I previously posted about disputes over bump up exclusions in D&O insurance contracts, which exclude from insurance coverage claims that shareholders of a merger target should have received more consideration for their shares. As I argued, the purpose of the exclusion is to ensure that the cost of the acquisition isn’t offloaded on to the insurer.
One of the cases I mentioned in that post, Harman Int’l Indus. Inc. v. Ill. Nat’l Ins. Co., was just affirmed by the Delaware Supreme Court, and the reasoning interests me.
In this case, Harman International was acquired by Samsung Electronics, and shareholders sued under Section 14(a), which prohibits false proxy statements, and Section 20(a), which adds joint and several liability to control persons – the substantive claim was Section 14(a). Shareholders argued that, due to false statements in the proxy, they were induced to vote in favor of a merger at a lowball price.
Eventually, the case settled for $28 million, and when the defendants sought insurance coverage, the insurer claimed the settlement was subject to the bump up exclusion. On appeal, the Delaware Court disagreed.
According to the court, the insurance contract had two clauses, both of which had to apply in order to trigger the exclusion.
First, the loss had to arise out of “a Claim alleging that the price or consideration paid or proposed to be paid for the acquisition or completion of the acquisition of all or substantially all the ownership interest in or assets of an entity is inadequate.” And second, the loss had to represent “the amount by which such price or consideration is effectively increased.” If such a loss occurred – based on an inadequate consideration claim – then the insurers would not be responsible for the portion of the loss representing a consideration increase.
Disagreeing with the Superior Court, the Delaware Supreme Court agreed that the shareholders’ claim in this instance – despite being rooted in federal proxy fraud – represented a claim for inadequate consideration.
The Operative Complaint alleged that “[t]he false and/or misleading Proxy used to obtain shareholder approval of the Acquisition” deprived the Investor Class of their right to “the full and fair value for [their] Harman shares.” The Operative Complaint also asserted that the “actual economic losses” were comprised of “the difference between the price Harman shareholders received and Harman’s true value at the time of the Acquisition.”
I agree with that much. But where the insurers faltered was they failed to show that the actual settlement – the $28 million – represented the amount by which such consideration was increased.
This was because the class itself didn’t just include shareholders who received compensation in the merger; in fact, it was defined to include “all Persons who purchased, sold, or held Harman common stock at any time from … the record date, through and including the date the merger closed.” In other words, it included people who sold before the merger closed. Additionally, the plaintiffs never submitted any kind of expert report estimating the true value of their shares, because the case settled “in the early stages of litigation with only minimal discovery completed; instead the settlement represented the litigation costs Harman expected to incur if the case continued.”
As a result, the claim was not subject to the exclusion, and was covered by insurance.
So … this strikes me as weird.
Start with the class definition. Leaving aside whether that was an appropriate Section 14(a) class, I actually have no idea how the $28 million was allocated among the former shareholders. That said, in most merger scenarios, you have an announcement, and the stock price goes up to reflect the expected merger consideration, possibly discounted for the uncertainty whether there are barriers to closing. At that point, merger arbs step in, buy at a price slightly discounted from the merger price, and profit when the merger closes. The prior shareholders, as a practical matter, accepted something a little below the merger price in order to remove uncertainty.
Outside of contexts where there is significant uncertainty as to whether the deal will close (think Twitter), those prior shareholders are the true beneficiaries of the merger price – whatever it happens to be. And they’re the ones who likely suffer the most if the merger price is inadequate. Which means, there is nothing inconsistent on its face with the idea that the payments represent inadequate consideration just because it’s paid out to shareholders who sold before the transaction was consummated.
It is also unclear to me why the defendants’ reasons for settling the claim should somehow have more significance than the nature of the claim that necessitated the settlement in the first place when determining what the payment was actually for. Surely very few defendants actually settle because they recognize the justice of the plaintiffs’ allegations.
And since in this case the shareholders solely alleged proxy fraud – they didn’t layer Section 10(b) on top or anything – and that proxy fraud claim was for inadequate consideration (per the Delaware Supreme Court), there is something incongruous about suggesting the settlement was for anything other than inadequate consideration. Was it a gratuity? If so, why was it covered by insurance at all?
