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OTK Associates, LLC v. Friedman

Court of Chancery of Delaware

February 5, 2014

OTK ASSOCIATES, LLC, directly on its own behalf and derivatively on behalf of Morgans Hotel Group Co., Plaintiff,
v.
Robert FRIEDMAN, Thomas L. Harrison, Michael D. Malone, Michael J. Gross, Ronald W. Burkle, Jeffrey M. Gault, Andrew Sasson, Yucaipa American Alliance Fund II, L.P., Yucaipa American Alliance (Parallel) Fund II, L.P., Yucaipa Aggregator Holdings, LLC, and The Yucaipa Companies LLC, Defendants, and Morgans Hotel Group Co., Nominal Defendant.

Submitted: Nov. 14, 2013.

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David J. Margules, Joel Friedlander, Albert J. Carroll, Jaclyn Levy, Bouchard Margules & Friedlander, P.A., Wilmington, Delaware; Peter J. Welsh, Jesse M. Boodoo, Aliza F. Goren, Ropes & Gray LLP, Boston, Massachusetts; Attorneys for Plaintiff.

Kenneth J. Nachbar, Shannon E. German, Morris, Nichols, Arsht & Tunnell LLP, Wilmington, Delaware; Greg A. Danilow, John A. Neuwirth, Stefania D. Venezia, Matthew S. Connors, Weil, Gotshal & Manges LLP, New York, New York; Attorneys for Defendant Robert Friedman.

Edmond D. Johnson, James G. McMillan, III, Pepper Hamilton LLP, Wilmington, Delaware; William A. Brewer III, Catherine Pastrikos, Bickel & Brewer, New York, New York; Attorneys for Defendant Thomas L. Harrison.

Richard D. Heins, Toni-Ann Platia, Ashby & Geddes, P.A., Wilmington, Delaware; Irving M. Brenner, William O.L. Hutchinson, R. Locke Beatty, McGuirewoods LLP, Charlotte, North Carolina; Attorneys for Defendant Michael D. Malone.

Collins J. Seitz, Jr., David E. Ross, Eric D. Selden, Seitz Ross Aronstam & Moritz LLP, Wilmington, Delaware; Attorneys for Defendants Michael J. Gross and Andrew Sasson.

Stephen B. Brauerman, Vanessa R. Tiradentes, Sara E. Bussiere, Bayard, P.A., Wilmington, Delaware; Robert L. Clarkson, Clarkson/Riley, LLP, Los Angeles, California; Attorneys for Defendant Jeffrey M. Gault.

Bruce L. Silverstein, Kathaleen St. J. McCormick, James M. Yoch, Jr., Nicholas J. Rohrer, Paul J. Loughman, Young Conaway Stargatt & Taylor, LLP, Wilmington, Delaware; George M. Garvey, Mark H. Epstein, Munger Tolles & Olson, Los Angeles, California; Attorneys for Defendants Ronald W. Burkle, Yucaipa American Alliance Fund II, L.P., Yucaipa American Alliance (Parallel) Fund II, L.P., Yucaipa Aggregator Holdings, LLC, and The Yucaipa Companies LLC.

Michael A. Pittenger, Timothy R. Dudderar, T. Brad Davey, Matthew F. Davis, Ryan T. Costa, Potter Anderson & Corroon LLP, Wilmington, Delaware; Attorneys for Nominal Defendant Morgans Hotel Group Co.

OPINION

LASTER, Vice Chancellor.

In March 2013, the board of directors (the " Board" ) of Morgans Hotel Group Co. (" Morgans" or the " Company" ) approved a two-part recapitalization involving The Yucaipa Companies, LLC (" Yucaipa" ), an entity controlled by prominent investor Ronald W. Burkle. Despite not owning a mathematical majority of the Company's common stock, Yucaipa held a combination of securities and contract rights that, together with Yucaipa's board representation and close relationships with management, gave Yucaipa effective control over Morgans. In the recapitalization, Morgans would transfer to Yucaipa two of its major assets in exchange for the Morgans securities that Yucaipa then held. Meanwhile, Yucaipa would backstop a $100 million rights offering at a substantial premium over the Company's market price. Yucaipa's financial advisor believed that by purchasing rights through the backstop, Yucaipa could acquire approximately 35% of Morgans's common stock and maintain its effective control.

