The Delaware Chancery Court Finds That an Unfair Process Resulted in a Fair Price
A recent Delaware Court of Chancery post-trial decision, In re Straight Path Communications, is another example of:
- “fair price” immunizing “unfair process” in the “entire fairness” analysis, and
- the importance of abiding by contractual notice provisions.
Despite finding that a controlling stockholder had engaged in a “flagrant[ly]” unfair process by “bullying” a committee of independent and disinterested directors into a transaction, the Chancery Court awarded only nominal damages (often a symbolic judgment of $1 plus attorneys’ fees) because the transaction price was deemed fair due to a series of events involving a company’s fraudulent scheme to deceive the FCC and an affiliate’s subsequent failure to provide adequate notice under an indemnification agreement. However, but for that series of events, the court appeared poised to enter a significant judgment against the controller due to his inequitable conduct. So, while the controller may have prevailed in the end, this case also illustrates the importance of the fair process element.
In 2013, telecommunications firm IDT Corporation created a spin-off company, Straight Path Communications, to hold certain of IDT’s intellectual property assets. Both IDT and Straight Path are publicly traded and controlled by Howard Jonas. The spin-off agreement provided that IDT would indemnify Straight Path for third-party claims arising from conduct occurring prior to the spin-off, so long as Straight Path provided IDT with written notice of the claim and its intention to seek indemnification from IDT.
For tax purposes, IDT also transferred a portfolio of broadband spectrum licenses to Straight Path in the spin-off transaction. These licenses were considered worthless at the time. Prior to the spin-off, IDT had to renew the licenses with the FCC, which required IDT to demonstrate that it can broadcast over the spectrum. Rather than construct permanent transmission equipment at each site, an IDT engineer would “obtain access to suitable rooftops, sometimes through bribes, where he would set up a homemade radio transmitter he built for $450,” create evidence of a “broadcast,” and then move the transmitter to the next site. IDT’s FCC filings deceptively conveyed a “present-tense” ability to broadcast from its transmission sites, such as claiming that a particular site “provides fixed wireless coverage” to more than a million individuals. The ruse worked; the FCC renewed the licenses.
By 2015, the once-worthless spectrum licenses had become a coveted part of future 5G cell networks, causing Straight Path’s stock price to skyrocket. However, an anonymous short seller published a report revealing that IDT had “likely committed over 150+ counts of fraud against the US government” because its transmission equipment was “never built on the sites as specified in the filings.” Straight Path’s stock price immediately plunged over 50%, and the FCC later launched an investigation. By then, Straight Path had begun to receive unsolicited attention from telecommunications giants who were interested in purchasing the licenses, but it was clear that maximizing the return in any sale would be dependent on resolving the open FCC investigation. IDT was well-aware of the FCC investigation: it was a target of the investigation, shared counsel with Straight Path, and both companies were run by Jonas family members. Nevertheless, Straight Path did not provide IDT with formal written notice of its intent to seek indemnification, as called for under the parties’ agreement. Straight Path eventually settled with the FCC for $15 million plus 20% of the proceeds from any sale of the licenses.
After the FCC settlement, Straight Path formed a Special Committee to pursue a sale of the company. The Special Committee determined to exclude an indemnification claim against IDT from any potential sale and instead preserve it in a litigation trust for the benefit of its shareholders. When Jonas learned of this determination, he called members of the Special Committee dozens of times, threatening personal reprisals, “verbally abus[ing]” them, and making it clear that he would withhold his support for any sale (and remove them from the board) unless the indemnification claim was immediately resolved to his satisfaction. Seeing no other path forward, the Special Committee agreed to Jonas’s offer of a $10 million settlement for the indemnity claim, even though a successful indemnity claim would have obligated IDT to pay Straight Path nearly $300 million. Having cleared this hurdle necessary to gain the controller’s support for a transaction, Straight Path was ultimately sold to Verizon for $3.1 billion following an intense bidding war with AT&T. Despite receiving a 400% premium in the sale transaction, multiple shareholders brought claims arising from the settlement of the indemnification claim and proceeded to trial against Jonas.
Jonas conceded that, given his controlling interest in both IDT and Straight Path, he bore the burden of establishing that the indemnity settlement was entirely fair to Straight Path’s minority shareholders. Delaware’s entire fairness test includes a “fair process” and a “fair price” component.
- Unfair process: The court first determined that the settlement agreement was reached via a fundamentally unfair process. As the court marveled: “This Court is frequently asked to make findings of controller overreach based on only circumstantial evidence, cryptic communications, or inference. This is not one of those cases. Here, [Jonas] made every effort to bully the Special Committee towards his desired outcome.” The court held that Jonas’s “campaign of abuse and coercion led the Special Committee to reasonably conclude that it had to settle the Indemnification Claim on [Jonas’s] terms or risk an even less favorable outcome for the Company,” resulting in a “flagrant[ly]” unfair process.
