The Court of Chancery Reaffirms a Board's Responsibility to Defend the Interests of the Minority Stockholders While Negotiating with a Controlling Stockholder

In La. Mun. Police Employees' Ret. Sys. v. Fertitta, C.A. No. 4339-VCL (Del. Ch. July 28, 2009), the Court of Chancery denied defendants' motion to dismiss plaintiff's class claims for breach of the fiduciary duty of loyalty and a derivative claim for waste in connection with a terminated going-private transaction between Landry's Restaurants, Inc. ("Landry's") and its CEO and largest stockholder, Tillman Fertitta ("Fertitta"). Louisiana Municipal, the last opinion written by Vice Chancellor Lamb as a member of the Court of Chancery, reaffirms the board of directors' responsibility to defend the interests of the minority stockholders while negotiating with a controlling stockholder in order to satisfy its duty of loyalty.

The case arose out of an offer by Fertitta, the owner of 39% of Landry's common stock, to acquire the remaining outstanding shares of Landry's in a going-private transaction. The Landry's board set up a special committee of independent directors to evaluate Fertitta's offer. On June 16, 2008, the Landry's board entered into an agreement (the "Merger Agreement") with Fertitta and two entities owned by Fertitta (jointly, the "Fertitta Entities"), pursuant to which one of the Fertitta Entities, Fertitta Acquisition Company ("FAC"), would be merged into Landry's and the outstanding common stock would be cashed out for $21 per share.

The Merger Agreement contained a two-way termination fee whereby Landry's would be required to pay $3 million for termination of the agreement during a 45-day "go-shop" period or $24 million for termination after the "go-shop" period ended, and FAC would be required to pay Landry's a $24 million reverse termination fee for failure to close the deal. Fertitta personally guaranteed FAC's obligation to pay the $24 million reverse termination fee. Additionally, the Merger Agreement contained a clause that allowed FAC to terminate the agreement without paying the reverse termination fee in the event of a material adverse effect arising from certain specified events, excluding such things as general economic conditions, natural disasters and "act[s] of God." To provide financing for the acquisition, Fertitta entered into a separate debt commitment letter with three banks (the "Lending Banks") which contained a material adverse effect provision substantially identical to that provision in the Merger Agreement.

Three months after the Merger Agreement was signed, Hurricane Ike struck Texas, causing damage to several properties owned by Landry's; although, as noted in the Landry's press release, the damage was limited to three cities, was temporary in nature, and was forecasted to have minimal negative long-term effect. Shortly thereafter, Fertitta initiated contact with the Lending Banks regarding the extent of the hurricane's damage and subsequently sent a letter to the special committee claiming that he would have to exercise his right to terminate the Merger Agreement pursuant to the material adverse effect provision if the Lending Banks withdrew their commitment to finance the transaction. Fertitta also informed the special committee that he believed the Lending Banks could be persuaded to move forward if the acquisition price were reduced. At the same time, Fertitta began acquiring shares of Landry's stock on the open market at prices in the range of approximately $11-14 per share.

Over the next month, the special committee negotiated with Fertitta and ultimately agreed to an amended merger agreement (the "Amended Agreement") with a revised acquisition price of $13.50 per share and a reduced reverse termination fee of $15 million in exchange for an agreement from Fertitta and the Lending Banks not to claim a material adverse effect as a result of any of the events known to them as of the date of the Amended Agreement. In addition, Fertitta, apparently acting on behalf of Landry's, negotiated, as part of his amended debt commitment letter, an alternative financing commitment from the Lending Banks, which would enable Landry's to refinance $400 million in senior notes coming due in February 2009 in the event that the merger failed to close.

After the Amended Agreement was in place, Fertitta continued purchasing Landry's stock on the open market, increasing his holdings to approximately 57% of outstanding shares and thus obtaining majority control of the corporation without consummation of a merger.¹

Following the announcement of the Amended Agreement, the Securities and Exchange Commission sent Landry's a request for disclosure of certain information from the amended debt commitment letter. The Lending Banks refused to provide such information due to confidentiality concerns, and Landry's terminated the Amended Agreement in order to avoid losing its alternative financing commitment from the Lending Banks, thereby waiving the $15 million reverse termination fee Fertitta would have been required to pay.

Plaintiffs filed a class and derivative complaint alleging, inter alia, class claims for breach of fiduciary duty against Fertitta and the Landry's directors and, in the alternative, a derivative claim against the Landry's board for waste based on its failure to require Fertitta to pay the reverse termination fee. Defendants moved to dismiss the class claims for failure to state a claim and moved to dismiss the derivative claim on the grounds that plaintiff failed to comply with the demand requirements of Chancery Court Rule 23.1.

In denying defendants' motion to dismiss the class claims against Fertitta, the Court cited three "key facts" that collectively enabled the Court reasonably to infer that Fertitta used his controlling stockholder status² to his benefit and to the detriment of the minority stockholders, namely: (i) Fertitta's negotiations in his capacity as CEO of Landry's (and the board's acquiescence in Fertitta taking that role) with the Lending Banks regarding the alternative financing commitment; (ii) the board's "apparent and inexplicable impotence" in the face of Fertitta's creeping takeover; and (iii) the board's decision to terminate the Amended Agreement permitting Fertitta to avoid paying the reverse termination fee.

In denying defendants' motion to dismiss the class claims against the board, the Court held that the allegations against the board were not merely for exculpable breaches of the duty of care, nor were they the type of "gross failure of process" allegations "to which Lyondell³ speaks." Rather, plaintiff's allegations that the board knowingly preferred the interests of the majority stockholder to those of the minority were loyalty claims, and the board's actions, including its failure to employ a poison pill or otherwise attempt to prevent Fertitta from acquiring control on the open market, supported a reasonable inference that the board breached its duty of loyalty.

Turning to the derivative waste claim, the Court found that, given Fertitta's economic stake in Landry's, the board's assertion that it had "no choice" but to terminate the Amended Agreement to avoid losing the alternative financing commitment and being forced into bankruptcy was unreasonable. The board's failure to recognize the "reality" that Fertitta would lose more money in the event of bankruptcy than he would by paying a $15 million termination fee raised the factual question of whether the board's decision was a rational exercise of business judgment. For this reason, the Court also denied defendants' motion to dismiss the derivative waste claim, finding that demand was excused under the second prong of Aronson⁴ since plaintiffs' complaint raised reasonable doubt that "the challenged transaction was otherwise the product of a valid exercise of business judgment."

¹The Amended Agreement included a provision sterilizing any shares acquired by Fertitta after the Merger Agreement with respect to the stockholder vote on the merger.

²For purposes of the motion to dismiss, the Court found that Fertitta exercised actual control of Landry's at all relevant times--not only when he owned 57% of Landry's stock, but also when he owned 39% because he also served as Landry's CEO and chairman and his actions in negotiating the alternative financing for the company suggest that he was acting as more than a minority stockholder.

³Lyondell Chem. Co. v. Ryan, 970 A.2d 235 (Del. 2009).

⁴Aronson v. Lewis, 473 A.2d 805 (Del. 1984).