Director Jason Taubman Kalisman, who voted against the recapitalization, and stockholder plaintiff OTK Associates, LLC obtained a preliminary injunction that temporarily

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blocked the recapitalization. Yucaipa then sent the Company a letter stating " we have no transaction to date" and proposing additional terms. One month later, the Company's stockholders elected a slate of directors nominated by OTK. OTK subsequently filed a Second Verified Amended and Supplemental Complaint (the " Complaint" ) without Kalisman as a co-plaintiff.

In the Complaint, OTK alleges that Yucaipa, three affiliated entities, Burkle, and the directors who approved the recapitalization breached their fiduciary duties, aided and abetted breaches of fiduciary duties, and engaged in other acts of wrongdoing when pursuing and approving the recapitalization. Counts I-VIII of the Complaint seek to recover from the defendants the damages that the Company suffered, including expenses such as legal and advisory fees and any termination fee that the Company may owe Yucaipa. Count IX of the Complaint seeks a declaration that the agreements governing the recapitalization are invalid.

Yucaipa, its affiliated entities, and five of the individual defendant have moved to dismiss Counts I-VIII as moot. Yucaipa and its affiliated entities have moved to dismiss Count IX in favor of an action they filed in New York and pursuant to Rule 23.1 for lack of pre-suit demand. Two of the defendant directors, Michael D. Malone and Jeffrey M. Gault, have moved for judgment in their favor on the grounds that the Company's certificate of incorporation contains an exculpatory provision authorized by Section 102(b)(7) of the Delaware General Corporation Law (the " DGCL" ), 8 Del. C. ยง 102(b)(7), and they only could have breached their duty of care.

Because OTK can recover damages on Morgans's behalf, Counts I-VIII are not moot, and the motion to dismiss on that basis is denied. Count IX is dismissed pursuant to Rule 23.1 to the extent it contends that Yucaipa and its affiliates repudiated the transaction agreements. Otherwise, the motion to dismiss Count IX is denied. Both Malone's and Gault's motions to dismiss in reliance on the exculpatory provision are denied. Given the allegations in the Complaint and the applicable standard of review, which is entire fairness, the court cannot apply the exculpatory provision summarily at the pleadings stage to enter judgment in their favor.

I. FACTUAL BACKGROUND

The facts are drawn from the Complaint and the documents it incorporates by reference. At this stage of the case, the Complaint's allegations are assumed to be true, and the plaintiff receives the benefit of all reasonable inferences. In short, the facts as recited represent the plaintiff's side of the story. In this case, however, the plaintiff's allegations are quite detailed, because in preparing the Complaint, the plaintiff benefitted from expedited discovery obtained during the injunctive phase of the case. Many of the Complaint's allegations quote from, paraphrase, or refer to deposition testimony or documentary evidence.

A. Morgans And Yucaipa

Nominal defendant Morgans is a Delaware corporation with its principal place of business in New York, New York. Its common stock trades on the NASDAQ under the symbol " MHGC." Morgans describes itself as a fully integrated lifestyle hospitality company that owns and operates boutique hotels. Its primary assets include the Delano brand, best known for the iconic Delano Hotel located in Miami Beach, Florida, and The Light Group, a food and beverage service that develops,

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redevelops, and operates venues primarily in Las Vegas.

Defendant Yucaipa is a Delaware limited liability company headquartered in Los Angeles, California. Defendant Burkle controls Yucaipa. Through two affiliated investment funds (the " Yucaipa Funds" ), Yucaipa exercises significant influence over Morgans. For purposes of this motion, Yucaipa is assumed to wield effective control over Morgans.

Yucaipa's control over Morgans stems from a combination of holdings at multiple levels of Morgans's capital structure, a web of contractual rights, board representation, and close relationships with management and certain directors. Yucaipa owns 51% of the Company's senior subordinated notes (the " Notes" ), a position with a face value of $88 million. The Notes come due in October 2014. Beginning in July 2014, Yucaipa can convert the Notes into shares of common stock. Yucaipa also owns 100% of the Company's Series A preferred stock (the " Series A Preferred" ), whose terms give Yucaipa blocking rights over various transactions, including the ability to veto a sale of all or substantially all of the Company's assets and other transactions where a vote of the Series A Preferred is required by law or the Company's certificate of incorporation. On top of this, Yucaipa owns warrants to purchase 12.5 million shares of the Company's common stock. Pursuant to a securities purchase agreement, Yucaipa has contractual blocking rights that give it the power to veto (i) a sale of substantially all of the Company's assets to a third party, (ii) the acquisition of the Company by a third party, (iii) any acquisition by the Company of a third party that involves an equity investment of $100 million or greater, and (iv) any change in the number of directors to more than nine or less than seven. Yucaipa also has the right to appoint one person to the Board, which Yucaipa has used to make Burkle a director. This right gives Yucaipa access to board-level information about the Company.

