Lessons from the Delaware Chancery Court

An unusual equitable remedy was applied recently by the Delaware Chancery Court in In Re Loral Space and Communications Inc. Consolidated Litigation (Sept. 19, 2008). Vice Chancellor Strine, finding that the terms of a $300 million convertible preferred stock financing with its controlling shareholder were unfair to the company, reformed the financing to convert the convertible preferred stock into non-voting common stock at a “fair price” determined by the court.

MHR Fund Management LLC, a hedge fund that invests in distressed middle-market companies (“MHR”), obtained a position in Loral Space and Communications Inc. (“Loral”) through Loral’s bankruptcy. Shortly after the bankruptcy, MHR used its influence to appoint Loral’s chief executive officer, and through him, propose the $300 million equity financing.

It is a long-standing principle of Delaware law that fiduciary duties limit the extent to which a director may benefit from dealings with the company. Section 144 of the Delaware General Corporation law provides that transactions between a corporation and its directors or officers are not void or voidable so long as:

• The material facts as to the director’s or officer’s relationship or interest and as to the contract or transaction are disclosed or are known to the board of directors or the committee, and the board or committee in good faith authorizes the contract or transaction by the affirmative votes of a majority of the disinterested directors, even though the disinterested directors be less than a quorum; or
• The material facts as to the director’s or officer’s relationship or interest and as to the contract or transaction are disclosed or are known to the shareholders entitled to vote thereon, and the contract or transaction is specifically approved in good faith by vote of the shareholders; or
• The contract or transaction is fair as to the corporation as of the time it is authorized, approved or ratified, by the board of directors, a committee or the shareholders.

Because five of the eight members of the board of directors of Loral were affiliated with MHR at the time of the financing, Section 144 of Delaware law applied. In determining whether a transaction is “fair” under clause (3) above, Delaware courts employ an “entire fairness” standard of review which has two components: fair dealing and fair price. A fair dealing analysis scrutinizes the timing, structure, and negotiation of the transaction, disclosure to the board of directors, and method of obtaining approval. Fair price relates to economic considerations and includes factors such as market value, earnings, future prospects and other relevant factors.

In In Re Loral Space, a two-person special committee (the “Special Committee”) was created to negotiate the $300 million financing with MHR. Delaware case law recognizes that the use of a special committee comprised of directors independent of the interested party to negotiate and approve an interested-party transaction shifts the burden of persuasion on the issue of fairness from the interested party to the plaintiff. To be effective, however, a special committee must function “as an effective proxy for arms-length bargaining, such that a fair outcome equivalent to a market-tested deal” is reached.

Nearly every aspect of the Special Committee was criticized by Strine, who noted in particular that the Special Committee’s chair was a close friend of the MHR appointed CEO and was touted by MHR as one of its investment advisors and that the Special Committee never made a market check to see whether capital was available on better terms than MHR was offering. Strine also noted that the Special Committee’s financial advisor was “outgunned and outwitted.” Ultimately, Strine concluded that the Special Committee did not fulfill its intended function largely due to “the sheer accumulation of examples of timorousness and inactivity,” and accordingly failed as an “effective guarantor of fairness.”

With respect to fair price, Strine was similarly critical, finding that the terms of the financing were unfairly advantageous to MHR. Rather than finding an effective balance between the dividend rate and conversion rate, MHR received a high dividend rate and a low conversion premium. The preferred stock provided for mandatory in kind dividends (payable in additional shares of preferred stock) rather than the market custom of allowing the company to pay in cash or in kind at its option. Strine also criticized the $6.75 million placement fee when the transaction was actually sought by MHR. Finally, Strine noted that the terms of financing provided MHR with class voting rights which “gave MHR an iron grip on Loral and the ability to extract a control premium for itself in any future Change of Control.”

Not surprisingly, MHR challenged the remedy, claiming that it went beyond the powers of the court. Strine disagreed, noting Delaware’s case law precedent emphasized “the broad remedial power of [the Chancery Court] to address breaches of the duty of loyalty.” If nothing else, this case serves as a strong and useful reminder of the importance of quality legal advisors to avoid the potential pitfalls in interested party transactions.