A Ripple or a Wave: Hedge Fund Litigation in Delaware

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Article

Mark A. Morton, Michael K. Reilly

Presented:
2nd Annual Mergers and Acquisitions Institute
The University of Texas School of Law
September 7-8, 2006
Dallas, Texas

In recent years, hedge funds have become dominant players in corporate America.  In addition to investing extraordinary amounts of capital, hedge funds have displayed an increasing appetite for direct confrontation with corporate boards when the hedge funds question the board’s competence, its vision, or the speed with which that vision is accomplished.  Not surprisingly, in recent years hedge funds increasingly have turned to the Delaware courts for redress for their concerns and several of those cases have resulted in decisions by the Delaware courts. 

To some observers, these cases simply represent an effort by well-financed stockholders to hold boards accountable for their competence and vision (or lack thereof).  Other observers, however, may view the new found litigious streak of hedge funds more cynically.  To those observers, the recent litigation merely reflects an effort by hedge funds to compel boards to abandon long term strategies, which are designed to significantly enhance stockholder value over time, in favor of short term decisions that offer stockholders (and, more particularly, the hedge funds) an immediate return on their investment.  For proponents of either perspective, however, three lawsuits filed recently in the Court of Chancery by hedge funds (one of which is still pending), offer valuable insights.  It remains to be seen, however, whether these cases are merely a ripple, or whether they portend a wave of similar lawsuits in the future.

I.  Highland Select Equity Fund, L.P. v. Motient Corporation.
Stockholders of Delaware corporations have a statutory right, pursuant to Section 220 of the General Corporation Law of the State of Delaware (“Section 220”), to demand to inspect the books and records of a corporation if the stockholder has a proper purpose for the inspection.  Importantly, the Delaware courts have held that a stockholder is entitled to inspect only those books and records that are necessary and essential to the satisfaction of the stated purpose.  If a corporation refuses to accede to a stockholder’s inspection demand within five business days, Section 220 provides the stockholder with the statutory right to commence a summary proceeding in the Court of Chancery to compel the corporation to permit the inspection.

A stockholder may utilize books and records requests under Section 220 for a wide variety of reasons, including to investigate possible mismanagement in order to determine whether to bring derivative litigation or to commence a proxy contest.  In fact, the Delaware courts have encouraged, for some time, the use of Section 220 demands by stockholders prior to asserting derivative actions against a corporation.[2]  However, in recent years, some stockholders (including some hedge funds) have begun using sweeping (or, in some cases, repetitive) books and records requests under Section 220 that some corporations considered oppressive and/or  unreasonable.  In its recent decision in Highland Select Equity Fund, L.P. v. Motient Corporation,[3] the Court of Chancery considered such allegations against a hedge fund for the first time and sent a strong signal that it will not tolerate the aggressive use by hedge funds (or any other stockholder) of a books and records action under Delaware law as a “tool of oppression,” particularly in the context of an ongoing proxy contest.[4]

At the center of the Highland case is Motient Corporation, a Delaware corporation (“Motient”), which provides two-way wireless mobile data services and nationwide internet services.  Motient’s primary assets are equity interests in two entities that operate and develop its services.  Highland Select Equity Fund, L.P., a Delaware limited partnership (“Highland Select”) is a hedge fund that was a stockholder of Motient. 

Beginning in 2005, Highland Select began to express concerns about possible mismanagement at Motient.  For example, Highland Select opposed a proposed transaction to combine Motient with the entities that owned its operating assets, asserting that the underlying Motient assets had been undervalued and that Motient’s management may be motivated by self-dealing.  In addition, Highland Select questioned certain consulting agreements that it believed were self-dealing transactions involving Motient’s management.  Highland Select also expressed concerns about Motient’s recent disclosure of material weaknesses in its internal controls and the fact that it was at risk of being classified as an investment company under the Investment Company Act of 1940.[5] 

