On November 6, 2014, Vice Chancellor J. Travis Laster approved the settlement of an action brought by public shareholders of ArthroCare Corporation (“ArthroCare” or the “Company”) challenging a proposed merger with Smith & Nephew.
The settlement provided for a $12 million payment to be distributed to ArthroCare’s public stockholders as of the closing date of the transaction. A monetary recovery of this size is unusual in merger litigation, especially when the merger is an arm’s-length transaction between unrelated entities. Here, however, Kessler Topaz and its co-lead counsel presented a novel claim for relief, and were then able to convince the acquirer to settle on favorable terms to the class just before a scheduled trial on the merits of that claim.
ArthroCare was a medical device manufacturer based in Austin, Texas. In 2009, One Equity Partners (“OEP”), the private equity subsidiary of J.P. Morgan Chase & Co. (“JPM”), purchased $75 million of ArthroCare preferred stock, becoming its largest stockholder, with more than 15% of the Company’s voting power. As part of that transaction, two OEP managing directors joined ArthroCare’s Board of Directors (the “Board”). The transaction included several “standstill” restrictions, including a prohibition on OEP (or OEP affiliates possessing confidential information about ArthroCare) assisting with any merger involving ArthroCare without the Board’s prior consent.
Despite this restriction, in the course of its role as an advisor to Smith & Nephew, a British-based multinational medical equipment manufacturer, J.P. Morgan Securities LLC (“J.P. Morgan Securities”), another JPM subsidiary, recommended that Smith & Nephew consider acquiring ArthroCare. This advice directly benefited JPM. In addition to receiving advisory and financing fees from the proposed transaction, the deal would help facilitate JPM’s plan to ei­ther sell OEP or spin it out as an independent company. OEP was struggling to raise money for new investments and JPM had trouble finding a buyer at its asking price, but the liq­uidation of OEP’s investment in ArthroCare would help to finance a spin-out.
This was particularly important because OEP’s Arthro­care investment was about to become significantly less liq­uid. On December 31, 2013, after extensive negotiations, ArthroCare entered into a deferred prosecution agreement with the U.S. Department of Justice, agreeing to pay a $30 million fine to end an investigation into its past account­ing practices. As a result of the agreement, OEP’s preferred stock in ArthroCare was automatically converted into com­mon stock, which meant that OEP would no longer receive pay-in-kind dividends and could not liquidate its stake in the Company without incurring substantial costs. JPM knew throughout the negotiation of the deferred prosecution agreement that this would be a likely component of any deal with the Department of Justice. An acquisition would give OEP an opportunity to liquidate its ArthroCare investment despite this new issue.
In October 2013, Smith & Nephew approached Arthro­Care about a possible merger. On December 10, 2013, that became a formal offer to acquire ArthroCare for $43.00 per share, and on December 26, the Board granted Smith & Nephew exclusive negotiations through January 21 at a price of $46.00 per share, a 16% premium to ArthroCare’s share price at the time.
However, after ArthroCare announced its entry into the deferred prosecution agreement on December 31, its stock jumped more than 10%, to $46.57. But rather than using the jump as an opportunity to shop the Company to oth­er potential acquirers and potentially obtain a better price, the Board continued to negotiate exclusively with Smith & Nephew. On February 1, 2014, Smith & Nephew increased its offer to $48.25 per share, which ArthroCare accepted. The next day, the companies entered into an agreement and plan of merger (the “Merger Agreement”), and Smith & Neph­ew entered into voting agreements with OEP as well as the members of the Board.
Kessler Topaz and its Delaware co-counsel brought suit in the Delaware Court of Chancery (the “Court”) on behalf of two ArthroCare stockholders. The complaint alleged that the sale process was flawed, that the price was inadequate, and that ArthroCare’s preliminary proxy statement soliciting support for the transaction contained inadequate and mis­leading disclosures.
The complaint also alleged that J.P. Morgan Securities’ role made its client, Smith & Nephew, an “interested stock­holder” within the meaning of Section 203 of Title 8 of the Delaware Code. Section 203 prohibits corporations from engaging in business combinations with an interested stock­holder (defined as the owner of 15% of a company’s voting stock, or an “affiliate” that is controlled by or controls the owner or is under the common control of a third party as the owner) for a period of 3 years from the time that the stock­holder becomes an interested stockholder without the prior approval of the corporation’s board unless 2/3 of holders of unaffiliated stock vote for the transaction. Kessler Topaz ar­gued that OEP’s affiliation with J.P. Morgan Securities sub­jected J.P. Morgan Securities to Section 203, and, likewise, J.P. Morgan Securities’ relationship with Smith & Nephew meant that the law would also cover Smith & Nephew. Since the ArthroCare Board did not approve a merger with an in­terested stockholder in advance and the Merger Agreement did not provide for an unaffiliated stockholder vote, the deal would violate Section 203. Kessler Topaz also alleged that JPM violated the standstill provisions of OEP’s 2009 invest­ment in ArthroCare by having one of its subsidiaries finance the transaction while another entered into a voting agree­ment with Smith & Nephew.
On March 21, the Court ordered a two-day trial on the merits of the Section 203 claim, as well as a hearing on a preliminary injunction based on plaintiffs’ other claims, to be held on April 28 and 29. Kessler Topaz then engaged in expedited discovery as well as extensive preparation for the preliminary injunction brief and trial, including working with financial experts to properly analyze the transaction.
The question of whether Smith & Nephew’s relationship with J.P. Morgan Securities would make it an “interested stockholder” of ArthroCare and therefore subject to Sec­tion 203 was a novel one in the Delaware Court of Chan­cery. Plaintiffs’ counsel recognized that while a favorable ruling from the Court could provide additional protection for shareholders, it could also effectively prevent Arthro­Care’s Board from consummating any deal, including one more favorable to the stockholders. There was also a risk that the Court would rule in the defendants’ favor. In recog­nition of these risks, in late March 2014, plaintiffs’ counsel began settlement negotiations to obtain a financial recov­ery that would fairly compensate ArthroCare’s unaffiliated shareholders for their stock. After several weeks of intense negotiations and nineteen days before the scheduled trial, on April 9, 2014, the parties agreed to a settlement that re­quired defendants to pay $12 million into a fund solely for the benefit of the class.
The settlement was approved on November 6, 2014. The Court described the novel Section 203 claim as particularly strong and recognized that Kessler Topaz and its co-coun­sel’s creativity in pressing the theory had managed to create significant additional value for stockholders.