B. Morgans Considers A Possible Restructuring.

In fall 2011, Morgans management began considering how Morgans might restructure Yucaipa's investment. In December 2011, management briefed the Board on a potential transaction, and the Board resolved to form a special committee (the " Special Committee" ) to consider it.

The directors at the time were Burkle, Kalisman, Malone, Gault, Michael J. Gross, Andrew Sasson, Robert Friedman, Thomas L. Harrison, Edwin L. Knetzger, III, and David T. Hamamoto. Of those, Burkle, Malone, Gault, Gross, Sasson, Friedman, and Harrison are defendants in this action. Knetzger left the Board in May 2012, and Hamamoto resigned in November 2012, before the events giving rise to OTK's claims.

For purposes of a transaction with Yucaipa, Burkle had an obvious conflict of interest. Gross had worked for Yucaipa from 2008 to 2011 sourcing opportunities for various Yucaipa investment funds. He joined the Board in October 2009 as Yucaipa's nominee, and in March 2011, he became the Company's CEO. Gault was described in an email by Yucaipa's financial advisor as " essentially one of [Burkle's] Directors." In January 2012, Gault would become the President and CEO of a Yucaipa portfolio company. Sasson not only had ties to Burkle, but also founded The Light Group, one of the Morgans assets that would be involved in the recapitalization. At the time, Morgans owned 90% of The Light Group and Sasson owned 5%. Company counsel explained in an email that Sasson owed Burkle, because Burkle

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had " leaned on Morgans" to buy The Light Group and " bail out Sasson," and it was at " Burkle's insistence" that Sasson was put on the Board. Kalisman, Malone, Friedman, Harrison, Knetzger, and Hamamoto did not have readily identifiable ties to Yucaipa. With the exception of Hamamoto, they became the initial members of the Special Committee.

The resolutions authorizing the Special Committee stated that it was created for the purpose of " considering the Potential Transaction." The resolutions defined the Potential Transaction as " a transaction ... relating to the securities of the Company owned by Yucaipa funds, which are affiliated with Ron Burkle." The resolutions granted the Special Committee " the full power of the Board to evaluate, and to discuss and negotiate, the Potential Transaction with Mr. Burkle and representatives of the Yucaipa funds." The resolutions were silent on the Special Committee's authorization to explore other alternatives or transactions falling outside the definition of a Potential Transaction. The members of the Special Committee believed that their mandate was limited to considering a potential transaction involving Yucaipa such that they had only two options: " figure out a way to do the deal" that Yucaipa wanted, or " say no."

The Special Committee designated Malone to be its lead negotiator. By February 2012, the discussions with Yucaipa had reached an impasse.

C. The Base Plan

With the Yucaipa transaction on hold, Morgans decided to evaluate its strategic alternatives. The Special Committee continued to meet, and in May 2012, the committee retained Greenhill and Co., Inc. as its financial advisor. The Special Committee asked Greenhill to develop alternatives to de-lever the Company's balance sheet. In June 2012, Greenhill presented its plan, denominated the " Base Plan." The Special Committee viewed this step as falling within its mandate because the Company needed an alternative to the Yucaipa transaction for the Special Committee to have any leverage in the negotiations with Burkle. Greenhill advised the Special Committee that Morgans only could " get Yucaipa to the table for a reasonable discussion" by showing that the Company had " a standalone Self Help Plan." Greenhill predicted that without an alternative like the Base Plan, Yucaipa would " effectively force an ‘ out-of-court restructuring’ to exert and obtain further control."

Greenhill believed that the Company's near-term cash position should be strengthened through a modest rights offering or a sale of the Delano Hotel. Either option would give the Company financial flexibility, and Greenhill projected that by executing the Base Plan, the Company could be " effectively debt free by the end of 2016" with a stock price of between $15 and $16.75 per share. Greenhill's plan did not depend on a recapitalization involving Yucaipa.