Beginning in August 2005, Highland Select or its affiliates commenced a number of actions against Motient and its board, including a breach of fiduciary duty action in the Court of Chancery,[6] and an action filed in Texas seeking to rescind the sale of Motient Series A Preferred Stock to Highland Select.  In response, Motient filed actions in the federal and state courts of Texas against Highland Select affiliates, claiming that the Highland Select director designee had breached his fiduciary duties and violated the securities laws.  On February 14, 2006, the Highland Select director designee resigned from the Motient board and Highland Select announced a proxy contest to replace the Motient board with its own slate.  Highland Select indicated that it was concerned about mismanagement at Motient and noted, in particular, concerns about material weaknesses in financial controls, certain disclosure inadequacies, a flawed April 2005 stock issuance and the failed roll-up transaction.

On April 12, 2006, Highland Select delivered a demand letter to Motient seeking to inspect Motient’s books and records pursuant to Section 220.  Highland Select’s demand letter was 25 pages in length and contained 47 separate paragraphs of substantive demands.  After Motient rejected the demand letter (claiming that Highland Select failed to state a proper purpose and that the demand was “unreasonably broad and burdensome”),[7] Highland Select filed an action in the Court of Chancery pursuant to Section 220.

As the trial date approached for the Court to consider the Section 220 demand, Highland Select began a “dramatic series of revisions to its Section 220 demand.”[8]  Highland Select claimed in its brief that it had substantially narrowed the demand and then, on the eve of trial, it revised the demand again and narrowed the 47 paragraphs of demands down to 10 paragraphs.  After reviewing a comparison of the demand letter, the Court stated that the revised demand, which only reduced the demands from 47 categories to 39 categories, “still suffers from the same overbreadth as its original letter.”[9]

Following a one day trial, the Court of Chancery denied Highland Select’s demand to inspect Motient’s books and records.  In its decision, the Court made several preliminary observations.  First, the Court noted that a stockholder must make its demand for inspection in good faith, and that the demand will be examined by the Court for possible abuse.  The Court stated that “[r]ecent experience teaches that the potential for abuse is very much alive when the Section 220 demand is made – as this one is – in the context of an impending or ongoing proxy contest.”[10]  The Court indicated that in the context of a proxy contest, where the plaintiff seeks to publicize certain information and the Court is asked to referee disputes about confidentiality, it is particularly important that the stockholder make a narrow request.  In addition, the Court warned that Section 220 is not a means to circumvent the discovery process. 

Turning to the demand asserted by Highland Select, the Court found the demand to be “extraordinarily overbroad” and to have been made “despite the fact that [Highland Select] (or its affiliates) could have conducted full discovery into the very same questions of mismanagement in various other cases filed in Texas federal and state court.[11]  In addition, the Court chided Highland Select for requesting expedited relief when Highland Select at the same time had “hamstrung Motient’s efforts to defend itself” when it proffered a Rule 30(b)(6)[12] witness who was “so bound by attorney-client privilege, a self-serving lack of tenure in the plaintiff corporation, and a simple lack of knowledge, that his designation raises serious legal questions about Highland [Select]’s compliance with the rule.”[13]  In addition, the Court noted that necessity for expedited relief was largely of Highland Select’s own making, given the fact that Highland Select had known almost every detail of the alleged mismanagement for months but waited until February to commence the proxy contest.

The Court concluded that “[t]hese facts describe a remarkable confluence of events that amount to an abuse of the Section 220 process, designed for some purpose other than to exercise Highland Select’s legitimate rights as a stockholder.”[14]  The Court accused Highland Select of using the demand for an improper purpose, reasoning as follows:

Highland [Select], from the beginning of this process, intended to file a proxy contest, and had all the information it needed to take that step, whether from public filings or from [Highland Select’s designee’s] long service as a Motient director. Highland [Select] thus appears to have maintained its books and records demand in large part because it has derived utility from the demand itself as a rhetorical platform. That is not the kind of compelling circumstance this court described in Disney, that would authorize the use of Section 220 as a way of publicizing concerns about mismanagement.[15]

The Court refused to “pick through the debris of the Section 220 demand in this state of disarray and to find the few documents that might be justified as necessary and essential to the plaintiff’s demand.”[16]  Instead of a limited and discrete investigation into possible mismanagement, as contemplated by Section 220, Highland Select chose to assert a demand that was “broadly inconsistent with that statutory scheme.”[17]  Therefore, the Court denied the demand, dismissed the complaint and entered judgment in favor of Motient.

