- Court of Chancery Finds that Preferred Equity Investment by Controlling Stockholder Fails Entire Fairness Review
- November 12, 2008
- Law Firm: Richards, Layton & Finger, P.A. - Wilmington Office
In In re Loral Space & Communications Inc. Consolidated Litigation, 2008 WL 4293781 (Del. Ch. Sept. 19, 2008), the Court of Chancery held that a stockholder's imposition of a significant preferred equity financing transaction on the corporation was an interested transaction that was subject to review under the entire fairness standard. In its post-trial opinion, the Court found that the transaction was not a product of fair dealing, based on the composition and actions of the special committee that was formed to negotiate and approve the transaction, as well as the role of its financial advisors in the process, and that the terms of the transaction were unfairly advantageous to the stockholder. As a remedy, the Court took the unusual step of reforming the transaction so that the terms were fair to the corporation.
Loral Space and Communications Inc. ("Loral") emerged from bankruptcy in 2005 with a large institutional stockholder base comprised of former creditors, the largest of which was MHR Fund Management LLC ("MHR"), which owned 35.9% of Loral common stock. Of the eight Loral directors, three, including chairman Mark Rachesky ("Rachesky"), were MHR executives. In addition, Loral's vice chairman and chief executive officer, Michael Targoff ("Targoff"), and another director, John Harkey ("Harkey"), were affiliated with MHR as "Investment Advisors." Targoff was appointed as chief executive officer in March 2006, pursuant to an agreement with Rachesky. Shortly after his appointment, Targoff recognized that Loral was in need of additional capital to continue its recovery and believed that an investment by MHR would be the most efficient solution. Accordingly, Targoff proposed that MHR make an additional $300 million equity investment in Loral--an amount equal to over half of Loral's existing stock market capitalization. Rachesky quickly agreed to the idea of a large capital contribution by MHR. Without considering the possibility of other forms or sources of financing, the Loral board appointed a two-member special committee (the "Committee"), consisting of Harkey as chairman and a director unaffiliated with MHR, to evaluate and negotiate the proposed transaction. The negotiations between the Committee and MHR resulted in a Securities Purchase Agreement (the "MHR Financing"). After learning of the MHR Financing, Loral stockholders sued, alleging that the MHR Financing was a conflicted transaction that was unfair to Loral.
In determining that the MHR Financing should be reviewed under the entire fairness standard, the Court pointed out that MHR had maintained publicly that it had control of Loral's board. Moreover, MHR directly controlled three of the eight directors on the Loral board and the two directors most responsible for negotiating the financing, Targoff and Harkey, could not be deemed to be independent of MHR. Thus, because five of the eight directors at the time the Securities Purchase Agreement with MHR was signed were affiliated with MHR, the financing was an interested transaction and the entire fairness standard presumptively applied. Notably, the Court also found that even though MHR owned less than a majority of the voting power of Loral, MHR was nonetheless a controlling stockholder because MHR possessed, as a practical matter, a combination of stock voting power and managerial authority enabling it to control the company.
The Court held that the defendants did not meet their burden under the entire fairness standard, finding that the MHR Financing was neither the product of fair dealing nor achieved at a fair price. With respect to fair dealing, the Court emphasized the inefficacy of the Committee, particularly in its composition and failure to consider all potential sources of financing. As described at length in the Court's opinion, the Committee was flawed in its composition based on Harkey's position as lead negotiator, its mandate to negotiate the proposed financing with MHR as opposed to finding the best deal reasonably available, and its futile negotiation approach. The Court found that MHR had dictated the timing, price and terms of the transaction with the company and that the Committee failed to use any leverage that it had or create additional leverage in negotiating the financing. The Court also criticized the competence of the investment banker hired by the Committee, noting the banker's lack of experience, failure to conduct any market test and reliance on the opinion of MHR's financial advisor that the lack of a market test was reasonable in this case. The Court concluded that "it is the sheer accumulation of examples of timorousness and inactivity that contributes to [the] conclusion that this Special Committee did not fulfill its intended function," and thus it was impossible to conclude that the Committee had acted as an effective negotiator.
In addressing fair price, the Court concluded that MHR received unfairly advantageous terms from Loral. The Securities Purchase Agreement gave MHR convertible preferred stock with a high dividend rate and low conversion rate compared to typical market terms. The Agreement also provided for dividends for five years on the preferred stock in paid-in-kind securities, a term inconsistent with market practices. Further, the "Change of Control Provisions" gave MHR extraordinary class voting rights with respect to almost any action by the Loral board, the right to put the convertible preferred stock to Loral in a change of control for a minimum value of $450 million, and the potential to acquire 63% of Loral's equity. These voting rights gave MHR veto power over virtually anything that Loral did and, as a result, anyone who wanted to take control of Loral would be obligated to hold a separate negotiation with MHR over whether to pay it a non-ratable share of the control transaction price. The Court concluded that the voting rights granted in connection with the preferred stock gave MHR an iron grip on Loral and the ability to extract a control premium for itself in any future change in control. The Court also noted that Loral paid to MHR a placement fee of $6.75 million, plus nearly $2 million to pay for MHR's financial advisor.
In determining the appropriate remedy and taking into account the unusual features of the MHR Financing, the Court held that the most equitable remedy would be to reform the Securities Purchase Agreement to convert the preferred stock that MHR received into non-voting common stock on terms fair to Loral. In fashioning its remedy, the Court sought to rectify the harm to Loral but to do so on a basis that was not punitive to MHR. As a result, post-reformation, MHR would hold 57% of the total equity of Loral, but remain at its prior level of voting power, 35.9%.