Litigation Prompted by Proposed BGE-PEPCO Merger Sheds Light on Important Issues of Corporate Law

In September 1995, Baltimore Gas and Electric Company ("BGE") and Potomac Electric Power Company ("PEPCO") announced that they had agreed to merge. More than two years later, in the wake of regulatory developments that had had an adverse impact on the proposed transaction, the boards of directors of the two corporations decided to terminate the merger agreement. Although the transaction was never consummated, it did give rise to litigation against the directors of BGE which shed light on three legal issues that are of critical importance to the directors of any corporation considering a negotiated merger. Since BGE is incorporated in Maryland, this litigation took place in the state courts of Maryland, where litigation of this sort is relatively rare. Ultimately, two of the three legal issues were addressed in one of the few published opinions that a Maryland appellate court has ever issued that relates to a merger of publicly traded companies.

Generally, judicial review of a decision by the board of directors of a corporation is governed by the Business Judgment Rule. Under the Business Judgment Rule, if certain preconditions are met, the court will not, except perhaps in extreme circumstances, substitute its judgment for the judgment of the board on the merits of the decision. The preconditions that must be met are that the board must have acted with due care when preparing itself to make the decision, and the board must have been free from self-interest. Put another way, the preconditions are that the board must have fulfilled its duty of care, and the board must have fulfilled its duty of loyalty.

Under the Business Judgment Rule, there is a presumption that these preconditions are met. Thus, when a shareholder asks a court to intervene, the burden is on him or her to plead facts which, if true, would support a reasonable inference that one or both of the preconditions are absent. Ordinarily, the court's role is confined to determining whether the pleading filed by the plaintiff meets this burden.

Even if the plaintiff ultimately establishes that the board breached its duty of care or that the board breached its duty of loyalty, that is not the end of the matter. Rather, the burden is then placed on the proponents of the challenged transaction to show that it was entirely fair to the corporation and its shareholders.

In many formulations of the Business Judgment Rule, the prohibition on second guessing the merits of the board's decision is absolute. If the plaintiff fails to establish that the directors breached their duty of care or breached their duty of loyalty, that is the end of the matter. In some formulations, however, the court retains a residual power to overturn a decision in extreme circumstances. Specifically, according to these formulations, the court retains a residual power to overturn a decision that it believes was so wrong on the merits that it amounted to fraud or a waste of corporate assets.

The deference afforded by the Business Judgment and the lack of deference inherent in the Entire Fairness Test are not the only alternatives. In certain circumstances, the Delaware courts have also adopted an intermediate level of scrutiny. This intermediate level of scrutiny is applied, for example, when a board of directors implements a defensive strategy (e.g., adopts a "poison pill" rights plan) in the face of a threat to the board's control of the corporation. Under this intermediate level of scrutiny, the presumption that is ordinarily part of the Business Judgment Rule is not applied. Rather, the burden is placed on the directors to show that they used due care and that their primary motive was a legitimate one, rather than self-interest. Even after the directors carry their initial burden, the court will subject the transaction to its own judgment in the limited sense that it will inquire whether the corporate action was reasonably calculated to achieve the goal that primarily motivated the board.

The litigation prompted by the announcement of the proposed merger between BGE and PEPCO raised three legal issues.

The Board had no Revlon Duties

The first of these issues was whether, in connection with the proposed transaction with PEPCO, the board of directors of BGE had an obligation to maximize immediate, short-term value for its shareholders, as opposed to selecting the merger partner that it believed represented the best long-term fit. A board of directors that has an obligation to maximize immediate, short-term value is commonly said to be subject to "Revlon duties." The phrase takes its name from a 1986 decision by the Supreme Court of Delaware in which the obligation was first articulated. When Revlon is applicable, the board of directors is required to conduct an auction of the company or some equivalent process to provide assurance that the company is being sold for the best available price, and a court will subject the board's conduct to intermediate scrutiny of the type described above.

