CLIENT NEWSFLASH

Delaware Court of Chancery Awards $1.26 Billion in Entire Fairness Case

October 21, 2011

On October 14, 2011, the Delaware Court of Chancery entered a $1.26 billion damages award in In re Southern Peru Copper Corp. S’holder Derivative Litig., a derivative action challenging the fairness of a merger involving a controlling stockholder.  This eye-popping award is a stark reminder of the Court’s heightened focus on the conflicts associated with transactions involving controlling stockholders, and, as detailed below, it highlights the importance of ensuring adequate procedural protections in such transactions.

The case arises out of the 2005 acquisition by Southern Peru Copper Corporation of Minera Mexico, a Mexican mining company, from Southern Peru’s own controlling stockholder, Grupo Mexico.  In 2004, Grupo Mexico first proposed that Southern Peru acquire Grupo Mexico’s 99.15% interest in Minera in exchange for shares of Southern Peru common stock valued at approximately $3 billion.  The Southern Peru board of directors created a special committee of independent directors whose “duty and sole purpose” was to “evaluate” Grupo Mexico’s proposal.  The resolutions creating the Committee did not provide it with the express power to negotiate, nor did they authorize the Committee to explore other strategic alternatives.

As detailed in Chancellor Strine’s 105-page opinion, the Committee’s financial advisor performed an initial “give/get” analysis, which showed the value of the Southern Peru stock (based on its NYSE trading prices) to be issued in the transaction to be worth roughly $1.4 billion more than the value of the non-publicly traded Minera (generated through DCF and other analyses).  The financial advisor and the Committee subsequently focused on valuing the companies on a relative basis, using various metrics to compare the intrinsic (rather than market) value of the Southern Peru shares to the intrinsic value of Minera in an “apples-to-apples” approach.  Following receipt of a fairness opinion from its financial advisor, the Committee approved the transaction.  Between signing and closing, the trading price of Southern Peru shares (and thus the price Southern Peru paid to acquire Minera) increased by roughly $650 million.

A stockholder of Southern Peru brought a derivative suit challenging the fairness of the transaction and alleging that Southern Peru substantially overpaid for Minera.  Following trial (during which all parties stipulated to the application of the “entire fairness” standard), Chancellor Strine concluded that the defendants were not entitled to a shift of the burden of demonstrating the fairness of the transaction (notwithstanding the use of a special committee advised by well-respected legal and financial advisors and inclusion of a supermajority vote) because, among other things, (i) the Committee had a narrow mandate, failed to explore potential strategic alternatives and could not be deemed “well-functioning”; (ii) the supermajority vote was not “conditioned up front”; and (iii) the supermajority vote was based on a proxy statement that omitted material information, including an initial counteroffer by the Committee to purchase Minera for $2.095 billion in response to Grupo Mexico’s $3.1 billion ask.

Chancellor Strine concluded that “[a] focused, aggressive controller extracted a deal that was far better than market, and got real, market-tested value of over $3 billion for something that no member of the Special Committee, none of its advisors, and no trial expert was willing to say was worth that amount of actual cash.”  In determining that Grupo Mexico and its affiliate directors had breached their fiduciary duties of loyalty, the Court focused on, among other things:

• the narrow mandate granted to the Committee;

• the fact that the Committee and its financial advisor ignored standalone valuation metrics that did not support the fairness of the transaction and instead strained to focus on relative valuation metrics; and
• the Committee’s failure to consider whether to change its recommendation in favor of the deal, prior to the stockholder vote, despite an increase in the stock price of Southern Peru shares during the period between signing and closing of the deal.

The Court awarded damages in an amount equal to the difference between the market value of the stock issued to Grupo Mexico as of the closing date and the price that would have been paid in an entirely fair transaction (as determined by the Court based on the standalone DCF value, the equity value derived from a comparable companies analysis, and a value implied by an initial counteroffer by the Committee).  The Court indicated that Grupo Mexico could satisfy the award by returning shares of Southern Peru common stock to the company.

Key Take-Aways

Chancellor Strine’s opinion highlights a number of key considerations for special committees in controlling stockholder transactions and with respect to conflicts of interest more generally.

• Obtain a clear, broad mandate and actively consider all alternatives.  The Court was highly critical of the narrow wording of the Committee’s mandate, which provided that its “duty and sole purpose” was to “evaluate” the transaction proposed by Grupo Mexico and did not include the authority to negotiate with Grupo Mexico or to explore other strategic alternatives. Moreover, Chancellor Strine noted that, “although the Special Committee members were competent businessmen and may have had the best of intentions, they allowed themselves to be hemmed in by the controlling stockholder’s demands.  Throughout the negotiation process, the Special Committee’s and [its financial advisor’s] focus was on finding a way to get the terms of the Merger structure proposed by Grupo Mexico to make sense, rather than aggressively testing the assumption that the Merger was a good idea in the first place.”  Chancellor Strine noted that there was no record that the Committee considered any other options, such as proposing that Grupo Mexico purchase Southern Peru.  As Chancellor Strine explained, “[e]ven if the practical reality is that the controlling stockholder has the power to reject any alternative proposal it does not support, the Special Committee still benefits from a full exploration of its options.”

• Continue to review the advisability of the transaction post-signing. The Court faulted the Committee and its financial advisor for failing to update its fairness analysis and make “a renewed determination of whether the deal was fair” after Southern Peru greatly exceeded its EBITDA projects and its stock price rose steadily in the period after signing and leading up to the stockholder vote.  The Committee’s recommendation remained critical because Southern Peru’s second largest stockholder had entered into a voting agreement which required it to vote in accordance with the Special Committee’s recommendation. 

• Maintain a contemporaneous record of rationale for decisions.  Chancellor Strine expressed skepticism regarding defendants’ testimony relating to the Committee’s bargaining strategy, including its willingness to agree on a fixed exchange ratio with no collar when only Southern Peru had publicly traded stock that was subject to market movement.  Referring to “concealed motivation and contradiction” that is “usually the stuff of international espionage, not M&A practice,” Chancellor Strine found no evidence in the record to support defendants theories as a “contemporaneous record of the negotiating period” as opposed to “an after-the-fact rationalization conceived of for litigation purposes.”
• Ensure interests of all committee members are aligned with those of all minority stockholders.  The Court noted that one of the Committee members had independent reasons for favoring the merger that were not shared by all stockholders.  As the board representative for the second largest stockholder, which was in contemporaneous negotiations for registration rights for its shares in the company, he had an interest in favoring the deal because Grupo Mexico had from the outset linked the granting of the registration rights to the successful negotiation of the merger.  Although Chancellor Strine did not conclude that this was the kind of self-dealing interest that would deem the Committee member interested in the merger, he found that he was “less than ideally situated to press hard.”  Likewise, since the stockholder that had designated him to the board was seeking liquidity with the aim of exiting its investment, he was “in an odd place to recommend to other stockholders to make a long-term strategic acquisition.”

Click here to view In re Southern Peru Copper Corp. S'holder Derivative Litig., C.A. No. 961-CS (Oct. 14, 2011).