The Highland decision sends a strong message that the Court will neither participate in, nor tolerate, efforts by a hedge fund (or any other stockholder) to impose burdensome and expedited requests to inspect books and records on a corporation during a contest for corporate control.  In such circumstances, a demand to inspect books and records must be narrowly focused.  In the most egregious circumstances, where the Court believes a stockholder’s efforts are simply an attempt to burden or otherwise oppress the corporation during such a time, the Court is willing to deny in totality a demand to inspect books and records.  One may reasonably expect to see a company rely in the future on this decision when rejecting a Section 220 demand by a hedge fund (or other stockholder) that the company considers either overly broad or unnecessarily repetitive.  However, it remains to be seen whether this decision should be read as an indication of a growing cynicism within the Delaware courts about the (ab)use of Section 220 by hedge funds (and other stockholders).

II.  Accipiter Sciences Fund, L.P. v. Helfer.
Hedge funds often seek to run proxy contests or submit stockholder proposals in an effort to put pressure on a corporation to meet its demands.  When submitting nominations or proposals, hedge funds must navigate a corporation’s advanced notice bylaw provisions, which  set forth deadlines for submissions.  In order to meet the requisite deadline, it is often critical for stockholders to understand the mechanics of the advance notice bylaw provisions and to remain vigilant for announcements of an annual meeting date.  In its recent decision in Accipiter Sciences Fund, L.P. v. Helfer,[18] the Court of Chancery considered a claim by a hedge fund that a corporation “buried” the announcement of an annual meeting in a press release reporting the corporation’s earnings and, as a result, caused the hedge fund to miss the deadline for nominating an opposing slate of directors.  The Court denied the hedge fund’s claims and, thus, put hedge funds on notice that the Court is unlikely to find that a sophisticated hedge fund was entitled to equitable relief for its own failure to properly monitor a corporation’s public disclosures.

The facts of Accipiter are straightforward.  LifePoint Hospitals, Inc., a Delaware corporation (“LifePoint”), had an advance notice bylaw requiring the board of directors to set a record date for the corporation’s annual meeting.  In prior years, LifePoint typically scheduled its meeting for mid-May.  In recent years, however, that schedule was disrupted and LifePoint scheduled its annual meetings in 2004 and 2005 for mid-June and late June, respectively.  LifePoint’s advance notice bylaw provided that stockholders must submit their nominations or proposals not less than 90 days prior to the first anniversary of the preceding year’s annual meeting.  However, in the event that the annual meeting was advanced by more than 30 days or delayed by more than 60 days, stockholders must submit their nominations or proposals either no later than the 90th day prior to the annual meeting or the 10th day following the day on which public announcement of the date of such meeting is first made.

In early January 2006, LifePoint began preparing for its annual meeting and anticipated setting a meeting date of May 8, 2006.  That plan changed when, on January 12, 2006, LifePoint received the first stockholder proposal in its history.  In response, LifePoint’s outside counsel suggested that LifePoint schedule an annual meeting in order to trigger the advance notice bylaw, thus requiring that all further stockholder proposals be submitted within ten days of that announcement.  Intending to “identify the universe of stockholder proposals” sooner rather than later and with no knowledge of any stockholder’s intent to nominate an opposing slate of directors, LifePoint decided to announce its annual meeting in an already drafted, and about to be published, press release announcing LifePoint’s fourth quarter earnings.[19]  On February 6, 2006, LifePoint issued a press release, which had a title that referred only to the fourth quarter earnings and which included eleven pages of text and financial results.  However, in the seventh paragraph at the bottom of the first page of that release, LifePoint included a separate paragraph announcing that the date for the annual meeting of stockholders was set for May 8, 2006. 