In the litigation challenging the BGE-PEPCO transaction, a BGE shareholder contended that the board of directors of BGE had been required to fulfill "Revlon duties." The defendants pointed out that there is no published opinion by a Maryland appellate court adopting Revlon as the law of Maryland. More importantly, the defendants argued that, even in Delaware, Revlon would not be applicable to the proposed transaction between BGE and PEPCO because it was a stock-for-stock transaction in which the former shareholders of BGE would become shareholders of the combined entity, which would be a widely held public company.

In making this argument, the defendants relied on Arnold v. Society for Savings Bancorp, a 1994 decision in which the Supreme Court of Delaware held that Revlon was inapplicable to a particular stock-for-stock merger. In Arnold, the court identified three scenarios in which Revlon is applicable: (1) when a corporation initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a break-up of the company, (2) when, in response to a bidder's offer, a target abandons its long-term strategy and seeks an alternative transaction involving a break-up of the company, or (3) when the board proposes a transaction that would result in a sale or change in control of the company. It was clear in both the transaction that was before the court in Arnold and in the proposed BGE-PEPCO transaction that the board had not initiated an active bidding process to sell itself or to effect a business reorganization involving a break-up of the company. Nor had the board in either instance responded to an offer by abandoning its long-term strategy and seeking an alternative transaction involving a break-up of the company. Rather, in Arnold, the plaintiff's primary argument for applying Revlon was that the exchange of stock in the old entity for stock in the new entity constituted a sale or change in control. Apparently, that was also the plaintiff's position in the first complaint filed to challenge the proposed transaction between BGE and PEPCO.

In Arnold, however, the Supreme Court of Delaware explicitly rejected that argument. The court reasoned that control of both the pre-merger company and the post-merger company remained in a "large, fluid, changeable and changing market." In so doing, the court explicitly distinguished its well known 1994 decision in Paramount Communications v. QVC Network. In QVC, there had been a pre-merger entity controlled by a fluid aggregation of unaffiliated stockholders, but the post-merger entity was to have been controlled by a single majority stockholder. In light of this change in control, the QVC court had subjected the transaction to intermediate scrutiny and required the board to "shop" the company.

In the litigation challenging the proposed transaction between BGE and PEPCO, the defendants argued that Revlon is only applicable when the shareholders are being "cashed out." Shareholders are "cashed out" when their ongoing equity participation in the business venture is terminated in return for a payment of cash or debt securities, or, as in QVC, when they are otherwise losing forever their opportunity to receive a control premium. It is only in these contexts that it is appropriate for a board to forget long-term considerations and to focus on short-term gain to the exclusion of all else.

The defendants argued that the BGE-PEPCO transaction, in which the shareholders of each entity would have exchanged their shares for shares in a new, consolidated entity, was legally indistinguishable from the one in Arnold. BGE currently is owned, and the post-merger entity would have been owned, by thousands of shareholders. Control of BGE rests, and control of the post-merger entity would have rested, in a large, fluid, changeable and changing market. No single shareholder or group of shareholders controls BGE, and there was no allegation in the complaint that any single shareholder or group of shareholders would take control as a result of the proposed transaction. BGE's stockholders would still have been full equity participants in the venture, only in a larger pool of owners. In Arnold, the Supreme Court of Delaware explicitly rejected the argument that there was a sale or change in control of a company simply because its former stockholders were relegated to minority status in the post-transaction entity. If anything, the defendants' position was even stronger in the litigation challenging the proposed transaction between BGE and PEPCO, because former BGE shareholders would have owned a majority of the shares in the combined entity.

In response to the defendants' motion to dismiss her Revlon claim, the shareholder who was challenging the proposed transaction between BGE and PEPCO surrendered. She simply amended her complaint and dropped the claim without comment. While there was no judicial ruling on the plaintiff's Revlon claim, the plaintiff's surrender can be read as a clear admission that the defendants' arguments were correct.

