The M&A community understands that corporate directors deciding to sell a company face significant risk of stockholder litigation and enhanced judicial scrutiny. Therefore sell-side directors routinely engage investment bankers and lawyers to guide them through the process and build a record that they acted reasonably to get the best deal for stockholders.
Recent cases involving Oracle Corp. (In re Oracle Corporation Derivative Litigation, C.A. No. 2017-0337-SG), Tesla Inc. (In re Tesla Motors, Inc. Stockholder Litigation, C.A. No. 12711-VCS), and New Senior Investment Group Inc. (John Cumming, derivatively on behalf of New Senior Investment Group, Inc. v. Wesley r. Edens, et al., C.A. No 13007-VCS), show how directors deciding to buy can also be vulnerable to stockholder lawsuits if the deal involves conflicts of interest.
Each of these three deals look appropriate to most experienced M&A professionals. Each made sense and was supported by an obvious strategic benefit to the acquiring company. The directors in each case relied on the advice of investment bankers and senior management. The only genuine business decision for directors of the target companies was price and all the prices looked okay. But each case also involved a visionary founder who had very substantial economic interest or outright control of both the buyer and the seller.
This conflict of interest, where the founder of the buyer had a big stake of the target, created serious problems for the buy-side directors.
In all three cases before Delaware Chancery Court, the stockholder plaintiffs claim that the deals were orchestrated for the benefit of the founder and accused the directors of breaching their fiduciary duty to maximize shareholder value because of conflicts arising from relationships with the founder or their own interest in the transaction. The chancellors judging the cases found that the management’s loyalty to the founder may have caused them to act unethically, and that the founder was motivated by economic self-interest rather than the good of the company. Rather than using the business judgment rule, which typically protects directors making routine business decisions, he put the burden on the founder or directors of the selling companies to prove the deal’s fairness.
These three cases significantly tilt the playing field in favor of stockholder plaintiffs and place a difficult burden – perhaps unreasonably so – on the buy-side directors and controlling stockholders to prove the deal is fair to the acquiring company. They also clearly show the need for careful structuring and planning by the buy-side board of directors in transactions involving conflict. As a practical matter, companies with powerful founders or controlling stockholders need truly independent directors without significant business or social ties to the founder in order to handle conflict transactions.
For example, in the New Senior Investment Group case, the chancellor found that all of the New Senior directors either had a conflict of interest because they were also had ownership stakes in the target, because they financially benefited from financing the transaction, or otherwise had deep personal and financial relationships with the founder. The chancellor found one director was conflicted because she was the executive director of a charity which the founder and his family generously supported. A second director was conflicted because he was a minority owner of a professional basketball team which the founder controlled. A third director, a retired banker, was conflicted because he received a substantial portion of his income from serving on the boards of various companies controlled by the founder.
It’s not enough for the conflicted founder to abstain from the vote on the deal and recuse himself from the board deliberations. In the Oracle litigation, the chancellor permitted the lawsuit to proceed against founder, Larry Ellison, and the Oracle CEO even though both abstained from the vote to approve the transaction. The chancellor stated “a corporate fiduciary who abstains from a vote on a transaction may nevertheless face liability if she played a role in negotiating, structuring or approval of the proposal.”
These three recent cases demonstrate the need for buy-side directors to approach conflict M&A transactions with extreme caution.
In order to reduce the risk, the board should contain a majority of directors who are unquestionably independent of the controlling stock-holder. Independence exists if a director’s decision is based on the corporate merits of the subject before the board rather than on extraneous conditions or influences. The board should condition discussions of a conflict acquisition up-front on both the negotiation and approval of an empowered independent committee and a majority-of-the-minority stockholder vote.
The independent committee, not the founder, should engage investment bankers and lawyers at the outset of the process. The independent directors need to meet often, develop a deep understanding of the facts and issues relating to the deal and bargain as hard as possible. For example, in the New South case, the directors only met twice with the bankers and never really pushed back against the price. The chancellor permitted the case to proceed against the directors. In contrast, in Oracle, the committee met 13 times and bargained robustly with seven offers and counteroffers going back and forth between buyer and target. Not surprisingly, the chancellor dismissed the independent directors from the case.
The Board of the buyer should adopt a process at the outset of discussions based on the procedure approved by the Delaware Supreme Court for controlling stockholder buy-outs. If the board adopts all of these safeguards, the director’s approval of a conflict M&A deal should be reviewed by the court under the more deferential business judgment rule standard, rather than an entire fairness standard of review. In that case, the claims against the defendant directors and controlling stockholder must be dismissed if a rational person could have believed that the acquisition was favorable to the minority stockholders.
The business judgment standard of review should be applied if:
- The Board of the buyer conditions the procession of the conflict M&A acquisition on the approval of both a special committee and a majority of the minority stockholders;
- The special committee is independent;
- The special committee is empowered to freely select its own advisers and to say no definitively;
- The special committee meets its duty of care in negotiating a fair price;
- The vote of the minority is informed; and
- There is no coercion of the minority stockholders.
