M&A

Shareholder Suit Threatens Worldcom, May Set Precedent

A shareholder suit against targets of a WorldCom buyout may add a new wrinkle to corporate law.
Ed ZwirnDecember 22, 2000

A Delaware court has a case pending that may frustrate communications giant WorldCom in its attempt to expand through acquisition.

The case may also have the side effect of setting a significant precedent in corporate law.

WorldCom agreed to purchase Intermedia Communications, a Tampa-based firm that provides data services to business and government for $3.9 billion. The Sept. 1 deal contained one catch: Intermedia needed to persuade the board of Digex, a Web and applications hosting company in which it owns a majority stake, to give up certain protection it enjoyed against hostile takeovers under Delaware law.

However open they may be to legal interpretation, most of the ascertainable “facts” in the case are not under dispute.

For instance, nobody denies that WorldCom’s desire to purchase Intermedia was motivated entirely by its desire to own Digex. Indeed, WorldCom, which is already trumpeting Digex as the next key step in its “Generation D” strategy, promised the Justice Department last month that it would sell all Intermedia assets except Digex within six months of closing the deal, a necessary step toward obtaining regulatory approval.

Ay, There’s the Rub

So why didn’t WorldCom just buy Digex?

The answer is simple. That course of action would have been much more expensive. At the time Worldcom made its decision, Intermedia’s 52 percent stake in Digex alone was worth about $3.3 billion, while Intermedia itself had a market capitalization of nearly $1.2 billion.

So the decision was basically a no-brainer. Offer Intermedia shareholders a hefty premium for their shares, pocket the difference between the price of the Intermedia acquisition and the price they would have had to pay for Digex, and everybody walks away happy.

Well, not quite.

The catch is that there are, of course, other Digex shareholders -—albeit second- class shareholders–involved.

A Tale of Two Cities

Let’s backtrack for a moment. Intermedia purchased Digex, a Beltsville, Md. concern, in July 1997 for about $150 million in cash. Intermedia then sold shares of Digex in public offerings in July 1999 and February 2000.

This left Intermedia with a slim majority–52 percent–of Digex shares. But the arrangement left Intermedia with even more solid control; It was left holding all “Class B” shares, which have 10 votes each, as opposed to the Class A shares held by the public, which have only one vote apiece.

Intermedia, therefore, possesses more than 94 percent of Digex shareholder votes. Five out of seven Digex board members are also Intermedia board members.

This is where things stood in August, when both Digex and Intermedia, both their stock prices and funding options having eroded substantially in the wake of the Internet meltdown of the Spring of 2000, found themselves entertaining takeover bids.

There were, of course, other suitors, particularly for Digex, which had been outperforming Intermedia of late. The others include Exodus Communications, which reportedly offered $120 a share, and Global Crossing. WorldCom had also considered buying Digex directly, also for a reported $120 per share.

Talkin’ ‘Bout My Generation

But by Aug. 31, WorldCom CEO Bernard Ebbers announced his final decision in a phone call placed to Intermedia. Taking into account all relevant “collars” and ratios, the price tag turned out to be about $39 a share, a 70 percent premium relative to Intermedia’s market value at that time.

There was just one sticking point.

WorldCom wanted to integrate Digex into its “Generation D” version of the digital future as soon as possible. But in doing so, it would incur the risk of running afoul of Delaware General Corporate Law.

DGCL Section 203, which dates back to 1987, says an “interested shareholder” holding between 15 percent and 85 percent of a firm’s “voting stock” must wait for three years from the time he reaches that level of ownership before entering into a business combination with that firm unless he has received the approval of two-thirds of the other shareholders in the meantime.

In what both sides agree was a series of wee- hour telephone calls lasting through Sept. 1, the two sides–WorldCom and Intermedia– hammered out the particulars of the acquisition, eventually reaching a compromise on WorldCom’s insistence that the Digex board agree to waive its rights under Section 203.

By early morning, the two sides had agreed that Digex would only waive its 203 protection following the closing of the deal if it could get the approval of independent directors.

Since most of the Digex board had been kept informed of the negotiations through the night by virtue of their status as Intermedia directors, that left just one other step: telling the independent directors.

Independents Jack Reich and Richard Jalkut were notified of the arrangement at about 7 a.m. Sept. 1 and agreed to it later that morning.