Once Greenhill had finished its preliminary assessment and made its initial recommendations, one of the members of the Special Committee— Harrison— sent Burkle a tip that suggested he had greater loyalty to Burkle than to the Company. In an email sent on June 13, 2012, Harrison provided Burkle with specific details about the Special Committee's discussions and progress with Greenhill. Harrison wrote that he wanted to keep Burkle informed about what the Special Committee and Greenhill were doing.

Shortly after Harrison's tip, Yucaipa took the first of several actions designed to sabotage the Company's standalone, self-help option. By letter dated June 18, 2012, Yucaipa's general counsel objected to

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the fact that Morgans had been " talking to a variety of potential investors and investment banks ... concerning a possible recapitalization of the company." The letter warned that " [u]nless such actions cease immediately (without appropriate board review and approval) we will have no option but to seek the intervention of the courts to prevent the unauthorized actions and the resulting damages that are being caused."

Yucaipa's threat arrived just before the full Board met to consider the Base Plan. After hearing from Greenhill and the Special Committee, the Board nevertheless instructed management to begin preparing for both of the alternatives that Greenhill had suggested to strengthen the Company's near-term cash position, first by getting ready for a $50 million rights offering, and second by starting the marketing process for the Delano Hotel. Shortly after the Board meeting, the Company hired Jones Lang LaSalle (" Jones Lang" ) to market the Delano Hotel.

D. Burkle Resumes Negotiations While Applying More Pressure.

In response to the Board's preparations to pursue the Base Plan, Burkle came back to the negotiating table and proposed a transaction. On July 2, 2012, during a call with Morgans's President and several Special Committee members, Burkle proposed that Yucaipa acquire the Delano Hotel, The Light Group, and the Delano brand in exchange for Yucaipa's various holdings in Morgans.

Separately, Burkle continued his efforts to sabotage the Base Plan. Some of Morgans's projects at the time included operating a Mondrian Hotel in Moscow, a Delano Hotel in Marrakesh, and a Delano Hotel in Las Vegas. Burkle had close relationships with Morgans's partners in Moscow and with MGM, its partner in the Las Vegas project. Burkle refused to let Morgans proceed with MGM until Morgans met with him to discuss his proposed transaction. Burkle subsequently told Morgans to " take or leave my deal [and] ..., by the way if you don't, the deals you have in the pipeline (Moscow, MGM ... and Marakesh) are probably going to crater." Around the same time, Sasson terminated The Light Group's involvement with MGM, ostensibly because he felt Morgans was not negotiating with Burkle in good faith.

On July 7, 2012, over the objections of Kalisman, the Special Committee responded to Burkle's July 2 offer and sent a letter outlining the basic terms of a potential transaction. Two days later, Burkle responded with more threats. He told the Special Committee that he was preparing for litigation, but would delay filing as long as he believed that the Special Committee was negotiating in good faith.

At this point, Burkle received another important tip. On July 10, 2012, Morgans's general counsel forwarded Burkle a package of materials prepared by Greenhill for the Special Committee. Burkle promptly forwarded them to his colleagues at Yucaipa and to Yucaipa's financial advisor, Moelis & Company. The Moelis team read the materials, and the Yucaipa team used the information when negotiating with the Special Committee.

More threats from Burkle followed. By letter dated July 21, 2012, Burkle demanded that Morgans make the following disclosure to its potential business partners:

Mr. Burkle is concerned that because of his relationship with your group and his board membership you have not done adequate diligence on the Morgans groups capabilities concerning your project both financially and operationally. We therefore encourage you not to rely on anything but your own diligence.

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Ron has various concerns regarding Morgans and is reviewing his relationship with the company and we encourage you to come to your own independent conclusion regarding our project.

Burkle warned that if Morgans did not make the disclosure, he would send it himself. Burkle knew that the disclosure would cause Morgans's business partners to have doubts about the Company and put its business relationships in jeopardy. Burkle gave the Special Committee an explicit ultimatum: " (1) agree to his deal, (2) sell him the Delano and The Light Group and license him the brand (at a higher price), or (3) World War III."

E. Yucaipa Adds A Proposal To Backstop The Rights Offering.

On August 1, 2012, Yucaipa amended its proposal by offering to backstop a $100 million rights offering at $6 a share, a 26% premium to the Company's then-current stock price of $4.73 per share (the " Rights Offering" ). Under Yucaipa's proposal, the Rights Offering would take place in addition to Morgans transferring the Delano Hotel and The Light Group to Yucaipa in return for Yucaipa's pre-Rights Offering securities. This basic transaction ...


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