On March 30, 2012, the Delaware Court of Chancery denied motions to dismiss breach of fiduciary duty claims in Frank v. Elgamal. It held that a merger involving a controlling group of stockholders who received an interest in the surviving entity is subject to the entire fairness standard, rather than the business judgment rule, if appropriate procedural protections are not in place to protect the minority stockholders. In particular, although the target company board appointed a special committee to negotiate the terms of the merger, the defendants needed to condition the merger on a non-waivable vote of the majority of all of the minority stockholders to invoke the protection of the business judgment rule. This case reaffirms the Court's holding in In re John Q. Hammons Hotels Inc. Shareholder Litigation (see Legal Update, In re John Q. Hammons Hotels: Chancery Court Examines When Entire Fairness Applies).

This case arose from the merger of American Surgical Holdings, Inc. (American Surgical) with AH Merger Sub, Inc., a wholly-owned subsidiary of AH Holdings, Inc. Under the terms of the merger agreement, each share of American Surgical stock was converted into a right to receive $2.87 in cash. However, four defendant stockholders, who together owned about 71% of American Surgical's common stock (the Control Group), also entered into:

The plaintiff, a minority stockholder, challenged the merger and claimed, among other things, that the Control Group, who together acted in concert and as a group, were controlling stockholders whose actions violated their fiduciary duties of loyalty and care to the minority stockholders of American Surgical. The defendants jointly filed motions to dismiss, arguing that the plaintiffs allegations were insufficient to rebut the presumptions of the business judgment rule.

The main issue presented in this case was whether the Court should apply the business judgment rule or the entire fairness standard when evaluating the plaintiff's claims.

The Court found the facts of this merger to be very similar to the merger in Hammons, except that, in Hammons, there was a single controlling stockholder rather than a group acting together as controlling stockholders. However, the Court found that the plaintiff had alleged sufficient facts showing that the members of the Control Group were "connected in a legally significant way" through the three agreements they entered into, making it reasonable to infer that they collectively acted as American Surgical's controlling stockholders.

As in Hammons, the Control Group did not stand on both sides of the transaction, so the entire fairness standard was not the exclusive standard of review. The defendants could have invoked the protection of the business judgment rule if they had adequate procedures in place to protect the minority stockholders. In particular, to invoke the business judgment rule, Hammons required the merger to be both:

Although American Surgical's board appointed a special committee, the merger "was not conditioned on a non-waivable vote of the majority of all the minority stockholders." Rather, the adoption of the merger agreement required only the affirmative vote of a majority of the common shares. Therefore, the Court held that the merger would be reviewed under the entire fairness standard and denied the defendants' motion to dismiss the fiduciary duty claims.

This case reaffirms the Court's holding in Hammons to apply an entire fairness review to a merger when adequate procedural protections are not in place for the minority stockholders. In a merger where the controlling stockholders maintain an interest in the surviving entity while the minority stockholders are cashed out, those adequate procedural protections must include a non-waivable affirmative vote by the majority of the minority stockholders. If these protections are missing, the Court will not apply the more discretionary business judgment standard to the merger.