Accipiter Life Sciences Fund, L.P. (“Accipiter”), is a hedge fund and LifePoint stockholder that monitored the public filings of LifePoint.  Accipiter’s employees testified that they were awaiting the earnings press release and read it, but that they overlooked the paragraph announcing the annual meeting date.  One of Accipiter’s employees also admitted that, if he had seen the paragraph announcing the annual meeting, he would have known that Accipiter had ten days to submit nominations for a competing slate of directors.[20] 

Unaware that a new meeting date had been set, Accipiter submitted a formal notice of nominations for a competing slate on March 31, 2006.  LifePoint responded by stating that the notice was not timely because the new annual meeting date was set in the February 6 press release, triggering the ten day window under LifePoint’s advance notice bylaw.  In response, Accipiter filed suit in the Court of Chancery asserting, among other things, that the manner and form by which the meeting date was set was inequitable, even though LifePoint set the annual meeting date in accordance with Delaware law.  Accipiter moved for summary judgment on its claim and requested the Court to order a new election of directors to the LifePoint board. 

In examining the facts presented, the Court considered the standard of equitable behavior articulated in Schnell v. Chris-Craft.[21]  In that case, the Delaware Supreme Court found that a corporation “may not take actions towards their stockholders which, though legally possible, are inequitable.”[22]  The Court noted, however, that its equitable power to set aside a corporate action must be used sparingly and a decision whether a particular act is inequitable must be decided on a case by case basis after a close examination of the relevant facts.  The Court noted that it has been more likely in prior cases to invalidate the application of an advance notice bylaw under the Schnell standard where the corporation was acting “with the intent of influencing or precluding a proxy contest for control of the corporation.”[23]  The Court added, however, that intent is not a required element and the Court went on to describe certain cases in which extraordinary circumstances led to the invocation of the Court’s equitable powers despite the absence of intent.[24] 

With respect to the present case, however, the Court found that the “facts … fall far short of the types of inequity which our courts have found determinative in the past.” [25]  First, the Court noted that LifePoint did not know about Accipiter’s intent to run a proxy contest at the time that the annual meeting date was announced.  In addition, the Court determined that “LifePoint’s actions did not … make the dissident’s challenge extremely difficult or impossible.”[26]  Moreover, no new material facts arose after the nomination period ended.  Finally, the Court found it important that, unlike in other cases, all Accipiter had to do “to preserve its rights was to read [LifePoint’s] press release carefully and fully.”[27]  Although the Court found “some appeal” to the argument that LifePoint violated Delaware law by making “important corporate information more difficult to discover than was necessary,” the Court found that the “troubling way” that LifePoint announced its annual meeting did not reach the standard required for equitable relief.[28]  The Court concluded as follows:

The reason this court grants the defendants’ motion for summary judgment, therefore, is not that the court views LifePoint’s method of disclosure with approbation, but that its equitable powers can only be roused under Schnell where compelling circumstances suggest that the company unfairly manipulated the voting process in such a serious way as to constitute an evident or grave incursion into the fabric of the corporate law. To rule in the plaintiff’s favor here, where the record shows that Accipiter could easily have preserved its rights with reasonable diligence, would extend Schnell well beyond those limits and would threaten to involve the court in matters better understood as regulatory in nature.[29]

The Accipiter decision indicates that the Court of Chancery will exercise caution before using its equitable powers to overturn an otherwise lawful board action to set an annual meeting date.  The Accipiter decision also puts hedge funds (and other stockholders) on notice that they have an obligation to carefully protect their rights as stockholders.  The Accipiter case should not be read as an invitation for corporations to “bury” important information in press releases.  However, the case does suggest that a corporation need not take extraordinary efforts, absent unusual circumstances, to highlight the setting of an annual meeting date in order to put stockholders on notice that the clock for nominations and proposals has commenced.  The absence of such extraordinary efforts may, of course, have the unintended consequences of foreclosing an unforeseen proxy contest.   

