March 21, 2003

Fairness to Whom: When Multiple Classes of Equity Require Multiple Fairness Evaluations

The Reader’s Digest case recently decided by the Delaware Supreme Court provided an example of when multiple classes of equity securities can pose special concerns for a board of directors in evaluating the fairness of a corporate transaction. The Delaware Supreme Court addressed the obligations of a Special Committee of the Board of Directors of The Reader’s Digest Association, Inc. ("RDA") to the holders of RDA’s non-voting Class A common stock in a proposed recapitalization. The recapitalization involved the repurchase of a significant amount of RDA’s voting Class B common stock by RDA and the conversion of the remaining Class B shares and all Class A shares into a new single class of Common Stock. The Class B was to receive a slightly better exchange ratio than the Class A in the transaction. The Court reversed the lower court’s denial of a preliminary injunction requested by the plaintiff, a holder of Class A shares, and in so doing emphasized the importance of a board of directors or special committee considering the entire fairness of a transaction to all of the distinct classes of shareholders. In finding that the Special Committee’s evaluation of the recapitalization was flawed as to both process and price, the Court found most persuasive the fact that the Special Committee’s financial advisor had tendered a fairness opinion to the "interests of RDA as a corporate entity," while failing to opine as to the transaction’s fairness to the holders of Class A common stock.

As a result of the Court’s ruling, the original recapitalization agreement was terminated and a new agreement with similar terms was negotiated. In connection with the approval of the new agreement, separate financial advisors were retained by the Special Committee to opine as to the fairness of the transaction, in one case, to the holders of Class A and, in the other, to the holders of Class B. The resulting opinions helped allow the recapitalization to proceed and the transaction closed on December 13, 2002. While engaging separate financial advisors to conduct the evaluations as to fairness may have evidenced an abundance of caution, the Court clearly felt that the board of directors should have received opinions as to the fairness of the transaction to each of the Class A and Class B shareholders, whether embodied in a single opinion or separate opinions.

Although Delaware law does not explicitly require that fairness opinions be sought in corporate transactions, such opinions go a long way in assisting directors in meeting their fiduciary duties to shareholders. This is particularly the case in transactions such as the RDA recapitalization where the presence of controlling shareholders can result in a court reviewing the "entire fairness" of the transaction. Furthermore, when a company has two or more classes of outstanding equity securities and a transaction treats those classes differently, directors must often evaluate fairness as to each class unless there is a basis for the disparate treatment in the preexisting contractual terms of the classes. The structure of the RDA transaction clearly treated the Class A and Class B common stock differently, which went a long way in leading the Court to greater scrutiny. It is important to note that any right to a separate fairness evaluation relates to equity securities, but does not apply in the case of typical convertible debentures, warrants or options as they do not have the status of equity until converted or exercised by their holders. The rights of these securities are defined by the contract terms under which they were issued.

In the case of preferred stock, the fiduciary obligations of directors are not without limits. Any rights or preferences specifically given to the preferred holders in the certificate of designation are a matter of contract right and will be strictly enforced by courts without reference to the fiduciary duties of directors (although consideration is given to the implied duty to at least act in good faith present in Delaware and many other jurisdictions). Where a contractual preference does not govern, but rather the transactional claim relates to an interest shared by shareholders generally, the fairness of a transaction to the preferred stock must be evaluated by directors.

Whenever this fairness evaluation is undertaken, any board or special committee engaging an investment bank to render an opinion, and any investment bank interested in seeing the transaction proceed smoothly, should carefully consider whether the opinion or opinions received should separately address the fairness of the transaction as to each class of equity securities. From an investment banking perspective, this can present significant challenges. It may require the opining bank to make judgments of relative value arising from subtle differences in features or rights of the multiple classes of equity. In light of Reader's Digest, investment banks should proceed with great caution and care in these situations.

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