And this decision creates some worrying incentives. For one thing it encourages plaintiffs – who know that defendants like to settle within insurance coverage – to overdefine the class, and defendants to agree to that – bad for insurers and shareholders alike. It encourages defendants to settle quickly, before plaintiffs have a chance to conduct discovery into the true value of the shares.
In any event, the Delaware Supreme Court made clear what insurers have to do in the future to protect themselves – base the contractual exclusion solely on the nature of the claim, as apparently some insurance contracts do. That said, I have no idea who has the bargaining power when these contracts are formed so it will be interesting to see whether any industry norms grow out of this.
Lagniappe. This decision by Chancellor McCormick is making headlines because she refused to dismiss claims against Jefferies LLC for aiding and abetting a fiduciary breach, where it served as financial advisor to an acquirer alleged to have issued false information about the target in a SPAC merger. But I’m interested in the case because of a fun agency problem.
It’s a classic SPAC kind of case. The blank entity was Forum III, and the target was Legacy ELMS. Forum III made a bunch of false statements about Legacy ELMS in the proxy statement, and shareholders sued Forum III’s directors for breach of fiduciary duty. They also sued the founders of Legacy ELMS, Taylor and Luo, for aiding and abetting that breach, due to their involvement in the false statements at issue. The claims against Taylor and Luo were sustained in an earlier round of briefing.
In this new opinion, the plaintiffs brought aiding and abetting claims against additional defendants, including a company called SF Motors, for which Taylor and Luo served as CEO and CFO, respectively.
The claim was that the entire SPAC transaction was actually part of a plan by Taylor and Luo, working for SF Motors, to unload a particular asset, a manufacturing plant in Indiana. The plan they came up with was to found Legacy ELMS, sell the plant to Legacy ELMS, have Legacy ELMS pay for the plant with cash and Legacy ELMS stock (apparently more of the latter than the former), and take Legacy ELMS public in the SPAC merger. SF Motors also loaned Legacy ELMS personnel to assist with the SPAC merger process. Apparently all of these employees, including Taylor and Luo, used their SF Motors email accounts when they worked on the SPAC merger for Legacy ELMS.
As a result of the close relationship between SF Motors and Legacy ELMS, plaintiffs alleged that SF Motors aided and abetted the false statements Forum III had issued about Legacy ELMS in connection with the merger. Specifically, plaintiffs alleged that SF Motors – acting through Taylor and Luo – had aided the false statements. In other words, plaintiffs alleged that SF Motors should be vicariously liable for aiding and abetting based on the actions of its employees, Taylor and Luo.
That claim was rejected by Chancellor McCormick, essentially on a “different hats” theory. Taylor and Luo’s actions in generating false information about the merger had been accomplished in their capacity as Legacy ELMS officers and directors. Legacy ELMS had a right and responsibility to review the proxy before it was filed; SF Motors had no such responsibility. SF Motors may be said to have received confidential information demonstrating the falsity of the proxy – because its employees, using SF Motors email accounts, received that information while they were negotiating for Legacy ELMS – but “this allegation does not demonstrate that withholding the information was within the scope of Taylor’s and Luo’s responsibilities for SF Motors.”
I mean, sure, I guess, viewed narrowly, and maybe the problem here is that plaintiffs just didn’t have the facts to back up the claim (the documents are heavily redacted so I can’t get the details), but it reads to me like the allegation is that SF Motors – through Taylor and Luo – conspired to defraud Forum III investors, and that scheme involved setting up a new entity, unloading a bad asset to that entity, and then misleading Forum III investors about the value of the asset. If this was an entire scheme hatched by Taylor and Luo in their capacity as managers of SF Motors, then … I mean, that makes aiding and abetting an appropriate accusation.
And two other things. Two episodes of the Shareholder Primacy have dropped since I last posted! This week, Mike Levin and I talked about the contest for control of Warner Brothers (here at Apple, here at Spotify, and here at YouTube), and last week, Mike and Matt Moscardi of Free Float Media answered some questions sent to Shareholder Primacy’s mailbag (here at Apple, here at Spotify, and here at YouTube).