Retaining a Seat on the New Company's Board did not Taint Approval of the Transaction

The second of the legal issues considered in the BGE litigation was whether the fact that some of BGE's directors were to retain their positions with the successor entity meant that their approval of the proposed transaction was self-interested. The merger agreement provided that BGE's two inside directors, who were its top two executives, were to become senior officers and directors of the successor entity. The agreement also provided that seven of BGE's twelve outside directors were to be on the board of the successor entity.

The plaintiff argued that, because each of the directors had at least a chance of being a director of the successor entity, they all had a disqualifying personal interest in the transaction. According to the plaintiff, the directors had disregarded the best interests of BGE's shareholders because they were tantalized by the prospect of serving on the board of a bigger, more prestigious company. The defendants argued that, because five of the twelve outside directors would lose their seats in the transaction, the personal interest of an outside director, if there were one, would have been to vote against the proposed transaction. More importantly, the defendants argued that, even if every member of BGE's board had been slated to retain his or her position with the successor entity, that would not have been a disqualifying personal interest. The last thing the courts should do is disqualify a director who is striving to be the director of a bigger, more prestigious company. Indeed, that is precisely what corporate law should incentivize directors to do.

The trial court agreed with the defendants, dismissing the plaintiff's complaint for failure to state a claim upon which relief could be granted. In a published opinion released on March 27, 1998, the Court of Special Appeals of Maryland affirmed. "The fact that many of the appellees were likely to become directors of the new corporation," the appellate court held, "did not justify judicial intervention. Appellant is unable to overcome the presumption that appellees acted in good faith and in the best interests of the corporation."

Informed Shareholder Vote Extinguishes Claims of Directors' Breach of Duty

The third of the legal issues considered in the BGE litigation was whether the plaintiff's claim could survive an informed vote by BGE's shareholders approving the proposed transaction. This issue was potentially dispositive of the plaintiff's action. The trial court held that the proxy statement that BGE disseminated to its shareholders was complete and accurate, and the plaintiff did not challenge that ruling on appeal. After receiving the proxy statement, more than 97 percent of the BGE's shareholders who appeared at the meeting in person or by proxy voted in favor of the proposed transaction.

Under Delaware law, an informed shareholder vote in favor of a transaction completely extinguishes any claim that the directors breached their duty of care. In Delaware, however, there is a recent decision by the Chancery Court holding that such a vote does not completely extinguish a claim that the directors breached their duty of loyalty (i.e., that their approval of the proposed transaction was self-interested). In that decision, In re Wheelabrator Technologies, the court held that, even after an informed shareholder vote in favor of the transaction, the plaintiff can attempt to persuade the court that the board's decision was so wrong on the merits that it amounted to fraud or a waste of corporate assets. Given the difficulty of persuading the court of such a thing, one might question why the extinquishment issue is important. It is important because, in litigation challenging a major corporate decision, any claim that survives a motion to dismiss acquires meaningful settlement value simply because of the ability of individual plaintiffs to impose a huge and largely one-sided discovery burden on the corporation. Therefore, the adoption of any legal doctrine that provides a bright-line rule for disposing of such cases without engaging in discovery is an important development.

In the litigation challenging the BGE-PEPCO transaction, the trial court declined to reach this issue. Given that it had concluded that the plaintiff had failed to state a claim upon which relief could be granted, the court chose not to address the issue of whether the informed shareholder vote would have extinguished such a claim. The Court of Special Appeals could have done the same. In the published opinion that it recently released, however, it chose to address the issue. After noting that the plaintiff argued that breaches of the duty of loyalty cannot be ratified by a shareholder vote, the appellate court held that there was "no merit in this argument. . . . We are persuaded that everything about which appellant complains could be, and was, ratified by a stockholder vote that occurred after a full and fair disclosure to the stockholders."

¹ David Clarke is the head of the Securities and Business Litigation Practice Group at Piper & Marbury. He was lead counsel for BGE and its directors in this case.