III.  In re: Appraisal of Transkaryotic Therapies, Inc.[30]
Stockholders of a Delaware corporation have the option in certain circumstances to petition the Court of Chancery for an appraisal of the fair value of their shares and to receive that fair value in lieu of the merger consideration.  While Delaware’s appraisal remedy has its share of critics, the empirical evidence shows that judicial appraisal values often exceed the merger price.  In the thirty eight post-Weinberger[31] appraisal cases decided through August 2005, the judicially determined appraisal value has exceeded the merger price by a multiple of approximately 3.55, with a median multiple of approximately 2.07.[32] 

It is not surprising, then, that hedge funds sometimes decide to purchase a corporation’s stock in the public market after the public announcement of, but prior to the vote on, a merger that will trigger appraisal rights.  In those cases, the hedge funds seek to preserve the ability to seek appraisal of the fair value of the shares, while also gaining the benefit of any later, upward revisions to the merger price.  Interesting legal issues may arise, however, if a hedge fund purchases shares in the market following the record date that was set for the merger. 

Delaware’s appraisal statute provides, among other things, that a stockholder shall not be entitled to an appraisal of shares that are voted in favor of a merger.[33]  Given the structure of the modern securities industry, in which many stockholders hold their shares beneficially through brokers, it is generally impossible to determine whether a “specific share” of stock, which has been transferred after the record date from one beneficial owner to another, has been voted in favor of the merger.  As a result, if a hedge fund purchases shares after a record date and seeks to assert appraisal of those shares, it may be confronted with an open legal question – can they seek appraisal of those shares without proving that the specific shares were not voted in favor of the merger?  In the recently filed, but still pending, appraisal action captioned In re: Appraisal of Transkaryotic Therapies, Inc.,[34]  the Court of Chancery is now considering that issue.

At issue in that appraisal action is a merger, announced on April 21, 2005, of Transkaryotic Therapies, Inc., a Delaware corporation and a biotechnology company (“TKT”), with and into a wholly owned subsidiary of Shire Pharmaceuticals Group plc.  A record date of June 10, 2005 was set for the vote on the merger and, as of that record date, the petitioners in the appraisal proceeding beneficially owned less than 3 million shares of TKT common stock.  After the record date and following the news of recent TKT clinical successes, a number of TKT investors became concerned that TKT had accepted an inferior offer.[35]  Following the news of TKT’s clinical success (and before the meeting of stockholders), the petitioners purchased more than 8 million additional shares in the market (presumably because they perceived the potential for either an increase in the merger consideration or a lucrative appraisal remedy).

At a meeting of stockholders held on July 27, 2005, the holders of approximately 52% of TKT’s outstanding common stock voted to approve the merger and, thereafter, a certificate of merger was filed to consummate the merger.  Following the consummation of the merger, the petitioners filed petitions for appraisal with the Court of Chancery seeking the appraisal of more than 11 million shares of TKT common stock.  Nearly 17 million shares of TKT’s common stock held of record by Cede & Co. were not voted in favor of the merger.

Given the timing of the share purchases, TKT moved for partial summary judgment in the Delaware appraisal action on the grounds that the petitioners should not be entitled to seek appraisal of the more than 8 million shares purchased after the record date.  In briefing on the motion for partial summary judgment, TKT has argued, among other things, that the petitioners cannot establish whether the 8 million shares purchased after the record date were voted in favor of the merger.  In response, the petitioners have argued, among other things, that the focus should be on the shares held by Cede, the record holder, and that a sufficient number of shares were not voted by Cede in favor of the merger to permit the petitioners to seek appraisal for all of their shares.  Briefing has been completed and an oral argument before the Court of Chancery is expected to occur in the near future.

Although the Court of Chancery has yet to decide the issue, the appraisal action highlights the types of issues that have arisen in Delaware courts as a result of recent activism by hedge funds.  Depending upon the outcome of the litigation, the Court’s decision may have a significant impact on hedge fund activity in this area.  A decision by the Court that a petitioner must prove that shares purchased after the record date were not voted in favor of the merger presumably will limit the ability of hedge funds to use a post-record date investment to influence board action.  On the other hand, if the Court permits the petitioners who acquired their beneficial interests after the record date to proceed with the appraisal proceeding, then in the future hedge funds will have one more economic rationale for investing after the record date in targets.

