The Court of Chancery Applies Entire Fairness Review to a Merger Involving a Third-Party Purchase of a Corporation Having a Controlling Stockholder

In In re John Q. Hammons Hotels Inc. S'holder Litig., C.A. No. 758-CC (Del. Ch. Oct. 2, 2009), the Court of Chancery applied the entire fairness standard to review the September 2005 merger of John Q. Hammons Hotels, Inc. ("JQH") with and into an acquisition vehicle indirectly owned by Jonathan Eilian. The Court's holding was significant because it applied the entire fairness standard of review to a merger involving a third-party purchase of a corporation that had a controlling stockholder, even though the Court held that the controlling stockholder was not "on both sides" of the transaction and that Kahn v. Lynch¹ did not apply to the transaction.

In early 2004, John Q. Hammons, who owned roughly 76% of the total vote of JQH through his ownership of 5% of JQH's Class A common stock and all of the nonpublic Class B common stock, told the JQH board that he was considering selling JQH (or his interest in JQH) to a third party. In October 2004, Barceló Crestline Corporation ("Barceló") informed the JQH board that it was offering $13 per share to acquire all of JQH's Class A stock. Soon after the Barceló transaction was announced, the JQH board formed a special committee of independent and disinterested directors to evaluate and negotiate proposed transactions on behalf of the unaffiliated stockholders and to make a recommendation to the board. The special committee retained Lehman Brothers as its financial advisor.

In December 2004, Jonathan Eilian submitted a proposal to the special committee, and the special committee rejected Barceló's original $13-per-share offer after Lehman Brothers advised the special committee that, based on its preliminary evaluation, the offer was inadequate, from a financial point of view, for the minority stockholders. Barceló and Eilian submitted revised proposals, and in January 2005 Eilian offered to take JQH private and acquire all outstanding Class A common stock for $24 per share.

Over the next few months, the terms of a transaction were negotiated with Eilian. The special committee negotiated with Eilian on behalf of the minority stockholders, and Hammons negotiated with Eilian on his own behalf. In June 2005, Lehman provided the special committee with a fairness opinion that the $24-per-share price for the JQH minority stockholders was fair from a financial point of view. Hammons had negotiated several side agreements with Eilian for his Class B stock, and Lehman calculated the value of Hammons's consideration to be between $11.95 and $14.74 per share. Lehman also advised the special committee of its opinion that the allocation of the consideration between Hammons and the minority stockholders was reasonable. Based on the special committee's recommendation, the JQH board (after Hammons recused himself) voted to approve the merger agreement and the agreements between Hammons and Eilian.

Pursuant to the merger agreement, each share of Class A common stock was converted into the right to receive $24 per share in cash. The merger was contingent on approval by a majority of the unaffiliated Class A stockholders. Although this condition was waivable by the special committee, the special committee never waived it. In addition to the merger agreement, Hammons entered into a number of other agreements with Eilian designed to provide Hammons the ability to continue developing hotels without triggering tax liability. Hammons's Class B shares were eventually converted into a preferred interest in the surviving limited partnership, in which he was allocated a 2% interest in the cash-flow distributions and preferred equity. Hammons was also provided with other rights and obligations, including a $25 million short-term line of credit and a $275 million long-term line of credit. At a special meeting of stockholders on September 15, 2005, over 72% of the issued and outstanding shares of Class A stock voted to approve the merger.

Plaintiffs brought a class action alleging, inter alia, breach of fiduciary duties against Hammons as controlling stockholder for negotiating benefits for himself that were not shared with the minority stockholders and against the JQH directors for deficient process in negotiating the merger and for approving the merger. All defendants filed motions for summary judgment, and plaintiffs filed a cross-motion for partial summary judgment, leaving only the issue of fair price for trial. The Court granted defendants' motions in part (related to one of plaintiffs' disclosure claims) and otherwise denied all parties' motions, holding that entire fairness was the appropriate standard of review.

At the outset, the Court held that the merger did not fall under the Kahn v. Lynch line of cases. Even though Hammons retained a minor stake in the surviving entity, the Court noted that a third party had made the offer to the minority stockholders and held that Hammons was not "on both sides" of the transaction.

Nevertheless, the Court held that entire fairness applied. Because Hammons was in a sense "competing" with the minority stockholders for the merger consideration, the Court held that business judgment review would only apply if the transaction were (i) recommended by a disinterested and independent special committee and (ii) approved by stockholders in a non-waivable vote of the majority of all the minority stockholders.

The Court then held that defendants had not met the two procedural requirements. Even though plaintiffs had conceded that the special committee was independent and disinterested, the Court left open for further factual development that the special committee had been "coerced" because Hammons's controlling position and alleged self-dealing conduct depressed the pre-transaction value of JQH's shares. Furthermore, the merger's majority-of-the-minority condition was waivable and was based only on those voting (and not all minority stockholders), so the Court held that entire fairness applied--even though the condition was not waived and even though a majority of all minority stockholders did approve the transaction. The Court also left open for future resolution plaintiffs' challenge of Lehman's opinion regarding the consideration Hammons received; therefore, the Court refused to find that Hammons had made a showing of fair price.

The defendants have filed an application for certification of an interlocutory appeal of the decision.

¹Kahn v. Lynch Commc'n Sys., Inc., 638 A.2d 1110 (Del. 1994).