The Corporate Council of the Corporation Law Section of the Delaware State Bar Association recently released its proposed amendments to the Delaware General Corporation Law (DGCL) for 2018. Noticeably, the proposed amendments would amend Section 262(b) of the DGCL to eliminate an inconsistency in the availability of appraisal rights in stock-for-stock public mergers structured as two-step transactions under DGCL Section 251(h) and those structured as long form mergers. The proposed amendments intend to confirm and extend the availability of ratification of defective corporate acts in certain circumstances and streamline the use of such a potentially powerful tool for companies to address innocent mistakes.
“Market-Out” Exception to Eliminate Appraisal Rights in Stock-for-Stock Public Mergers Under Section 251(h)
Stockholders of Delaware corporations generally have appraisal rights in corporate mergers and consolidations. There is, however, a “market-out” exception which eliminates appraisal rights for certain transactions affected pursuant to a long form merger in which the target company calls a special meeting for the purpose of obtaining stockholder approval. Such market-out exception applies to mergers in which the target corporation’s stock is listed on a national securities exchange or is held of record by more than 2,000 holders, provided that the consideration being paid to the target stockholders consists of stock of either the surviving corporation or any other corporation listed on a national securities exchange or held of record by more than 2,000 holders. The market-out exception presumes that stockholders do not need appraisal rights when they are not being cashed out in the merger and there is a public and liquid market for the consideration that they are receiving.
Mergers can generally be affected in two ways under the DGCL: a long form one-step merger as discussed above, which involves a stockholder meeting to approve the transaction, or a two-step merger, affected pursuant to DGCL Section 251(h) which permits the corporation to proceed without a stockholder vote by initiating a cash tender offer or stock exchange offer to acquire the target corporation’s stock directly from the stockholders and then effecting a back-end merger to acquire the balance of the shares. Under Section 251(h) of the DGCL, if the acquirer has obtained enough stock in a tender or exchange offer to approve a merger under Section 251(c) of the DGCL (generally a majority of the outstanding shares unless a higher threshold is specified in the target’s organizational documents), such acquirer may effect a back-end merger without a vote of the target stockholders. Under present law, while one-step mergers qualify for the market-out exception, such exception was not applicable to the back-end merger of a two-step transaction.
In the past, dealmakers have almost always preferred a one-step merger over a two-step Section 251(h) merger in stock-for-stock transactions involving publicly traded corporations. One of the reasons for such preference is the availability of the market-out exception to appraisal rights in one-step mergers. The proposed amendments, if enacted, would level the playing field to the extent that the market-out exception would apply, and therefore appraisal rights would be eliminated in the back-end merger of the two-step transactions under Section 251(h). This change could make two-step mergers more attractive to dealmakers. However, there remain other factors to consider in structuring stock-for-stock public mergers. Acquirer stock issued to target stockholders in a public merger is required to be registered with the US Securities and Exchange Commission, a process which usually obviates any timing advantage of the two-step mergers. In addition, in certain industries, regulatory approval is required for an acquirer to purchase a significant amount of the target’s shares. For two-step mergers in these regulated industries, the acquirer must allow the target stockholders to withdraw from exchanging their shares at any time prior to the completion of the regulatory review period. An extended offer period resulting from the regulatory review process potentially exposes the acquirer in a two-step merger to additional risk that an interloper may try to top the primary bid during the extended period. As such, it remains a question whether the elimination of appraisal rights in Section 251(h) stock-for-stock public mergers would be enough to increase the utility of two-step mergers.
Ratification of Defective Corporate Acts
Under the DGCL, a defective corporate act is an act taken by a corporation that is within its power, but is void or voidable due to a failure of authorization. Sections 204 and 205 were added to the DGCL in 2014 to provide a safe harbor procedure for ratifying defective corporate acts. The proposed amendments would clarify that a corporation can ratify defective corporate acts even when such corporation has no shares of valid stock outstanding. This change is intended to confirm that a corporation with no shares of valid stock outstanding may nevertheless take advantage of the safe harbor ratification procedure, even if a stockholder vote would otherwise be required to approve the ratification. The proposed amendments would also clarify that the definition of “failure of authorization” includes any failure of an act to be approved in compliance with a disclosure in a company’s proxy statement or consent solicitation. This would allow public companies to cure authorization failures arising out of disclosure misstatements (but does not address any securities law liabilities arising as a result thereof) by stockholder ratification under the safe harbor procedures. The proposed amendments would also allow nonstock corporations to utilize the safe harbor procedures to ratify defective corporate acts.
In addition, the proposed amendments seek to clarify that a corporation may ratify any defective act that is within a corporation’s power under Subchapter II of the DGCL. This particular change is proposed in reaction to the Delaware Chancery Court’s decision in Nguyen v. View, Inc., in which the Delaware Chancery Court held that the ratification was invalid under Section 204 of the DGCL because the corporation lacked the power to take the defective acts in the first place. In recognition that every defective corporate act in essence stems from an act that the corporation did not initially validly authorize, either because it was not approved in accordance with the DGCL or the corporation’s organizational documents, this proposed change intends to clarify that a corporation’s “failure of authorization” cannot in and of itself disqualify the act from ratification. However, consistent with the Delaware Chancery Court’s intent in Nguyen v. View, Inc. to distinguish a mistake and rewinding the clock to rewrite history, this proposed amendment would not indiscriminately allow corporations to ratify all defective acts that were not validly authorized. Section 205 of the DGCL confers broad power on the Delaware Chancery Court to determine the validity of a defective corporate act upon application of affected parties and directs that the Delaware Chancery Court may consider, among other things, whether the corporation believes that such defective act was taken in compliance with the DGCL and the corporation’s organizational documents or intends to evade proper authorization at the time of taking the defective act.
The proposed amendments relating to appraisal rights and ratification of defective corporate acts (together with some technical amendments) would become effective August 1, 2018, if adopted.