- Fair price: The court determined, however, that the price Jonas “bullied” the Special Committee into accepting was fair to Straight Path’s minority shareholders because the indemnification claim was “of no economic value” due to Straight Path’s failure to follow the notice requirements contained in the parties’ agreement. While IDT was unquestionably aware of the FCC investigation and its potential indemnity obligations with respect to that investigation, Straight Path had failed to take the additional step of formally declaring its intention to seek indemnification from IDT prior to settling with the FCC. The agreement had standard language stating that the failure to adhere to the notice requirement “shall not relieve [IDT] of its obligations . . . except to the extent such a failure materially prejudices IDT”; however, the court held that IDT was materially prejudiced. The court reasoned that IDT would not have consented to a settlement with the FCC that ultimately required payment of nearly $300 million (which exceeded IDT’s liquidation value) had Straight Path provided advance notice of its intention to seek reimbursement of this amount from IDT.
The court noted that “a fair price ‘does not ameliorate a process that was beyond unfair’” and “[b]oth aspects of the entire fairness test — fair dealing and fair price — must be satisfied.” Therefore, the court held that the settlement was not entirely fair, resulting in liability to Jonas.
However, the court’s damages analysis made this a symbolic victory for stockholders. To set damages, the court assessed whether the Special Committee would have reasonably been able to obtain more than $10 million for the indemnification claim in “an arms-length settlement” with no interference from Jonas. Applying precedent established in Bomarko, Inc. v. Int’l Telecharge, Inc., 794 A.2d 1161 (Del. Ch. 1999), the court took the gross value of the indemnification claim (i.e., the total FCC fine of nearly $300 million) and made downward adjustments for the costs of litigating an indemnity claim and a probabilistic analysis based on whether Straight Path would have likely overcome various “claim-dispositive hurdles to collection.” For instance, the court found that Straight Path had only a 20% chance of surviving a summary judgment motion on the indemnity notice issue alone. By multiplying various such probabilities together, the court ultimately determined that Straight Path would have stood a mere 3.2% chance of success in seeking indemnity from IDT, reducing Straight Path’s net expected recovery to $8.3 million. The court determined that the $10 million settlement amount was therefore fair to the minority shareholders and resulted in no damages. Thus, the court awarded stockholders only nominal damages for Jonas’s breach.
In re Straight Path makes it increasingly clear that Delaware courts will carefully evaluate the merits of a transaction before awarding damages, even when process flaws result in a breach of duties. The court’s finding of no damages is the latest in a line of recent Delaware post-trial decisions prioritizing “fair price” to immunize an “unfair process.” For example, in In re Tesla Motors, Inc. Stockholder Litigation, 2022 WL 1237185 (Del. Ch. Apr. 27, 2022), aff’d, 298 A.3d 667 (Del. 2023), the court found that Tesla’s acquisition of Solar City, both of which were alleged to be controlled by Elon Musk, was fair even though no special committee was formed, “the process employed by the Tesla board to negotiate and ultimately recommend the acquisition was far from perfect,” and Musk “was more involved in the process than a conflicted fiduciary should be.” Similarly, in In re BGC Partners, Inc. Derivative Litigation, 2022 WL 3581641 (Del. Ch. Aug. 19, 2022), the court found the combination of two companies with a common controller was entirely fair, despite identifying numerous substantial process flaws. Likewise, in Dieckman v. Regency GP LP, 2021 WL 537325 (Del. Ch. Feb. 15, 2021), aff’d, 264 A.3d 641 (Del. 2021), the court held that the challenged merger “was fair and reasonable to the Partnership” despite a process that was “less than ideal,” primarily because one of the members of Regency’s conflicts committee was himself conflicted. Finally, in In re Energy Transfer Equity LP Unitholder Litigation, 2018 WL 2254706 (Del. Ch. May 17, 2018), aff’d, 223 A.3d 97 (Del. 2019), the court held that directors had unfairly added “downside risk” protection to an otherwise fair securities offering, but because the potential downside never occurred (and thus, the protective provision was never triggered), the unfair provision did not cause any harm. In each of those cases, as in In re Straight Path, the court’s determination hinged on a finding that the process flaws did not “infect” the price obtained.
In re Straight Path and these other recent decisions demonstrate that all is not lost for defendants in entire fairness cases presenting significant process flaws, provided that the economic terms of the transaction can be justified. Nevertheless, companies and their directors and officers planning potentially conflicted transactions should not be dismissive of the importance of a good process based on these decisions. First, these recent defense victories came post-trial, with all of the attendant expenses and uncertainties. A good process can in some circumstances spare defendants this ordeal. Second, despite these recent decisions, a court is likely to deem a good process as evidence of a fair price, and to be more deferential to defendants on the price component of the analysis. In contrast, in cases involving an unfair process, a court is likely to view defendants’ price evidence with a jaundiced eye and, as a result of the process issues, would likely be more willing to assess significant damages.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.