Is "Fair Dealing" Required When Freezing Out Minority Stockholders?

April 24, 2002

If a freeze-out is effected through a “short-form” merger (i.e. a merger of a subsidiary into a parent company owning at least 90% of the subsidiary), the Delaware Supreme Court says “no.” In Glassman v. Unocal Exploration Corporation, the court recently declared that a majority stockholder may eliminate the minority without regard to notions of fair dealing. Absent fraud or illegality, the exclusive remedy for a minority stockholder dissatisfied with its merger consideration is dissenters’ appraisal rights.

In Unocal, the court answered the long-standing question of whether a duty of “entire fairness” is owed minority stockholders in the context of a short-form merger. Born in the landmark Delaware case of Weinberger v. UOP, Inc., the entire fairness doctrine generally provides that in a parent/subsidiary transaction, the controlling parent is required to demonstrate that the subsidiary’s minority stockholders were dealt with fairly and received a fair price. “Fair dealing” refers broadly to the manner in which the transaction was timed, initiated, structured, negotiated, disclosed and approved, while the concept of a “fair price” implicates an analysis of all elements of value. Historically, majority stockholders attempting a freeze-out of minority interests have frequently landed in court, struggling to establish the fairness of the majority’s inherent self-dealing. To shift the burden of proof, the corporate parent has often appointed a special committee of independent subsidiary directors to provide a strong semblance of arm’s-length negotiation and/or disinterested decisionmaking. Such committees, however, have often proven unpredictable, and if truly independent, unwilling to rubber stamp the majority’s agenda.

While acknowledging that a corporate parent and its directors undertaking a short-form merger are “self-dealing fiduciaries,” the Unocal court nonetheless concluded that a requirement of entire fairness is incompatible with the summary procedure authorized by the statute (Section 253 of the Delaware General Corporation Law). The court characterized this procedure as a “unilateral act”—“a decision by the parent company that its 90% owned subsidiary shall no longer exist as a separate entity…. The minority shareholders receive no advance notice of the merger; their directors do not consider or approve it; and there is no vote.” Should a corporate fiduciary attempt to demonstrate fair dealing through the use of special committees, independent experts and similar procedural mechanisms, it will, according to the court, “have lost the very benefit provided by the statute”—“a simple, fast and inexpensive process” for freezing out the minority through completion of the merger.

Without access to entire fairness-based claims for relief, a dissatisfied minority owner must now rely solely on an appraisal remedy. Reaffirming Weinberger’s guidance on the scope of such appraisal, the Unocal court explained that the determination of fair value must be based on “all relevant factors, including damages and elements of future value.” As to “future value,” pertinent factors might include a merger “timed to take advantage of a depressed market or low point in the company’s cyclical earnings” or one which “preceded an anticipated positive development.”

Finally, the Unocal court emphasized that while short-form mergers obviate the general requirement of fair dealing, the majority stockholder’s duty of full disclosure remains. “Where the only choice for the minority stockholders is whether to accept the merger consideration or seek appraisal, they must be given all the factual information that is material to that decision.”

Unocal may also settle the fair dealing question in Pennsylvania, where, to date, the legislature and the courts have offered conflicting answers. The Pennsylvania Business Corporation Law expressly provides that structuring a merger for the purpose of eliminating not only minority shareholders, but also their dissenters’ rights, does not constitute “fundamental unfairness.” Pennsylvania courts, however, have required controlling shareholders to justify the use of freeze-out mergers with an independent business rationale.

The full implications of Unocal will take time to digest. It is evident, however, that appraisal proceedings will assume heightened importance when controlling stockholders seize total ownership.

For more information, please contact ccohen@cohenlaw.com or bburt@cohenlaw.com.