples to Minera, which was questionable in view of Minera’s liquidity problems.

The Delaware Court rhetorically suggested that if it made sense for Grupo Mexico to consolidate Minera and Southern Peru, the Special Committee could have asked Grupo Mexico to make an offer to acquire Southern Peru at a premium to the market price as the buyer and not the seller. This would have revealed the deficiencies in Grupo Mexico’s offer, namely that Minera had liquidity problems, and undermined the credibility of Grupo Mexico’s “give.” As the Chancellor said: “[B]y acting like a third-party negotiator with its own money at stake and the full range of options, the Special Committee could have put Grupo Mexico back on its heels” and thus caused the “get” to be more consistent with the “give.”⁵

The transaction’s voting provisions also troubled the Court. The Minera acquisition would be subject to approval by two-thirds of Southern Peru’s stockholders instead of approval by a majority of the minority stockholders unaffiliated with Grupo Mexico. However, a major unaffiliated stockholder agreed to vote in favor of the merger in exchange for Southern Peru granting it registration rights. The result was that even if the Special Committee recommended that the stockholders not approve the transaction, the two-thirds majority vote would be achieved and Southern Peru would have to close.

Key Holdings

Because a controlling stockholder was on both sides of this transaction, the Court evaluated the defendants’ conduct under the “entire fairness” test rather than the deferential standard of the business judgment rule. The entire fairness test requires the defendants to show that the transaction is entirely fair to the minority stockholders by demonstrating their “utmost good faith and the most scrupulous inherent fairness of the bargain.”⁶

“Entire fairness” requires both a fair process and a fair price. If the controlling stockholder can show that the transaction was approved by a properly functioning committee of independent directors or by an informed vote of a majority of the minority stockholders, the burden on the defendants to persuade the court that the transaction was entirely fair shifts to the plaintiffs who must show that the transaction was not fair.

Because the defendants in Southern Peru “fell victim to a controlled mindset,” the Court found that the defendants would not have prevailed under the entire fairness test even if the burden shifted to the plaintiffs. The Court’s conclusion was informed by several factors:

• Southern Peru’s Special Committee did not have “real bargaining power” to negotiate at arms’ length with the controlling stockholder.⁷
  • The Special Committee accepted the mandate of the controlling stockholder and looked only at the transaction Grupo Mexico proposed. The Committee did not consider alternatives, which “took off the table other options that would have generated a real market check” and had the effect of “depriv[ing] the Special Committee of negotiating leverage to extract better terms.”⁸
  • The Special Committee and its financial advisor went to “strenuous lengths” to reduce the value of Southern Peru rather than insisting that Grupo Mexico demonstrate that Minera’s value justified Grupo Mexico’s asking price.⁹
• The vote of Southern Peru’s independent minority stockholders was not informed and did not give them a “genuine chance to disapprove the transaction.”¹⁰
  • Southern Peru’s proxy statement failed to disclose a $2.0 billion counteroffer the Special Committee made in the process that showed the disparity of value in the give/get equation.
  • The minority stockholders were not informed of the standalone valuations for Minera and Southern Peru or that the Southern Peru’s actual market value had been discounted by $2 billion less to reach an “implied” equity value.
• Because the transaction was subject to approval by two-thirds of all stockholders (not a majority of the minority stockholders), and the largest stockholders were intent on voting for the transaction regardless of the Special Committee’s recommendation, the minority stockholders were not truly protected.

Headlines

In re Southern Peru articulates many principles that are helpful to Board committees considering a transaction with an interested stockholder. These should be considered planning tools in any transaction that may be subject to the entire fairness test and should ultimately minimize the total costs of the transaction by reducing litigation expense and the likelihood of an unfavorable verdict:

• The resolutions creating the special committee should give it all the power and authority to conduct arms’ length bargaining and the committee should engage in a “meaningful back-and-forth”¹¹ with the controlling stockholder, so that even if the controlling stockholder rejects alternative proposals all options can be explored for the benefit of minority stockholders. Thus, both the creation and functioning of the committee are important.
• The special committee’s role as protector of the minority stockholders’ interests should not be undermined by a stockholder approval process that trumps any negative position the committee may take.
• The committee’s decision-making process should be laid out in its minutes and other records. The Southern Peru Court observed on a number of instances that the lack of an appropriate record undermined the credibility of various defenses, even characterizing one rationale on commodity pricing the defendants offered for their view of Minera’s value as an “after-the-fact rationalization conceived of for litigation purposes.”¹²
• It is important to identify potential conflicts on the special committee early. One member of Southern Peru’s Special Committee participated in the Committee’s deliberations only to conclude on the eve of signing that he was conflicted and had to recuse himself.

By: Matthew I. Hafter

Matthew I. Hafter is a partner in the Corporate Department in the firm’s Chicago office. If you would like further information, please contact your Seyfarth Shaw LLP attorney, or Matthew I. Hafter at mhafter@seyfarth.com.

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¹ In re Southern Peru Copper Corporation Shareholder Derivative Litigation, C.A. No. 961-CS, slip op (Del. Ch. Oct. 14, 2011).
²Id. at 12.
³Id. at 17.
⁴Id. at 19.
⁵Id. at 21.
⁶Id. at 46, citing Weinberger v. UOP, Inc., 475 A.2d 701 (Del. 1984).
⁷The controlling stockholder must form an independent committee but also show that “each of the contending parties had in fact exerted its bargaining power at arms’ length” to shift the burden to the plaintiffs. Id. at 50, quoting Kahn v. Lynch Communication Systems, Inc., 638 A.2d 1110, 1121 (Del. 1994).
⁸Id. at 64.
⁹“In plain terms, the special committee turned the ‘gold’ it was holding in trust into ‘silver’ and did an exchange with ‘silver’ on that basis, ignoring that in the real world the gold they held had a much higher market price in cash than silver. That non-adroit act of commercial charity toward the controller resulted in a manifestly unfair transaction.” Id. at 4.
¹⁰Id. at 57.
¹¹Id. at 69.
¹²Id. at 82.