This article was original published in The Delaware Business Court Insider | 2011-07-06
On May 31, Vice Chancellor Leo E. Strine Jr. issued an opinion denying a motion for preliminary injunction to halt a merger between Massey Energy Company and an affiliate of Alpha Natural Resources Inc. One of the critical issues in the opinion was the value of the derivative claims Massey had against certain current and former directors and officers arising out of Massey's compliance with federal mining safety regulations.
Massey's attitude toward federal mining safety regulations arguably manifested itself in the Upper Big Branch mine disaster, which resulted in the loss of 29 lives. In his opinion, Strine found that the plaintiffs had probably stated a Caremark claim against the directors of Massey and criticized the board of Massey for failing to assess the value of the derivative claims but ultimately refused to enjoin the merger, concluding that the derivative claims did not have the value plaintiffs believed.
While this result has received some negative commentary, is it really a surprise? In fact, the court's analysis is consistent with prior analyses addressing the value of derivative claims in the context of a merger. The fact that the party here is more infamous than many others did not change the analysis under Delaware law.
The plaintiffs valued the derivative claims based on the "aggregate negative financial effect on Massey that the Upper Big Branch Disaster and its Fall-Out has caused." According to the plaintiffs' expert, these damages range from at least $900 million to $1.4 billion. The court, however, rejected this theory, in large part because the computation of the value of the derivative claims was far more complicated than the plaintiffs' theory.
First, even though the plaintiffs had stated a viable Caremark claim against the directors, because of the business judgment rule and the exculpatory provisions in Massey's certificate of incorporation, in order to obtain a monetary judgment against the directors, they would have to prove that the directors acted with scienter — a difficult standard to meet, particularly with independent directors.
Second, the court also found that even as to the autocratic former leader of Massey, Don Blankenship, who was arguably responsible for Massey's approach to mining safety, meeting this standard would be difficult. The court noted that there is a large gap between pushing the limits of federal regulations while accepting minimal loss of life and knowingly endangering the mine itself by putting its very operations at risk. Moreover, Blankenship was not directly in charge of any specific mine, and tying his policies directly to any disaster would be challenging.
Third, proving that the directors acted with scienter may entitle the corporation to a monetary judgment from the directors, but it would simultaneously expose the company to third-party civil liability and potential criminal liability, and potentially deprive the directors of the ability to rely on insurance coverage, all of which would harm the company.
Fourth, after the merger, Alpha will continue to have to address direct claims against Massey from its lost and injured miners, regulatory consequences of the company's mining safety approach, and other elements of the "Disaster Fall-Out." To the extent possible, Alpha will have every incentive to shift that liability to the former directors.
Fifth, it is impossible to determine the potential derivative liability of the directors until Massey's direct liability is determined. Indeed, it is not even in the interest of Massey's stockholders to press their claims of derivative liability now, before third-party civil and criminal adjudication, lest the plaintiffs expose the company to additional liability.
Sixth, the plaintiffs' expert put no value on the ability of the company or its stockholders to collect on a potential $1 billion judgment. The company's insurance policy, even assuming it is available to cover claims against the former directors, is only $95 million. While this is no small amount, it is, as the court put it, "not material in the context of an $8.5 billion merger."
While the vice chancellor was quick to note that the Massey board's approach to valuation of the derivative claims was less than ideal, because of the factors noted above, he found that the plaintiffs had not persuaded him that the merger was unfairly priced because of the failure to value separately the derivative claims. Was this conclusion so unprecedented, however, to justify criticism of the valuation?
Delaware courts previously have been asked to consider the value of unliquidated, contingent claims belonging to the company in the valuation context. These courts have never valued derivative claims at the full value of all potential damages, but instead have considered many of the factors Strine addressed in Massey.
For instance, in Onti Inc. v. Integra Bank Inc., petitioners in an appraisal action argued that their derivative claims should have been valued as an asset of the company in the appraisal proceeding. The stockholders' expert valued the claims at more than $19 million, while the company's expert valued the claims at negative $2.5 million. The court determined that the claims had no value. In reaching that conclusion, the court adopted the theory advanced by the company's expert, that all litigation factors should be considered, including the likelihood of success on the merits, the attorney fees necessary to obtain that result and any indemnification that the company would owe to its directors. Citing to prior precedent, the court noted that "there would be strong logic in including the net settlement value of such claims as an asset of the corporation for appraisal purposes."
Later that same year, the court took a similar approach in Bomarko Inc. v. International Telecharge Inc. The court valued the claim in that case by multiplying the probability of success by the likely amount of recovery while subtracting costs incurred to obtain that result.
More recently, in Arkansas Teacher Retirement System v. Caiafa, the Court of Chancery overruled an objection to a settlement that released claims that the board failed to ascribe any value to federal derivative claims in a merger. After noting that there is no case law supporting the proposition that the board was required to undertake a separate and discrete valuation of the derivative claims pending at the time of the challenged merger, the court reached the same result as Strine did in Massey, albeit with less analysis. That is, the court noted that the claims asserted in the federal action were difficult to win, and even those that had a higher probability of success could not have the $2 billion value the objectors claimed they did. On appeal, the Delaware Supreme Court affirmed the Court of Chancery's decision to overrule the objection for the reasons set forth in the Court of Chancery's opinion.
Given these precedents, is the result in Massey all that surprising? While some contingent claims have been given value, it is the exception, and not the rule, to assign material value to contingent derivative claims. Moreover, in the context of a merger worth billions of dollars, the likelihood is low that derivative claims have material value, particularly when reasonable defenses can be interposed.
But does this decision mean that boards can just eschew any analysis of the value of a derivative claim in the context of a merger? Probably not. The Court of Chancery certainly did not condone the practice, and had the court not been persuaded that the board otherwise acted properly, the failure to do so could have had more importance.
Further, because the exception to the derivative standing rule that entering into a merger for the purpose of extinguishing derivative claims remains viable, particularly in light of the Supreme Court's opinion in Caiafa, failure to value the claims could support the conclusion that a merger was negotiated simply to avoid liability. Finally, not all derivative claims are equal in this context. As Strine noted in Massey, if Massey had a liquidated claim against a former fiduciary reduced to a judgment but failed to get any value for this claim, he could see the substantial unfairness in failing to obtain value for that claim in a merger. Alternatively, if recovery on any derivative claim after a cash-out merger would inure solely to the benefit of the acquirer, then perhaps there would be value to the buyer in obtaining that claim.
Put simply, as with many issues of fiduciary law, the context of the situation is important. What is fairly clear, however, is that unliquidated contingent derivative claims are not ascribed much value, if any, in a merger context, unless a party can demonstrate a reasonable likelihood that the net value of the claim to the company is material.
Peter B. Ladig (email@example.com) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. He represents both stockholders and directors in corporate litigation. The majority of his practice is in the Delaware Court of Chancery, although he has extensive experience in the other state and federal courts in Delaware and has been involved in over 50 published decisions. The views expressed herein are his alone and do not necessarily reflect the firm or any of the firm's clients.