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[1] Mark A. Morton is a partner in, and Michael K. Reilly is an associate with, the Wilmington, Delaware law firm of Potter Anderson & Corroon LLP.  The views expressed herein are solely those of the authors and do not necessarily represent the views of the firm or its clients.

[2] See Scattered Corp. v. Chicago Stock Exch., 701 A.2d 70, 78 (Del. 1997); Rales v. Blasband, 634 A.2d 927, 935 n. 10 (Del. 1993); Disney v. Walt Disney Co., 857 A.2d 444, 448 (Del. Ch. 2004).

[3] 2006 WL 1903129 (Del. Ch. July 6, 2006).

[4] Id. at *1.

[5] In light of those concerns, Highland Select requested, through its then director designee on the Motient board, that Motient’s audit committee conduct an investigation.  Motient’s board ordered the audit committee to conduct an investigation with the assistance of independent counsel and later generated a report that purportedly exonerated the Motient board of any wrongdoing.  Highland Select’s designee on the Motient board, who subsequently resigned, was never given a copy of that report.

[6] The Delaware breach of fiduciary duty action later was dismissed for failure to state demand futility under Chancery Court Rule 23.1.

[7] 2006 WL 1903129, at *4.

[8] Id. at *6.

[9] Id.

[10] Id. at 7 (emphasis added).

[11] Id. at 8.

[12] Chancery Court Rule 30(b)(6) permits a litigant to name an entity as a deponent.  The entity so named is required to designate one or more persons, who consent to testify on behalf of the entity, and to set forth the matters on which the person will testify.  The rule requires the person so designated to “testify as to matters known or reasonably available to” the entity.  Ch. Ct. Rule 30(b)(6).  

[13] 2006 WL 1903129, at *8.

[14] Id. at 9.

[15] Id.  Motient argued that the Section 220 demand was made for an improper purpose, i.e., “as a vehicle through which to attack Motient’s management in preparation for the proxy contest, with little regard for whether it receives any information or not.”  Id. at 6.

[16] Id. at 9.

[17] Id.

[18] 2006 WL 2252376 (Del. Ch. Aug. 2, 2006).

[19] Id. at *2.

[20] The Court found it important that Accipiter did not challenge the ten day window and thus concluded that Accipiter could have complied with that deadline if its employees had noticed the paragraph announcing the meeting date.

[21] 285 A.2d 437 (Del. 1971).

[22] 2006 WL 2252376, at *7.

[23] Id.

[24] See, e.g., Linton v. Everett, 1997 WL 441189, at *10 (Del. Ch. July 31, 1997) (finding the application of an advance notice bylaw to be inequitable where the corporation had not held an annual meeting for three years and then announced a meeting triggering a ten day window for nominations, and where the stockholders did not actually receive the notice until three days before the window closed).

[25] 2006 WL 2252376, at *9.

[26] Id.

[27] Id.

[28] Id.

[29] Id. at 10.

[30] The authors’ law firm represents several of the petitioners in this litigation. 

[31] 457 A.2d 701, 713 (Del. 1983) (rejecting the previous practice of exclusive reliance on the “Delaware Block,” or weighted average method of valuation, and instead directing that, in valuing shares, the Court of Chancery should consider “proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court”).

[32] Donald J. Wolfe & Michael A. Pittenger, Corporate and Commercial Practice in the Delaware Court of Chancery, § 8-10[d] (2006).

[33] 8 Del. C. § 262.

[34] C.A. No. 1554-N (Del. Ch.).

[35] See Press Release, Transkaryotic Therapies, Inc., Primary Endpoint Achieves Statistical Significance (June 20, 2005); Robert Steyer, Dissidents Emerge in Drug Merger, The Street.com (July 8, 2005), available at http://www.thestreet.com/stocks/robertsteyer/10231423.html.

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