Bring On The Lawyers

Given the interconnected aspects of the arrangement, it is hardly surprising that lawsuits alleging conflicts of interest began springing up shortly after the deal was announced to the public Sept. 5.

There were two basic thrusts to the cases put forth on behalf of the more than 8,000 Class “A” or public, shareholders.

One was that the Intermedia/Digex directors had abused their fiduciary obligation to represent both their companies and the interests of their individual shareholders. Those members of the Digex board who were also Intermedia board members had obvious conflicts of interest, the argument runs, and their approval of the WorldCom purchase of Intermedia rather than a direct WorldCom purchase of Digex, ran counter to the interests of both Digex and Digex’s public shareholders.

The other charge was that the Intermedia and Digex boards had acted improperly in engineering the Section 203 waiver, failing to meet the “entire fairness” standard by which such dealings are to be judged under Delaware law.

“As the Digex directors were well aware, the WorldCom proposal deprived Digex’s minority shareholders of any [emphasis in original] opportunity to obtain a premium for their shares; whereas other proposals on the table provided a premium for all of Digex’s shareholders,” read a brief presented to Delaware Chancery Court on behalf of plaintiff Marilyn Kalabsa and other class members by Rosenthal Monhait Gross & Goddess, a Delaware law firm.

The votes to approve the deal, the brief added, “represented an unfair self-dealing transaction, which benefited Digex’s controlling shareholder, Intermedia, at the expense of Digex’s minority shareholders.”

The attorneys representing defendants Intermedia and Digex and their directors denied, of course, that there had been any improprieties.

On Dec. 13, Chancery Court Judge William Chandler issued an opinion that gave both sides room to declare victory.

The shareholder suit was foiled on most of its counts. The ruling failed to find against the defendants on the conflict charges or take any action stopping the merger from going forward.

On the other hand, Chandler had harsh criticism for the way the defendants conducted themselves during the negotiations, particularly in regard to the Section 203 waiver.

“The trade put before the Digex board was simple: waive Section 203 and give up the protections granted by the terms of the statute in exchange for a stronger parent who had much to offer… and the end of the burdensome relationship with Intermedia,” Chandler wrote.

“Was this the best deal available?” the opinion asks rhetorically. “Because of the manner in which the negotiating process was handled, it is impossible to say.”

The bottom line: The ruling stated that the plaintiffs have a “reasonable probability of success on the merits of their Section 203 claim.”

In other words, the court wasn’t stopping WorldCom from proceeding with the acquisition, but serving notice that if it did so it would stand a good chance of being exposed to an unfavorable judgement, along with damages, on this charge.

But there’s another catch. Attorneys for the defendants as well as the judge acknowledge that Section 203 may not be applicable to this case.

The law as written applies to “interested shareholders,” or those holding between “15 percent and 85 percent of voting stock.” But is Intermedia an interested shareholder because it owns 52 percent of Digex voting stock or is it something else entirely because it commands 94.2 percent of the firm’s votes?

“Section 203 is kind of uncharted ground,” says Brian Gallagher, a Kronish Lieb partner representing Intermedia. “No one’s ever construed how the 85 percent works.”

“You could argue it one way or the other way,” he adds.

In the meantime, with neither of the involved parties having announced any change of plans, the stakes remain enormous.

Both WorldCom and Intermedia stocks took a nosedive shortly after the court ruling was announced and analysts quickly calculated worst-case estimates of possible damages ranging as high as $2.5 billion.

This, following a bad year for technology stocks, means bad news all around:

  • As of Dec. 20, WorldCom was trading at $15.19 versus a March high of more than $55.
  • Intermedia, which suffered the most from the ruling, was hovering above $5, versus a March 10 high of $77.38.
  • Digex, at $27.13, was much closer to its 52-week low of $21 than its March 10 high of $178.

Industry analysts argue that the firm badly needs success in the acquisition, both to foster its business plan by getting hold of Digex’s 3,000-plus Web servers and to burnish its deal reputation, which badly suffered after it backed away from its bid for Sprint earlier this year.

WorldCom spokesman Peter Luch refuses to say whether the firm was considering backing out of or renegotiating the Intermedia deal. He says that at this point the firm is still proceeding with the remaining regulatory approvals it needs to go forward, including endorsement from several states and the Federal Communications Commission.

He adds matter-of-factly, “We’ve already said that we expected to close within the first quarter.”