In re Loral and the Entire Fairness Standard

In the case In re Loral Space and Communications Inc., Consolidated Litigation, 2008 WL 4293781 (Del. Ch., Sept. 19, 2008), shareholders of Loral Space and Communications Inc. (“Loral”), sued the board of Loral and MHR Fund Management LLC (“MHR”).   Shareholders claimed that the equity capital finance agreement (“Finance Agreement”) between Loral and MHR was not the product of arms-length negotiations.  The court applied the entire fairness standard and invalidated the Finance Agreement because the defendants failed to prove it was the result of fair price and fair dealing.

MHR was a large stockholder of Loral and used its influence to place one of its own advisors, Michael Targoff, as Loral’s CEO.  Targoff sought to invest in Loral in an effort to allow it to pursue acquisitions and grow its existing business lines.  The Loral board formed a Special Committee to raise the equity capital it desired.  Eventually, the Special Committee adopted the terms of the Finance Agreement.  The terms provided class voting rights, which gave MHR control of 63 percent of Loral’s equity and control over almost any major transaction.  Plaintiffs alleged that the Finance Agreement was not the product of arms-length negotiations because the majority of the board was interested and the terms of the Finance Agreement were unfair.   

To determine whether the transaction was fair, the Delaware Court of Chancery applied the entire fairness standard.  The entire fairness standard applies when a majority of the board is interested or lacks independence from the interested party.  If the majority of the board is interested or lacks independence, the court will then consider two factors as a whole to determine whether the transaction is valid: fair price and fair dealing. Using this test, the court held that the entire fairness standard applied to the analysis of the Finance Agreement.  Because MHR and the Loral directors failed to meet their burden of proving the Finance Agreement was the product of a fair price and fair dealing, the court invalidated the Finance Agreement. 

The Entire Fairness Standard

The court held that the entire fairness standard applied to the Finance Agreement because the majority of Loral’s directors were interested and lacked independence from MHR. The court analyzed the relationships Loral’s directors had with MHR.  The two directors most responsible for negotiating the Finance Agreement, the Special Committee chairman and Targoff, were not independent of MHR.  MHR insisted that Targoff, who is also one of MHR’s investment advisors, become Loral’s CEO.  The Special Committee chairman had business and personal relationships with MHR.  Additionally, the Special Committee chairman was one of MHR’s investment advisors, which the court considered “too material” and thus not independent of MHR.  The court also highlighted that the Special Committee chairman and another director were business school classmates and close friends. The fact that MHR was a controlling stockholder also weighed in favor of invoking the entire fairness standard.  Since the entire fairness standard applied, the burden shifted to the defendants to prove the Finance Agreement was the result of fair price and fair dealing.

Fair Dealing

To assess fair dealing, the critical issue is whether the special committee functioned as an effective proxy for an arms-length bargain, such that the outcome was equivalent to a market tested result. An effective special committee must function in a manner that indicates the controlling shareholder did not dictate the terms of the transaction and that the committee exercised real bargaining power at an arms-length.

The court held that the defendants did not meet their burden of proving the Finance Agreement was fairly dealt.  Here, like measuring whether the parties were interested, the court looked at the relationships of the parties.  In addition, the court considered that the Special Committee chairman forwarded Loral’s internal corporate communications concerning the Finance Agreement to MHR.  Also, the Special Committee did not disclose to Loral’s legal advisors any if its relationships with MHR.  Furthermore, the court explained that in the context of a special negotiating committee, “[c]ourts evaluate whether the relationships among the members of the committee and interested parties placed them in a position to objectively consider a proposed transaction, and whether the committee members in fact functioned independently.”

The effectiveness of a special committee lies in the quality of the advice it receives from its legal and financial advisors.   Here, the Special Committee chose an unqualified financial advisor who did not perform a market test. The financial advisor made two calls to gauge interest but never sought to raise market interest.  The court found the financial advisor merely sought to make the deal look fair, rather than provide an objective opinion to the Special Committee.  As a result, the court held that the Finance Agreement was not a product of fair dealing. 

Fair Price

Under the second factor of the entire fairness standard, the court considered whether the Finance Agreement resulted in a fair price.  Here, the court determined that the financial terms of the Finance Agreement were more favorable to MHR.  MHR, along with Loral’s directors, tried to prove fairness by arguing that MHR was the only source of capital, took a high risk, and therefore deserved compensation for that risk.  The court stated that MHR took on risk for its own advantage, and that the terms of the Finance Agreement were excessively generous to MHR due to the unfair price paid for an equity stake, the unusually low conversion premium, and the unusually high dividend rate. The Special Committee did not take advantage of numerous opportunities to obtain equity at terms more favorable to Loral.   Additionally, the Special Committee failed to consider other available financing options, which were less risky.  This undercut the defendant’s claim that it was merely being compensated for taking a high risk.  Because the financial terms of the Finance Agreement favored MHR, the court held that the defendants did not prove the Finance Agreement resulted in a fair price.

In conclusion, the court held that the entire fairness standard applied to the analysis of the Finance Agreement.  Because MHR and the Loral directors failed to meet their burden of proving the Finance Agreement was the product of fair price and fair dealing, the court invalidated the Finance Agreement.

We have previously followed the Loral decision.  Here.  

The primary materials for this are available on the DU Corporate Governance website.